Richard Thaler awarded nobel prize in 2017 for his ground-breaking contributions to Behavioral Economics. He has incorporated insight from psychology into analysis of economic decision making. He explored how human traits like mental accounting, self-control and bounded rationality systematically affect individual decisions and market outcomes.
Mental accounting is people’s tendency to divide money into separate categories. According to Thaler, mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate and keep track of financial activities. Many people normally place money in silos: expenditures (food, housing, entertainment, vacation), wealth (checking account, retirement savings), and income (salary, bonus). They are not actual account but are mental constructs. Mental accounting can be helpful in that it may stop you from overspending on any one category. But mental accounting itself cause people to overconsume or underconsume particular kind of goods. For example, if a person’s mental “entertainment” account is seen overspent and his “clothing account” is seen as having money left in it, he/she might spend more on clothing account even though they would maximize utility by spending more on entertainment. Traditionally, economists have assumed that these accounts are fungible (substitutable), but the silo approach created by mental accounting may not permit the fungibility of the accounts. Such type of behavior violates fungibility: the idea that money has no labels.
Homo economicus is next assumed to choose the optimum. Real humans, even when they know what is best, sometimes fail to select it for self-control reasons. Most of us at some or other point of time, have eaten, drunk or spent too much, and exercised, saved or worked too little. When people are time inconsistent-meaning they prefer A to B ahead of time, but B to A when time arrives-they are said to have self-control problems. Thaler also shed light on that New Year’s resolution can be hard to keep. Succumbing to short term temptation is an important reason why our plan to save for old age, or make healthier life style choices often fail. Thaler demonstrated how nudging may help people exercise better self-control.
Bounded rationality assumes that individual do not make fully optimal decisions because of cognitive limitations or costs involved in information gathering. To cope up with the complexity, bounded rational individuals use heuristic or rule of thumb in decision making process. Thaler also shows how aversion to losses can explain why people value the same item more highly, when they own it than they don’t. The phenomenon is called the endowment effect.
Thus, Richard Thaler work have built a bridge between the psychology and economics aspects of decision making. His research definitely instrumental in expanding the field of Behavioral Economics which in turn will have a profound impact even in many areas of economic policy.
Finance Insight 