Misbehaving: The Making of Behavioral Economics
Tags: #economics #psychology #behavioral economics #finance #decision-making
Authors: Richard H. Thaler
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Overview
This book tells the story of the birth and growth of behavioral economics, a field that challenges traditional economic models by incorporating insights from psychology and other social sciences. It’s a journey that began with my own “list” of quirky human behaviors that seemed to defy rational economic explanation, like refusing to part with a coffee mug even for a price higher than what I paid for it. This journey led me to collaborate with trailblazing psychologists like Danny Kahneman and Amos Tversky, whose work on cognitive biases and decision-making provided a framework for understanding why humans often “misbehave” in the eyes of traditional economic theory.
Through years of research, often met with resistance from those entrenched in traditional economic thinking, we demonstrated that these seemingly irrational behaviors are not random, but rather predictable and systematic, influenced by factors like loss aversion, mental accounting, and framing. Our work has shed light on phenomena like the endowment effect, the sunk cost fallacy, and overreaction in financial markets, revealing that people are not always the rational, self-interested actors that traditional economic models assume them to be.
But this book is not just a theoretical exercise. It also explores the practical implications of behavioral economics for real-world problems, from encouraging retirement savings with programs like Save More Tomorrow to improving public policy with the help of “nudge units” like the Behavioural Insights Team in the U.K. We’ve shown that by understanding the nuances of human behavior, we can design policies and interventions that help people make better decisions, as judged by themselves, without resorting to coercion or heavy-handed regulation.
The book is written for a general audience and aims to make complex economic concepts accessible and engaging. It’s filled with stories, anecdotes, and examples drawn from my own experience, as well as the work of other behavioral economists. It’s a call for a more realistic and human-centered approach to economics, one that embraces the messy reality of human behavior instead of clinging to idealized models of rationality. It’s my hope that this book will inspire more economists, policymakers, and everyday people to take behavioral economics seriously, and use its insights to make the world a better place.
Book Outline
1. Supposedly Irrelevant Factors
This section introduces the two main characters in the book: Amos Tversky and Danny Kahneman. It highlights the impact they had on my thinking and the field of economics, setting the stage for the rest of the book.
Key concept: “Would Amos approve?” - This was my unofficial test for every paper I wrote, always striving for intellectual rigor and seeking out constructive criticism from my friend and mentor, Amos Tversky.
2. The Endowment Effect
This section introduces the concept of the “endowment effect,” a key concept in behavioral economics that shows how people value things they own more highly than things they could own. It challenges the traditional economic view of opportunity costs, arguing that people do not treat opportunity costs the same as out-of-pocket costs.
Key concept: The “endowment effect” - This describes people’s tendency to value things they own more highly than things they could own, even if the initial allocation was random.
3. The List
This section presents a list of real-life examples that contradict the assumptions of standard economic theory. These examples highlight various behavioral biases, including the tendency to ignore sunk costs and the inconsistency in valuing time.
Key concept: “The List” - A collection of anecdotes about people’s behavior that contradicts the assumptions of standard economic theory. It serves as a starting point for identifying and examining behavioral anomalies.
4. Value Theory
This section differentiates between normative and descriptive theories. It argues that traditional economic theory often uses one theory for both purposes, leading to inaccurate predictions. Prospect theory is introduced as a descriptive theory that aims to better predict actual human behavior.
Key concept: Normative vs. Descriptive Theories - Normative theories describe the “right way” to think about a problem, while descriptive theories seek to predict how people actually behave. Prospect theory breaks from the traditional idea that a single theory can be both.
5. California Dreamin’
This section focuses on my early efforts to combine psychology and economics, particularly during a research stay at Stanford University. It explores the challenges of bridging these two disciplines and emphasizes the importance of gathering evidence to support behavioral economic theories.
Key concept: No quote provided, but the concept of combining psychology and economics to understand real-world decision making is emphasized. The concept of the “slow hunch” is introduced, referring to the long process of developing a novel idea.
6. The Gauntlet
This section outlines the main challenges I faced from traditional economists who resisted the ideas of behavioral economics. I present and address those common critiques, including the “as if” argument, the belief that incentives will eliminate biases, and the faith in the market’s ability to discipline misbehavior.
