Misbehaving: The Making of Behavioral Economics Read online

  To:

  Victor Fuchs who gave me a year to think,

  and Eric Wanner and the Russell Sage Foundation

  who backed a crazy idea

  And to:

  Colin Camerer and George Loewenstein,

  early students of misbehaving

  CONTENTS

  Preface

  I. BEGINNINGS: 1970–78

  1. Supposedly Irrelevant Factors

  2. The Endowment Effect

  3. The List

  4. Value Theory

  5. California Dreamin’

  6. The Gauntlet

  II. MENTAL ACCOUNTING: 1979–85

  7. Bargains and Rip-Offs

  8. Sunk Costs

  9. Buckets and Budgets

  10. At the Poker Table

  III. SELF-CONTROL: 1975–88

  11. Willpower? No Problem

  12. The Planner and the Doer

  INTERLUDE

  13. Misbehaving in the Real World

  IV. WORKING WITH DANNY: 1984–85

  14. What Seems Fair?

  15. Fairness Games

  16. Mugs

  V. ENGAGING WITH THE ECONOMICS PROFESSION: 1986–94

  17. The Debate Begins

  18. Anomalies

  19. Forming a Team

  20. Narrow Framing on the Upper East Side

  VI. FINANCE: 1983–2003

  21. The Beauty Contest

  22. Does the Stock Market Overreact?

  23. The Reaction to Overreaction

  24. The Price Is Not Right

  25. The Battle of Closed-End Funds

  26. Fruit Flies, Icebergs, and Negative Stock Prices

  VII. WELCOME TO CHICAGO: 1995–PRESENT

  27. Law Schooling

  28. The Offices

  29. Football

  30. Game Shows

  VIII. HELPING OUT: 2004–PRESENT

  31. Save More Tomorrow

  32. Going Public

  33. Nudging in the U.K.

  Conclusion: What Is Next?

  Notes

  Bibliography

  List of Figures

  Acknowledgments

  Index

  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, 1906

  PREFACE

  Before we get started, here are two stories about my friends and mentors, Amos Tversky and Daniel Kahneman. The stories provide some hints about what to expect in this book.

  Striving to please Amos

  Even for those of us who can’t remember where we last put our keys, life offers indelible moments. Some are public events. If you are as old as I am, one may be the day John F. Kennedy was assassinated (freshman in college, playing pickup basketball in the college gym). For anyone old enough to be reading this book, September 11, 2001, is another (just getting up, listening to NPR, trying to make sense of it).

  Other events are personal: from weddings to a hole in one. For me one such event was a phone call from Danny Kahneman. Although we speak often, and there are hundreds of calls that have left no trace, for this one I know precisely where I was standing. It was early 1996 and Danny had called to share the news that his friend and collaborator Amos Tversky was ill with terminal cancer and had about six months to live. I was so discombobulated that I had to hand the phone to my wife while I recovered my composure. The news that any good friend is dying is shocking, but Amos Tversky was just not the sort of person who dies at age fifty-nine. Amos, whose papers and talks were precise and perfect, and on whose desk sat only a pad and pencil, lined up in parallel, did not just die.

  Amos kept the news quiet until he was no longer able to go into the office. Prior to that, only a small group knew, including two of my close friends. We were not allowed to share our knowledge with anyone except our spouses, so we took turns consoling one another for the five months that we kept this awful news to ourselves.

  Amos did not want his health status to be public because he did not want to devote his last months to playing the part of a dying man. There was work to do. He and Danny decided to edit a book: a collection of papers by themselves and others in the field of psychology that they had pioneered, the study of judgment and decision-making. They called it Choices, Values, and Frames. Mostly Amos wanted to do the things he loved: working, spending time with his family, and watching basketball. During this period Amos did not encourage visitors wishing to express their condolences, but “working” visits were allowed, so I went to see him about six weeks before he died, under the thin disguise of finishing a paper we had been working on. We spent some time on that paper and then watched a National Basketball Association (NBA) playoff game.

  Amos was wise in nearly every aspect of his life, and that included dealing with illness.* After consulting with specialists at Stanford about his prognosis, he decided that ruining his final months with pointless treatments that would make him very sick and at best extend his life by a few weeks was not a tempting option. His sharp wit remained. He explained to his oncologist that cancer is not a zero-sum game. “What is bad for the tumor is not necessarily good for me.” One day on a phone call I asked him how he was feeling. He said, “You know, it’s funny. When you have the flu you feel like you are going to die, but when you are dying, most of the time you feel just fine.”

