Prize Lecture: Richard Thaler, The Sveriges Riksbank Prize in Economic Sciences 2017

thanks Magnus thanks to all the members of the committee and thanks for that great introduction so I've I've been interested in gravitational waves for a long tono so I I began this inquiry really with a series of stories stories and thought experiments and I thought what I would do in the lecture today is give you a sense of the path of behavioral economics how it started from these stories and thought experiments and we will end up with the Swedish Social Security system which is another experiment so maybe my most famous story involves a dinner party and a bowl of cashew nuts this was back when I was in graduate school a bunch of economists were coming over for dinner we put out a bowl of cashews and serve drinks and after a while about half the bowl had been consumed we were worried about our appetites and so I took the bowl and hid it in the kitchen and I think came back and first of all everybody thanked me thank God you got rid of those nuts and then since it was a group of economics graduate students we began to analyze it which shows you the danger of going to a dinner party with a group of economists and so the the analysis was a that we were happy and B that we were not allowed to be happy because it's a basic axiom of economics that more choices are always preferred to fewer and before we had the choice to eat the nuts or not and now we didn't so what were we doing being happy so how is it that having a choice removed can make us better off this led to a series of papers with my friend here schefren self-control my second story involves the then chairman of the Economics Department at the University of Rochester where I was studying who I followed in his footsteps in becoming a wine lover and so when I met him he had been collecting and drinking wine for a long time and had made some wise purchases early on possibly including even this bottle but for this story we're gonna say he bought a bottle for $4.95 and later was able to sell it for $100 and he had a rule that he wasn't willing to pay more than $30 for a bottle of wine but he sometimes would drink one of his old bottles well that's a puzzle if you're an economist he won't buy he won't sell but he will drink so that's kind of the economists reaction to this and that story eventually led to another research stream on what we'll call the endowment effect loss aversion status quo bias and so forth here's a third story these are all from the same vintage kind of when I was in grad school a friend and I were given tickets to a basketball game in Buffalo we were living in Rochester there was a big snowstorm and we wisely decided not to go to the game but my friend said had we bought those tickets we would have been we would go to that game now of course the economists call this the sunk cost fallacy and the question is why would anybody think going to the game helps so yes in that hypothetical where we had paid a lot of money for these tickets there would be that wasted money but going to the game wasn't gonna get that money back so why is it that there was this temptation to feel like we should go to the game if we had paid for the tickets and this and many other stories led to a research program on mental accounting so I then met these two guys these two young handsome guys here Amos Tversky and Daniel Kahneman and I got an idea from them the kind of that made my research possible they were busy studying how people make judgments this is before they wrote their famous paper on prospect theory and the idea related to earlier work by herb Simon it says okay people how are boundedly rational and so they use simple rules of thumb to help them make decisions and then here was the aha moment I got from reading their research which is that the use of these heuristics not only leads to errors economists would have no problem with that we know how to add an error the idea was that they would lead to systematic bias so an example is you can ask people what do they think is the ratio of gun deaths by homicide to gun deaths by suicide in the United States people think homicides are much more frequent cause of death in fact suicides are about twice as often that's an example of what they call the availability bias and it's just you can you can win bar bets based on their research so one lesson from these stories is that there's a bunch of things that economic theory tells us we can leave out and in fact makes the strong prediction that they simply will not matter I call these supposedly irrelevant factors and really my research can be summarized as there are a lot of these supposedly irrelevant factors that are not irrelevant they matter so I call these sifts supposedly irrelevant factors so my three little stories illustrate them if you push the cashews just even to the other side of the table as we've all done on occasion you know maybe with the prior of the delicious bread they insist on giving you in Swedish restaurants we pushing you to the other side of the table can help why in the world should that help you can reach over there and get it the location of the bread is as if the fact that professor rosette owned that bottle of wine is as if his willingness to drink it should not depend on whether he owns it assuming he can buy and sell at the same price and the sunk cost is another sip how much we paid for the tickets should affect our decision to go to the game so once we realize that there's this long list of sifts we can expand the predictive power of economic theory because a lot more stuff matters so how do we get from stories to science I'm gonna illustrate that with one