REPORT ABOUT RICHARD THALER’S WORK – CONTRIBUTIONS TO

BEHAVIORAL ECONOMICS

Presented by:

Viral Shah
Thibault Bastide
Sana Samad
Cytlali Murrieta Figueroa

Professor:
Patricia Charlety-Lepers

December 18th, 2023 Cergy, France

Table of Contents

MOTIVATION................................................................................................................. 3
BIOGRAPHY ................................................................................................................... 4
BOUNDED RATIONALITY ................................................................................................ 4
Early Work: ..........................................................................................................................4
Loss Aversion and Endowment Effect: ................................................................................5
Mental Accounting: .............................................................................................................6
LIMITED SELF-CONTROL ................................................................................................. 7
Early Work: ..........................................................................................................................7
Planner-Doer Model:...........................................................................................................8
Nudges:................................................................................................................................8
SOCIAL PREFERENCES .................................................................................................... 9
Early Work: ..........................................................................................................................9
Fairness in Pricing and Wage-setting: .................................................................................9
Fairness in Individual Interactions: ...................................................................................10
CONCLUSION ............................................................................................................... 11
MOTIVATION
Our motivation for choosing Richard Thaler is his groundbreaking contribution to behavioral
economics. Unlike traditional economic theories that assume rational decision-making, Thaler’s
work illuminated the complexities of human behavior in economic contexts. His research
showcased how individuals often diverge from rationality due to cognitive biases and emotional
influences, altering the expected economic outcomes.

Thaler's concepts, notably "nudge theory," emphasize the significance of choice architecture in
shaping decisions. This notion suggests that subtle changes in how choices are presented can
significantly impact people's decisions. Such insights have profound implications, not just in
academia but also in real-world applications across policymaking, finance, and consumer
behavior.

By studying Thaler’s work, we can be part of a paradigm shift in economics, recognizing the
integration of psychology, sociology, and cognitive sciences within the discipline. The
interdisciplinary approach expands the traditional boundaries of economic theory and offers a
richer understanding of human decision-making processes. Thaler’s approach challenges
conventional economic models, prompting reconsideration of how individuals behave in specific
economic environments. He acknowledges human fallibility and the impact of psychological
factors in financial decision-making, ultimately enriching theoretical understanding and practical
applications within the field.
BIOGRAPHY
Born on September 12, 1945, in East Orange and raised in Chatham, New Jersey, USA, Thaler
embarked on an academic journey that culminated in an illustrious career in economics. He studied
at Case Western Reserve University (BA) and the University of Rochester (MA, PhD). His
academic tenure started at the University of Rochester in 1974, where he began exploring
economic decision-making.

From Earl (2018), we know that Thaler's pivotal transition occurred during his tenure at Stanford
University in 1977–1978, where he had the opportunity to collaborate and learn from influential
figures such as Daniel Kahneman and Amos Tversky, pioneers in experimental economics. This
pivotal encounter laid the foundation for exploring the economic implications of bias-inducing
heuristics on decision-making, incorporating Kahneman and Tversky's Prospect Theory into
economic paradigms.

Earl categorizes Thaler's contributions to economics into three fundamental domains. Firstly,
Thaler meticulously exposed the limitations of rational choice theory, utilizing the perspectives of
Kahneman and Tversky to decipher various anomalies in economic behavior. Secondly, he
developed the theory of 'mental accounting,' unraveling how consumers respond to diverse pricing
strategies. Thirdly, in collaboration with Cass Sunstein, he pioneered the concept of 'libertarian
paternalism,' delving into its practical implications for policymaking, notably through the 'nudge'
technique.

We can say that his impact is extended beyond academia. His ability to articulate complex
economic concepts through relatable everyday examples significantly elevated behavioral
economics public profile and policy influence. He played a crucial role in integrating behavioral
economics into the mainstream economics curriculum, as mentioned by Sent in an article from
2004.

