Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social science from the principles of psychology. —VILFREDO PARETO, 1906

“You know, it’s funny. When you have the flu you feel like you are going to die, but when you are dying, most of the time you feel just fine.”

I think there is a long Jewish tradition that history and wisdom are being transmitted from one generation to another not through lectures and history books, but through anecdotes, funny stories, and appropriate jokes.

Finally, an idea occurred to me. On the next exam, I made the total number of points available 137 instead of 100. This exam turned out to be slightly harder than the first, with students getting only 70% of the answers right, but the average numerical score was a cheery 96 points. The students were delighted! No one’s actual grade was affected by this change, but everyone was happy.

It is time to stop making excuses. We need an enriched approach to doing economic research, one that acknowledges the existence and relevance of Humans.

Let a six-year-old girl with brown hair need thousands of dollars for an operation that will prolong her life until Christmas, and the post office will be swamped with nickels and dimes to save her. But let it be reported that without sales tax the hospital facilities of Massachusetts will deteriorate and cause a barely perceptible increase in preventable deaths—not many will drop a tear or reach for their checkbooks.

Ask people whether there are more gun deaths caused by homicide or suicide in the U.S., and most will guess homicide, but in fact there are almost twice as many gun deaths by suicide than homicides.†

replete

germane

People think about life in terms of changes, not levels. They can be changes from the status quo or changes from what was expected, but whatever form they take, it is changes that make us happy or miserable. That was a big idea.

The Weber–Fechner Law holds that the just-noticeable difference in any variable is proportional to the magnitude of that variable.

Roughly speaking, losses hurt about twice as much as gains make you feel good.

The fact that a loss hurts more than an equivalent gain gives pleasure is called loss aversion. It has become the single most powerful tool in the behavioral economist’s arsenal.

Psychologists tell us that in order to learn from experience, two ingredients are necessary: frequent practice and immediate feedback. When these conditions are present, such as when we learn to ride a bike or drive a car, we learn, possibly with some mishaps along the way.

Because learning takes practice, we are more likely to get things right at small stakes than at large stakes. This means critics have to decide which argument they want to apply. If learning is crucial, then as the stakes go up, decision-making quality is likely to go down.

These results show that people are willing to pay different prices for the same beer, consumed at the same spot on the beach, depending on where it was bought. Why do the respondents care where the beer was bought? One reason is expectations. People expect prices to be higher at a fancy hotel, in part because the costs are quite obviously higher. Paying seven dollars for a beer at a resort is annoying but expected; paying that at a bodega is an outrage! This is the essence of transaction utility.

For those who are at least living comfortably, negative transaction utility can prevent our consuming special experiences that will provide a lifetime of happy memories, and the amount by which the item was overpriced will long be forgotten. Good deals, on the other hand, can lure all of us into making purchases of objects of little value. Everyone has items in their closets that are rarely worn but were “must buys” simply because the deal was too good, and of course somewhere in the garage or attic is our version of Maya’s quilt.

eschewed

Perhaps surprisingly, the one group of people that come closest to thinking this way about opportunity costs is the poor. In their recent book Scarcity, Sendhil Mullainathan and Eldar Shafir (2013) report that, on this dimension, the poor come closer to behaving like Econs than those who are better off, simply because opportunity costs are highly salient for them. If a $100 windfall could pay the overdue utility bill or replace the kids’ shoes that are now too small, opportunity costs are front and center. However, this incessant fretting about opportunity costs takes a toll. Having to constantly worry about where the money is going to come from to pay the rent makes it hard to keep up with everything, and may contribute to some of the bad decisions made by the poor, such as taking out and rolling over payday loans.

difficult to follow the advice to ignore sunk costs in practice. Driving to the game in the blizzard, or playing tennis in pain, are mistakes no Econ would make. They rightly treat sunk costs as irrelevant.

A good rule to remember is that people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse. Watch out!

When most people think about Adam Smith, they think of his most famous work, The Wealth of Nations. This remarkable book—the first edition was published in 1776—created the foundation for modern economic thinking. Oddly, the most well-known phrase in the book, the vaunted “invisible hand,” mentioned earlier, appears only once, treated with a mere flick by Smith. He notes that by pursuing personal profits, the typical businessman is “led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it.”

For one thing, Fisher believed that time preference depends on an individual’s level of income, with the poor being more impatient than those who are better off.

The basic idea is that consumption is worth more to you now than later. If given the choice between a great dinner this week or one a year from now, most of us would prefer the dinner sooner rather than later. Using the Samuelson formulation, we are said to “discount” future consumption at some rate. If a dinner a year from now is only considered to be 90% as good as one right now, we are said to be discounting the future dinner at an annual rate of about 10%.

