A revelation over a predinner snack started professor Thaler on a pathfinding study into our limits as rational problem solvers.
- By October 10, 2015
- Behavioral Science
A quiet revolution in economic thinking instigated by Richard H. Thaler traces its beginnings to a dinner party he hosted in the 1970s. As Thaler explains in his latest book, Misbehaving: The Making of Behavioral Economics, the guests while waiting with cocktails for the meal, were devouring the cashews—the entire bowl half-eaten in minutes. So Thaler, worried that his guests would fill up on the salty snacks, whisked the bowl away.
He recalled that when he came back, his friends thanked him for it (and found themselves with room to enjoy a big dinner). “But then, since we were economics graduate students,” Thaler recalled, “we immediately started analyzing this. Because that’s what economists do.” Even cashews could hold the key to unlocking insights about our idiosyncratic behaviors.
Without the temptation of the nuts, he said, “We realized that a.) we were happy, and b.) we weren’t allowed to be happy, because a first principle of economics is more choices are better than fewer choices.”
In this contradiction lies the insight that put Thaler on the path to becoming a leader in the field that is now known as behavioral economics—a discipline that challenged economists’ assumptions that humans are rational problem solvers.
“Newton had his apple,” Thaler said in an interview, with the bit of mischief he’s known for in the classroom. “I had my cashews.”
The idea that people don’t always know what they want, much less what’s best for them—whether that’s resisting nuts at a party or socking away money in a 401(k)—built a career for Thaler, Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics, and author of the international best-selling 2009 book Nudge: Improving Decisions About Health, Wealth, and Happiness, written with Cass R. Sunstein. Over the course of his career, Thaler has elucidated how living, breathing human beings make real choices in life, as opposed to the choices made by the logical, utility-maximizing creatures that classical economics has imagined people to be. In Nudge, Thaler suggests that you can help people make better decisions for themselves if you set up “choice architecture” that guides them in a certain direction—a default mechanism such as automatic enrollment in a retirement plan is one example—without forcing them to do anything. “Libertarian paternalism” is the phrase he coined to describe this. “Many times what we’re doing is suggesting alternatives to more heavy-handed interventions,” he said.
Richard H. Thaler:
Real architecture at some points meets choice architecture. Our great building has some nice features that imply that, this is one of my favorite spots, this internal stairwell. Because of these stairs we all feel like we're in one place and everyone walks here. Nobody ever takes the elevator to get from five to three, so we get a little bit more exercise and you even hear people up there, which will cause an incidental contact with somebody that you might not otherwise run into. So this just makes the whole building work better.
Richard H. Thaler:
In my book Nudge, we start with an example of a cafeteria director who discovers that the order in which the food is displayed influences what people eat, and I'm happy to say that our cafeteria uses some good choice architecture. The first thing you see is the salad bar, which is over here. You have to walk all the way past this to get over there where they've got the burgers and fries. Just sticking you right up front with the salad will make people more likely to eat the salad and that'll be good for people. I've been bragging about how great our building is, how beautiful it is, where there are some little things that they still get wrong. See this handle? You know what the name of this handle is? It's called a pull. It's shouting to you, "Pull." To use this door, what do you have to do? You have to push. Some designer liked the look of these things and thought that it should have the same look on both sides. That's just bad choice architecture.
Richard H. Thaler:
This is the center of the building, the atrium, the focal point of the building. It's such an attractive place to be. It's where people hang out. It's a place where people run into each other, the faculty walk through here and will have chance encounters with students. It makes the school into more of a community.
His work has roiled the worldview of academic economics and influenced private enterprise and government policy—from corporate boardrooms to 10 Downing Street. Governments are devising policies and drafting regulations to steer citizens toward decisions that are in their citizens’ long-term best interest, without forcing them to do something they don’t want to. Thaler’s work also has become part of the mainstream. When the Wall Street Journal headlines an article, “A Nudge in the Opposite Direction,” the assumption is that its readers know the reference.
In reviewing Misbehaving, best-selling author Michael Lewis (Moneyball and The Blind Side, among others) suggested that a chief characteristic of behavioral economists is a “willingness to allow oneself to be distracted from one’s assigned task.” That goes along with other traits “not normally found in economists: a sense of wonder, a tendency to ask embarrassing questions, and a mistrust of grown-ups’ ideas about what’s worth spending time thinking about and what is not.”
That is a good description of the tone of Thaler’s book—an engaging read that chronicles the development of behavioral economics through his eyes. On the page Thaler is quizzical and funny, and given to good-natured needling of many of the orthodoxies of economics. (Misbehaving this summer was named to the longlist for the 2015 Financial Times and McKinsey Business Book of the Year Award.) The problems that rivet his attention aren’t ones you’d normally associate with classical economics:
• Why do people dislike unfair offers so much that they will take a financial hit to punish people who make them?
