Book Summary: "Misbehaving - The Making of Behavioral Economics" - Richard H Thaler

The bulk of Misbehaving covers many aspects of behavioural economics that Thaler was personally involved in uncovering, including endowment effects (i.e. people value something substantially more when they own it than before they own it), mental accounting (i.e. people treat money as non-fungible – for example, they pay only the smallest required payment off their credit card bill while having sufficient savings to pay off the whole bill, and are thus paying interest on debt that is many multiples higher than the interest earned on their savings), and issues of self-control, which include the hefty emphasis that people place on the immediate moment (i.e. present bias).

Thaler also examines transaction utility, which refers to the pleasure people experience when they secure a good deal and the discomfort they feel when taken advantage of. This idea extends beyond the typical economic view that only acquisition utility is significant.

The phenomena, some of which have been observed in other species, no doubt have evolutionary explanations. If survival at the moment rather than maximisation over a lifetime is the objective, then present bias and loss aversion are not so difficult to comprehend. Thaler agrees that evolution was probably the cause behind the phenomena but sees little import for these explanations in economic analyses: “…there was no doubt that many aspects of human behaviour…had evolutionary roots. But…accepting the theory of evolution as true does not mean that it needs to feature prominently in an economic analysis. We know people are loss averse; we don’t need to know whether it has an evolutionary explanation.”

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Book publication date: May 2015.

Brief about the Author:

Richard H. Thaler

Richard H. Thaler received the 2017 Nobel Memorial Prize in Economic Sciences for his contributions to behavioural economics. Thaler studies behavioural economics, finance, and decision-making psychology, which lies in the gap between economics and psychology. He investigates the implications of relaxing the standard economic assumption that everyone in the economy is rational and selfish, instead entertaining the possibility that some economic agents are sometimes human.

Thaler is the co-author (with Cass R. Sunstein) of the global best seller Nudge (2008) in which the concepts of behavioral economics are used to tackle many of society’s major problems. In 2015, he published Misbehaving: The Making of Behavioral Economics. He has authored or edited four other books: Quasi-Rational Economics, The Winner's Curse: Paradoxes and Anomalies of Economic Life, and Advances in Behavioral Finance (editor) Volumes I and II. He has published numerous articles in prominent journals such as the American Economics Review and the Journal of Finance and Political Economy.

Thaler is a member of the National Academy of Science, the American Academy of Arts and Sciences, a Fellow of the American Finance Association and the Econometrics Society, and 2015 served as the President of the American Economic Association.

Before joining the University of Chicago faculty in 1995, Thaler taught at the University of Rochester and Cornell, as well as visiting stints at the University of British Columbia, the Sloan School of Management at MIT, the Russell Sage Foundation, and the Center for Advanced Study in Behavioral Sciences at Stanford.

Originally from New Jersey, Thaler attended Case Western Reserve University, where he received a bachelor's degree in 1967. Soon after, he attended the University of Rochester, where he received a master's degree in 1970 and a PhD in 1974. He joined the Chicago Booth faculty in 1995.

Misbehaving:- Book Review

Exordium:

Thaler’s ambivalence to a discourse on explanation is grounded in his faith in the normative weight of expected utility theory. However, an analysis of the possible causes of the behavioural economic findings might lead us to conclude not only that people often fail to behave according to the axioms of economic rationality but that in certain circumstances, they ought not necessarily comply with these axioms either.

Second, the ethics of using behavioural economics in policy formation warrants further and closer scrutiny. Thaler, clearly stung by charges of manipulation, states at several points in his book that most nudges are visible, but this defence misses the point. They may be physically visible, but the reasons why nudges are being used are not always, or indeed often, transparent, and thus, the charge that they are somewhat circumnavigating deliberative scrutiny ought not to be ignored. Following sufficient ethical scrutiny, many of us may decide that nudges (to name but one form of behavioural economic-informed policy) are generally, on balance, acceptable. Still, that debate has yet to be had.

Popular science books implicitly use a behavioural economic phenomenon – present bias – to introduce areas that might otherwise be too arduous for most people to study. That is, they aim to make ideas and concepts fun to read. A downside is that they sometimes trivialise and misrepresent necessary scholarly fields. Richard Thaler’s Misbehaving is guilty of neither of these latter charges, although, like most of us and indeed, as he points out, like most economists, he might be a little guilty of being resistant to challenges to his ideas. This is perhaps unavoidable. It is human nature, an endowment effect of sorts.

Nonetheless, Richard Thaler has done more to popularise behavioural economics in the policy discourse than perhaps anyone else. For anyone who wishes not just to be entertained frivolously but is serious about learning about the core concepts in the behavioural economic field, then Misbehaving, read together with Daniel Kahneman’s Thinking Fast and Slow, is a good place to start.

