Nobel Prize in Economics 2017: Richard Thaler and Behavioural Economics

This note covers the Nobel Prize in Economics 2017: why Richard H. Thaler won it, what behavioural economics is, how limited rationality, fairness and self-control shape real decisions, the mental accounting and planner-doer models, nudging, how his work developed over four decades, why it matters for policy, and quick facts for exams.

What was the Nobel Prize in Economics 2017 awarded for?

The prize was awarded with the citation "for his contributions to behavioural economics". In plain words, the Royal Swedish Academy of Sciences recognised one economist for showing that real people do not make decisions the way traditional economic models assume.

Traditional economics usually assumes that people are fully rational: they weigh every option carefully, never let emotion get in the way, and always act in their own self-interest. Thaler's work showed that actual human behaviour is messier.

People take mental shortcuts, care about what is fair, and often fail to stick to their own plans. By building these realistic traits into economic models, he helped create a new field that blends economics with psychology.

The official name of this award is the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, which is widely called the Nobel Prize in Economics.

It is not one of the five prizes Alfred Nobel created in his will; it was established later by Sweden's central bank and is awarded alongside the original Nobel Prizes.

Who are the laureates?

Richard H. Thaler

Richard H. Thaler was born on 12 September 1945 in East Orange, New Jersey, USA. At the time of the award he was affiliated with the University of Chicago, Chicago, IL, USA, where he held the position of Charles R.

Walgreen Distinguished Service Professor of Behavioral Science and Economics at the university's Booth School of Business. He received the whole prize (1/1 share), worth 9 million Swedish kronor.

Thaler completed his doctoral degree in 1974 at the University of Rochester, New York, after earlier studies at Case Western Reserve University in Cleveland, Ohio.

He went on to work at the University of Rochester, then at Cornell University in Ithaca, New York, before moving to the University of Chicago, where he continued to work at the time of the award.

His contribution was to take three everyday features of human psychology, namely limited rationality, social preferences about fairness, and lack of self-control, and show systematically how each one shapes economic decisions and, in turn, market outcomes.

The Nobel Prize's own materials describe him as a pioneer in behavioural economics whose contributions "built a bridge" between economic and psychological analysis of decision-making.

What problem was Thaler's work trying to solve?

For much of the twentieth century, economists built their models around a simplified picture of a human being, often nicknamed "homo economicus" in commentary on the field, who processes information perfectly, always carries out long-term plans, and cares only about personal gain.

This simplification let economists build powerful mathematical models of markets, firms and consumers.

But the Academy noted that the gap between this simplified theory and how people actually behave is sometimes systematic and significant. Earlier laureates had already chipped away at the fully rational model.

As early as 1951, Maurice Allais had pointed out that actual behaviour under risk can differ systematically from what the standard expected-utility theory of rational choice predicts.

Herbert Simon introduced the idea of "bounded rationality", the notion that people and organisations have limited cognitive capacity, and argued that decision-makers typically settle for an acceptable solution rather than a perfect one.

Building on Simon's idea, Reinhard Selten examined how bounded rationality affects firms, and provided early experimental evidence of departures from rational economic behaviour.

Daniel Kahneman, working with psychologist Amos Tversky, developed "prospect theory" to describe how people actually judge risky choices, for which Kahneman later won the Economics Prize himself.

Thaler entered this emerging conversation as a doctoral student who noticed that even trained economists did not always behave like the rational agents of their own textbooks.

He began collecting what he called "anomalies": situations where real behaviour clearly broke the predictions of standard theory.

He then set out to find systematic psychological explanations for these anomalies rather than treating them as random noise, and his 1980 paper "Toward a positive theory of consumer choice" first laid out this programme, applying Kahneman and Tversky's prospect theory to ordinary economic decisions rather than only to risky gambles.

How does limited rationality shape our financial decisions?

The first strand of Thaler's work concerns limited rationality: the idea that people cannot, and do not, carefully calculate every long-term consequence of every decision. Instead they use simplified rules of thumb.

The endowment effect

Thaler coined the term endowment effect for the finding that people value an item more highly simply because they own it.

