The book is semi-autobiographical, the tale of a young iconoclast and his stalwart allies seeking validation and acceptance for new, more realistic foundations for economics, particularly in how people are modeled. The writing is for the general public, and the book is very readable. There are humorous anecdotes and jokes. The cast of supporting characters contains many of the prominent economists of the 2nd 1/2 of the 20th century - I linked to the Wikipedia articles of a lot of these.
I found it somewhat disingenuous for the obviously very accomplished author to tell us several times how lazy he is. Also, the writing seemed a little disorganized in places: he would introduce 2 terms, define 1, start telling stories, and forget to define the 2nd; or he says he's going to talk about a list, but it is hard to identify just what the items in the list are. This was much more noticeable when I made the pass through to prepare this summary.
I also found some of the chapters towards the end of the book to be a little off-target. Yes, they were about humans "misbehaving", but not so much about economics. I guess it just shows that humans "misbehaving" doesn't just occur in their economic decisions.
The book is 432 pages. It has a preface and a conclusion, and 33 chapters in 8 generally chronological sections and an interlude. Thaler describes in detail many of the experiments he and other researchers performed in developing this new science. I will mostly skip these details and focus on the results of the experiments.
Prior to behavioral economics, people were assumed to be "perfectly rational" - and also highly skilled mathematicians, at least intuitively. All economic decisions - how much to charge or pay for an item, how much to pay or demand for wages - are made with perfect rationality, and possibly using models that span the entire lifetime of the decision maker! Thaler devoted his career to exploring what happens when you realize that people are far from "perfectly rational", and are in fact prone to numerous cognitive biases. Yay, these are a favorite topic of mine, and have been discussed before in this blog as "cognitive illusions".
Section 1 is titled "Beginnings: 1970-78". In this section Thaler lays the groundwork that led him to his work at Cornell.
In traditional economics, anything outside of perfect rationality is a SIF - Supposedly Irrelevant Factor, the title of Chapter 1. Thaler defines the "perfectly rational" people in standard economics as "Econs". The more realistic people who misbehave (as in the title of the book) per standard economics he defines as "Humans". Thaler gives a simple definition of economics:
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.Chapter 2 is titled for one of the most important of the cognitive biases that exist in the human mind, which Thaler calls the endowment effect. Humans weight more strongly things they already have than things they don't, even if economically there is no difference. Hmmm, is this basically "A bird in the hand is worth 2 in the bush"? Thaler's thesis and one of his early papers looked at "The Value of Saving a Life" (currently around $7M).
In Chapter 3, "The List", Thaler goes into "Dumb stuff people do", which he kept in a list on the blackboard in his office starting in the mid '70s. One example we can all relate to is that humans consistently ignore the economic dictum "Ignore sunk costs". Sunk costs are money that has already been spent. Later in the book where is a funny story, where he is chiding his daughter about skipping lessons in an after-school ski program (prepaid), and the daughter replying
"Ha! Sunk costs!" Only the daughter of an economist would come up with that line.But everyone I know does that. If we've spent money on something, by gawd, we want to get "our money's worth", even if it inconveniences or otherwise negatively affects us.
Another cognitive bias: "hindsight bias" ... after the fact, we think that we always knew the outcome was likely, if not a foregone conclusion. Hindsight bias on the part of corporate managers helps keep corporate underlings from pushing for risky projects - because if the project fails, the manager will be sure that he had opposed it from day 1.
One paper that affected Thaler's early work was titled "Judgement Under Uncertainty: Heuristics and Biases", by 2 psychologists who became his mentors, Amos Tversky and Daniel Kahneman. I always think of heuristics, or "rules of thumb", that we use to solve problems as good things. But, they aren't always. Sometimes they mislead us, and then they are better characterized as a bias.
This is an illustration of the big idea of this article, one that made my hands shake as I read: using these heuristics causes people to make predictable errors.Tversky and Kahnemann's theory was first known as "Value Theory", the title of Chapter 4. It later became known as "Prospect Theory",
The organizing principle was the existence of two different kinds of theories: normative and descriptive. Normative theories tell you the right way to think about some problem. By “right” I do not mean right in some moral sense; instead, I mean logically consistent, as prescribed by the optimizing model at the heart of economic reasoning, sometimes called rational choice theory.He illustrates this with a problem involving the Pythagorean theorem (the normative theory), where we are asked to guess the outcome of the problem. I guessed what most people do (the descriptive theory) - which turns out to be off by a factor of around 200! Hmmm, I think maybe other terms for "descriptive theory" would be "folk psychology" or "common sense".
This gets to the heart of the problem with traditional economics and the conceptual breakthrough offered by prospect theory. Economic theory at that time, and for most economists today, uses one theory to serve both normative and descriptive purposes.
One forerunner of "prospect theory" was the concept of "bounded rationality" put forward by Herbert Simon. We also learn about "risk aversion" and "expected utility theory". The former was initially developed by Bernoulli, the latter by von Neumann. Both assume rational behavior, i.e., Econs as the actors.
Next we learn about the Weber-Fechner Law of psychology. and what psychologists refer to as a just-noticeable difference or JND:
The Weber-Fechner Law holds that the just-noticeable difference in any variable is proportional to the magnitude of that variable.This law is instantiated in the value function shown below. This function also incorporates one of Thaler's early experimental results: that people hate losses more than they like gains, a corollary of the endowment effect, known as "loss aversion".