experiment that I did with my friends Daniel Kahneman and Jack connect and you'll see the the mug here is place a crucial role in this my last remaining mug is now in the Nobel Museum so I stole these Legos from my grandchildren and you'll see they're gonna play a crucial role in in this little illustration so here's how the experiment works we start using a technique that was invented by Vernon Smith who shared the Nobel Prize with Danny Kahneman fifteen years ago and in using Vernon Smith's technique we assign values to people so we do that by saying if you end up with one of these tokens at the end of the experiment you can redeem it for the value indicated here then we assign tokens at random which we've done here and incidentally my friend linea who produced all these beautiful slides has assigned these at random in the way that condiment and Tversky would say is the most random looking way of a random the assigning took nicely done Linea so we've assigned these at random and now we conduct a market in which we allow people to trade so people who don't have tokens can buy them people who have tokens can sell them and then we see what happens and this is what happens which is exactly what is supposed to happen and this is an example of what's called the Coase theorem named after Ronald Coase in 1991 Nobel laureate his basic idea is that in a market where transaction costs are low as they are in this experiment then the initial assignment of property rights which in this case was done at random will not affect the eventual allocation of resources and we see that's true here the people the guys the Legos on the top row who really love tokens end up with all the tokens okay now we have the Legos back and here the values we've now arranged the Legos in the order in which they like a Cornell coffee mug so that guy in the left really wants one of those mugs it's worth twenty dollars to him whereas whoever that guy is in the bottom right Wood has no interest in a Cornell mug maybe it doesn't like Cornell or it doesn't love coffee or what-have-you so now we're gonna do the same random assignment coincidentally just the same way in the very random looking assignment and now we're gonna do a another market just the way we did with tokens and if the Coase theorem worked again the people who love the mugs most would end up with all the mugs what actually happened well we got about a third as much trading as we should have and the reason for that was that the people who had mugs didn't want to give them up but the people who didn't have mugs were not that interested in buying one so what did we learn from this two things one is we can't learn much about human behavior by running experiments in which we assign values to people because that's not the way life works when we go into the market there's nobody telling us what we should pay for that loaf of bread or that bundle of Swedish meatballs and when we deal with the real world then we observe two little trading why well it's kind of over determined part of it is loss aversion the idea that it hurts more to give something up than to acquire it and there's also something called status quo bias which we will see again later where people tend to stick with whatever they have and there are other factors that are reinforcing these we know what we have and we kind of like it and something else we're not sure what what we would get and then there's just our basic laziness that the sort of thing that when we're watching television we can find ourselves watching the show that comes on on the same station we've been watching even though the cost of switching is exactly one thumb click so as Magnus mentioned one of the questions we asked in behavioral economics is what happens if we relaxed assumptions of unlimited rationality and unlimited willpower so we deal with humans and suppose that these humans are not all as smart as Einstein and don't have perfect self-control they're more like Homer Simpson then what well let's take another Nobel prize-winning theory this one from Franco Modigliani that's called the life cycle hypothesis this is the standard economic model of saving for retirement so let me just illustrate how that's supposed to work it's basically two steps first figure out how much you expect to make over your lifetime how long you're gonna live then decide how you'd like to smooth consumption over that lifetime and then do it so here's an illustration here's a very simple case suppose your income is going to steadily increase until you reach 65 at which point you retire and stop earning money and suppose you wanted to have a perfectly flat consumption profile then you would borrow early in your life you would save later in your life and then you would just save and you would when you were 20 you would formulate that plan and then you would do it now of course life is more complicated than that for example income might have unexpected changes so oops you get laid off and you go to Silicon Valley and make a bundle of my UPS there's a the startup doesn't do so well but then you write them then you write a book so you know that that's those are income surprises we can have consumption surprises that sports car was irresistible kids move back in kids don't even think about it maybe the grandchildren they're cute but then you know you get old and all kinds of stuff happens that you don't anticipate so you can see this is hard and so people might need some help and the econ's in economic theory don't need any help they can just figure all this out they can figure out what they need to do and they don't have any self-control problems so they just do it now this is a new problem that