Key concept: “The Gauntlet” - A series of common critiques from traditional economists used to dismiss behavioral economics, such as the “as if” argument, the argument that incentives will eliminate behavioral biases, and the belief that markets will discipline those who misbehave.
7. Bargains and Rip-Offs
This section focuses on the concept of “transaction utility,” which explains why people are willing to pay different prices for the same good depending on the context. It highlights the role of reference prices and the perception of bargains and rip-offs in shaping consumer choices.
Key concept: Acquisition utility vs. Transaction Utility - Acquisition utility is the standard economic concept of consumer surplus, while transaction utility captures the perceived quality of the deal, influenced by the difference between the price paid and the reference price.
8. Sunk Costs
This section explores the “sunk cost fallacy,” highlighting the difficulty people have in ignoring sunk costs even when they understand the concept. It uses various examples, from personal decisions to national policy, to illustrate the pervasiveness of this bias.
Key concept: The “sunk cost fallacy” - The mistake of paying attention to sunk costs when making decisions, even though those costs cannot be recovered.
9. Buckets and Budgets
This section delves into the concept of “mental accounting,” showing how people create mental budgets and categorize their spending. It argues that while this system can be helpful for managing money, it often leads to violations of fungibility and can result in inefficient decisions.
Key concept: “Mental Accounting” - The process by which people categorize and track their income and expenses, often leading to non-fungible treatment of money. Examples include budgeting with envelopes and the tendency to treat home equity as a sacred account.
10. At the Poker Table
This section examines the “house money effect,” using the example of a poker game to illustrate how people become more risk-seeking when gambling with money that has been won recently. This behavior is linked to mental accounting and the idea that winnings are not treated as “real money.
Key concept: The “house money effect” - The tendency for people to become more risk-seeking when gambling with money that they have won, treating those winnings as “not real money.
11. Willpower? No Problem
This section explores the concept of self-control and challenges the traditional economic assumption of unlimited willpower. It revisits the historical roots of behavioral economics, highlighting Adam Smith’s recognition of the conflict between our passions and our long-term interests.
Key concept: “Willpower? No problem” - A common assumption in traditional economics, but one that behavioral economics challenges by acknowledging the limitations of willpower in resisting temptation and making consistent intertemporal choices.
12. The Planner and the Doer
This section introduces the “planner and the doer” model as a framework for understanding self-control problems. It uses the analogy of Odysseus and the Sirens to illustrate the importance of commitment devices and explores how guilt can be used as a tool to influence behavior.
Key concept: The “Planner and the Doer” - A metaphor used to represent the conflict between our long-term goals (the planner) and our short-term impulses (the doer). It highlights the need for commitment strategies and the role of guilt in managing self-control problems.
13. Misbehaving in the Real World
This section focuses on applying behavioral economics to real-world business problems, particularly in the context of pricing. It describes my consulting experience helping a struggling ski resort improve its revenue model by incorporating behavioral insights.
Key concept: No key quote, but the concept of a “secret sale” is introduced as a pricing strategy that fails to fully capitalize on consumers’ willingness to pay.
14. What Seems Fair?
This section explores the concept of fairness in economic transactions. It uses survey data to reveal how people’s perceptions of fairness often conflict with the predictions of standard economic theory. It also highlights how “theory-induced blindness” can lead economists to miss important insights about human behavior.
Key concept: “Theory-induced Blindness” - The tendency for economists to ignore or dismiss evidence that contradicts their favored theories. This is illustrated by the resistance to the idea that raising prices after a natural disaster is unfair.
15. Fairness Games
This section introduces the Ultimatum Game and the Dictator Game as tools for studying fairness and punishment. It shows that people are willing to punish unfair behavior, even if it means giving up some of their own money, challenging the assumption that people are purely self-interested.
Key concept: The “Ultimatum Game” and the “Dictator Game” - These games demonstrate that people are willing to punish those who act unfairly, even at a personal cost. This challenges the traditional economic assumption of pure self-interest.
16. Mugs
This section revisits the endowment effect, using experiments involving coffee mugs to provide further evidence for this phenomenon. It shows that even in a market setting, people are reluctant to trade items they own, leading to lower trading volume than predicted by standard economic theory.
