On Balance: Nobel Laureate Richard Thaler, Behavioral Economics, and Benefit-Cost Analysis

October 26, 2017

By David L. Weimer

Rational action lies at the heart of neoclassical economics. Sovereign consumers make choices that maximize their utilities. By observing the tradeoffs implicit in actual choices, or eliciting tradeoffs for hypothetical choices, benefit-cost analysts impute willingness to pay for desirable policy impacts and willingness to accept undesirable ones. Yet, it appears that sometimes consumers seem to make mistakes. The field of behavioral economics seeks to provide a more realistic psychological model of consumers and other economic actors that helps us understand apparent deviations from neoclassical rationality. The 2017 Nobel Memorial Prize in Economic Sciences recognizes Richard H. Thaler’s pioneering contributions to behavioral economics.

A handful of Nobel prizes have gone to scholars who have mounted fundamental challenges to the assumption of rational action––Hebert Simon with satisficing, Robert Schiller with irrational exuberance, and, most fundamentally, Daniel Kahneman with cognitive limits and judgmental biases. Whereas Kahneman is a psychologist who exported these ideas into economics, Thaler imported them into economics, extended them, and in the process helped create the new field of behavioral economics, which treats apparent deviations from individual rationality as the subject of systematic study rather than just anomalies that can be ignored. 

Thaler’s earliest work was both neoclassical and directly relevant to BCA. With his thesis advisor, Sherwin Rosen, he did some of the earliest work that attempted to impute a value of statistical life from observed tradeoffs between occupational risks and wages. Although his prominent work on behavioral finance is a bit removed from BCA practice, his work on the endowment effect, time inconsistency, and other “anomalies” have direct relevance to interpreting both revealed and stated preferences. His articles on the endowment effect, co-authored with Kahneman and Jack Knetsch1, have been particularly influential in the continuing debates within the BCA community about the implications of the often observed large difference between the willingness to pay for a gain and the willingness to accept compensation for a loss of comparable magnitude.

When consumer choices do not appear consistent with rational action, the usual acceptance of revealed preferences as the basis for estimating willingness to pay comes into question. Often consumers themselves recognize that their weighing of alternatives differ between the time they make a choice (based on their decision utility) and the time they bear the consequences (their experience utility). To the extent that we accept the latter as the basis for individual welfare, choices do not reveal the right preferences. In other words, BCA analysts should not only address the internal and external validity of studies of observed tradeoffs in pursuing benefit transfer but also the validity of assuming these tradeoffs appropriately reveal benefits. 

Stated preference methods, such as contingent valuation, face challenges from non-economic responses. The hypothetical nature of willingness-to-pay elicitations opens the door for non-economic responses because the respondents do not actually bear the consequences of their choices. Further, unlike consumers making actual choices in markets and other institutional contexts, respondents usually do not have an opportunity to learn from experience. Growing up chronologically together, contingent valuation and behavioral economics have been intellectually entwined. Behavioral critiques of contingent valuation, often quite heated in the early days, have propelled it toward methods and craft that better accommodate behavioral responses. Some examples: because of large endowment effects, contingent valuations generally elicit willingness to pay even when willingness to accept better fits the policy impact being valued; because of non-commitment, contingent valuations generally follow elicitations with questions about the certainty of response and use this information to adjust bid acceptances; and despite the desire for more data, contingent valuations generally avoid multiple elicitations because initial choices can affect subsequent choices. These and many other developments in contingent valuation came as responses to behavioral critiques (see Knetsch et al 2012). Although not the direct source of these critiques, Thaler’s contributions, especially on the endowment effect, clearly influenced the debate. Indeed, one might reasonably argue that behavioral economics has had its biggest impact on BCA by driving the evolution of contingent valuation.

Perhaps Thaler’s greatest influence on policy has been through his work with Cass Sunstein on nudging individuals to make more rational choices through changes in the architecture of choice. In addition to widespread public attention, whole units of government have been created in the United Kingdom, United States, and other countries to look for ways of incorporating behavioral findings into policy designs. Assessing the efficiency impacts of nudges requires BCA analysts to step beyond consumer sovereignty to assess impacts paternalistically. We already do so with respect to choices made by children and the mentally impaired. Should we accept this responsibility when relatively small changes in circumstances alter individual choices? We will likely be addressing this issue for many years to come.

As BCA practitioners (and advocates) we owe an intellectual debt to Thaler. Examples of Thaler’s influence can be found in the Special Issue of JBCA on [Ir]rationality, Happiness, & BCA (2016). We want to use our craft to help government guide the allocation of society’s scarce resources to their most valued uses. Behavioral economics forces us to think harder about how we are assessing value. Although much of what we do remains well grounded in neoclassical theory and the interpretation of evidence it frames, behavioral economics has identified a number of empirical regularities that force us to think even harder about how to practice our craft in a responsible way. 

David Weimer is the Edwin E. Witte Professor of Political Economy, University of Wisconsin–Madison and was president of the Society for Benefit-Cost Analysis in 2013. He is the author of Behavioral Economics for Cost-Benefit Analysis (Cambridge University Press 2017).  

1. Kahneman, Daniel, Jack L. Knetsch, and Richard H. Thaler. "Experimental tests of the endowment effect and the Coase theorem." Journal of Political Economy 98, no. 6 (1990): 1325-1348.