Misbehaving: The Making of Behavioral Economics

 

Summary:

What do economics, psychology, and experimental science have in common? As Richard Thaler implies in Misbehaving, most economists would say little to none — but this couldn’t be further from the truth. Misbehaving is, first and foremost, a story of how modern economics, finance, and theoretical analysis have become increasingly specialized and narrow without substantial practical value. Utilizing empirical studies and anecdotes, funny stories, and even some jokes, Thaler persuades the reader that behavioral studies — or psychology-motivated disciplines which focus on humans, not mythical rational agents — are here to stay. Finally, as the book progresses, it becomes increasingly clear that a behavioral revolution in the realm of public policy is on the horizon. Ultimately, organizations will not thrive unless their assumptions and forecasts focus on people.

Connection to Ethical Systems:

Thaler’s findings have numerous and far-reaching implications for designing and implementing ethical systems within organizations. In order to promote a strong ethical culture, widespread awareness of policies and modeling ethical behavior remain imperative at all levels.

On the managerial side, incentivizing ethical behavior in the workplace can be achieved via simple guidelines. First, if issues exist, make it easier for employees to speak up within the company. This can be done by reducing red-tape and bureaucratic measures, adding am ombuds program and creating a whistleblowing hotline. Secondly, it is important to remember that people — not economic models — are highly sensitive to fairness and emotional impact. If you want employees to act justly and productively, acknowledge how business decisions will affect communities and employees. Lastly, swift, systematic punishment for unethical behavior should be broadcast widely to reinforce their commitment to ethics and regulation.

On the employee side, one lesson needs to be emphasized: even managers and executives are humans, subject to their own biases and mistakes. Generally speaking, an us vs. them attitude can be pervasive in organizations. In order to overcome this mindset and promote ethical behavior, both employees and managers would do well to acknowledge the possible biases and boundaries of rationality and find solutions to combat conflict of interests.

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PART I: BEGINNINGS 1970–78

Overview:

Too often, formalized economics is assumed to be a bulletproof system. However, most economic models neglect the study of Humans, and instead study “Econs.” In times when models fail greatly — during financial crises or simply in everyday life — economists brush off this criticism and errors by referring to Supposedly Irrelevant Factors (SIFs).

What are some of these SIFs? Consider the endowment effect. Studies and experiments have shown that people value things that they already own or feel connected to (or their “endowment”) more highly than things that could be part of their endowment. Essentially, the more personal the decision, the less economic models can remain accurate.

Additionally, consider sunk costs, or costs that were undertaken in order to realize a certain project or activity. Normally, economists stress that the utility of a project or action does not and should not depend on sunk costs. However, as Thaler proves, this is not the case with Humans. People constantly think about what they spent and their utility can be related to such costs. Finally, unlike Econs, Humans use simple rules of thumb called “heuristics” to help them make judgments. To expect normal people to engage in complex analysis in most situations — even business-related ones — remains unrealistic. Humans clearly have “bounded rationality”.

In order to account for these “SIFs,” Thaler introduces “Prospect Theory.” Prospect Theory displaces mainstream notions of utility, as two core findings underpin the theory. First, people’s happiness increases as they get wealthier, but at a decreasing rate. Utility is essentially marked by “diminishing sensitivity.” Secondly, changes in wealth matter more than levels of wealth. Ostensibly, Humans will be risk-averse for gains, but risk-seeking for losses.

However, this is not to say that Prospect Theory is perfect. However, the mere existence of “SIFs” and Prospect Theory is telling. A more enriched approach to doing economic research which focuses on Humans — or behavioral economics— is imperative and has begun to flourish. This book is the story of how such growth occurred.

 Notable quotes:

“Humans do a lot of misbehaving, and that means that economic models make a lot of bad predictions, predictions that can have much more serious consequences than upsetting a group of students.”

“In saying that people have bounded rationality, Simon meant that they [Humans] lack the cognitive ability to solve complex problems, which is obviously true.”