He linked this to "loss aversion", the idea from prospect theory that losing something feels worse than gaining the equivalent amount feels good.

In a well-known 1990 experiment with Daniel Kahneman and Jack Knetsch, decorative mugs were handed to a randomly chosen group, who were then offered the chance to sell them to a second group that had not received a mug.

Because the two groups were chosen at random, a rational model predicts roughly half the mugs would change hands at a fair price.

Instead, far fewer than half were sold, because owners valued their mugs more highly than non-owners were willing to pay, and this gap did not shrink even after repeated rounds of trading in which participants could learn.

The endowment effect has a further consequence: because people resist giving up what they already hold, the starting allocation of property can affect where resources end up, even without any transaction costs, which is a direct challenge to the standard prediction in law and economics that final outcomes should not depend on who started with the rights.

Mental accounting

Thaler's theory of mental accounting describes how people mentally sort their money into separate accounts, such as one for household bills and another for holidays, and then make decisions based on each account's narrow effect rather than on their overall wealth.

The popular science background gives the example of a shopper who will go to another shop to save 100 Swedish krona on a 1,000 krona watch but will not make the same trip to save the same 100 krona on a 10,000 krona watch, because she focuses on the percentage saved rather than the actual amount.

Draw a single large box labelled "total household income" broken into separate smaller boxes labelled "bills", "groceries", "holidays" and "savings", each with its own arrow showing money only flowing within that box, to show how people resist moving money between categories even when it would be more efficient.

A further example from the sources is a study of New York taxi drivers, who tend to set a daily income target and stop working once they reach it.

This means they work shorter hours on busy, high-earning days and longer hours on quiet, low-earning days, the opposite of what a profit-maximising model would predict.

Mental accounting also shapes how people treat money that has already changed hands. Thaler described a house money effect, in which someone who has just won money, for instance at a casino, becomes more willing to take risks with it than with money they had to work for.

A related pattern, the disposition effect, shows that investors tend to sell shares that have risen in value too quickly, to lock in the gain, while holding on to shares that have fallen, because selling at a loss means closing a mental account on a loss rather than hoping it recovers.

How did Thaler explain fairness and self-control?

Social preferences: what counts as fair

Thaler's research showed that people do not only care about their own material benefit; they also hold strong views about fairness, and will sometimes give up money to enforce it.

The committee's popular science background gave the example of consumers who punish a shopkeeper who raises umbrella prices during unexpected rain, even though the price rise reflects ordinary supply and demand.

Thaler and his co-authors also devised the dictator game, an experimental tool later used worldwide to measure attitudes to fairness.

Lack of self-control: the planner-doer model

To explain why people struggle to keep resolutions, such as saving for old age, Thaler and collaborator Hersh Shefrin proposed the planner-doer model.

This treats a single person as containing two competing selves: a far-sighted "planner" who cares about lifetime wellbeing, and a short-sighted "doer" who cares only about the present moment.

The Academy noted this is similar to the framework used today by psychologists and neuroscientists to describe tension between long-term planning and short-term impulse.

The popular science background illustrates the same tension with the ancient story of Odysseus and the Sirens, where Odysseus has himself tied to the mast and his crew's ears plugged with wax so that his long-term goal of reaching home safely cannot be undone by the short-term lure of the Sirens' song.

From this work Thaler developed and popularised the idea of a "nudge", a term he coined for gentle, low-cost measures that help the planning self win out, without removing anyone's freedom to choose differently.

His best-known applied example is the "Save More Tomorrow" pension programme, designed with Shlomo Benartzi, in which employees commit in advance to saving a share of their future pay rises, since it is psychologically easier to promise future saving than to cut today's spending.

How did the discovery unfold?

Why does it matter?

Thaler's work turned what the Scientific Background calls a once "somewhat controversial, fringe field" into a mainstream part of economic research, inspiring large numbers of economists to build formal theories and run empirical tests of behavioural ideas.

Together with 2013 laureate Robert Shiller, Thaler is considered a founder of behavioural finance, the study of how investor psychology, combined with limits on arbitrage, can move prices in financial markets away from what standard theory predicts.

