Figure 3
Massey and Thaler, 2012
Indeed, as shown in Figure 3, the surplus value of picks does not decline sharply during the first round. Instead, we find that the players who provide the highest surplus to their teams are those picked early in the second round, picks that teams value at less than 20 percent of the first pick, based on the trades they make. We attribute this anomaly to overconfidence. Teams (that is, owners and managers) overestimate their ability to distinguish between great players and good players, and so put too high a price on picking early. Although teams seem to gradually be getting better at Romer’s fourth-down decision-making (though it is still dreadful), they show no signs of improving in their draft-pick trading. NFL owners and general managers, it seems, are not in Becker’s top 10 percent.xi
Nudging
My original interests in economics, including my PhD thesis on how to calculate the value of saving lives in cost-benefit analyses, were based on public-policy questions; but when I began studying the combination of psychology and economics, I deliberately stayed away from policy issues. I did so because I wanted behavioral economics to be perceived as primarily a scientific rather than political enterprise. Some of the original resistance to the research came from economists who feared that our findings would be used to support intrusive government interventions.
The research on self-control was particularly fraught with this danger. Many of the laissez-faire economic policies advocated by economists such as the late Milton Friedman were based on the notion of consumer sovereignty—that is, that no outsider can know an individual’s preferences better than the person himself. Furthermore, the concept of revealed preference proposed by the late Paul Samuelson of MIT stated that preferences are essentially defined by what we choose. If Alan chooses ice cream over salad, then it follows that he prefers ice cream to salad. It is the same line of thinking that led Becker and Booth’s Kevin M. Murphy to argue that because addicts choose to be addicts, they must prefer to be addicts.
How, then, can we make sense of my moving that bowl of cashews out of reach? Did my friends prefer to eat them or not? And if people sometimes do things that they later regret (having one too many drinks the night before, buying something on sale, etc.), what are their true preferences? Most provocatively, is it possible to help people make better choices, even if they are already fully informed (say about the relative merits of ice cream and salad)? I first decided to dip my toe into these waters by asking whether it was possible to help people save for retirement.
Save more tomorrow
If people are present biased, they may have trouble saving for retirement. In the language of the planner-doer model, the planner may wish to save a higher proportion of current income, but she has trouble controlling the impulsive purchase decisions of a succession of doers who are tempted by myriad opportunities to buy immediate gratification. Are there ways to give our planners a little help?
In a short paper on this subject, I made a few suggestions, including increasing withholding taxes. This would have the effect of increasing the size of tax refunds (which are already substantial in the United States), and the evidence suggests that people find it easier to save when they receive a large windfall. Another suggestion was to change the default on defined-contribution savings plans. At that time, participants had to actively opt in to join such plans. I suggested changing the default so that if people did nothing, they would be automatically enrolled. This suggestion went unnoticed, but fortunately a Booth colleague of mine at the time, Brigitte C. Madrian, published a paper a few years later with Dennis F. Shea of the UnitedHealth Group demonstrating that this policy dramatically increased enrollments in a company that tried the idea. With the help of that evidence, the idea has now spread widely.
Madrian and Shea also highlighted a potential pitfall to automatic enrollment. If the default savings rate picked by the company is too low, some people will passively accept the default rate (perhaps taking it as a suggestion) and will end up saving less than they would have if left to their own devices. This compounded an existing problem that savings rates in 401(k) plans were generally too low to support an adequate retirement nest egg, especially for baby boomers who were late getting started. A few years later, I was asked by a large mutual-fund company to speak to the clients of their retirement-plan record-keeping business about ways to increase savings rates.
After some discussions with a former student, Shlomo Benartzi, now at UCLA, I suggested a plan we later named “Save More Tomorrow.” The idea was to think about the behavioral biases that were contributing to low savings rates and a reluctance to increase them, and then use those insights to design a plan to help. We based our plan on three observations. First, people have more self-control regarding future plans than immediate behavior. (We plan to start diets next month, not tonight at dinner.) Second, people are loss averse in nominal dollars, and thus resist any reduction in their take-home pay that would happen if they immediately increased their retirement savings rate. Third, retirement savers display strong inertia. As we will see below, they can go for periods of many years without making any changes to their plan. Understanding these causes of low savings rates, we asked how we could overcome them.
