9 OCTOBER 2017

Scientific Background on the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017

RICHARD H. THALER: INTEGRATING ECONOMICS WITH PSYCHOLOGY

The Committee for the Prize in Economic Sciences in Memory of Alfred Nobel

THE ROYAL SWEDISH ACADEMY OF SCIENCES, founded in 1739, is an independent organisation whose overall objective is to promote the sciences and strengthen their influence in society. The Academy takes special responsibility for the natural sciences and mathematics, but endeavours to promote the exchange of ideas between various disciplines.

BOX 50005 (LILLA FRESCATIVÄGEN 4 A), SE-104 05 STOCKHOLM, SWEDEN TEL +46 8 673 95 00, KVA@KVA.SE WWW.KVA.SE

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RICHARDTHALER’SCONTRIBUTIONSTOBEHAVIORALECONOMICSOctober3,2017

1.IntroductionEconomistsaimtodevelopmodelsofhumanbehaviorandinteractionsinmarketsandothereconomicsettings. Butwehumansbehaveincomplexways.Althoughwetrytomakerationaldecisions,wehavelimitedcognitiveabilitiesandlimitedwillpower.Whileourdecisionsareoftenguidedbyself-interest,wealsocareabout fairnessandequity.Moreover cognitive abilities, self-control, andmotivation can vary significantly acrossdifferentindividuals.1Inordertobuildusefulmodels,economistsmakesimplifyingassumptions. Acommonand fruitful simplification is to assume that agents are perfectly rational. Thissimplificationhasenabledeconomiststobuildpowerfulmodelstoanalyzeamultitudeof different economic issues andmarkets.Nevertheless, economists andpsychologistshavedocumentedsystematicdeviationsfromtherationalbehaviorassumedinstandardneoclassical economics. Incorporating insights from psychology into traditionaleconomicanalysishasspawnedthefieldofbehavioraleconomics,aflourishingareaofresearchwithsignificantimpactonmanysubfieldsofeconomics.2This year’s Laureate Richard Thaler played a crucial role in the development ofbehavioral economics over the past four decades. He provided both conceptual andempirical foundations for the field. By incorporating new insights from humanpsychology into economic analysis, he has provided economists with a richer set ofanalytical and experimental tools for understanding and predicting human behavior.This work has had a significant cumulative impact on the economics profession; itinspireda largenumberofresearcherstodevelopformaltheoriesandempirical tests,which helped turn a somewhat controversial, fringe field into a mainstream area ofcontemporaryeconomicresearch.Thaler’svisionforincorporatinginsightsfrompsychologyintoeconomicswasfirstlaidoutinhis1980article“Towardapositivetheoryofconsumerchoice.”Inhiswell-known“Anomalies” series in the Journal of Economic Perspectives, as well as in many otherarticles, comments, and books, he continued to document and analyze how economicdecisionsareinfluencedbythreeaspectsofhumanpsychology:cognitivelimitations(orbounded rationality), self-control problems, and social preferences. We organize thisoverviewofThaler’scontributionsaroundthesethreetopics.3

1Forexamplesofresearchtryingtounderstandthedeterminantsandcorrelationsofsuchtraits,seeBenjaminetal.(2013).2Forsurveysofbehavioraleconomics,seee.g.Rabin(1998),CamererandLoewenstein(2004),Dellavigna(2009),andCamerer(2014).3Thaler(2015,p.258)himselfrefersto“thethreebounds”:boundedrationality,boundedwillpower,andboundedself-interest.

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A first contribution by Thaler is his pioneeringwork on how deviations from ideallyrationalbehaviorsystematicallyshapeeconomicdecisions.InThaler(1980),hecoinedthe term endowment effect for the tendency of individuals to value items more justbecausetheyownthem,andshowedhowthisphenomenonrelates to lossaversion inprospecttheory(KahnemanandTversky1979).Insubsequentwork,hedevelopedthetheoryofmentalaccounting (Thaler1985,1999) inorder tounderstand thecognitiveoperationsusedby individualstoorganizeandevaluatetheireconomicactivities.Thistheory shows how individuals can overcome cognitive limitations by simplifying theeconomicenvironmentinsystematicways,butalsohowsuchsimplificationscanleadtosuboptimaldecisions.Asecondcontributionrelatestoself-controlproblemsthatpreventagentsfromcarryingout their optimal plans, even if they can compute them. In theplanner-doermodel ofThaler and Shefrin (1981), an individual is assumed to be both a myopic doer, whoevaluates options only for their current utility, and a farsighted planner, who isconcerned with lifetime utility. Later, Thaler and co-authors applied this model tounderstandthesavingsbehaviorofindividualsandhouseholds.Theplanner-doermodelis an early example of a so-called two-system or dual model of behavior, which is acommon way of modeling human behavior in contemporary psychology andneuroscience.Thaler’swork on limited cognition and self-control has been influential among policymakers. This includes specific ideas, such as how to boost retirement savings (ThalerandBenartzi2004),aswellas themoregeneralperspectiveof libertarianpaternalism(Thaler and Sunstein 2003), which recommends minimally invasive policies that“nudge”peopleintomakingbettereconomicdecisions.A third contribution by Thaler is to show how social preferences are essential foreconomic decision-making. Together with his collaborators, Thaler designed andimplementedelegantandhighlyinfluentiallaboratoryexperiments,suchasthedictatorgameformeasuringsocialpreferences.Healsoshowedhowconcernsforfairnessaffectthebehaviorofindividualsinconsumerandlabormarkets,withimportantimplicationsforoptimalfirmbehavior(Kahneman,Knetsch,andThaler1986a,b).4Finally,Thalerhasprovidedempiricalevidencesuggestingthatindividualpsychologicalaspects do not disappear when many economic agents interact together in markets.TogetherwithRobertShiller(2012LaureateinEconomicSciences),heisconsideredthefounderof the fieldofbehavioral finance,whichanalyzeshow investorpsychology, inconjunctionwithlimitstoarbitrage,canaffectpricesinfinancialmarkets.5Hisworkhasalso found wide applications in academic fields neighboring to economics, such asmarketingandlaw.

4Thisinspiredanimportanttheoreticalliteratureonsocialpreferences,includingRabin(1993),FehrandSchmidt(1999),BoltonandOckenfels(2000),andCharnessandRabin(2002).5Shiller’spioneeringworkinbehavioralfinanceincludesShiller(1981,1984).SeeBarberisandThaler(2003)forasurvey.

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We now describe, in one main section each, Thaler’s contributions to the study ofboundedrationality(Section2), limitedself-control(Section3),andsocialpreferences(Section4).WealsobrieflydiscussThaler’sworkonbehavioralfinance(Section5).2.BoundedrationalityInthissection,wediscussThaler’sresearchonboundedlyrationaldecisionmaking.Westart by briefly mentioning some important predecessors. Then we discuss the“endowment effect,” a term coined by Thaler to describe the observation that a goodoftenappears tobemorehighlyvaluedwhen it ispartof an individual’s endowment,compared to when it is not. Finally, we turn to his mental-accounting model, whichdescribeshowboundedlyrationalindividualsadoptinternalcontrolsystemstoevaluateandregulatetheirbudgets,andpredictshowthiswillaffectspending,saving,andotherhouseholdbehavior.2.1PredecessorsExpected-utility theory was axiomatically derived by von Neumann andMorgenstern(1944)asacriterionforrationaldecision-making.Thisworkwashighlyinfluentialandstillservesasthebenchmarktheoryofindividualdecision-making.However,asMauriceAllais (1988 Laureate in Economic Sciences) pointed out as early as 1951, in somesituationsactualbehaviordifferssystematicallyfromthepredictionsofexpected-utilitytheory(Allais1953).Inthe1950’s,HerbertSimon(1978LaureateinEconomicSciences)exploredtheeffectsoflimitedcognitionandanalyzedtheimplicationsofindividualboundedrationalityonthedesignandperformanceoforganizations(Simon1955). Simonarguedthat,ratherthanfindingoptimalsolutionsthatmaximizelifetimeexpectedutility,decision-makerstypicallytrytofindacceptablesolutionstoacuteproblems.Theverydifficultproblemoffindinganoptimumis thusreplacedbythesimplerproblemofsatisfyingasetofself-imposed constraints. This fruitful idea underlies Thaler’swork onmental accounting,discussed below. Inspired by Simon’s work, Reinhard Selten (1994 Laureate inEconomic Sciences) investigated the impact of bounded rationality on firm behavior(SauermannandSelten1962)andprovidedearlyexperimentalevidenceondeviationsfromrationaleconomicbehavior(SeltenandBerg1970).In2002,psychologistDanielKahnemanreceived theEconomicsPrize forhis researchonhumanjudgementanddecision-makingunderuncertainty,muchofwhichwasdonetogether with fellow psychologist Amos Tversky. Kahneman and Tversky’s (1979)prospect theory aims to describe the actual behavior of individuals when makingdecisionsunderrisk,whichmaynotnecessarilyberationaloroptimal.Theirtheorywasmotivatedbyanumberoffindingsonhowpeoplesystematicallyviolatethepredictionsofexpected-utilitytheory.6

6Inlaterwork,KahnemanandTverskyprovidedanimportantextensionofprospecttheorycalled“cumulativeprospecttheory”(TverskyandKahneman1992).

