Richard Thaler wins Economics Nobel; he showed how irrationality makes economies tick: Financial Express Oct 10, 2017

From conventional macroeconomic theory which dominated the discourse for several decades after the Great Depression, the field of behavioural economics has caught on as it sounds more real and less theoretical. More important, its tenets are used by businesses to further their interests. It is, hence, not surprising that the Nobel Prize in Economics for this year recognises this branch of economics—Richard Thaler, this year’s winner,  is one of the protagonists of the field. Influenced by the work of the likes of Daniel Kahneman, Dan Ariely, Robert Lucas, etc, Thaler’s own work has been quite epochal and has broken many barriers. The catchy part of behavioural economics is that we can relate to it quite easily.

His contribution has centred on the issue of rationality in decision-making. Economics always starts with the assumption that we make rational decisions. Are we really rational in taking decisions when alternatives are placed before us? The answer is not really as we do tend to behave like human beings, and not like programmed robots—that is, in many cases, the laws of demand-and-supply may not hold for us in a textbook fashion. This is what Thaler reiterates in his seminal works.

Three deviations are normally noticed when such decisions are taken, either at the individual level or as a policy stance. The first is what is called ‘bounded or limited rationality’. Here, the concept is that we tend to compartmentalise everything in our minds, a tendency termed ‘mental accounting’ by Thaler. Hence, when we purchase a particular product, we compare the prices between two, or even multiple, outlets, and choose to buy the one that is cheaper irrespective of the amount involved. A `10 -difference in the price—irrespective of whether the product costs Rs 1,000 or Rs 10,000—is valued the same. Similarly, we are quite happy to buy a holiday using our credit card and pay 30% interest on an annual basis rather than remove money from our savings account which would give us a loss of just 3.5%. This goes against the grain of rationality. This is what is also exploited by business. The various ‘sales’ offered by different online e-commerce sites and retail outlets bear testimony to this. Just notice the advertisements on Wednesday in newspapers where these retailers offer Rs 5 discount on both a kilo of potatoes as well as washing powder (which has an MRP of `390). They appear similar to the human mind.

The second deviation is called ‘social preferences’, where we look at being fair in pricing and wage fixation. The concept of a government-determined minimum support price is based on this tenet of fairness though it distorts the market. Hence, we have this situation where prices increase even when supplies are high which goes against the dictates of market economics. While this may be termed as being politically motivated, the basic aim is to be fair to farmers so that their incomes are protected. This is also one reason as to why it becomes difficult to forecast prices of farm products.

Related to this subject is the issue of sticky wages, where employers are not in a position to normally lower the salaries of their staff even when business is low. One can recollect here that all theories from Keynes and Friedman talk of wages being flexible and wages adjusting to changing demand conditions. But this does not always happen. This has been eschewed in the private sector where a variable component enters the compensation package which depends on how the firm performs. Also, annual increments are no longer fixed but become variable. This is one of the reasons as to why spending power in the country has been low in the last three years as companies have not been giving the normal increments. But when it comes to the government or public sector, salaries cannot be reduced and very often the increments are also fixed by statute. It is again the idea of fairness which motivates such a measure.

The third deviation spoken of by Thaler was the lack of self-control. Marketers exploit this through impulse buying and know very well that people cease to be rational when other aspects like the ‘snob’ or ‘Veblen’ effects are highlighted. Lower prices on products which we do not require become our first choice when the pricing is attractive. The Café Coffee Day employee tempts you with a layer of ice cream or flavouring which pushes up the cost of the cup of coffee, which we would not normally have.

At another level, Thaler spoke of the trade-off between today and tomorrow. People always prefer the present and hence the concept of interest rate and savings develops from this motivation of migrating people from the present to the future. Therefore, he speaks of a ‘planner and doer’ model where we need to plan for the future rather than ‘do’ today which is what the concept of pension is all about.
The solution here is to ‘nudge’ the individual to the future and this can be through an incentive like a return on savings or even a tax on consumption and exemption on savings which helps the individual to transition from the present to the future.

It is true that economies, to begin with, work on the basis of rational economic behaviour as it seems feasible. But as economies advance and become more sophisticated and people become more diverse based on income and exposure, it becomes possible to leverage the “not-so-rational” behaviour of human beings. This is well exploited by the corporates which keep raining new products with some differentiation to capture a greater share of the wallet. This is what keeps innovation growing. If people were to seriously stop and think before opting for a new car or pair of shoes and work on the basis of value being attained then they could behave differently. Even governments are not immune to such behaviour either, in the guise of being fair or counting on political accolades. This is why we need to look at behavioural economics more closely to understand why conventional economic theory breaks down more than often.