Misbehaving

Thaler examines the concept of sunk costs, a common financial fallacy where people continue an endeavor due to the number of resources already invested, regardless of future costs or benefits. Thaler uses various real-life examples to illustrate how people often irrationally allow sunk costs to influence their decisions.

For instance, Vince, a tennis club member, continued to play despite developing tennis elbow, driven by the desire not to waste his membership fee. This is a classic example of the sunk cost fallacy, where the initial investment overshadows the current negative utility or pain.

Thaler also discusses a personal story involving his friend Joyce and her daughter Cindy. Joyce insisted Cindy wear dresses she had bought for her, despite Cindy’s preference for pants. Thaler explains to Joyce the money spent on dresses is a sunk cost and should not influence Cindy’s clothing choice. Joyce is relieved to hear this, as it resolves her guilt over “wasting” money on unworn dresses.

These scenarios highlight a common struggle with sunk costs, where individuals feel compelled to get their money’s worth out of an investment, even if it leads to unfavorable outcomes. Thaler emphasizes this behavior is not just limited to small personal decisions but can also be seen in larger contexts, like corporate investments or even military strategies.

Thaler discusses the concept of mental accounting, focusing on how individuals and organizations use budgeting rules to manage finances. The author highlights how households, particularly those on tight budgets, often divide their money into different categories or “buckets,” such as rent, food, and utilities. This method, which can involve physical envelopes or jars for different expenses, is a way to exercise control over spending and ensure essential costs are covered.

Thaler points out that while this approach helps in managing finances, it violates the economic principle of fungibility, where money should be interchangeable and not restricted to specific uses. For instance, excess funds from a utility budget could be used for other needs, but mental accounting often prevents this transfer of funds.

Organizations similarly allocate budgets to different departments, but this can lead to inefficient spending, as funds in one category can’t be reallocated to meet urgent needs in another. This inflexibility highlights how mental accounting can lead to suboptimal financial decisions.

Thaler also explores how mental accounting impacts personal spending behaviors. For example, people are more willing to spend “budgeted” money, like a weekly entertainment allowance, but hesitate to draw from savings accounts. This behavior can lead to paradoxical situations, like carrying high-interest credit card debt while having funds in low-interest savings accounts.

The chapter concludes with a discussion on how mental accounting affects perceptions of wealth. Different “accounts” such as cash, checking accounts, and long-term savings are treated with varying degrees of spending reluctance. Thaler suggests understanding and occasionally bypassing these mental accounting rules can lead to more rational financial decisions.

Thaler explores the psychology of gambling, particularly in the context of poker and how it relates to mental accounting. Thaler, observing a regular low-stakes poker game among Cornell economics faculty, notes players’ behavior often changed depending on whether they were winning or losing. This is intriguing because the amount won or lost was relatively insignificant compared to the players’ overall net worth. The key insight is that losses in the “poker mental account” only influenced behavior within the context of the game itself.

Thaler connects this observation to Kahneman and Tversky’s prospect theory, which suggests people are risk-seeking when dealing with losses. However, he finds this explanation incomplete, as it doesn’t account for why players prefer small bets with slim winning chances over larger, more rational bets. His experiences indicated players who were behind were more attracted to bets with a small chance for a big win and were averse to larger bets that increased their potential loss.

This behavior extends beyond the poker table to casinos, where gamblers treat winnings as “the house’s money,” leading to a more relaxed attitude toward risk. Thaler worked with Eric Johnson to conduct lab experiments, replicating these observations under ethical conditions. Their findings revealed people exhibited risk-seeking behavior when they perceived themselves as playing with “house money” or trying to break even.

These insights into mental accounting and risk behavior have broader implications, influencing financial markets and investment behaviors. During financial bubbles, investors often risk recent gains, perceiving them as less valuable “house money.” Similarly, mutual fund managers and rogue traders have been observed to take greater risks when trailing benchmarks or trying to recover losses.

Thaler investigates the concept of self-control in economic decision-making, highlighting how traditional economic models often overlook human tendencies and behavioral quirks. The chapter begins with Thaler’s observation of a low-stakes poker game among Cornell faculty, where he noticed players’ decisions were influenced by whether they were winning or losing, despite the small amounts involved. This behavior was inconsistent with traditional economic theory, which assumes rational, consistent decision-making.

Thaler relates these observations to the broader context of mental accounting, where people treat money differently based on its source and their current financial state. He notes that when people are ahead financially, they tend to view the gains as “house money” and are more willing to take risks with it, illustrating a clear departure from the economic principle that money is fungible.

To further explore these concepts, Thaler and Eric Johnson conducted experiments to replicate these behaviors in a controlled setting. Their findings showed that people exhibited risk-seeking behavior when they perceived themselves as playing with “house money” or trying to break even. This insight into human behavior has implications for understanding financial markets, investment behaviors, and the psychology of gambling.

Thaler probes the complexities of self-control in economic decision-making, a topic that was relatively unexplored in economic literature at the time Thaler began his research. He references the work of economists and psychologists who have touched on self-control, such as Robert Strotz, Walter Mischel, and George Ainslie, to build his own understanding of the subject.

Thaler introduces the concept of the “Planner” and the “Doer” to explain self-control issues. The Planner is a forward-looking self, concerned with long-term well-being and making rational decisions for the future. In contrast, the Doer is impulsive, living for the present and often giving in to temptations. This dichotomy is used to model internal conflicts within individuals when making decisions that have implications both now and in the future.

Thaler and his colleague Hersh Shefrin developed a formal model to capture these interactions, employing a principal-agent framework commonly used in organizational theory. In this model, the Planner acts as the principal, setting rules and guidelines, while the Doer is the agent who must follow these rules but often seeks immediate gratification.

The model suggests self-control can be managed through commitment strategies (like Odysseus, Thaler suggests, binding himself to the mast to resist the Sirens) and by manipulating environmental factors (such as removing temptations from sight). However, these strategies can have limitations, such as inflexibility and the need for continual enforcement.

Thaler discusses his practical experiences applying behavioral economics to real-world business challenges, focusing on two cases: Greek Peak, a ski resort near Ithaca, New York, and a consulting opportunity with General Motors.

At Greek Peak, Thaler used behavioral economics principles to address the ski resort’s financial struggles. He suggested gradually increasing lift ticket prices to avoid customer backlash and improve the overall skiing experience to justify the price hike. To cater to price-sensitive local markets, they introduced discounted pre-season ticket packages like the “ten-pack,” offering a mix of weekend and weekday passes at a significant discount. This strategy not only boosted early revenue, reducing the need for off-season borrowing, but also helped mitigate the risk of poor snowfall seasons. Thaler also found that only 60% of the pre-sold tickets were redeemed, effectively bringing in revenue at the full price.

Thaler’s consulting opportunity with General Motors (GM) revolved around their successful but poorly understood low-interest car loan promotion, which was outperforming the traditional cash rebate offers. Despite the success, GM did not have a clear understanding of why the promotion was so effective. Thaler’s visit to GM revealed a lack of analytical rigor in their marketing strategies, with no one responsible for evaluating the promotion’s success. He proposed that GM should thoroughly analyze why the promotion worked and plan for the future. However, GM declined his proposal, opting instead to focus on production planning to avoid excess inventory, a plan they failed to adhere to in subsequent years.