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Prospect theory contains fourmainelements. First, individualsderiveutilitynot fromwealth (or consumption) levels, but rather from gains and losses relative to somereferencepoint.7Second,individualsaremoresensitivetolossesthantogains,i.e.,theyexhibit lossaversion.Theutility function captures the loss aversionof individuals in akink at the reference point, with the function being steeper in the losses regioncomparedto thegainsregion.Third, individualsexhibitdiminishingsensitivity togainsandlosses, i.e.,movingfroma$100toa$200gain(or loss)hasa largerutility impactthanmovingfroma$10,100toa$10,200gain(orloss).Fourth,thetheoryincorporatesprobability weighting: individuals weigh outcomes by subjective, transformedprobabilitiesordecisionweights,overweighting lowprobabilitiesandunderweightinghighprobabilities.Thaler(1980)wasthefirsteconomisttoapplyprospecttheorytoeconomicissuesandproblems.WhileKahnemanandTversky(1979)hadfocusedonriskydecisions,Thalershowedthe importanceofreferencepointsand lossaversion indeterministicsettings.His work inspiredmany followers and helpedmake Kahneman and Tversky’s article(1979)oneofthemostcitedinallofeconomics(seeBarberis2013foranoverview).82.2LossaversionandtheendowmenteffectWhileworkingonhisPh.D.thesisattheUniversityofRochester,whichhedefendedin1974,Thalerstartedexperimentingwithhypotheticalsurveyquestionstoestimatethevalueofmortality risk reductions (Thaler1974).9Thismethodology canbe illustratedbythefollowingtwosurveyquestionsfromhis1980paper:(a)Assumeyouhavebeenexposed toadiseasewhich if contracted leads toaquickandpainlessdeathwithinaweek.Theprobability youhave thedisease is0.001.What is themaximumyouwouldbewillingtopayforacure?(b)Supposevolunteerswouldbeneededforresearchontheabovedisease.Allthatwouldberequiredisthatyouexposeyourselftoa0.001chanceofcontractingthedisease.Whatis the minimum you would require to volunteer for this program? (You would not beallowedtopurchasethecure.)Both questions involve the evaluation of a 0.001 probability of death. However, asThaler (1980,p.44)describes theresults, “manypeoplerespond toquestions (a)and(b)withanswerswhichdifferbyanorderofmagnitudeormore!(Atypicalresponseis$200[to(a)]and$10,000[to(b)]).”Peopleseemmuchlesswillingtopayfor“acquiring

7Apartfrombeingconsistentwithexperimentalevidence,KahnemanandTverskynotedthatourperceptualsystemismuchbetteratdetectingchangesinattributes(e.g.brightnessortemperature)thanevaluatingabsolutelevels.8Kahneman(2011,p.291-293)providesanaccountofThaler’spivotalroleinapplyingprospecttheorytoeconomicsand,intheprocess,establishingthefieldofbehavioraleconomics.9Thaler’sPh.D.thesiscontainsoneofthefirstwage-riskstudiestoestimatethe“valueofastatisticallife.”Basedonthethesis,hepublishedajointpaperwithhisPh.D.advisorSherwinRosenonthistopic(ThalerandRosen1976).Thissubsequentlybecameamajortopicinhealtheconomics.Today,value-of-statistical-lifeestimatesarecommonlyusedbygovernmentagenciesincost-benefitanalyses(Viscusi1993).

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health,” compared to howmuch theywould require as compensation to “sell health.”Thaler (1980) discusses several other scenarioswhere the price atwhich a person iswillingtobuyacertaingoodorserviceisconsiderablylowerthanthepriceatwhichthepersonwouldbewillingtosellthesamegoodorservice.10Neoclassical economic theory can hardly explain such a large difference between thewillingness to pay (WTP) and the willingness to accept (WTA).11But Thaler (1980)foundanexplanationinprospecttheory.Henotedthatifgivingupanobjectisperceivedasa loss, then loss-averse individualswillbehaveas if theobjects theyownaremorehighly valued than similar objects they do not own. This effect, which Thaler (1980)namedtheendowmenteffect,canexplainthelargedifferencesbetweenWTPandWTA.Thaler also showed that the endowment effect implies a difference between out-of-pocket costs andopportunity costs. People tend to viewout-of-pocket costs as losses,weightedmoreheavily,whileopportunitycostsareconsideredforegonegains,weightedless heavily. Thaler provided several examples of how firms utilize the endowmenteffectwhenmarketing their products to consumers. One example is to refer to “cashdiscounts” rather than “credit-cardsurcharges” inorder toportray thecostofusingacreditcardasaforegonegainratherthanarealizedloss.Thaler’suseofprospect theory toexplain theendowmenteffect stimulated importantsubsequent work. On the theoretical side, Tversky and Kahneman (1991) as well asKőszegi and Rabin (2006) modeled the endowment effect formally and derivedadditional behavioral implications. Loss-averse individuals have a strong tendency toremainatthestatusquo,becausethe losses fromachangeareweightedmoreheavilythan thegains.Thisso-calledstatus-quobiaswas firstdocumentedbySamuelsonandZeckhauser(1988;seealsoKahneman,Knetsch,andThaler1991).Status-quobiaswasan importantmotivation forThaler’s subsequentworkonpensionplans anddefaults,whichwedescribefurtherinSection3.3.On the empirical side, Thaler’s original evidence consisted mainly of answers toquestionnaireswith hypothetical questions. Subsequently,Knetsch and Sinden (1984)and Knetsch (1989) provided evidence for an endowment effect using real stakes.However,othereconomistsarguedthatthefindingswerelikelytodisappearifsubjectswereexposedtoamarketenvironment,wheretheyhadtheopportunityto learnovermultipleroundsoftrading.12Tosettlethisissue,Kahneman,Knetsch,andThaler(1990)testedtherobustnessoftheendowment effect in market experiments with real stakes and repetitions. They

10Forexample(Thaler1980,p.43):“Mr.Hmowshisownlawn.Hisneighbor’ssonwouldmowitfor$8.Hewouldn’tmowhisneighbor’ssame-sizedlawnfor$20.”11InhisrecentbookMisbehaving:TheMakingofBehavioralEconomics(2015),Thalerwrites:“Toaneconomist,thesefindingsweresomewhatbetweenpuzzlingandpreposterous.”Infact,Thaler(1980)wasnotthefirsttopublishempiricalevidenceforalargeWTP-WTAdisparity.EarlierfindingswerereportedbyHammackandBrown(1974),Sinclair(1978),Banfordetal.(1979)andBishopandHeberlein(1979).However,thesestudiesdidnotinterprettheWTP-WTAdisparityintermsoflossaversion.12Forexample,anearlystudybyCourseyetal.(1987)foundpartiallyconflictingresults:theWTP-WTAdisparitydecreasedwithrepetition,usingaVickreyauctionproceduretoelicitWTPandWTA.

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assignedsubjectsalternatingrolesasbuyersorsellers:sellersreceivedobjectsthattheycouldsellatdifferentprices,whilebuyershadtheopportunitytobuyattheseprices.Inthe first three market periods, the objects were induced-value tokens, with differentvalues for different individuals. After each period, the market-clearing price and thenumberof tradeswereannounced,and threebuyersand threesellerswererandomlypickedforrealpayments.Aftertheseperiodsoftokentrading,halfofthesubjectsweregivencoffeemugs,whichtheycouldselltotheotherhalf.Thiswasfollowedbysimilartrialswithtradeinballpointpens.Aspredicted,noendowmenteffectwasobservedinthe markets for induced-value tokens. However, the markets for mugs and pensexhibitedsizeableendowmenteffectsthatshowednotendencytodecreasewithmoretrials. For coffeemugs and pens, themedian reservation selling price (theWTA)wasabouttwiceashighasthemedianbuyingprice(theWTP).These results showed thatmarket-like institutions can indeed exhibit the endowmenteffect.Moreover,repeatedtradingwithfeedback,allowingforlearning,didnotseemtoeliminatetheeffect.Bynow,asubstantialliteraturehasestablishedtheexistenceoftheendowment effect. A recent meta-analysis included 337 estimates of the WTA/WTPratiofrom76differentstudies(TuncelandHammitt2014).ThegeometricmeanoftheWTA/WTP ratio was 3.28. However, the WTA/WTP ratio varied systematically fordifferenttypesofgoods,withthehighestratiosfoundforpublicandnon-marketgoodsandthelowestforgoodswithwell-knownmonetaryvalue.Thaler’soriginalexplanationbased on loss aversion is still the leading explanation for the endowment effect, eventhough alternative explanations also have been offered (see e.g. Hanemann 1991,Shogrenetal.1994,Brenneretal.2007,EricsonandFuster2014,MorewedgeandGiblin2015).13Some evidence suggests that the endowment effect is less significant in marketsdominated by professional traders. List (2004) confirmed the existence of anendowment effect in a sampleofnon-dealers recruited at amarket for sports tradingcards, but found no endowment effect for a sample of professional dealers from thismarket(whentradingcoffeemugsandcandybars).Anexplanationforthisfindingcouldbe that professional traders are less likely to become attached to the goods they aretrading;forthem,tradingcoffeemugsissimilartotradinginduced-valuetokens.14,15The endowment effect has an important implication: the initial allocation of propertyrightswill determine the final allocationof resources even if there areno transactioncostsandthevaluationsaretoosmallforincomeeffectstomatter.ThiscontradictsthefamousCoase theorem(Coase1960),a cornerstone in the fieldof lawandeconomics,which predicts that final allocations are independent of initial allocations, absent

13Forexample,Morewedgeetal.(2009)suggest,onthebasisofexperimentalevidence,thatownershipandnotlossaversioncausestheendowmenteffect.14ThetheoreticalmodelofKőszegiandRabin(2006)isconsistentwiththisfinding.Intheirmodel,thereferencepointisaperson’sexpectationaboutfutureoutcomes.Sincedealersexpecttoexchangeobjectsthatcomeintotheirpossession,theydonotexperiencemuchlossaversionwhentheytradethem.15PlottandZeiler(2005)implementedanexperimentalprotocolwithsubstantialtraininginbuyingandsellingbeforeelicitingtheWTPorWTAofamugandfoundnosignificantWTA-WTPgapformugs.However,asshownbyIsoni,LoomesandSugden(2011),theexperimentalprotocolstillresultedinasignificantWTA-WTPgapforlotteriesthatwerealsotradedinthesameexperiment.

