Professor Richard Thaler from the University of Chicago won the 2017 Nobel Prize in economics for injecting much needed behavioral insights into a field of study that has long resisted them. He follows Herbert Simon (1978 Nobel) and Daniel Kahneman (2002 Nobel) in this great honor in that all three emphasized that economists are overly enamored with the idea that humans always make rational economic decisions and that markets are always efficient.
I got to know Thaler and his work while I was doing research in this field at University of Chicago and the Wharton School; his award is much deserved. The field of behavioral economics that Thaler helped pioneer holds many implications for real-world entrepreneurs and business leaders.
Keep in mind that markets may still be efficient even if we as humans are not always optimal in our decision making. What matters is whether margin traders, who disproportionately make the market, are rational. As a simple example, suppose you are driving on a four-lane highway and your lane is going much slower than the others. Unless you really like to go slow, it would be irrational for you to stay in that lane and not switch to a faster one. But since other drivers will be doing this as well, the differences in traffic speeds among the four lanes may not last long. This dynamic presents in a nutshell what needs to be examined in economic markets; how many rational traders does it take for the whole market to be efficient, so that no single participant is sub-optimal.
Here are some of the research topics in behavioral economics associated with this year's Nobel Prize:
1. Status quo bias
Thaler himself did some excellent early work on the so-called endowment effect, meaning that people overvalue what they have and will not easily switch to something else. When students in a class were randomly given either a coffee mug or a nice pen of equal value, most wanted to keep what they were handed when given the opportunity to trade their gift for the other. Rationally, about 50% should switch, assuming the items are indeed equally desirable on average. This status quo effect makes us sticky.
One thing entrepreneurs excel at is upsetting the apple cart. The message here is that you must also appreciate why you will encounter much, and not necessarily logical, opposition along the way.
Thaler also examined the so-called winner's curse. In auctions, all bidders try to be rational in their assessment of what is on offer and what they should pay at most but, being human, their bids will contain some random noise. This means that some people will bid too low relative to their true preference and some too high. Since the high bidder wins, it is likely that this person's bid contains an upward error--thus producing the winner's curse. Later on, they may regret their bid. To avoid this trap and the downside of over bidders cutting corners later, some government sales of oil or gas tracts use a sealed-bid Vickrey auction in which the winner pays the price of the second highest bid (which is not known to them), but not their own higher one.
So, when bidding aggressively for talent, patents or office space in your business, don't fall victim to the winner's curse. Sleep on your aggressive move for a night and see if you still favor it.
3. Nudge strategies
Cass Sustein and Thaler wrote the best-selling book Nudge, which helps teachers, parents, and policy leaders to overcome some of the biases we are all prone to. Rather than adopt a strict disciplinarian approach, with hard and rigid rules, they favor a supportive strategy whereby the decision context is changed enough to bring about the desired behavior. So, no more candy displays at the school cafeteria's cash register-- healthy snacks only. Or, making it a default on driver licenses that the organs of fatal accident victims can be donated for transplant, unless the license holder has explicitly opted out. Various governments, including the U.S. and U.K., introduced nudge strategies to avoid being paternalistic.
The aim of the nudge is to guide people to doing the right thing on their own regarding their savings, education, eating, parenting and exercise. But sometimes nudges may not be enough, and we need stronger medicine. So then there is:
Ulysses is the hero in Homer's epic Greek poem The Odyssey and he realized he could not withstand the lure of the Sirens as he passed them on his ship. To resist their bewitching songs, he had himself tied to the mast in order to avoid steering his ship onto nearby rocks. Less beguilingly, Thaler examined how to tie ordinary people to long term savings plans, such as encouraging Christmas clubs in which you pre-commit to payments and pay a penalty if you skip one. Rational actors, which is what economic models typically assume us to be, would not wish to pre-commit to this choice since it is generally better keep your options open. When structuring incentives in companies, it may pay, however, to pre-commit to certain plans or strategies to overcome sub-optimal temptations along the way. You just need to know who to tie to the mast, and for how long, to contain their foolish behavior. How far do you commit your firm to key talent through severance and options contracts, or what guarantees do you offer customers?
After Captain Cortés landed in Veracruz in 1519 to conquer new lands, he told his soldiers to burn all the ships. This committed his troops to either victory or defeat, without any option of retreat. When a soldier ridiculed his move, Cortés promptly put a sword in his chest and killed him; point made.
5. Mental accounting
Thaler also researched the role of mental accounting, to uncover the roots of irrational behavior. If you have paid $30 to attend a football game and it starts to pour rain, will you leave early? Many people would say yes. But now imagine you paid $200 for that ticket. Will you stay longer "to get your money's worth." Some would, but that may not be rational; you should ask how much exposure to rain this game is worth to you. The money spent on the ticket is gone whether you leave or get wet, so it should cancel out of your cost-benefit equation. But likely it will not, just as people are more upset when missing their plane by 5 minutes than by 30 minutes. Should that 25 minute difference really matter? You simply missed the plane and that is your loss. Leaders need to understand how their customers and employees frame issues, especially in situations where their views are less than rational. For example, why do consumers focus on the percentage of a discount rather than the absolute dollar savings, or why do people prefer low deductibles in insurance policies when this is very expensive?
This is just a partial list of the many traps and biases that behavioral economists study to better explain and predict human behavior in economic situations. Thaler also examined risk-taking biases, excess volatility in the stock market, the role of fairness, and even legal policy matters.
The good news here is that people's bounded rationality creates opportunities for entrepreneurs. If markets were as well-informed and efficient as economists like to believe, there may be few ways to achieve above-average returns.
Entrepreneurial firms often arbitrage the unmet needs or new opportunities created by changes in society, technology, regulations and politics. Those who excel at this kind of innovation need to understand people's predictable irrationalities, in themselves, their colleagues, the market place and the world at large. This is why behavioral economics matters in business.