Outside academia, governments in several countries, including the UK and the USA, set up "nudge units" that apply behavioural insights to public administration, often by changing default options, such as automatically enrolling people in pension schemes unless they actively opt out.

The presentation speech noted that Thaler's ideas on nudging people to save more have helped create "billions of dollars" of retirement wealth for ordinary savers around the world.

The sources also note an open tension: nudging and libertarian paternalism have been criticised in some quarters for being paternalistic, though the Academy's own materials stress that such programmes remain voluntary, with participants free to opt out at any time.

Thaler's work has additionally influenced neighbouring fields such as marketing and law, including an early paper applying behavioural economics to legal analysis with Christine Jolls and Cass Sunstein.

The presentation speech also placed Thaler's contribution in a long historical debate, tracing it back to the eighteenth-century economist Adam Smith, who in his earlier book described a struggle between short-term "passions" and a long-term, rational "impartial spectator" within every person.

According to the speech, Thaler's planner-doer model and his research on fairness and mental accounting brought these older psychological insights from the margins of economics into its mainstream, and helped connect economics more closely with psychology and neuroscience.

His research also remains an active area of study: economists continue to debate exactly why effects such as the endowment effect occur, and how strongly they apply to professional traders compared with ordinary consumers.

How did behavioural ideas spread into financial markets and other fields?

Thaler did not stop at individual decisions; he also asked whether these same psychological traits survive when many people trade against each other in a market.

Together with fellow laureate Robert Shiller, Thaler is regarded as a founder of behavioural finance, a field that studies how investor psychology, combined with limits on the ability of other traders to correct mispricing, can push market prices away from what standard efficient-market theory predicts.

Thaler documented cases where share prices appeared to behave in ways that are hard to reconcile with full rationality, including instances where a company's shares appeared to have a negative market value, which is logically impossible since an unwanted share can simply be discarded.

Experiments on investment choices also showed that people are sensitive to how far ahead they are asked to look: when shown only short-term outcomes, test subjects preferred safe, low-risk options, but when shown the same investments over a longer time horizon, they were more willing to choose riskier assets such as shares.

The popular science background also connects Thaler's work to everyday marketing practices, noting that offers such as "buy three, pay for two" work partly by shifting a shopper's reference point so that the deal feels like a gain.

Lotteries, it notes, are often marketed by drawing attention to rare winners while the much larger number of losers goes unmentioned, exploiting the same psychological tendencies that Thaler studied.

His ideas have also reached law and economics: in a paper written with Christine Jolls and Cass Sunstein, Thaler set out a behavioural approach to legal analysis, questioning assumptions, such as the Coase theorem's prediction that the initial allocation of legal rights should not affect final outcomes once trading is allowed.

Quick facts for exams

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017, commonly called the Nobel Prize in Economics 2017, was announced on 9 October 2017 by the Royal Swedish Academy of Sciences.

It was awarded in full to Richard H. Thaler, an American economist at the University of Chicago, "for his contributions to behavioural economics".

Thaler is known for the endowment effect, the theory of mental accounting, the planner-doer model of self-control, and for coining the term "nudge".

His work bridges psychology and economics by showing how limited rationality, fairness concerns, and weak self-control systematically shape decisions and markets. The prize carried 9 million Swedish kronor, as a single, undivided share.

Note: Source. The prize facts in this note are from the Nobel Prize's official site, nobelprize.org.

Glossary

• Behavioural economics — a field that applies insights from psychology to economic decision-making, rather than assuming people are always fully rational.
• Bounded rationality — Herbert Simon's term for the idea that people's thinking and decision-making are limited by their cognitive capacity.
• Endowment effect — the tendency to value an item more highly simply because you own it, compared with an identical item you do not own.
• Loss aversion — the tendency to feel the pain of a loss more strongly than the pleasure of an equivalent gain.
• Mental accounting — the habit of sorting money into separate mental categories, each judged on its own rather than on overall wealth.
• Reference point — the benchmark, such as a purchase price, against which a person judges whether an outcome counts as a gain or a loss.
• Planner-doer model — a model treating a person as two competing selves, a far-sighted planner and a short-sighted doer, used to explain self-control problems.
• Nudge — a term coined by Thaler for a gentle, low-cost measure that steers people's choices without removing their freedom to choose otherwise.
• Libertarian paternalism — Thaler and Sunstein's view that institutions should nudge people towards better choices while preserving free choice.
• Dictator game — an experimental tool devised by Thaler and colleagues to measure people's attitudes to fairness.
• Behavioural finance — the study of how investor psychology and limits on arbitrage affect prices in financial markets.
• Prospect theory — Kahneman and Tversky's theory describing how people actually evaluate risky choices, which Thaler applied to everyday economic decisions.
• Save More Tomorrow — a pension savings programme designed by Thaler and Shlomo Benartzi in which people commit in advance to saving future pay rises.