 “As cruel as the market may be, it cannot make you rational. And except in rare circumstances, failing to act in accordance with the rational agent model is not fatal.”

Applications to ethical systems design:

• If designing ethical systems for the workplace, don’t assume that employees — or people in general — will always make the “rational” choice. There are many different factors at play, and each person’s decision will depend less on facts and more on their beliefs, biases, and interpretation of the different elements. See a study on rational choice and decision making.

• If you’re in a leadership position, ask yourself if your decision is one that is truly ethical or one that is personally-motivated. In order to arrive at more comprehensive decisions, perhaps push yourself to actively seek out outside opinions. 

• Connect to “walking the talk” and modeling leadership behavior that influences others to act ethically.
   
• People are highly sensitive to change. In order to build a substantive ethical system and culture, implement new rules gradually to promote continual ethical behavior.

 

PART II: MENTAL ACCOUNTING 1979–85

Overview:

In Part II, Thaler builds on previous SIFs and introduces new ones. First, contrary to modern economic theory, there are two types of utility: “acquisition utility” and “transaction utility”. Acquisition utility is based on standard economic theory and resembles a “consumer surplus” where one gains purely monetarily for given prices. On the other hand, transaction utility is the difference between the price actually paid for the object and the price one would expect to pay in a certain situation. Basically, transaction utility is a quality judgment based on sunk costs and situational factors. What makes transaction utility problematic, though, is that Humans have trouble separating sunk costs from out-of-pocket costs and other expenses. This fact allows sellers to change the perceived reference price and create the illusion of a “deal.”

Moving away from individuals, Thaler also discusses budgets of households and companies. In organizations, there are usually limits for specific categories within those budgets, as bosses do not want to approve every expenditure made in the organization. However, the very existence of budgets violates a core principle of traditional economics: that money is “fungible”, or that it has no labels restricting what it can be spent on. This leads to Thaler’s observation that people generally spend money — without budgeting — via “two-pocket” mental accounting. When people fluctuate between gaining money and then losing the gains — during a game such as Poker — or when people earn money without saving it, a “house money” attitude occurs. This attitude is marked by nonchalance, as people are risk-seeking. Nevertheless, the house money effect is only applicable if people can break even or retain their amount of wealth before they gained such wealth. If they cannot, people become rigidly risk-averse and aim to limit their losses — hence, a “break-even” effect.

 Notable quotes:

“Econs do not experience transaction utility. For them, the purchase location is another supposedly irrelevant factor, or SIF.”

“Driving to the game in the blizzard, or playing tennis in pain, are mistakes no Econ would make. They rightly treat sunk costs as irrelevant. But for Humans, sunk costs linger and become another SIF, and not only for things like dinners and concerts.”

“A good rule to remember is that people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse. Watch out!”

Applications to ethical systems design:

• If ethical behavior can be incentivized with certain monetary benefits (along with its moral benefits), people may find more motivation to act ethically. This could relate to the idea that ethics pays.

• When designing ethical systems in the workplace, instituting a system which rewards hard work — or sunk costs — may improve the likelihood of ethical behavior. Since employees would be putting more effort in projects and work for certain rewards, they will also want to see and present their work as representative of their efforts and virtues.

 

PART III: SELF-CONTROL 1975-88

Overview:

With many SIFs established, Thaler focuses specifically on self-control. Unlike traditional economics, which presupposes that humans are rational actors, humans seem to be unable to contain themselves. This is because Humans are plagued by a tension between passion and reason, emotion and logic — as Adam Smith himself acknowledged.

With modern economic theory unable to account for our self-control problems, Thaler set out to create a conceptual framework to discuss such issues. The model he and partners come up with is based on a “planner-doer” metaphor. At any point in time, an individual consists of two “selves”. The first self is a forward-looking “planner” who intends to idealize and plan about the future; the second is a harmful “doer” who lives for and in the present.