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transaction costs and income effects.16In a paper with Jolls and Sunstein, Thalerproposed a general behavioral-economics approach to law and economics (Jolls,Sunstein,andThaler1998).Thisfieldhasgrownsubstantiallyoverthelasttwodecades,andanextensiveoverviewcanbefoundintheOxfordHandbookofBehavioralEconomicsandtheLaw(ZamirandTeichman2014).2.3MentalaccountingLikestandardeconomicmodels,Thaler’s(1980)explanationoftheendowmenteffectinterms of loss aversion assumes that individualsmaximize their preferences, althoughthesepreferencesdependonareferencepoint(theendowment).Amoreradicalbreakwiththestandardneoclassicalmodelofutility-maximizingconsumerscameafewyearslaterwiththetheoryofmentalaccounting(Thaler1985,1999).Mentalaccountingisapsychological theory of how limited cognition affects spending, saving, and otherhouseholdbehavior.InthewordsofThaler(2015,p.56),thistheorytriestoanswerthequestion“Howdopeoplethinkaboutmoney?”Thekeytotheansweristorealizethatdecision-making is piecemeal rather than comprehensive. The theory is related toThaler’s work on limited self-control (described in Section 3), as mental-accountingstrategiesmaymitigateself-controlproblems,andtohisworkonfairness(describedinSection4)throughtheconceptoftransactionutility.Onemotivation for the theory ofmental accounting is the empirical observation thatpeoplegroup their expenditures intodifferent categories (housing, food, clothes, etc.),with each category corresponding to a separate mental account. Thaler argues thatmentalaccountsareusedmoregenerallyasawayforboundedlyrationalindividualstosimplify their financialdecision-making.Eachaccounthas itsownbudgetand itsownseparatereferencepoint,whichresults in limitedfungibilitybetweentheaccounts.17Akey implication is then that thevalueapersonattributes toagivenamountofmoneymaydependontheaccountitisassignedto,whichinturndependsoncontext,framing,andsituation.Thaler(1985)suggeststhatthepracticeofmaintainingseparateaccountsfordifferentspending categories also provides a commitment device against overspending,especially for non-essential or addictive goods. Consider the common practice ofsimultaneouslykeepingmoneyinasavingsaccountandhavingcredit-carddebt(ThalerandSunstein2008,p.51).Inviewofthesubstantiallyhigherinterestrateonthelatter,this arrangement is hard to square with the standard model of rational behavior.However, a personwho suffers from a lack of self-control (as discussed in Section 3 16Farnsworth (1999) provided evidence against the Coase theorem based on the lack of attemptednegotiationsbetweenpartiesincivillawcases,evenwhenthecourtfailstoawardtherightstothepartywillingtopaythemostforthem.17To illustrate this, Thaler and Sunstein (2008, pp. 53-54) use an exchange between the actors GeneHackmanandDustinHoffman:“HackmanandHoffmanwerefriendsbackintheirstarvingartistdays,andHackmantellsthestoryofvisitingHoffman’sapartmentandhavinghishostaskhimforaloan.Hackmanagreedtotheloan,butthentheywentintoHoffman’skitchen,whereseveralmasonjarswerelineduponthecounter,eachcontainingmoney.Onejarwaslabelled‘rent,’another‘utilities,’andsoforth.Hackmanaskedwhy, ifHoffmanhad somuchmoney in jars, he couldpossiblyneed a loan,whereuponHoffmanpointedtothefoodjar,whichwasempty.”

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below)maybeexpectedtoquicklyrunupthecredit-carddebtagainafterpayingitoff.Maintainingsavingsasaseparateaccountwithaseparatereferencepoint(presumablyitscurrentamount)maydeter theperson fromusinghisorhersavings topayoff thecreditcard,thusprovidingacommitmentagainstexcessivespending.In addition to loss aversion, the theory also uses the diminishing-sensitivity property(risk aversion for gains and risk seeking for losses) to predict when compoundoutcomes will be integrated (that is, added together) or separated before beingevaluated. Specifically, if individuals try to edit outcomes to maximize their utility(“hedonicediting”),theywilltrytosegregategainsandintegratelosses,tocancelsmalllossesagainstlargergains,and(undersomeconditions)tosegregatesmallgains(“silverlinings”) from large losses.18As Thaler (1999) discusses, the evidence suggests thatpeoplebyandlargedobehaveaspredictedbythehedonic-editinghypothesis,althoughintegratinglossesseemsdifficultformanypeople.Buildingonthetheoryofreferencepoints,Thaler(1985)separatessourcesofconsumerutilityintoonecomponentassociatedwithconsumingthecommodityorservice,calledacquisition utility, and another component associated with the buy/sell transaction,calledtransactionutility.Acquisitionutilityissimilartostandardconsumersurplus:thevalueofthegoodtotheconsumerifreceivedasagift,minusthepricepaid.Transactionutilityisthedifferencebetweentheactualpriceandtheexpectedor“fair”pricecalledthe referenceprice. The transaction-utility part implies that the consumer gets addedvaluefroma“gooddeal”(buyingaproductbelowtheexpectedprice),butsuffersalossinutilityfrombuyingatahighpriceperceivedtobea“baddeal.”Indeed,theconsumermayabstainfrombuyingagoodthatwouldotherwiseyieldapositiveconsumersurplusifthepriceisperceivedasresultinginaparticularly“baddeal”In defining these concepts, Thaler ties the theory of reference points to the theory ofsocialpreferences.Ashortcomingoftheoriginalformulationofprospecttheorywasitssilenceonhowthereferencepointwasdetermined.Thalerproposesthatthereferencepriceisdeterminedbywhatisconsideredtobe“fair”tobothtransactingparties.Thatis,a buyer suffers a particularly large loss in utility from a transaction if the price isconsidered unfairly high. The importance of perceived fairnesswas demonstrated byThalerandco-authors inseveralstudies(Thaler1985,Kahneman,KnetschandThaler1986a,b),discussedinSection4.ImplicationsofmentalaccountingFollowingThaler(1985),alargeamountofworkbyThalerandbyothershasexploredanddocumentedtheconsequencesofmentalaccounting.HastingsandShapiro(2013)provideevidenceforakeyaspectofmentalaccounting:thelackoffungibilityofmoney.They studied the choice between regular and premium gasoline when the price ofgasoline fell by about 50% in 2008 and found that the shift from regular gasoline to

18The lastprediction,whichresults fromthe fact that thevalueofasmallgaincanexceedthevalueofslightly reducing a large loss, depends on the exact parameters of the value function and the exactdifferencebetweenthelargelossandthesmallgain.Lossaversionpersefavorsintegrationinthiscase,butthediminishingsensitivitytothesizeoflossesimpliesthatthevalueofasmallgaincanstilloutweighthevalueofslightlyreducingalargeloss.

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premiumgasolinewas14 times greater thanpredictedby a standarddemandmodel.Mentalaccounting–withaspecificaccountforgasoline–explainsthisexcessiveshift.Interestingly,andalsopredictedbymentalaccounting,theyfoundnosimilarshiftsfromlower tohigherqualityproducts inotherproduct categories forwhichpriceshadnotchanged.Thedynamicsofmental accountingwas further explored inPrelec andLoewenstein's(1998) prospective-accounting model. This “double-entry” mental-accounting theoryanalyzesthereciprocalinteractionsbetweenthepleasureofconsumingagoodandthepainofpaying for it. It leads to thenotionof “coupling,”whichrefers to thedegree towhichconsumptioncallstomindthoughtsofpayment,andviceversa.ShafirandThaler(2006) provide evidence on these phenomena from individuals who collect wine.Advancepurchases(e.g.,buyingacaseofwine)aretypicallythoughtofasinvestmentsratherthanpurchases.Atthesametime,consumptionofagoodpurchasedearlierandusedasplanned(abottleofwineopenedfordinner)isoftencodedas“free,”orevenassavings.Decouplingspendingandconsumptioninthiswayreducesthepainofbuying,anotherexampleofhedonicediting.Inmental-accounting theory,consequencesareperceivedandevaluateddependingoncontext,19as well as on how the decision-problem is “edited,” such as when hedoniceditingleadsindividualstocancelthepainofalossbygroupingittogetherwithalargergain.Boundariesarealsosetintime;mentalaccountsmustbe“opened”and“closed.”20Forexample,whenafinancialassetisbought,anewaccountisopenedwithareferencepointsettoitsacquisitionvalue.Sinceitispainfultoclosetheaccount(selltheasset)ata loss, the theoryhas important implications for trade in financial assets (ShefrinandStatman 1985, Thaler 1999). If losses and gains are evaluated and experienced onlywhen a mental account is closed, investors will more likely sell stocks that haveincreasedinvaluethanstocksthathavedecreasedinvalue.Investorswilltendtoholdontolosingstocks,becausesellingimpliesclosingtheaccountandexperiencingtheloss.ShefrinandStatman(1985)providedthefirstempiricalevidenceforthiseffect,whichthey labeled the disposition effect. The disposition effect was confirmed by Odean(1998),usingalargedatasetfromadiscountbrokeragefirm.Read, Loewenstein andRabin (1999) coined the term “choice bracketing” to describe

19Thaler(1999)illustratesthecontext-dependencewithahypotheticalscenariofromTverskyandKahnemann(1981):Imagine you are about to purchase a jacket for $125 and a calculator for $15. The calculator salesmaninformsyouthatthecalculatoryouwishtobuyisonsalefor$10attheotherbranchofthestore,located20minutes’driveaway.Wouldyoumakethetriptotheotherstore?Comparethiswith:Imagine you are about to purchase a jacket for $15 and a calculator for $125. The calculator salesmaninformsyouthatthecalculatoryouwishtobuyisonsalefor$120attheotherbranchofthestore,located20minutes’driveaway.Wouldyoumakethetriptotheotherstore?Both questions concern whether it is worth driving 20minutes in order to save $5. But in fact, mostpeoplesaythatitisworthitinthefirstscenario,butnotinthesecond.20Thefollowing(hypothetical)exampleillustratesthis(Thaler1980):afamilythatboughtexpensiveticketsforabasketballgamewilldrivethroughasnowstormtogettothegame,sincenotattendingthegamewouldimplyclosingthementalaccountataloss,buttheywouldhavestayedhomeiftheyhadreceivedtheticketsasafreegift.

