Richard Thaler, of the Stern School of Business at Chicago University, won the Nobel Prize for Economics this month. Since I've read much of his work and followed him online for some time, I was quite pleased
He won a Nobel Prize for proving what we know
Thaler is clearly a brilliant man. Forbes magazine labelled him the most important economist of his era.
So what was his contribution?
Well, Thaler proved that people are not rational. Of course, we all know intuitively that the people around us are not rational, but it turns out that neither are we. Further, the economic and general definitions of ‘rational’ are not exactly the same.
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In general conversation, rational means logical or unemotional – summing up the facts and making a considered choice. Rational in an economic context involves ‘making the choice that will deliver the optimal level of benefit or utility to the individual’.
While there is some crossover in these two definitions, rational in an economic context is much more than logic. Judgments about whether a decision is rational in an economic sense requires knowing what is being purchased.
For example, buying a Ferrari to drive to and from work is hardly logical if you live in a crowded city. A Ferrari performs badly at low speed and this can damage the vehicle. Ferraris are not especially comfortable cars, specially when you are stuck in traffic. It also seems illogical to buy a car that can get up to speeds of 400km/hr and never be able to try it out.
Of course, all of this assumes that the owner of the vehicle is buying a car. As a car, it is not a logical purchase, but as a status symbol, it may well be a logical or even optimal purchase. Everybody knows what it is, they know it is expensive and they know the driver can afford one. As a means of acquiring status, the perception of success and attracting the opposite gender, a Ferrari may well ‘deliver optimal benefit or utility to the individual’.
This is a critically important issue, as all, or most of the laws of classical or traditional economics are predicated on human beings behaving rationally, at least in an economic sense. Thaler is threatening the very foundations of economics – and, as such, has attracted his share of detractors
So, of what value is knowing that human beings are not rational in the general and economic meanings of the word?
To start with, Thaler’s theories are not accepted by all. There are many academic economists that still maintain that it is safe to assume that decisions made by all consumers are rational – at least in an economic context. There are any number of traditional economists that spurn Thaler's work.
The fact is, however, whether or not the conclusion he has drawn about humans not making decisions that are rational in an economic sense, his considerable research has uncovered a wide range of truths that have been very helpful to business, governments and the community as a whole.
In research undertaken in Europe, Thaler demonstrated the power of opting out over opting in. This was found to be most useful in terms of organ donation rates. He found that in countries where people had to opt out of being an organ donor, the rates of donation were significantly higher, than in countries where there was an opt-in (yes, I want to donate) system. This study has since been validated.
There are those who would say that this does not prove consumers are behaving irrationally in an economic sense, but it certainly demonstrates that they are behaving irrationally in a general sense. Traditional economists might say that opting in requires more work and that explains the lower rates.
Thaler found that you can increase demand for a product by increasing its price. The increased price can, if managed well, increase the perception of value and prestige, and, as such, increase demand. Classical economics would suggest, based on the laws of supply and demand, that increasing prices should lower demand.
Some traditional economists would still argue that this is not absolute proof that people have behaved irrationally in an economic sense, although it is clearly irrational in a general sense. It is also a useful finding for marketers.
Thaler cites research that shows that offered one chocolate today or two chocolates tomorrow, most people (around 70 percent) choose one chocolate today. This has been verified many times. But if the same people are offered one chocolate in a year's time or two chocolates in a year and a day, the vast majority (perhaps 70 percent) will select the two chocolates.
In another study, people offered a $100 discount on a $1000 suit would travel significantly further than for $100 off a $50,000 car. But why? The fact is, $100 is $100 no matter how expensive the product is.
In both cases, human beings consistently behave irrationally.
Again, some defensive economists may suggest that this does not satisfy the requirements of being economically irrational, but I would argue that it satisfies both definitions of irrational.
It has also provided great data for businesses and governments developing marketing strategies.
My points here are two-fold.
Firstly, the work of Nobel Prize winners, while often not well understood, is often much more practical than many people think.
Secondly, Richard Thaler is a worthy winner, if only because he is testing a classical view of economics that has been around for eons and has not always provided the most reliable predictions.
Don't you just love people with the courage to challenge the status quo?