The difference between losing $10 and $20 feels much bigger than the difference between losing $1,300 and $1,310.
Working with the psychologists taught Thaler how to conduct experiments by asking questions. However, the economic wisdom of the time was that people might answer hypothetical questions as Humans, but when it came to spending real money, they would answer as Econs.
Thaler started working at Cornell in August, 1978. In Chapter 6, "The Gauntlet", he describes "reasons why economists could safely ignore behaviors such as those on the List". He heard these some or all of the time he presented is new ideas, making him feel like he was running the gauntlet over and over.
First up in the gauntlet is the "As If" argument:
even if people are not capable of actually solving the complex problems that economists assume they can handle, they behave “as if” they can.One example was "marginal analysis" applied to hiring in a firm. Marginal analysis in this case says that the manager will decide to hire more people as long as the marginal (or incremental) cost of hiring a worker is equal to or less than the increases in revenue that the worker produces. Talking to real-life managers reveals that they have no knowledge of these numbers and do not even vaguely use marginal analysis. But the argument was carried by Milton Friedman and "Positive Economics":
Friedman argued that it was silly to evaluate a theory based on the realism of its assumptions. What mattered was the accuracy of the theory’s predictions.Friedman used as an example an expert billiard player, who could make all kinds of shots without measuring angles, using a calculator, etc. Thaler answered in his 1st behavioral economics paper "Toward a Positive Theory of Consumer Choice".
I too began with billiards. My main point was that economics is supposed to be a theory of everyone, not only experts. An expert billiard player might play as if he knows all the relevant geometry and physics, but the typical bar player usually aims at the ball closest to a pocket and shoots, often missing. If we are going to have useful theories about how typical people shop, save for retirement, search for a job, or cook dinner, those theories had better not assume that people behave as if they were experts.The next argument in the gauntlet involves incentives:
Economists put great stock in incentives. If the stakes are raised, the argument goes, people will have greater incentive to think harder, ask for help, or do what is necessary to get the problem right.The next argument in the gauntlet involves learning - that people will learn to act like Econs over time. But, Thaler notes that large-stakes problems - buying a house or car, determining your retirement strategy - do not come along very often, so, we have very little chance to practice with such problems. On the other hand, small problems come along much more frequently, and we have many more chances to improve our decision making on such problems.
This assertion, unsupported by any evidence, was firmly believed, even in spite of the fact that nothing in the theory or practice of economics suggested that economics only applies to large-stakes problems.
Psychologists tell us that in order to learn from experience, two ingredients are necessary: frequent practice and immediate feedback.The penultimate item in the gauntlet Thaler calls "the invisible handwave". This a reference to Adam Smith's invisible hand:
The learning and incentives arguments are, to some extent, contradictory.
The vague argument is that markets somehow discipline people who are misbehaving. Handwaving is a must because there is no logical way to arrive at a conclusion that markets transform people into rational agents.The final item in the gauntlet is a combination of earlier items:
Sometimes the invisible handwave is combined with the incentives argument to suggest that when the stakes are high and the choices are difficult, people will go out and hire experts to help them. The problem with this argument is that it can be hard to find a true expert who does not have a conflict of interest.More misbehaving: psychologists Sarah Lichtenstein and Paul Slovic performed experiments that led to the discovery of "preference reversals".
This finding upset a theoretical foundation essential to any formal economic theory, namely that people have what are called “well-defined preferences,” which simply means that we consistently know what we like. Economists don’t care whether you like a firm mattress better than a soft one or vice versa, but they cannot tolerate you saying that you like a firm mattress better than a soft one and a soft one better than a firm one. That will not do. Economic theory textbooks would stop on the first page if the assumption of well-ordered preferences had to be abandoned, because without stable preferences there is nothing to be optimized.This was the background against which Thaler chose the top 2 topics he would explore.
The first was to understand the psychology of spending, saving, and other household financial behavior, what has now become known as mental accounting. The second was self-control and, more generally, choosing between now and later.Another description for mental accounting might be "folk economics".
Section 2 is titled "Mental Accounting: 1979-85". Chapter 7 is titled "Bargains and Rip-Offs". When do we think we got a good deal vs not? Thaler introduces 2 terms:
Acquisition utility is based on standard economic theory and is equivalent to what economists call “consumer surplus.” As the name suggests, it is the surplus remaining after we measure the utility of the object gained and then subtract the opportunity cost of what has to be given up. For an Econ, acquisition utility is the end of the story.
transaction utility ... 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. Negative transaction utility is a “rip-off.” In contrast, if the price is below the reference price, then transaction utility is positive, a “bargain”
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. In America, some products always seem to be on sale, such as rugs and mattresses, and at some retailers, men’s suits. Goods that are marketed this way share two characteristics: they are bought infrequently and quality is difficult to assess. The infrequent purchases help because consumers often do not notice that there is always a sale going on.Another example is the complicated-to-the-point-of-baroque couponing schemes used by department stores. But Thaler says that when Macy's and JC Penney tried to get away from constant sales and coupons their sales dropped. People will buy more if they think they are getting a deal.
Similarly, attempts to replace the annoying $9.95 or $9.99 price with a $10 price also led to reduced sales and were abandoned.
