Tuesday, June 19, 2018

Thaler on the Evolution of Behavioral Economics

Richard Thaler won the Nobel Prize in economics in 2017  "for his contributions to behavioural economics.  He tells the story of how the field evolved from early musings through small-scale tests and more comprehensive theories and all the way to public policy in his Nobel prize lecture, "From Cashews to Nudges: The Evolution of Behavioral Economics." It is ungated and freely available in the June 2018 issue of the American Economic Review (108:6, pp. 1265–1287).  Video of the lecture being delivered is here. 

I certainly won't try to recap the readable and accessible lecture here. (One of Thaler's many virtues is that he wears his learning lightly.) But here are three stories that Thaler collected near the start of his career, when mulling over these subjects. Thaler writes:

  • At a dinner party for fellow economics graduate students I put out a large bowl of cashew nuts to accompany drinks while waiting for dinner to finish cooking. In a short period of time, we devoured half the bowl of nuts. Seeing that our appetites (and waistlines) were in danger I removed the bowl and left it in the kitchen pantry. When I returned everyone thanked me. But, as economists are prone to do, we soon launched into analysis: how is it that we were all happy now that the nuts were gone? A basic axiom of economic theory is that more choices are always preferred to fewer—because you can always turn down the  extra option.
  • The chair of the University of Rochester economics department (and one of my advisors), Richard Rosett was a wine lover who had begun buying and collecting wine in the 1950s. For as little as $5, he had purchased some choice bottle that he could now sell to a local retailer for $100. Rosett had a rule against paying more than $30 for a bottle of wine, but he did not sell any of his old bottles. Instead he would drink them on special occasions. In summary, he would enjoy his old bottles worth $100 each, but he would neither buy nor sell at that price. Therefore his utility of one of those old bottles was both higher and lower than $100. Impossible.
  • My friend Jeffrey and I were given two tickets to a professional basketball game in Buffalo, normally a 75-minute drive from Rochester. On the day of the game there was a snowstorm and we sensibly decided to skip the game. But Jeffrey, who is not an economist, remarked, “If we had paid full price for those tickets we would have gone!” As an observation about human behavior he was right, but according to economic theory sunk costs do not matter. Why is going to the game more attractive if we have higher sunk costs? 

For an economist, each of these stories suggests a departure from purely rational behavior. More important, it suggest that the departure from rational behavior is in some way understandable, plausible and predictable as a matter of human psychology.  By understanding the rules of thumb (or "heuristics") that guide such behavior, one can build a branch of economics.

For example, the cashew story describes the issue that people can sometimes lack self-control, in the sense that they give in to short-run temptations even when say that they would prefer not to do so. As Thaler says, there is a "planner" and a "doer" inside each of us--and they are not always in synch. As a result, people look for self-control devices (like moving the cashews out of the room), to  help them act in the way that they wish to do, but seem incapable of actually doing. One can immediately think of applications of this framework in retirement plans to help us save, diet plans to help us eat healthier food, exercise clubs and plans to get us moving, book clubs so we read something worthwhile every now and then, and more.

The wine story is an example of what Thaler would later come to call "the endowment effect" or "status quo bias." People often seem to have a bias to holding on to what they have, in part because the fear of that change will incur a loss is bigger than the lure that change will incur a gain. An interesting application here is that many people will have a tendency to stick with what they've got, even if they learn more about alternatives that might be better: the same quantity of savings in a retirement plan and the same way of investing those savings, the same insurance policies with the same levels of deductibles, and so on. People may originally make a choice for no particular reason--perhaps it was just the default option at the time--but then they become more likely to stick with that default option in the future. If a firm or the government changes the default options, it can also change behavior in a lasting way.

 The ticket story describes an issue of how people perceive losses. As Thaler writes:
"When a family spends $100 to buy tickets in advance of some event, the purchase will not create either pleasure or pain so long as the price is equal to the expected price. However, if there is a snowstorm, there is a $100 purchase that now has to be “recognized” and it will then be experienced as a loss. This helps explain why someone can think that going to the event is a good idea—it eliminates the need to declare the original purchase as a loss. ... When I was thinking about these issues, the United States government’s continued involvement in the Vietnam war seemed best explained in these terms." 
Conversely, when Thaler and his friend were given tickets as a gift, not using the tickets was not perceived as a loss in the same way. This unwillingness to face losses, even when they are sunk costs in the past, shows up in a number of settings: for example, the way in which investors are more likely to continue holding stocks that have declined in value, hoping they will rise again, while being more willing to sell stocks that have risen in price.

The policy version of behavioral economics is often called "nudging," where the notion is to alter the default options or the presentation of information in a way that causes more people to make the choices that people wish they could be making in the first place. Thaler (along with Cass Sunstein) originally referred to this as "libertarian paternalism." I had not known that the "nudge" terminology was suggested by a publisher who turned down their proposed book on the subject. Thaler writes:
"When we were looking for a publisher for the book we found the reaction to be rather tepid, probably in part because the phrase “libertarian paternalism” does not exactly roll off the tongue. Fortunately one of the many publishers that declined to bid on the book suggested that the word “nudge” might be an appropriate title. And so we published Nudge: Improving Decisions about Health, Wealth and Happiness. In this roundabout way, a new technical term came into social science parlance: a nudge. The book Nudge is based on two core principles: libertarian paternalism and choice architecture. It is true that the phrase libertarian paternalism sounds like an oxymoron, but according to our definition it is not. By paternalism we mean choosing actions that are intended to make the affected parties better off as defined by themselves. More specifically, the idea is to help people make the choice they would select if they were fully informed and in what George Loewenstein (1996) calls a “cold state,” meaning, unaffected by arousal or temptation."
Of course, nudges are not just the result of government policies. Instead, we are being nudged all the time, often in ways we don't perceive clearly at the time. Firms can try to use nudges to their advantage, as well, which Thaler nicely describes as "sludge:"
"People have been nudging as long as they have been trying to influence other people. And much as we might wish it to be so, not all nudging is nudging for good. The same passive behavior we saw among Swedish savers applies to nearly everyone agreeing to software terms, or mortgage documents, or car payments, or employment contracts. We click “agree” without reading, and can find ourselves locked into a long-term contract that can only be terminated with considerable time and aggravation, or worse. Some firms are actively making use of behaviorally informed strategies to profit from the lack of scrutiny most shoppers apply. I call this kind of exploitive behavior “sludge.” It is the exact opposite of nudging for good. But whether the use of sludge is a long-run profit maximizing strategy remains to be seen. Creating the reputation as a “sludge-free” supplier of goods and services may be a winning long-run strategy ..."

For those who would like additional doses of Thaler, here are some starting points: links to two interviews and another academic lecture.