An Irrational Choice: Behavioural Economist wins Nobel Prize

Konstantinos Efstathiou explores the prize winner's contributions.

Martin Sandbu in the FT lists some of Thaler’s seminal contributions to behavioural economics, which reveal people’s bounded rationality, willpower and self-interest. Firstly, Thaler discovered the endowment effect, whereby an individual’s willingness to pay for a given object only a fraction of what they are willing to part with it. Secondly, his demonstration that people have a bias for consumption today, leading them to take less care of their future than they intend to. Finally, his popularisation of experiments that showed people have a strong preference for fairness, such as the “dictator” and “ultimatum” games. Sandbu notes that although Thaler developed topics many other contemporary economists have touched upon, he is unique in the influence his work has had on policymaking and the economics profession.  Specifically, Thaler contributed to a new approach in public policy called “nudging” or “libertarian paternalism”, which exploits people’s behavioural biases and irrationalities rather than using coercion in order to make them behave in ways seen as more desirable than policymakers.

On a similar note, Paul Krugman writes that Thaler did not just document deviations from rationality but also showed that there are consistent, usable patterns in those deviations. For Krugman, however, the key question is what this realization should imply for the practice of economics. What needs to change? Between those who argue that imperfect rationality changes everything and those suggesting that the assumption of rationality is still the best game out there, Krugman asserts that the answer depends on the field. He finds the concept of rationality as used in finance, though imperfect in detail, beneficial and correct in its broad implications. The assumption that rational investors will build all available information into asset prices is consistent with the observed unpredictable movement of those prices – which creates patterns that are subtle, unstable, and hard to make money from. In macroeconomics, however, Krugman argues that the assumption of rationality has been both very influential and hugely destructive.  Wage- and price-setting do not reflect the agents’ best available information about future monetary policies; if it did, we’d be seeing wage contracts moving rapidly.  Krugman posits that in financial markets, smart investors can, within limits, arbitrage against the irrationality of others but no equivalent exists in labour and goods markets or consumer behaviour.

Roger Farmer, an advocate of including beliefs as an economic fundamental in macroeconomic models, argues that this year’s Nobel Prize will spread awareness of how important the connection between economics and psychology is. He draws a distinction between the broad and the narrow definition of rationality. Broad rationality is essentially a tautology: rational individuals always choose their preferred action. It is the narrow definition of rationality, a set of axioms that was introduced by John Von Neumann and Oscar Morgenstern, which has been shown to be violated in experimental situations. According to Farmer, those axioms make a great deal of sense when applied to choice over monetary outcomes, but they have less power when applied to complex decisions which involve sequential choices and payoffs from different commodities at different points in time.

Kevin Bryan at “A Fine Theorem” agrees that Thaler’s work is brilliant, but views it also as potentially dangerous to young economists. Bryan’s scepticism has several aspects but his central argument is that repeated experience, market selection, and other aggregative factors mean that irrationality may not matter much for the economy at large. In general, experts in a field and markets with all the tricks they develop, are very good at ferreting out irrationality. This is because many economic situations involve players doing things repeatedly with feedback. This means that heuristics approximated by rationality evolve over time, or players who “perform poorly” are selected out of the game.

As a result, Bryan argues, situations such as saving through defined contribution pension plans are the exception than the rule: this is a decision with limited short-run feedback, taken by unsophisticated agents who will learn little even with experience. Here Bryan is referring to the “Save More Tomorrow” (SMarT) programme for defined contribution pension plans proposed by Thaler, in which employees commit upon joining to increase their contribution with every future rise in their pay but can also opt out of the plan at any time. The SMarT plan, which has been successful in increasing pension savings, is an example of “nudging” that specifically addresses self-control biases. Bryan also cites the mounting importance of robo-advisors, index funds, and personal banking in managing saving decisions as another reason why irrationality in the lab may not translate into irrationality in the market.

Noah Smith directly replies to Bryan’s criticisms and dismisses them as inadequate. Against Bryan’s main argument about the “the invisible hand wave” (Thaler’s own term for the assumption that markets have emergent properties that make individual not-quite-rational agents behave like a group of complete-rational agents), Smith argues that the justifications given for it are typically vague and unsupported. A few perfectly rational individuals do not actually compete all the other less rational agents out of the market. He also remarks that people typically pay financial advisers a fifth of their life’s savings or more. If the market for financial advice is an efficient market where individuals pay to counter their behavioural biases, then these behavioural biases are as severe as suggested by the high price that individuals are ready to pay. Smith also challenges Bryan’s assumption that someone with nontrivial behavioural biases can be completely rational in her choice of an adviser.

Konstantinos, a Greek citizen, works in Bruegel as an Affiliate Fellow in the Macroeconomics and Governance area. Before joining Bruegel, Konstantinos was at the European Commission, as a Blue Book Trainee in the Cabinet of President Juncker. He also interned at the Central Bank of Luxembourg (BCL) as a research assistant, involved in projects related to the Wage Dynamics Network (WDN) research group.

This post first appeared on Bruegel.

Image Credit: Ihor Malytskyi