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theextent towhichchoicesareseparated(narrowbracketing)orgroupedtogether inmental accounting. The piecemeal decision-making typically predicted by mentalaccounting is a formofnarrowbracketing thathas substantial empirical support (seeThaler and Johnson 1990, Read, Loewenstein and Rabin 1999, and Rabin andWeizsäcker2009).In a well-known study, Thaler and co-authors studied labor-supply decisions of taxidrivers in New York City (Camerer et al. 1997). They found evidence for reference-dependentpreferencesandnarrowbracketinginthesensethatdriversbehaveasiftheytrytoattainatargetincome(thereferencepoint)everydayandtherebysufferfromlossaversion if they fail to reach the target. In other words, each working day seems tocorrespondtoaseparatementalaccount.Driversthereforedrivelessondayswithhighdemand andmore ondayswith lowdemand,which is the opposite ofwhat standardeconomictheorywouldpredict.21,22ThalerandJohnson(1990)showedthateventhoughindividualstendtoberiskaverse,theyoftenbecomerisk-seekingwithmoneyrecentlygained in, for instance,gambling.This “house-money effect” occurs because the gains are put into a special mentalaccount,whichistreateddifferentlyfromothermoney.ThalerandJohnson(1990)alsofindevidence fora “break-eveneffect”: anextra tendency for risk-seekingbehavior inthelossdomainwhenthereisachancetobreakevenfromapreviousloss.InlaterworkbyThalerandco-authors(Postetal.2008),boththehouse-moneyeffectandthebreak-eveneffectareconfirmed inahigh-stakesenvironment(basedondata fromthegameshowDealorNoDeal).3.Limitedself-controlConsumingmoretodayusuallymeansconsuminglesstomorrow,sotheconsumermustweighcurrentdesiresagainstfuturedesires.Thestandardneoclassicalmodelofrationalintertemporal choice is the exponential discounting model of Fisher (1930) andSamuelson(1937).Thismodelhasservedadmirablyformanypurposes,bothnormativeand descriptive. The standard exponential discounting model implies time-consistentpreferences, however, which makes it hard to explain certain types of observedbehavior, for example, preference reversals and the demand for commitmenttechnologies.23,24

21ThisfindingwaschallengedbyFarber(2005,2008)usinganotherdatasetonNewYorktaxidrivers.However,usingFarber’sdata,CrawfordandMeng(2011)foundsupportforreference-dependentpreferenceswithadailyevaluationperiod.FehrandGoette(2007)alsofoundsupportforreference-dependentpreferencesinafieldexperimentofbicyclemessengers.22Evidencefornarrowbracketinginfinancialmarketswillbediscussedinsection5.23Willpower,however,maybeimplicitlyinvolvedindeterminingthediscountfactor.Böhm-Bawerk(1889)arguedthatdiscountingoffutureconsumptionmaybeduetoa“defectofwill.”Pigou(1920)insteadattributedittoafailureofimagination.24Infact,asThaler(2015)pointsout,Fisher(1930)himselfhaddoubtsaboutthedescriptivevalidityoftheneoclassicalmodel.

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In this section,we largely abstract from the cognitive limitations of people, and focusinstead on the struggle between a person’s different “selves.” We begin by brieflyreviewingsomeearlywork,includingThaler’sempiricalstudyofdiscounting.Wethenturntotheplanner-doermodelofThalerandHershShefrin.Finally,weconsiderpolicymaking,includingThalerandCassSunstein’sadvocacyoflibertarianpaternalism.3.1Earlyworkonself-controlproblemsAs early as Aristotle’s discussion of akrasia (weakness of the will), philosophers andsocial scientists have considered the possibility that peoplemay fail to dowhat theyknowisright.25Inthefieldofpsychology,thestudyofself-controlwasenergizedbythework of Freud (1955). In the 1960’s the psychologist Walter Mischel introduced hisfamousmarshmallow test,where children canhaveonemarshmallow immediatelyortwomarshmallowsafteradelay(Mischel2014).26Strotz(1956)hypothesizedthatpeoplearebornwithatendencytoovervaluecurrentconsumption. Incontradictionof thestandardmodelofexponentialdiscounting,morediscountingoccursbetweenthepresentandthenearfuturethanbetweenperiodsinthemoredistantfuture.Aspecialcaseofthisphenomenonishyperbolicdiscounting(Ainslie1992).27Weuse this termas shorthand for themoregeneral kindof “present-biased”discount functionstudiedbyStrotz (1956).Strotzshowed thathyperbolicdiscountingleadstoaproblemoftime-inconsistency:the“presentself”wouldliketosavemoreinthe future, but the “future self” will prefer not to implement the plan.28Allais (1947,Appendix3)andThomasSchelling(1960,1978;2005Laureate inEconomicSciences)also discussed the possibility that intertemporal choice involves a conflict betweendifferent“selves.”29

25Forexample,DavidHume(1739,BookIII,SectVII)arguedthatimperfectself-controlisoneofthethreereasonsforwhypeopleneedagovernment,andAdamSmith(1759)describedself-controlasastrugglebetweenthepassionsandanimpartialspectator.WilliamJames(1890)wrotethatthe“[e]ffortofattentionistheessentialphenomenonofthewill.[…]Whatconstitutesthedifficultyforamanlabouringunderapassionofactingasifthepassionwaswise?Certainlythereisnophysicaldifficulty.Itisaseasyphysically[…]topocketone’smoneyastosquanderitonone’scupidities,towalkawayfromastowardsacoquette’sdoor.Thedifficultyismental:itisthatofgettingtheideaofthewiseactiontostaybeforethemindatall.”26Mishel’smeasureofself-controlwaslaterfoundtocorrelatewithlife-outcomessuchasSATscoresandeducationalattainment(Mischel,ShodaandRodriguez1989,Mischel2004).Thaler(2015)notesthatMischel’sexperimentsinspiredhisownworkonself-controlandtheplanner-doermodel.27PhelpsandPollak(1968)consideredwhatisnowreferredtoas“quasi-hyperbolic”discounting.ThisformulationwouldlaterbecomehighlyinfluentialviaLaibson’s(1997)studyofcommitmenttoprudentconsumptionthroughinvestmentinilliquidassets,andO’DonoghueandRabin’s(1999,2001)workonprocrastination.28Atage30,Imightplantostartsavingforretirementatage35.WhenIturn35,however,Idonotwanttostartsavingsincethatmeanslesscurrentconsumption.29Thismanifestationoftime-inconsistencyisdifferentthantheonetreatedinthemacroeconomicliterature,whererationalpolicy-makershaveincentivestodeviatefromtheirpreviousplansbecausetheconstraintstheyfacearechangingovertime.Researchonthissecondtypeoftime-inconsistencywasoneofthemotivationsfortheprizetothe2004LaureatesinEconomicSciences,FinnKydlandandEdwardPrescott(KydlandandPrescott1977).

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Thaler (1981) provided the first experimental evidence of hyperbolic discounting inhumans.30Thaler’ssubjectswereaskedtomakehypotheticalchoicesbetweenpayoffsatdifferenthorizons, andhe found thatdiscounting is in factmuch steeperbetween thepresent and the near future than between periods in the more distant future. Hefurthermore found that gains are discounted more than losses, and that smalleroutcomesarediscountedmorethanlargeroutcomes.Thaler’s findings raised the interest among economists in self-control problems andtime-inconsistent preferences. The discounting patterns identified by Thaler (1981)havesincebeenconfirmedinmanysubsequentstudies;seeFredericketal.(2002)forareview.Hyperbolicdiscountingcanexplainmanypuzzlingobservations,e.g.,thatpeoplewho want to quit smoking keep postponing the decision. It also naturally creates ademand forcommitment technologies,ademandwhichdoesnotexist in thestandardexponential-discounting model. Real-world examples of commitment devices includethe“ChristmasClubs”mentionedbyStrotz(1956)andThaler(1981),whereindividualscommit to saving for Christmas; the drugs Xenical (that gives unpleasant side-effectswhenovereating)orAntabuse(thatmakesyousickifyoudrinkalcohol);andcommonlyusedrulesofthumblike“donotshopwhenyouarehungry”or“donotkeepalcoholathome.”3.2Theplanner-doermodelMotivated by the observed deviations from exponential discounting, Thaler and hiscollaboratorHershShefrinproposedtheplanner-doermodel(ThalerandShefrin1981,ShefrinandThaler1988).Intheplanner-doermodel,apersonhastwoselves:amyopicdoer and a farsighted planner. The planner is concerned with the maximization oflifetime utility (discounted present value), while the doer cares only about currentutility.Becausethedoerisunconcernedwiththefuture,herbehaviortendstobecomeshort-sighted, just ashypothesizedbyStrotz (1956).However,while theStrotzmodelsuggestsaconflictbetweendifferentselvesthatexistatdifferenttimes(currentselfvs.future self), the planner-doermodel suggests a conflict between different selves thatexistsimultaneously(plannervs.doer).To maximize lifetime utility, the planner can either force the doer to reduce currentconsumptionbyapplyingcostlywillpower,orimposerulesthatlimittherangeofdoerdiscretion.Theseself-imposedrulesofthumbconstrainthebehaviorofthedoer,albeitimperfectly.Theplanner-doermodelcapturestheideathatwillpowercanbeappliedtoresist temptation, but this carries a psychic cost. That costly willpower is used toconstrain the behavior of the doer implies that the effective degree of self-control isendogenous (in contrast to the exogenously given hyperbolic discounting of Strotz1956).Individualcharacteristicswilldeterminehoweffectivelytheplannercancontrolthedoer,suchthatdifferentpeoplewillexhibitdifferentdegreesofself-control.

