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The Making of Behavioural Economics

Richard Thaler

Gave his students grades out of 137 instead 100, and told them "This scoring system has no effect on the grade you get in the course, but it seems to make you happier." And, after I made that change, I never got another complaint that my exams were too hard.

If everyone was an Econ, we would all save for our retirement. But we're Humans, so we don't unless we're nudged.

Problem of Hindsight Bias - if something goes wrong, we greatly over-estimate how well it should have been anticipated.

We use heuristics - simple rules - to make decisions. "Do you think Dhruv is a common name world-wide?" If you live in the West you'd say no. But it is a common name in India, and since India has a large population, it is a common name. So just because you can't recall anyone by that name isn't a good basis for decision-making.

Asked whether more gun deaths in US are caused by homicide or suicide, most people will say homicide, but in fact twice as many suicides as murders.

To really learn from experience you need two things - frequent practice and immediate feedback. And we get that from small scale stuff, like buying milk and bread, bc we do it often. But we don't get that from big stuff like buying a car or choosing a spouse, bc we do it so infrequently. So even though the stakes have increased dramatically, our decisions are likely to be much worse.

It is illogical to think that someone who is not sophisticated enough to choose a good portfolio for their retirement will somehow be sophisticated about choosing an expert to advise them.

You're lying in the sun on beach on a hot day. You send your mate to buy cold drinks. You will be prepared to pay more for a cold drink that he buys for you from a flash hotel than from a shabby bottle store, even though you're not getting anything in any way better.

Everyone has items in closet that rarely wear, but bought bc they were a 'good deal'.

We care about sunk costs. Vince pays $1000 for right to play tennis once a week at a flash club. After two months he develops tennis elbow, but he keeps playing, even though painful. If a friend offered him game for free at another flash club, he would refuse bc of the pain, but bc he's paid the $1000 he keeps going to his club.

Common scenario of wine collectors. They have a bottle of wine for which they paid $20 five years ago. It is now worth $80. He now decides to drink the bottle. Surveyed collectors to ask what that drink cost them:

a) nothing, I already paid for it (30%)
b) $20, what I paid for it (18%)
c) $20 plus interest (7%)
d) $80, what I could get selling it (20%)
e) -$60, saved by paying $20 for an $80 bottle (25%)

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So over half thought it was either free, or it saved them money. Of course correct answer according to economic theory, is that it cost you $80, since that was what you were giving up by drinking it. (The $20 buy cost is gone, no matter what you do, all that remains is the opportunity cost of selling the bottle). You can get people to see this by asking them how they would feel if they accidentally smashed the bottle - then nearly everyone will tell you they lost $80.

(The author, himself an economist, admits to being Human with his precious wine - when he hauls out a vintage bottle, he doesn't want to know what he could sell it for.)

In Econ theory, removing an option should never make you happy. But author put a bowl of cashews on table as friends waiting for dinner to be served. Noting how quickly everyone was tucking in, he removed the bowl and out it out of sight in the kitchen. Everyone thanked him.

Walter Mischel's famous marshmallow expts on self-control also used Oreo cookies. One video showed a kid unable to resist the temptation of the cookies carefully pulling each one apart, licking out the delicious filling, then re-assembling them as best he could.

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At any point in time an individual is two selves - a forward looking planner with good intentions who cares about the future, and a devil-may-care doer who just cares about the present. The planner is a benevolent dictator but she has limited control over the doer, especially if the doer is aroused in any way by food, sex, alcohol, or an urgent desire to go outside and goof off. But we all are in denial about the gap between our hot and cold motivations.

Car sales tried rebates to stimulate sales, but they gradually lost impact as others copied. So then offered low or no-interest loans, which were far more popular. But when actually crunched the numbers, you were better off with the rebate. But "$700 off" seemed like a small fraction of the purchase price, whereas interest rates a third of normal rate, sounded like a major bargain.

A store normally sells snow shovels for $20. During a big snow storm they double the price. 82% think this is unfair; 18% rate as acceptable. That's if you ask Joe Public. But if ask a class of MBA students, figures other way round 76:24%.

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Store finds one last Cabbage Patch doll in a sold out market one day before Christmas. They announce they will auction it to highest bidder. Unfair 74%, acceptable 26%. So they announce that proceeds to charity, now 79% rate as acceptable.

Car dealer selling popular car with a wait list. He now charges a $200 premium. Unfair 71%, acceptable 29%. Same situation, except that in the past he's been selling those cars at $200 discount. Now that there's a wait list, he reverts to list price. Acceptable 58%, unfair 42%./

Thomas Kuhn's model of scientific revolutions is that paradigms change only once experts believe there are too many anomalies that are not explained by the current paradigm.

Dutch gameshow variation on the Prisoner's Dilemma calledGolden Balls. Two players divide a pot. Can choose either 'split' or 'steal'. If both say split, they split the pot. If one says split and other says steal, then the stealer gets the lot. But if both say steal, neither gets anything. (They could make statements about their intentions prior to commitment, but the only reliable one was an explicit promise to split - people tend to lie by omission, but are less keen to tell a direct lie.

When taxpayers come to fill out their annual return, if they find they owe the govt money, will almost always go back and invent some expenses to tip the balance.