  Amos died in June and the funeral was in Palo Alto, California, where he and his family lived. Amos’s son Oren gave a short speech at the service and quoted from a note that Amos had written to him days before he died:

  I feel that in the last few days we have been exchanging anecdotes and stories with the intention that they will be remembered, at least for a while. I think there is a long Jewish tradition that history and wisdom are being transmitted from one generation to another not through lectures and history books, but through anecdotes, funny stories, and appropriate jokes.

  After the funeral, the Tverskys hosted a traditional shiv’a gathering at their home. It was a Sunday afternoon. At some point a few of us drifted into the TV room to catch the end of an NBA playoff game. We felt a bit sheepish, but then Amos’s son Tal volunteered: “If Amos were here, he would have voted for taping the funeral and watching the game.”

  From the time I first met Amos in 1977, I applied an unofficial test to every paper I wrote. “Would Amos approve?” My friend Eric Johnson, whom you will meet later on, can attest that one paper we wrote together took three years to get published after it had been accepted by a journal. The editor, the referees, and Eric were all happy with the paper, but Amos was hung up on one point and I wanted to meet his objection. I kept plugging away at that paper, while poor Eric was coming up for promotion without that paper on his vita. Fortunately Eric had written plenty of other strong papers, so my stalling did not cost him tenure. In time, Amos was satisfied.

  In writing this book I took Amos’s note to Oren seriously. The book is not the sort you might expect an economics professor to write. It is neither a treatise nor a polemic. Of course there will be discussions of research, but there will also be anecdotes, (possibly) funny stories, and even the odd joke.

  Danny on my best qualities

  One day in early 2001, I was visiting Danny Kahneman at his home in Berkeley. We were in his living room schmoozing, as we often do. Then Danny suddenly remembered he had an appointment for a telephone call with Roger Lowenstein, a journalist who was writing an article about my work for the New York Times Magazine. Roger, the author of the well-known book When Genius Faile
d, among others, naturally wanted to talk to my old friend Danny. Here was a quandary. Should I leave the room, or listen in? “Stay,” Danny said, “this could be fun.”

  The interview started. Hearing a friend tell an old story about you is not an exciting activity, and hearing someone praise you is always awkward. I picked up something to read and my attention drifted—until I heard Danny say: “Oh, the best thing about Thaler, what really makes him special, is that he is lazy.”

  What? Really? I would never deny being lazy, but did Danny think that my laziness was my single best quality? I started waving my hands and shaking my head madly but Danny continued, extolling the virtues of my sloth. To this day, Danny insists it was a high compliment. My laziness, he claims, means I only work on questions that are intriguing enough to overcome this default tendency of avoiding work. Only Danny could turn my laziness into an asset.

  But there you have it. Before reading further you should bear in mind that this book has been written by a certifiably lazy man. The upside is that, according to Danny, I will only include things that are interesting, at least to me.

  ________________

  * 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.

  I.

  BEGINNINGS

  1970–78

  1

  Supposedly Irrelevant Factors

  Early in my teaching career I managed to inadvertently get most of the students in my microeconomics class mad at me, and for once, it had nothing to do with anything I said in class. The problem was caused by a midterm exam.

  I had composed an exam that was designed to distinguish among three broad groups of students: the stars who really mastered the material, the middle group who grasped the basic concepts, and the bottom group who just didn’t get it. To successfully accomplish this task, the exam had to have some questions that only the top students would get right, which meant that the exam was hard. The exam succeeded in my goal—there was a wide dispersion of scores—but when the students got their results they were in an uproar. Their principal complaint was that the average score was only 72 points out of a possible 100.

  What was odd about this reaction was that the average numerical score on the exam had absolutely no effect on the distribution of grades. The norm at the school was to use a grading curve in which the average grade was a B or B+, and only a tiny number of students received grades below a C. I had anticipated the possibility that a low average numerical score might cause some confusion on this front, so I had reported how the numerical scores would be translated into actual grades in the class. Anything over 80 would get an A or A–, scores above 65 would get some kind of B, and only scores below 50 were in danger of getting a grade below C. The resulting distribution of grades was not different from normal, but this announcement had no apparent effect on the students’ mood. They still hated my exam, and they were none too happy with me either. As a young professor worried about keeping my job, I was determined to do something about this, but I did not want to make my exams any easier. What to do?

