Thursday, October 12, 2017

Why Richard Thaler thinks we've two brains, in one body

The winner of this year's Nobel Prize for Economics nearly lost his first job as soon as he got it.

As a young professor, Richard Thaler designed an exam that would easily sort the students into three categories: the superstars, those who understood things well enough, and those that couldn't. It worked, but he faced a revolt. The average score turned out to be just 72 out of 100.

The number out of 100 made no difference to the eventual grades. The As, Bs, and Cs were awarded in accordance with the standard grading curve, and he told his students so. But he says they still "hated my exam, and they were none too happy with me".

Worried he wouldn't keep his job, he redesigned the exam (but not the questions, and not the ultimate allocation of As, Bs and Cs) so that it was marked out of 137 instead of 100.

"The students were delighted! No one's actual grade was affected, but everyone was happy," he wrote in his 2015 book Misbehaving.

He chose 137 for two reasons. "First, it produced an average score well into the 90s, with some students even getting scores above 100, generating a reaction approaching ecstasy. Second, because dividing one's score by 137 was not easy to do in one's head, most students did not seem to bother to convert their scores into percentages."

He even said so, writing to his students that the scoring system had "no effect on the grade you get in the course, but it seems to make you happier". None of them complained again.

A few years ago I took part in a mass experiment conducted by one of Thaler's colleagues. He asked each of us to take out our driver's licence and write the last two digits of the identification number at the top of a page. Then he showed us a bottle of red wine and asked up to write at the bottom of the page our guess as to what it was worth; anything between 00 and 99 dollars.

Astonishingly, those of us with licences whose last two digits spelled out a low number thought the wine was cheap. Those whose licences produced a high number thought it was expensive.

In both cases we were misled by an anchor; the students by the anchor of 100, and those of us in the experiment by the digits at the end of our licence numbers. As Thaler accumulated more and more examples, and tested them in experiments, he set them out in a list on his backboard entitled "dumb stuff people do".

"Dumb" was too harsh. We are lazy more than we are than dumb. Most of us could make a proper guess as to the value of a bottle of wine, and most of us could work out percentages, but, as Thaler puts it, we have "limited time and brainpower". We find it easier not to bother, to fall back on shortcuts.

And yet mainstream economics has been built around the assumption that we are always calculating and mostly getting it right. When shown that we don't, that we consistently get things wrong, traditionalist economists have excuses: "If the stakes are high enough people will get it right; in the real world people learn and avoid mistakes; in aggregate errors cancel out," and so on.

Thaler's greatest contribution has been to show that our mistakes aren't random; that they are predictable, and that they are often worse when the decisions are big. We are good at grocery shopping. We do it all the time. But only rarely do we buy a house, or enrol in a savings plan. It's these decisions that we often get spectacularly wrong, in predictable ways.

One of his greatest practical contributions has been "Save More Tomorrow", a US scheme in which companies sign up their employees not to squirrel away more of their pay packet today (when it would hurt) but to do it later, when they get a pay rise. It came from his insight that rather than acting as if we are rational when it comes to decisions about saving and splurging (or dieting and eating) we act as if we are two separate beings fighting for control of ourselves.

It's been more or less proven. In one experiment, economists from Columbia and Stanford universities offered 6000 Americans the chance to take part in a lottery. They were given a choice of what to accept as a prize: either $55 in cash, or a lesser-value $50 bottle of wine. Astonishingly, about a quarter chose the wine.

When asked why, they said things like: "If I chose the cash, I would probably spend it on something I need rather than something I would really enjoy" and: "This way I will have to pamper myself ." Part of them is trying to escape from a straitjacket strapped on by the other part.

Thaler might be best known for his appearance in the movie The Big Short where he explained collateralised debt obligations to the pop star Selena Gomez; and also for his co-written book Nudge, now used as something of a guide by governments in the UK, the US, and now Australia and NSW who have set up behavioural economics units. He is on to something big.

In The Age and Sydney Morning Herald