Key concept: The “Endowment Effect” - This refers to the tendency for people to value items they own more highly than items they do not own, even if the items are identical. This is demonstrated through experiments involving coffee mugs, providing further evidence against traditional economic theory.
17. The Debate Begins
This section describes a key conference at the University of Chicago that marked a turning point for behavioral economics. It highlights the arguments presented by both sides of the debate, with behavioral economists challenging the traditional assumptions of rationality and efficient markets.
Key concept: “Rationality is neither necessary nor sufficient to do good economic theory.” - This was a key takeaway from Kenneth Arrow’s presentation at the University of Chicago conference.
18. Anomalies
This section introduces my “Anomalies” column in the Journal of Economic Perspectives, which I used as a platform to document and discuss findings that challenged standard economic theory. It highlights the importance of identifying and exploring these anomalies to push the boundaries of economic thinking.
Key concept: “Anomalies” - These are empirical findings that are difficult to explain within the standard economic paradigm. The chapter introduces my “Anomalies” column for the Journal of Economic Perspectives, which served as a platform to document and discuss such anomalies.
19. Forming a Team
This section focuses on the early efforts to build a community of behavioral economists. It describes how, with the help of the Russell Sage Foundation, we created summer camps to train graduate students, helping to establish behavioral economics as a viable field of study.
Key concept: “Russell Sage summer camps” - These were intensive summer programs designed to train graduate students in behavioral economics, fostering the growth of a new generation of researchers in the field.
20. Narrow Framing on the Upper East Side
This section explores the concept of “narrow framing,” showing how people often make decisions by focusing on individual choices in isolation rather than considering them as part of a broader portfolio. It examines the implications of narrow framing for managerial decision-making and its role in explaining the equity premium puzzle.
Key concept: “Narrow framing” - This is the tendency to focus on individual decisions in isolation rather than considering them as part of a larger portfolio. It can lead to overly cautious behavior, as seen in the example of managers who are reluctant to take on risky projects.
21. The Beauty Contest
This section introduces the concept of “the beauty contest,” using the example of a number guessing game to illustrate how investors try to predict what other investors will think rather than focusing on fundamental value. This behavior can lead to market bubbles and crashes, as prices become detached from underlying economic reality.
Key concept: Keynes’s “beauty contest” analogy - This analogy describes the stock market as a game where investors try to predict what other investors will think, rather than focusing on the fundamental value of companies. This highlights the role of social dynamics and speculation in driving market prices.
22. Does the Stock Market Overreact?
This section presents evidence that stock markets “overreact,” meaning that prices tend to move too much in response to new information. It examines the performance of “winner” and “loser” stocks, finding that loser stocks outperform winner stocks over time, suggesting that investors systematically overreact to both good and bad news.
Key concept: “Overreaction” hypothesis - This posits that investors tend to overreact to new information, driving prices too high for good news and too low for bad news. This leads to predictable patterns of mean reversion, where “loser” stocks tend to outperform “winner” stocks.
23. The Reaction to Overreaction
This section explores the reaction to the findings of overreaction in financial markets, particularly the resistance from efficient market proponents. It highlights the “value effect,” where value stocks (those with low price-to-earnings ratios) outperform growth stocks, and the challenge this phenomenon poses to traditional finance theory.
Key concept: The “value effect” - This describes the tendency for value stocks, those with low price-to-earnings ratios, to outperform growth stocks. While initially dismissed as inconsistent with efficient markets, this effect has been acknowledged even by staunch defenders of market efficiency like Eugene Fama.
24. The Price Is Not Right
This section focuses on the debate about whether stock markets are always “right,” meaning that prices accurately reflect fundamental value. It presents Robert Shiller’s research, which shows that stock prices are far too volatile to be justified by changes in fundamental value. This research, along with the subsequent stock market crash of 1987, provides evidence against the efficient market hypothesis.
Key concept: “Irrational exuberance” - This term, coined by Alan Greenspan, describes the excessive optimism that can drive asset prices to unsustainable levels. This is illustrated by Shiller’s research on the historical volatility of both stock and housing prices, which shows periods of significant mispricing.