Common errors and misconceptions

• Misconception: The Nobel Prize in Economics is one of the original five prizes set out in Alfred Nobel's will. Correct: It is the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, established later and awarded alongside the original prizes.
• Misconception: Thaler argued that people are irrational in a random, unpredictable way. Correct: His work shows that deviations from strict rationality follow systematic, predictable psychological patterns.
• Misconception: Nudging means forcing people to make a particular choice. Correct: A nudge preserves freedom of choice; it only makes one option easier or more natural to pick, such as through a sensible default setting.
• Misconception: The endowment effect means people simply like familiar objects more over time. Correct: It specifically concerns the act of ownership itself, shown experimentally even with items such as mugs received only minutes earlier.
• Misconception: Mental accounting is the same as keeping a written household budget. Correct: It refers to a mental habit of separating money into categories, which can lead to inefficient decisions even without any written budget.
• Misconception: Thaler won the prize for a single invention or product. Correct: He won it for building, over several decades, a broad body of theory and evidence connecting economics with psychology.

Exam-style questions with model answers

Q1. In which year was the Nobel Prize in Economics awarded to Richard H. Thaler, and for what citation? [2 marks]

1. It was awarded in 2017, "for his contributions to behavioural economics".

Q2. Name the official body that awards the Nobel Prize in Economics. [1 mark]

1. The Royal Swedish Academy of Sciences awards the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.

Q3. Explain the endowment effect with the example used by the Nobel committee. [4 marks]

1. The endowment effect is the tendency for people to value an item more highly simply because they own it, rather than because of its actual worth. Thaler linked this to loss aversion, the idea that losing something feels worse than an equivalent gain feels good. In a 1990 experiment with Daniel Kahneman and Jack Knetsch, mugs were given to one randomly chosen group, who could then sell them to a second group without mugs. Since the groups were random, a rational model predicts about half the mugs would be traded at a fair price, but far fewer actually changed hands, because owners asked for more than non-owners were willing to pay.

Q4. What is mental accounting, and how does the taxi-driver example illustrate it? [4 marks]

1. Mental accounting describes how people mentally sort their money into separate accounts, such as bills, holidays or daily earnings, and make decisions based on each account's narrow effect rather than overall wealth. In the taxi-driver study cited by the Academy, drivers set a daily income target and stop working once they reach it. This means they work shorter hours on busy, high-fare days and longer hours on quiet, low-fare days, which is the opposite of what a profit-maximising model predicts, since treating each day as its own separate account creates an inefficient overall pattern of effort.

Q5. Describe the planner-doer model and explain how it connects to the idea of nudging. [6 marks]

1. The planner-doer model, developed by Thaler with Hersh Shefrin, treats a single individual as containing two competing selves. The "planner" is far-sighted and cares about lifetime wellbeing, while the "doer" is short-sighted and cares only about immediate satisfaction. This internal tension explains why people often fail to keep resolutions, such as saving for old age or eating more healthily, even when they genuinely intend to. The Academy compared this framework to the planner self and the doer self that psychologists and neuroscientists now use when describing long-term planning against short-term impulse, and illustrated the same conflict with the ancient story of Odysseus binding himself to the mast so that his long-term goal of reaching home could not be undone by the Sirens' short-term temptation. From this idea, Thaler developed the concept of a "nudge": a gentle, low-cost measure that helps the planning self win out without removing anyone's freedom to choose otherwise. His applied example is the "Save More Tomorrow" pension programme designed with Shlomo Benartzi, in which employees commit in advance to saving a share of future pay rises, since promising to save tomorrow is psychologically easier than cutting spending today.

