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School of Business

Nobel Prize in Economics

October 10, 2017

By Timothy S. Sullivan, Ph.D.

I remember very well in 1986 when James M. Buchanan won the Nobel Prize in Economics. I was in college -- majoring in economics -- and a friend asked me about Buchanan's research. I summarized it by saying that "when politicians make decisions about economic policies, they worry about being re-elected." When my friend asked about previous winners, I noted that the 1985 winner, Franco Modigliani had formulated the life-cycle hypothesis, which explains why people would save money during their working years so that they could maintain their lifestyle when they got old. On the surface both of these sound like giving the Nobel Prize in Physics to someone who demonstrates that backing your car into a dumpster will put a dent in your bumper.

So it is again this year, as the Nobel Committee announced yesterday that Richard Thaler is the 2017 laureate. Most press reports summarized his work with a fairly obvious statement -- human beings often behave irrationally. Thaler's work inspired a new branch of economics, behavioral economics, which examines human economic behavior, often through lab experiments that seem more at home in a psychology department.

I've always found it interesting that economists spend so little time examining actual human behavior. Shouldn't a social science strive to understand humans? But I also believe that some press outlets have gone overboard presenting it as an indictment of the profession. To be blunt, if your economics class taught you that human beings always behave rationally, the problem was with your professor, not the profession.

But nevertheless, Thaler's work is remarkable, and I'm thrilled he won. His 1980 paper "Toward a Positive Theory of Consumer Choice" is one of a handful of papers that got me excited about economics when I was a college student. Among other ideas, Thaler uses a hypothetical wine customer to illustrate the so-called endowment effect. Thirty years after buying a particular bottle, the wine is a considered a classic, and a wine merchant offers the customer $100 for it. The customer, who would never consider paying more than $35 for a bottle of wine, refuses. Thus the seeming irrationality: If the bottle was on the shelf, the customer wouldn't give the merchant $100 for it because he'd rather have the $100 than the wine. But if the customer already owns the wine, he mysteriously concludes the opposite; he'd rather have the wine than the $100.

Fascinated with the paradox, I performed my own experiment using my friends. There were 12 of us in a fantasy baseball league, and I asked each friend to secretly write down the player that they would pick first if we were to start a new league. The year being 1988, Wade Boggs and Jose Canseco were popular choices. I noticed that the friend with Wade Boggs on his team selected Jose Canseco, and the friend with Jose Canseco on his team wrote down Wade Boggs. I suggested a trade between them -- the friend who preferred Boggs would get him in exchange for Canseco and visa versa. They both refused. Once a player is "yours," you really don't want to give him up.

Why is Thaler's research important? When the thing that's "yours" isn't a bottle of wine or a baseball player, but a stock, a house, or a job, it can affect some pretty important decisions. If a company automatically puts new workers into a 401k plan with the option of opting-out, they'll be more likely to keep saving than if you require them to fill out a form to opt-in. It partly explains why housing markets adjust so slowly -- a home owner always believes that their house is worth more per square foot than all of the other houses in the neighborhood. Many folks remain underpaid in jobs they hate because they fear the unknown. The job may stink, but it's their job. What Thaler provided was a framework for these decisions. What I learned as an economist was to embrace the "human-ness" in these decisions, regardless of their (ir)rationality.


Timothy S. Sullivan, Ph.D. is an Instructor in the Department of Economics & Finance and the Director of the Office of Regional Economic Analysis in the School of Business at Southern Illinois University Edwardsville. He can be reached at tsulliv@siue.edu.

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