Thaler's success illustrates a unique approach to economics. He didn't rely solely on encyclopedic
knowledge or technical expertise but observed human behavior, reflected on conventional
economic implications, and critiqued theories through practical insights. His ability to adapt and
challenge established norms, as seen in his seminar interaction with Ken Binmore, exemplifies his
innovative approach. Finally, lucky connections played a crucial role in shaping Thaler's trajectory.
His encounter with psychologists Baruch Fischhoff and Paul Slovic exposed him to Kahneman
and Tversky's Prospect Theory, a vital moment that fueled his exploration into phenomena like the
'endowment effect.' (Earl, 2018) (1)

BOUNDED RATIONALITY

Early Work:

The journey of behavioral economics was started with von Neumann and Morgenstern's
groundbreaking work in 1944. They pioneered expected-utility theory as a standard for rational
decision-making, a concept that continues to influence our understanding of individual choices.
Yet, Maurice Allais, awarded the 1988 Laureate in Economic Sciences, observed as early as 1951
that real-world behaviors often stray from the theory's predictions, a notion he expanded upon in
1953.

In 2002, the realm of psychology and economics intersected significantly when Daniel Kahneman,
a psychologist, earned the Economics Prize. His collaborative work with Amos Tversky,
particularly their 1979 development of prospect theory, sought to depict more accurately how
people make decisions under risk, acknowledging that these choices might not always align with
rationality or optimality.

We then see Richard Thaler's influential role starting in 1980. Thaler, an economist, was
instrumental in applying Kahneman and Tversky's prospect theory to broader economic contexts.
His focus extended beyond just risky decisions to underscore the significance of reference points
and loss aversion in more predictable situations. His contributions not only expanded the
application of Kahneman and Tversky's 1979 theory (2) but also played a key role in making their
work widely cited and respected within the economic community, as noted by Barberis in 2013 (3).

Through this narrative, we understand the evolving landscape of behavioral economics, marked
by a blend of psychology and traditional economic theory to better grasp how individuals make
decisions.

Loss Aversion and Endowment Effect:

During his Ph.D. research at the University of Rochester, which he successfully defended in 1974,
Richard Thaler began exploring the valuation of mortality risk reductions. This exploration is
exemplified in his 1980 paper through two hypothetical survey questions:

One question asks us to consider the maximum amount we'd be willing to pay for a cure if exposed
to a deadly disease with a low probability of contraction (p=0.005).

The other asks for the minimum compensation we'd require to volunteer for research involving a
similar risk of contracting the disease, without the option to purchase the cure (again p=0.005).

We observe through Thaler's studies a distinct trend: people generally demonstrate a lower
willingness to pay for gaining health compared to their demands for compensation to risk losing
health. In his 1980 analysis, Thaler links this phenomenon to prospect theory. He points out that
when relinquishing an item is perceived as a loss, individuals who are averse to loss will value
possessions they own higher than similar items they do not own. He names this phenomenon the
"endowment effect," providing an explanation for the significant gaps we see between willingness
to pay (WTP) and willingness to accept (WTA).

Further, we learn from Thaler that the endowment effect creates a distinction between out-of-
pocket expenses and opportunity costs. Out-of-pocket costs are often seen as more significant
losses, while opportunity costs are perceived as lesser foregone gains. Thaler highlights how
companies capitalize on this effect in their marketing strategies. For example, they may frame
additional charges as missed opportunities for cash discounts, instead of direct surcharges for using
credit cards.

An important implication of the endowment effect, as we understand from Thaler's work, is its
influence on the allocation of property rights and resource distribution. This insight challenges the
Coase theorem, which posits that without transaction costs and income effects, initial allocations
of property rights do not impact final resource distributions. Thaler's findings suggest otherwise,
indicating a fundamental revaluation in the fields of law and economics.

Mental Accounting:

We dive into Richard Thaler's significant advancements in behavioral economics, beginning with
his reimagining of the endowment effect in 1980 (1). Thaler's approach diverged from traditional
economic models, suggesting that individuals' preference maximization hinges on specific
reference points, particularly their current possessions. This perspective offered a dynamic view
of preference formation, contrasting with the static utility maximization in classical economic
theory.

