People Are Predictably Irrational – A Nobel Memorial Prize Winning Theory

You may have seen the news recently about the Nobel Memorial Prize in Economic Sciences being awarded to Professor Richard Thaler. He’s the author of a best selling book you may have read or heard of, Nudge, which talks all about why we make the choices we do and how we can make better ones. Today lets explore more about his theories and exactly why the idea that humans make irrational choices was groundbreaking (because it sounds like it should be obvious, right?). I’ll also talk about some examples of Nudges that I’ve noticed in my day-to-day life and find out how you feel about these kinds of nudges.

Traditional Economic Theory of Rational Choice

I’m an accounting major and an MBA by way of formal education, so I’ve taken plenty of economic courses in both undergrad and grad school. And one of the dumbest things ever taught in an economics course is the idea that human beings are perfectly rational when it comes to evaluating their spending decisions. From Investopedia:

A rational behavior decision-making process is based on making choices that result in the most optimal level of benefit or utility for the individual. Most conventional economic theories are created and used under the assumption all individuals taking part in an action/activity are behaving rationally.

Essentially the traditional theory of economics states that people carefully evaluate the cost of a product or service, and the benefit they receive from it, and only make a purchase if the benefit exceeds the cost. By this metric, markets are inherently self-regulating and there would be no bubbles, as every investment decision would be carefully weighed against the the benefit they would receive from it. Warren Buffet and Ben Grahams “Mr. Market” would never offer you a deal or an amount above what an investment is really worth. Anyone who knows about bubbles (like the Dutch tulip craze, internet stocks in the late 90’s, or the housing bubble in the mid-2000’s) would know this isn’t even remotely true

Human beings are, at their core, irrational. We buy things we don’t need, to impress people we don’t like. We go into debt in order to look more successful (I’m looking at you, people with fancy cars and negative net worth). We eat unhealthy food even though we’re not hungry, because it’s there and everyone else is having some. We convince ourselves that there’s a good reason for whatever it is we’re doing at the moment, even when from the outside an objective person would say it makes no sense.

If this is the case, and has been obvious for hundreds of year, why would the rational theory have been so popular?

Well the reason it was popular is very simple-it’s very easy for a logical person to calculate. A person will always make the choice that has the highest net benefit for them-the choice where benefit minus cost is the highest. Rational choice theorists will claim that it can predict the outcome and pattern of peoples choices.

That sounds like a great theory, but we all know that human beings never make perfectly rational decisions. No ones sitting with a calculator at the Apple store, calculating the expected utility they’ll receive from the new iPhone minus the cost, and comparing that with a Samsung model. No, people are irrational. They’re impulsive. There’s a reason “impulse purchases” are a thing, and why you likely have at least one drawer or closet full of things just collecting dust (or more than one). So what explains this?

Enter – behavioral economics.

What Makes Behavioral Economics Different

Behavioral economics theorizes that cognitive biases prevent people from making optimal choices, despite their best efforts. This is why people will spend $300 per month eating out while being “unable to save a dime”, and why people will go deep into debt for a car loan because they can afford the monthly payments. It’s those pesky cognitive biases sneaking in there, preventing humans from making decisions in the robotic, coldly calculating way that the rational choice theory would have them do.

This is where Professor Thaler comes in. He showed that behavior economics was not a field of just shrugging your shoulders and saying, “well, people make no sense!”, but instead people made choices in predictably irrational ways that could be modeled and influenced.

For example, when gas prices go down, rational people should spend less in total on gas. They’re receiving the same benefit for a reduced cost, right? They should take that extra money and use it to purchase something else that would gain them a bigger benefit. Instead, though, people just drive more and buy more expensive gas. This is because people think of “gas” as a fixed dollar amount in their budget, and if the cost goes down, they simply buy more of it/pay more for it.

This is also where the theories talked about in Nudge come in – using peoples predictable cognitive biases against them.

For example, take 401k contributions. When I started in the workforce, there was a great deal of hand-wringing over the fact that lots of people just weren’t contributing to their 401ks at all. It wasn’t that they didn’t want to save for retirement-it was just that inertia kept them from doing so. When they would start to research retirement savings options and work on calculating what they needed, it would be so complex (and sometimes depressing) that they would just give up. So instead of relying on people to make the rational choice, you can take that same inertia and have it work in their favor. Make the default option investing in the 401k unless someone opted out. Most people won’t opt in, but they won’t opt out either. Inertia and doing that research is still overwhelming so they let the default choice win.

It sounds so simple, but it was groundbreaking. Instead of forcing people to become rational robots, simply use human nature to nudge people into choices that are better for them, or for society, in the long run.

Of course, this theory can also be used against you. Take the initial launch of the iPhone, something that you may have long forgotten. When it was first launched, Apple priced the phone at $600 and then quickly lowered it to around $400. Why? This was the first product of its type, with no other products or price points to compare it to. By first pricing it at $600, people thought that by paying $400 (really $399) they were getting a bargain. Using traditional economics and focus groups, they would have calculated their break even and polled people to see what they would pay, then use that data to set the price. Instead they imprinted a higher cost to make the lower price look like a good deal. Genius.

Interestingly one of his most important concepts was that of “fairness”. This is why people get outraged at so-called “price gouging” during a crisis. If gasoline was $2.50, and now there’s a shortage of gas, using traditional economics the price should rationally increase. But as we saw during the Texas and Florida hurricanes, people won’t stand for this. He showed that this is why, for examples, stores selling umbrellas don’t raise their prices during a rainstorm. Rationally, they should, but people would see that as unfair and complain.

Where I’ve Seen The Nudge

As I mentioned above, I’ve definitely seen this in the 401k space. In the mid-2000’s, the Pension Protection Act allowed for auto-enrollment for the first time, and the companies that I’ve worked for have always implemented this. The one I work for now not only has auto-enrollment, but also auto-increase, where they’ll increase your contribution by 1% per year until you reach a maximum amount.

My current employer also tries to nudge folks toward healthier lunch options by putting different colored tongs and cards next to the foods. Green = good to go; Yellow = use caution; and Red = only a little bit/use as a treat. Of course, they also still sell candy bars, but those are in the vending machines and not colored.

I bet you’ve seen this in play with our favorite cost, taxes. Taxes are automatically taken out of our paychecks and calculated for us rather than us needing to calculate them ourselves. So even if you don’t file, you’ve already paid. It goes against inertia to change your taxes, and of course you know if you don’t pay you’ll need to fork over high penalties and fees.

I’ve used this concept in my own life and pursuit of financial independence. Setting up automatic contributions to my kids college funds, and to my mortgage payoff fund, make it so that I need to go against inertia in order to spend that money. Also I got a 15 year mortgage so that my mortgage would be automatically paid off faster.  If you better understand how marketers and governments can use these concepts to nudge you toward better behavior, you can use them yourself rather than relying on yourself to be rational.

Where Have You Been Nudged?

Have you noticed somewhere where your (or your friends/co-workers) behavior has been nudged in a certain direction? Or have you seen people be predictably irrational? What’s the most irrational thing you’ve done? Let me know in the comments.

Be sure to follow my blog for more great posts via e-mail or WordPress, or connect with me on Facebook or Twitter and say hello! You can also check out what I’m buying or baking on Instagram,  what I’m pinning on Pinterest, or the latest books I’m reading (or want to read) over on Goodreads.