Chapter 8 is devoted to sunk costs, or, more accurately, the "sunk cost fallacy". Funny how once you start talking about the psychology of economics, old adages seem to spring to mind. Thaler in this chapter mentions "don't cry over spilt milk" and "let bygones be bygones" as being related to the economists dictum to ignore sunk costs.
But it is not just us Humans who refuse to ignore sunk costs. Thaler talks about how perhaps the US "continued its futile war in Vietnam because we had invested too much to quit." It seems like in every war of our ongoing series of wars that statements such as "we cannot allow our troops deaths to have been in vain" are used to justify our continued involvement. Somehow I don't think telling the hawks that "economists say to ignore sunk costs" would do much good.
Another example of Humans failing to ignore sunk costs comes from a fitness club that bills its members 2x a year:
attendance at the club jumps the month after the bill arrives, then tails off over time until the next bill arrives. They called this phenomenon “payment depreciation,” meaning that the effects of sunk costs wear off over time.Chapter 9 is titled "Buckets and Budgets".
For families that dealt mostly in cash (credit cards were just coming into use at this time in the late 1970s), many would often use some version of an envelope system. One envelope (or mason jar) for rent, another for food, another for utilities, and so forth.Violations of this economic dictum, that money is fungible, takes some surprising forms. I definitely would not expect the result of a 2008 survey: that, when gas prices drop a lot, people take more road trips, but also fill their cars up with higher grade gas!
Organizations do something similar. Departments have budgets, and there are limits for specific categories within those budgets. The existence of budgets can violate another first principle of economics: money is fungible, meaning that it has no labels restricting what it can be spent on.
Another division of money is into cash, savings, and long-term (retirement) savings. Here too, people behave in illogical ways, such as not paying off high interest credit card debt with money from a savings account earning low interest. Ha ha, people know they are Humans, not Econs, and don't trust themselves to do the right thing later.
Chapter 10 is titled "At the Poker Table".
My poker observations yielded another wrinkle on mental accounts. Players who were ahead in the game did not seem to treat their winnings as “real money.” This behavior is so pervasive that casino gamblers have a term for it: “gambling with the house’s money.”The other major misbehavior shown in gambling is the "break even effect". Gamblers who are behind feel they have to continue to gamble so they can "break even". They refuse to realize that their losses so far represent sunk costs.
Section 3 is titled "Self-Control: 1975-88". One of Thaler's early examples of non-Econ behavior was the act of putting a bowl of cashews out of sight to eat less of them. This is non-Econ because Econs always want choices and will always make the right choice, in this case, to not binge on the cashews.
Chapter 11 is titled "Willpower? No Problem". No less than the father of economics, Adam Smith, is quoted on the issue of willpower:
The crucial feature of Smith’s conception of our passions is that they are myopic, that is, shortsighted. As he framed it, the problem is that “The pleasure which we are to enjoy ten years hence, interests us so little in comparison with that which we may enjoy to-day.”This came from Smith's earlier book, "The Theory of Moral Sentiments". I have seen several references to this book lately, I may have to add it to the reading list.
The 1st modern discussion of this was by Irving Fisher in 1930. He "believed that time preference depends on an individual's level of income, with the poor being more impatient than those who are better off." The formulation of this principle that is still widely used in economics came from Paul Samuelson in 1937.
The basic idea is that consumption is worth more to you now than later. If given the choice between a great dinner this week or one a year from now, most of us would prefer the dinner sooner rather than later. Using the Samuelson formulation, we are said to “discount” future consumption at some rate. If a dinner a year from now is only considered to be 90% as good as one right now, we are said to be discounting the future dinner at an annual rate of about 10%.This methodology is known as the discounted utility model with exponential discounting. Samuelson noted that the utility discount probably is not constant over time.
Samuelson correctly notes that if people discount the future at rates that vary over time, then people may not behave consistently, that is, they may change their minds as time moves forward.In fact, most people greatly discount the near future much more heavily than the far future. This is known as "quasi-hyperbolic or present-biased discounting". But, economists developed "theory-induced blindness", and chose to use the flat exponential discounting. And it got worse from there. For, the concept of "intertemporal choice" also plays a big role in macroeconomics, "where it underlies the consumption function, which tells us how the spending of a household varies with its income". This is a key factor in predicting the effect of tax cuts or other economic stimuli. The progression of economic thought in determining this function is somewhat funny but also somewhat scary. What does a family save when given a tax refund or other windfall?
- John Maynard Keynes, in his "General Theory" published in 1936, stated that a family would save the same percentage amount that they did with their normal income up front. This percentage would increase as family wealth went up.
- Milton Friedman in 1957 proposed the "permanent income hypothesis", under which a family would save the same percentage as above, but would then spread out the consumption of the rest over 3 years.
- Shortly thereafter, Franco Modigliani and Richard Brumberg proposed the "life-cycle hypothesis", where the family spreads out the consumption of the windfall over life!
- Finally, modern economist Robert Barro theorizes that the family will spread out the consumption of the windfall over its own life, but also over the life of its children, grandchildren - "effectively forever". But "if the windfall is a temporary tax cut that is financed by issuing government bonds, then Barro’s prediction changes. The bonds will have to be repaid eventually. The beneficiary of the tax cut understands all this, and realizes that his heir’s taxes will eventually have to go up to pay for the tax cut he is receiving, so he won’t spend any of it. Instead he will increase his bequests by exactly the amount of the tax cut." Seriously? That is one smart Econ!
