Misbehaving: The Making of Behavioral Economics

Richard H. Thaler, “Misbehaving: The Making of Behavioral Economics” W.W.Norton, 2015, 358 pp.

Before reading this book, I recommend reading “Nudge” by the same author.  Mr. Thaler’s work is built on the groundbreaking insights of the psychologists Amos Tversky and Daniel Kahneman, whose work would earn a Nobel Memorial Prize in Economic Science in 2002.

Author Thaler has spent his career studying the radical notion that the central agents in the economy are humans—error-prone individuals. Misbehaving is his account of the struggle to bring economics as a discipline back down to earth—and change the way we think about economics, ourselves, and our world. 

Traditional economics, beginning with Samuelson,  assumes rational actors. Early in his research, Thaler realized these Spock-like automatons were nothing like real people. Whether buying a clock radio, selling basketball tickets, or applying for a mortgage, we all succumb to biases and make decisions that deviate from the standards of rationality assumed by economists. In other words, we misbehave. More importantly, our misbehavior has serious consequences as economists have increasingly become the go-to experts on every manner of business and public policy issue facing society.

Early in his career, Professor Thaler created a list of observed behaviors that were obviously inconsistent with the predictions of established orthodoxy. These found names like “the endowment effect,” which leads individuals to systematically value things they already own much more than the identical item in someone else’s hands.

My Notes (6/11/15: note I actually read this book last year, which I discovered when half through when again reading it):

Pg. 5:  Economic theory and models are based on fictional creatures that the author calls Econs (people who always make the most rational choices versus real Humans).  The core premise of economic theory is that people choose by optimizing.  Of all the goods and services a family could buy, the family chooses the best one that it can afford.  This premise of constrained optimization, that is, choosing the best from a limited budget, is combined with the other major workhorse of economic theory, that of equilibrium.  In competitive markets where prices are free to move up and down, those prices fluctuate in such a way that supply equals demand. To simplify somewhat, we can say that Optimization + Equilibrium = Economics.  This is a powerful combination, nothing that other social sciences can match.  (It’s too bad it is generally not true).

Pg. 18:  Endowment Effect:  In economists’ lingo, the stuff you own is part of your endowment and people value things that they already own more highly than things that could be part of their endowment, that were available but not yet owned.

Pg. 34:  Humans, as opposed to Econs, find losses twice as painful as equivalent gains.  This has become the single most powerful tool in the behavioral economist’s arsenal.

Pg. 80:  Because racetracks take about 17% of each dollar wagered, bettors are collectively losing money at a rate of 17% per race. 

Pg. 87:  The bulk of Adam Smith’s writings on what we would now consider behavioral economics appeared in his earlier book The Theory of Moral Sentiments, published in 1759.

Pg. 89:  From Adam Smith in 1776 to Irving Fisher in 1930, economists were thinking about intertemporal choice with Humans in plain sight.  (Intertemporal choice: choices made about the timing of consumption).  Econs began to creep in around the time of Fisher, as he started on the theory of how Econs should behave, but it fell to a twenty-two-year old Paul Samuelson to finish the job.  Samuelson at the University of Chicago set out to give economics a proper mathematical foundation. 

Pg. 131:  Perceptions of fairness are related to the endowment effect.  Both buyers and sellers feel entitled to the terms of trade to which they have become accustomed, and treat any deterioration of those terms as a loss.  This feeling of ownership of the usual conditions of sale is particularly true when a seller starts to charge for something that has traditionally been given away for free or included in the price. 

Pg. 173 footnote:  Journal of Economic Perspectives is available free online at www.aeaweb.org/jep

Pg. 208:  Modern financial economics began with theorists such as Harry Markowitz, Merton Miller and William Sharpe, but the field as an academic discipline took off because of two key developments: cheap computing power and great data. 

Pg. 250:  Author’s position on the efficient market hypo

thesis (EMH):  as a normative benchmark of how the world should be, the EMH has been extraordinarily useful.  In a world of Econs (as opposed to Humans) the author believes that the EMH would be true.  And it would not have been possible to do research in behavioral finance without the rational model as a starting point.  Without the rational framework, there are no anomalies from which we can detect misbehavior. 

Pg. 251:  When it comes to the EMH as a descriptive model of asset markets, the report card is mixed.  The author judges the no-free-lunch component to be ‘mostly true.’  There are definitely anomalies: sometimes the market overreacts, and sometimes it underreacts.  But it remains the case that most active money managers fail to beat the market.  And even when investors can know for sure that prices are wrong, these prices can still stay wrong, or even get more wrong (think ‘housing’ up until 2006).  Certainly investors who accept the EMH gospel and invest in low-cost index funds cannot be faulted for that choice. 

The author has a much lower opinion about the price-is-right component of the EMH, and for many important questions, this is the more important component.  Intuitively he believes the prices are often incorrect by a factor of 2 and the market is efficient about 90% of the time.       

Pg. 348:  The capital asset pricing model has clearly been rejected as an adequate description of the movements of stock prices.  Beta, the only factor that was once thought to matter, does not appear to explain very much.  The field appears to be converging on ‘evidence-based economics.’