30Ainslie (1974) provided experimental evidence on time-inconsistent behavior in pigeons consistentwith hyperbolic discounting, even arguing that (some) pigeons engage in impulse control by makingcommitments(seealsoAinslie1992).Ainslie(1975)alsodiscussedimpulsecontrolinhumans,informallyarguingthatsingle-playerindefinitelyrepeatedgamescouldhavemultipleequilibria.

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ThalerandShefrin(1981)treatedtheself-controlproblemasaprincipal-agentproblem,with the planner (principal) trying to constrain and incentivize the doer (agent) tomaximize lifetimeutility.The sameapproachhasbeenused in subsequent theoreticalanalysesofself-control,suchasBénabouandTirole(2004).Theplanner-doermodelhasrecentlybeenreformulatedandextendedbyFudenbergandLevine(2006,2011,2012)inaseriesofpapers.BénabouandPycia(2002)alsoshowedthattheaxiomatictheoryofself-controlbyGul andPesendorfer (2001) canbe reexpressed in termsof aplanner-doermodel.The planner-doer model of Thaler and Shefrin (1981) encapsulates the modernneuroscientific view that thehumanbrain is a collectionofmany interacting systems.Because these systemsdon’t alwayswork seamlessly together,behaviormaynot looklike that of a fully rational agent with consistent preferences and beliefs (see, e.g.,Kurzban2012).ShefrinandThaler(1988)notedthatonecouldthinkoftheplannerastheprefrontalcortexandthedoerasthelimbicsystem.Theprefrontalcortexhasbeenidentified as the location in the brainwhere long-run planning takes place (it is “theexecutive of the brain”; Fuster 1980), while the evolutionarily older limbic systemgeneratesshort-termemotionsanddesires.Neuro-economicsresearch,suchasMcLureet al. (2004), has provided evidence that self-control problems indeed involve theinteractionoftheprefrontalcortexandthelimbicsystem.31Alongsimilarlines,theplanner-doermodelcanbecomparedwithdual-processtheoriesin psychology. In these theories, decisions are assumed to be governed by intuitiveprocesses(System1),typicallycharacterizedasbeingfast,automaticandeffortless;aswellasbydeliberativeprocesses(System2),characterizedasbeingslower,controlledandeffortful.32Asalludedtoabove,theideaofdifferent,conflicting“selves”inthebrainhasa longhistory ineconomicsandwasalreadyarticulatedbyAdamSmith(1759) inTheoryofMoralSentiments.ButThaler and Shefrin (1981)were the first to present adual-selfmodelofself-control.The planner-doermodelmakes a number of predictions that have been supported insubsequentempiricalwork.Forinstance,itpredictsthatamandatorypensionplanwillincreasetotalsavings(thatis,themandatorysavingsarenotfullyoffsetbyareductionin other savings), because the plan produces savings without the psychic costs ofinducing willpower. This prediction is empirically supported in the recent study byChettyetal. (2014).Themodelalsopredictsthatthemarginalrateof timepreferencewillexceedtheafter-taxinterestrateduetoself-imposedborrowing-constraints.Thalerand Shefrin (1988) refer to several studies estimating the marginal rate of time 31Camerer(2007,p.C28)alsonotesthatcurrentneuroeconomics,bytreatinganindividualeconomicagentlikeafirm,followsThalerandShefrin’slead:“Therapidemergenceofvariousdual-selfordual-processapproachestestifiestohowwelleconomictheorycanbeadaptedtostudythebrainasanorganizationofinteractingcomponents.”32SeeEvansandStanovich(2013)foradiscussionofdual-processtheoriesinpsychology,andalsoKahneman(2003a).SeealsotheearlycontributionsofWasonandEvans(1975),SchneiderandShiffrin(1977)andShiffrinandSchneider(1977),andthemorerecenthot/cooltwo-systemmodelofself-controlbyMetcalfeandMischel(1999).TheSystem1/System2modelisthebasisforKahneman’s2011bookThinkingFastandSlow.Kahneman(2011)notesthatheandTverskydidnothaveadualsysteminmindwhendevelopingprospecttheory,butlaterheinterpretedprospecttheoryintermsofadual-systemmodel.

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preferencewithestimatesfarexceedinginterestrates.Thispatternisalsoconfirmedinmorerecentstudies(Harrisonetal.2002,Attemaetal.2016).3.3Policy-makingIndividualswithlimitedcognitiveabilitiesandlimitedwillpowerwillnotalwaysactintheirownbestinterests.Anindividualmaywishshecouldstopsmoking,orsavemoreforretirement,butfindsherselfunabletodoso.Whatpoliciescanhelpsuchindividualsmakedecisionsmoreinlinewiththeirownlong-terminterests?Inmanyways,Thalerhasshownhowbehavioraleconomicscanhelpanswerthisquestion.Togetherwith his collaborator Cass Sunstein, Thaler has been a leadingproponent oflibertarian paternalism (Thaler and Sunstein 2003, 2008, Sunstein and Thaler 2003).According to this view, beneficial changes in behavior can be achieved by minimallyinvasive policies that nudge people tomake the right decisions for themselves.33Thisapproach emphasizes the use of choice architecture, that is, the design of theenvironmentwherechoicestakeplace.Nudging can have profound effects through the design of default options. For manydecisionproblems,adefaultoptionisspecifiedinadvancebytheorganizationoragentwho designs the decision problem. This is an important part of choice architecturebecausemanyindividualswillsimplystaywiththedefaultoption.Twohighlyimportantareas where the default option has been shown to be crucial are organ donations(Johnson and Goldstein 2003, van Dalen and Henkens 2014) and retirement savings(MadrianandShea2001,Choietal.2004).MadrianandShea’s(2001)contribution inparticularstimulatedtheinterestinthedesignofdefaultoptions.ThemostnoteworthyapplicationoftheideaisembodiedinThalerandShlomoBenartzi’sproposaltoincreasepensionsavings,towhichwenowturn.ApplicationstopensionsavingsAsearlyas1994,Thalerproposedchangingthedefaultindefinedcontributionplansforpension savings offered by US employers, such as 401(k) plans (Thaler 1994). Theprevailingdefaultwasthatemployeesneededtoactivelysignupfortheplanbyfillinginseveral forms, choosing a savings rate and deciding how to invest themoney. Thaler(1994)suggestedthatthenewdefaultoptionshouldbejoiningtheplanatsomedefaultsavingsrateandinsomedefaultinvestmentstrategy–thatis,automaticenrollment.In the absence of a sensible default option, pension savers can be led to highlysuboptimal choices, depending on seemingly innocuous design choices. Benartzi andThaler(2001)showthatwhenindividualsarefacedwithanumberofpossiblefundstowhich they can allocate their pension savings, they tend to follow a naïve “1/N”diversification strategy,where they allocate their savings equally across the availablefunds.Thisleadstounintendedeconomiceffects,wheretheresultingriskprofileoftheindividual’ssavingsisstronglyaffectedbythemenuoffundsoffered;e.g.,whenthereis 33Arelatedideaof“asymmetricpaternalism”wasproposedbyCamereretal.(2003).Theysuggestedthatpoliciesshouldbeimplementediftheycreatelargebenefitsforindividualswhomakemistakes,withoutimposingsubstantialcostsonthoseindividualswhosedecisionsareperfectlyrational.

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alargernumberofbondfundsrelativetoequityfunds,individualswillputmoreoftheirsavingsintobondsasaresult.CronqvistandThaler(2004)usetheintroductionoftheSwedish Premium Pension (PPM) system, where individuals can invest part of theirpublic-pensionsavingsinfundsoftheirchoice,toillustratehowdifferentdesignchoicescanleadtodesirableorundesirableeconomicoutcomes.A number of empirical studies have revealed substantial default effects on savings(Madrian and Shea 2001, Choi et al. 2004). In a pioneering study, Madrian and Shea(2001) found that automatic enrolment increased the participation rate in a 401(k)savingsplanfrom49%to86%.ThalerandBenartzi(2004)designandimplementamechanismthatincreasespensionsavingsbyovercoming self-controlproblemsandotherbehavioral biases.Their “SaveMoreTomorrow”(SMarT)programhasfourmainingredients.First,employeesdecidewhether to increase their savings a considerable time before a pay increase, so thedecision does not involve a trade-off between current consumption and futureconsumption, but rather a trade-off between consumption at different times in thefuture.By the logic of hyperbolic discounting, this reduces the effectivediscount rate,andmitigatestheself-controlproblem.Second, if employees join, their contribution is increased beginning with the firstpaycheckafterthepayraise.Becausethe increasedsavingscomesoutofa futuregain(thepayraise),loss-averseindividualsneednotfearareductionintake-homepay.Third,thereisautomaticescalation:thecontributionratecontinuestoincreaseoneachscheduledpay raiseuntil the contribution reaches apre-setmaximum, so that inertiaandstatus-quobiasworktowardkeepingpeopleintheplan.Fourth,theemployeecanoptoutoftheplanatanytime,whichmakeemployeesmorecomfortableaboutjoining.Thefactthatjoiningisvoluntary,andoptingoutisallowed,also addresses the fact that individuals have heterogeneous preferences; a “perfectlyrational” employee would not be hurt by the plan. On the other hand, for thoseemployeeswhowant tomake a commitment to savemore in the future, the fact thattheycanoptoutdoesnotundo the commitment–once theyareenrolled, inertiaandstatusquobiasworkinfavorofstayingin.Thaler and Benartzi tested three implementations of the SMarT program in threedifferentcompanies,withvariationsonhowtheprogramwasoffered.Theprogramwasparticularlysuccessfulwhentheprogramwasofferedinone-on-onemeetings,resultinginsubstantially increasingpensionsavings.TheSMarTprogramwasimportantforthePension Protection Act passed by the 2006 US Congress, which encouraged firms toimplementautomaticenrollmentandautomaticescalationin401(k)retirementsavingsplans. The evidence suggests that this act has substantially increased US pensionsavings.Benartzi andThaler (2013)estimated thatabout4.1millionpeople in theUSwere enrolled in some kind of automatic escalation plan by 2011, and that this hadincreasedannualsavingsby$7.6billionby2013.TheUKrecently launchedanationalpersonal savingplanwithautomatic enrolment,where theopt-out ratehasbeenonlyabout12%(Thaler2015).UsingDanishdata,Chettyetal.(2014)recentlyshowedthatautomatic-enrolmentsavingplansneithercrowd-outothersavingsnorincreasedebt.

