Misbehaving

“Dean did not understand how his friend could possibly think he could afford to go to the game. His friend could not understand why Dean didn’t realize the tickets were free. That is the endowment effect.”

This captures the essence of the endowment effect, a key concept in behavioral economics. It highlights how ownership changes our valuation of items. Dean’s friend values the experience of attending the game more because he owns the tickets, while Dean sees the opportunity to sell them for profit. This divergence in behavior due to ownership status demonstrates the irrational yet predictable ways humans assign value to possessions. Thaler uses this real-world example to illustrate the practical implications of the endowment effect.

“The discrepancy between buying and selling prices got my mind wandering. What else do people do that is inconsistent with the economists’ model of rational choice?”

This captures a pivotal moment for Thaler, sparking his dive into behavioral economics. It highlights his observation that human decisions frequently stray from what traditional economics would predict as rational. Thaler’s inquiry into the different values people assign to things they own versus those they don’t leads to uncovering the complex and often irrational nature of human decision-making.

“If I take away Professor Rosett’s bottle of wine, he will feel it as a loss equivalent to twice the gain he would feel if he acquired a bottle; that is why he would never buy a bottle worth the same market price as one in his cellar.”

This example highlights loss aversion, where the pain of losing is often felt more intensely than the joy of gaining. Using Professor Rosett’s wine, Thaler shows emotional factors heavily influence economic decisions. This challenges traditional models based on rationality and material value alone.

“At some point during my year in Stanford I decided I was going ‘all in’ on this new venture. The University of Rochester was not an ideal venue given the intellectual proclivities of the senior faculty, who were deeply wedded to traditional economic methodology, so I looked elsewhere.”

This quote marks a critical turning point in Thaler’s career, representing his commitment to pioneering behavioral economics. It highlights the struggle between traditional and innovative approaches within academia. Thaler’s shift to a more supportive environment underscores the impact of academic culture on research development and the importance of embracing new ideas for progress in economic theory.

“One of the most prominent of the putdowns had only two words: ‘as if.’ Briefly stated, 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.”

This quote challenges the “as if” argument in economics, which assumes people act rationally for model simplicity. Thaler highlights the gap between this idealized rationality and actual human behavior. His critique underscores the need for economic theories to realistically represent human complexity, questioning the relevance of models based solely on rational assumptions.

“Eventually I settled on a formulation that involves two kinds of utility: acquisition utility and transaction utility. Acquisition utility is based on standard economic theory. […] Humans […] also weigh 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 reference price.”

This quote introduces acquisition utility and transaction utility, reshaping an understanding of consumer behavior. While acquisition utility reflects the conventional economic view of consumer surplus, transaction utility adds a psychological dimension, focusing on the perceived quality of a deal. Thaler’s insight challenges traditional economic assumptions by emphasizing how consumers value the deal itself, beyond just the intrinsic utility of a product.

“When an amount of money has been spent and the money cannot be retrieved, the money is said to be sunk, meaning gone. […] But this is hard advice to follow, as the example from the List about driving to a basketball game in a blizzard, and the story of Vince and his tennis elbow, illustrate.”

This quote illuminates the concept of “sunk costs,” showing how people often irrationally consider past, irretrievable expenses in current decisions. Vince’s example, where he continues to play tennis despite pain due to previously paid fees, typifies this fallacy. It contrasts economic logic with human behavior, where past expenditures undesirably influence present choices.

“In those interviews with families that I used to inform my thinking about how households manage their finances, we learned that many households, especially those on a tight budget, used explicit budgeting rules.”

This quote reflects the use of mental accounting in family finance management, where households, especially on tight budgets, categorize their spending. This practice, despite conflicting with the economic principle of fungibility, illustrates a realistic approach to budget management. It reveals a gap between economic theories and actual financial strategies used in daily life, demonstrating how practical needs shape financial behavior.

“During my time at Cornell, a group of economics faculty members met periodically for a low-stakes poker game. […] Losing money in the poker account only changes behavior while you are still playing poker.”

This quote highlights how financial losses in dynamic contexts like poker games evoke stronger reactions than static investment losses. It shows that even economists, expected to be rational, are subject to these behavioral biases. This example challenges the traditional economic view of rational decision-making by demonstrating how people’s responses to losses vary based on context, suggesting a more complex picture of human financial behavior than traditional models account for.

“Economists have not always been so dense about self-control problems. For roughly two centuries, the economists who wrote on this topic knew their Humans. […] Adam Smith was not the only early economist to have sensible intuitions about self-control problem.”

This quote reveals the fluctuating understanding of human behavior in economic thought. Early economists like Adam Smith recognized the complexities of human psychology, contrary to later models focusing solely on rational decision-making. This historical view shows economic thought has alternated between acknowledging human irrationality and relying on more abstract models, with a recent return to behavioral insights.

“By the time I was thinking about self-control problems in 1978, Strotz’s paper was already more than twenty years old, and there was no one else in economics who seemed interested (though Tom Schelling would soon chime in). I turned to psychology for inspiration.”

This quote highlights the interdisciplinary approach essential for understanding complex economic behaviors like self-control. With limited focus on such topics within economics at the time, the author turns to psychology exemplifies the need to integrate diverse perspectives for a more comprehensive understanding of economic decision-making. It underlines a growing trend in economics to embrace more realistic and nuanced views of human behavior.

