Misbehaving | Richard H. Thaler

Summary of: Misbehaving: The Making of Behavioral Economics
By: Richard H. Thaler


Dive into the realm of behavioral economics as we explore Richard H. Thaler’s book ‘Misbehaving: The Making of Behavioral Economics’. Uncover the shortcomings of traditional economic theories and their unrealistic assumptions that individuals always make optimal decisions. The introduction of behavioral economics brings in the study of psychology and the predictably irrational ways in which real people behave. This summary will discuss concepts such as the endowment effect, hindsight bias, heuristics, prospect theory, loss aversion, the invisible hand, and the power of nudging people towards better decision-making.

The Imperfections of Economic Theory

Economics is considered influential because of its foundational theories, which assume that individuals make optimal decisions and free markets tend towards equilibrium. However, these assumptions are flawed. Human decision-making is often biased and imperfect, which leads to inaccurate economic forecasts. Behavioral economics, which integrates psychology and other social sciences, provides better explanations for economic behavior. While economic models assuming everyone behaves like a rational decision-maker still have value, they are not based on reality. Decision-making in everyday life, such as shopping or choosing a spouse, is far from optimal. The financial crisis of 2008 also revealed the shortcomings of economic models based on the rational behavior of “Econs.” In conclusion, behavioral economics offers a more interesting and accurate alternative to traditional economic theory.

The Endowment Effect and Human Misbehavior

Humans have a predictable misbehavior known as the endowment effect, which makes them value what they already own more than what they can acquire. This limits analysts’ reliance on Econs’ theoretical behavior. People underestimate their severity of self-control problems while overestimating their sophistication level. Credit card companies offered discounts to those who paid with cash to combat this effect because people dislike surcharges rather than forgoing a discount. Understanding the endowment effect can help companies better market their products and services.

Hindsight Bias and Bounded Rationality in Decision Making

Psychologist Baruch Fischhoff suggests that humans tend to exhibit hindsight bias – believing they knew all along what the outcome of an event would be after it has already happened. However, this bias can be detrimental to businesses as decision-makers may penalize individuals associated with a failed project. Fischhoff’s colleagues Daniel Kahneman and Amos Tversky contended that the use of shortcuts or heuristics can lead to predictable biases and errors in decision-making. economist Herbert Simon’s approach of using bounded rationality in decision-making suggested that individuals do not have the mental capacity to handle complicated issues. The errors in the economist’s model of including an “error term” are only random, so the frequency of overestimates and underestimates are equal. However, Kahneman and Tversky’s work implies that rational decision-making models could produce non-random errors.

Rational vs. Human-Based Economic Theories

In 1944, economists John von Neumann and Oskar Morgenstern presented their popular “expected utility theory” that suggests the marginal utility of wealth decreases as individuals accumulates more wealth. However, psychologists Kahneman and Tversky proposed an alternative “prospect theory” that emphasizes human irrationality in decision-making. According to prospect theory, changes in wealth impact people more than their absolute levels of wealth and individuals display aversion to losses, twice as much as their fondness for gains. This theory highlights that humans’ emotional biases and reactions can contradict rational economic principles. One such bias is loss aversion, where people take excessive risks to recover from losses. Despite economists’ preference for mathematical models, prospect theory shows how human emotions and behaviors can affect economic performance.

The Limits of Market Rationality

The invisible hand and sunk cost fallacy expose the limits of rational behavior in markets and economics.

The invisible hand, a metaphor coined by Adam Smith, posits that independent actions of buyers and sellers benefit society through disciplined behavior in markets. However, the power of the invisible hand is both overstated and mysterious, as markets do not necessarily turn individuals into perfectly rational agents. Even when prices are known to be incorrect, markets may not rectify them. Similarly, the sunk cost fallacy, where individuals persist in investing in something despite the harm it causes, calls into question the rationality of economics. Although economists promote the notion of ignoring sunk costs, large-scale errors, such as the prolonged Vietnam War, may occur because of a commitment to realizing a perceived loss. The importance of these concepts lies in their recognition of the limits of rational behavior in markets and economics. By acknowledging these limitations, we can immunize ourselves from costly errors and broaden our understanding of market activity.

The Psychology of Fairness

Companies can benefit from fairness, but perceptions of fairness are complex. People tend to view price increases to cover costs as appropriate but view increases to increase profits as unfair. This is due to the endowment effect where people feel entitled to the terms of their transactions. Research has shown that people’s behavior is not solely driven by rational economic explanations, and some are cooperative even if it’s not in their financial interest. This is evident in the public goods game, where players contribute about half their stakes on average to the public good. This game showcases the gap between rational Econs and real human beings. Companies that serve customers over the long term should prioritize fairness as it could benefit their business.

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