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Take-Aways Economics is the most influential of the social sciences because of its far- reaching theories and their impact on people’s lives – however, its assumptions are faulty.  Standard economic models posit that people are always rational and that markets send reliable signals.  Instead peop...

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Economics is the most influential of the social sciences because of its farreaching theories and their impact on people’s lives – however, its assumptions are faulty. Standard economic models posit that people are always rational and that markets send reliable signals. Instead people “misbehave.” Their routine use of heuristics leads to errors in judgment and to biases that belie rational decision making. Behavioral economics incorporates psychology and other social sciences into economics. It finds that people value what they own more than what they could acquire. Investors dislike losses about twice as much as they like gains. Most people can’t ignore sunk costs, though that’s the most rational response. Investors who check their portfolios more frequently tend to invest more cautiously. The efficient market hypothesis is a useful guide to how markets should work, but it’s less effective in predicting actual market behavior. 136 nations, including the US, have applied behavioral science to some public policies.

Summar y Accounting for Human Behavior in Economics Economics is the most influential of the social sciences because of its far-reaching foundational theories and their impact on people’s lives. These theories say that individuals always make optimal purchasing decisions within their budgetary constraints and that free markets tend toward a state of equilibrium in which the supply of a good or service equals its demand. “Behavioral economics is more interesting and more fun than regular economics. It is the undismal science.” But these assumptions are faulty. Ideal decision making is impossible for ordinary people. Consider the act of shopping at a supermarket. With the countless goods available, how can individuals always make the best choices? Optimizing is even harder in such tasks as choosing a spouse; high divorce rates suggest that marital selections are hardly optimal. “As cruel as the market can be, it cannot make you rational.” Unbiased decision making is another flawed staple of economic theory. Economic models have substituted the human being, or Homo sapiens, for “a fictional creature called Homo economicus,” or “Econ,” a perfectly rational decision maker who always optimizes. Real human decision making often amounts to “misbehaving” in the artificial world of economics, so forecasts based on the rational behavior of Econs are

often wrong. For example, few economists predicted the financial crisis of 2008 because it “simply could not happen” in their version of economic reality. “A theory of the behavior of Econs cannot be empirically based, because Econs do not exist.” While economic models in which everyone behaves like an Econ still have value as “useful starting points” for accurate analyses, better explanations of the economy are emerging from behavioral economics, which incorporates psychology and other social sciences into economics. “The Endowment Effect” The endowment effect is one of many, predictable human misbehaviors that should limit analysts’ reliance on Econs’ theoretical behavior. Unlike Econs, people value what they already own – their endowment– more than whatever they could acquire and add to it. “Most of us realize that we have self-control problems, but we underestimate their severity. We are naive about our level of sophistication.” For example, consider the retail pricing of cash versus credit card purchases when cards first appeared. Because retailers had to pay fees to the credit card issuers, retailers wanted to charge customers more for credit card purchases. But the issuers insisted that if a retailer chose to set different prices, the normal price should be what credit card customers paid, while cash customers would get a discount off the regular price. Whether the price differential is a surcharge or a discount doesn’t matter to an Econ, since the two pricing policies are identical. However, the practice of calling the difference a discount helped the credit card industry. People tend to perceive a surcharge as an out-of-pocket expense, which they dislike, while forgoing a cash discount is only an opportunity cost to which they’re indifferent. Hindsight, Heuristics and Other Misbehaviors Psychologist Baruch Fischhoff wrote a thesis on hindsight bias – that is, people’s tendency to believe, after an event’s outcome, that they always knew all along what the result would be. This propensity can hurt a company if, for example, mid-level executives risk their jobs if they promote projects that fail. For instance, a chief executive officer might fire talented staffers who were associated with an unsuccessful project just because the CEO believes the failure was predictable and thinks he or she always knew the project would flop. “One of the things MBAs learn in business school is to think like an Econ, but they also forget what it is like to think like a human.” Fischhoff worked at the Hebrew University in Israel with two other academics – Daniel Kahneman and Amos Tversky – who published a paper entitled “Judgment Under Uncertainty: Heuristics and Biases.” They wrote that people have limited time and intelligence to make good judgments, so they try to reach decisions by using basic rules of thumb, or heuristics. Kahneman and Tversky contended that the use of heuristics can lead to predictable errors and biases.

“In many situations, the perceived fairness of an action depends not only on who it helps or harms but also on how it is framed.” A forerunner of Kahneman and Tversky, Herbert Simon wrote about his concept of the use of bounded rationality in individual decision making. He posited that people don’t have the mental capacity to handle complicated problems. Economists believe that their models account for that possibility by including an “error term” in their calculations. Imagine a model for predicting the height children will attain at adulthood that uses their parents’ heights as a base. Tall adults tend to have tall offspring, so the model is accurate to some extent, though imperfect. “In physics, an object in a state of rest stays that way, unless something happens. People act the same way: They stick with what they have unless there is some good reason to switch, or perhaps despite there being a good reason to switch.” In economic terms, the model is reliable if its errors are “random,” meaning the frequency of overestimates and underestimates is equal, so that the errors offset one another. Though economists believed the error term compensated for bounded rationality in their Econ-based models, Kahneman and Tversky’s work warned that rationality-based economic models could produce nonrandom errors. Injecting Human Emotion into Expected Utility In 1944, mathematician John von Neumann and economist Oskar Morgenstern published a paper that popularized their “expected utility theory,” which economists embraced as a guide to rational choice. The authors argued that the marginal utility of wealth – that is, the value of its incremental increases – will decline as a rational individual, an Econ, accumulates wealth. “The more often people look at their portfolios, the less willing they will be to take on risk, because if you look more often, you will see more losses.” Kahneman and Tversky developed “prospect theory,” a human-based alternative to the expected utility theory. Prospect theory says changes in wealth affect people more than their absolute levels of wealth. Individuals dislike losses about twice as much as they like gains. People exhibit their loss aversion when the intensity of their distress at losing $100 exceeds the intensity of their delight at gaining $100. An Econ, of course, would feel distress or delight in equal measure. “It is much easier to detect that we may be in a bubble than it is to say when it will pop.” Loss aversion, which can vary by circumstances, constitutes another common form of human misbehavior that undermines economic convention. Investors who lose money may take unusually big risks to move their portfolios back to a break-even point. Ain’t Misbehaving? The influential philosopher Adam Smith famously used the metaphor of an invisible hand to describe how the independent actions of buyers and sellers make markets work for the benefit of society. The implication of the metaphor is that this unseen

