Misbehaving

For much of the 20th century, economics was dominated by the notion that people behave in a rational manner that is consistent with classical economic theory. Whether the decisions were about what to purchase, how much to save for retirement, or maintaining a healthy weight, people were assumed to behave like Star Trek’s Mr. Spock—in a logical and rational manner. The problem with this approach is that human beings do not always behave as economic theory would suggest. People are driven by emotion as well as by the inability to solve complicated problems and thus cannot always behave in a perfectly rational manner. In order to deal with some of these inconsistencies, some economists and other social scientists started to question the standard economic model. The new field that emerged from this work, which has come to be known as behavioral economics, began as a small band of renegade economists who, along with researchers in psychology, searched for better ways to understand economic decision making. Today, the field has gained much wider acceptance, as evidenced by the number of leading journals that publish articles on behavioral economics as well as the number of universities that offer courses and degrees in behavioral economics.

In Misbehaving: The Making of Behavioral Economics, Richard H. Thaler of the University of Chicago’s Booth School of Business, one of the founders of behavioral economics, takes us on an entertaining journey through its evolution. Thaler’s gift for writing has produced a book that is a blend of his life as a professor, stories of other economists he met along the way, and a history of behavioral economics.

Misbehaving is divided into eight sections that take us chronologically through Thaler’s academic career, starting at the University of Rochester as a graduate student with a burning curiosity about how people behave in the real world. Along the way, we are treated to Thaler’s recollections of how he and other luminaries in the field, such as Daniel Kahneman and Amos Tversky, established behavioral economics, recounted with his self-deprecating humor and deft storytelling.

As with any analysis that goes against conventional wisdom, these early researchers encountered numerous critics. One common criticism, attributed to Milton Friedman, was the “as if” argument. Using an example from billiards, Friedman argued that expert billiards players may not understand all the geometric calculations necessary to play well, but they behave as if ;they were able to do the calculations. Similarly, managers may not understand the concept of maximizing profits by equating marginal cost to marginal revenue, but they behave as if they did.

Another criticism of the behavioral school was that although consumers and perhaps business managers might make mistakes, the stakes were small and the limited opportunities to exploit those mistakes made them unimportant. This criticism led Thaler into a riskier, though potentially more rewarding, area of research: the financial markets, where it was assumed that professional traders would be able to identify mispricings and exploit them. Because Thaler had little knowledge of the financial markets, he enlisted colleagues and graduate students, including such well-known scholars as Andrei Shleifer, Hersh Shefrin, and Shlomo Benartzi. The conclusions of Thaler and his colleagues showed that even financial market professionals are prone to make the types of behavioral mistakes that laypeople make.

Misbehaving not only addresses many of the topics that are now mainstays of behavioral economics, such as mental accounting and stock market mispricing, but also provides entertaining looks at irrational behavior in various walks of life. Using the game show Deal or No Deal, Thaler and several of his colleagues showed that participants frequently make choices that are inconsistent with expected utility theory. Research by Thaler and his former student Cade Massey showed that National Football League teams tend to behave irrationally by placing too high a value on players taken early in the annual college draft. In a personal story, Thaler describes how arguably the most ardent supporters of rationality—University of Chicago business professors—tended to make irrational choices when it came to selecting available offices by placing too much weight on the wrong factors.

Thaler concludes the book with a section devoted to how these behavioral concepts can be used to “nudge” individuals into behaving optimally.¹ Understanding human behavior can enable anyone who deals with people to find a better way of getting them to behave optimally. For example, although most people understand the need to save for retirement, surveys have shown that people tend to lack the discipline to begin a savings plan at work or to increase the amount they save as their wages increase. One solution to the problem is to change the way employees participate in a plan from “opt in” to “opt out.” Research has shown that when people must opt in to participate in a 401(k) plan, many choose not to sign up. But when they are given the choice of opting out, more people tend to contribute. Similarly, a default option that increases the amount contributed as the employee’s salary increases leads to higher contribution rates.

The lessons of Misbehaving are clear: Human beings, no matter how well trained in models of rational choice, make mistakes that are based on either emotion or a misunderstanding of the facts. Thaler shows how to avoid such errors and exploit the errors of others. He has a true gift for intertwining discussions of academic research with stories of how people actually behave. This book is an excellent read on the shortcomings of classical economic and finance theory.

—R.L.M.