Chapter 12 is titled "The Planner and The Doer" and gives our 1st glimpse of Thaler's concept of a Human. In the late 1970s, Thaler found 2 "treasures" in the study of "delayed gratification".
- Psychologist Walter Mischel experimented with children choosing between "a small reward now and a larger reward a bit later". The kids did better if the treats (marshmallows or oreos) were out of sight. Particularly interesting was that 1/3 of these test subjects were followed and questioned every decade for the next several decades. "The amount of time a kid waited in one of those experiments turned out to be a valid predictor of many important life outcomes, from SAT scores to career success to drug use."
- Psychiatrist George Ainslie published a paper in 1975 which "summarized everything academics knew about self-control at the time". In particular, animal studies, mostly rats and pigeons, had generated lots of data, which showed "Animals discount hyperbolically, and have self-control problems too!"
Mischel has priceless videos from some of the early experiments that demonstrate the difficulty kids had in exerting self-control. There is one kid I am particularly curious about. He was in the toughest setup, in which the bigger prize, three delicious Oreo cookies, was sitting right in front of him. After a brief wait, he could not stand it anymore. But rather than ring the bell, he carefully opened each cookie, licked out the yummy white filling, and then put the cookie back together, arranging the three cookies as best he could to avoid detection. In my imagination, this kid grows up to be Bernie Madoff.
Thaler got inspiration from this quote by social scientist Donald McIntosh:
“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.”So Thaler concludes "Maybe I needed a model with two selves." He christens these 2 selves The Planner and The Doer.
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.But how do they interact? Making them competitors in a game and using game theory was rejected. Instead they used a model popular at the University of Rochester, where Thaler had taught. It came from the theory of organizations, and was called the "principal-agent model". In organizations, the principal is the boss and the agent is the employee, and they have asymmetric knowledge and authority.
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 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.But Thaler's theory turned out not to be too popular. Since around 1997, the main model of self control has been the "beta-delta model", which appears to be pretty much quasi-hyperbolic discounting. Also now in the mix is the degree to which people are "aware of their self-control problems". Are they "sophisticated" or "naïve"? Or are they somewhere in between: "partial naiveté"?
The planner has two sets of tools she can use to influence the actions of the doers. She can either try to influence the decisions that the doers make through rewards or penalties (financial or otherwise) that still allow them discretion, or she can impose rules, such as commitment strategies, which limit the doers’ options
Most of us realize that we have self-control problems, but we underestimate their severity.
Section 4 is titled "Working With Danny: 1984-85". The 3 chapters all deal with the issue of fairness, explored in work Thaler did with Daniel Kahneman in Vancouver.
Chapter 14 is titled "What Seems Fair?". We have already discussed "bargains" and "ripoffs". Kahneman and Thaler got access to free telephone polling from the Canadian government and "we were able to try out lots of ideas, get quick feedback, and learn in the best possible way: theory-driven intuition tested by trial and error." Price gouging is universally despised, as you would expect. The endowment effect is invoked again:
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.Wage stickiness seems to me to be another example of this. Even worse is the example of a vending machine, say selling cold Coke, whose prices change, rising as the temperature does. Coke actually tried this, and the uproar cost the CEO who championed the idea his job. Uber surge pricing is another example which has led to major consumer push-back.
Chapter 15 is titled "Fairness Games". These experimental games include: the Ultimatum Game; the Dictator Game and an offshoot called the Punishment Game; the Prisoner's Dilemma and an offshoot called the Public Goods Game. The results of all these games contradict what standard economics would predict. People will try to be altruistic when they can. I found it interesting that in the Public Goods Game, people would put about 50% of their holdings into the common pot, which I think is around the percentage required to maintain a modern state with universal health care and basic income.
a large proportion of people can be categorized as conditional cooperators, meaning that they are willing to cooperate if enough others do.Chapter 15 is titled "Mugs", referring to the prize of another game. This game showed that the endowment effect can apply to things that we have had only a very short time: the "instant endowment effect". We also find that the endowment effect has a partner. Known as "inertia" in physics, in economics it becomes "status quo bias".
People ... stick with what they have unless there is some good reason to switch, or perhaps despite there being a good reason to switch.
Section 5 is titled "Engaging with the Economics Profession: 1986-94". This section is mostly about Thaler battling to get traction with the mainstream economics community. A conference in October 1985 was one of the 1st engagements. The best argument of the behavioral side was made by Kenneth Arrow:
rationality (meaning optimization) is neither necessary nor sufficient to do good economic theory.Thaler spoke on the the items in "the Gauntlet", covered above, and proposed that discussions could avoid lots of wasted time if everyone agreed that the following 2 statements were false:
1. Rational models are useless.A surprise at this conference was a paper by Merton Miller, who was on the traditionalist side. Thaler summarizes Miller's paper as:
2. All behavior is rational.
Theory tells us that firms should not pay dividends and yet they do. And a behavioral model admittedly best describes the pattern by which they pay them.Chapter 18 is titled "Anomalies". Thaler got a great chance to push his ideas via writing a column on anomalies, or examples of misbehaving, in a new journal, the Journal of Economic Perspectives, edited by Joseph Stiglitz, who is probably currently my fav economist after Paul Krugman. Thaler framed this in the context of looking for a paradigm shift, as defined in Thomas Kuhn's book The Structure of Scientific Revolutions. The column was a success, with 1/2 of the readers of the journal reporting that they read the "Anomalies" feature "regularly".
