Misbehaving: How Psychology Won Economics Over

By Lucio Buffalmano/ 14 minutes of reading

Misbehaving(2015) is the history of how behavioral economics became a recognized discipline in-between psychology and economics.
For the uninitiated, that means that the author, Richard Thales, tells the story of how psychology fought its way into economics.

Contents

Bullet Summary

Old economic theories centered around fully rational individuals are deficient
Even financial markets are not rational and not always efficient
Economists have long rejected the idea of an irrational individual (and the meddling of psychologists into economics)
Behavioral economics, such as economics with good psychology, is today widely accepted

Misbehaving Summary

Little by little, psychology supplanted the myth of the (inexistent and hyper-rational) “homo economicus” to give us all a better understanding of how people make financial and (ir)rational decisions.

Albeit psychology was only taking us closer to the truth, it wasn’t easy to change economists’ minds.

Beginnings 1970–78: Homo Economicus

Richard Thaler, with the first salvo of wit that will characterize all of “Misbehaving” says that economists replaced homo sapiens with a fictional creature called “homo economicus”.

For short, Thaler will call refer to “homo economicus” as “econ” (pl.: “econs”).
Econs are rational and always make the best rational decisions considering all information available and all alternatives available.

Econs are not good representations of real humans though, who make all sorts of mistakes and irrational decisions.

Economical models designed by economists, which the author also call “optimization theories”, have long been built around “econs”. And that means that, since econs don’t really exist in real life, optimization theories make all sorts of bad predictions.
Just as an example, not only no economists failed to predict the 2007-2008 financial crisis, but economic theories based around econs also postulate that financial bubbles are impossible.

Ironically, notes Thaler, the homo economicus theories based on math and rationality long gave economics the reputation of the most powerful of the social sciences.

Economic Theories Rest on Flawed Assumption

There is a problem with economic theories though: they rest on completely flawed premises.

Optimizations people face are too complex to be solved with perfect rationality (even going to the grocery store presents way too many options to be all resolved rationally, let alone the complexities of a career to choose)
We make choices on biased beliefs (ie.: overconfidence)
There are too many factors the optimization model leaves out and that economists simply shrug off as “Supposedly Irrelevant Factors” (ie.: econs would never buy more food for tomorrow because they’re hungry today and they would never finish an already bought meal even though they’re full middle-meal)

Thaler says we don’t need to throw the optimization theories away, but we have to stop to base our policies and predictions on them.

Enter: Behavioral Economics

Behavioral economics is still economics but with te an injection of good psychology and social science.

Thaler then dedicates a few chapters of “Misbehaving” to describe experiments which clearly show that optimization theories are wrong, that “SIFs” are not irrelevant at all and that econs don’t exist.
Or, if they do, they certainly don’t overlap with humans.

Prospect Theory

Thaler describes how he first stumbled upon Kahneman -author of Thinking Fast and Slow– and Tversky (check out “The Undoing Project” for the history of these two).

Kahneman and Tversky are the two main psychologists behind the emergence of prospect theory.
Prospect theory maintains that:

Diminishing sensitivity of utility: the more we get of something, the less impact it will have (valid for both gains and losses)
Changes matter more than levels (if I win a million dollar today and in a week I lose 700k I will be sad in spite that I am still at +300k)

No Need to Throw Out All Econ-Theories

Thaler doesn’t say we need to completely supplant all optimization theories. He says they remain good starting points for more realistic models.

And when the problems are very easy or the individual is highly skilled and approaching the problem with his full attention, then optimization theory may work fine (but these situations are the exception and not the rule)

PART II: Mental Accounting 1979–85

The author, parallelly but independently of Kahneman wondered how people thought about money.
He first called it “psychological accounting”, but later followed suit with Kahneman and Tversky’s to call it “mental accounting”.

Opportunity Costs Theory (& Limitation)

An econ takes any decision by analyzing all possible alternatives. But real humans cannot compute infinite alternatives and, at most, they select a couple to choose from.

The people closest to an econ are actually poor people, who need to make ends meet and thus spend more time wondering about money allocation and opportunity costs.

My Note: Disagree with the generalization. Poor people are not always econs
I don’t fully agree with the author here or, at least, there are plenty of exceptions. Many people are actually poor because they do not think about money allocation and opportunity costs. Ever.
Think of psychopaths who live in the moment without a worry for the future.
Or those people who spend everything their whole monthly salary before the middle of the month (just visit the Philippines and you’ll meet those).

Transaction Utility

Humans don’t just think in terms of number and utility maximization, but also take into account the perceived quality of the deal.

If you buy a sandwich at a sporting event and pay it 3 times the price you would pay for it outside, the sandwich has negative transaction utility (ie: a rip off).

