Blog Post

An irrational choice: behavioural economist wins Nobel Prize

Richard Thaler was awarded this year's Nobel Prize in Economics for his contributions to the field of behavioural economics. His work documents a set of cognitive biases affecting economic decision-making and casts doubt on commonly-held assumptions about the rational ‘homo economicus’ that inhabits economic models and theories. What are the implications for the economics discipline and public policy?

By: Date: October 16, 2017 Topic: Global Economics & Governance

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.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

The inverted yield curve

Longer-term yields falling below shorter-term yields have historically preceded recessions. Last week, the US 10-year yield was 21 basis points below the 3-month yield, a feat last seen during the summer of 2007. Is the current yield curve a trustworthy barometer for future growth?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 11, 2019
Read article More on this topic More by this author

Blog Post

The 'seven' ceiling: China's yuan in trade talks

Investors and the public have been looking at the renminbi with caution after the Trump administration threatened to increase duties on countries that intervene in the markets to devalue/undervalue their currency relative to the dollar. The fear is that China could weaponise its currency following the further increase in tariffs imposed by the United States in early May. What is the likelihood of this happening and what would be the consequences for the existing tensions with the United States, as well as for the global economy?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 3, 2019
Read article More on this topic More by this author

Blog Post

The next ECB president

On May 28th, EU heads of state and government will start the nomination process for the next ECB president. Leaving names of possible candidates aside, this review tries to isolate the arguments about what qualifications the new president should have and what challenges he or she is likely to face.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: May 27, 2019
Read article More on this topic More by this author

Blog Post

The latest European growth-rate estimates

The quarterly growth rate of the euro area in Q1 2019 was 0.4% (1.5% annualized), considerably higher than the low growth rates of the previous two quarters. This blog reviews the reaction to the release of these numbers and the discussion they have triggered about the euro area’s economic challenges.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: May 20, 2019
Read article More by this author

Blog Post

Is an electric car a cleaner car?

An article published by the Ifo Institute in Germany compares the carbon footprint of a battery-electric car to that of a diesel car, and argues a higher share of electric cars will not contribute to reducing German carbon dioxide emissions. Respondents rejected the authors’ calculations as unrealistic and biased, and pointed to a series of studies that conclude the opposite. We summarise the article and responses to it.

By: Michael Baltensperger Topic: Energy & Climate, Innovation & Competition Policy Date: May 13, 2019
Read article More on this topic More by this author

Blog Post

All eyes on the Fed

Last week the US Federal Reserve left the federal funds rate unchanged and lowered the interest rate on excess reserves. We review economists’ recent views on the monetary policy conduct and priorities of the United States’ central bank system.

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: May 6, 2019
Read article More on this topic More by this author

Blog Post

Is this blog post legal (under new EU copyright law)?

How new EU rules on using snippets from news publishers and on copyright infringement liability might affect circulation of information, revenue distribution, market power and EU business competitiveness.

By: Catarina Midoes Topic: European Macroeconomics & Governance Date: April 8, 2019
Read article More on this topic More by this author

Blog Post

Secular stagnation and the future of economic stabilisation

Larry Summers’ and Łukasz Rachel’s most recent study documents a secular fall in neutral real rates in advanced economies. According to the authors, this fall would be even more marked in the absence of offsetting fiscal policies. Policymaking in a world of permanently low interest rates may be hard to navigate, especially in troubled waters. We review economists’ views on the matter

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: April 1, 2019
Read article More on this topic More by this author

Blog Post

On Modern Monetary Theory

An old debate is back with a kick. The discussion around modern monetary theory first gained traction in the economic blogosphere around 2012. Recent interventions in the US and UK political arenas rekindled the interest in the heterodox theory that is now seeping into mainstream debates.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: February 11, 2019
Read article More on this topic More by this author

Blog Post

The American tax debate

The debate over two different proposals for tax reforms: Senator Elizabeth Warren’s plan for a tax on wealth, and Congresswoman Alexandria Ocasio-Cortez’s plan for a higher top marginal tax rate on income

By: Enrico Bergamini Topic: Global Economics & Governance Date: February 4, 2019
Read article More on this topic More by this author

Blog Post

The microeconomics of Christmas

It’s that time of the year, again. Silvia Merler reviews major contributions to the literature on the controversial topic of the deadweight loss of Christmas.

By: Silvia Merler Topic: Global Economics & Governance Date: December 24, 2018
Read article More on this topic More by this author

Blog Post

Brexit: Now for something completely different?

The life of Brexit. After a week of ECJ rulings, delayed votes, Theresa May’s errands across Europe and the vote of no confidence, we review the latest economists’ opinions to try to make sense of what has changed and what hasn’t.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: December 17, 2018
Load more posts