Chapter 19 is titled "Forming a Team", and chronicles the growth of behavioral economics.
In the late 1980s, there were really just three people besides me who thought of themselves as behavioral economists. One was George Loewenstein ... . Another was Robert Shiller, and the third was Colin Camerer.Colin Camerer has "has been at the forefront of neuro-economics, which uses techniques such as brain imaging to learn more about how people make decisions." Behavioral economics has hardware!
Thaler got the Russel Sage Foundation to provide funding that led to 2 meetings of all-star groups of psychologists and behavioral economists. But the outcome of these meeting was disappointing. Basically, he says that "interdisciplinary is hard", because of disjoint vocabulary and knowledge bases. After that, in 1992, the Foundation funded the Behavioral Economics Roundtable. They put on a 2 week "summer camp" each year. These attracted new, young talent to the field. At the 1st meeting, one of those was Ernst Fehr, whose 1st paper
showed that in a laboratory setting, “firms” that elected to pay more than the minimum wage were rewarded with higher effort levels by their “workers.” This result supported the idea, initially proposed by George Akerlof, that employment contracts could be viewed partially as a gift exchange. The theory is that if the employer treats the worker well, in terms of pay and working conditions, that gift will be reciprocated with higher effort levels and lower turnover, thus making the payment of above-market wages economically profitable.As of 2014, there had been 10 summer camps, with over 300 graduates. Behavioral economics was a going concern.
Chapter 20 is titled "Narrow Framing on the Upper East Side". The Russell Sage Foundation also had a visiting scholars program on the Upper East Side of Manhattan. This longish chapter mostly explores the flavor of misbehaving which they called "narrow framing".
when do people get themselves into trouble by treating events one at a time, rather than as a portfolio?There is an interesting illustration of "bold forecasts" from the book "Thinking, Fast and Slow". Members of a group make estimates of the time needed to create a curriculum on decision-making for middle school students. The estimates range from 18 to 30 months. Then they ask one member who is an expert in curriculum development. He answers "no group had finished a similar task in less than seven years, and worse, 40% of the teams never finished!" This contrasts the "outside view" versus the "inside view".
decision-making was driven by two countervailing, but not necessarily offsetting, biases: bold forecasts and timid choices.
"Timid choices" refers to loss aversion, which we saw above. An extended example of a CEO determining how many new projects to take on illustrates this.
Another anomaly or misbehavior discussed is the "equity premium puzzle". The equity premium refers to the higher returns of equities (stocks) vs bonds, due to the increased risk associated with equities.The puzzle is that, when economists did the math, the equity premium computed as "0.35%, nowhere near the historical 6%".
Thaler attributes this behavior to "myopic loss aversion". The cognitive bias is to weight short-term events more heavily than long-term. Hmmm, kind of like hyperbolic discounting that we saw in the discussion on self control. In the short-term, stocks can be scary, and we let that override their provable long-term benefit. There are also examples given of this phenomenon involving series of bets.
Section 6 is titled "Finance: 1983-03". Playing the stock market is the Ultimate Test.
Nothing would help the cause of behavioral economics more than to show that behavioral biases matter in financial markets, where there are not only high stakes but also ample opportunities for professional traders to exploit the mistakes made by others. Any non-Econs (amateurs) or non-Econ behavior (even by experts) should theoretically have no chance of surviving.Chapter 21 it titled "The Beauty Contest". This refers to Keynes likening picking the best stocks to going through photos of pretty women and picking not the ones you find prettiest, but the ones that you think other pickers will find prettiest. But, no, that's not good enough, you should pick the ones you think the other pickers will pick, and you are now in a recursive loop.
This concept was explored in read life via an experiment delivered by the Financial Times in 1997. Readers were asked:
Guess a number from 0 to 100 with the goal of making your guess as close as possible to two-thirds of the average guess of all those participating in the contest.The winning guess (13) showed that most of those who played recursed to the 3rd level. Note that per game theory, you should pick 0 as your answer - that is the Nash equilibrium in this game, and some Econs did indeed make that their answer.
- the rationality of prices, or "the price is right". "Essentially, the idea is that any asset will sell for its true “intrinsic value”" ... " If prices are “right,” there can never be bubbles."
- the nonexistence of a way to "beat the market", or "there is no free lunch". "because all publicly available information is reflected in current stock prices, it is impossible to reliably predict future prices and make a profit."
I enjoyed the Groucho Marx theorem.
Groucho famously said that he would never want to belong to any club that would have him as a member. The economist’s version of this joke — predictably, not as funny — is that no rational agent will want to buy a stock that some other rational agent is willing to sell.So "most financial economists agree ... that trading volume is surprisingly high." One reason given is "overconfidence" - every trader thinks that they are smarter than the other traders. Thaler finds this implausible. Instead he goes back to Keynes, who felt traders overreacted "to "ephemeral and non-significant" day-to-day information".
So volatility is a problem with EMH. Another problem of a different type: the superior performance of value stocks (low P/E) compared to growth stocks (high P/E). And another problem: a study by one of Fama's students found that "portfolios of small firms outperformed portfolios of large firms".