In his subsequent work, notably in 1985 (4) and 1999 (5), Thaler developed the concept of mental
accounting. This theory, grounded in psychology, explores the impact of cognitive limitations on
household spending and saving behaviors. We recognize that individuals tend to organize their
expenses into distinct mental categories, each with its own budget and reference point. Thaler's
insights suggest that these mental categories help individuals with limited rationality streamline
their financial decisions, leading to a constrained interchangeability among different accounts. The
value we assign to money, therefore, can vary based on its allocated mental account, shaped by
contextual and situational factors.

Thaler also identified that segregating financial categories serves as a safeguard against excessive
spending, especially on discretionary or addictive purchases. Keeping savings in a separate mental
account, distinct in its reference value, can discourage using these funds for impulsive
expenditures. Moreover, Thaler's theory introduces the notion of diminishing sensitivity, which
explains how individuals handle risk differently for gains and losses. According to this principle,
people prefer to separate gains while combining losses, aiming to lessen the impact of minor losses
against more substantial gains, and in some instances, to isolate modest gains from significant
losses.

Another key aspect of Thaler's work is the concept of transaction utility. This concept revolves
around the disparity between the actual price paid and the consumer's preconceived reference
price. He posits that a product is perceived as a value if it's cheaper than the reference price, but as
overpriced if it exceeds it. This perceived value, or lack thereof, influences purchasing decisions,
balancing against the utility derived from the product itself. Thaler's 'beer at the beach' experiment
serves as a classic example, demonstrating how consumer willingness to pay is influenced by
factors beyond the product's inherent attributes. This insight disrupts traditional economic theory
by showing that consumer perception of value can be swayed by external factors like the type of
vendor.
In discussing pricing strategies, Thaler explains why promotions like 'weekly specials' often
surpass strategies like 'everyday low prices,' despite similar overall cost implications. He suggests
that the allure of a perceived bargain often outweighs the benefit of consistently modest pricing.
Finally, in their 1990 study (6), Thaler and Johnson introduced the concepts of the "house-money
effect" and the "break-even effect." They found that individuals tend to become more risk-tolerant
with recent gains, such as gambling winnings, and show an increased inclination towards risk in
attempts to recover past losses. These behaviors were further corroborated in high-stakes
scenarios, like on the game show 'Deal or No Deal'. Through these groundbreaking theories, Thaler
significantly enriched our understanding of economic behavior, intertwining psychological
insights with economic principles to unravel the complexities of financial decision-making.

LIMITED SELF-CONTROL

Early Work:

We delve into the longstanding inquiry, dating back to Aristotle's exploration of akrasia or
weakness of will, about why individuals sometimes fail to act in accordance with what they know
is right. This topic gained momentum in psychology with Freud's contributions in 1955. In the
1960s, psychologist Walter Mischel further invigorated the discussion with his marshmallow test,
examining children's self-control in delaying gratification (Mischel, 2014) (7).

In 1956, Strotz proposed the theory that individuals naturally tend to prioritize immediate
consumption, challenging the standard model of exponential discounting. He observed that people
discount the near future more heavily than more distant future periods. This observation is a
particular instance of hyperbolic discounting, a term coined by Ainslie in 1992, referring to a
general "present-biased" discount function. Strotz demonstrated how hyperbolic discounting
creates time-inconsistency problems, where one's present self prefers to save more in the future,
but the future self tends to resist this plan. This idea of conflicting selves in intertemporal choice
was also explored by Allais (1947) and Thomas Schelling (1960, 1978; 2006 Laureate in Economic
Sciences) (8).

In 1981, Thaler conducted groundbreaking experimental research, providing the first evidence of
hyperbolic discounting in humans. His experiments involved subjects making hypothetical choices
between different time horizons, revealing that discounting is significantly steeper between the
present and near future compared to more distant periods. Thaler also discovered that gains are
discounted more heavily than losses, and smaller outcomes are discounted more than larger ones.