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PolicyimpactNudging is similar to marketing, in that it uses insights into human psychology toinfluencebehavior.But itdiffers in that the intention is to raise thepeople’s long-runwelfare, as judged by themselves. This is the “paternalism” part. The “libertarian”principleisthatpeople’schoicesshouldnotberestricted;specifyingasensibledefaultoptiondoesnotmeanpeopleareforcedtochoosethisoption.EspeciallyafterthepublicationofthebookNudgebyThalerandSunstein(2008),policy-makinginseveralcountries(inparticulartheUSAandtheUK)hasbeeninfluencedbythisapproach,notonlyintheareaofpensionsavingsbutalsoinhealthcare,education,andotherareaswherecurrentchoiceshavelong-termconsequences.OnSeptember15,2015, US President Obama signed an executive order for “using behavioral scienceinsightstobetterservetheAmericanpeople.”Itwasclearlyinspiredbythelibertarianpaternalismparadigm. In fact,Sunsteinservedas theadministratorof theUSOfficeofInformationandRegulatoryAffairsforfouryears(Thaler2015).AWhiteHouseSocialandBehavioralSciencesTeamwasformed,andinitsfirstyearembeddedaboutadozenfieldexperimentsintofederalprograms(Thaler2015).ThaleralsohadaninstrumentalroleintheUKBehaviouralInsightsTeam,whichusesbehavioraleconomicstocraftnewpolicies.Similar“nudgeunits”existinothercountries.Arecentstudyinvestigatingtheglobal spread of nudging found that “51 countries have central state-led policyinitiatives that have been influenced by the new behavioral sciences. In addition, wefound evidence of public initiatives that have been influenced by the new behavioralsciences(butwerenotcentrallyorchestrated)inatotalof135statesandTaiwan(outofatotalof196possiblestates)”(Whiteheadetal.2014,p.9).34An importantpartofnudging is tocollectevidenceonwhichpoliciesactuallyworkasintended,beforetheyareimplementedonalargerscale.Ideally,thepoliciesshouldbetestedandevaluatedinrandomizedfieldexperiments.35Libertarianpaternalismhas comeunder critique fromsomeother economists.RobertSugden and his co-authors articulated concerns with the deviations from consumersovereignty they consider inherent in libertarian paternalism (Infante et al. 2016,Sugden2013,2015).Theyargue that libertarianpaternalism, and “behavioralwelfareeconomics”moregenerally, treatsdeviations fromconventionalrational-choice theoryasmistakestobecorrectedbypolicy-makers,implyingthatpolicy-makerscanmaximizethe latent preferences of an “inner rational agent trapped in an outer psychologicalshell.” They criticize the interpretation of deviations from the conventional model as“mistakes”anddoubtwhetherpolicy-makerscanknowwhichlatentpreferencesshould 34Forapartiallistofsuccessfulapplications,nudginghasbeenfoundtoimprovefarminginadevelopingcountry(Dufloetal.2011),decreasetheuseofenergy(Shultzetal.2007,Ayresetal.2013),Brownetal.2013), increasetaxcompliance(Hallsworthetal.2014), increaseworkerproductivity(HossainandList2012),increasevoterturnout(NickersonandRodgers2010,Bondetal.2012),increasecharitablegiving(Shang and Croson 2009, Breman 2011), increase compliancewithmalariamedication (Raifman et al.2014),improvelearningforchildren(KraftandRogers2014,YorkandLoeb2014),andincreasesavingsindevelopmentcountries(Karlanetal.2016).35Thaler(2015,p.338)referstothisas“evidence-basedpolicy.”

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bemaximized.Sugden(2013)insteadarguesfora“contractarian”approachtowelfareeconomics, trying to identify mutually beneficial agreements between individuals.Further, Arad and Rubinstein (2015) argue that libertarian paternalism may havenegative effects on individuals who dislike being manipulated (independently of thematerial consequences of this). They provide some evidence for negative attitudestowards libertarian-paternalisticgovernment interventions,basedondata fromonlinehypotheticalchoiceexperiments.Thaler and Sunstein (2008) themselves argue that not all libertarian-paternalisticintervention is desirable; they constrain their recommendation to policies that“influencechoicesinawaythatwillmakechoosersbetteroff,asjudgedbythemselves.”GivenThaler’sdistinctionbetweentheplannerandthedoer,thisisbestinterpretedastheplannermakingthejudgment.Also,theirapproachemphasizesthevoluntaryaspect,whereindividualsalwayshavethechoicenottoparticipateortooptoutatalatertime.Thisacknowledgesthatindividualsdifferincognitiveabilitiesanddegreeofself-control,andthattheyalsohavedifferentpreferences,sothatthecostsandbenefitsofdefaultsarenotthesameacrossindividuals.Recent studies generally have found relatively high public support for libertarian-paternalistnudging (Hagmanetal.2015,YungandMellers2016,ReischandSunstein2016, Reisch et al 2017, Sunstein 2017). Based on his findings for the US, Sunstein(2017) concludes that “there is widespread support for nudges of the kind thatdemocratic societies have adopted or seriously considered in the recent past;surprisingly, that support can be found across partisan lines.” Benartzi et al. (2017)calculated ratios of impact to cost for a large number of governmental interventions,including traditional policy tools such as tax incentives and other financial controlmechanisms. They found that nudge interventions generally compare favorably withtraditional interventions. They conclude that “nudging is a valuable approach thatshouldbeusedmoreofteninconjunctionwithtraditionalpolicies,butmorecalculationsareneededtodeterminetherelativeeffectivenessofnudging”(Benartzietal.2017).364.SocialPreferencesMany situations can be reasonably approximated by assuming that agents behave intheirownself-interest.Inothersituations,moresociallyorientedmotivationssuchasadesireforfairnessandequitymayplayarole,whichwasnotedalreadybyAdamSmith(1759).37Morerecently,GaryBecker(1992LaureateinEconomicSciences)formalized 36Theinsightsofbehavioraleconomicscanalsobeusedtoinformmoretraditionalpolicyinterventions,forexamplethetaxationof“sinfulgoods”(i.e.,goodsthatyieldimmediategratificationattheexpenseoflongrunwelfare).Self-controlproblemsprovideanargumentforsuchtaxes,overandabovetraditionalargumentsbasedonexternalities:ataxoncigarettescanmakeasmokerbetteroff(asjudgedbyhimself)byhelpinghimquitorreducesmoking.GruberandKöszegi(2001)studiedoptimalcigarettetaxationwhenindividualshaveself-controlproblems,andO’DonoghueandRabin(2006)consideredtheroleoftaxationofsinfulconsumptioningeneralinaworldwheresomepeoplehaveself-controlproblemsandothersdonot.37InTheTheoryofMoralSentiments,Smithwroteextensivelyaboutsympathy(altruism)asanimportantpassion,andheviewedfairnessasanimportantmotivation.Forinstance,hewroteaboutfairnessthat“[n]aturehasimplantedinthehumanbreast,thatconsciousnessofill-desert,thoseterrorsofmerited

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howpeoplemaycareaboutthewell-beingofothers(Becker1974),whileAmartyaSen(1998 Laureate in Economic Sciences) argued that both sympathy (altruism) andcommitment are important motivations – the distinction being that sympathy has adirect effect on one’s own welfare, whereas commitment involves moral principlesaboutrightandwrong(Sen1977).Inthe1980s,Thaler’sworkwasimportantinestablishingfairnessasamajorresearchtopic in economics. In the theoryofmental accounting, perceived fairnessdeterminesthe transaction utility (Thaler 1985). In jointworkwithKahneman and JackKnetsch,Thaler provided empirical evidence that fairness is important in consumer decisions.Their findings support the hypothesis that fairness is a constraint on profitmaximization,preventingcompaniesfromfullyexploitingtheirmarketpowerinpricingdecisions. As a consequence, goods are sometimes allocated by quantity rationing, aswhenticketstobigsportingeventsinstantlyselloutatpricesbelowmarketclearing,orwhensnowshovelsareinshortsupplyfollowingasnowstorm.Together with Kahneman and Knetsch, Thaler also invented novel experiments anduncovered three important manifestations of fairness preferences in interactionsbetween individuals: first, some individualswill behave fairly towards others even inanonymoussettingswithoutreputationalconcerns;second,someindividualsarewillingtoforegoresourcestopunishindividualsthatbehavedunfairlytowardsthem;andthird,some individuals arewilling to forego resources to punish unfair behavior and normviolationseveniftheunfairbehaviorwasdirectedtowardssomeoneelse.Priortothis,economistshadexperimentallyverifiedonlythesecondofthesemanifestations, intheworkofGüthetal.(1982)ontheultimatumgame.WenowdiscussThaler’sworkon the roleof fairness inpricingandwage-settingandothertypesofinteractions.4.1FairnessinpricingandwagesettingRobert Solow andGeorgeAkerlof, Laureates in Economic Sciences in 1987 and 2001,respectively, have argued that fairness concerns may explain why companies arereluctanttocutwagesinarecession(Solow1980,Akerlof1979).Okun(1981)pointedout that fairness concerns could also impact pricing decisions. Still, more directevidenceontheimpactoffairnessonpricesandwageswaslacking.To provide evidence on the hypothesized role of perceived fairness in consumermarkets,Kahneman,KnetschandThaler(1986b)collecteddatabytelephonesurveysofrandomly selected individuals in the Toronto and Vancouvermetropolitan areas. Therespondents were asked about the fairness of different (hypothetical) scenarios. AtypicalquestionistheirQuestion1:A hardware store has been selling snow shovels for $15. The morning after a large

punishmentwhichattenduponitsviolation,asthegreatsafe-guardsoftheassociationofmankind,toprotecttheweak,tocurbtheviolent,andtochastisetheguilty.”SeeAshraf,CamererandLoewenstein(2005)foranoverviewofthewritingsofAdamSmithonsocialpreferences(aswellasboundedrationalityandlimitedself-control).

