Richard H. Thaler, the “father of behavioral economics,” has this week won the 2017 Nobel Prize in Economics for his work in that field. Thaler has long been known for challenging a foundational concept in mainstream economics — namely, that people by-and-large behave rationally when making purchasing and financial decisions. Thaler’s research upended the conventional wisdom and showed that human decisions are sometimes less rational than assumed, and that psychology in general — and concepts such as impulsiveness — influence many consumer choices in often-predictable ways.
Once considered an outlier, behavioral economics today has become part of generally accepted economic thinking, in large part thanks to Thaler’s ideas. His research also has immediate practical implications. One of Thaler’s big ideas – his “nudge theory” – suggests that the government and corporations, to take one example, can greatly influence levels of retirement savings with unobtrusive paperwork changes that make higher levels of savings an opt-out rather than an op-in choice. In fact, he co-authored a book, Nudge: Improving Decisions About Health, Wealth and Happiness, which became a best-seller.
In this Knowledge at Wharton interview, Katherine Milkman, a Wharton professor of operations, information and decisions — and a behavioral economist herself — discusses Thaler’s influence in economics and the practical applications of his ideas already underway. She attributes part of his success to his great clarity in thinking and in writing. She had interviewed professor Thaler for Knowledge at Wharton in 2016 regarding his then-new book, Misbehaving: The Making of Behavioral Economics.
An edited transcript of the conversation follows.
Knowledge at Wharton: It must be an exciting time for behavioral economists such as yourself to see one of their leading lights recognized this way. Could you give us a brief sketch of the key concepts in behavioral economics, and how they differ from mainstream views of economics? And also, why is Thaler such a leader in the field?
Milkman: Standard economics makes assumptions about the rationality of all of us, and essentially assumes that we all make decisions like perfect decision-making machines, like Captain Spock from Star Trek who can process information at the speed of light, and crunch numbers, come up with exactly the right solution.
“Humans are not perfectly rational…. We have impulse-control problems, we have social preferences. We care about what happens to other people instead of being entirely selfish.”
In reality, that’s not the way humans make decisions. We often make mistakes. And Richard Thaler’s major contribution to economics was to introduce a series of predictable ways that people make errors, and to make it acceptable to begin modeling those kinds of deviations to make for a richer and more accurate description of human behavior in the field of economics.
Knowledge at Wharton: What would be a classic example of a decision that an economist would expect someone to make rationally, but in fact they don’t?
Milkman: Well, a great example from Richard’s own work relates to self-control challenges. And he has talked about the cashew problem, or the challenge, if you’re at a dinner party, of resisting the bowl of cashews that you know will spoil your dinner.
A traditional economist would expect that’s not a challenge. No one should have any difficulty withstanding that temptation. They should know it will spoil their dinner; we don’t need the cashews. And Thaler noted that, in fact, everyone struggles with this, and everyone breathes a sigh of relief when a host puts away that bowl of cashews so they’re not reachable and they’re not in front of everyone anymore.
It seems small, but it actually highlights a major challenge for humans with self-control, which can perhaps explain the obesity epidemic, and under-saving for retirement, the under-education among many groups. The range of things that this simple observation can begin to shed light on is just extraordinary. And that’s only one of his contributions.
Knowledge at Wharton: It’s this idea that human beings happen to be impulsive a lot of times, and that should be taken into account. They aren’t sitting there with calculators all the time figuring out an economic decision or a financial decision.
Milkman: That’s exactly right. That’s the contribution that Richard Thaler made to economics in a nutshell: that humans are not perfectly rational, sitting there with calculators. We have impulse-control problems, we have social preferences. We care about what happens to other people instead of being entirely selfish. We are limited in our rationality in a number of ways, and he has pointed that out over the last 50 years, and highlighted opportunities for policy makers to improve the lives of billions of people by taking these insights into account.
Knowledge at Wharton: It appears a little odd that these ideas were consigned to the corner for so long. Now people are talking about them more.
Milkman: I think that’s right. At some level it took a personality like Richard Thaler; he’s someone who likes to break the mold and misbehave, which is the title of his autobiography. It took someone like that to point out the absurdity of the assumptions in a standard economic model, and help change the assumptions so that we could start doing the science better.
Knowledge at Wharton: And those standard models, they worked really well a lot of the time, maybe even most of the time — it’s just that when they didn’t work, it could be a major failing. Is that right?
Milkman: I think that’s right. And it also meant there was an opportunity for improvement. So even if they were working fairly well much of the time, they weren’t actually fully accurate. And so the more accurate we can make them, the more opportunities we have to make better policy and so on.