“A week before Christmas a single [Cabbage Patch] doll is discovered in a storeroom. […] The managers announce over the store’s public address system that the doll will be sold by auction. [Survey results showed] Acceptable 26% Unfair 74%.”

This instance demonstrates how fairness perceptions can override market logic, especially in emotionally charged contexts like holidays. While auctioning a scarce item like the Cabbage Patch doll seems economically rational, the public perceived it as unfair, reflecting societal values that prioritize equitable access and emotional considerations. This scenario underlines how businesses must balance economic decisions with societal expectations to avoid potential backlash, especially in situations perceived as exploiting scarcity.

“Would people be willing to punish a firm that behaves unfairly? We designed an experiment in the form of a game to investigate […] The Responder can either accept the offer, leaving the remaining amount to the Proposer, or can reject it, in which case both players get nothing.”

This passage highlights the Ultimatum Game, where individuals often reject unfair offers despite personal loss. This behavior challenges the rational, self-interested economic model, revealing a deeper human tendency to prioritize fairness. The game demonstrates ethical and social norms heavily influence economic decisions, emphasizing the complexity of human decision-making beyond mere self-interest.

“In October 1985, […] two University of Chicago Graduate School of Business professors—Robin Hogarth, a psychologist, and Mel Reder, an economist—organized a conference at the University of Chicago, […] Rationalists and behavioralists were to come together and try to sort out whether there was really any reason to take psychology and behavioral economics seriously.”

This event signifies an important juncture in behavioral economics, challenging traditional models at the University of Chicago. It reflects the growing integration of psychological insights into economic theories, marking a shift from conventional approaches to a more comprehensive view of economic behavior. Thaler did not want to replace earlier models but simply improve them.

“[Taxi drivers] would set a goal for how much money they wanted to make after paying for the car and the fuel, and when they reached that goal they would call it a day.”

This quote exemplifies behavioral economics in action. Taxi drivers’ income strategy contradicts traditional economic theories of maximizing earnings, demonstrating real-world decision-making influenced by psychological factors. This highlights the human element in economic behavior.

“It is difficult to express how dubious people were about studying the behavioral economics of financial markets. It was one thing to claim that consumers did strange things, but financial markets were thought to be a place where foolish behavior would not move market prices an iota.”

This quote captures the initial skepticism toward applying behavioral economics to financial markets, emphasizing the perceived immunity of these markets to irrational behaviors. It contrasts the accepted unpredictability in consumer behavior with the then-prevailing confidence in the rationality and self-correcting nature of financial markets. This perspective underscores a fundamental shift in economic thinking, challenging the infallibility of markets and acknowledging the potential influence of human psychology on markets.

“An important property of rational forecasts—as a stock price is supposed to be—is that the predictions cannot vary more than the thing being forecast.”

This quote underscores a key tenet in rational forecasting: forecasts should not fluctuate more than the subject being forecasted. Applied to stock prices, it means price changes should mirror actual shifts in a company’s value, often gauged by dividends. This challenges the rationale behind extreme stock price volatility, questioning its alignment with underlying value changes. It’s a critical critique of the efficient market hypothesis, questioning market rationality.

“The stock market was saying that the remaining 3Com business, a profitable business, was worth minus $23 billion.”

This quote demonstrates a market anomaly with 3Com’s valuation. Despite being profitable, the market depicted its value as negative, highlighting irrationality in financial markets. This case questions market efficiency, showing how market prices can differ starkly from intrinsic values, leading to illogical market valuations.

“If people make mistakes, then it becomes conceivable, at least in principle, that someone could help them make a better choice.”

The quote signifies a shift in law and economics, acknowledging human error in decision-making. It introduces the idea of “soft” paternalism, where guided choices help individuals make better decisions. This concept challenges traditional notions of rationality, emphasizing the need to consider cognitive limitations in policy and legal structures.

“When the championship or the future of the company is on the line, managers tend to rely on their gut instincts.”

This quote reveals a tendency in high-pressure situations, like sports or business, for managers to trust their instincts over data. It challenges the notion of always making rational, analytical choices. This shows human decision-making often blends instinct and analysis, which can lead to unexpected outcomes.

“People are interesting.”

This brief statement reflects on the unpredictability and complexity of human behavior, especially in high-stakes decisions. It highlights the challenge in creating models that fully capture human nature’s multifaceted and often surprising aspects in economics and psychology. Thaler also makes his book on economics, a seemingly dry topic, interesting by making it about real people.

“But Save More Tomorrow is a voluntary program. I said as much and went on to say that if this is paternalism, then it must be some different variety of paternalism. Struggling for the right words, I blurted out: ‘Maybe we should call it, I don’t know, libertarian paternalism.’”

This quote introduces “libertarian paternalism,” a key concept in Thaler’s work, highlighting a nuanced approach to policy design. It emphasizes a balance between respecting individual autonomy and guiding beneficial behaviors. This innovative idea differs from traditional paternalism by avoiding coercion, instead nudging people toward better choices like increasing retirement savings.

“In our increasingly complicated world people cannot be expected to have the expertise to make optimal decisions in all domains […] But we all enjoy having the right to choose for ourselves, even if we sometimes make mistakes.”

This quote highlights the dilemma of decision-making in a complex world. It acknowledges that while people value their autonomy and the right to choose, they often lack the expertise required for optimal decision-making across various domains. The essence of the passage lies in recognizing the balance between individual freedom and the need for guidance, suggesting facilitating better decision-making does not necessarily mean imposing choices but rather enhancing the process to align with personal goals and preferences.