October 11, 2017

Richard Thaler's Nobel Prize: A Celebration of Heresy

Robert Graboyes

Senior Research Fellow

The Nobel Memorial Prize in Economic Sciences went to Richard Thaler on Monday to honor his scholarly heresy. His work challenges the central principle of modern economics — the assumption that people are rational.

The sheer audacity of this project makes Thaler a worthy and satisfying Nobel pick. But like most heresies, the field he helped create, behavioral economics, poses risks.

The rationality assumption has a specific meaning to economists: People can make choices, and those choices are mutually consistent. If John prefers an apple to a pear and a pear to an orange, then he also prefers an apple to an orange. With many twists on this theme, this definition of rationality has given economics coherence, rigor and humanity. 

Contorting "Anna Karenina," one might say, “All rational people are alike; each irrational person is irrational in his own way.” It’s tough to devise a coherent theory explaining a thousand varieties of irrational. But when we focus on rational behavior, viewing everyone as fundamentally alike, the range of questions becomes manageable.

As a side benefit, treating people as rational also gives economics an egalitarian lilt. It’s no coincidence that early economists were prominent foes of slavery. 

Thaler and his behavioralist colleagues, though, correctly note that people are often far from rational, in ways that are essential to understanding human society. For example, rationality implies that more choices are better, but too many menu choices can paralyze diners. Too many investment options can deter people from making financial decisions. 

Thaler has written on the “winner’s curse” — the observation that those who win auctions are often those who most overvalue the purchase. Sometimes, our choices are mutually inconsistent, or we change our minds erratically. Mainstream economists understand this but find it useful to leave such observations to psychologists and others.

But Thaler and crew argue that in certain areas of human behavior, the Anna Karenina analogy fails. Irrational people can be rather alike, after all. Their irrationality can be consistent and predictable. By exploring these realms, behavioralists find insights where standard economics never sheds light.

In this, Thaler joins other Nobelists who were recognized for their deviation from the standard operating procedures of economics —  among them Friedrich von Hayek, Daniel Kahneman, Elinor Ostrom and Vernon Smith. 

But rebellion poses risks. Once you view people as myopic and erratic and manipulable, it’s tempting to manipulate them. Thaler and Cass Sunstein co-authored a popular and brilliant book on manipulating people’s choices — "Nudge: Improving Decisions About Health, Wealth and Happiness."

A nudge is a device for influencing choices without mandating or forbidding options. A grocery that places candy at eye level nudges shoppers to buy more candy without forcing them to do so.

Behavioral economics has stoked enthusiasm for using nudges as tools of public policy. If elites believe Americans are too fat, then require restaurants to display calorie counts. Thaler and Sunstein call this “libertarian paternalism” —paternalistic in assuming policymakers know what diners need better than diners do and libertarian in allowing diners to make the final choice of what to eat.

But on closer inspection, this is quite paternalistic and not so libertarian. Such a policy requires the use of involuntarily collected taxpayer money to devise and manage such nudges. It forces restaurants to comply with the regulation.

And, as we see with recent government nutritional advice, experts can be very wrong in what they believe is best for us. Add together thousands of government-imposed nudges, and costs can become quite high. Policymakers, too, are irrational, so their desire for nudges should be treated with caution.

Nevertheless, it’s Richard Thaler’s week, and reason to celebrate.