Nobel Prize in Economics

Why in news?

Recently Richard.H.Thaler, an American received Nobel Prize for his behavioural Economic theory.

What are economic theories based on?

Most economic theories are based on a certain set of assumptions without which it would be difficult to talk in a coherent fashion about any theory.
These assumptions simplify the complex everyday reality.
So an economic model could assume that economic agents have perfect information or that the transaction costs are zero.
In a similar vein, one of the dominant assumptions has been about economic agents being rational.
That is to say, they only act in self-interest, but often there are gaps between the behaviour as predicted by the model and as it is in reality.

What is the finding of Thaler?

He has refined economic analysis by taking into account three psychological traits
Limited rationality - It underlines that it isnot realistic to assume that individuals could be completely rational and think of all possible effects of their choices.
Thaler built on this insight to come up with his theory of mental accounting, which describes how people organise, formulate and evaluate financial decisions.
For instance, this tendency to create separate mental accounts for day-to-day expenses and holiday expenditure explains why individuals might not dip into their long-term savings and instead use a credit card to tide over some imbalances in daily expenses.
Perceptions about fairness - Full rationality assumption of traditional theories cannot explain behaviour when it deviates to accommodate an individual’s sense of fairness.
Through large experiments, Mr Thaler shown how people can set aside personal gain and concern themselves with questions of fairness.
For instance, Consumers judge negatively a company which is seen to be unjustly raising prices in times of pressure.
Lack of self-control -Actual human behaviour has shown that people may, contrary to notions of rationality, choose something that goes against their interest.
For instance, a smoker who chooses to yield to an immediate temptation instead of favouring better health in the longer term.

Why is Thaler’s contribution significant?

His contribution goes to the very heart of economic modelling and has a profound impact on many areas of economic research.
Since field of economics concerns itself with how human behaviour explains the deviations from the established theoretical model, it has wide-ranging impact.
Studying the so-called “irrationalities” has implications for

Financial behaviour - Something like unjustified market volatility
Marketing - The “buy two get one free” schemes providing a sense of having gained.
Public policy making - Wherein politicians “nudge” individuals towards a societal improvement.

Source: Business Standard