Suppose you're carrying thousands of dollars of debt on your credit card, which charges high interest, but you have slightly more than that sum in your checking account, which pays low interest. No brainer, right? Pay off the credit card debt in one fell swoop and you will save money. But few people actually do that, and this year's winner of the so-called Nobel Prize in economics explained why.
Most people mentally compartmentalize their money, according to Richard Thaler, an economist at the University of Chicago in Illinois. In particular, they divide their dough into money that can be spent now and money that should be saved for future contingencies. So even though paying off the credit card bill would save them money, most people carry the balance in order to maintain a reserve of money for future. That insight is just one of many that sprung from Thaler's melding of traditional economic theory with behavioral psychology, work that has now won him the 2017 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
"It's extremely well-deserved," says William Schulze, an economist at Cornell University. "He's been extremely creative in basically selling psychology to economists," Schulze says. "He's changed the way economists think." Drazen Prelec, a behavioral economist at the Massachusetts Institute of Technology in Cambridge, agrees. "This was an overdue prize," he says.
Thaler is already something of a minor celebrity. In 2008, he and Cass Sunstein, a lawyer at Harvard Law School in Cambridge, co-authored the book Nudge: Improving Decisions about Health, Wealth, and Happiness. After the announcement, Sunstein tweeted, "Thrilling news … an unboundedly rational choice for the Nobel." Thaler also made a cameo appearance in the 2015 movie The Big Short, a fictional account of the past decade's global financial crisis.
Traditional economics assumes that human beings act in a completely rational way and make decisions to maximize their well-being. Thaler's work showed that to understand what people actually do, social scientists must also account for people's systematic and predictable psychological biases, said Peter Gärdenfors, a member of the economics prize committee and professor at Lund University in Sweden, at the press conference announcing the prize. "He's made economics more human," Gärdenfors said.
In making the award, the committee highlighted three of Thaler's main conceptual contributions. The first, called limited rationality, helps explain why people do not necessarily follow the dictates of classical economics. For example, in the case of the credit card debt, classical economics would predict that people should do whatever maximizes their money. But Thaler argued that people do mental accounting that breaks their wealth up into different accounts that are targeted for specific needs and not for maximizing their overall wealth. Similarly, he showed that people's innate aversion to admitting a loss will cause them to hang on to a losing stock longer than a winning one.
Second, Thaler studied how so-called social preference influences economics. For example, in the aftermath of a hurricane, gasoline may be in short supply, and classical economics would predict that gas stations should dramatically increase their prices in response. But doing so would violate people's sense of fairness, and that psychological effect explains why prices remain relatively stable even in response to such emergencies.
Third, Thaler has probed people's struggles with self-control. For example, workers may resolve to save more for retirement, only to find that they cannot ever get around to squirreling away even a small monthly amount. Borrowing a concept from behavioral psychology and neuroscience, Thaler and colleagues explained that apparent contradiction by developing a "planner-doer" model. According to the model, each of us as an economic agent is torn between the part of us that plans for the future and the part that acts in the moment. So the planner's desire to save 10% of every paycheck may be constantly overshadowed by the doer's need to buy snow tires or fix the upstairs toilet. This dichotomy can even be exploited through policies that coax people into better preparing for the future or making better choices, such as by requiring people to opt out of, instead of into, pension contributions.
Thaler is not the first scholar honored by the Nobel Committee for integrating psychology and economics. Daniel Kahneman, a psychologist at Princeton University, won a share of the 2002 prize for his work with Amos Tversky, developing the behavioral foundations of economics. But Thaler's work makes a strong connection between the science and policy, says Chris Starmer, an economist at the University of Nottingham in the United Kingdom. "What Thaler has done on a scale like nobody else before is to translate the science to action," Starmer says.
In particular, Nudge has clearly influenced policymakers, says Amelia Fletcher, an economist at the Norwich Business School of the University of East Anglia in the United Kingdom. From 2001 to 2013, Fletcher served as the chief economist in the U.K. Office of Fair Trading and saw firsthand the government's response to the publication of the book. The U.K. Cabinet Office set up a Behavioural Insights Team, she says, as did the Office of Fair Trading and other regulators. "In the U.K., it is not an overstatement to say that the publication of Nudge changed the face of economic policy thinking within [the] government," she says.
The new laureate also has a distinctive and admirable style, Prelec says. Whereas many economists tend to rely on a lot of mathematical formalism and can be difficult to follow, Prelec says, Thaler "has shown that he can be rigorous with a modest amount of mathematics and clear without being dull."
Thaler seems somewhat bemused by the prize. "I was pleased," he said by telephone at the press conference. Referring to Eugene Fama, another University of Chicago economist who won the prize in 2013, he quipped, "I will no longer have to call my buddy … Professor Fama on the golf course." The prize money totals $1.1 million. When asked what he would do with it, Thaler replied, "I will try to spend it as irrationally as possible."