• Why is it easier to tolerate generalized inflation than to take an actual cut in your nominal wage?
• Why do NFL teams consistently overpay and overbid for college football stars who often fizzle once they go pro?
• Why are people who are randomly given coffee mugs unwilling to sell them while others, who by chance did not receive a mug, show little interest in buying one? More generally, why do so many of us hold onto some much useless junk?
All of these questions share one thing in common: they demonstrate how people depart from the standard economic models. Thaler believes that in their models, economists don’t describe Homo sapiens; instead they study idealized creatures called Homo economicus, those utility-maximizing creatures who are purely rational, like Mr. Spock. Thaler refers to them as Econs.
Compared to this fictional world of Econs, Humans do a lot of misbehaving, and that means that economic models fail to anticipate problems and make a lot of bad predictions, he writes. Most financial economists would have thought that the 1987 stock market crash was an impossible event. If investors had been making rational decisions based on perfect knowledge, the Dow Jones industrial average wouldn’t have fallen by 508 points on October 19, 1987—the largest percentage decline on record, on a day with no relevant economic news, he writes. Similarly, the financial crisis of 2007–8 was largely unanticipated, and many economists, including former Fed chairman Alan Greenspan, later admitted that they had gravely underestimated the risk created by such a highly leveraged economy.
When Thaler was in graduate school, “The people I knew weren’t like the creatures I learned about in classes,” Thaler said. Many traditional academics seemed to think that regular folks were “as smart as the smartest economist and completely lacking in emotions, with no self-control problems, and given the chance would act like complete jerks. Real people are not as smart as economists think, but are quite a bit nicer.”
Misbehaving starts with Thaler’s days as a self-confessed “lazy” graduate student making idle observations of all the ways ordinary people analyze risks and rewards differently from economists. It proceeds through the maturation of these irreverent questions into a still-suspect subfield of economics, culminating in Thaler’s election in 2015 as president of the American Economic Association (AEA), the hub for the academic establishment.
His ideas initially were anathema to the world of economics at Booth, the University of Chicago, and other institutions whose school of thought held that the vagaries of human behavior are anomalies and shouldn’t distract from the useful pursuit of constructing models to understand how markets function. Nobel laureate Eugene F. Fama, MBA ’63, PhD ’64, Robert R. McCormick Distinguished Service Professor of Finance, whose efficient-markets hypothesis Thaler delights in questioning, became an intellectual sparring partner and golfing buddy at Booth. The first university faculty member Thaler met outside the business school was Cass R. Sunstein, then a professor at the law school, now at Harvard, who became his coauthor on Nudge.
Dean Karlan, ’97, a professor of economics at Yale and founder of New Haven, Connecticut-based nonprofit Innovations for Poverty Action (IPA), recalls Thaler as “funny and inspiring” in the classroom. “He basically gets up and tells stories, but in a way that leaves you with a better understanding of the ideas. When you start observing the world around you, you can immediately see the stories coming to light.”
Karlan works in developing countries, helping design better public policies to alleviate poverty. “Absolutely essential are realistic understandings of how people behave,” he said. For example, an IPA study in Kenya found that installing chlorine dispensers next to community water sources led to a six-fold increase in the percentage of households that treated their water before use.
“If there’s a governing insight in all of behavioral economics,” Karlan said, “it’s, make it easy for people to do the things they would say they would want to do, if asked in a moment of informed and self-aware reflection.”
Karlan is the subject of one of Thaler’s choice anecdotes in the book. In the 1990s, when Michael Jordan was leading the Chicago Bulls to multiple NBA championships, Karlan, then a Booth student,was given a pair of free tickets to a playoff game. Instead of treating himself and a friend to the game, Karlan researched which of his business school professors had the most lucrative consulting gigs, and planned to sell his tickets for hundreds of dollars. But another friend, in divinity graduate school, could not have been more enthused to go to the game, even though he did not ever expect to have much money.
“Both Dean and his friend thought the other’s behavior was nuts,” Thaler writes in Misbehaving. “Dean did not understand how his friend could possibly think he could afford to go to the game. His friend could not understand why Dean didn’t realize the tickets were free.” Karlan’s friend’s reaction illustrates what Thaler refers to as the “endowment effect.” People don’t want to let go of something they’ve already got, and they’ll commit an economically irrational act to keep it. Karlan, acting as an Econ, did the rational thing. His friend, a mere Human, did the irrational thing and went to the game, as most Humans would, Thaler’s research shows repeatedly.