Thaler's findings sparked an increased interest among economists in self-control issues and time-
inconsistent preferences. The discounting patterns he identified have been validated in numerous
subsequent studies, as reviewed by Frederick et al. (2002) (9). Hyperbolic discounting helps explain
various perplexing behaviors, such as why individuals intending to quit smoking often delay their
decision. It also creates a natural demand for commitment technologies, which are absent in the
traditional exponential-discounting model. Examples of such commitment devices include
"Christmas Clubs," as mentioned by Strotz and Thaler, where people commit to saving for
Christmas expenses, drugs like Xenical and Antabuse that deter overeating and alcohol
consumption, respectively, and practical rules like avoiding shopping when hungry or not keeping
alcohol at home. These devices and strategies represent tangible applications of the principles of
hyperbolic discounting in everyday life.

Planner-Doer Model:

In response to deviations from traditional exponential discounting, Thaler, in collaboration with

Hersh Shefrin, developed the planner-doer model (Thaler & Shefrin, 1981; Shefrin & Thaler,
1988) (10). This model introduces the concept of an individual possessing two distinct selves: a
myopic doer focused on immediate utility, and a farsighted planner concerned with maximizing
lifetime utility (discounted present value).

Unlike the Strotz model, which posits a conflict between the current self and the future self, the
planner-doer model presents a simultaneous internal conflict between the planner and the doer. In
this dynamic, the planner seeks to optimize lifetime utility, which often involves curbing the doer's
inclination for immediate gratification. This restraint can be exercised either through the exertion
of costly willpower or by setting self-imposed rules that limit the doer's choices.

The planner-doer model encapsulates the idea that resisting temptation involves a psychic cost.
The application of costly willpower to control the doer's impulses indicates that the level of self-
control is not a fixed attribute but varies based on individual characteristics. Hence, people exhibit
varying degrees of self-control. Empirical evidence supports several predictions made by the
planner-doer model. For example, the model suggests that mandatory pension plans would boost
total savings, as these plans generate savings without the psychic costs typically associated with
willpower. This hypothesis finds support in a study by Chetty et al. (2014) (11). Additionally, the
model anticipates that the marginal rate of time preference will be higher than the after-tax interest
rate, owing to self-imposed borrowing constraints. Both Thaler and Shefrin (1988) and later studies
(Harrison et al. 2002, Attema et al. 2016) (12) confirm this prediction, finding that estimates of the
marginal rate of time preference significantly surpass interest rates.

Nudges:

In our exploration of how behavioral economics can guide individuals with limited cognitive
abilities and willpower towards better decision-making, we turn to Thaler's innovative concept of
libertarian paternalism. Alongside Sunstein, Thaler has advocated for policies that subtly guide
people towards more beneficial choices while preserving freedom of choice. This approach focuses
on the design of choice architecture, the environment in which decisions are made.

A key strategy in this approach is the use of nudges, particularly in setting default options.
Organizations often pre-define these default options, which many individuals tend to stick with.
Significant impacts of this strategy have been observed in fields like organ donation and retirement
savings. The design of default options, as highlighted by Madrian and Shea and further developed
in Thaler and Shlomo Benartzi's work, is a prime example. These nudges aim to enhance pension
savings, addressing common cognitive biases such as loss aversion and status quo bias.
The "Save More Tomorrow" plan, co-created by Thaler and Benartzi, illustrates this approach
well. It involves employers setting a retirement savings plan as the default, with a low initial
contribution rate that gradually increases as incomes rise. This approach helps counter loss
aversion and encourages employees to save more for retirement without reducing their take-home
pay unless they choose to opt-out.