Some objected to Nudge bc saw it as 'paternalistic', but authors point out their objective was to "influence choices in a way that will make them better off, as judged by themselves."

Only worthwhile nudge on disasters like Katrina was a NYT suggestion that if people refuse to move to higher ground they should be given a black marker and told to write their Social Security number on their body to aid identification of victims.

(London Times)

The closest I ever got to a Nobel prize was when, years ago, I was sitting next to a colleague, an economist, who was poring over a page of figures and muttering: 'Why won't people maximise their utility?' I saw at once about a dozen answers to that question, including idleness, stupidity, daydreaming, better things to do and uncertainty about what their 'utility' was. I did not know but I was a decade ahead of my time. I had stumbled upon behavioural economics (BE).

The creation of BE was what historians of science call a 'paradigm shift', a fundamental change in our view of things. Einstein's relativity, for example, was a move away from Isaac Newton's 'clockwork' view of the universe. Such a shift does not invalidate all that came before. You can still land a man on the moon using Newton, but your satnav wouldn't work without Einstein. Equally, classical economics still works but BE, like relativity, has exposed it as no more than a generalisation.

What happened was that in the late 1970s two great psychologists - Daniel Kahneman and Amos Tversky - began to conduct experiments that undermined our understanding of human rationality. They found that we all do mathematically stupid things all the time. Not only that, we made these errors so consistently one could actually predict irrationality.

This was a problem for classical economists because their world view was based on the assumption of the rational agent. 'We have,' observed the pro- BE economist Kenneth Arrow, 'the curious situation that scientific analysis imputes scientific behaviour to its subjects.'

Not, apparently, noticing the absurdity of this idea, economists ignored all evidence of irrationality in the conviction that these aberrations in human conduct - misbehaviour - would always be smoothed out statistically.

But some, including Richard H Thaler, realised that the great ship of classical economics had sprung a potentially fatal leak.

Conventional wisdom seldom survives first contact with BE. Saving money by paying employees as little as you can is, for instance, counterproductive: employer generosity is generally rewarded by more dedicated employees.

Then there is what Thaler calls the endowment effect, which means that people tend to overvalue what they have, even when offered a very favourable deal. This explains a crucial BE discovery: people are much more upset by losing £100 than they would be happy about gaining the same sum. This is an irrational distortion that affects all sorts of spending and investment decisions.

Misbehaving takes us on a tour round these and many other discoveries. It is a long, genial, often humorous account of the progress of BE by one of its most gifted practitioners. Kahneman has described Thaler as lazy; he meant it as a compliment because Thaler's laziness means he concentrates only on the really important questions that get him out of bed in the morning. Thaler is also an odd combination of combative and liberal-minded. At some points in this book he seems ready to beat up some opponents of BE; elsewhere he bends over backwards to say they are not completely wrong.

The truth is, though, he thinks they are. He calls the supposedly rational agents of classical economic 'Econs', and the irrational agents of BE 'Humans'. The latter are real, the former are a fantasy. 'A theory of the behaviour of Econ,' he writes, 'cannot be empirically based, because Econs do not exist.'

BE isn't, strictly speaking, new. Adam Smith, the godfather of modern economics, showed a lively awareness of the human factor, and John Maynard Keynes used the phrase 'animal spirits' as away of including real, capricious humans in his analyses.

Nevertheless, in the latter half of the 20th century, the idea of mathematically readable rational agents took hold and sustained an assortment of wrong-headed ideologies, most obviously market fundamentalism. This was undermined in turn not just by BE but also by the astoundingly irrational behaviour exposed by the 2007/8 crash.

The seeds of BE were sown by Kahneman and Tversky. By the 1990s, Thaler was well under way with his research into the misbehaviour of all those supposedly rational agents.

But the idea was first popularised in 2005, in Freakonomics by Steven D Levitt and Stephen J Dubner. Memorably, this book showed that the crime rate in American cities was not reduced by new forms of policing but by the liberalisation of the abortion law.

Thaler himself became famous with Nudge (2008), co-written with Cass Sunstein. It showed a way of integrating BE into public policy by introducing aform of soft paternalism (they call it libertarian paternalism) that aimed, through gentle and sometimes subliminal encouragement, to induce people to do the right thing, which was also the thing they really wanted to do. The most famous example was the drawing of a fly in the urinals at Schiphol Airport that cut cleaning costs by nudging men to aim straighter.

David Cameron's government embraced the idea - not the fly, the analysis - and Nudge was, for a while, the policy wonks' favourite book.

In spite of which, Thaler acknowledges that BE has had little effect in macroeconomics, the study of economies as a whole as opposed to their parts. This is the economics that generates the big figures with which we are daily assaulted.

Whether BE can be scaled up to change the way these numbers are generated is, so far, an open question.

Misbehaving is along but, on the whole, enjoyable read. Thaler communicates his ideas clearly, although the eccentricities of the recruitment of players in American football eluded me and, I confess, after 300 pages I was beginning to feel a little battered by the number of case studies. Nevertheless, this is important stuff and BE should be celebrated. The overthrow of mechanistic, scientistic economics is an unarguable good, and every time you see a fly in a urinal (there are now millions around the world) you should cheer BE and the legions of misbehavers otherwise known as you and me.

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