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snowstorm, the store raises theprice to $20. Please rate this actionas: Completely Fair,Acceptable,Unfair,VeryUnfair.In this scenario, 82%of the respondents considered it unfair to raise theprice,when“Unfair”and“VeryUnfair”weregroupedintoone“unfair”category.Kahneman, Knetsch and Thaler (1986b) distinguished three determinants of fairnessattitudestowardanactiontakenbyafirm:thereferencetransaction,thecodingoftheaction, and the occasion for the action. The reference transaction refers to trading atsomeprevailingpriceorwage.Changesfromthisreferencelevelareperceivedasunfair.Forexample,ifacurrentemployeeearnsawageof$9,thenthiswouldtypicallybehisreference wage, but for a new employee, the reference wage may be lower. In arecession,loweringthecurrentemployee’swagefrom$9to$7wouldthenbedeemedmoreunfairthanhiringanewemployeeat$7ifthecurrentemployeeleaves.When prices are evaluated relative to some reference level, how the price change isframed will be important, something that Kahneman, Knetsch and Thaler (1986b)confirmedempirically. For instance, aprice increaseof $200 for anewcar isdeemedmoreunfairifitisframedasanincreaseinthelistpricethanifitisframedasareduceddiscountonthelistprice.Thisisconsistentwithlossaversion,sinceanincreaseinthelistpriceiscodedasaloss,whileareduceddiscountiscodedaslessofagain.Finally,Thalerandco-authorsfoundthattheoccasionthattriggeredthepricingdecisioninfluencesperceived fairness.A consumer-price increase is typically acceptable if it isdue toan increase in inputprices,butnot if it isdue toan increase inmarketpower.Raisingthepriceofsnowshovelsafterasnowstormisanexampleofthelatter.38Kahneman, Knetsch and Thaler (1986b) discussed a number of implications andpredictionsoffairnessconsiderationsinconsumermarkets.Marketswillfailtoclearintheshortruninresponsetodemandshocks,asitisconsideredunfairtoraisethepriceto themarket clearing level.Therewillbea shortageof themostvalued itemwhenasingle supplier provides a family of goods with no variation in input prices, as it isconsideredunfair to chargemore for themostvalued item if it costs the same.Priceswillbemoreresponsivetocostvariationsthantodemandvariations,asitisconsideredmore acceptable to raise prices in response to cost increases than demand increases.Similarly, prices will be more responsive to cost increases than to cost decreases.Finally,pricecutswillbelabeledasdiscountsratherthandecreasesinlistprices,duetotheframingofgainsandlosses.Removingadiscountis lesslikelytobeperceivedasaloss and thus less likely tobeperceivedasunfair, compared to an increase in the listprice.Theyalsotestedtheeffectoffairnessonlabormarkets,whereitcanpotentiallyexplainthepuzzleofstickywages(forevidenceofstickywages,see for instanceAkerlofetal.

38Anotherexampleisthefollowing[Question13onp.735inKahneman,KnetschandThaler(1986b)]:Agrocerychainhasstores inmanycommunities.Mostof themfacecompetitionfromothergroceries. Inonecommunitythechainhasnocompetition.Althoughitscostsandvolumesofsalearethesameaselsewhere,thechainsetspricesthataverage5percenthigherthaninothercommunities.Thisscenariowasconsideredunfairby76%oftherespondents.

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1996).Inrecessions,employersarereluctanttocut(nominal)wagesastheemployeesmay view wage cuts as unfair (and perhaps retaliate by putting in less effort).Kahneman,KnetschandThaler(1986b)findthatanominalwagecutwithnoinflationisconsideredmuchmoreunfair thanaconstantnominalwagewith inflation,even if therealwage decrease is the same. This suggests that inflationmay have important realeffects. The importance of this kind of money illusion is supported by subsequentexperimentalworkofFehrandTyran(2001).394.2FairnessinindividualinteractionsTo study fairness and generosity in individual interactions Kahneman, Knetsch andThaler (1986a) introduced an experiment, subsequently known as the dictator game.Students in an undergraduate psychology class at Cornell University were asked todivide an endowment of $20 between themselves and a randomly drawn anonymousclassmate. The students could choose between two different allocations: an unequalsplitwith$18 to self and$2 to theother,oranequal splitwith$10 toeach.Aselfishperson,concernedonlywithhisownmonetarypayoff,wouldtakethe$18.Butitturnedoutthat76%ofthestudentsdividedthemoneyequally,asiftheyhadapreferenceforfairness or equity. Apparently, not all individuals will maximize their own monetarypayoff,eveninanonymousinteractionswithoutreputationalconcerns.There is now a large literature on the dictator game (see Camerer 2003 for anintermediate overview). Typically, the subjectwho divides themoney (the “dictator”)can freely divide the endowment (rather than being forced to choose between twodifferent allocations, as in Kahneman, Knetsch and Thaler 1986a). Ameta-analysis ofdictator game studies published in 2011 included 129 papers and 616 experimentaltreatments(Engel2011).Onaverage,dictatorsgaveaway28%oftheendowment.Only36%ofdictatorsbehavedastheconventional“selfisheconomicman”andtookasmuchmoneyas theycould.And17%of thedictatorschoseanequalsplit, suggestingstrongpreferencesforfairness.Kahneman,KnetschandThaler’s(1986a)dictatorexperimenthadasecondpart,whereeach student was told that she or he would be randomly matched with two otherstudents.Ifthosetwostudentshadmadedifferentdecisionsinthefirstpart(thesimpledictatorgamedescribedabove),thenthefirststudentwasaskedtochoosebetweenthefollowingtwoallocations:40

39 Thaler (2015) mentions several real-life examples where the perceived unfairness of businessdecisionshadstrikingconsequences.WhentheFirstChicagobankintroducedaUS$3banktellerfee(togetconsumerstouseATMsinstead),itwasmetwithconsumeroutrageandlossesofmarketshares,andthepolicywaseventuallyabandoned(afterthebankwaspurchasedbyanationalbank).TheCEOofCocaColatestedadynamicpricingschemeforvendingmachineswherepriceswoulddependondemand(forexample, the price would increase in hot weather); the CEO was fired and the dynamic pricing wasscrapped.Sometimescompaniesareinfactprohibitedbylawto“excessively”raisepricesinresponsetodemand shocks, so-called anti-gauging laws (Thaler 2015). These laws can be understood in terms ofperceptionsoffairness.Thaler(2015,p.131)emphasizesthat“perceptionsoffairnessarerelatedtotheendowmenteffect.Bothbuyersandsellersfeelentitledtothetermsoftradetowhichtheyhavebecomeaccustomedandtreatanydeteriorationofthosetermsasaloss.”40Ifthetwootherstudentshadmadethesamedecisioninthefirstpart,therewouldbenodecisiontomakeinthesecondpart.

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$5 to yourself, $5 to the student splitting equally in the first stage, and nothing to thestudentwhotook$18inthefirststage;or:$6 to yourself, nothing to the studentwho split equally in the first stage, and $6 to thestudentwhotook$18inthefirststage.Astudentwhochoosesthefirstallocationforegoes$1(takes$5insteadof$6),butgetstorewardsomeonewhowasafairallocatorinthefirstpartandpunishsomeonewhowasselfish;asmanyas74%ofthestudentschosethefirstallocation.Thus,asinthefirstpart,onlyaminoritymaximizedtheirownmonetarypayoffwhenfairnesswasatstake.Butwhatthesecondpartsuggestsisthatmanyindividualsarewillingtopunishunfairbehaviorandnormviolations,eveniftheunfairbehaviorhadnothurtthempersonally.This experimental design is related to subsequent “third-party punishment”experiments,whereathirdparty(notdirectlyaffectedbytheunfairbehaviorornormviolation) can punish unfair behavior among other individuals (Fehr and Fischbacher2004).Itisanexampleofbehaviornowcommonlylabeledindirectreciprocity(Nowak2006).Kahneman,KnetschandThaler (1986a)also includedexperiments involving the (nowwell-known) ultimatum game.41In the ultimatum game, the first player proposes anallocationoftheendowmentandthesecondplayercanacceptorrejectthisproposal.Iftheproposalisaccepted,bothplayersgetpaidaccordingtotheproposal;iftheproposalisrejectedbothplayersgetnothing.Kahneman,KnetschandThaler(1986a)foundthatthetypicalfirstplayer’sproposalwasclosetoequalsplit.Theyalsofoundthatmostofthesecondplayerswouldrejectproposalsthatwouldgivethemlessthanabout25%ofthe endowment. These results are in line with those originally observed by Güth,Schmittberger and Schwarze (1982), as well as with those of the subsequent largeliteratureontheultimatumgame(Camerer2003).Manyindividualsarewillingtopayacost(getnothing)inordertopunishindividualswhomadean“unfair”proposaltothem,which is a form of negative reciprocity (Fehr and Gächter 2000b). Subsequentexperimentshaveshownhowtheabilityandwillingnesstopunishcanencouragepro-social behavior (Ostrom, Walker and Gardner 1992, Fehr and Gächter 2000a). Inaddition,Henrichetal.(2005)havefoundsimilarresultsoftheultimatumandrelatedgamesin15small-scalesocietiesfromaroundtheworld.The current literature on social preferences and reciprocity is substantial, withnumerous laboratory and field experiments as well as theoretical models. Twoimportant early contributions were Rabin’s (1993) theoretical model of fairnessequilibrium, and Fehr, Kirchsteiger and Riedl’s (1993) laboratory experiments thatprovided support for the “fairwage-effort” hypothesis of Akerlof (1982). A few yearslater, two very influential theoreticalmodels appeared: Fehr and Schmidt (1999) andBoltonandOckenfels(2000).Theseauthorsarguedthatalargenumberofexperimental 41TheultimatumgamehadpreviouslybeenintroducedbyGüthetal.(1982).Kahneman,KnetschandThaler(1986a)wereapparentlyunawareofthatpaperwhentheydesignedtheirexperiment(Thaler2015).