Nudges are not only beneficial for individuals but can also serve broader societal interests. For
instance, Thaler's collaboration with the UK’s Behavioral Insights Team aimed to expedite tax
payments by appealing to people's desire to conform to social norms, reminding them that most
people pay taxes on time. However, nudges can have varied outcomes. In healthcare, for example,
nudging women over 50 to undergo mammograms might result in different experiences – from
early cancer detection to unnecessary stress due to false alarms. This highlights the importance of
carefully considering the potential impacts of nudges. While libertarian paternalism champions
nudges to improve decision-making, it's crucial to recognize that not all nudges lead to positive
outcomes for everyone involved. Therefore, a balanced approach is needed to ensure that nudges
are implemented ethically and effectively.

SOCIAL PREFERENCES

Early Work:

In understanding human behavior, we often start with the assumption that people act in their own
self-interest. However, as Adam Smith observed in 1759, social motivations like fairness and
equity also significantly influence decisions. Expanding on this idea, Gary Becker, the 1992
Laureate in Economic Sciences, developed a formal framework showing how individuals might
consider the well-being of others in their actions (Becker, 1974). Similarly, Amartya Sen, awarded
in 1998, distinguished between sympathy (altruism) and commitment in human motivations. He
noted that while sympathy directly affects one's own welfare, commitment is driven by moral
principles of right and wrong (Sen, 1977) (13).

In the 1980s, Thaler's research played a crucial role in highlighting fairness as a key economic
research area. His theory of mental accounting proposed that perceived fairness is a critical factor
in determining transaction utility (Thaler, 1985) (14). Collaborating with Kahneman and Knetsch,
Thaler developed innovative experiments that revealed three significant aspects of fairness in
interpersonal interactions: firstly, some individuals display fair behavior even in anonymous
settings where reputational concerns are absent; secondly, certain individuals are ready to sacrifice
resources to penalize those who have treated them unfairly; and thirdly, there are individuals who
will forfeit resources to sanction unfair actions and violations of norms, even when such actions
are directed at others, not themselves.

Fairness in Pricing and Wage-setting:

To investigate the impact of perceived fairness in consumer markets, Kahneman, Knetsch, and
Thaler (1986b) (15) conducted surveys in Toronto and Vancouver. They asked respondents to
evaluate the fairness of various hypothetical scenarios.
One such scenario involved a hardware store raising the price of snow shovels from $15 to $20
after a heavy snowstorm. Here, a significant majority (82%) of respondents labeled the price hike
as unfair, combining responses of "Unfair" and "Very Unfair" into a single category.

This study also highlighted the importance of how price changes are framed. For example, a $200
increase in a new car's price is perceived as more unfair when presented as a hike in the list price
rather than a reduced discount on the same. This aligns with the concept of loss aversion, where a
direct price increase is seen as a loss, whereas a reduced discount is viewed as a smaller gain.

Furthermore, Thaler and his colleagues noted that the context of a price change affects its perceived
fairness. Consumers generally accept price increases due to higher input costs but not when they
result from increased market power. Raising snow shovel prices following a storm is an example
of the latter.

Kahneman, Knetsch, and Thaler's work led to several insights about fairness in markets. They
observed that markets might not adjust quickly to demand shocks due to the perceived unfairness
of raising prices. When a supplier offers a range of goods without input price variation, charging
more for the most valued item is seen as unfair. Additionally, prices tend to respond more to cost
changes than demand fluctuations, as cost-related price increases are more socially acceptable.

Their research also extended to labor markets, exploring the role of fairness in wage dynamics.
They found that employers are hesitant to cut nominal wages during recessions due to concerns
about perceived unfairness and potential retaliation from employees. Interestingly, they discovered
that a nominal wage cut without inflation is viewed as much more unfair than a constant nominal
wage with inflation, even if the real wage decrease is the same. This finding supports the concept
of money illusion and its real effects, as further evidenced by Fehr and Tyran's experimental work
in 2001 (16).