Thaler and his 1st behavioral economics grad student, Werner De Bondt, explained the discrepancy between value and growth stocks based on simple regression toward the mean - outliers will naturally tend back towards average values. Helping to drive the regression toward the mean was that the outlier stocks got that way because of "generalized overreaction" by traders - another form of misbehaving. Thaler and De Bondt did a study that showed low performing stocks consistently did better than high performing stocks, going forward, confirming overreaction and contradicting the EMH, which says "the past cannot predict the future".
Chapter 23 is titled "The Reaction to Overreaction". The Traditionalists Strike Back, led by Fama. Ha ha, a nice case of "model creep". So 1st, they say you need to look at "some model of risk and return" as well as market efficiency.
At that time, the right and proper way to measure the risk of a stock was to use the capital asset pricing model (CAPM) developed independently by financial economists John Lintner and William Sharpe.Thaler and De Bondt checked the beta value for their low vs high performing stocks - the average beta was lower for the low performing stocks, meaning, they were less risky - so no help for EMH there.
According to the CAPM, the only risk that gets rewarded in a rational world is the degree to which a stock’s return is correlated with the rest of the market ... a measure that is called “beta.”
Next up: the "Fama-French Three Factor Model". In addition to beta, the size of the company must be factored in with small cap stocks favored. But there were still problems, so 2 more factors were added: the firm's profitability, and how aggressively the firm invests. And finally, "many practitioners would add a sixth factor: momentum." So we are left hanging as to why value stocks outperform growth stocks:
the debate has continued for years as to whether value stocks are mispriced, as behavioralists argue, or risky, as rationalists claim.Chapter 24 is titled "The Price Is Not Right". Another blow is struck against EMH by a paper published in 1981 by Robert Shiller titled “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” Shiller noted that a dividend stock's price should be correlated with the future dividends that stock will pay. But when he studied data going back to 1871, he found that the stock price varied wildly while the future dividend forecast varied hardly at all. "Shiller’s results caused a firestorm in finance circles."
But a far more damning argument against "the price is right" came on Monday, October 19, 1987, when stock prices fell drastically all over the world, for no apparent reason. In 1984, De Bondt published a paper titled "Stock Prices and Social Dynamics", which stated
social phenomena might influence stock prices just as much as they do fashion trends. Hemlines go up and down without any apparent reason; might not stock prices be influenced in other similar ways that seem to be beyond the standard economist's purview?So we come back to what Keynes called "animal spirits".
Chapter 25 is titled "The Battle of Closed-End Funds" and takes another swipe at "the price is right".
an important principle at the very heart of the EMH [is] the law of one price. The law asserts that in an efficient market, the same asset cannot simultaneously sell for two different prices.A contradiction to the law of 1 price was easy to find: closed-end mutual funds. These funds have a fixed number of shares, and should always be priced at the total asset values of their holdings (Net Asset Value or NAV) divided by the number of shares in the fund. Instead, their prices vary over time, and are both higher and lower than the rational price. Additionally, a normal pattern for these funds is that are sold with a 7% commission but usually within 6 months have lost 10% of their share value.
So the first puzzle is: why does anyone buy an asset for $107 that will predictably be worth $90 in six months? This pattern had induced Benjamin Graham to refer to closed-end funds as “an expensive monument erected to the inertia and stupidity of stockholders.”Larry Summers had an unpublished paper that started "THERE ARE IDIOTS". Summers and some of his former students had written papers that talked about "noise traders", who react to noise (called SIFs earlier) instead of news. Thaler and a grad student wrote a paper that speculated that individual, rather than institutional, investors were more sensitive to "investor sentiment". They identified individual investors as tending to buy more small cap stocks and closed-end funds than institutional investors, so they investigated these. They found
The average discount on closed-end funds was correlated with the difference in returns between small and large company stocks; the greater the discount, the larger the difference in returns between those two types of stocks. This finding was the equivalent of finding footprints for Bigfoot or some other creature that is thought to be a myth.Chapter 26 is titled "Fruit Flies, Icebergs, and Negative Stock Prices". In another example of "the price is not right", Thaler explores in depth a case from 1999 as 3Com was spinning off Palm. At one point, based on the prices of the 2 stocks, the implication was that the total worth of 3Com without Palm was negative $23B! So a clear violation of the "one price" rule.
Concluding his analysis the EMH, Thaler concludes
It should be stressed that as a normative benchmark of how the world should be, the EMH has been extraordinarily useful. In a world of Econs, I believe that the EMH would be true. And it would not have been possible to do research in behavioral finance without the rational model as a starting point.
When it comes to the EMH as a descriptive model of asset markets, my report card is mixed. Of the two components, ... I would judge the no-free-lunch component to be “mostly true.”
I have a much lower opinion about the price-is-right component of the EMH, and for many important questions, this is the more important component.
the price is often wrong, and sometimes very wrong.
Section 7 is titled "Welcome to Chicago: 1995-Present". Ha ha, another economist joke:
a Chicago economist would not bother to pick up a twenty-dollar bill on the sidewalk because if it were real, someone would already have snagged it.Chapter 27 is titled "Law Schooling". In 1994-95, Thaler did some work applying behavioral economics to law.