Knowledge at Wharton: Let’s talk about some of the practical applications of his ideas. Thaler was a government advisor not long ago. Perhaps you could tell us about his contributions and about how he has a lot of practical ideas for how his concepts can be put to use.
Milkman: In 2008, along with Cass Sunstein, he wrote a book called Nudge which was a bestseller. The book articulated an opportunity for governments by using behavioral economics. And the basic idea was that there are all of these ways in which people make sub-optimal choices, and governments have an opportunity to use their knowledge and insights about those errors to actually try to improve decision making.
Let me give you a really concrete example from that book that I think is incredibly powerful. He points out that whenever we walk into a cafeteria, we’re faced with a wide range of options about what to put on our tray. Something comes first, something comes last, and the first thing we encounter is much more likely to be the thing we purchase and eat than the last thing, because we have an empty tray when we encounter that very first option.
“It took a personality like Richard Thaler … to point out the absurdity of the assumptions in a standard economic model.”
What this means is that whoever laid out the cafeteria was actually, whether or not they meant to, influencing our choices dramatically depending on where they place certain foods. The first thing we encounter is much more likely to end up on our plate, as I just said, and therefore whatever they place first, whether it was broccoli or chocolate cake, was more likely to end up on our tray.
There’s no such thing as neutral choice architecture. Thaler pointed out that we should try to architect environments where people are making decisions in a way that, in his words, nudges us towards better choices. So why not put the broccoli first and the chocolate cake last in order to help people be healthier in a cafeteria?
Thaler also talks a lot about how to improve retirement savings outcomes using similar understandings of psychology. For instance, why not assume that people want to save for retirement and allow them to opt out rather than what was historically typically done when you signed up or started working at a new employer, which was to assume people didn’t want to enroll unless they said please sign me up for the retirement savings program. With small changes [in] the environments where we make choices, that don’t restrict choice in any way … we can have a huge impact on human life for the better.
Knowledge at Wharton: Another interesting idea — along the same lines — is that you agree in advance that when you get a raise in the future, a bigger chunk of that would go into your retirement than just the standard percentage based on what you had chosen in advance. It turns out through the “miracle” of compounding interest that these things can make a huge difference at retirement.
Milkman: That’s right. And you had specifically asked about how governments were using this. I also want to note many folks in governments read the book Nudge, and there are now literally hundreds of offices in governments around the world that have developed what they lovingly refer to as Nudge Units, where they’re trying these insights from this field to try to improve outcomes for citizens.
And we have one in the U.S. government, we have one that was founded I believe in 2015 if I’m getting my dates right. And before that, the very first Nudge Unit came in the U.K. under David Cameron, and it was literally referred to as the Nudge Unit. Now it’s called the Behavioral Insights Team and they have operations in the U.S. and in the UK. They’re helping many cities in the U.S. improve their outcomes for citizens. And so he’s just had an enormous impact, not only here but abroad.
Knowledge at Wharton: Thaler won the Nobel Prize in Economics for his work in behavioral economics, but as we were talking earlier you noted he considers himself a behavioral scientist. Can you talk about the distinctions there?
Milkman: One of the things that is important about Richard Thaler’s work is that it bridges disciplines, and so while many economic Nobel Prizes are awarded to people who are truly only economists and only recognized in economics, some go to people who have impacted a far wider range of fields, and this is one of those.
So Richard Thaler often refers to himself not only as a behavioral economist but as a behavioral scientist, because there’s a community that includes many who aren’t economists who are doing this work that is spurred by his ideas, his thinking about peculiarities of human behavior that aren’t captured by economic science.
So behavioral science is a broader term. It includes psychologists, many folks in business schools who don’t have an identity as a psychologist or an economist. You can find the stray neuroscientists and sociologists who think of themselves as behavioral scientists as well.
Knowledge at Wharton: It’s interesting that there’s the word “behavioral” in here, and “psychology.” I don’t hear the word “emotion,” when it would appear that that is part of it all. We talk about emotional intelligence — is that somehow connected to this idea? That also seems to be an area that is slightly outside of the strictly rational, and it applies to behavior, and it is talked about oftentimes in the work setting.
Milkman: That’s a great question. I think that emotions specifically haven’t been exactly the center of Richard’s work, but at some level they are an underpinning of all behavioral science, and all of behavioral economics, because if you fundamentally ask where do these deviations from optimal decision making come from, many are driven by emotions.
So a lot of Richard’s work looking at social preferences — for instance, the fact that we intrinsically seem to care about other people’s outcomes and not only our own — is fundamentally the result of emotion. We emotionally care about other people; we have an emotional reaction when we see something happening that we think is unfair to someone else.
“The very first Nudge Unit came in the U.K. under David Cameron, and it was literally referred to as the Nudge Unit.”