25. The Battle of Closed-End Funds
This section examines the “closed-end fund puzzle,” where these funds, which are essentially baskets of stocks that trade as individual securities, often trade at prices that differ significantly from the value of their underlying assets. This anomaly provides further evidence against the efficient market hypothesis and highlights the limitations of arbitrage in correcting mispricing.
Key concept: The “law of one price” - This states that identical assets should trade at the same price, but closed-end funds, which are essentially portfolios of stocks that trade as individual stocks, often violate this law. They frequently trade at discounts or premiums to the value of their underlying assets, providing a clear example of market inefficiency.
26. Fruit Flies, Icebergs, and Negative Stock Prices
This section explores additional cases of mispricing, using the example of the Palm/3Com spin-off to demonstrate how prices can diverge from fundamental value. This episode, and other similar cases, are referred to as “finance’s fruit flies” because they provide a clear example of market inefficiency in a controlled setting, similar to how fruit flies are used in genetic research.
Key concept: “Finance’s fruit flies” - This refers to cases of clear mispricing, such as the Palm/3Com episode, which, like fruit flies in genetics, offer a unique opportunity to study market inefficiency in a controlled setting.
27. Law Schooling
This section describes my foray into the field of law and economics, collaborating with legal scholars to explore how behavioral economics can inform legal policy. Our work introduced the “three bounds” – bounded rationality, bounded willpower, and bounded self-interest – as key elements of a behavioral approach to law and economics.
Key concept: “Bounded Rationality, Bounded Willpower, and Bounded Self-Interest” - These “three bounds” are the cornerstones of behavioral economics, highlighting the limitations of traditional economic assumptions about human behavior.
28. The Offices
This section recounts the amusing story of an office draft at the University of Chicago Booth School of Business, highlighting the human tendency to overreact and become emotional even in seemingly rational environments.
Key concept: No quote provided, but the concept of an “office draft” and the intense interest it generated among faculty highlight the human tendency to overvalue certain goods or positions, even in a seemingly rational environment.
29. Football
This section examines decision-making in the NFL draft, finding evidence that teams systematically overvalue early draft picks, a finding that contradicts the efficient market hypothesis and challenges Gary Becker’s conjecture that markets will discipline irrationality.
Key concept: “Division of labor strongly attenuates if not eliminates any effects [caused by bounded rationality.]” - This is Gary Becker’s conjecture, which suggests that in competitive markets, only those who act rationally will succeed. This chapter challenges that conjecture by examining decision-making in the NFL draft.
30. Game Shows
This section explores the use of game shows as a natural laboratory for studying decision-making under uncertainty. It presents research on the game show ‘Deal or No Deal,’ which reveals evidence for both prospect theory and path dependence, showing that people’s choices are influenced not just by current options but also by prior gains and losses.
Key concept: “Path dependence” - This refers to the idea that decisions are influenced not just by current options, but also by the sequence of past events. This is illustrated by the behavior of contestants on the game show ‘Deal or No Deal,’ who become more risk-seeking after experiencing big losses or wins.
31. Save More Tomorrow
This section describes the development and success of the “Save More Tomorrow” (SMarT) program, a behavioral intervention designed to help people save more for retirement. It illustrates how combining behavioral insights with thoughtful plan design can lead to significant changes in behavior.
Key concept: “Save More Tomorrow” (SMarT) - This is a savings program designed to overcome inertia and loss aversion by allowing employees to commit to saving more in the future, when they get their next raise. This program has been shown to significantly increase savings rates.
32. Going Public
This section introduces the concept of “libertarian paternalism,” a philosophy that advocates for using choice architecture to nudge people towards making better decisions while preserving their freedom of choice. It describes the origins of this concept and the resistance it initially faced from some economists who viewed it as an oxymoron.
Key concept: “Libertarian paternalism” - This refers to the use of choice architecture to nudge people towards making better decisions without restricting their freedom of choice. This concept, introduced in a paper with Cass Sunstein, sparked significant debate and eventually led to the publication of the book ‘Nudge’.
33. Nudging in the U.K.
This section describes the establishment of the Behavioural Insights Team (BIT), also known as the “nudge unit,” by the U.K. government. It highlights the team’s efforts to apply behavioral science to improve public policy, using randomized control trials to evaluate the effectiveness of interventions.