And again, humans are willing to pay different prices depending on where an item is bought.
They are OK with higher prices in an expensive resort, for example, because they understand the expenses are higher there, the ambiance might be nicer and, well, they might even be happy with the splurge.

Transaction utility explains why people sometimes never buy something that would give them great memories for a lifetime.
Because, irrationally, they feel it’s not a good deal and don’t want to live with the feeling of having overpaid.
And on the other hand, we often buy stuff that we won’t even use because we feel it’s a great bargain.

And this is the reason why shops always fake sales: to give people the feeling they are getting a bargain.

Econs instead would never experience transaction utility.

Sunk Costs

People also wear dresses they don’t like anymore simply because they bought it and if they don’t use it, they feel like they wasted money.

This is an example of sunk costs.

People expense sunk costs because of mental accounting.
If you buy something and use it, the account is neutral. But if you spend money on something without using or enjoying it, it feels like you wasted money.

If instead, you use what you spent money on, it feels like you got a bargain and we feel good about it.

Indeed, the more we pay for something, the more we will try not to leave it unused and the more we will resist throwing it away.

Of course, econs would never deal with sunk costs.

Delayed Consumption & Mental Accounting

When we buy something for later consumption our mental accounting goes out of whack.

Buying expensive wine which we will consume in the future feels for many people like an investment rather than an expense.
And when we consume it in the future, it feels like we didn’t even spend money on it (the paper research is called “Invest now, drink later, spend never“).

Vacation timesharing properties leverage the same mental inconsistency to make people feel like they are investing in their future holidays.

The House Money Effect

The house money effect turns the normal the risk-aversion of most people on its head.

The “house money effect” refers people to have won money or somehow received unexpected money.
In that case, normal mental accounting goes out of whack and they feel free to throw money around and take risks and bets that they would normally never take with their own money.

That’s why non-professional gamblers who start winning become much more aggressive and take many more risks with their new “house money”.

Break Even Effect

Another SIF, not just for econ-based theories but also for the more psychologically-driven prospect theory, is the behavior that people present when they are losing but are given the chance of breaking even.

In that case, they are willing to take larger risks for the chance of erasing their losses.

PART III: Self-Control 1975-88

Economic theories have long presumed that self-control problems do not exist.
And that’s another inconsistency between economic theories and actual humans.

In this part, Richard Thaler makes even more fun of economists and their models and theories growing more and more sophisticated as they implied that also people became more and more rational and sophisticated (check quotes below).
He discussed and explains Keynes, Milton Friedman and Modigliani and also about “The Marshmallow Test” (albeit the Marshmallow Test is pop-psychology).

Of course, the reality of humans was much different.

PART IV: Working With Danny 1984-85

“Danny” is, of course, Daniel Kahneman, and in this part, the author keeps stacking more examples and proofs that humans are not rational decision-makers.

Perception of Fairness

The author says that perceptions of fairness are related to the endowment effect.
Both buyers and sellers feel entitled to the terms of the deal to which they have become accustomed.

Perceptions of fairness also explain why it’s difficult for employers to lower wages during recessions.
It’s difficult because employees think it’s unfair to take away, which is something that would never happen in the world of econs where supply and demand are all that matter.

Humans are also willing to lose money to “punish” other humans whom they feel are behaving unfairly.

Some People Cooperate, Econs Shouldn’t

Richard Thaler talks about prisoner dilemma and ultimatum games (also read “Game Theory Bargaining“).

In the rationally cynic econs’ world, players will defect because it’s in their best interest to do so.
Yet the game played in laboratories shows that 40-50% of people cooperate.

In more relevant scenarios called “public goods games” many people still cooperate to enhance the public good albeit that it not in their most selfish interest.

We see examples of this every day when people donate for charities and bring bags to clean their dogs’ poop.
And that’s not how econs would behave.

There is still an issue for many public goods which are no produced in enough quantity for everyone, but the problem is only half as bad as standard economic theory would predict.

Fun fact: the only people who act like econ and share nothing are economic graduates :).

Says Thaler:

A purely economic man is indeed close to being a social moron.

However, there is a caveat.
If public good games are repeated consequently, public contributions tend to fall.

Economists argued that people learned over time that the best strategy is to be selfish.
But that’s not the case.

Andreoni ran an experiment where the game was going to restart after 10 rounds.
And after 10 rounds, the contributions jumped back up. The author says it’s because people learn that some people are jerks and nobody wants to be the fool who’s taken advantage of (a sort of vicious circle).
But when the game restart again, people contribute again.

Most people thus are “conditional cooperators”: they are willing to cooperate as long as others are willing to cooperate.