Given this established metaphor, now consider an organization. For Thaler, on a more practical level, relations with firms follow a principal–agent model, which mirrors the “planner-doer” on an individual level. In a principal–agent model, the principal is the boss (most often owners and managers of firms), while the agent is someone to whom authority is delegated. Tensions occur between both principal and agent because the agent knows some things that the principal does not, while it is unrealistic for the principal to monitor every action of the agent. Thus, as a result of principal-agent tension, the firm institutes a set of rules, procedures, and norms that are designed to minimize conflicts of interest. All of these findings and theories, for Thaler, reveal that employing willpower requires effort. Humans can realize that they have self-control problems but significantly miscalculate their importance.

 Notable quotes:

“As economists became more mathematically sophisticated, and their models incorporated those new levels of sophistication, the people they were describing evolved as well. First, Econs became smarter. Second, they cured all their self-control problems. Calculate the present value of Social Security benefits that will start twenty years from now. No problem! Stop by the tavern on the way home on payday and spend the money intended for food? Never! Econs stopped misbehaving.”

“To understand the consumption behavior of households, we clearly need to get back to studying Humans rather than Econs. Humans do not have the brains of Einstein (or Barro), nor do they have the self-control of an ascetic Buddhist monk.”

“Our model is really based on a metaphor. We propose that at any point in time an individual consists of two selves. There is a forward-looking “planner” who has good intentions and cares about the future, and a devil-may-care “doer” who lives for the present.”

Applications to ethical systems design:

• As a manager or executive, understand that employees — and all humans — are susceptible to emotions and passions. Encourage long-term thinking in order to balance any short-term emotional reactions.

• Creating an effective ethical system will require emotional impact and significance to workers. Possibly emphasize a shared value stakeholder model of business.

• There is a wealth of literature on solving conflicts of interests between principals and agents to promote ethical behavior. Any ethical system must make sure to reduce possible points of conflict between principals and agents. If in a conflict of interest situation, consider asking yourself what you want to occur and then understand the counter arguments to better evaluate your situation

• Disclosure may also be an effective yet cheap method for smaller firms to solve conflicts of interest between principals and agents.

• Again, encouraging long-term thinking in the firm may help both principals and agents to avoid issues and see each other’s point of view.

 

PART IV: WORKING WITH DANNY 1984-85

Overview:

What makes an economic transaction seem “fair”? First, perceptions of fairness are related to the endowment effect. Both buyers and sellers feel entitled to certain terms of trade and treat any deterioration as an “unfair” loss. Persuading people to go against their “status quo” proves a tall task — regardless of “rationalizing” factors, such as markets and education. Additionally, the perceived fairness of an action depends not only on who it helps or harms, but also on how it is framed. Consider “sales” or “discounts”. These “bargains” can be seen as positive and very fair, since they diverge from the “real” asking price.

The next question to ask, though, after determining some relations of fairness, is this: would people be willing to punish firms behaving unfairly? Results of various experiments show that there is evidence that people dislike unfair offers and are willing to take a financial hit to punish those who make them. However, it is less clear that people feel morally obliged to make fair offers themselves. Essentially, economists need to a more complex view of human nature — not one that is simply dominated by Humans’ rationality.

Notable quotes:

“Too often, formalized economics is assumed to be relatively flawless.”

“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.”

Applications to ethical systems design:

• While ethics may pay, unfairness clearly does not. If employees or managers are not treated fairly by ethical systems, those same agents will be willing to revolt against, punish, or simply leave the system and company.

 

PART V: ENGAGING WITH THE ECONOMICS PROFESSION 1986-1994

Overview:

In Part V, Thaler focuses on the emergence and history of behavioral economics. In October 1985, it was finally time for behavioral economists to confront traditional economic adherents in October 1985. The debate began with traditional economists supporting the idea that rationality is necessary. However, the last issue discussed was the issue of firms and dividends: why did firms punish shareholders by paying dividends? Traditional economic theory postulates that firms should not pay dividends — but, yet, they do. Furthermore, a behavioral model best describes the pattern by which they pay them. Hence, behavioralists could claim at least one victory in the aftermath of the debate.