  Finally, an idea occurred to me. On the next exam, I made the total number of points available 137 instead of 100. This exam turned out to be slightly harder than the first, with students getting only 70% of the answers right, but the average numerical score was a cheery 96 points. The students were delighted! No one’s actual grade was affected by this change, but everyone was happy. From that point on, whenever I was teaching this course, I always gave exams a point total of 137, a number I chose for two reasons. First, it produced an average score well into the 90s, with some students even getting scores above 100, generating a reaction approaching ecstasy. Second, because dividing one’s score by 137 was not easy to do in one’s head, most students did not seem to bother to convert their scores into percentages. Lest you think I was somehow deceiving the students, in subsequent years I included this statement, printed in bold type, in my course syllabus: “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.” And indeed, after I made that change, I never got a complaint that my exams were too hard.

  In the eyes of an economist, my students were “misbehaving.” By that I mean that their behavior was inconsistent with the idealized model of behavior that is at the heart of what we call economic theory. To an economist, no one should be happier about a score of 96 out of 137 (70%) than 72 out of 100, but my students were. And by realizing this, I was able to set the kind of exam I wanted but still keep the students from grumbling.

  For four decades, since my time as a graduate student, I have been preoccupied by these kinds of stories about the myriad ways in which people depart from the fictional creatures that populate economic models. It has never been my point to say that there is something wrong with people; we are all just human beings—homo sapiens. Rather, the problem is with the model being used by economists, a model that replaces homo sapiens with a fictional creature called homo economicus, which I like to call an Econ for short. Compared to this fictional world of Econs, Humans do a lot of misbehaving, and that means that economic models make a lot of bad predictions, predictions that can have much more serious consequences than upsetting a group of students. Virtually no economists saw the financial crisis of 2007–08 coming,* and worse, many thought that both the crash and its aftermath were things that simply could not happen.

  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—powerful in two distinct ways. The first way is indisputable: of all the social scientists, economists carry the most sway when it comes to influencing public policy. In fact, they hold a virtual monopoly on giving policy advice. Until very recently, other social scientists were rarely invited to the table, and when they were invited, they were relegated to the equivalent of the kids’ table at a family gathering.

  The other way is that economics is also considered the most powerful of the social sciences in an intellectual sense. That power derives from the fact that economics has a unified, core theory from which nearly everything else follows. If you say the phrase “economic theory,” people know what you mean. No other social science has a similar foundation. Rather, theories in other social sciences tend to be for special purposes—to explain what happens in a particular set of circumstances. In fact, economists often compare their field to physics; like physics, economics builds from a few core premises.

  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.” If people starting new businesses on average believe that their chance of succeeding is 75%, then that should be a good estimate of the actual number that do succeed. Econs are not overconfident.

  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.

  There is, 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, or even come close to solving. Even a trip to a decent-sized grocery store offers a shopper millions of combinations of items that are within the family’s budget. Does the family really choose the best one? And, of course, we face many much harder problems than a trip to the store, such as choosing
a career, mortgage, or spouse. Given the failure rates we observe in all of these domains, it would be hard to defend the view that all such choices are optimal.

  Second, the beliefs upon which people make their choices are not unbiased. Overconfidence may not be in the economists’ dictionary, but it is a well-established feature of human nature, and there are countless other biases that have been documented by psychologists.

  Third, there are many factors that the optimization model leaves out, as my story about the 137-point exam illustrates. In a world of Econs, there is a long list of things that are supposedly irrelevant. No Econ would buy a particularly large portion of whatever will be served for dinner on Tuesday because he happens to be hungry when shopping on Sunday. Your hunger on Sunday should be irrelevant in choosing the size of your meal for Tuesday. An Econ would not finish that huge meal on Tuesday, even though he is no longer hungry, just because he had paid for it and hates waste. To an Econ, the price paid for some food item in the past is not relevant in making the decision about how much of it to eat now. An Econ would also not expect a gift on the day of the year in which she happened to get married, or be born. What possible difference can a date make? In fact, Econs would be perplexed by the entire idea of gifts. 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. Come to think of it, even if your spouse is an economist, this is probably not a great idea.

  You know, and I know, that we do not live in a world of Econs. We live in a world of Humans. And since most economists are also human, they also know that they do not live in a world of Econs. Adam Smith, the father of modern economic thinking, explicitly acknowledged this fact. Before writing his magnum opus, The Wealth of Nations, he wrote another book devoted to the topic of human “passions,” a word that does not appear in any economics textbook. Econs do not have passions; they are cold-blooded optimizers. Think of Mr. Spock in Star Trek.