Why are we so bad at keeping New Year's resolutions and why did so many Swedes close their Nordea accounts after the banking giant moved its headquarters from Stockholm to Finland?
Because we lack self-control and we have a keen sense of fairness which takes precedence over purely rational decisions.
Those are some of the questions answered by Richard H Thaler's research. The University of Chicago professor took home the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (commonly referred to at the Nobel Prize in Economics) on Monday, "for his contribution to behavioural economics".
The Local spoke with Magnus Johannesson, professor at the Stockholm School of Economics and a member of the Royal Swedish Academy of Sciences' Nobel Committee of the Economics Prize, to find out more.
Richard H Thaler has been described as a "pioneer" in integrating psychology and economics, whose work has "paved the way for a new field in economics". How has he changed the world of economics?
I think it's been groundbreaking work. When he started his research in the 1980s, economics was dominated by the standard model based on rational consumers with no self-control problems at all. Between then and now this has changed a lot. Now behavioural economics is a major field of economics and a lot of the ideas are incorporated in mainstream economics. I think, yes, he has had a huge influence in that regard.
It was mentioned in the presentation of Thaler's research that so many theories of economics are based on the idea of consumers being completely rational, but he showed that this is not always true. Have any major economic theories been proven false as a result of his research?
Well… you could say that this conventional standard model that's based on full rationality to some extent has been proven false.
But how important this is can differ from field to field, so in some cases it may still be enough to use these standard models, and in other cases maybe fairness (one of the principles examined in Thaler's work) for instance is crucial for what happens.
I think in terms of behaviour the standard model has been proven false, but of course it's already been known to be kind of a simplification, easy to use. One difficult thing is that there is one way you can be rational but very many different ways you can be irrational – so as soon as you leave this assumption of full rationality it becomes much more complicated to model this.
Magnus Johannesson of the Royal Swedish Academy of Sciences. Photo: Emma Löfgren/The Local
So people are not always completely rational, but can knowledge about behavioural economics and insight into our own flaws help us improve our own behaviour and act in a more rational way?
Yes, I think it can. You can think of nudging here, which is already quite well-known and used a lot. It uses psychological insights to try to move the behaviour of individuals in a desirable way, in a way they would like to but don't have the self-control or cognitive abilities to do. Being aware of this already from the beginning might help you make better decisions.
It can also protect you a little bit from marketing campaigns for instance, because that is based on the same kind of psychological insight, but instead used in a way that goes against your interests because it tries to persuade you to buy things you don't want – and being aware of these mechanisms can potentially protect you. So you're not fooled by the "buy three and pay for two" campaigns and things like that!
Here is 2017 Laureate in Economic Sciences Richard H. Thaler explaining nudging – a term he coined (from 2011) https://t.co/s15Ldzf5yX— The Nobel Prize (@NobelPrize) October 9, 2017
How great a power do we have as consumers?
I think it differs a lot depending on the specific situation. It is clear that in some situations people can respond very strongly to being unfairly treated for instance in pricing, and this can mean that companies don't exploit this to raise prices in situations where the standard model would think that they would.
It's a little bit extreme, but one example would be the recent storms that hit the Caribbean countries and the USA. We had stories where food, water and so on sold out almost immediately in the shops. The standard model would have us think that the shopkeeper would raise the price, so that it becomes more expensive, but typically they didn't do that, the shops sold out at the same prices as before. The reason for this is that the shopkeeper is worried that if you raise the price too much consumers will shop somewhere else in the future.
Social preferences: Unexpected rain increases demand for umbrellas, but a company exploiting the situation will be unpopular and boycotted. pic.twitter.com/XJd0MKuh4H— The Nobel Prize (@NobelPrize) October 9, 2017
Another recent example where I think fairness is important is when Nordea decided to move headquarters to Helsinki. We had a lot of Swedish organizations and individuals who reacted strongly to this and even left the bank. That's also a similar situation: they think it's unfair that they move the headquarters to Finland and therefore they take their money elsewhere.
I think these are two examples where it is important, but perhaps most important is wage-setting in firms.
It is very hard to lower wages nominally in a recession, for example, because people think that is very unfair and they react by working less hard. We say typically in recessions that wages are sticky downwards (the sticky wage theory). But there's also an illusion in the sense that they seem to think of wages in nominal terms, so if there's inflation the wages can be lowered without getting a negative reaction. For instance, if we have no inflation and we lower the wage by five percentage units, people will react very strongly and think this is very unfair. But if we have ten percent inflation and they get a five percent wage increase, they will not react as negatively because they focus on the nominal wage – even though the situation is exactly the same.
“Richard Thaler’s findings have paved the way for a new field in economics” - Per Strömberg on the impact of the 2017 Laureate’s research. pic.twitter.com/VXOC5wiSRN— The Nobel Prize (@NobelPrize) October 9, 2017
After the announcement, when Secretary General Göran K Hansson asked "are there any questions", the room went completely silent. Then when we had Professor Thaler on the phone, one of the first questions was about his cameo in Hollywood movie 'Big Short'. We only get a few minutes between the announcement and the interviews, which doesn't leave a lot of time for reading up on the research, so do you ever get tired of explaining all this science to journalists like myself, who may not necessarily have enough knowledge to ask intelligent questions?
No, actually I think the questions are quite good, and I think in a sense in this particular case it is almost the opposite in a way – that people will think of this and say "but it's obvious that we're not rational, it's obvious that we have self-control problems, it's obvious that we care about fairness". And you might think that you realized this very long ago, but it took very long for us to realize this! Although we did of course realize it, but it took a very long time to incorporate it into economics.