The upshot is that Matthew finds waiting most painful at the beginning, since it feels longer.

To understand the consumption behavior of households, we clearly need to get back to studying Humans rather than Econs. Humans do not have the brains of Einstein (or Barro), nor do they have the self-control of an ascetic Buddhist monk. Rather, they have passions, faulty telescopes, treat various pots of wealth quite differently, and can be influenced by short-run returns in the stock market. We need a model of these kinds of Humans. My favorite version of such a model is the subject of the next chapter.

One partial explanation for this fact is that cutting wages makes workers so angry that firms find it better to keep pay levels fixed and just lay off surplus employees (who are then not around to complain). It turns out, however, that with the help of some inflation, it is possible to reduce “real” wages (that is, adjusted for inflation) with much less pushback from workers.

An actual cut in the nominal wage is viewed as a loss and is therefore unfair, whereas failing to keep up with inflation is judged acceptable since the nominal wage is still going up. This is one of many reasons why some economists (including me) felt that central banks should have been willing to tolerate a bit more inflation after the financial crisis. Even 3% inflation might have allowed firms to effectively cut real wages enough to speed the jobs recovery that has been so slow in most of the world.

For example, after Hurricane Katrina devastated New Orleans, Home Depot and other chains loaded up trucks with emergency supplies of food and bottled water to give away. At the same time, such a natural disaster will induce some entrepreneurial folks to load a truck with plywood in a nearby city and sell it in the devastated areas for whatever price it will fetch. In this case, both sellers are profit-maximizing. The chain store is establishing a reputation for fair dealing that will have long-term payoffs, whereas the “temporary entrepreneurs” will be back home in a couple days with a tidy profit and either a slightly guilty conscience or pride in their efforts to help improve the allocation of scarce resources, depending on their point of view.

My takeaway from these examples is that temporary spikes in demand, from blizzards to rock star deaths, are an especially bad time for any business to appear greedy.

In the more general version of this game without the prisoner cover story, there are two strategies, cooperate (stay silent) or defect (confess). The game theoretic prediction is that both players will defect because, no matter what the other player does, it is in the selfish best interest of each player to do so. Yet when this game is played in the laboratory, 40–50% of the players cooperate, which means that about half the players either do not understand the logic of the game or feel that cooperating is the just the right thing to do, or possibly both.

So repeated play of the Public Goods Game does not teach people to be jerks; rather it teaches them that they are playing with (some) jerks, and no one likes to play the role of the sucker.

Economists need to adopt as nuanced a view of human nature as the farmers. Not everyone will free ride all the time, but some people are ready to pick your pocket if you are not careful. I

A new prisoner arrives at a jail where everyone else has been locked up for a long time. He notices that occasionally someone shouts out a number, and everyone else laughs. He asks his cellmate what is going on and is told that they have been in jail so long together that they have all heard all the jokes that anyone knows, so to save time they have numbered the jokes. After hearing a few more numbers followed by howls of laughter, he decides to try it himself and shouts out “Thirty-nine!” No one laughs. He asks his cellmate why no one laughed and was told, “Well, some people just can’t tell a joke.”

A paradigm shift is one of the rare cataclysmic events in science when people make a substantial break with the way the field has been progressing and pursue a new direction.

predilection,

The first paper by Fehr that captured our attention was experimental. He and his coauthors showed that in a laboratory setting, “firms” that elected to pay more than the minimum wage were rewarded with higher effort levels by their “workers.” This result supported the idea, initially proposed by George Akerlof, that employment contracts could be viewed partially as a gift exchange. The theory is that if the employer treats the worker well, in terms of pay and working conditions, that gift will be reciprocated with higher effort levels and lower turnover, thus making the payment of above-market wages economically profitable.

So, does increasing the happiness of someone else make us happier too, or does it make us less happy, perhaps because of envy? The answer, Rabin suggested, hinges on reciprocity. We are nice to people who treat us nicely and mean to people who treat us badly. The finding discussed earlier, that people act as “conditional cooperators,” is consistent with Rabin’s model.

ex ante,

Keynes is now remembered primarily for his contributions to macroeconomics and especially for his controversial argument that governments should use fiscal policy to stimulate demand during recessions or depressions. Regardless of your views about Keynesian macroeconomics, you would be foolish to dismiss his thoughts on financial markets.

Take, for example, the fact of high trading volume in security markets. In a rational world there would not be very much trading—in fact, hardly any. Economists sometimes call this the Groucho Marx theorem. Groucho famously said that he would never want to belong to any club that would have him as a member. The economist’s version of this joke—predictably, not as funny—is that no rational agent will want to buy a stock that some other rational agent is willing to sell.