Key concept: The “nudge unit” (Behavioural Insights Team (BIT)) - This is a team established by the U.K. government to apply behavioral insights to improve public policy, using randomized control trials to test the effectiveness of interventions.
34. Conclusion: What is Next?
This concluding section emphasizes the need for evidence-based economics, arguing that both theory and policy should be grounded in empirical data and experimental results. It calls for more research on the role of Humans in all areas of economics, particularly macroeconomics, and encourages a more data-driven approach to decision-making in all aspects of life.
Key concept: “Evidence-based economics” - This emphasizes the need for economic theory and policy to be grounded in empirical observation and experimental testing, rather than solely on assumptions about rationality. It highlights the need for more research in areas such as behavioral macroeconomics and the importance of using diverse methods, including field experiments and randomized control trials.
Essential Questions
1. How do humans ‘misbehave’ according to behavioral economics, and why does this matter?
Traditional economic theory, which assumes humans act like rational ‘Econs’, fails to predict real-world behavior. Humans, unlike Econs, are influenced by emotions, cognitive biases, and social norms. This leads to ‘misbehaving’ – actions that deviate from the predictions of standard economic models. Examples of misbehaving include the endowment effect, the sunk cost fallacy, and overreaction in financial markets.
2. What is ‘mental accounting,’ and how does it influence our financial decisions?
Mental accounting is the process by which people categorize and track their money, often leading to non-fungible treatment of money. For example, people might be more willing to spend money from a ‘bonus’ account than from a ‘savings’ account, even though money is fungible. This concept challenges traditional economic assumptions and has implications for understanding consumer spending and saving behavior.
3. How does the ‘planner and the doer’ model explain self-control problems, and what are its implications for policy design?
The ‘planner’ represents our long-term goals and rational thinking, while the ‘doer’ is driven by short-term impulses and emotions. This internal conflict explains why we often struggle with self-control and make choices that we later regret. Understanding this duality can help us design better policies and interventions that help people achieve their long-term goals.
4. What is ‘libertarian paternalism,’ and how can it be used to improve public policy and individual well-being?
Libertarian paternalism advocates for using ‘nudges’ – subtle changes in choice architecture – to steer people towards making better decisions without restricting their freedom of choice. For example, making enrollment in a retirement savings plan the default option is a nudge that can significantly increase savings rates. This approach balances individual autonomy with the recognition that people can benefit from help in making complex decisions.
5. What is the future of behavioral economics, and what are some key areas for future research?
To advance the field, we need to embrace evidence-based economics, both in theory and practice. This means grounding our models in empirical observation and experimental testing, rather than relying solely on assumptions about rationality. We need more research in areas like behavioral macroeconomics, and we need to use diverse methods to collect data, including field experiments and randomized control trials.
Key Takeaways
1. Losses loom larger than gains (Loss aversion).
Loss aversion is a powerful bias that explains why people are more motivated to avoid losses than to achieve gains. It highlights the importance of framing choices in a way that emphasizes potential losses rather than potential gains.
Practical Application:
Imagine you’re designing a retirement savings app. By understanding loss aversion, you could frame contribution increases as a way to ‘avoid losing future income’ instead of as a ‘reduction in current take-home pay’. This framing might encourage users to save more.
2. People are attached to what they have (Endowment effect).
The endowment effect describes the tendency for people to overvalue things they own, even if the ownership is temporary. It emphasizes the importance of considering ownership and possession in designing products and services.
Practical Application:
Consider a product manager designing a new e-commerce platform. By understanding the endowment effect, they could offer free trials or ‘risk-free’ return policies. This could reduce the perceived risk of trying a new product, encouraging more purchases.
3. People budget with mental accounts (Mental accounting).
Mental accounting demonstrates how people mentally categorize and track their finances, often in ways that violate the principles of fungibility. Understanding these mental buckets can help us design more effective financial products and interventions.
Practical Application:
Let’s say you’re leading a team developing a financial planning tool. By understanding mental accounting, you could design features that help users categorize their spending and saving into separate ‘buckets’ – like a ‘vacation fund’ or an ‘emergency fund’. This could make it easier for users to budget effectively and achieve their financial goals.