You can also think about an emotional reaction, or a visceral reaction leading to impulse control problems in many situations, and his work on self-control then is all about emotions. So while he doesn’t typically get recognized for being a scholar of emotions, at some level everything we have learned about limited rationality is somehow connected to emotions it seems.
Knowledge at Wharton: So tell me some of the ways that he has influenced many other researchers, including yourself.
Milkman: Well he opened up new fields of inquiry that really weren’t in existence before he began doing this work. I personally study self-control and nudging, and those are two things that were not really being studied by the community of behavioral scientists in nearly the same way, not with the same lens, before he came along and made them central to behavioral economics and created this field, along with his predecessor, Daniel Kahneman, who was also a Nobel laureate roughly 15 years ago. Thaler has been instrumental in opening up doors for young scientists to think about things that previously weren’t talked about by rigorous academics.
Knowledge at Wharton: What are some of the things you are looking at that you might not have looked at if you hadn’t had that influence in your life?
Milkman: Well one of my areas is looking at something I call the Fresh Start Effect. We’ve done research showing that at the beginning of new cycles in our lives, like the start of a new year would be a very obvious one to think about, but also the start of a new week, following birthdays, we have renewed self-control and extra motivation to pursue our goals.
And we find that people visit the gym at a higher rate at the beginning of these new cycles, for instance, and they’re more likely to search the term “diet” on Google at the start of these new cycles, and they’re more likely to create goal contracts on goal-setting websites. And that draws directly on Richard Thaler’s work, pointing out that we don’t treat time and money as if it is simply all the same and fungible; we actually use what he calls “mental accounts.”
So we think of time as having these categories, or money as having these categories, and we don’t move money around between the categories — or move time around. So a new year is a new account, it’s a new category, and we treat it differently. When we have that new year, in my work we show that it feels like a fresh start — we feel like all our failings from last year, that’s a separate category, it’s behind us.
And Richard has used this mental accounting theory to explain lots of anomalies in the way people engage with their personal finances among other things. So that’s an example of something that influenced my work.
Knowledge at Wharton: Regarding Thaler’s work, I read that, for example, if you create something called a heating account in your personal budget, you end up spending more on heating. How does one influence the other?
Milkman: The idea is that we treat money as if it is labeled. So say you get a gift certificate — this is the study I actually did in graduate school — to use at the grocery store where you shop for groceries every week. Say it’s for $10. Well you’re just $10 richer overall in all of life, right, because you were going to spend at least $10 at the grocery store next week anyway, since you go there every week.
But because you label money, instead of feeling like, “Oh, I have $10 dollars for whatever I want this week; I can go to the movies or out for lunch an extra time,” we feel like that money is labeled for groceries and we act richer in our grocery account. We actually go splurge and buy things like seafood that we wouldn’t normally buy instead of just buying whatever extra thing would make us happier in life.
So it’s a labeling phenomenon, when money comes in in one place, we think of it as only usable in that one place in spite of the fact that traditional economics would say we should recognize all money as totally fungible. It’s just another $10 in your pocket.
Knowledge at Wharton: What haven’t I asked you about Richard Thaler that would be important for people to understand?
Milkman: I think one of the most amazing things about Richard is how well he writes, and how simple his insights about human behavior are, and easy for anyone to appreciate. He’s actually the first scholar of behavioral economics whom I read when I was a graduate student actually studying computer science and business. I picked up a wonderful collection of his essays in a book called The Winner’s Curse about anomalies and the way that economic agents behave.
I was immediately captivated because it was so incredibly simple and elegant, and funny and true, and I think many of the scholars who have been influenced by him wouldn’t have been as influenced if it weren’t for his incredible ability to communicate in that way. So for anyone listening and anyone thinking about being either a scholar or a communicator in other ways, it just emphasizes the importance of clear, simple writing, and clear, simple examples to have a huge impact on the world.
Knowledge at Wharton: Is there any other kind of theory, or set of theories or ideas, out there that is emerging — that people are thinking about — that could be parallel to behavioral economics and that probably will turn out to be important, but people just don’t get it yet?
Milkman: Well, one of Richard Thaler’s disciples — and his disciples are all incredibly impressive in their own right — is Sendhil Mullainathan, an economist at Harvard who thinks the next big thing is how machine learning will change social science. And I think he’s on to something; I think that could be the next revolution in the social sciences — using machine learning to better predict everything.
Knowledge at Wharton: So we’re heading to a future of algorithms, I guess.
Milkman: Well, certainly a future where algorithms do more to help social science.
Mastering Innovation: From Idea to Value Creation
Become the catalyst for company-wide change when you learn how to construct the architecture that drives innovation in an organization.