The plan we devised had components to address each of the three issues listed above. First, workers were asked whether they would be interested in joining a program that would increase their savings rate “in a month or two, not today.” Second, to mitigate loss aversion, the increases in the savings rate would be timed to coincide with pay increases, so workers would never see their pay go down. Third, once the worker joined, the program would remain in place until he actively opted out or his savings rate reached some target or maximum.
This idea also went nowhere until a small company in Chicago decided to try it. They had a problem of low participation and low savings rates among their mostly low-paid workers, and hired a financial adviser to personally meet with each employee and offer advice. Since savings rates were typically quite low, the adviser, Brian Tarbox, usually suggested that they increase their annual contributions by five percentage points. Most workers turned this advice down on the grounds that they could not afford it. To these reluctant savers, Tarbox offered a version of Save More Tomorrow in which savings rates would increase 3 percentage points at each pay raise. About 80 percent of those offered this plan signed up, and after four pay raises, their savings rate had gone from 3.5 percent to 13.6 percent. (Those who accepted the advice to increase their savings rate by 5 percentage points plateaued at that new level.)
Benartzi and I presented a paper based on these and other findings at a conference held at the University of Chicago honoring my thesis advisor Sherwin Rosen, who had recently died quite prematurely. The UChicago economist Casey Mulligan, who maintains orthodox Chicago School views, was the discussant. Mulligan agreed that the results were impressive but asked a question I had not anticipated. “Isn’t this paternalism?” I stammered a bit and noted that the program was completely voluntary and thus absent any of the coercion normally associated with paternalistic policies such as Prohibition. “If this is paternalism,” I said, “it must be a different sort of paternalism. I don’t know, maybe we should call it libertarian paternalism.”
Libertarian paternalism is not an oxymoron
I mentioned this interaction to my friend and colleague at the University of Chicago Law School, Cass R. Sunstein, telling him that I thought the idea of libertarian paternalism seemed intriguing (albeit a mouthful to say). We wrote two papers on the topic, one that I drafted that was five pages and one that Cass took the lead on that was 52 pages, by far my longest paper. In fact, it was so long that it looked to me to be nearly the length of a book. At one of our lunch meetings, I may have used the word “book” carelessly in conversation, which can be dangerous when talking to Cass, who seems to be able to write books faster than I can read them. One thing led to another and, with me cruelly slowing Cass down to what he considered a snail’s pace, we eventually wrote the book.
When we were looking for a publisher for the book, we found the reaction to be rather tepid, probably in part because the phrase “libertarian paternalism” does not exactly roll off the tongue. Fortunately, one of the many publishers that declined to bid on the book suggested that the word “nudge” might be an appropriate title. And so, we published Nudge: Improving Decisions about Health, Wealth, and Happiness. In this roundabout way, a new technical term came into social-science parlance: a “nudge.”
The book Nudge is based on two core principles: libertarian paternalism and choice architecture. It is true that the phrase “libertarian paternalism” sounds like an oxymoron; but according to our definition, it is not. By “paternalism” we mean choosing actions that are intended to make the affected parties better off as defined by themselves. More specifically, the idea is to help people make the choice they would select if they were fully informed and in what Carnegie Mellon’s George Loewenstein calls a cold state, meaning unaffected by arousal or temptation. (For instance, we ask you today how many cashews you would like to eat during cocktails tomorrow.) Of course, deciding what choices satisfy this definition can be difficult, but the concept should be clear in principle. The word “libertarian” is used as an adjective to modify the word “paternalism,” and it simply means that no one is ever forced to do anything.
Choice architecture is the environment in which people make decisions. Anyone who constructs that environment is a choice architect. Menus are the choice architecture of restaurants, and the user interface is the choice architecture of smart phones. Features of the choice architecture that influence the decisions people make without changing either objective payoffs or incentives are called nudges. The example of the default option in pension plans is a now-classic example of a nudge: joining is made easier, but no one is forced to do anything. To rational economic agents (whom we call econs), it should not matter whether one of the boxes in a yes-no choice is already clicked in an online form. The cost of clicking the other box is trivial. But in a world of humans, nudges matter, and good choice architecture, like good design, makes the world easier to navigate.xii Indeed, GPS maps are a perfect illustration of libertarian paternalism in action. Users choose a destination, the map suggests a route that the user is free to reject or modify, and for those of us who are directionally challenged, we get to our desired destination with fewer unintended detours. Importantly, no choices are precluded. Both automatic enrollment (with easy opt-out) and Save More Tomorrow are nudges.
