By William Mellor
VP & General Manager
You probably saw this post coming a mile away. I mean, what kind of economic research firm would we be if we didn’t comment on the recent Nobel Prize winner in Economics?
This month, Dr. Richard Thaler of the University of Chicago, won the Nobel Prize in Economics for his work in Behavioral Economics. For the uninitiated, Behavioral Economics is a sub-field of economics that challenges the assumption that people act rationally. Now, I can practically see the look on your face, and I agree. How has it taken us this long to challenge such an assumption? The truth is, of course we have always known that people don’t act rationally 100% of the time. Humans are impossibly complex beings that are motivated by a million of competing – and oftentimes contradictory – forces. However, the assumption of rationality allows economists to establish a baseline of expected outcomes. After which, the endeavoring economist can speculate about anticipated deviations.
Behavioral Economics does what all good economists love to do, which is to use mathematical and statistical models to explain and even predict outcomes. In the case of Richard Thaler, his models explain how personal and psychological biases cause us to behave in ways that can be in opposition to our own self interests.
Example: as evidenced by Dr. Thaler’s work, we can use Behavioral Economics to craft more effective public policy. We can use “nudges” to prompt individuals to make better choices. A signature area of his research focuses on savings. The vast majority of Americans are not savings nearly enough for retirement, i.e. they are acting irrationally by over prioritizing current consumption at the expense of financial security at retirement. Dr. Thaler’s research suggests that individuals can be nudged to save more by creating programs that automatically opt people in to retirement accounts. Moreover, a certain percentage of subsequent pay raises can be allocated towards retirement, slowly escalating savings over time. The results are clear, even though individuals had the same level of autonomy regarding their choices for retirement savings, when these types of programs were implemented within participating organizations, individuals chose to remain opted in.
A key tenant of this whole theory is that individuals always have total control. No one is being forced to do anything and no one’s choices are being legislated. As with the above example, people are merely nudged in a certain direction that will optimize their choices, and ultimately their well-being.
This brings us to the major flaw within this growing field of economics. While we have eliminated the assumption that all people act rationally all of the time, we have replaced that assumption with another: the entity that is doing the nudging knows what best for us. That’s a big assumption, and one that ignores the unique circumstances of individuals.
While some find this assumption to be totally untenable, I don’t find it much different from our initial predicament. To be sure, we all have unique circumstances, but Behavioral Economics works well in aggregate. Likewise, the assumption that people act rationally works well in aggregate.
I’ll show my bias here, but Behavioral Economics pushes us a little further down the road of understanding. It isn’t perfect, but it improves upon an assumption that was also imperfect. And to be honest, it is a really interesting field of study.
I’ll leave you with a couple of personal book recommendations for those who like to spend their spare time reading about social experiments and practical applications of economic principles – they are really is interesting, I swear!
- Predictably Irrational by Dan Ariely
A bit tertiary to Behavioral Economics, but still applicable:
- Thinking Fast and Slow by Daniel Kahneman
- Blink by Malcolm Gladwell