Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

well-known joke among psychologists was that he made possible a one-item IQ test: the sooner you realized he was smarter than you, the smarter you were.

In the eyes of an economist, my students were “misbehaving.” By that I mean that their behavior was inconsistent with the idealized model of behavior that is at the heart of what we call economic theory.

Economists get in trouble when they make a highly specific prediction that depends explicitly on everyone being economically sophisticated.

in economists’ lingo, the stuff you own is part of your endowment, and I had stumbled upon a finding that suggested people valued things that were already part of their endowment more highly than things that could be part of their endowment, that were available but not yet owned.

Humans have limited time and brainpower. As a result, they use simple rules of thumb—heuristics—to help them make judgments.

Similarly, the theory of human capital formation, pioneered by the economist Gary Becker, assumes that people choose which kind of education to obtain, and how much time and money to invest in acquiring these skills, by correctly forecasting how much money they will make (and how much fun they will have) in their subsequent careers. There are very few high school and college students whose choices reflect careful analysis of these factors. Instead, many people study the subject they enjoy most without thinking through to what kind of life that will create.

The full treatment of the formal theory of how to make decisions in risky situations—called expected utility theory—was published in 1944 by the mathematician John von Neumann and the economist Oskar Morgenstern.

A key prediction of prospect theory is that people react differently to losses than they do to gains. But it is nearly impossible to get permission to run experiments in which subjects might actually lose substantial amounts of money.

Friedman argued that it was silly to evaluate a theory based on the realism of its assumptions. What mattered was the accuracy of the theory’s predictions.

“Binmore continuum” in his honor. I wrote a list of products on the blackboard that varied from left to right based on frequency of purchase. On the left I started with cafeteria lunch (daily), then milk and bread (twice a week), and so forth up to sweaters, cars, and homes, career choices, and spouses (not more than two or three per lifetime for most of us). Notice the trend. We do small stuff often enough to learn to get it right, but when it comes to choosing a home, a mortgage, or a job, we don’t get much practice or opportunities to learn. And when it comes to saving for retirement, barring reincarnation we do that exactly once. So Binmore had it backward. 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.

there is no logical way to arrive at a conclusion that markets transform people into rational agents.

deal. That is what transaction utility captures. It is defined as the difference between the price actually paid for the object and the price one would normally expect to pay, the reference price.

In America, some products always seem to be on sale, such as rugs and mattresses, and at some retailers, men’s suits. Goods that are marketed this way share two characteristics: they are bought infrequently and quality is difficult to assess. The infrequent purchases help because consumers often do not notice that there is always a sale going on.

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 you ask people whether they would rather lose $100 for sure or choose a gamble in which they have a 50% chance of losing $200 and a 50% chance of breaking even, a majority will choose the gamble. These results are the opposite of those found when the choice is between a guaranteed gain of $100 and a 50-50 gamble for $0 or $200, where people prefer the sure thing.

This distinction between what we want and what we choose has no meaning in modern economics, in which preferences are literally defined by what we choose. Choices are said to “reveal preferences.”

But once Samuelson wrote down this model and it became widely adopted, most economists developed a malady that Kahneman calls theory-induced blindness.

the endowment effect, if true, will reduce the volume of trade in a market. Those who start out with some object will tend to keep it, while those who don’t have such an object won’t be that keen to buy one.

Interdisciplinary meetings, especially those with high-level agendas (reduce poverty, solve climate change) tend to be disappointing, even when the attendees are luminaries, because academics don’t like to talk about research in the abstract—they want to see actual scientific results. But if scientists from one field start presenting their research findings in the manner that the colleagues in their field expect, the scientists from other disciplines are soon overwhelmed by technical details they do not understand, or bored by theoretical exercises they find pointless.

behavioral economics has turned out to be primarily a field in which economists read the work of psychologists and then go about their business of doing research independently.

The idea is called “narrow framing,” and it is related to a more general mental accounting question: when are economic events or transactions combined, and when are they treated separately?

many situations in which agents are making poor choices, the person who is misbehaving is often the principal, not the agent. The misbehavior is in failing to create an environment in which employees feel that they can take good risks and not be punished if the risks fail to pay off. I call these situations “dumb principal” problems.

There’s no better way to build confidence in a theory than to believe it is not testable.

no rational agent will want to buy a stock that some other rational agent is willing to sell.

The theorem can be easily stated: in the absence of transaction costs, meaning that people can easily trade with one another, resources will flow to their highest-valued use.

the topic of paternalism. The core principle underlying the Chicago School’s libertarian beliefs is consumer sovereignty: the notion that people make good choices, and certainly better choices than anyone else could make for them. By raising the specters of bounded rationality and bounded self-control, we were undercutting this principle. If people make mistakes, then it becomes conceivable, at least in principle, that someone could help them make a better choice.

Becker conjecture. Becker believed that in competitive labor markets, only people who are able to perform their jobs like Econs are able to land the key positions. Becker made this conjecture when he was asked his opinion of behavioral economics. “Division of labor strongly attenuates if not eliminates any effects [caused by bounded rationality.] . . . [I]t doesn’t matter if 90 percent of people can’t do the complex analysis required to calculate probabilities. The 10 percent of people who can will end up in the jobs where it’s required.”

the approach I took was to make a list of the most important behavioral reasons why someone might fail to save enough for retirement, and then design a program that could overcome each of these obstacles.

“A regulation is asymmetrically paternalistic if it creates large benefits for those who make errors, while imposing little or no harm on those who are fully rational.”

Nudge find that we define our objective as trying to “influence choices in a way that will make choosers better off, as judged by themselves.”

Nudges are supposedly irrelevant factors that influence our choices in ways that make us better off.

Designing good public policies has a lot in common with designing any consumer product.

Robert Cialdini, author of the classic book Influence.

If you want to encourage someone to do something, make it easy.

shows how experimentation can increase economists’ tool kit, which often has had a single tool: monetary incentives. As we have seen throughout this book, treating all money as the same, and also as the primary driver of human motivation, is not a good description of reality.