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Nobel Prize in Economics 2017 – Richard H. Thaler

The American economist / professor  Richard Thaler won the 2017 Nobel Price in economics. He was awarded the Nobel Memorial Prize in Economic Sciences for his research in the field of behavioural economics into why people make bad decisions.

Richard Thaler is a pioneer in behavioural economics, a research field in which insights from psychological research are applied to economic decision-making. A behavioural perspective incorporates more realistic analysis of how people think and behave when making economic decisions, providing new opportunities for designing measures and institutions that increase societal benefit.

From his bio:

Richard H. Thaler studies behavioral economics and finance as well as the psychology of decision-making which lies in the gap between economics and psychology. He investigates the implications of relaxing the standard economic assumption that everyone in the economy is rational and selfish, instead entertaining the possibility that some of the agents in the economy are sometimes human.

Thaler is popular for his 2008 best selling book Nudge which he co-authored with Cass R. Sunstein, in which the concepts of behavioral economics are used to tackle many of society’s major problems.

In 2008 Richard Thaler also wrote a paper “Deal or No Deal? Decision Making under Risk in a Large-Payoff Game Show“, which examines the choices contestants face in TV game shows such as “Deal or No Deal”. According to the paper, contrary to the traditional view of expected utility theory, the choices can be explained in large part by previous outcomes experienced during the game. Risk aversion decreases after earlier expectations have been shattered by unfavorable outcomes or surpassed by favorable outcomes.

Coming back to the Nobel Prize, the committee said that Thaler’s research has contributed to economic analysis by considering three psychological traits that systematically influence economic decisions – limited rationality, perceptions about fairness, and lack of self-control.

Let’s look at these three traits briefly:

Limited Rationality

This suggests that people often take decisions using a narrow focus and do not really consider all feasible alternatives and their long-term consequences. Given people’s cognitive limitations the decision-making rules are simplified. Thaler explains this with the theory of mental accounting. People simplify their decisions by creating separate accounts in their minds and making decisions based on the impacts on individual accounts rather than considering the overall impact. Another aspect of mental accounting is that we use reference points to make economic decisions. For example, while making a purchase decision, the lowest price we find for a product in our internet searches or the price at which a friend bought a product becomes our reference point and we use that to assess whether we made a deal or not. Our understanding of these aspects of decision making can help us plan our finances and protect long-term savings.

Perceptions about Fairness

Another aspect of decision making is that people not only consider the benefits for themselves but also their perception of what is fair in both a positive (cooperation) and a negative way (Jeolousy). The research by Thaler suggests that fairness plays an important role in decision making. A common example is that unexpected rain creates unusually high demand for umbrellas and if the shopkeeper chooses to raise the umbrella’s price, people will react negatively and feel that shopkeeper has behaved greedily.

Lack of Self Control

This can be seen in all aspects or our life – food and drink, smoking, consumption, saving for distant goals, or post-retirement planning. A person who chooses a longer education has a lower income during their studies, but can in return look forward to benefits in the future. This is because the experiences that are close in time take up more of our awareness than those that are further off.

In total, Richard Thaler’s contributions have built a bridge between the economic and psychological analyses of individual decision-making.

Previous winners

Last year’s economics prize went to Harvard University’s Oliver Hart and Bengt Holmstrom of the Massachusetts Institute of Technology for their work on contract theory and its role in shaping everything from executive pay to public sector privatizations. Previous laureates have included Milton Friedman, James Tobin, Paul Krugman and Friedrich August von Hayek.

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