force somehow discourages irrational decision making that is detrimental to society. But the power of the invisible hand is “both overstated and mysterious.” The assertion is that markets somehow discipline people who are misbehaving, but no logical argument supports the notion that markets turn people into perfectly rational agents – that is, Econs. “Even when investors can know for sure that prices are wrong, these prices can still stay wrong or even get more wrong.” The sunk-cost fallacy is another source of irrational behavior that economics can’t explain. Economists say ignoring sunk costs is logical. An old maxim, “Don’t cry over spilt milk,” expresses the same idea. Imagine buying expensive shoes that end up hurting your feet. Many people will go on wearing them, despite the pain, because they refuse to acknowledge the loss. Large-scale errors can stem from believing the sunk cost fallacy. The United States, for example, may have prolonged the Vietnam War because of a belief that Americans had sacrificed too much to withdraw from the conflict before it finally ended. The Fairness Factor Research shows that people believe companies are behaving unfairly when they raise prices to increase profits, but that they are acting appropriately when they raise prices to cover increased costs. Fairness can benefit firms, especially those that serve the same customers over the long term. Perceptions of fairness have their roots in the endowment effect. Buyers and sellers who become accustomed to the terms of their transactions develop a sense of entitlement and will perceive a downgrade of the terms as a loss. “Economists are really good at inventing rational explanations for behavior, no matter how dumb that behavior appears to be.” Additional evidence that rational Econs are fundamentally different from real human beings emerges from a fairness game called the “public goods” game. The outcomes consistently show that some people are cooperative even when that behavior is contrary to their own financial interests. Researchers give 10 players five $1 bills each and tell them they can anonymously contribute any amount (or none) to a public good. Researchers will then double their donations and distribute the proceeds equally to all the players. The logical individual strategy would be to make no contribution: If you donate $1, you will get back just 20 cents of your dollar with no acknowledgement of your generosity, while everyone else gains an incremental 20 cents. But in practice, players typically contribute about half their stakes, on average, to the public good. Missing the Big Picture The concept of narrow framing means viewing events or transactions separately, not as part of a larger body of experience. An investor’s reasons for focusing on events or items in isolation can include “myopic loss aversion.” In an experiment to demonstrate this aversion, investors who saw their portfolio results more frequently – and thus had a greater chance of seeing losses – invested with greater caution.

Those who saw their results eight times annually put 41% of their portfolios in riskier stocks, but those who saw results once a year put 70% in shares.

Reconsidering the Efficient Market The efficient market hypothesis holds that a share’s price reflects its true value. For a dividend-paying stock, that consists of the present value of future dividend payments. But in 1981, Robert Shiller, now a professor of economics at Yale University, published research showing that while this value was stable, the actual prices of dividend-paying stocks were extremely variable. Shiller thus dented the notion that the stock market is perfectly priced, but the debate over the efficient market hypothesis goes on. “Nudges are effective for humans but not for Econs, since Econs are already doing the right thing.” The hypothesis would also predict, for example, that the price of shares in closed-end funds would equal their net asset value. Yet shares of closed-end funds usually sell at 10% to 20% discounts to net asset value. The efficient market hypothesis is a useful “normative” guide to how markets should work, but less effective as a “descriptive” tool for predicting real market behavior. Prodding the Public Econs always act rationally, but flawed human beings make mistakes and sometimes need a “nudge” in the right direction. That’s why many companies automatically enroll new employees in retirement plans. Some firms obtain their employees’ consent to put more of their paychecks into savings as their wages rise. In another example of nudging, Amsterdam’s Schiphol International Airport encouraged men to take better aim when using airport urinals by placing the image of a housefly near the drain on each urinal. This reduced “spillage” by 80%. “Behavioral scientists have a lot of wisdom to offer to help make the world a better place.” A 2014 study calculated that 136 countries, including the US, have embraced behavioral sciences in at least some public policies. The United Kingdom has experimented with letters urging citizens to pay their delinquent taxes. The most effective missive included a nudge stating that the “great majority of people…pay their taxes on time” and that the neglectful taxpayer is in a tiny minority of those who don’t pay punctually. The new language raised the number of people paying their taxes on time by more than five percentage points. Nudging the Profession Since the 1970s, behavioral economics has transcended its former status as a “fringe operation” in the study of economics. Surprisingly, the behavioral school of thought has influenced finance more than any other industry due to its allegiance to

fundamental theories that researchers can test using the sector’s massive trove of analyzable data. But realistic behavior-based thinking is still largely absent from the field of macroeconomics, where Econs roam free. Behavioral analysis could improve the success rate of tax cuts intended to ignite economic growth. And because people fear loss more than they like gains, mitigating the cost of business failures could encourage more entrepreneurialism. Behavioral economics eventually may cease to exist as a special segment of the economics profession, and then economics will be “as behavioral as it needs to be.”

Aboutt heAut hor Richard H. Thaler, the American Economic Association’s 2015 president, is a professor of behavioral science and economics at the University of Chicago. He cowrote the bestseller Nudge...