Fairness in Individual Interactions:

To explore fairness and generosity in individual behaviors, Kahneman, Knetsch, and Thaler
(1986a) (15) devised an experiment known as the dictator game. In this study, undergraduate
students at Cornell University were given $20 and asked to share it with an anonymous classmate.
They had two choices: an unequal division ($18 for themselves and $2 for the other) or an equal
split ($10 each). Despite the option to maximize their own gain, 76% of the students chose the
equal split, demonstrating a preference for fairness or equity over personal monetary gain, even in
anonymous interactions without reputational concerns.

In the second part of the experiment, students were paired with two others who had made different
choices in the first part. The students were presented with two allocation options: either $5 for
themselves and the student who chose equally in the first part, with nothing for the student who
took $18, or $6 for themselves and the student who took $18, with nothing for the student who
split equally. Remarkably, 74% chose the first option, sacrificing personal gain to reward fairness
and punish selfishness, even when they were not personally harmed by unfair behavior.

This study laid the groundwork for later "third-party punishment" experiments by Fehr and
Fischbacher (2004) and highlighted the concept of indirect reciprocity, as discussed by Nowak
(2007) (17). The research on social preferences and reciprocity has since grown extensively,
incorporating both laboratory and field experiments as well as theoretical models.

CONCLUSION
Thaler's work in behavioral economics is widely recognized for its influence in challenging
traditional economic ideas. Unlike some behavioral economists of the past who questioned the
very roots of conservative economics, Thaler has focused on areas where traditional economic
theories have failed in explaining real-world behavior in a strategic way. His main emphasis was
on heuristics and biases, which were cognitive shortcuts and errors in judgment. Thaler’s work is
often referred to as ‘misbehaving’, and Thaler’s work is known for focusing on how people move
away from making perfectly rational decisions.

However, some critics point to limitations in his approach. One notable criticism is that Thaler’s
work focuses more on consumer reactions and less on decisions heard within firms. This narrow
focus can limit the overall understanding of how the human mind deals with various challenges.
The study suggests that Thaler's success in basic economics may be due to its alignment with
traditional methods. Despite the increased interest in Thaler-style behavioral economics, the
traditional economics approach still retains its status as the benchmark.

In contrast to other approaches that advocate rethinking the traditional model, Thaler is consistent
with standard rational choice theory. This dichotomy reflects a broader debate in behavioral
economics about whether paradoxes can be explained within an existing framework. Some view
Thaler's success in basic economics as a strategic counterpoint to the current paradigm. While its
empirical focus has led to the recognition of the limitations of the traditional approach, it has not
led to significant changes from it. Critics insist that Thaler’s work primarily analyzes consumer
behavior, neglecting institutional decision-making. This limited approach contrasts with the more
comprehensive approach advocated by scholars who advocate a holistic understanding of how
individuals and firms make choices. Thaler’s emphasis on heuristics and biases, while shedding
light on irrational decision making, has also faced criticism. Some argue that this approach portrays
people as inherently pathologically flawed, potentially ignoring alternative perspectives from
personality theory and social psychology Compared to other perspectives, it reveals different
perspectives on how individuals interpret and respond to information. For example, Thaler sees
the framing effect as evidence of irrational attitudes, while others suggest that it may be due to
individuals applying ‘social wisdom’ in incomplete terms.

Thaler’s ideas have had a profound impact on the business environment, especially in shaping
marketing strategies and pricing decisions. His emphasis on behavioral economics has led
companies to take a more nuanced approach to understanding and influencing consumer behavior.
Companies are now recognizing the importance of shaping consumer choices and providing
strategic information to influence opinion. Additionally, Thaler’s insights into fairness and social
priorities have influenced corporate practice, particularly in areas such as pricing. Companies
consider not only economic principles but also the psychological aspects of fairness when pricing,
finding that consumer perceptions of fairness can have a significant impact on purchase decisions.
Thaler’s project helped businesses incorporate behavioral considerations into their decision-
making processes. In conclusion, Richard Thaler’s groundbreaking work in behavioral economics
has left an indelible mark on the field, changing the way economists and firms see decision-making
processes.

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