Q6. How did fairness concerns, according to Thaler's research, affect firms' pricing decisions? [3 marks]

1. Thaler's research on social preferences showed that consumers hold strong views about what counts as a fair price. The popular science background gave the example of a shopkeeper who raises the price of umbrellas during a sudden spell of unexpected rain; even though higher demand would justify a higher price under standard theory, many consumers react negatively and feel the shopkeeper has behaved greedily. This fairness concern can stop firms from raising prices during periods of high demand, even when it would otherwise be profitable to do so.

Q7. What was the dictator game, and why was it significant? [3 marks]

1. The dictator game was an experimental tool devised by Thaler and his colleagues in which one participant decides how to divide a sum of money with another participant who has no say in the outcome. It became significant because it has since been used in numerous studies worldwide to measure people's underlying attitudes to fairness, helping researchers test whether self-interest alone, or also fairness, drives economic behaviour.

Q8. Discuss how Thaler's work changed economics as a discipline, with reference to behavioural finance. [6 marks]

1. Before Thaler's contributions, mainstream economics largely modelled people as fully rational agents who process information perfectly and always act in their self-interest. Thaler, building on earlier work by laureates such as Herbert Simon and Daniel Kahneman, systematically incorporated three realistic psychological traits, limited rationality, social preferences, and lack of self-control, into economic analysis. His empirical findings, including the endowment effect, mental accounting and the planner-doer model, gave other researchers tools to test and extend behavioural ideas, helping move the field from what the Scientific Background called a "somewhat controversial, fringe field" into a mainstream area of contemporary economics. Together with fellow laureate Robert Shiller, Thaler is considered a founder of behavioural finance, which studies how investor psychology, combined with limits on arbitrage, can cause market prices to move away from what standard efficient-market theory would predict. His work has also influenced policy design, inspiring government "nudge units" in countries including the UK and the USA, and has spread into neighbouring fields such as marketing and law.

Key takeaways

• Richard H. Thaler won the 2017 Nobel Prize in Economics alone, for his contributions to behavioural economics.
• He built economic analysis around three realistic psychological traits: limited rationality, social preferences, and lack of self-control.
• The endowment effect shows people value items more highly once they own them, as seen in the mug-trading experiments.
• Mental accounting describes how people sort money into separate mental categories rather than judging decisions by total wealth.
• The planner-doer model explains self-control failures as a conflict between a far-sighted planner and a short-sighted doer.
• Thaler coined the term "nudge" for gentle measures that help people make better choices while preserving free choice.
• His Save More Tomorrow programme applied nudging to raise pension savings in practice.
• With Robert Shiller, Thaler helped found behavioural finance, which studies psychology's effect on financial markets.
• His ideas have influenced public policy through nudge units in countries including the UK and the USA.

Test yourself

What was the official citation for Thaler's 2017 Nobel Prize in Economics?

The citation was "for his contributions to behavioural economics", as stated by the Royal Swedish Academy of Sciences.

Where was Richard H. Thaler affiliated when he won the prize?

Richard H. Thaler was affiliated with the University of Chicago, Chicago, IL, USA, at the time of the award.

What is the endowment effect?

The endowment effect is the tendency to value an item more highly simply because one owns it, compared with an identical item one does not own.

What two selves make up the planner-doer model?

The planner-doer model has a far-sighted planner who cares about lifetime wellbeing and a short-sighted doer who cares only about the present.

What term did Thaler coin for gentle measures that steer choices without removing freedom of choice?

Thaler coined the term "nudge" for such low-cost, freedom-preserving measures.

Which pension programme did Thaler design with Shlomo Benartzi?

Thaler and Shlomo Benartzi designed the "Save More Tomorrow" programme, where employees commit to saving future pay rises.

Which fellow laureate did Thaler work with to found behavioural finance?

Thaler is considered, together with Robert Shiller, a founder of the field of behavioural finance.

What example did the Nobel committee give for fairness affecting pricing?

The committee cited a shopkeeper raising umbrella prices during unexpected rain, which many consumers see as unfair and greedy.