The American economist who proved that people make irrational decisions when it comes to money has won the 2017 Nobel Economics Prize[1]. Richard Thaler is synonymous with the term ‘behavioral economics’, a field of economics that explores the impact of social, psychological, and emotional factors on financial decisions. This article explains some of the key concepts introduced by Richard Thaler[2] in most simple terms.

Mental Accounting

One of the most important concepts of the field, mental accounting indicates that people tend to divide their money into separate accounts in their minds such as ‘party fund’, and not using such funds for more pertinent needs such as an impending loan installment.

The Endowment Effect

This effect says that people place a higher value on things they already own, compared to a situation when they don’t own the item yet. This explains why car owners place greater value on a car they are selling compared to the buyer interested in the same car.

Status Quo Bias

People prefer to stick to their decision once they have invested in a situation. This leads them to choose the default option. Status quo bias explains many other behaviors such as brand loyalty and the phenomena of ‘word of mouth’ (higher trust of familiar sources than unfamiliar ones).

The Hot-Hand Fallacy

This fallacy says that people who believe what is happening today will happen tomorrow as well. So if house prices are rising, more people will start buying houses thinking their investment value will increase. But often, the trend reverses and people end up losing money on their bet. This can also lead people to not save for their retirement because they believe their present income stream will continue in the future.
Understanding these human fallacies and biases have had a profound impact on policy and decision making. For example, often, saving for retirement fund is made the default[3] option. Due to the ‘status quo’ bias, people do not opt out and hence are nudged into saving for their future. Also, the gambler must not forget the ‘Hot-hand’ fallacy and remember that his winning streak will not continue. Understanding of the endowment effect can lead to better negotiations between buyers and sellers. By breaking away from the idea of ‘rational decisions’, Thaler ‘nudged’ the field of economics to explore its more human side and made its applications more practical.