By this point I had adopted the pedagogical device of calling these essential elements “the three bounds”: bounded rationality, bounded willpower, and bounded self-interest. In law and economics these properties of Humans had heretofore been assumed to be thoroughly unbounded.He and two lawyers published a long paper on "A Behavioral Approach to Law and Economics". An interesting idea from the paper: place parking tickets on the driver's side window as a bright orange sticky note, rather then under the windshield wiper.
it might increase the perceived probability of getting a ticket, thus discouraging illegal parking at almost no cost. This example may not seem either profound or controversial, but remember that part of the received wisdom in law and economics is that people have correct beliefs, including about the probability of getting caught committing some crime, and base their decisions about whether to commit a crime, from illegal parking to robbing a bank, by calculating the expected gains and losses.Also controversial was an experiment they had performed which did not support the Coase theorem, which states
in the absence of transaction costs, meaning that people can easily trade with one another, resources will flow to their highest-valued use.The experiment was the one from Chapter 15, Mugs, and the "instant endowment effect" was what appeared to sink the Coase theorem.
A commentary was written by Richard Posner. Among other things, he argued that all the observed misbehaving must have come about through evolutionary biology, implying that "such behavior is good for us, in some sense, and therefore rational." Ha ha, nice handwaving!
When the paper was presented at the University of Chicago, long the center of conservative economics, it raised a furor not just for attacking rationality, but for implying support for something completely abhorrent to the libertarian view: paternalism.
The core principle underlying the Chicago School’s libertarian beliefs is consumer sovereignty: the notion that people make good choices, and certainly better choices than anyone else could make for them. By raising the specters of bounded rationality and bounded self-control, we were undercutting this principle. If people make mistakes, then it becomes conceivable, at least in principle, that someone could help them make a better choice.Chapter 28 is titled "The Offices", and notes (not particularly economic) misbehaving in the assigning of offices in a new economics building.
Chapter 28 is titled "Football". Player selection in the NFL is used to illustrate more misbehaving. Thaler quotes Gary Becker for what Thaler calls the Becker conjecture:
“Division of labor strongly attenuates if not eliminates any effects [caused by bounded rationality.] . . . [I]t doesn’t matter if 90 percent of people can’t do the complex analysis required to calculate probabilities. The 10 percent of people who can will end up in the jobs where it’s required.”[Man, doesn't all this stuff just seem like unbelievable handwaving at this point?]
Thaler and his grad student conducted an in-depth study of how teams pick players in the NFL draft and found serious misbehaving. And this is misbehaving by people who are presumably the tops in their field and Becker's 10%. Thaler and crew found that teams put too high a value on early picks. They should trade for multiple lower picks, this year or in the future. They give 5 reasons for this, all flavors of misbehaving.
He also looks at a decision made during football games: whether or not to go for it on 4th down. Economist David Romer crunched the numbers and concluded teams don't go for it enough. Since the paper was published, and Romer's model made available to all as the "New York Times 4th Down Bot", going for it has gone down slightly, not up! Nate Silver, noted statistician of sports and politics and editor-in-chief of 538, estimates bad 4th down decisions cost each NFL team 1/2 game per year.
Chapter 30 is titled "Game Shows". Apparently the game show "Deal or No Deal" was about as close to a perfect game "to test prospect theory and mental accounting" as is imaginable. Thaler was particularly interested in the role of "path dependence":
Does the way the game has played out influence the choices people make? Economic theory says that it shouldn’t.Thaler finds misbehaving both when players are ahead - "playing with house money" - and behind - "trying to break even".
Next up is British show named "Golden Balls" which was based on the Prisoner's Dilemma. Cooperation was observed, but also some interesting factoids relative to how the players negotiated with each other:
- “cheap talk.” In the absence of a penalty for lying, everyone promises to be nice.
- People are more willing to lie by omission than commission.
Section 8 is titled "Helping Out: 2004-Present".
By the mid-1990s, behavioral economists had two primary goals. The first was empirical: finding and documenting anomalies, both in individual and firm behavior and in market prices. The second was developing theory. ... But there was a third goal lurking in the background: could we use behavioral economics to make the world a better place? And could we do so without confirming the deeply held suspicions of our biggest critics: that we were closet socialists, if not communists, who wanted to replace markets with bureaucrats?Chapter 31 is titled "Save More Tomorrow". Helping people to save for retirement seems like a great place to overcome their "bounded willpower". The (only) tool governments use to encourage saving is tax breaks. But, in some cases, lowering taxes on retirement savings, say in the case of someone who is already saving at their target rate, and does not want to save more, could result in such a person saving less ?!?!? Thaler quotes economist Douglas Bernheim:
“As an economist, one cannot review the voluminous literature on taxation and saving without being somewhat humbled by the enormous difficulty of learning anything useful about even the most basic empirical questions.”Thaler made some interesting suggestions for increasing retirement savings:
- allow taxpayers to use their income tax refund to make a contribution that counts on the return currently being filed.
- increase withholding. People tend to save more from windfalls, and they see tax refunds as windfalls. So increase the tax refund by increasing withholding.
- when onboarding new employees, make signing up rather than not the default for 401(k) participation.
- offer employees Save More Tomorrow: sign up to automatically have your saving percentage increased for their next 4 pay raises.
When Thaler presented his results on Save More Tomorrow at the University of Chicago, he was accused of paternalism.
