Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

Build descriptive economic models that accurately portray human behavior.

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. If I gain one ounce, I don’t notice it, but if I am buying fresh herbs, the difference between 2 ounces and 3 ounces is obvious.

People will be risk-averse for gains, but risk-seeking for losses,

The puzzle is this: Suppose you are offered a gamble where you keep flipping a coin until it lands heads up. If you get tails on your first flip you win $2, on your second flip $4, and so forth, with the pot doubling each time. Your expected winnings are ½ x $2 + ¼ x $4 + 1/8 x $8 . . . The value of this sequence is infinite, so why won’t people pay a huge amount to play the bet? Bernoulli’s answer was to suppose that people get diminishing value from increases in their wealth, which yields risk aversion. A simpler solution is to note that there is only a finite amount of wealth in the world, so you should be worried about whether the other side can pay up if you win. Just forty tails in a row puts your prize money at over one trillion dollars. If you think that would break the bank, the bet is worth no more than $40.

National Bureau of Economic Research (NBER) office,

Economists do not put much stock in the answers to hypothetical questions, or survey questions in general for that matter. Economists say they care more about what people do as opposed to what they say they would do.

A slow hunch is not one of those “aha” insights when everything becomes clear. Instead, it is more of a vague impression that there is something interesting going on, and an intuition that there could be something important lurking not far away. The problem with a slow hunch is you have no way to know whether it will lead to a dead end.

experimental economics,

Economists had their way of doing things and would resist change, if for no other reason than that they had invested years building their own particular corner of this edifice.

One of the most prominent of the putdowns had only two words: “as if.”

the argument is that even if people are not capable of actually solving the complex problems that economists assume they can handle, they behave “as if” they can.

The two central concepts of economics remained the same—namely, that agents optimize and markets reach a stable equilibrium—

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.

And if actual incentives were introduced in a laboratory setting, the stakes were typically low, just a few dollars. Surely, it was often said, if the stakes were raised, people would get stuff right. This assertion, unsupported by any evidence,

nothing in the theory or practice of economics suggested that economics only applies to large-stakes problems.

learn from experience, two ingredients are necessary: frequent practice and immediate feedback.

Because learning takes practice, we are more likely to get things right at small stakes than at large stakes. This means

assumes we have few large stakes and many small stakes opportunities

If learning is crucial, then as the stakes go up, decision-making quality is likely to go down.

The problem with this argument is that it can be hard to find a true expert who does not have a conflict of interest.

context: when the stakes are high, why I can get a expert to help me.

Many people have made money selling magic potions and Ponzi schemes, but few have gotten rich selling the advice, “Don’t buy that stuff.”

Ithaca is a small town with long, snowy winters, and not much to do. It was a good place to work.

The first was to understand the psychology of spending, saving, and other household financial behavior, what has now become known as mental accounting.

The second was self-control and, more generally, choosing between now and later.

They also explicitly entertained the possibility that the perverse results were obtained simply because the experimenters were psychologists, who were known to deceive people in experiments.

“How do people think about money?”

all economic decisions are made through the lens of opportunity costs. The cost of dinner and a movie tonight is not fully captured by the financial outlay—it also depends on the alternative uses of that time and money.

you have a ticket to a game that you could sell for $1,000, it does not matter how much you paid for the ticket. The cost of going to the game is what you could do with that $1,000. You should only go to the game if that is the best possible way you could use that money. Is it better than one hundred movies at $10 each?

when starting from zero, it is steeper going down than going up. Losses hurt about twice as much as gains make us feel good. This raises the question: if you pay $5 for a sandwich, do you feel like you just lost $5? For routine transactions, the answer is clearly no. For one thing, thinking that way would make you miserable.

acquisition utility and transaction utility.

measure the utility of the object gained and then subtract the opportunity cost of what has to be given up.

A purchase will produce an abundance of acquisition utility only if a consumer values something much more than the marketplace does.

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

Good deals, on the other hand, can lure all of us into making purchases of objects of little value.

Because consumers think this way, sellers have an incentive to manipulate the perceived reference price and create the illusion of a “deal.”

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.

And when the quality of a product, like a mattress, is hard to assess, the suggested retail price can do double duty. It can simultaneously suggest that quality is high (thus increasing perceived acquisition utility) and imply that there is transaction utility to be had because the product is “on sale.”

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.

When an amount of money has been spent and the money cannot be retrieved, the money is said to be sunk, meaning gone. Expressions such as “don’t cry over spilt milk” and “let bygones be bygones” are another way of putting economists’ advice to ignore sunk costs.

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.

the more you use something that you have paid for, the better you can feel about the transaction.

The bigger lesson is that once you understand a behavioral problem, you can sometimes invent a behavioral solution to it. Mental accounting is not always a fool’s game.

The existence of budgets can violate another first principle of economics: money is fungible, meaning that it has no labels restricting what it can be spent on. Like most economic principles, this has strong logic behind it. If there is money left over in the utilities budget because of a mild winter, it will spend perfectly well at the children’s shoe store.

Money should be spent in whatever way best serves the interests of the organization or household; if those interests change, we should ignore the labels that were once assigned to various pots of money. But we don’t. Labels are SIFs.

Once you recognize the break-even effect and the house money effect, it is easy to spot them in everyday life. It occurs whenever there are two salient reference points, for instance where you started and where you are right now. The house money effect—along with a tendency to extrapolate recent returns into the future—facilitates financial bubbles.

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.

This means that the prediction from prospect theory that people will be risk-seeking in the domain of losses may not hold if the risk-taking opportunity does not offer a chance to break even.

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.

“The pleasure which we are to enjoy ten years hence, interests us so little in comparison with that which we may enjoy to-day.”

Arthur Pigou famously wrote in 1920, it could be a failure of imagination: “Our telescopic faculty is defective and . . . we, therefore, see future pleasures, as it were, on a diminished scale.”