This week, Professor Richard Thaler was awarded the Nobel Prize for his groundbreaking work in the field of behavioral economics, the cross section where psychology and economics converge. It is a relatively new and rapidly growing field, originally explored by psychologists, Kahneman and Tversky in their 1979 publication, “Prospect Theory: An Analysis of Decision under Risk.”
The study of behavioral economics seeks to understand what role psychology, cultural surrounding, and even fads play in both driving why economic decisions are made and how seemingly arbitrary value is determined. Adding a human dimension, behavioral economics challenges the static economic theories, like ‘cheaper is better,’ or ‘more is more.’
Instead, questions are posed such as: Why would a customer choose a lower quality good to get the job done even if an objectively better option is within one’s willingness to pay? Why is this good still chosen at a more expensive price? Is there personal attachment involved? Is it an instinct? How are these factors quantifiable? Are they quantifiable?
The answers to these questions are ultimately what is driving economies around the world. With his conclusions in behavioral studies, namely, the idea of human behavior being irrational, Professor Richard Thaler has changed the field of economics, forever.
What is “Nudging”?
Professor Thaler of The University of Chicago, Booth, is best known for co-authoring the book Nudge: Improving Decisions About Health, Wealth, and Happiness with Professor Cass Sunstein of The Harvard Law School.
In short, Nudge provides a theory for how to persuade consumers to make more efficient decisions for themselves, and furthermore, society. It challenges the idea that rational humans (termed “homo economicus” in Nudge) always choose the option that is 'best for them,’ and unpacks how to ‘nudge’ individuals into making better decisions, based on the new assumptions that consumers are simply irrational.
Irrationality encapsulates a human’s tendency to be disproportionately loss averse – to value their own possession more than another’s – even if they were identical, and most of all, their tendency to procrastinate when this is clearly not in their best interest. These principles have refocused the study of economics to be more applicable and tangible in today’s society; they have even reached deep into modern day public policy initiatives.
In everyday experiences, we can observe examples of campaigns attempting to ‘nudge’ our actions. We are told to buy reusable bags or be charged a premium for a disposable one; scholarships encourage us to apply for something that may not be financially in reach; we even reward people who are better liked – even if there is no rational reason why the Kardashians are good for us.
From managers, to policy makers, to family members, alike, nudging is applicable across the board.
Consider This!
Imagine you are at a casino and they are offering a new game. The game works as follows: you flip a coin - if it lands on heads, the game ends and you win $1. But if it lands on tails, you flip again. Now, if it lands on heads, you win $2 and the game ends. But if it lands on tails again, you continue to flip. Each round, your payout doubles. So if you flip three tails in a row and then get a heads you receive $8. If you flip five tails and then a heads you get $32. And so forth. You are guaranteed to make at least $1, but possibly much more. How much would you be willing to pay to play this game?
As you can see, most people would pay less than $20. But it turns out that the expected value of this game is greater than $1 million dollars. In fact, the expected value is infinite! Clearly you and others are not behaving as a classical expected utility model would predict. But why? Behavioral economics has some possible answers, but the jury is still out.