Finally, Thaler examines an idea called “narrow framing.” Narrow framing relates to a mental accounting question: when are certain events, payments, and projects intertwined, and when are they seen as separate? Experiments and studies indicate that, in organizations, too often, events and projects are seen and presented as separate entities.

In essence, narrow framing prevents a hypothetical CEO from getting many projects from managers, and, instead, gives him or her only three. The reason for this is complex. Too often, new projects and initiatives are pitched as separate projects. This appearance of many disparate projects then subliminally causes executives to become risk-averse and whittle down their options. These situations are called “dumb principal” problems, relating back to the principal-agent model. The solution would be to encourage managers to consider multiple projects as a portfolio and establish collections of investments to view projects as interrelated. If this solution is not implemented, the firm ends up being too risk-averse.

Notable quotes:

“Not only did Miller concede that the best model of how firms pay dividends is behavioral, but he was also happy to grant the same about how individual investors behave.”

“The bottom line is that in many situations in which agents are making poor choices, the person who is misbehaving is often the principal, not the agent. The misbehavior is in failing to create an environment in which employees feel that they can take good risks and not be punished if the risks fail to pay off. I call these situations “dumb principal” problems.”

Applications to ethical systems design:

• In order to encourage innovation along with corporate governance and responsibility, aim to prevent narrow framing. If one is a manager, one can propose pools of projects which are both ethically and financially beneficial to appeal to CEOs and increase likelihood of approval.

 

PART VI: FINANCE 1983-2003

Overview of the section:

After spending most of the book talking about economics, Thaler turns briefly to finance and one of its core assumptions: the Efficient Market Hypothesis (EMH). The EMH has two components. The first component concerns the rationality of prices; the other relates to the possibility of “beating the market.”

The first component relies on the idea is that any asset has an “intrinsic value” which it sells for. If a rational valuation of a company is $100 million, then its stock will trade such that the market cap of the firm is $100 million. However, Robert Shiller published a paper in 1981 with a conclusion that countered the first component. Specifically, Shiller argued that stocks didn’t have intrinsic value; a stock price was just an ever-changing forecast of the market’s expectation regarding the present value of all future dividend payments. Additionally, Thaler writes that, to the chagrin of EMH proponents, a violation of the law of one price and intrinsic value of assets exists quite prominently if one considers closed-end funds. Unlike other funds, a closed-end fund can sell assets either at a premium or a discount and is open about it.

Now, consider the second component, which relies on the “no free lunch” principle — or the idea that there is no way to beat the market. Essentially, EMH proponents state that, because all publicly available information is contained in current stock prices, one can’t predict future prices and make a profit for oneself. However, even this component is debatable. Consider Keynes’ criticism of markets. According to Keynes, emotions, or “animal spirits,” play a significant role in decision-making. Indeed, such emotionality manifests itself in investment decision-making, as investor overconfidence remains prevalent. In fact, studies and experiments show that people — and investors — can respond to insignificant “noise” and information, which can cloud their judgments. Thus, Thaler introduces the reader to prodigious financial author Benjamin Graham, who argued that, by being a contrarian, one could beat the market. Indeed, Thaler conducted many experiments which showed that “value stocks” outperformed “growth stocks” and were less risky. In short, the second component of EMH is more falsifiable than one would expect.

Notable quotes:

“To this day, there is no evidence that a portfolio of small firms or value firms is observably riskier than a portfolio of large growth stocks.”

“The only thing that makes an Econ change his mind about an investment is genuine news, but Humans might react to something that does not qualify as news, such as seeing an ad for the company behind the investment that makes them laugh. In other words, SIFs are noise, and a noise trader, as Black and Summers use the term, makes decisions based on SIFs rather than actual news.”

 

PART VII: WELCOME TO CHICAGO 1995-PRESENT

Overview:

Once Thaler moved to the University of Chicago to teach, he began to explore how interdisciplinary field of law and economics could be modified in light of recent findings in behavioral economics. In short, in order to solve traditional legal and economic policy issues, Thaler proposes a so-called “libertarian paternalism.” Essentially, such libertarian paternalism would entail systems-building in firms and in public organizations that would incentivize people to make better choices — but always allowing them to make mistakes. This idea had many opponents. However, Thaler points out that these critics are negligent of the complexity and difference between libertarian paternalism and other types of paternalism.