Supposedly Irrelevant Factors:-

Supposedly, Irrelevant Factors (or SIFs) should typically not influence the considerations of an Econ (a hypothetically rational person) according to economic theory but turn out to affect their decisions. Thaler argues that many assumptions in economic theory ignore these SIFs, resulting in their inability to accurately describe and predict human behaviour. He believes that by including SIFs in traditional economics, theories that explain human behaviour will become more realistic, and their predictive power will also increase. This was how the field became known as “Behavioural Economics”, which he says is still economics but is being meaningfully informed by psychology and other social sciences.

Endowment Effect

The endowment effect is a phenomenon where people value what they own more than things they do not or have yet to own, even if they were of the exact cost. According to economic theory, if the objects are of the same monetary value, then such preferences should not exist, which makes the endowment effect a SIF. Yet Thaler and other decision-making psychologists like Kahneman and Tversky consistently find this effect in their experiments. One of the most famous examples is the study where Thaler and Kahneman gave participants a mug and offered them a chance to sell it or trade it for an equally valued object. They found that the amount participants required to compensate for the ownership of the mug (“willingness to accept”) was approximately twice the amount they were initially willing to pay for the mug (“willingness to pay”).

Thaler attributed this effect to loss aversion and status quo bias. He believes that mentally, giving up the mug they already own may be considered a “loss” for the participants. Besides, people usually stick to what they have unless there is a good reason to switch, even despite a good reason to switch. Thaler suggests that loss aversion and status quo bias often work together to inhibit change, and policies that want to drive behaviour change must be considered.

Mental Accounting

Mental accounting is budgeting money into different expense categories, ignoring the fungible property of money. In classical economic theory, Econs should treat all their money the same, regardless of where it comes from or what it will be used for. But more often than not, people and organisations don’t behave that way. Despite having no real difference in money, people treat the cash in their hands and the savings in their bank accounts very differently. “If it isn’t labelled as savings, I don’t have to save a penny of it” is the type of mentality many people have. Similarly, many companies have clearly defined budget rules. Suppose the budget for a particular purpose has leftover money. In that case, it may not be easy to use it for other purposes, even if it is in the company's interest.

While this behaviour would seem irrational in the eyes of an Econ, Thaler acknowledged that it may not be all that bad. Mental accounting forces people to live within their means, especially if they are not disciplined enough to stick to their financial plans. Clearly defined budgets in companies also ensure that departments don’t count on the budget to be flexible and end up overspending. But if these budgets become too rigid, bad decision-making can still ensue.

Libertarian Paternalism

The word “paternalism” is often frowned upon by liberal societies, as people generally don’t like the idea of the government or anyone else telling them what to do. So when Thaler coined the term “Libertarian Paternalism“, it sounded to many like an oxymoron. But Thaler explained that it isn’t an oxymoron because what he means by “paternalism” is helping people achieve their own goals, which, in an analogy, is showing the way to someone who is already looking for the subway station. The reason why he used “libertarian” to describe the type of “paternalism” is because he feels that such “paternalism” does not have to restrict choices. However, the term “Libertarian Paternalism” would never catch on, so one publisher suggested another word that seemed to capture this meaning, and that was how the term “nudging” was born.

One of the most famous examples of nudging used in public policy is the default option of organ donation. Countries with an opt-out policy for organ donation often see a higher donor rate than those with an opt-in policy. Technically, countries with an opt-out policy are not forcing people to donate their organs after they pass on, as people are still given a choice to opt-out. However, because donors don’t have to make an active choice now, they will generally stick with the default if they don’t have a preference.

Epilogue:

The concepts above are probably Thaler’s most important contributions to Behavioural Economics. The book Misbehaving is a great place to start for anyone new to the field and interested in learning more.

The history and details of what inspired Thaler make the book fascinating for people already familiar with behavioural economics. However, it would be a mistake to assume that the book covers everything about Behavioural Economics. While Thaler played an essential role in formalising this field, there are other brilliant researchers whose ideas and work have helped lay the foundation of Behavioural Economics, and Thaler has given due credit to many of them in his book.

Learning:

We are all human, and we act like humans.?However, economic models treat humans as "homo economicus" - the fictitious, always rational, continually optimizing beings.?Richard Thaler refers to this creature as an "Econ" - and humans do not act like Econs.?

In his book Misbehaving, he discusses how humans tend to misbehave much when modelled as Econs. In other words, many economic models make dire predictions by treating humans as perfectly rational optimizers… which they are not. Recently, I read Misbehaving and thoroughly enjoyed it.?

Thaler casually walks through the formative history of Behavioral Economics from his perspective as one of its founders.?Thaler is informative and punchy in "Misbehaving" - well worth the read.?

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