Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

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.

The core premise of economic theory is that people choose by optimizing. Of all the goods and services a family could buy, the family chooses the best one that it can afford. Furthermore, the beliefs upon which Econs make choices are assumed to be unbiased. That is, we choose on the basis of what economists call “rational expectations.”

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. In competitive markets where prices are free to move up and down, those prices fluctuate in such a way that supply equals demand. To simplify somewhat, we can say that Optimization + Equilibrium = Economics. This is a powerful combination, nothing that other social sciences can match.

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, ...

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

Third, there are many factors that the optimization model leaves out,

An Econ would know that cash is the best possible gift; it allows the recipient to buy whatever is optimal. But unless you are married to an economist, I don’t advise giving cash on your next anniversary.

You know, and I know, that we do not live in a world of Econs.

Theories based on the assumption that everyone is an Econ should not be discarded. They remain useful as starting points for more realistic models.

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,

The second approach is to use either naturally occurring experiments

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.

supposedly irrelevant factors, what I will call SIFs

My only advice for reading the book is stop reading when it is no longer fun. To do otherwise, well, that would be just misbehaving.

We went on to coauthor a paper based on my thesis entitled, naturally, “The Value of Saving a Life.” Updated versions of the number we estimated back then are still used in government cost-benefit analyses. The current estimate is roughly $7 million per life saved.

“willingness to pay”

“willingness to accept.”

consider a fifty-year-old who, before he ran into me, was facing a .004 chance of dying in the next year. Suppose he gives the answers from the previous paragraph: $2,000 for scenario A and $500,000 for scenario B. The first answer implies that the increase from .004 to .005 only makes him worse off by at most $2,000, since he would be unwilling to pay more to avoid the extra risk. But, his second answer said that he would not accept the same increase in risk for less than $500,000. Clearly, the difference between a risk of .004 and .005 cannot be at most $2,000 and at least $500,000!

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.

if a store did charge different prices to cash and credit card customers, the “regular price” would be the higher credit card price, with cash customers offered a “discount.” The alternative would have set the cash price as the regular price with credit card customers required to pay a “surcharge.”

To an Econ these two policies are identical.

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.

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.

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?

“hindsight bias.”

after the fact, we think that we always knew the outcome was likely, if not a foregone conclusion.

we all recognize this bias in others but not in ourselves.

“Judgment Under Uncertainty: Heuristics and Biases.”

heuristic

Humans have limited time and brainpower. As a result, they use simple rules of thumb—heuristics—to help them make judgments. An example would be “availability.”

using these heuristics causes people to make predictable errors. Thus the title of the paper: heuristics and biases.

Suppose you try to predict the height that a child will reach at adulthood using the height of both parents as predictors. This model will do a decent job since tall parents tend to have tall children, but the model will not be perfectly accurate,

as long as the errors are random—that is, the model’s predictions are too high or too low with equal frequency—then all is well. The errors cancel each other out. This was economists’ reasoning to justify why the errors produced by bounded rationality could safely be ignored. Back to the fully rational model! Kahneman and Tversky were waving a big red flag that said these errors were not random.

having a gun in the house increases the risk that a member of the household will commit suicide.

In time the authors changed the title to “Prospect Theory.”*

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.