Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

This premise of constrained optimization, that is, choosing the best from a limited budget, is combined with the other major workhorse of economic theory, that of equilibrium.

To simplify somewhat, we can say that Optimization + Equilibrium = Economics.

There is, however, a problem: the premises on which economic theory rests are flawed. First, the optimization problems that ordinary people confront are often too hard for them to solve, or even come close to solving. Even a trip to a decent-sized grocery store offers a shopper millions of combinations of items that are within the family’s budget. Does the family really choose the best one?

Second, the beliefs upon which people make their choices are not unbiased.

It is easy to dismiss a story about the grading of an exam. It is harder to dismiss studies that document poor choices in large-stakes domains such as saving for retirement, choosing a mortgage, or investing in the stock market.

We need an enriched approach to doing economic research, one that acknowledges the existence and relevance of Humans.

Two research tools that have emerged over the past twenty-five years have greatly expanded economists’ repertoire for learning about the world. The first is the use of randomized control trial experiments, long used in other scientific fields such as medicine. The typical study investigates what happens when some people receive some “treatment” of interest. The second approach is to use either naturally occurring experiments (such as when some people are enrolled in a program and others are not) or clever econometrics techniques that manage to detect the impact of treatments even though no one deliberately designed the situation for that purpose.

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

But there may also be useful lessons about how to try to change the way people think about things, especially when they have a lot invested in maintaining the status quo.

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.

The hospitals stand in for the concept Schelling calls a “statistical life,” as opposed to the girl, who represents an “identified life.”

The opportunity cost of some activity is what you give up by doing it.

Giving up the opportunity to sell something does not hurt as much as taking the money out of your wallet to pay for it. Opportunity costs are vague and abstract when compared to handing over actual cash.

“hindsight bias.” The finding is that, after the fact, we think that we always knew the outcome was likely, if not a foregone conclusion.

As a result, they use simple rules of thumb—heuristics—to help them make judgments.

The organizing principle was the existence of two different kinds of theories: normative and descriptive. Normative theories tell you the right way to think about some problem. By “right” I do not mean right in some moral sense; instead, I mean logically consistent, as prescribed by the optimizing model at the heart of economic reasoning, sometimes called rational choice theory.

many people study the subject they enjoy most without thinking through to what kind of life that will create.

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 difference between losing $10 and $20 feels much bigger than the difference between losing $1,300 and $1,310.

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

fact that people have diminishing sensitivity to both gains and losses has another implication. People will be risk-averse for gains, but risk-seeking for losses, as illustrated by the experiment reported below which was administered to two different groups of subjects.

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

We don’t play chess like a grandmaster, invest like Warren Buffett, or cook like an Iron Chef.

Polling data, which just comes from asking people whether they are planning to vote and for whom, when carefully used by skilled statisticians such as Nate Silver, yield remarkably accurate predictions of elections. The most amusing aspect of this anti-survey attitude is that many important macroeconomic variables are produced by surveys!

Economists put great stock in incentives. If the stakes are raised, the argument goes, people will have greater incentive to think harder, ask for help, or do what is necessary to get the problem right.

Bill Murray’s character keeps waking up and reliving the same day, over and over. Once he figures out what is going on, he is able to learn because he can vary things one at a time and see what happens. Real life is not as controlled as that, and thankfully so. But as a result, learning can be difficult.

Psychologists tell us that in order to learn from experience, two ingredients are necessary: frequent practice and immediate feedback.

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.

acquisition utility and transaction utility. Acquisition utility is based on standard economic theory and is equivalent to what economists call “consumer surplus.” As the name suggests, it is the surplus remaining after we measure the utility of the object gained and then subtract the opportunity cost of what has to be given up.

Humans, on the other hand, also weigh another aspect of the purchase: the perceived quality of the 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. Suppose you are at a sporting event and you buy a sandwich identical to the one you usually have at lunch, but it costs triple the price. The sandwich is fine but the deal stinks. It produces negative transaction utility, a “rip-off.” In contrast, if the price is below the reference price, then transaction utility is positive, a “bargain,” like Maya’s extra-large quilt selling for the same price as a smaller one.

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.

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.

Sharp readers (and shoppers) might wonder about large-format discount retailers such as Walmart and Costco. These retailers successfully operate under an everyday low pricing strategy, sometimes without explicit reference to an original higher price. But they have not eliminated transaction utility; just the opposite. They have convinced their customers that the entire shopping experience is an orgy of bargain hunting, and go out of their way to reinforce that image.

But we don’t want to get caught buying something we won’t use just because the deal is too good to pass up.

the sunk cost fallacy—and the fallacy is often mentioned in basic economics textbooks. But many people, even if they understand the concept in principle, can find it difficult to follow the advice to ignore sunk costs in practice.

Paying $100 for a ticket to a concert that you do not attend feels a lot like losing $100. To continue the financial accounting analogy, when you buy the ticket and then fail to use it you have to “recognize the loss” in the mental books you are keeping. Going to the event allows you to settle this account without taking a loss.

They called this phenomenon “payment depreciation,” meaning that the effects of sunk costs wear off over time.

Typically, the prospective vacationer “invests” a sum of money, say $10,000, which entitles her to spend a week at the property in perpetuity, or at least until the property falls down or the company goes bankrupt. The mental accounting works this way. The original payment is an investment (not a purchase), the annual “maintenance fee” is a nuisance, but future vacations at the property are “free.” Whether such an investment makes sense for a family will depend, in part, on how painful it is for them to spend money on vacations. But such investments should be seen for what they are: a way to disguise the cost of taking a vacation.

become a “prime member” which entitles them to “free” shipping. Again, the cost of the membership may well be viewed as an investment that does not “count”

toward the cost of a particular purchase.

More dangerous to the accumulation of wealth than loans are job changes. When employees switch jobs they are often offered the chance to take their account balance in cash.

This means that the fall in stock prices did not impact spending as much as the fall in home prices.

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!

Smokers paid more for their cigarettes by purchasing them one pack at a time instead of by the carton. Dieters did not stock any ice cream in the freezer. Academics (including me) would commit themselves to present a paper that was still a work in progress at a conference several months off, to give themselves an incentive to finish it. People who had trouble getting up in the morning put their alarm clocks on the other side of the room so they could not just reach over and switch off the alarm without getting out of bed. What these examples have in common is the presence of self-control problems. We want to eat just a few more nuts, but are worried that if the bowl is left on the table, we will submit to temptation.

“intertemporal choice”—that is, choices made about the timing of consumption—also stressed the importance of concepts such as “willpower,”

The technical term for discounting of this general form that starts out high and then declines is quasi-hyperbolic discounting.

will avoid this term and use the modern phrase present-biased to

It plays a vital role in macroeconomics, where it underlies what is called the consumption function, which tells us how the spending of a household varies with its income.

if a household received some incremental income, it would consume a fixed proportion of that extra income.