humans face we've been around for millions of years they tell us and for most of our time on earth saving for retirement was not something anyone needed to worry about the reason is you would die first so those that did manage to live long enough to be able to stop working the solution was move in with their kids who conveniently were living next door and still were willing to have their parents move in and then in the 20th century these norms started to break down the kids moved away parents started living longer and so we had to solve this problem and some of the solutions the early solutions were things like social security systems and companies sponsoring defined benefit pension plans and those are the old plans where what you you got an annuity based on how long you worked and what you made and these plans were very easy for us humans because there were no choices you just you got taxed on your income and then you got your Social Security payments the same with your job you worked there were you there were this the retirement was all in the background and then when you retired you got this annuity and life was easy well firms and countries discovered that especially pay-as-you-go pension plans can lead to problems and so they created new strategies called defined contribution plans and in these are much harder for humans humans have to decide whether to join the plan and then if they join how much to save and then if they and then how to invest that money and some people don't bother to join those who join may not save enough or may not invest particularly wisely and notice that the traditional model is of no help whatsoever in solving this problem because it assumes people have solved it and if they're not saving enough well that's because they don't expect to live very long or are happy not having very much when they retire so if they're just saving the right amount you have no advice to give them and and there's no reason to offer them help so how can behavioral economics help well one way is using what Cass Sunstein and I refer to as choice architecture so choice architecture is the environment in which we make decisions so one example is a menu if you go to a restaurant the chef has decided what he or she wants to cook but there's somebody at the restaurant whose job is to write that down into a menu and it could be a simple menu you can have a four-course or a six-course dinner and you have no choices or it could be you know one of these menus at a Chinese restaurant that seems to be endless and so one lesson from Averill economics is that what you order will depend on the structure of the menu and in an Italian restaurant if the pasta courses are in a separate category people will order differently than if they are mixed in with the other appetizers or entrees store layouts again if you assume people just go to the store and buy the optimal bundle then the way the store is arranged won't matter it'll be another SIF but stores have learned that's not right and they spend a lot of money figuring out how they want you to walk through a supermarket and make sure you pass by the things that are most profitable and they stick things like milk in the back of the store because that's the thing you buy most often and you're be sure to walk by a lot of tempting other things when you go by places like Amazon of course I've spent billions thinking about choice architecture so one of the lessons of choice architecture and the title of the book Cass and I wrote is that the choice architecture can influence what we pick because it will include what we call nudges so what are nudges dodges are features of the environment that influence the behavior of humans but would not influence the behavior of econ so we're an item is on the menu doesn't affect Homo economicus but it does affect us so the feature of nudges that we stress in our book is that nudges are a way to influence choices without forcing anyone to do anything and we called the philosophy we espoused libertarian paternalism many people did think this phrase was an oxymoron we wrote a paper called libertarian paternalism is not an oxymoron a law professor wrote another paper saying libertarian paternalism is an oxymoron I was lobbying with gas that we should write a rejoinder that says no it's not Reason prevailed so what are some nudges maybe the most powerful nudge we have in our arsenal is simply to change the default so what what is the default the default is simply what happens if you do nothing now we're really good at doing nothing passivity is one of humans greatest skills so an application of this idea in the domain of pension plans is what's come to be known as automatic enrollment so in the old system when you were first eligible for the pension plan you there were a bunch of forms you had to fill out and you'd have to decide how much to save and then how to invest there could be a big long pile of these forms some people like my friend castes are very norm averse forum averse and if caste has to fill out a form he's almost certain not to do it so what does automatic enrollment do it says you get the same pile of forms but on the top page it says if you don't fill these forms out we will enroll you in the pension plan at this saving rate and in this fund and you don't have to do anything so that's a SIF right the default is this if it takes a minute or two to fill out these forms so it shouldn't matter does it matter yes big time so this is some data from Vanguard that administers thousands of these plans the purple lines are the percentage of people that are enrolled for plants that use automatic enrollment the gray lines are for those that don't and