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outcomes, including those from dictator and ultimatum games, can be explained byinequalityaversion.Inturn,anumberofpaperstriedtodistinguishbetweeninequalityaversion and other aspects of behavior, such as different kinds of reciprocity. AnoteworthycontributioncamefromCharnessandRabin(2002).Forfurtherreading,seeFehrandGächter(2000b)andCamerer(2003).5.Marketmanifestations:BehavioralfinancestudiesWhile humans might behave irrationally in laboratory experiments or individualinstances,itisfarfromclearthatsuchirrationalbehaviorwouldsurviveincompetitivemarkets,sincelessrationalagentsmightbeoutcompetedbymorerationalagents(Fama1970). If irrationalbehavior canbeshown toaffect financialmarkets, thiswouldbeaparticularly strong argument that behavioral biases affect prices and allocationseverywhereintheeconomy.Thaler has made numerous contributions to the study of financial markets, therebybecoming one of the founders of the field of behavioral finance.42This field usesbehavioraleconomicstoexplainpatternsinassetpricesthatarehardtoreconcilewithtraditional concepts of investor rationality and market efficiency. Thaler introducednovelmodelsof investorpsychology inorder toexplainempiricalpuzzles suchas thepredictabilityofstockpricesandtheso-calledequitypremiumpuzzle.Thedispositioneffect (Shefrin and Statman 1985, Odean 1998) discussed above (Section 2.3) is alsopredicted by the theory of mental accounting. In addition, Thaler has documentedinstanceswherepricesappear toclearlydeviate fromfundamentalsandare thereforehardtoreconcilewithmarketefficiencyandinvestorrationality.Intheirhighlycitedsurveyofbehavioral-financeresearch,BarberisandThaler(2003)emphasizethattheirrationalityofsomeinvestorsinitselfisnotenoughtoaffectassetprices. There also must be limits to arbitrage that prevent rational investors fromexploitingthemispricing(ShleiferandVishny1997).Thaler’sbehavioral-financeworkhas thus focused on two issues: (1) investigating the asset-pricing implications ofinvestorpsychologyand(2)documentingviolationsofthelawofonepriceinfinancialmarkets,implyingtheimportanceoflimitstoarbitrage.AssetpricingimplicationsofinvestorpsychologyInaninfluentialstudy,DeBondtandThaler(1985)questionedtheassumption,inherentin the traditional finance model, that rational traders hold “correct” beliefs that arerevised according to Bayes’ rulewhen new information arrives. Thework of TverskyandKahneman(1974)suggests thatmany individualssystematicallydeviate fromthisassumptionbyoverreactingtonewinformation.To test for stock-market overreactions to new information, De Bondt and Thalercompared returns of loser stocks (stocks that recently dropped in value) andwinner 42AnotherleadingfigureinthisfieldisRobertShiller,2013LaureateinEconomicSciences.In1991,ShillerandThalerstartedco-organizingthesemi-annualNBERworkshoponbehavioralfinance,whichbecameanimportantforumforpromotingandstimulatingresearchinthisarea(Thaler2015).

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stocks(stocksthatrecentlyincreasedinvalue).Inlinewiththeoverreactionhypothesis,theyfoundthattheportfolioofloserstocksoutperformstheportfolioofwinnerstocks.Inafollow-uppaper,DeBondtandThaler(1987)testedtherobustnessoftheseresultsfurther,aswellasanumberofalternativeexplanations,findingrobustsupportfortheoverreactionhypothesis.While the cross-sectionalmean-reversionpatterndiscoveredbyDe Bondt and Thaler has been shown to be robust in subsequent empiricalwork,their interpretationhasbeendisputed. Inparticular, thehigherreturnsof loserstocksarealsoconsistentwiththesestocksexhibitingmoresystematicriskandinvestors’needforcompensationforthisriskintheformofhigherriskpremia.Benartzi and Thaler (1995) offered a behavioral-finance explanation for the so-calledequitypremiumpuzzle:thefindingthatthehistoricalreturnonstocksrelativetobondsappears tobe too large tobeconsistentwithstandardexpectedutilitymodels(Mehraand Prescott 1985). Benartzi and Thaler propose an explanation based on narrowbracketingandlossaversion.Intheirmodel,theimpactoflossaversiondependsonhowofteninvestorsresettheirreferencepoint(i.e.,onhowoftenthey“closetheiraccounts”),andBenartziandThaler(1995)foundthatlossaversioncanexplaintheequitypremiumif the evaluation period of investors is one year. 43 This “myopic loss aversion”explanationhasreceivedsomesupportfromsubsequentlabexperiments(Thaleretal.1997 and Benartzi and Thaler 1999). Barberis, Huang and Thaler (2006) argue thatnarrow bracketing can explain why a substantial fraction of households do notparticipate in the stock market, the so-called stock market participation puzzle.Although there is no general consensus among financial economists on whether theextensionsofneoclassicalmodelsorthebehavioralmodelsbestexplainstheriskpremiaobserved in financialmarkets, studiesof loss aversion remainanactive strand in thisliterature.MispricingandlimitstoarbitrageWhile the contributions above provide behavioral-finance explanations for observedfinancial-market returns, this does not mean that returns are in fact influenced byoverreactionsorotherbehavioral“anomalies.”Indeed,thereexistotherexplanationsforthesephenomenathatareconsistentwithinvestorrationalityandefficientmarkets.Inhis work on market mispricing, Thaler has looked for evidence that more clearlydemonstrateviolationsofmarketefficiency.Closed-end funds are investment funds, tradedon the stockmarket,whichownotherfinancial assets such as shares in other publicly traded companies. The closed-endpuzzlereferstotheobservationthatthesharesofclosed-endfundstypicallyarevalueddifferentlythantheassetstheyown,violatingthelawofonepriceandimplyinglimitstoarbitrage.BuildingonZweig (1973)andDelongetal. (1990),Lee, ShleiferandThaler(1991)proposeanexplanationfortheclosed-endfundpuzzlebasedontheexistenceof“noisetraders”withincorrectbeliefs.Insomeperiods,thesenoisetradersoverestimatethe expected returns (relative to rational expectations); in other periods theyunderestimate expected returns. These fluctuations in noise trader sentiment create

43Barberisetal.(2001)provideamulti-periodextensiontheBenartziandThaler(1995)model,andincorporatetheeffectofpastoutcomesonrisk-taking,inadditiontolossaversion.

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additional volatility in the price of closed-end funds. Rational traderswill need to becompensatedforthisrisk,leadingtoclosed-endfundstradingatadiscountonaverage.Consistent with their theory, the authors document that (1) there are significant co-movementsinthediscountsofdifferentclosed-endfunds(theyaredrivenbycommoninvestor sentiment); (2) new closed-end funds are formed when existing closed-endfundssellatapremiumoratalowdiscount(periodswithhighinvestorsentiment);and(3)discountsofclosed-endfundsarecorrelatedwithpricesofotherassetsaffectedbyinvestor sentiment, such as small stocks. Still, the interpretation of closed-end funddiscounts as measures of investor sentiment has been criticized, and there arealternativeexplanationsofthisdiscountbasedonrationalinvestors(whilemaintainingthelimitstoarbitrageassumption),suchasBerkandStanton(2007).Still,followingLeeetal.(1991),thediscountonclosed-endfundsisacommonlyusedmeasureofinvestorsentimentthathasbeenshowntoberelatedtoseveralotherasset-pricingphenomena(see,e.g.,BakerandWurgler2013).Lamont andThaler (2003) provide even clearer evidence that the lawof one price isviolated.Theyexaminedataonso-calledequitycarve-outs,inwhichaparentcompany(companyY)hassolda stakeofa subsidiary (companyX)on thepublic stockmarketandhasannouncedtheintentiontospinofftheremainingsharesincompanyXatsomepointinthenot-too-distantfuture.Inthesecases,thelawofonepriceprovidestestablerestrictionsontherelationbetweenthestockpricesofXandY.Inparticular,themarketvalueofYcanneverbelowerthanthevalueofthesharesofXthatitowns,andshouldgenerally be higher if company Y has additional assets apart from the shares in X.Lamont and Thaler examine the implied value of the additional assets of Y, the “stubvalue,”bydeductingthemarketvalueofthesharesYownsinXfromthemarketvalueofY.Theyfoundapositivestubvalueinninecompanies,amarginallynegativestubvalueinthreecompanies,andanunambiguouslynegativestubvalueforsixcompanies,aclearviolationof the lawofoneprice.LamontandThaler (2003)argue that the reason forlimits toarbitrage in thesecases is thedifficultyof short-selling theoverpricedcarve-outshares.6.ConclusionTogetherwithhiscollaborators,Thalerhasgiveneconomistsnewinsights intohumanpsychologyandnewframeworksforunderstandingandpredictingeconomicoutcomes.Hiscontributionsincludethetheoryofmentalaccounting,anewapproachtoboundedlyrational behavior; the planner-doer model, with a new framework for self-controlproblems;andhisworkonsocialpreferences,whichhasgivenusanewperspectiveonfairness.Lastbutnotleast,hehasshownhowpoliciesbasedoninsightsfrombehavioraleconomicscanhelpindividualsmakebetterdecisions.

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