The Reality of Irrationality

By: Dr. M. Ray Perryman
Published in syndication October 11, 2017

"For his contributions to behavioral economics," Richard H. Thaler has been awarded this year's Nobel Prize in Economics (or, more formally, "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017"). Every year, the Nobel Prize is awarded to someone whose ideas and research have increased our understanding of important issues in economics and related areas, and Dr. Thaler certainly meets and exceeds these criteria. In fact, many of us felt he should have shared the prize with Dan Kahneman back in 2002 because of the similarity and importance of their work.

Dr. Richard Thaler is the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago's Booth School of Business.

The Nobel Prize in Economics was created by the central bank of Sweden 1968, and the Royal Swedish Academy of Sciences decides on the recipients. This year, the prize award is worth more than $1.1 million. The Nobel Prize is given for groundbreaking work in economics, and areas of study include general equilibrium theory, traditional micro and macroeconomics, bargaining theory, and economic history. Sometimes, awards have gone to individuals who have explored the linkages between economics and other arenas (political science, psychology, sociology, law, and others).

Selection criteria used by the Royal Swedish Academy of Sciences include the originality of the contribution, its scientific and practical importance, and its impact on scientific progress. The effects of the work on society and public policy may also factor into the process. Dr. Thaler's work is outstanding on all of these counts. When told that he won, he indicated that he would try to spend the prize money "as irrationally as possible," a fitting synopsis of his life's work.

As the decision committee puts it "Richard H. Thaler has incorporated psychologically realistic assumptions into analyses of economic decision-making. By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes."

Before Thaler and his colleagues came along a few decades back, it was common for economists to assume that consumers, workers, investors, and others were basically rational. It was certainly recognized that we are human and made mistakes, but taken as a group we were generally thought to be, on average, pretty reasonable. Well, it turns out that there are situations where we are not. By knowing this fact, we can better model and explain economic actions and at times even change them in positive ways.

One primary example of Thaler's work is known as "limited rationality," a theory related to how people make financial decisions by focusing on the impact of the individual decision rather than its overall effect. It's a way for individuals to simplify such decisions, and it can lead to results that aren't optimal from an overall perspective. As an example, when investors have portfolios of strong stocks and weak stocks and need to liquidate some of the assets, they almost invariably sell the good ones and keep the bad. The end result us that they are left with a bundle of bad stocks. The reason is that they think of each stock individually and feel like they need to hold the bad ones to "make their money back."

Another interesting result from this type of analysis is the so-called "endowment effect," the notion that we tend to value things that we own much more than other people do. This phenomenon explains why most people are dissatisfied with the proceeds from estate sales. Another interesting application was a detailed study of the National Football League draft picks and subsequent performance by the selected players which showed that team executives are systematically overconfident of their abilities to identify talent.

Dr. Thaler was a founder of the field of behavioral finance, which deals with how cognitive limitations of individuals influence financial markets. He also looked at how firms may set prices in response to consumer concerns about fairness, which could stop them from raising prices during high demand (such as for bottled water after a natural disaster) in contrast to market theory.

Perhaps his most famous work is the idea that he calls "nudging;" with a little short-term incentive, people may make better long-term decisions. Given a lack of self-control (which most of us suffer from at times), it can be difficult to take actions to achieve long-term plans or goals. With a little incentive in the short term (or a "nudge"), people will be more likely to do what they need to do for long-term success, whether saving for retirement or living a healthier lifestyle.

Nudging is essentially encouraging, but not compelling, appropriate actions. For example, something as simple as requiring people to opt out of rather than into a program, such as a retirement savings plan, can increase participation. Helping with paperwork to obtain student loans can increase college enrollment. There are many public policy applications, and governments around the world are studying and using Thaler's theories.

Much of the study of economics is rooted in mathematical theories and models. However, economic actions are taken by humans. While traditional economic theories assume that people and firms are rational, that is not always the case. Dr. Thaler's work has helped us better understand and incorporate the consequences of the psychological aspects of people and their thought processes on markets and the economy.

By combining psychology with economic and financial theory, he opened the door to a rapidly growing area of research and analysis. His ideas are not only academically thought provoking, but also extremely relevant. He has helped us bridge the gap between a purely mathematical model and the humans actually making decisions (who are not always perfectly rational). In fact, some of us now even build that irrationality into our systems. Congratulations to Dr. Thaler, a man who has truly changed the way we think about economics and finance in important and fundamental ways.