Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

“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 feel that in the last few days we have been exchanging anecdotes and stories with the intention that they will be remembered, at least for a while. 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.

“If Amos were here, he would have voted for taping the funeral and watching the game.”

When Genius Failed,

When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein

“Oh, the best thing about Thaler, what really makes him special, is that he is lazy.”

I don't remember the source, but isn't laziness, impatience and hubris considered the three programmers' virtues. Lazy programmers automate tasks, write reusable code and invest considerable effort in finding more efficient solution to problems that ultimately save them time and effort. Impatience programmers often find quicker and more efficient solutions to common problems. Hubris leads to finding solutions to problems once consider impossible to solve.

While Amos was alive, a 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.

Misbehaving blog at misbehavingbook.org. Contributions and suggestions are welcome.

The core premise of economic theory is that people choose by optimizing.

the premises on which economic theory rests are flawed.

1) people make the best choice given limited resources (constrained optimization 2) in a competitive market, prices/supply/demain fluctuate until supply equals demand

the optimization problems that ordinary people confront are often too hard for them to solve, or even come close to solving.

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

there are many factors that the optimization model leaves out,

Econs would be perplexed by the entire idea of gifts.

Econ would know that cash is the best possible gift;

that is cash is fungible, e.g easily exchange for whatever the recipient wants

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.

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

We don’t have to stop inventing abstract models that describe the behavior of imaginary Econs. We do, however, have to stop assuming that those models are accurate descriptions of behavior, and stop basing policy decisions on such flawed analyses.

we have to start paying attention to those supposedly irrelevant factors, what I will call SIFs for short.

“behavioral economics.”

list of examples of odd behaviors that did not seem to fit the models

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.

One economist who did warn us about the alarming rate of increase in housing prices was my fellow behavioral economist Robert Shiller.

Thomas Schelling in his wonderful essay “The Life You Save May Be Your Own.”

the typical domestic public policy decision is abstract. It lacks emotional impact. Suppose we are building a new highway, and safety engineers tell us that making the median divider three feet wider will cost $42 million and prevent 1.4 fatal accidents per year for thirty years. Should we do it? Of course, we do not know the identity of those victims. They are “merely” statistical lives.

To crack the problem you needed some situation in which people make choices that involve a trade-off between money and risk of death.

Suppose Aidan is required to play one game of machine-gun Russian roulette using a gun with many chambers, say 1,000, of which four have been picked at random to have bullets. Aidan has to pull the trigger once. (Mercifully, the gun is set on single shot.) How much would Aidan be willing to pay to remove one bullet?†

The first asks how much you would pay to reduce your probability of dying next year by some amount, say by one chance in a thousand. The second asks how much cash you would demand to increase the risk of dying by the same amount. To put these numbers in some context, a fifty-year-old resident of the United States faces a roughly 4-in-1,000 risk of dying each year.

even economists have trouble equating opportunity costs with out-of-pocket costs. 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.

Kahneman and Tversky would call this distinction “framing,” but marketers already had a gut instinct that framing mattered. Paying a surcharge is out-of-pocket, whereas not receiving a discount is a “mere” opportunity cost.

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.

Typical Schelling thought experiment: suppose there was some medical procedure that will provide some modest health benefit but is extremely painful. However, the procedure is administered with a drug that does not prevent the pain but instead erases all memory of the event. Would you be willing to undertake this procedure? † The question that Zeckhauser was

“ignore sunk costs,” meaning money that has already been spent.

buying and selling prices should be about the same.

spends ten minutes to save $10 on a small purchase but not a large one, she is not valuing time consistently.

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

One of the toughest problems a CEO faces is convincing managers that they should take on risky projects if the expected gains are high enough. Their managers worry, for good reason, that if the project works out badly, the manager who championed the project will be blamed whether or not the decision was a good one at the time. Hindsight bias greatly exacerbates this problem, because the CEO will wrongly think that whatever was the cause of the failure, it should have been anticipated in advance.

What makes the bias particularly pernicious is that we all recognize this bias in others but not in ourselves.

summary paper published in Science: “Judgment Under Uncertainty: Heuristics and Biases.”

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

In guessing how frequent something is, we tend to ask ourselves how often we can think of instances of that type.

http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/.

Normative theories tell you the right way to think about some problem.

logically consistent, as prescribed by the optimizing model at the heart of economic reasoning, sometimes called rational choice theory.

people’s happiness—or utility, as economists like to call it—increases as they get wealthier, but at a decreasing rate.

A utility function of this shape implies risk aversion because the utility of the first thousand dollars is greater than the utility of the second thousand dollars, and so forth.

100,000 and I offer you a choice between an additional $1,000 for sure or a 50% chance to win $2,000, you will take the sure thing because you value the second thousand you would win less than the first thousand, so you are not willing to risk losing that first $1,000 prize in an attempt to get $2,000.

formal theory of how to make decisions in risky situations—called expected utility theory—was published in 1944 by the mathematician John von Neu...

The Theory of Games and Economic Behavior,

Expected utility is the right way to make decisions.

“bounded rationality,”