As we left the business school to walk over to the faculty club where we would have lunch, I spotted a twenty-dollar bill lying on the sidewalk, right outside the building. Naturally I picked it up, and then everyone started laughing. We were laughing because we all realized the irony of this situation. There is an old joke that says a Chicago economist would not bother to pick up a twenty-dollar bill on the sidewalk because if it were real, someone would already have snagged it. There is no such thing as a free lunch or a free twenty-dollar bill. But to a heretic like me, that twenty looked real enough to be worth bending over.

began by reminding everyone that standard law and economics assumes that people have correct beliefs and choose rationally. But suppose they don’t? How should law and economics change?

Judge Posner remained quiet for about five minutes, but then he could no longer contain himself. Why, he asked out of the blue, were we ignoring evolution? Didn’t evolutionary biology explain many of the odd behaviors discussed in the paper, such as turning down small offers in the Ultimatum Game, or ignoring sunk costs? Couldn’t evolution explain these and all our other “cognitive quirks” (a slyly deprecating term he insisted on using)? His thought was that if humans had evolved to pay attention to sunk costs, or resist unfair offers in the Ultimatum Game, then such behavior must be good for us, in some sense, and therefore rational. Problem solved. I assured him that I was not a creationist and accepted evolution as a scientific fact. I added that there was no doubt that many of the aspects of human behavior that we were talking about had evolutionary roots. But, I argued, accepting the theory of evolution as true does not mean that it needs to feature prominently in an economic analysis. We know people are loss averse; we don’t need to know whether it has an evolutionary explanation. (Amos used to joke that there once were species that did not display the endowment effect, but they are now extinct.) Furthermore, the real point of behavioral economics is to highlight behaviors that are in conflict with the standard rational model. Unless we change the model to say that people pay attention to sunk costs, the model will make poor predictions.

The fact that the strongest resistance to behavioral economics came from those who had the greatest investment in building up the rational actor model raised an amusing possibility. Might their objections be more evidence in support of the sunk-cost fallacy?

1. People are overconfident. They are likely to think their ability to discriminate between the ability of two players is greater than it is. 2. People make forecasts that are too extreme. In this case, the people whose job it is to assess the quality of prospective players—scouts—are too willing to say that a particular player is likely to be a superstar, when by definition superstars do not come along very often. 3. The winner’s curse. When many bidders compete for the same object, the winner of the auction is often the bidder who most overvalues the object being sold. The same will be true for players, especially the highly touted players picked early in the first round. The winner’s curse says that those players will be good, but not as good as the teams picking them think. Most teams thought that Ricky Williams was an excellent prospect, but no one loved him as much as Mike Ditka. 4. The false consensus effect. Put basically, people tend to think that other people share their preferences. For instance, when the iPhone was new I asked the students in my class two anonymous questions: do you own an iPhone, and what percentage of the class do you think owns an iPhone? Those who owned an iPhone thought that a majority of their classmates did as well, while those who didn’t thought iPhone ownership uncommon. Likewise in the draft, when a team falls in love with a certain player they are just sure that every other team shares their view. They try to jump to the head of the ...

So our research yielded two simple pieces of advice to teams. First, trade down. Trade away high first-round picks for additional picks later in the draft, especially second-round picks. Second, be a draft-pick banker. Lend picks this year for better picks next year.

The results were a surprise to me. I thought that choosing in front of the crowd would induce students to take more risks, but in fact the opposite happened. The students were more risk averse in front of the crowd.

* I agreed but with some warnings. I said that a collaboration might be unwise on at least two counts. First, I am notoriously slow. (I didn’t mention the lazy part.) Second, I worried about the “Matthew effect,” a term coined by sociologist Robert K. Merton, which states that excessive credit for any idea will be attributed to the most well-recognized person who is associated with it. Stephen Stigler, a statistician at the University of Chicago, called his alternative version of this effect Stigler’s Law (irony intended): “No scientific discovery is named after its original discoverer.” The joke, of course, is that Stigler’s Law was just a restatement of Merton’s proposition. Thierry and the group decided that we would collaborate, with the proviso that if I did not think I was adding anything, I would withdraw.

The first obstacle is inertia. Surveys reveal that most people in retirement savings plans think they should be saving more, and plan to take action, uh, soon. But then they procrastinate, and never get around to changing their saving rate. In fact, most plan participants rarely make any changes to their saving options unless they change jobs and are confronted with a new set of forms they have to fill out. Overcoming