you can see for any income group about 90% of the people join if we use automatic enrollment much less for other groups particularly for lower income groups so this this is this is a nudge that's particularly effective at helping lower-income people save for retirement well there's a problem with automatic enrollment and that is that particularly in the United States the firms that employ this strategy almost universally enroll people at too low of a level often 3% of income that is not enough to save for retirement so how can we solve this problem my former students loma been artsy and i took this on and what we decided to do is think about this starting with the psychology and and ask well what is it that's preventing people from saving enough well one is self control problems we can go out for a fancy dinner tonight that's tempting we're are saving for retirement that's some time off in the future and we know people have more self control for the future then for now many of us are planning diets not this week certainly maybe after the new year the second is loss aversion that i've previously mentioned people don't like to see their income go down so we wanted to take that into consideration and then inertia people are good at doing nothing so our idea was we know these things are preventing people from saving let's flip the problem around and use those to create a plan that will take those weaknesses if you want to call it that and use them to help so the plan we created who we called save more tomorrow and the basic idea was to invite people now to save more later because self-control is easier for later it's like the our diet plan that will start in January and particularly to invite them to save more when they get their next raise so they won't see their income go down that will eliminate the loss aversion and then we're gonna keep that up until they hit some goal so we'll get inertia working for us so we spent years trying to get any company to try this and we finally found one in Chicago and in this particular implementation the company it was a small company they hired a financial advisor and offered his services to any employee it was about 300 employees and for most of them he the advisor said we think you should save at least five percentage points more and most of the employees said that you're nuts I can't afford that so then and only then were they offered the same or tomorrow plan and it was a quite an aggressive one they're saving was increased by three percentage points every time they got a raise so notice this is all a SIF right with life cycle savers a they would have no interest in joining save more tomorrow because they're already saving the right amount and if it was put in they would undo it because they are already saving the right amount so so it shouldn't work a no one should join and be their behavior won't change well let's see what happened the first line of this chart are the people who said they didn't want to talk to this financial advisor and you can see the inertia in this system these numbers fluctuate a little it's not that anyone is doing anything it's in there's attrition so we some people leave the company then here is the group that took the advice to go up by five percentage points you can see they did that and then stopped then here are our guys and you can see we almost quadrupled saving rates using supposedly irrelevant factors now a question we asked and we were asked at hundreds of workshops yes but maybe you get them to save more over here but then they're undoing it somewhere else that you can't see and for 30 years or so I was trying to figure out how to test and possibly reject this alternative hypothesis I never could find the data that would allow me to do that fortunately in Scandinavia there are no secrets and so the great young economist rush Shetty and some colleagues were able to test this hypothesis in nearby Denmark and here's essentially what they did they looked at people who switched jobs where their pension contributions went up by at least three percentage points and you can see what happens to their pension saving it goes up and they write so this is people being passive the way we've seen in the other things I've shown you so far but what are they doing in their other behavior here's their company pensions nothing here's their other saving nothing so no we're not stealing from some other pot it's all net saving okay let me end with some new research I've been doing with two of my former students Henrik cronquist who's Swedish and Frank you who's not this is a multinational team and it involves as the locals may know in 2000 Whedon introduced something they called the premium pension system and it has the following key features there's a 16% payroll tax that goes to fund Social Security 2.5 percent is directed toward this new premium pension system there were four hundred and fifty options in this plan essentially any mutual fund approved by the EU that wanted to get in was allowed in now when it was launched the system had two nudges now they weren't called nudges because we hadn't coined that term yet but they were not just nonetheless so nudge number one was there was a default if you didn't fill out a form then you would be given this default fund with the spiffy title a p7 and so anybody who didn't want to make a choice was in that fund and then some people who attractive and was actually a pretty well-designed fund with low fees they would also get that that choice that fund has done pretty well so all the economists I know here claim they actively picked it I want to tell those people we now have your data so we're gonna be checking so we're gonna