Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

I share a view held by all three authors that the “truth” is somewhere in between the two extremes: partial naiveté. Most of us realize that we have self-control problems, but we underestimate their severity. We are naïve about our level of sophistication. In particular, we suffer from what George Loewenstein has called “hot-cold empathy gaps.” When we are in a cool, reflective mood—say, contemplating what to eat at dinner on Wednesday after just having finished a satisfying brunch on Sunday—we think we will have no trouble sticking to our plan to eat healthy, low-calorie dinners during the week. But when Wednesday night comes along and friends suggest going out to a new pizza place featuring craft beers, we end up eating and drinking more than we would have predicted on Sunday, or even on Wednesday before arriving at the restaurant with its tempting aromas wafting from the wood-burning oven, not to mention an intriguing list of special brews to sample. For such cases we may need a planner to have established a rule—no midweek beer and pizza outings—and then to think of a way of enforcing that rule.

One principle that emerged from our research is that perceptions of fairness are related to the endowment effect. Both buyers and sellers feel entitled to the terms of trade to which they have become accustomed, and treat any deterioration of those terms as a loss.

It turns out, however, that with the help of some inflation, it is possible to reduce “real” wages (that is, adjusted for inflation) with much less pushback from workers.

But firms don’t always get these things right. The fact that my MBA students think it is perfectly fine to raise the price of snow shovels after a blizzard should be a warning to all business executives that their intuitions about what seems fair to their customers and employees might need some fine-tuning.

“If you gouge them at Christmas they won’t come back in March.”

“It is incredibly important for any business, no matter how great the demand, not to charge a customer more than the good or service is worth—even if the customer is willing to pay more.” He felt that even if someone was willing to pay $2,000 to eat at Next, that customer would leave feeling, “Yeah, that was great but it wasn’t worth $2,000.” And crucially, Kokonas believes that such a customer will not come back, and may share his disgruntled experience with other potential diners.‡

“The purely economic man is indeed close to being a social moron. Economic theory has been much preoccupied with this rational fool.”

The endowment effect experiments show that people have a tendency to stick with what they have, at least in part because of loss aversion.

while loss aversion is certainly part of the explanation for our findings, there is a related phenomenon: inertia. In physics, an object in a state of rest stays that way, unless something happens. People act the same way: they stick with what they have unless there is some good reason to switch, or perhaps despite there being a good reason to switch. Economists William Samuelson and Richard Zeckhauser have dubbed this behavior “status quo bias.”

Danny said: “You know, at some point people reach an age at which they can no longer be considered ‘promising.’ I think it is about the time they turn forty.” I am sure that Danny did not know my exact age, but I was thirty-nine. By the time classes resumed and I returned to Cornell, I would be forty. Damn. I had kind of enjoyed being “promising.”

paradigms change only once experts believe there are a large number of anomalies that are not explained by the current paradigm. A few scattered unexplained facts are not enough to upend the conventional wisdom.

When the expert was thinking about the problem as a member of the project team, he was locked in the inside view—caught up in the optimism that comes with group endeavors—and did not bother thinking about what psychologists call “base rates,” that is, the average time for similar projects. When he put on his expert hat, thereby taking the outside view, he naturally thought of all the other projects he’d known and made a more accurate guess. If the outside view is fleshed out carefully and informed with appropriate baseline data, it will be far more reliable than the inside view.

Narrow framing prevents the CEO from getting the twenty-three projects he would like, and instead getting only three. When broadly considering the twenty-three projects as a portfolio, it is clear that the firm would find the collection of investments highly attractive, but when narrowly considering them one at a time, managers will be reluctant to bear the risk. The firm ends up taking on too little risk. One solution to this problem is to aggregate investments into a pool where they can be considered as a package.

But the cost of the experiment was tiny, compared to the size of the company. It just looked risky compared to the particular manager’s budget. In this example, narrow framing prevented innovation and experimentation, two essential ingredients in the long-term success of any organization.

He said that he did not like one bet, but would be happy to take 100 such bets.

Michael Jensen’s PhD thesis provided the most convincing analysis. In it he showed that professional money managers perform no better than simple market averages, a fact that remains true today. If the pros can’t beat the market, who can?

To buttress his point, he noted the fact that shares of ice companies were higher in summer months when sales are higher. This fact is surprising because in an efficient market, stock prices reflect the long-run value of a company, a value that should not reflect the fact that is it warm in the summer and cold in the winter. A predictable seasonal pattern in stock prices like this is strictly verboten by the EMH.¶

no rational agent will want to buy a stock that some other rational agent is willing to sell.

No one takes the extreme version of this “no trade theorem” literally, but most financial economists agree, at least when pressed, that trading volume is surprisingly high. There is room for differences of opinion on price in a rational model, but it is hard to explain why shares would turn over at a rate of about 5% per month in a world of Econs.

However, if you assume that some investors are overconfident, high trading volume emerges naturally. Jerry has no trouble doing the trade with Tom, because he thinks that he is smarter than Tom, and Tom thinks he’s smarter than Jerry. They happily trade, each feeling a twinge of guilt for taking advantage of his friend’s poor judgment.

Roughly speaking, if a stock has a beta of 1.0, then its movements are proportional to the overall market. If a stock has a beta of 2.0, then when the market goes up or down by 10% the individual stock will (on average) go up or down by 20%. A stock that is completely uncorrelated with the market has a beta of zero.

Think of it another way. Suppose an Econ is interested in investing in Palm. He could pay $95 and get one share of Palm, or he could pay $82 and get one share of 3Com that includes 1.5 shares of Palm plus an interest in 3Com. That does not seem to be a tough decision! Why buy Palm directly when you can get more shares for less money by buying 3Com, plus get a stake in another company thrown in for free? This was a colossal violation of the law of one price. In fact it was so colossal that it was widely publicized in the popular press. Nevertheless, the value of the 3Com stub remained negative for several months.

Back in 1923, a young Benjamin Graham noticed that DuPont owned a large number of shares of General Motors and strangely, the market value of DuPont was about the same as its stake in GM. In spite of the fact that DuPont was a highly profitable firm, its stub value was close to zero. Graham made the smart trade, buying DuPont and selling GM short, and made a bundle when the price of DuPont went up.

sometimes the market overreacts, and sometimes it underreacts. But it remains the case that most active money managers fail to beat the market.

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.

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.

People are more willing to lie by omission than commission. If I am selling you a used car, I do not feel obligated to mention that the car is burning a lot of oil, but if you ask me explicitly: “Does this car burn a lot of oil?” you are likely to wangle an admission from me that yes, there has been a small problem along those lines. To get at the truth, it helps to ask specific questions.

in our increasingly complicated world people cannot be expected to have the expertise to make anything close to optimal decisions in all the domains in which they are forced to choose. But we all enjoy having the right to choose for ourselves, even if we sometimes make mistakes.

if you want people to comply with some norm or rule, it is a good strategy to inform them (if true) that most other people comply.

If you want to encourage someone to do something, make it easy.

As one United States senator famously remarked, “A billion here, a billion there, pretty soon you’re talking about real money.”