PART V: Engaging The Economic Profession 1986-1994

The evidence was starting to accumulate for economists to have to pay attention to.

Thaler discusses the equity premium, such as the premium that the riskier equity asset class should grant above less risky assets such as bonds.

And the equity premium is much, much higher than economic models with rational players would warrant for (should have been 0,4% VS the actual 6%).
Investors should have been implausibly risk-averse to explain such a huge gap.

Myopic Loss Aversion

Myopic loss aversion is the idea that refusing to risk once can be mitigated by playing the game several times and using the law of large numbers to take advantage of the favorable odds.

But Thaler says that doesn’t make sense.
If you have good odds you should be willing to play one time as well.

PART VI: Finance 1983-2003

Richard Thaler says that the field where the “homo economicus” was strongest and most entrenched was in financial markets.

With all the big banks and all the money at stake, financial markets had to be efficient.
So if psychology and behavior finance could prove also financial markets to be irrational, then the evidence could not be ignored anymore.

He spoofs Frank Sinatra to basically say that “if you can make it in New York (financial markets), you can make it anywhere”.

The Efficient Market Hypothesis

The efficient market hypothesis rests on two assumptions:

You can’t beat the market
There is no such thing as a free lunch

The author, again, says that the rational model hypothesis is not to be completely thrown away and it presents a great starting point.

But when it comes to a descriptive model of how things actually work, the model is not realistic.

The Irrationality of Financial Markets

Here is why financial markets are irrational:

High trading volumes (in a world with efficient prices there would be no need for high trading)
People overreact to news
Sentiment and optimism have been proven to drive prices, at times, more than “fundamentals” do
Stock prices move too much to justify forecasted dividends
Mispricing of the same asset in different markets can last for a long time
Stocks sometimes fall without reason (ie.: 1987 crash)
Split companies can end up being value differently than the whole
People make extreme forecasts based on flimsy data
Most people shun underperforming company out of stereotyping

Value investing, as espoused by Warren Buffet and Benjamin Graham and author of “The Intelligent Investor” does indeed work and can deliver superior results.

But no strategy should deliver superior results if markets were really efficient which, again, proves that financial markets are not efficient (the author then recommends to buy funds trading at a discount, a strategy also endorsed, he notes, by the author of “A Random Walk Down Wall Street“).

PART VII/VIII: 1994-PRESENT

In the last two parts, Thaler provides even more examples to prove that the standard economic models do not explain real-world behavior.

By the mid-2000s behavioral economics has become widely accepted and Thaler applies its concepts to real-world problems that the discipline can help tackle (ie.: nudging people to save for retirement, paying taxes on time etc.).

Misbehaving Quotes

I absolutely love a smart author who drops knowledge and does so in a witty way (which is why I love Nassim Taleb).

And Thaler does exactly that.
Here are some great quotes from “Misbehaving”:

In fact econs would be perplexed by the whole idea of gifts. An econ would know that cash is the best possible gift, which allows the recipient to buy whatever is optimal.
But unless you are married to an economist, I don’t advice you to give cash on the next anniversary.
Come to think of it, even if your spouse is an economist, it’s still not a great idea.

On psychologist bantering:

Psychologists refer to a “just noticeable difference” as JND. If you want to impress an academic psychologist add that term to your cocktail party banter.

On economists resisting change:

Economists have their way of doing things and will resist change. If for no other reason, that they invested years building their own corners of this edifice.

On people (econs) becoming smarter and smarter as the math formulas improved:

As economists became more mathematically sophisticated and their models incorporated their new methods of sophistication, the people they described evolved as well.
(…)
Calculate the present value of social security benefits that will start 20 years from now? No problem!
Stop by the tavern on payday and spend intended for food? Never!

On unrealistic models developed around omniscient, super-smart (and non-existing) individuals:

Barro’s insight is ingenious, but for it to be descriptively accurate we need econs who are smart as Barro.
(..) the difference between our models is that he assumes the agents in his models are as smart as he is, while I assume they are as dumb as I am.

On status in psychology research and Cialdini, author of Influence:

For some reasons the study of applied problems in psychology has traditionally been considered a low-status activity.
Studying the reasons why people fall into debt or drop out of school has just not been the type of research leading to fame and glory -with the exception of Rober Cialdini-.

Talking about the confidence that economists had in the rationality of financial markets, Thaler says that the confidence came from the impossibility of proving the theory (either wrong or correct).
After all, who can “prove” what’s the right price of a stock:

There is no better way to build confidence in a theory than to believe that it’s not testable.

On Chicago school economists:

The old joke is that a Chicago economist would not bother to pick a 20 dollar bill on the sidewalk becuase if it were real, someone would have already snagged it.
There is no such thing as a free lunch. And a free 20 dollar bill.