call these delegate errs they delegate their investment decisions to the people at a p7 nudge number two and this one is a bit curious the government decided that in spite of creating this 13 basis point globally diversified fund really people should choose their own portfolios from this array of 450 funds and they launched a big advertising campaign saying choose for yourself it's your duty as a Swedish citizen to create the best possible portfolio so the government advertised that was the largest advertising campaign in Swedish history it was supplemented by funds advertising as well saying yes choose for yourself and in particular choose our fund these ads were not particularly informative here's here's one so Indiana Jones thinks you should invest in whatever this fund is it's kind of a scary picture I'm not my wife used to teach advertising I don't know whether she would approve of this ad but anyway there were those ads and so what happened we have a battle of the nudges the default versus the urging which one our Theory doesn't tell us anything about that but the the ad campaign won so 2/3 of Swedish citizens decided to form their own portfolios the rest took the default now since then new people entered the system mostly young people entering the workforce for the volta first time or immigrants the advertising campaigns stopped both the government and the funds stopped advertising and there were some lingering effects of those some people are joining just a month after the campaign ended but then it wore out and here's what happened so you can see this is year one when two thirds of the people chose their own portfolios that tapered off and in recent years almost no one is choosing their own portfolio those numbers on the right are about half a percent so that's kind of interesting right so but one of the questions we're interested in is well how long do not just last right so those guys on the left were well actually until 2008 they were locked in there was an obscure rule the justification of which no one has been able to explain to me but if you maybe somebody here knows but if you turn down the default fund you weren't allowed to take it later until 2008 then they changed that rule but so one of the question is those guys who were nudged to be individualistic did they stay that way and if so that'd be interesting because almost no one has chosen to do that since so 27 percent of the people in the default fund have left and decided to become do-it-yourselfers but essentially no one that started as into it yourselfer has switched their so this nudge has lasted more or less forever and that's in spite of the fact that the default fund has had drastic changes so in 2010 the managers of the fund decided they wanted to juice the returns well hopefully so they decided to add leverage you know what does that mean technically they were borrowing and buying options but the details of that are not important you they initially had a hundred and twenty five percent leverage meaning that if the market went up 10% the fund would go up 12 then they switch to 50% leverage so 50 percent leverage means that if the market goes up 10% you go up 15% but if the market Falls 10% the fund Falls 15% now in hindsight these guys look like geniuses since the market has pretty much steadily gone up since they took these but we can ask what would happen if we had another financial crisis so what would this fund have done in the period 2006 to 2008 the answer is down 82% so you know this is a pretty big change and so a question that Frank and Henrik and I have been exploring is did anybody notice this so by the way there are now 900 funds because 450 really wouldn't do so and one of those 900 funds is identical to the default fund but has no leverage so it was possible if you liked the thing you were in and these guys in the room and I know who you are who claim they picked the default fund by choice in their wisdom I'm looking at you pear presumably they were picking an unlevered fund and you know might have noticed that this thing has gotten a lot of risk maybe I should switch into this other fund that's just like the one I allegedly actively picked so did anyone notice so here's a plot of the leverage over time this is the number of people that were leaving the default fund I don't know whether you can read those numbers the scale goes from 0 to 400 maybe up to 600 there are 3 million investors in this fund so our conclusion is we cannot reject the hypothesis that 3 million Swedish investors are asleep they may be asleep we cannot rule that out they certainly are not deserting the fund in droves so what can we conclude from this the first is nudges can be quite powerful both the nudge of creating a default which has recently been all powerful and the earlier nudge saying please don't take the default that was also very powerful second and this we've never been able to test before Thank You Sweden for giving us this opportunity we now know nudges can last at least 17 years possibly longer and it's suggesting a new marketing campaign for our nudging efforts so let me conclude it is possible many people told me early on it's just not possible to do economics any other way it wouldn't be economics so that's not true it's possible to do economics without homo economics sorry second if we learn from other social scientists we can improve economics we can increase its explanatory power and it can give us all kinds of new tools that we can use to improve people's outcomes so in short we can nudge for good thank you [Applause]

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Length: 49min 45sec (2985 seconds)

Published: Fri Dec 08 2017