4. Defaults matter (Status quo bias).
Defaults have a significant influence on our choices because people tend to stick with the pre-selected option, even when it’s not the best choice. This insight can be applied to design choice environments that guide people toward making better decisions.
Practical Application:
Imagine a team designing a productivity app. By understanding the power of defaults, they could make ‘proactive task scheduling’ the default setting. This could nudge users towards better time management without forcing them to use the feature.
5. People Overreact.
Overreaction describes the tendency to overestimate the significance of new information or recent trends. This bias can be particularly problematic in complex domains like financial markets, where it can contribute to bubbles and crashes.
Practical Application:
Imagine you are an AI ethicist concerned about the risk of over-reliance on AI models. By being mindful of the potential for overreaction, you could advocate for more robust testing and validation procedures for AI systems, especially in high-stakes domains like healthcare or finance.
Memorable Quotes
Preface. 4
“The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social science from the principles of psychology.” - Vilfredo Pareto
Supposedly Irrelevant Factors. 19
“Ironically, the existence of formal models based on this misconception of human behavior is what gives economics its reputation as the most powerful of the social sciences.”
Value Theory. 46
“Losses hurt about twice as much as gains make you feel good.”
Narrow Framing on the Upper East Side. 106
“If you gouge them at Christmas they won’t come back in March.”
The Beauty Contest. 209
“It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” - John Maynard Keynes
Comparative Analysis
“Misbehaving” stands out for its personal and engaging narrative style, making it accessible to a broader audience compared to more technical works like Kahneman’s “Thinking, Fast and Slow”. While Kahn man delves deeper into the psychological mechanisms behind cognitive biases, Thaler focuses on the real-world applications of these biases, particularly in economics and finance.
This book aligns with other behavioral economics works like Ariely’s “Predictably Irrational” and “The Upside of Irrationality”, emphasizing the predictability of human irrationality. However, while Ariely often focuses on consumer behavior and marketing, Thaler’s focus on finance and public policy provides a unique contribution.
Thaler’s work also intersects with Shiller’s research on market bubbles and “irrational exuberance”. However, while Shiller focuses more on the macro-level impact of behavioral biases, Thaler explores a wider range of applications, from individual decision-making to organizational behavior.
Reflection
This book serves as a powerful reminder that even in seemingly rational domains like economics and finance, human behavior is often driven by predictable, yet often irrational, biases. While some might argue that Thaler’s focus on anomalies and “misbehaving” paints a pessimistic view of human nature, I believe his work provides valuable tools for understanding and addressing these shortcomings.
The book’s strength lies in its ability to connect academic research with real-world examples, making complex ideas accessible and engaging for a broad audience. However, a potential weakness is the lack of a unified, overarching theory of behavioral economics. While prospect theory and the planner-doer model offer valuable frameworks, much work remains to be done to develop a more comprehensive theoretical foundation for the field.
Overall, “Misbehaving” is a seminal work in behavioral economics, challenging traditional economic thinking and paving the way for a more realistic and human-centered approach to economic theory and policy. Its insights are particularly relevant in the age of AI, where understanding the intersection of human behavior and technology is crucial for designing safe, effective, and ethical AI systems.
Flashcards
What is the endowment effect?
The tendency for people to value things they own more highly than things they could own.
What is status quo bias?
The tendency to stick with the default option, even if it’s not the best choice.
What is mental accounting?
The process by which people categorize and track their money, often leading to non-fungible treatment of money.
What is the house money effect?
The tendency for people to become more risk-seeking when gambling with money that they have won recently.
What is the sunk cost fallacy?
The mistake of paying attention to sunk costs when making decisions.
What is overreaction?
The tendency for people to make forecasts that are too extreme based on limited information.
What is Save More Tomorrow?
A savings program where people commit to saving more in the future, when they get a raise.
What is libertarian paternalism?
A philosophy that advocates for using choice architecture to nudge people towards making better decisions while preserving their freedom of choice.
What is the Behavioural Insights Team (BIT)?
A team established by the U.K. government to apply behavioral insights to improve public policy.