Richard Thaler, the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago's Booth School of Business (there's a funny story behind his endowed chair), won the Nobel Prize in Economics yesterday.
Specifically he won it at 4 a.m.; he was sworn to secrecy for an hour, then took part in a press conference, then dealt with the press, then took part in another press conference at 11 a.m. at the university. Before he took questions yet again, Thaler took a moment to cover the question every Nobel laureate gets, and provide a little economic lecture on how his work is distinguished from so many other economists—especially before people started listening to him—and gave a little window into how he thinks.
"I'll preempt one question that some reporter may ask. I've answered it a couple times this morning," Thaler said, "which is, 'so what are you going to do with the money?' Most economists are too polite to explain that they think this is a stupid question. The reason why they think it's a stupid question is that economists know that money is fungible. So what do you mean 'this money?' If I go out to dinner, is it this money, or some other money? This isn't a completely stupid question to me, since I believe in something called mental accounting, which is precisely people putting labels on money. So what am I going to do with the money? Any time I spend any money that's really fun, I'm going to say that came from the Nobel Prize."
Thaler's Nobel comes after years of asking questions other economists thought were stupid, which is why his climb to the peak of the profession was slow and somewhat unlikely; his thesis advisor literally said "we didn't expect much of him." And the questions he asked had a lot to do with how stupid people are, and in what ways.
Early on in his career, according to his book Misbehaving: The Making of Behavioral Economics, Thaler started making a list of things people do that are "inconsistent with the economists' model of rational choice," or as he alternately put it, "dumb stuff people do." One seemingly trivial example he mentions in his book is getting free tickets to a basketball game and skipping it on account of a blizzard; the friend who would have gone with him mentioned that, had they paid face value for the tickets, they would have attended because they paid handsomely for the tickets. This is the sunk cost fallacy—either way, at the time the decision is made, they already have the tickets, so the cost shouldn't matter.
Maybe his friend's reaction makes more sense to you than it does to Thaler. Maybe, putting yourself in their shoes, you would have gone and enjoyed it more because you spent money on it; maybe you wouldn't have gone but would have regretted it, because in spending the money you put a value on that experience that your rational mind couldn't eliminate. (I can tell you concerts that I bought tickets to, skipped, and still feel dumb for doing it; I can't tell you the ones I've had the chance to go to for free and passed on.)
That's because you're a person, and people behave irrationally. Not necessarily unpredictably—sometimes they are irrational in entirely predictable ways, like with the sunk-cost fallacy—but irrational nonetheless. And as he was working on his list of dumb stuff people do, he attended a conference where he met a psychologist, Baruch Fischhoff, who had worked with Daniel Kahneman and Amos Tversky, pioneers in the study of judgment and decision-making. Fischhoff himself pioneered the study of hindsight bias.
Of course people have hindsight bias, you might think, everyone knows that. But economists don't always think that way. Often, and certainly more often before Thaler, they assumed perfect markets with rational thinkers on all sides of them. As Thaler puts it in Misbehaving, "the core premise of economic theory is that people choose by optimizing…. Econs do not have passions; they are cold-blooded optimizers. Think of Mr. Spock in Star Trek."
Instinctively we know people are not Mr. Spock; otherwise, Spock wouldn't be a notable character. But a lot of economists, obviously, didn't think instinctively. Thaler's breakthrough was to marry those observations about people to economic research, and to prove logically that people are illogical.
Sometimes that involved proving that people don't optimize outcomes because they aren't trying to. That led to one of Thaler's most important ideas: being opted in to retirement programs. Instead of having to choose to join your company's 401k program, you have to choose not to participate, and perhaps your company even opts you into an automatic increase in your contributions every year.
(My 401k doesn't automatically increase every year, but I can check a box that ensures my contribution goes up every year, rather than having to remind myself every so often, the kind of very occasional but potentially important decision that people easily forget. I also have an app that rounds up my purchases to the nearest dollar and invests that in an index fund so I do it without thinking, and thus do it without agonizing about it. Without the explosion of work in the field of behavioral economics in recent decades, those might not exist.)
The problem this solves is, like so much of Thaler's work, pretty obvious: It's good to save for retirement, but people, being irrational unoptimizers, just don't do it. Maybe they think they can't afford it. Maybe there's so much going on when they take a new job that they overlook it. Maybe they're young and not thinking about retirement. We know a lot of people don't think about it, so Thaler's insight was to change the default option to the thing that's better for them.
He calls it "libertarian paternalism": They still have a choice, you're just changing the result if they don't choose. The result can be powerful. When Thaler looked at the numbers recently, he found that "more than four million people were using some form of automatic escalation, and had collectively increased annual savings in the United States by over $7 billion a year."
And you can do it the opposite way. Take the new pension plan for the state of Illinois. The state really, really wants new hires to be in a hybrid defined-benefit/defined contribution plan, basically a combination of an old-school pension plan and a 403b, because they estimate it will save the state money. So new hires are automatically enrolled in the hybrid unless they choose to opt for a defined-benefit plan.
This type of irrational behavior isn't limited to uneducated or unmotivated players. Even people who try very hard to optimize their economic decisions, and who have unfathomable resources with which to do so, still do a terrible job of it. In 2005, Thaler collaborated with the similarly inclined Cade Massey on a study of the NFL draft. Few economic tests have more riding on them: those who pass it can gain immense wealth and glory, those who fail it, as sports fans know, will not only lose their jobs but will become subjects of derision for years.
They found that NFL teams systematically overvalued high draft picks, who were generally better than lower draft picks, but not worth the prices teams were paying for them. A team optimizing its strategy in the existing draft market would be better off trading down and getting more good players—who will also command a lower salary—instead of one great player. As the authors write, "if picks are valued by the surplus they produce, then the first pick in the first round is the worst pick in the round, not the best!" Teams also value current-year picks over future-year picks, meaning that if a team is willing to be patient, they can stockpile future talent at a discount, as the newly data-driven Cleveland Browns are trying to do.
The authors were not the first people to think of this. As they themselves acknowledge, the New England Patriots built their dynasty outside the early picks of the draft. But the Patriots were able to do that because other teams didn't—even though NFL teams will pay virtually any price to succeed. They were simply paying the wrong price.
At the press conference recognizing the new Nobel laureate, Madhav Rajan, the new dean of the Booth School, gave a brief introduction to Thaler. "He studies the implications of relaxing the standard assumption of the self-interested, rational economic agent, instead entertaining the possibility that sometimes, some people actually choose to behave as human beings," Rajan said. There was polite, knowing laughter. It's a funny thing, and a funny thing to laugh about. It seems obvious. But it's a funny world and we don't always, or even usually, do the obvious thing, which is what Thaler has spent a career studying, and why he won the Nobel Prize.