Much to our delight and surprise, nudging has become a global success. Governments, starting with Britain and later the US, have created behavioral-insight teams that explore policies informed by behavioral science and subject to rigorous tests, using randomized controlled trials wherever possible.xiii
When nudges are forever
There are many unanswered questions about the impact of nudges. One that has been difficult to evaluate is: How long do nudges last?
Take the case of a default option. At one extreme, one could imagine that the effect of the default is fleeting, as people learn relatively quickly that the default option is not to their liking. This would likely be the case when feedback is direct and immediate, such as when the default side dish at a frequently visited restaurant is one you dislike, and you ask for an alternative. At the other extreme, one can imagine defaults lasting years, perhaps decades. This scenario is plausible when there is little or no feedback, or when the feedback is infrequent.
A recent project with University of Miami’s Henrik Cronqvist and China Europe International Business School’s Frank Yu investigates this question, coincidentally in a Swedish context, namely the Premium Pension Plan that was introduced by the Swedish government in 2000. Briefly, this initiative created a defined contribution component to the Swedish social-security system in which a portion of the payroll tax (2.5 percent of income) was assigned to be invested in the stock market. Citizens were given over 450 mutual funds to choose from in forming their individual portfolio. At the launch, the choice architecture employed two powerful nudges. First, a default fund was named. Anyone who failed to make an active choice was assigned to this fund, and investors could also actively choose it. Second, the government launched a large advertising campaign urging citizens to decline the default fund and form their own portfolio instead. Additionally, individual funds could and did advertise as well, trying to convince investors to pick their fund.
As reported in an earlier paper, in this battle of the nudges, the advertising campaign won. One-third of investors chose the default fund, while two-thirds decided to manage their own portfolios. But in the years after the launch, new entrants to the workforce, primarily young people and immigrants, have faced the same set of choices but without the second nudge to choose for themselves. In these subsequent years, the government ceased its advertising campaign urging do-it-yourself portfolio management, and private-sector advertising also dried up, since the number of people choosing had greatly diminished. The share of new entrants choosing the default fund immediately rose, and in recent years has been nearly 99 percent. Nudges can be powerful.
But here is the interesting question we can now answer: What happened to all those folks who were nudged to choose their own portfolios back in 2000? Remarkably, 97 percent are still “managing” their portfolios themselves. I use quotation marks for the word “managing” because they are not very active. Less than 10 percent of these investors make a trade in an average year. So while nearly everyone who joins the system now is invested in the default fund, nearly everyone who was nudged to eschew that fund 17 years ago, in favor of a do-it-yourself strategy, is sticking with that original “choice” and doing very little portfolio rebalancing.
The investors in the default fund are, perhaps unsurprisingly, equally passive. The default fund is essentially a global index fund with low fees, so investors can hardly be questioned for sticking with this sensible option. But in 2010, the managers of the fund received permission to add leverage, and in 2011 they decided to take advantage of that freedom to employ 50 percent leverage, meaning investors in the fund essentially had a 150 percent exposure to the market. To put this in some perspective, had this strategy been in place during the financial crisis, the value of the portfolio would have fallen by 82 percent. This radical change in the fund seems to have gone unnoticed by nearly all investors. Although over 4 million people were (and still are) invested in this fund, the number reacting to the drastic (and in retrospect either lucky or brilliant) change in strategy was tiny. Again, people stick with defaults, even when the default changes dramatically.
In hindsight, these findings are not so surprising. Many people put their retirement savings on autopilot (perhaps wisely), so this domain is a perfect storm in which to expect strong elements of inertia. This will not always be the case, but when it is, choice architects need to be especially wary about their choice of nudges. As Sunstein and I frequently stress, there is often no alternative to nudging. The designers of this retirement savings plan had to choose some choice architecture—if not this one, another, and any plan will have its potential pitfalls.xiv
Conclusion
Behavioral economics has come a long way from my initial set of stories. Behavioral economists of the current generation are using all the modern tools of economics, from theory to big data to structural models to neuroscience, and they are applying those tools to most of the domains in which economists practice their craft. This is crucial to making descriptive economics more accurate. As the last section of this lecture highlighted, they are also influencing public-policy makers around the world, with those in the private sector not far behind. Sunstein and I did not invent nudging—we just gave it a word. People have been nudging as long as they have been trying to influence other people.
