Book Review: Misbehaving
In my previous book review, I shared about The Undoing Project by Michael Lewis, which is a biography of two prominent psychologists, Daniel Kahneman and Amos Tversky, and the unique friendship that they shared. Interestingly, the book also introduced how Richard Thaler, coauthor of bestselling book Nudge and the 2017 recipient of the Nobel Memorial Prize in Economics, helped to start the field of Behavioural Economics, by getting to know Kahneman and Tversky.
When Kahneman and Tversky presented their findings of how human behaviour violates assumptions in classical economic theory, not all economists were receptive to the idea. There was one economist, however, who had always felt out of place among economists, and thought that Kahneman and Tversky’s research made a lot of sense. This person was none other than Richard Thaler. Thaler noticed this peculiarity as well, and decided to keep a list of irrational things people do, that economists claim they don’t do because economists presume that people are rational. He used methods like questionnaires to study the research questions he had, which were unconventional in economics, to the point where his advisor told him to stop wasting time and start doing real economics. And when he shared his findings with other economist colleagues, they brushed him off and argued that people do make mistakes randomly from time to time.
Thaler struggled to push this idea forward, until in 1976 he came across Kahneman and Tversky’s “Judgment Under Uncertainty” article in the reputable journal of Science, which sought to explain why people did irrational things. He was thrilled with this discovery, and went to look for all the other publications by Kahenman and Tversky. He realised that contrary to his colleagues’ idea that people made mistakes randomly, if people actually had a systematic bias, they wouldn’t be able to ignore their mistakes. What convinced Thaler even more, was that Kahneman and Tversky had used mathematics to back their findings, which would definitely be more appealing to economists. Thaler wasted no time in finding the mailing address for the Hebrew University Psychology Department, wrote a letter to Tversky, and the rest is history.
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“Misbehaving” is a book written by Richard Thaler, describing his own journey in establishing the field of Behavioural Economics. While his background isn’t exactly covered in the book, Thaler is an American economist at the University of Chicago Booth School of Business. He received his PhD degree in 1974 from the University of Rochester, writing his thesis on “The Value of Saving A Life: A Market Estimate”. In 2008, Thaler shot to fame in pop science literature with his coauthor Cass Sunstein for their book Nudge, which discusses how public and private organisations can help people make better choices in their daily lives. Then in 2017, Thaler was awarded the Nobel Memorial Prize in Economics for “incorporat(ing) psychologically realistic assumptions into analyses of economic decision-making” and for “show(ing) how (some) human traits systematically affect individual decisions as well as market outcomes”.
“Misbehaving” captures the events between 1970 to after 2004, that influenced Thaler in striving to change the perspective that economics have of human behaviour. In this book review, I will not summarise every single event, but instead, focus on some of the concepts invented by Thaler while he was shaping the field of Behavioural Economics.
Supposedly Irrelevant Factors
Supposedly Irrelevant Factors (or SIFs) are things that should normally not influence the considerations of an Econ (a hypothetically rational person) according to economic theory, but actually turn out to have an effect on their decisions. Thaler argues that there are many assumptions in economic theory that ignore these SIFs, resulting in its inability to accurately describe and predict human behaviour. He believes that by including SIFs in traditional economics, theories that describe human behaviour will become more realistic, and their predictive power will also increase. This was how the field became known as “Behavioural Economics”, which he says is still economics, but is being meaningfully informed by psychology and other social sciences.
Endowment Effect
The endowment effect is a phenomenon where people value what they own more than things that they do not own or have yet to own, even if they were of the same cost. According to economic theory, if the objects are of the same monetary value, then such preferences should not exist, which makes the endowment effect an SIF. Yet Thaler and other decision-making psychologists like Kahneman and Tversky consistently find this effect in the experiments that they conduct. One of the most famous examples is the study where Thaler and Kahneman gave participants a mug, and then offered them a chance to sell it or trade it for an equally valued object. They found that the amount participants required to compensate the ownership of the mug (“willingness to accept”) was approximately twice the amount they were originally willing to pay for the mug (“willingness to pay”).
Thaler attributed this effect to loss aversion and status quo bias. He believes that mentally, giving up the mug that they already own may be considered a “loss” for the participants. And besides, people usually stick to what they have, unless there is a good reason to switch, and even despite there being a good reason to switch. Thaler suggests that the loss aversion and status quo bias often work together to inhibit change, and policies that want to drive behaviour change need to take them into consideration.
Mental Accounting
Mental accounting is the act of budgeting money into different expense categories, ignoring the fungible property of money. In classical economic theory, Econs should presumably treat all their money as the same, regardless of where it comes from or what it will be used for. But more often than not, people and organisations don’t actually behave that way. Despite having no real difference in terms of money, people treat the cash on their hands and the savings in their bank accounts very differently. “If it isn’t labelled as savings, I don’t have to save a penny of it” is the type of mentality many people have. Similarly, many companies have clearly defined budget rules. If the budget for a certain purpose has leftover money, it may not necessarily be easy to use it for other purposes, even if it is to the interest of the company.
While this behaviour would seem irrational in the eyes of an Econ, Thaler acknowledged that it may not be all that bad. Mental accounting forces people to live within their means, especially if they are not disciplined enough to stick to their financial plans. Clearly defined budgets in companies also ensure that departments don’t count on the budget to be flexible and end up overspending. But if these budgets become too rigid in any case, bad decision-making can still ensue.
Libertarian Paternalism
The word “paternalism” is often frowned upon by liberal societies, as people generally don’t like the idea of the government, or anyone else for that matter, telling them what to do. So when Thaler coined the term “Libertarian Paternalism”, it sounded to many like an oxymoron. But Thaler explained that it isn’t an oxymoron, because what he means by “paternalism” is the act of helping people to achieve their own goals, which in an analogy is showing the way to someone who is already looking for the subway station. And the reason why he used “libertarian” to describe the type of “paternalism”, is because he feels that such “paternalism” does not have to restrict choices. But the term “Libertarian Paternalism” was never going to catch on, so one publisher suggested another word that seem to capture this meaning, and that was how the term “nudging” was born.
One of the most famous examples of nudging used in public policy is the default option of organ donation. Countries that have an opt-out policy for organ donation often see a higher donor rate than countries with an opt-in policy. Technically, countries with an opt-out policy are not forcing people to donate their organs after they pass on, as people are still given the choice to opt-out. But because now the donors don’t have to make an active choice, they will generally stick with the default if they don’t have a preference.
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The concepts above are probably Thaler’s most important contributions to the field of Behavioural Economics. The book “Misbehaving” is a great place to start for anyone who is new to the field of Behavioural Economics and is interested to learn more. For people who are already familiar with Behavioural Economics, the history and details of what inspired Thaler still makes the book a pretty fascinating read. However, it would be a mistake to assume that the book covers all there is to know of Behavioural Economics. While Thaler played an important role in formalising this field, there are also other brilliant researchers whose ideas and work have helped to lay the foundation of Behavioural Economics, and Thaler has given due credit to many of them in his book.
In my next book review, I will share about an agency that was founded based on Thaler’s concept of “nudging”, from the book Inside the Nudge Unit by David Halpern.
If you would like to know more about Michael Lewis’ “The Undoing Project”, check out this book review:
If you would like to know more about David Halpern’s “Inside the Nudge Unit”, check out this book review:
Originally published at: https://learncuriously.wordpress.com/2020/04/24/book-review-misbehaving
