Behavioral economics has gone from a backwater discipline to the forefront of economic research over the last four decades and Richard Thaler has been one of the pioneers to take the field forward. Misbehaving: the making of behavioral economics is both the personal story of Richard Thaler as well as a strong overview of many of the experimental findings that have propelled the field forward and highlighted the relevance of experimental economics. With the financial crisis leading to much soul-searching among macro-economists behavioral finance has seen much renewed interest and representative agent models have been questioned more thoroughly. Misbehaving gives the reader a comprehensive overview of the value of psychology within economics and how our irrational behavioral failings don't get averaged out by the law of large numbers.
Misbehaving is developed chronologically and is split into 8 sections. The author starts with his beginnings as a graduate student and early professor in the 70s. He starts by describing how when he first was constructing his exams he had a series of questions of increasing difficulty that would be a good measure of the depth of understanding of the student and how the average of his test was in the low 70s. Despite the grade curve being a normal one, the student's disdain for such a low mean led to an outcry and so he changed the denominator to a much larger number such that the numerator mean was much closer to 100. The proportion of correct answers was the same but the psychology of the results was totally different to the students. With this irrationality the author got caught in the growing interest in what economists consider supposedly irrelevant factors. The author starts to describe how early studies noticed endowment effects where people valued objects more as soon as they became their possessions which imply large transactional frictions. The author also highlights the work of Tversky and Khaneman on prospect theory and how declining marginal utility was insufficient to describe our economic decisions. The author gets into how people frame bargains and ripoffs and how the mental accounting that people have for acquisitions is based on transactional utility as well as consumption utility. In particular the value of getting a deal in and of itself leads people to buy unnecessary goods. This doesn't make sense if we were only focused on utility from the use of a good. The author discusses how people anchor on sunk costs and overuse goods for which they don't want to waste due to historic cost. The author also discusses how in peoples mental accounting they budget for categories and don't let those budgets spillover from one another leading to inefficient usage of capita. The author notes for example that when the price of gas collapsed people bought premium gas rather than other goods or services which should have been their preference. The author also highlights how people treat their winnings with different level of care than their initial endowments as they consider themselves playing with 'house money'. The author then tackles how people recognize they don't have self control and as a consequence sometimes remove temptation. Such a strategy would be irrational if people were trying to maximize their welfare but its obvious to people that we are often of more than one mind. Given results from brain science and split brain research results, for economists to actually belief people are of one mind and can optimize their behavior would be remarkable.
The author then moves on to his work with Khaneman in the mid 80s. He documents the results of the ultimatum and dictator games. These are basic game theory games in which there is a game with first mover advantage that should result in heavily skewed outcomes in favor of the first mover. With no repetitions the outcomes should be that the winner takes all but people don't act like the rational actors of game theory calculating their Nash equilibrium and use rules of thumb based on perceptions of fairness. The results of these experiments have let to similar results on how to divide a pie across varying cultures reinforcing that fairness is a property people care about deeply. The author discusses fairness and market clearing mechanisms discussing concepts like outcomes that people think are repugnant - like hiking prices during a crisis. The author also highlights how in real business losing your customer base is far more detrimental than securing higher short term profits are beneficial.
The author moves from experimental results to the academic debates around their relevance which picked up in the mid 80s and continued to the mid 90s. The author describes some of the early debates that occurred with Arrow on the behaviorist side against Chicago School with Merton Miller a staunch opponent. One of the debated points was the Modigliani-Miller theorem in which the capital structure should be irrelevant to the value of equities but is clearly not in practice. The author discusses the growth of journals which started to focus on behavioral economics and some of the puzzles posted. He includes a great puzzle which highlights confirmation bias for the reader. The author gets into the mission of building an economics team as well as discusses how people can get caught in the trap of forecasting time horizons with very narrow frames of reference instead of trying to step outside the project and reflect on past experiences. The author highlights how completing a book takes much longer than the author usually assumes it will take and repeating that time miscalculation time and time again despite realizing the result when advising others.
The author then starts to cover finance which is where a lot of focus is for behavioral finance these days. The author gives some simple puzzles to note how investing requires thinking in the shoes of other people and how it resembles a beauty contest in which you are trying to pick the choices you believe others will make- a reference to Keynes. The author discusses episodes like the 87 crash and how volatility of dividends is a fraction of that of markets implying that noise is potentially a large component of volatility. The author brings up examples of irrational behavior like closed end fund premiums and discounts and highlights the mispricing of the stub investment of 3M vs pal during the internet bubble.
The author then moves in to some interesting case studies he worked on where he discusses the NFL draft and the time inconsistency of people's decisions as well as their over emphasis of trying to pick superstars. He goes into the humorous example of office assignment for economics and business school professors- an area in which homo economicus should reign supreme; unsurprisingly he did not. He also discussed some of the risk taking behavior of people on game shows in which playing with house money led to risk loving behavior that would be totally contrary to behavior based on gambling with one's own capital. The author then moves into how this field can be useful and discusses his book Nudge and some policy reform in which better guiding policies can lead to more self enhancing outcomes for the population. The decisions by people to opt in to a program vs opt out are quite different and framing and laziness can have large impacts on how people make decisions.
Misbehaving gives an informative overview of behavioral economics as it evolved. One learns about the field itself and the intertwining of disciplines with psychology as well as the internal conflicts faced by the economics profession. It presents a readable overview of the author's personal and professional life and is highly educational as well. Definitely worth reading.
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Timo Rupprecht
Verhaltensökonomie entmystifiziert
Reviewed in Germany on January 18, 2024Morgana
It's one of the greatest books ever
Reviewed in Spain on September 16, 2023
