Richard Thaler: from Nudge to Nobel Prize

Richard Thaler Nudge

Last year in October, Richard Thaler was awarded the Nobel Prize in Economics for his contribution to Economics and Psychology. For the general public Thaler is best known through his bestselling book Nudge. In this book he describes the way in which people make choices and the conditions to successfully apply nudging. Although Thaler is now a well-known name, it is good to zoom in on what exactly it is for which he receives this prize. That is why in this blog we will focus on his most important contributions to our knowledge about behavior change.

Thaler has an impressive career with his first scientific publication in 1974 until his most recent in this year. Thaler took a leading role in his early period in research into how people deal with financial decisions. Thaler found it particularly fascinating that people are not always rational. This was at odds with the conviction that people are rational decision-makers. Thaler showed with a number of interesting experiments that this is not always the case.

Nudging

Richard Thaler Nudge

Richard Thaler wrote, in collaboration with social psychologist Cass Sunstein, the bestseller Nudge. In this book they describe how nudging works and how to use it to help people live healthier, happier and more sustainable.

This book is the tangible result of bridging the gap between Social Psychology and Economic Sciences. Do you want to know more about nudging? Read on in this blogpost about nudging, or view our workshop ‘nudging in practice‘.

 

Researcher

What does money do with your behavior?

Mental Accounting Richard ThalerThe idea that people are rational decision-makers was the guiding principle in the 1970s. But Thaler showed that people can be irrational by unconsciously using a mental strategy. Thaler wondered: ‘How do people think about money?’ He stated that people simplify their financial housekeeping by dividing costs into categories such as ‘housekeeping’, ‘eating’ or ‘vacation’, while keeping a mental budget (mental accounting) for each category.

Thaler also showed why this is irrational. Think, for example, of people who have a savings account, but also a credit card for which interest must be paid. In the event of an unforeseen expense, the rational person would spend his saved holiday pay. After all, he does not pay interest on this, which makes it more advantageous on balance. But the mental strategy dictates that this is reserved for the holidays. In practice, it appears that the credit card is used but that people pay interest unnecessarily.

This simple example shows how a mental budget works in a household context. But this effect also exists in other situations. For example, it appears that people take more risks with money won in a lottery. Thaler states that this is divided into a separate mental budget and may be used differently. Mental budgets can also affect behavior. Research into the division of labor of taxi drivers shows that they try to meet daily targets based on their mental budget. As a result, they are motivated to work overtime on days when there is little business to achieve these targets. This is irrational because they can also work at times when it is busier and the price is higher so that they can achieve their targets faster. These examples show that people make irrational decisions based on their mental budgets.

What is the value of ownership?

A second contribution from Thaler to the research field is the introduction of the endowment effect. Thaler discovered that people attribute more value to goods that they possess than those that they do not possess. This stems from a resistance of people to give up ownership. This is perceived as a loss, even if one gets value (for example, money) in return.

Thaler demonstrated this fallacy in an experiment with coffee mugs. In this experiment, one participant received a coffee mug (the seller) and another participant was allowed to buy this mug. In the negotiation process time and time again the seller of the mug asked for a higher price than the buyer wanted to pay for it. The striking thing in this experiment was that the endowment effect did not occur when these were professional traders. After all, they did not assign any irrational value to the coffee mug. They only saw the mug as a trading good.

In practice, the endowment effect affects the way people experience financial expenses. Do you have an unexpected expense? Then this feels like a loss. But do you make a spontaneous purchase? Then this feels like passing up on a profit. The latter feels a lot less negative. Companies make use of this by cleverly framing their offers. An example of this is the advertisement campaign called the ‘cashback days’. Instead of deducting the discount from the purchase, consumers can claim the discount afterwords and feel it as future profit rather than a loss. This is a smart trick to make a purchase experience a lot more pleasant, and therefore more likely.

Do you opt for the short or long term?

Another research field where Thaler has made an important contribution is that of the research into self-control. Classical economists who believed in the rational human could not explain why there was a conflict between choices for now or later. In other words: why do people often opt for short-term goals that jeopardize long-term goals, such as saving for retirement, smoking or unhealthy eating habits?

Self control ThalerThaler showed that there are big differences in value allocation. For example, $100,- today is considered more valuable than $100,- next year. In reality, of course, this is equally valuable. On the basis of this insight, Thaler developed a model in which he distinguished between the planner and doer in every person ( planner-doer model ).

The planner aims to get the most out of life and is focused on the long term while the doer focuses on the short term. Depending on personal characteristics and self-control, these conflicts are resolved. For example, it requires willpower to give up short-term gratification such as smoking to eventually live a healthier and longer life.

Bridging the gap

With the above studies Thaler (and many others) has demonstrated  that people are irrational: people do not always have sufficient mental capacity, attention or willpower to make the best decisions. This was, as mentioned earlier, not yet a common way of thinking in the Economic Sciences, whereas in Psychology this was already being tested. Thaler has brought the Economic Sciences and Psychology closer together with his work.

Thaler, in collaboration with social psychologist Cass Sunstein, wrote the influential book ‘Nudge’ in which knowledge from 40 years of research has been applied to policies to help people live healthier, happier and more prosperous. With this book Thaler went into the domain of the policymaker, and with success. The book contains numerous examples in which, on the basis of scientific insights, policy has been adapted to help people make better choices.

Policy maker

An example of this is the ‘Save More Tomorrow‘ plan that helps employees to make better choices with regard to their pension. This is a good example, because saving for your pension is a goal for the long term, so that people prefer to refrain from doing so in the short term. In addition, it is less attractive because, in order to save up, you later have to deduct part of your salary in the short term. Because this feels like giving up salary , this feels like a loss rather than a deferred profit.

Thaler achieved very good results with the ‘Save More Tomorrow‘ plan by offering pension accrual as a default option. This means that people have to opt out of the pension plan instead of opting in. In practice, it appears that only 12% opt out from the program. In addition, choices about how much savings would be offered were far ahead of payment of the salary. Because of this the choice to save more felt less as a loss of salary. An important aspect here is that the program is nonetheless voluntary and that employees could opt out at any time.

Meanwhile, nudging has found its way into the policy of several Western countries. For example, England rolled out the ‘Save More Tomorrow‘ plan nationally and in 2010 the Behavioral Insights Team was set up to further develop and investigate applications of nudging. This development was followed in the United States where President Obama gave an order to use scientific insights to serve the people better. The Dutch government has also recently started using nudging, as written in the state budget for 2018. In addition, more and more municipalities are scanning and exploring what is possible to better serve citizens and employees.

Nobel laureate

Nudging

All in all, Thaler has left an impressive footprint in science and beyond. Because of his great contribution to the knowledge about how people make decisions, a new way of thinking has developed within the Economic Sciences. In addition, this has created a bridge between the Economic Sciences and Psychology. This ultimately led to new insights that even influence national policy level. With this, Thaler has shown that he is worthy of a Nobel Prize for Economics.

Want to read more?

Want to know more about nudging? Check out our other blog postings about nudging. Do you have specific questions or do you want to know what the possibilities are for your organization please contact us.

Are you already convinced about the possibilities of nudging for yourself or your organization? Then take al ook at our workshop program ‘nudging in practice‘ and register.