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Responsible banking 08 Nov 2017

Richard H. Thaler, the Nobel laureate who put behavioral economics on the map

Richard H. Thaler was awarded the Nobel Prize in Economic Sciences by the Royal Swedish Academy, for his “contributions to behavioral economy

Richard H. Thaler, who is currently professor of Behavioral Science and Economics at the University of Chicago Booth School of Business, has played, according to the Academy, “a pivotal role in the development of behavioral economics over the past four decades.” This is not the first time that the Swedish Academy distinguishes a researcher in this field. In 2002, psychologist Daniel Kahneman received the Nobel Prize in Economic Sciences for “integrating psychological research into economics.”

Behavioral economics combines economy and psychology to study market developments and analyze people’s behavior, their limitations and the issues arising from these limitations. In contrast with classical economic theory, behavioral economics tries to gauge the role of irrationality in financial decisions made by economic agents. Thaler, always concerned with communicating his theories to a broader public, is the author of several books on these topics, including the bestseller “Nudge: Improving Decisions About Health, Wealth and Happiness.” Thaler also made a brief cameo appearance in the movie ‘The Big Short’.

In his theories, Thaler explores the impact of three crucial aspects of people’s behavior not only on their individual decisions, but also on market behavior. 

1- Mental Accounting, an unresolved issue 

“This amount to pay for the house, this for utilities, this for children’s school, this for groceries…” People tend to keep separate accounts in their minds, focusing on the impact that each decision will have on the corresponding item, not on their finances as a whole. This would be the explanation for certain impulsive behaviors, such as taking into account only the discount on product, not its original price, or taking out a consumer loan to avoid withdrawing money from another account.

Thaler has also proven the existence of what he calls the “endowment effect”:  People value the same item more highly when they own it than when they don’t. This behavior is explained by the aversion to losses that individuals feel, also known as “divestiture aversion.” Thaler, a wine enthusiast, uses this example to explain it: The pain people feel when they get rid of a high-quality bottle of wine is greater than the pleasure they get when they buy another one of the same or higher value. People’s willingness to buy or sell depends on whether they do or do not own the product.

2- What’s fair and what’s unfair? 

Thaler has also arrived at the conclusion that the social perception of what is fair and unfair can affect the economic decisions that companies make, preventing them from raising prices when demand increases, but not when costs increase.

For example, on rainy days, as the demand for umbrellas increases, sellers could have an incentive to raise prices. However, a steep price hike would trigger the opposite effect. Consumers would think that the company is taking advantage of them and would boycott it for trying to exploit the situation, which would ultimately undermine its business.

3- Today’s temptation, a problem for the future 

According to Thaler, people already have problems planning for the long-term because they tend to succumb to short-term temptation. This is the reason why retirement savings plans or resolutions to lead healthier lives fail. 

During a recent BBVA Asset Management and BBVA Insurance retirement savings seminar, Diego  Valero, chairman of Novaster and professor of Universidad de Barcelona, delivered a presentation on the keys to a comfortable retirement, using a clear example to explain this aspect. If, during a cocktail party, guests are told that the menu includes assorted trays of deep fried canapés and fresh fruit, most will be probably be inclined towards eating fruit. However, at the time of making the actual choice, they will have a hard time sticking to their intentions. “Despite thinking: ‘I’ll only eat fruit,’ when the waiter walks by with the croquettes or the ham, we will leave the apple for dessert,” said Valero. 

A ‘nudge’ for retirement

The solution that the new Nobel in Economic Sciences laureate proposes to make up for the lack of self-control is what is known as the “nudge theory”:  Authorities need to design policies that encourage people to make the right decisions, guiding them to achieve the life they want. In the case of retirement, Thaler argues that institutions should encourage people to save by offering them small ‘nudges’ or stimuli that lead them to make the right decisions. An example of these nudges could be pension plans that are deducted from workers’ paychecks.

Diego Valero used the $100 example, published in several specialized magazines, to illustrate this theory during his presentation: “In an experiment, subjects were given $100 to invest, and told to choose between a current account with no withdrawal restrictions and a fixed income account with a 10% penalty, both offering the same interest rate. What would you choose? It is easy to think that Option A would be the one chosen by most, but results were surprising: 35% chose option B. Moreover, if the penalty was increased to 20%, the percentage increased to 43%, and if no withdrawal options were offered, the figure increased to 56%. The explanation is based on the “Ulysses Strategy”, the mythological hero that had his ship’s crew tie him to the mast so that he could resist the song of the Sirens. “We would rather be tied,” says Valero. “Regarding pensions, we prefer being helped to do things right, so that we don’t have to make decisions.” 

Being aware of these behavioral biases, one solution would be to define a suitable financial plan that helps us make decisions, providing a roadmap to achieve the life we want. As Rafael Verástegui, head of Collective Pension Arrangements at BBVA Insurance, explained, “We shouldn’t be impulsive; we should plan, reason and force ourselves to save.”

Would you like to know more about behavioral economics? Visit the Center for Financial Education and Capability and discover all the relevant information about financial education in the world.

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