The 2017 Nobel Prize in economics was won by the University of Chicago’s Richard Thaler. The Royal Swedish Academy of Sciences gave the prize “for his contributions to behavioural economics,” which is the integration of economics with psychology. The award was not a total surprise since Thaler’s name was floated earlier on the list of potential winners.
The Economics Nobel Prize
The award is for 9 million Swedish Kronor, which at today’s exchange rate is about 1.1 million US dollars. Unfortunately, since he is a U.S. winner the entire award is taxable income, unless it is donated to a charity.
The Nobel Prize in Economics is the only prize not created by Alfred Nobel in his will. While the other Nobel prizes have been given since 1901, the first economics prize wasn’t awarded until 1969 when it was won by Ragnar Frisch and Jan Tinbergen. This relatively new prize is funded not by Alfred Nobel but by Sweden’s central bank, the Sveriges Riksbank. The Riksbank on its 300th anniversary donated money to the Nobel Prize Foundation and also promised to fund each year’s economics award.
Who is Thaler?
His Ph.D. thesis was one of the earliest estimates on the value of saving a life. These are calculations that help governments and businesses determine how much should be spent to prevent fatalities. His estimates using 1967 data were around US$200,000 per life saved, or about $1.5 million in today’s terms. While governments and businesses use higher figures today, these estimates helped pave the way for determining how much money to spend on improving dangerous roads, bridges and even air quality.
People who have heard of Thaler most likely know him because of his New York Times bestselling book “Nudge,” co-written with Cass Sunstein. Nudge offers idea from economics and psychology for getting people to make better choices like eating healthier foods, saving more money for retirement, and even increasing the number of organ donors.
Thaler and Sunstein argue people should not be forced to do things with bans or laws. Instead, small interventions that make the right choice easy are the best way to go. They offer examples such as putting healthy food in a cafeteria where people can see and reach it easily and putting unhealthy food in hard to reach far away spots. Since people like the easy choice, moving food around will result in less junk food being eaten.
Another example is making automatic retirement contributions the default choice when someone begins a new job. This makes new employees fill out paperwork to stop retirement contributions, instead of to start them. The extra effort means few people fill in the forms, resulting in more people saving for retirement.
What Work Earned Him the Prize?
The Swedish Academy of Sciences selected Thaler for his work in three areas: limited rationality, social preferences and lack of self-control. Many economists before Thaler assumed that humans acted like Spock on Star Trek. People were supposed to be calculating machines that looked at all the information and made correct choices.
Thaler pointed out that many people do not and cannot solve many problems in their economic lives. Instead of solving these problems people simplify and use rules-of-thumb. However, these simplifications lead to strange choices.
Mental accounting is one area of strange choices that Thaler was the first to identify. Because our financial lives are complex, we mentally put money in separate buckets and only spend the money available in that bucket.
One of Thaler’s first mental accounting examples was about a couple who received $300 in cash compensation from an airline for lost baggage. The couple took the $300 and spent it on a fancy dinner. They only splurged for the dinner because the $300 mentally was classified as a windfall. If their salary had increased by $300 they would likely not have splurged on eating out but instead mentally classified the amount as spending for rent and other bills.
Thaler’s work suggests the importance of not putting a mental label on money. Instead, he suggests if we compare the value we get from a purchase to its price before buying, we would be better off.
He also won the Nobel Prize for his work on social preferences and fairness. Thaler, with co-authors Kahneman and Knetsch, pointed out customers don’t always expect businesses to profit maximize. For example, customers expect after blizzards stores will not raise the price of shovels. Stores that do are often punished by customers who view them as overcharging.
This work has relevance today for understanding consumers’ reactions to drug companies pushing prescription drug prices ever higher and reactions to businesses price gouging after hurricanes. Thaler points out that emotions, like feelings about fairness, are an important but overlooked area of economics.
The final area cited by the Swedish Academy was Thaler and co-author Shefrin’s work on a theory of self-control. They point out people spend money to avoid making poor choices. They also spend to avoid engaging in the wrong kinds of behaviors.
For example, Thaler points out that people “pay to go to ‘fat farms’ which essentially are resorts that promise not to feed their customers.” Individuals not only pay for self-control but also create special rules to ensure they don’t go beyond self-imposed limits. For example, smokers often buy cigarettes by the pack, instead of by the carton. This ensures they smoke less each day, even though they pay more per cigarette.
Thaler’s work on self-control is becoming more important as the Internet and almost instant delivery make more of the world’s temptations easier to access without waiting.
The list of past economic Nobel Prize winners contains many people whose work is fascinating to economists, but whose relevance to the lives of regular people is tenuous. Richard Thaler’s work, however, has direct relevance for many people. His early research helps save lives. His later research helps people save for their retirement and helps save us from our own worst tendencies. The Swedish Academy made a wonderful choice in selecting Richard Thaler for the 2017 Nobel Prize in economics.