Normally we think that paternalism involves coercion, as when people are required to contribute to Social Security or forbidden to buy alcohol or drugs. 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.”Chapter 32 is titled "Going Public". [sarcasm]The commies show their true colors![/sarcasm] Another group publishes a paper titled "Asymmetric Paternalism", defined as:
“A regulation is asymmetrically paternalistic if it creates large benefits for those who make errors, while imposing little or no harm on those who are fully rational.”Ha ha, earlier we had "anti-anti-paternalism", now the 2 above, plus 2 more, "cautious paternalism" and "optimal paternalism".
We were all trying to dig into the question that had been the elephant in the room for decades: if people make systematic mistakes, how should that affect government policy, if at all?Thaler proposed an article and a book to his lawyer collaborator Cass Sunstein.
The premise of the article, and later the book, is that 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. Are there ways to make it easier for people to make what they will deem to be good decisions, both before and after the fact, without explicitly forcing anyone to do anything? In other words, what can we achieve by limiting ourselves to libertarian paternalism?The 1st publisher they talked to about the book suggested the word "nudge" in place of any of the various "paternalism"s above. The book "Nudge", subtitled "Improving Decisions About Health, Wealth, and Happiness", was published in 2008. Some examples of "nudges":
- rumble strips on highways;
- an etched image of a fly on near the drain of urinals to improve men's aim;
- offering, to people choosing not to evacuate ahead of Hurricane Katrina, a marker with which to put their SSN on their body to aid in identification of victims after the storm ?!?!?
- asking people renewing their driver's license if they want to be organ donors ("prompted choice").
- If you want to encourage someone to do something, make it easy.
- We can’t do evidence-based policy without evidence.
Their team - the Behavorial Insights Team or BIT - first successfully ran a campaign to get late taxpayers to pay more promptly. They then tried a campaign to get people to increase attic insulation that was not very successful.
Meanwhile, the other author of "Nudges", Cass Sunstein, took a regulatory post in the Obama administration. After 4 years he left, but then Dr. Maya Shankar succeeded creating the White House Social and Behavioral Sciences Team (SBST). On Sept 15, 2015, Obama issued an Executive Order: Using Behavioral Science Insights to Better Serve the American People, calling for all government agencies to make use of the SBST.
In one final note, Thaler points that nudges can for bad as well as good, and that he always adds the phrase "nudge for good" when he signs a copy of the book.
Finally, the conclusion! Yay!
Thaler feels that behavioral economics is fairly well established, although there are, of course, still pockets of resistance.
The field appears to be converging on what I would call “evidence-based economics".Stimulating the economy by tax cuts is one area where we could use behavioral economics to improve outcomes. Another one is encouraging people to start businesses, i.e., become entrepreneurs. Ha ha, this is funny:
It would be natural to wonder what other kind of economics there could be, but most of economic theory is not derived from empirical observation. Instead, it is deduced from axioms of rational choice, whether or not those axioms bear any relation to what we observe in our lives every day. A theory of the behavior of Econs cannot be empirically based, because Econs do not exist.
Here is one such suggestion ... offered during an impromptu television interview (so pardon the grammar):There are several examples of using behavioral economic approaches to improving aspects of our educational system.What we need to do in this country is make it a softer cushion for failure. Because what [those on the right] say is the job creators need more tax cuts and they need a bigger payoff on the risk that they take. . . . But what about the risk of, you’re afraid to leave your job and be an entrepreneur because that’s where your health insurance is? . . . Why aren’t we able to sell this idea that you don’t have to amplify the payoff of risk to gain success in this country, you need to soften the damage of risk?This idea did not come from an economist, not even a behavioral economist. It came from comedian Jon Stewart, the host of The Daily Show, during an interview with Austan Goolsbee, my University of Chicago colleague who served for a while as the chairman of President Obama’s Council of Economic Advisors. Economists should not need the host of a comedy news show to point out that finding ways to mitigate the costs of failures might be more effective at stimulating new business startups than cutting the tax rate on people earning above $250,000 a year, especially when 97% of small business owners in the U.S. earn less than that amount.
Thaler wants all fields to be evidence-based. Who an argue with that? Science! Thaler exhorts all of us, in all fields, to observe, collect data, and speak up when you see space for improvement.
Good leaders must create environments in which employees feel that making evidence-based decisions will always be rewarded, no matter what outcome occurs.
Behavioral economics appears to me to be going strong. It's interesting that somehow "behavioral" winds up being "liberal" or progressive, and being opposed by conservative, market economists. I think Thaler gives it away when he says that they started wondering if they could use behavioral economics to "make the world a better place". Conservatives worship free markets, and those markets are clearly the only way to make the world a better place - even when they are not.
As Thaler says, they need theory. I'm not sure if it uses equations or computer simulations - I would suspect more of the latter. I think they need to integrate more evolutionary biology and psychology into their overall formulation as well. This book does make me hopeful for the future of economics as a science. Then we just have to convince conservative legislators to respect it - and the rest of science as well.
Here's a paper from 2011 on "Last-place Aversion", another flavor of misbehaving. I think this helps us to understand how the oligarchs' strategy of pitting the working class against the poor works as well as it does. Too bad it doesn't suggest a fix!
Probably an unnecessary point of clarification, but, personally, I Ain't Misbehavin'.