Misbehaving

Thaler explores the divergence between traditional economic theory and human behavior, a theme that emerged during his graduate studies at the University of Rochester. Thaler’s journey begins with his thesis on “The Value of a Life” (26), where he attempts to quantify the monetary value people place on life and risk. He uses examples like Russian roulette to illustrate the complexity of determining the trade-off between money and the risk of death.

Central to this chapter is the concept of “willingness to pay” versus “willingness to accept” (28). Thaler discovers a significant discrepancy in how people value risk depending on whether they are avoiding it or accepting it. This finding contradicts the logical consistency and rational behavior predicted by economic models.

Thaler introduces the “endowment effect” through various anecdotes, such as a wine collector who values his own bottles more than their market price but is unwilling to buy or sell at that price. This effect demonstrates how people ascribe higher value to things they own compared to identical items they do not own, highlighting a disparity between perceived opportunity costs and actual expenses.

The chapter uses real-world examples, like ticket pricing for events, to show how the endowment effect influences decisions based on perceived costs. Thaler concludes by acknowledging the endowment effect’s challenge to conventional economic thought, emphasizing its role in understanding human decision-making’s irrational aspects.

Thaler presents a series of real-life examples that challenge traditional economic theories of rational choice. These examples, which Thaler started compiling on a blackboard in his office, highlight the often-irrational behaviors of people in various everyday situations.

One example involves Thaler and a friend deciding not to attend a basketball game due to a snowstorm. They noted that if they had paid for the tickets, they would have gone despite the weather, illustrating the difficulty in ignoring sunk costs—costs that have already been incurred and cannot be recovered. Another instance describes a friend who refuses to pay someone to mow his lawn to avoid allergies; yet he wouldn’t mow another lawn for double the pay. This contradiction questions the economic principle that buying and selling prices should align.

Thaler also discusses Linnea, who considers driving to another store to save $10 on a $45 clock radio but would not do the same for a $10 discount on a $495 television. This inconsistency in valuing time challenges the notion of consistent valuation. Another example is Lee, he explains, who feels more comfortable receiving an expensive sweater as a gift from his wife than buying it himself, despite their shared finances. This scenario explores the concept of perceived value and decision-making in a shared economic unit.

Lastly, Thaler talks about removing a bowl of cashews during a dinner party to save guests’ appetites. This action goes against the economic idea that more choices are always better, highlighting how limiting options can sometimes be beneficial.

Thaler lays out the foundational concepts of what would later become known as Prospect Theory, developed by Daniel Kahneman and Amos Tversky. Thaler’s discovery of their work marked a turning point in his understanding of economic behavior, particularly in how people make decisions under uncertainty.

Thaler distinguishes between normative and descriptive theories. Normative theories describe how people should make decisions logically and consistently, much like the Pythagorean Theorem in geometry. Descriptive theories, on the other hand, aim to predict how people actually behave. Traditional economics often conflates these two, assuming people behave rationally as per normative models. Thaler illustrates this with an example involving the expansion of railroad tracks, where most people’s intuitive answers differ greatly from the correct mathematical solution.

Prospect Theory challenges this conventional approach by supplying a descriptive model of decision-making, particularly under conditions of uncertainty. It introduces the concept of a “value function,” which focuses on changes in wealth rather than absolute levels. This model recognizes that people experience diminishing sensitivity to both gains and losses and that they are more significantly affected by losses than gains (loss aversion).

Thaler comments on the simplicity and elegance of the value function graph, which captures key behavioral insights: People are risk-averse when it comes to gains but risk-seeking in the face of losses. This is due to the asymmetric nature of the value function, where the curve is steeper for losses than gains, showing losses are felt more intensely than equivalent gains.

Thaler narrates his journey to Stanford in the summer of 1977, driven by his growing interest in the intersection of psychology and economics. This period marks a pivotal time in Thaler’s career, as he begins to solidify his ideas about behavioral economics.

Thaler’s initial motivation for going to Stanford is to work with Sherwin Rosen on the value of life. However, learning Daniel Kahneman and Amos Tversky will be at Stanford in the fall, he seeks a way to extend his stay, intrigued by their work that inspired him. His persistence pays off when Victor Fuchs, the director of the National Bureau of Economic Research (NBER) office at Stanford, offers him a position funded through his grant.

During this period, Thaler’s interactions with Kahneman and Tversky are instrumental in shaping his thinking. He is fascinated by their approach to behavioral research, particularly their use of hypothetical scenarios to study decision-making. Thaler contrasts this with the skepticism of economists toward hypothetical questions, noting how Kahneman and Tversky’s research gradually gained acceptance due to its utility in explaining real-world behaviors.

Thaler reflects on his own research approach during this time, considering different methodologies, including experimental economics. He visits Vernon Smith and Charlie Plott, pioneers in the field, but remains unsure about fully committing to experimental economics. Thaler’s interest lies in studying behavior in various contexts, not limited to controlled experiments.

Thaler discusses the challenges he faced in introducing behavioral economics to a field dominated by traditional economic thinking. He outlines the skepticism and resistance he encountered from fellow economists, who were deeply invested in the prevailing models of rational choice and optimization.

Thaler describes a series of common objections, or “putdowns,” he often encountered when presenting his research. One such objection is the “as if” argument, suggesting that even if people are not capable of solving complex optimization problems, they behave as if they can. Thaler counters this by asserting that economic theories should apply to all people, not just experts, and that many real-life decisions do not offer the opportunity for the kind of learning and practice that would enable optimal decision-making.

Another objection he addresses is the belief in the power of incentives. Critics argued that higher stakes would lead people to make more rational decisions. However, Thaler points out that incentives alone are insufficient to ensure rational behavior, citing studies that showed increased stakes sometimes led to worse decision-making.

Thaler also tackles the argument that markets, through competitive forces, will correct irrational behaviors. He argues that while market forces do exert some influence, they cannot entirely counteract human irrationality. Businesses can survive and even thrive despite being poorly managed, and individuals often make irrational financial decisions.