Additionally, Thaler gives examples of behavioral economics at work, including: a fiasco at the University of Chicago regarding faculty office assignments, player selection in the National Football League, and decision-making by contestants on television game shows. These examples provide overwhelming evidence for behavioral explanations, while weakening traditional economists’ criticisms. SIFs can clearly become criteria for people to base their decisions on — rendering SIFs more significant than traditional economic concepts in some cases.

 Notable quotes:

“If people make mistakes, then it becomes conceivable, at least in principle, that someone could help them make a better choice.”

“It seems that the endowment effect can occur even for an office that was selected in what had been clearly labeled a practice exercise.”

“Clearly, in order to understand how teams or any other organizations make decisions—and therefore how to improve them—we need to be fully aware that they are owned and managed by Humans.”

Applications to ethical systems design:

• When resolving conflicts of interest within firms, encourage communication between parties. If each side can speak to one another, negotiation and agreements can occur without executive intervention.

• Having a company-wide motto and/or mantra that stresses the “Human-ness” of each individual — regardless of position — can be beneficial when considering conflicts of interest.

• If one is creating ethical systems, or if one is embroiled in a dispute at work and/or wants to intervene to resolve an issue, remember to establish specific rules, ask precise questions and address particular concerns. The broader statements or questions are, lies of omission and other unethical behavior can be more likely as “loopholes” will be exposed.

 

PART VIII: HELPING OUT 2004-PRESENT

Overview:

With behavioral findings academically acceptable by the mid-2000s, Thaler attempted to apply behavioral insights to practical situations. The main issue Thaler tackled was finding ways to help people save for retirement, given that there are numerous problems with traditional economic theory and its treatment of retirement savings. However, after advocating for libertarian paternalist solutions, Thaler was accused of outright paternalism and coercion.

To counter this accusation, Thaler gives an important rejoinder. For starters, it is important to remember that libertarian paternalism gives a nuanced answer. On one hand, people cannot be expected to make anything close to optimal decisions given the layers of complexity found in nearly every choice to make in life. However, all people enjoy having the right to choose, even if mistakes are made. Thus, libertarian paternalism primarily advocates giving people a “nudge” in the right direction. These nudges cannot solve every problem; it simply means incentivizing Humans to solve their own problems in the right way through certain systems and rules.

In conclusion, looking forward, the future for behavioral economics is bright. Most recently, Thaler teamed up with Rohan Silva of the U.K. Conservative Party to form the Behavioural Insights Team (BIT). The BIT aims to make the U.K. government more effective and efficient and to propose innovative economic policies. Thus far, the insights gained from working on the BIT have been enriching to the discipline of behavioral economics itself. However, Thaler stresses that businesses or governments can use behavioral sciences for self-serving and malevolent purposes. It remains important that, going forward, behavioral insights are applied prudently and within reason.

 Notable quotes:

“Someone who is trying to accumulate a specific nest egg can achieve that goal with less saving if rates of return go up. Behavioral economics offers more potential in this and many other policy domains because more stuff matters, namely, all those SIFs.”

“Normally we think that paternalism involves coercion, as when people are required to contribute to Social Security or forbidden to buy alcohol or drugs…I said as much and went on to say that if this is paternalism, then it must be some different variety of paternalism.”

Applications to ethical systems design:

• One can improve ethical systems in the workplace by adopting libertarian paternalism’s methodology. This could entail first hiring certain consultants to observe what the most common ethical errors and unethical behaviors are in the workplace and then subsequently devising policies which can reduce the observed error(s).
   
• Another alternative could include focus groups, or meetings where employees could air concerns about unethical behaviors without fear of repercussion. With focus groups, companies could compile information about unethical behavior in-house and could continually update and improve their ethical systems.

 

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