Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

makes decisions based on SIFs rather than actual news.

My view was that these special cases are finance’s equivalent of geneticists’ fruit flies. Fruit flies are not a particularly important species in the grand scheme of things, but their ability to quickly reproduce offers scientists the chance to study otherwise difficult questions. So it is with finance’s fruit flies.

Central banks around the world have had to take extraordinary measures to help economies recover from the financial crisis. The same people who complain most about these extraordinary recovery measures are also those who would object to relatively minor steps to reduce the likelihood of another catastrophe.

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 logic is easy to explain.

And if Alexa wins the right to play her music, Julia will be unwilling to pay her enough to stop, since her value of silence is less than Alexa’s joy of music. Either way, Julia will have to find somewhere else to study if she wants quiet.

And the reason was the endowment effect: people given mugs valued them about twice as much as people not given the mugs. How goods were allocated did affect who would end up owning the mugs. In other words, the Coase theorem worked in theory, when trading for tokens redeemable for cash, but it did not work in practice, when trading for real-world objects like coffee mugs.

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.

chapter about a problem that every organization faces: how to choose employees.

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 ...

Should a rational team be willing to give up that many picks in order to get one of the very high ones?

The salary cap is what makes our study possible. Its existence means that each team has to live within the same budget.

In order to win regularly, teams are forced to be economical.

This binding budget constraint means that the only way to build a winning team is to find players that provide more value than they cost.

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.

Can drafting a high-profile player sell enough tickets to make it worthwhile, even if he does not become a star? No. First of all, most NFL teams have waiting lists to buy season tickets. But more to the point, no one comes to watch a bad player even if he is famous.

limits to arbitrage

Of course, coaches are Humans. They tend to do things the way they have always been done, because those decisions will not be second-guessed by the boss.

This is the famous Peter Principle: people keep getting promoted until they reach their level of incompetence.

When the championship or the future of the company is on the line, managers tend to rely on their gut instincts.

It is clear that a necessary condition is to have clear buy-in from the top, starting with the owner, but then that owner has to convince everyone who works for him that they are really going to be rewarded for taking smart but unconventional chances, even (especially!) when they fail.

Economists are really good at inventing rational explanations for behavior, no matter how dumb that behavior appears to be.

“big peanuts” hypothesis. The idea is that a certain amount of money can seem small or large depending on the context.

People are more willing to lie by omission than commission.

By the mid-1990s, behavioral economists had two primary goals. The first was empirical: finding and documenting anomalies, both in individual and firm behavior and in market prices. The second was developing theory.

But there was a third goal lurking in the background: could we use behavioral economics to make the world a better place? And could we do so without confirming the deeply held suspicions of our biggest critics: that we were closet socialists, if not communists, who wanted to replace markets with bureaucrats? The time was right to take this on.

The government cannot change how old you are, but it can change the after-tax return to your saving, for example, by creating tax-free retirement savings plans. And yet, there is a basic problem with the use of this policy tool—economic theory does not tell us how responsive savers will be to such a change.

At first blush, it would seem that increasing the returns to saving by creating tax-free accounts should increase saving, since the rewards for saving have gone up. But upon further reflection, one can see that the higher rates of return mean that it takes less saving to achieve a given retirement savings goal.

So economic theory offers only one policy tool, the after-tax rate of return, but we don’t know whether to raise or lower it to induce more saving.