“Real people are not as smart as economists think, but are quite a bit nicer.”
Beyond academia and nonprofits, behavioral economics has influenced the world of finance. “The work that Thaler and other people at Booth have done means a lot to us,” said Emmanuel Roman, ’87, CEO of London-based Man Group plc, which specializes in alternative investments.
Behavioral economics, Roman noted, has helped highlight flaws in human decision making such as heuristics, the mental shortcuts people use to solve problems but that are prone to errors; anchoring, the reliance on an initial piece of information to make subsequent judgments; and bias. Man Group uses specialized coaches to work with investment professionals in their decision making.
“Someone who loses money will act differently than someone who makes money, in terms of risk aversion and in terms of cutting the loser or running the winners,” Roman said. Good coaching may contribute to the success of money managers. “Hopefully they’ll bring a better return, which is good for our investors and ultimately our shareholders,” he said.
Behavioralist perspectives have attained wide currency in the world of private pension planning. Instead of asking employees to opt in to pension savings plans, many companies and nonprofits now automatically enroll employees and offer them the opportunity to opt out. Changing the default has drastically raised the uptake of pension deductions among workers while increasing their long-term savings, Thaler writes in Misbehaving. This is the “nudge” in the right direction that people need.
Thaler’s interest in helping formulate better public policies may have had its largest impact in the United Kingdom during the administration of prime minister David Cameron. In 2010, members of the newly elected coalition government formed by the Conservatives and Liberal Democrats wanted to incorporate the findings of behavioral science. They established a behaviorial insights team, which came to be known as the “nudge unit.” “There was no manual for this task, so we had to figure it out on the fly,” recalled Thaler, who served as adviser to the team.
Their first assignment came from the British taxation authority, which wanted to get taxpayers to pay more promptly. The nudge unit altered the wording of a letter to delinquent payers, informing them, “Most people pay, and you are one of the few that hasn’t.” Findings in psychology show that if you want people to comply with some norm or rule, it helps to inform them that most other people already have complied. The letter sped up the intake of millions of pounds to the government. Since it doesn’t cost anything to add a sentence to a letter, this was “a highly effective strategy,” Thaler writes.
For all his attentiveness to avoiding top-down, forced solutions, Thaler has been criticized from the Right for a watered-down proto-socialist nanny-statism, and harangued from the Left for leaving people too much freedom when mandatory policies are called for.
“The idea that nudging is a left-wing conspiracy is pretty amusing, considering that Cameron, the head of the UK’s Conservative Party, was its first active proponent, and now countries all over the world are creating their own nudge units,” Thaler said. “I don’t detect any trend that those governments tend to be progressive or conservative.” A nudge unit is starting in Germany—“I don’t think anyone would consider Angela Merkel a left-winger.”
Government mandates inflame passions and aren’t worth the headache, he said. The Obama health-reform law’s requirement that individuals purchase health insurance shows the downside of mandates. “I would have automatically enrolled people if they were eligible and I would have said anybody who opts out can’t opt in for, say, five years,” Thaler said. “That prevents the ‘sign-up-when-you-get-sick’ problem, and now there’s no mandate.” That wouldn’t necessarily have placated Republicans in Congress, but it might have made the plan more palatable to the public, he said.
Behavioral notions may have another future in US health care. A recent essay in the New England Journal of Medicine suggested that Thaler’s principles could help the system migrate away from the expensive fee-for-service model. Electronic order-entry systems for prescriptions could be set up to default to generics instead of expensive brand-name drugs, for instance. Such clinical decisions, the authors write, could be a powerful force for change.
Thaler recalled that, as a young man, his goal was to get a paper published, then get tenure. “When you’re a new assistant professor, you don’t think about starting any revolutions. You just think about one paper at a time. I would never have forecast any of what has happened. I’m still surprised.”
He is pleased and amused that his successor as president of the AEA will be his friend and colleague, Nobel laureate Robert J. Shiller, the Yale professor who made his reputation by showing that investors trade as much on emotional responses as on rational calculations of future earnings. “The lunatics are running the asylum!” Thaler writes. The ascension of behavioralists to the top of a mainstream academic association might lead some to suggest that the discipline has assumed its rightful place in the profession.
“I wouldn’t say that,” Thaler said. “It is always a mistake to prematurely declare ‘mission accomplished.’” If you open an economics textbook, there’s probably one chapter devoted to behavioral economics, and many fields such as macroeconomics have not yet incorporated much in the way of behavioral findings, he said. “What I say at the end of the book is that I would eventually like the field to die. I’d like behavioral economics to no longer exist because economics has become as behavioral as it needs to be,” he said. “But that will take a while. We are just getting started.”