And much as we might wish it to be so, not all nudging is nudging for good. The same passive behavior we saw among Swedish savers applies to nearly everyone agreeing to software terms, or mortgage documents, or car payments, or employment contracts. We click “agree” without reading, and can find ourselves locked into a long-term contract that can only be terminated with considerable time and aggravation, or worse. Some firms are actively making use of behaviorally informed strategies to profit from the lack of scrutiny most shoppers apply. I call this kind of exploitive behavior “sludge.” It is the exact opposite of nudging for good. But whether the use of sludge is a long-term profit-maximizing strategy remains to be seen. Creating the reputation as a sludge-free supplier of goods and services may be a winning long-term strategy, just like delivering free bottles of water to victims of a hurricane.
Although not every application of behavioral economics will make the world a better place, I believe that giving economics a more human dimension and creating theories that apply to humans, not just econs, will make our discipline stronger, more useful, and undoubtedly more accurate. And just as I am far from the first behavioral economist to win the Nobel Prize,xv I will not be the last.
Richard H. Thaler is Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at Chicago Booth and was the recipient of the 2017 Nobel Memorial Prize in Economic Sciences. This essay is adapted from his Nobel Prize Lecture, given December 8, 2017, in Stockholm, and is printed with permission from the Nobel Foundation. © The Nobel Foundation 2017
I should say that this article is not a transcription of the lecture I delivered in Stockholm during Nobel week. There are two reasons for this. One is simple procrastination. The talk was on December 9, 2017. The written version was not “due” until January 31, 2018, which is surely an aspiration rather than a real deadline. Why do something now that you can put off until later? The other reason is more substantive. Talks and articles are different media. Readers interested in seeing the actual lecture can find it at Nobelprize.org. [return]
This article is not intended to be comprehensive. My recent book Misbehaving: The Making of Behavioral Economics (Thaler, 2015) is more thorough, both in terms of contents and especially references. [return]
Both prospect theory and the planner-doer model are examples of what might be called minimal departures from neoclassical economic theory. Both theories retain maximization, for example, as a useful simplifying assumption. This is intentional. Matthew Rabin, the most important behavioral-economics theorist of his generation, has advocated creating what he calls PEEMs: portable extensions of existing models (2013). The beta-delta model, pioneered by David Laibson (1997) and O’Donoghue and Rabin (1999) is a leading example. It has been a more widely adopted model of self-control than the planner-doer, in part because it is more easily “portable.” [return]
That is not to say that there is not a problem with “leakage.” For example, some 401(k) plans allow participants to borrow against their account. Also, when people change jobs, retirement accounts are often cashed out if the total is relatively small. [return]
The same thinking applies to security purchases. Investors tend to sell winners more quickly than losers, although there are (at least in the US) tax benefits to selling the losers. See Shefrin and Statman (1985) and Odean (1998). [return]
This hypothesis was supported at high stakes using choices from the game show Deal or No Deal. See Post et al. (2008). [return]
This experiment also showed that neither income effects nor transaction costs were significant in this market. [return]
There is a large literature that followed the publication of these two papers. For a summary of the behavioral view on how to interpret excess returns to value stocks see Lakonishok, Shleifer, and Vishny (1994). For the efficient-markets view, see (for one example) Fama and French (1993). [return]
It might be possible to argue that 3Com managers were holding Palm back, but then the right thing to do would be to get rid of management, not sell off Palm. In any case, the really strange behavior is what comes next. [return]
Estrin (2015) [return]
A recent paper by DellaVigna and Gentzkow (2017) finds similar evidence of poor firm decision-making in retail pricing. [return]
In writing Nudge, we were strongly influenced by Don Norman’s (1988) classic book, The Psychology of Everyday Things. (In later editions, the title was changed to The Design of Everyday Things.) [return]
For progress reports, see Halpern (2015), Benartzi et al. (2017), and Szaszi et al. (2017) [return]
For a thoughtful discussion of how to go about choosing nudges to make people better off “as judged by themselves,” see Sunstein (2017). [return]
Some of the former winners who made important contributions to the field include (in the order in which they were awarded the prize): Arrow, Allais, Sen, McFadden, Akerlof, Kahneman, Schelling, Ostrom, Diamond, Roth, Shiller, Tirole, and Deaton. [return]