Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

“Exams will have a total of 137 points rather than the usual 100. This scoring system has no effect on the grade you get in the course, but it seems to make you happier.”

An Econ would know that cash is the best possible gift; it allows the recipient to buy whatever is optimal.

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.

Schelling writes the way he speaks: with a wry smile and an impish twinkle in his eye. He wants to make you a bit uncomfortable.

Here, the story of the sick girl is a vivid way of capturing the major contribution of the article. The hospitals stand in for the concept Schelling calls a “statistical life,” as opposed to the girl, who represents an “identified life.” We occasionally run into examples of identified lives at risk in the real world, such as the thrilling rescue of trapped miners. As Schelling notes, we rarely allow any identified life to be extinguished solely for the lack of money. But of co...

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.

Economic theory is not alone in saying the answers should be identical. Logical consistency demands it. Again 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.

the credit card lobby hedged its bets and shifted focus to form over substance. They insisted that 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.

Paying a surcharge is out-of-pocket, whereas not receiving a discount is a “mere” opportunity cost.

called this phenomenon the “endowment effect” because, in economists’ lingo, the stuff you own is part of your endowment, and I had stumbled upon 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.

“Dumb stuff people do” is not a satisfactory title for an academic paper.

Baruch told me about his now-famous thesis on “hindsight bias.” The finding is that, after the fact, we think that we always knew the outcome was likely, if not a foregone conclusion.

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

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.” Suppose I ask you if Dhruv is a common name. If you are from most countries in the world you would likely say no, but it happens to be a very common name in India, a country with a lot of people, so on a global scale it is in fact a rather common name.

using these heuristics causes people to make predictable errors.

If you remember your high school geometry, have a calculator with a square root function handy, and know that there are 5,280 feet in a mile and 12 inches in a foot, you can solve this problem. But suppose instead you have to use your intuition. What is your guess? Most people figure that since the tracks expanded by an inch they should go up by roughly the same amount, or maybe as much as two or three inches. The actual answer is 29.7 feet! How did you do?

The average answer that people give is about 2 inches.

Bernoulli invented the idea of risk aversion. He did so by positing that people’s happiness—or utility, as economists like to call it—increases as they get wealthier, but at a decreasing rate. This principle is called diminishing sensitivity. As wealth grows, the impact of a given increment of wealth, say $100,000, falls.

If I had an important decision to make—whether to refinance my mortgage or invest in a new business—I would aim to make the decision in accordance with expected utility theory, just as I would use the Pythagorean theorem to estimate the altitude of our railroad triangle. Expected utility is the right way to make decisions.

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.

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

The fact that a loss hurts more than an equivalent gain gives pleasure is called loss aversion. It has become the single most powerful tool in the behavioral economist’s arsenal.

So, we experience life in terms of changes, we feel diminishing sensitivity to both gains and losses, and losses sting more than equivalently-sized gains feel good.

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.

Because learning takes practice, we are more likely to get things right at small stakes than at large stakes. This means critics have to decide which argument they want to apply. If learning is crucial, then as the stakes go up, decision-making quality is likely to go down.

If you understand opportunity costs and 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?

Thinking like that is a right and proper normative theory of consumer choice. It’s what Econs do, and in principle we should all strive to think this way most of the time. Still, anyone who tried to make every decision in this manner would be paralyzed. How can I possibly know which of the nearly infinite ways to use $1,000 will make me happiest?

Losses hurt about twice as much as gains make us feel good.

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.

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.

For those who are at least living comfortably, negative transaction utility can prevent our consuming special experiences that will provide a lifetime of happy memories, and the amount by which the item was overpriced will long be forgotten.

Because consumers think this way, sellers have an incentive to manipulate the perceived reference price and create the illusion of a “deal.” One example that has been used for decades is announcing a largely fictional “suggested retail price,” which actually just serves as a misleading suggested reference price.

Goods that are marketed this way share two characteristics: they are bought infrequently and quality is difficult to assess.

Getting a great deal is more fun than saving a small and largely invisible amount on each item.

JC Penney similarly eschewed coupons for a brief period in 2012 in pursuit of an everyday low price strategy. Noting that less than 1% of revenues came from full-price transactions, CEO Ron Johnson in a surprisingly candid press release announced an end to what he dubbed “fake prices”—the mythical suggested retail price—and the start of a simpler pricing scheme. In addition to abolishing traditional sales via coupons, the new scheme did away with prices ending in .99, rounding them up to the nearest dollar. JC Penney claimed the end price consumers paid was effectively the same, after all these changes. It might well be true that consumers were not paying any more under the new regime, but they were missing out on lots of transaction utility. They even lost that tiny pleasure of paying just “under” a given dollar amount, e.g., $9.99 rather than $10. The experiment was a flop. JC Penney’s sales and stock price plummeted as the changes took effect in 2012.

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

For businesses, it is important to realize that everyone is interested in a good deal. Whether it is via sales or genuine low prices, the lure of a deal will attract customers. The parking lot at Costco, a warehouse-style retailer with a reputation for low prices, always has a large number of luxury automobiles. Even affluent consumers get a kick from transaction utility.

the poor come closer to behaving like Econs than those who are better off, simply because opportunity costs are highly salient for them.

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.

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!

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.”

The crucial theoretical question I wanted to answer was this: if I know I am going to change my mind about my preferences (I will not limit myself to a few more cashew nuts, as I intend, rather I will eat the entire bowl), when and why would I take some action to restrict my future choices?

We all have occasions on which we change our minds, but usually we do not go to extraordinary steps to prevent ourselves from deviating from the original plan. The only circumstances in which you would want to commit yourself to your planned course of action is when you have good reason to believe that if you change your preferences later, this change of preferences will be a mistake.

“The idea of self-control is paradoxical unless it is assumed that the psyche contains more than one energy system, and that these energy systems have some degree of independence from each other.” The passage is from an obscure book, The Foundations of Human Society. I do not know how I came by the quote, but it seemed to me to be obviously true. Self-control is, centrally, about conflict.

We propose that at any point in time an individual consists of two selves. There is a forward-looking “planner” who has good intentions and cares about the future, and a devil-may-care “doer” who lives for the present.§ The key question for any model of this behavior was deciding how to characterize interactions between the two.

In our intrapersonal framework, the agents are a series of short-lived doers; specifically, we assume there is a new doer each time period, say each day. The doer wants to enjoy himself and is completely selfish in that he does not care at all about any future doers. The planner, in contrast, is completely altruistic. All she¶ cares about is the utility of the series of doers. (Think of her as a benevolent dictator.) She would like them to be collectively as happy as possible, but she has limited control over the actions of the doers, especially if a doer is aroused in any way, such as by food, sex, alcohol, or an urgent desire to go outside and goof off on a nice day.

If there are no commitment strategies available, the only other tool the planner has in our model is guilt. Through some process of indoctrination, either by the planner herself or by parents and society, doers can be made to feel bad about leaving future doers with nothing to eat. But imposing guilt is costly.

Even in this highly simplified version of the model, it is possible to illustrate many interesting subtleties about intertemporal choice; these subtleties depend in part on whether people are aware of their self-control problems. When David Laibson wrote his first paper on this subject he assumed that agents were “sophisticated,” meaning that they knew they had this pattern of time preferences. As a graduate student trying to get a job with a paper on behavioral economic theory (a category that was then essentially unknown), it was clever of David to characterize the model this way. David’s agents were pure Econs except for one detail; they had problematic time preferences. When O’Donoghue and Rabin decided to join the party they considered a more radical approach, in which agents have present-biased preferences but are unaware of their affliction. Such agents are considered “naïve.”