Usually, when the winner of the Economics Nobel Prize is announced, people who care about the real world, and pragmatic business folk, don’t pay much attention, other than perhaps fulfilling a sense of curiosity. This time around it is different, this year’s winner, Richard Thaler, among many other things co-author of the brilliant book Nudge, has developed theories and ideas that have changed how many of us think about ourselves, other people and our approach to business.
We are not always rational. That insight is not Richard Thaler’s alone, the likes of Daniel Khaneman and Amos Tversky, got in there first. But Thaler has been a key contributor to what these days we call behavioral science and behavioral economics.
If you never read Nudge, it is worth it.
Here is one anecdote from the book. When Dustin Hoffman was starting out, as a budding actor, he shared a flat with fellow budding actor, Gene Hackman. Times were tough, money tight, and Hoffman used a method to make ends meet which Thaler calls mental accounting. The young Hoffman kept his money in pots: rent pot, bills pot, food pot, going out pot. When Hackman invited him out, his flatmate checked the going out pot, alas it was empty. So Hoffman asked if he could borrow money from Gene Hackman, even though there was plenty of money in the other pots.
According to the organisers of the Nobel prize, “Thaler developed the theory of mental accounting, explaining how people simplify financial decision-making by creating separate accounts in their minds, focusing on the narrow impact of each individual decision rather than its overall effect.”
But he also advanced the idea of loss aversion, also called the endowment effect: “people value the same item more highly when they own it than when they don’t.” It’s a concept entrepreneurs need to take on board, they need rugged determination, but also need to know when to let ideas go. This is where the idea of the Lean Start-up comes in, it’s the real world solution to the problem identified by Thaler, indeed the creators of the Lean Start-up model leant heavily on behavioral economics.
Thaler also advanced ideas such as social preference, showing “how consumers’ fairness concerns may stop firms from raising prices in periods of high demand, but not in times of rising costs.” So,when Uber raised prices during the terrior attack on London Bridge it was pilloried in the media, it had transgressed a golden rule: upsetting people’s sense of fairness. The snag here is that the algorithms that set price had not been taught about social preference. It is interesting to speculate whether machine learning can independently learn about the heuristics behind human behaviour.
He also looked at how we can succumb “to short-term temptation. This “is an important reason why our plans to save for old age, or make healthier lifestyle choices, often fail.” Thaler suggested we can be nudged into changing our behaviour. Maybe the truly successful entrepreneurs are able to rise above the short term thinking that characterises the markets, and be like Jeff Bezos, more long-term in our thinking.
The Nobel Prize for Economics is often described as not being a proper prize – not like prizes for peace, literature, physics, and Chemistry that were bequeathed in the will of Alfred Nobel in 1898. But, back then, hardly anyone studied economics. At times the economics discipline throws up theories that seem to bear no relevance to the real world, the elegance of the maths seems more appealing to economists than the relevance of the theory. Such a criticism is not relevant when talking about Richard Thaler, his work has helped create a better understanding of ourselves.