The Making of Behavioural Economics

ETHOS Issue 17 June 2017

Misbehaving: The Making of Behavioural Economics is Richard Thaler’s fascinating account of how the field of behavioural economics came about, and how it has revolutionised modern economics in the last four decades. Thaler, one of the first economists to apply behavioural ideas to his field, lays out the once-mainstream intellectual arguments against the emerging approach of behavioural economics — and then proceeds to rebut them.

Challenging the Rational Choice Model

In his early career, Thaler made a list of ways in which people’s behaviour appeared inconsistent with the rational choice model. One of these illustrated a behaviour which violated the assumption that sunk costs would be ignored in decision making:

“Jeffrey and I somehow get two free tickets to a professional basketball game in Buffalo, normally an hour and a half drive from where we live in Rochester. The day of the game there is a big snowstorm. We decide not to go, but Jeffrey remarks that, had we bought the (expensive) tickets, we would have braved the blizzard and attempted to drive to the game.” (p. 20)

While working alongside psychologists Amos Tversky and Daniel Kahneman at Stanford, Thaler came upon what he describes as his “slow hunch” — something that did not come from any one “aha” moment — that something important was to be discovered. Subsequently he helped develop many important ideas in behavioural economics, such as endowment effect (i.e., how we value things that we own more than things that we do not yet own) and how we need help to control our behaviour (such as hiding away cashews before dinner to avoid overeating).

“Misbehaving” in the title suggests a point Thaler repeats throughout the book, which is the importance of sticking with one’s convictions even in the face of unrelenting opposition. He refers to running the “gauntlet” — a set of familiar objections that would be raised repeatedly about his theories and case studies whenever he presented them in the work’s early days. These included the following arguments:

• “As if”: Even though people are not able to grasp the complexity of an issue, their eventual decisions would be “as if” they had been able to do so, and they would thus still end up behaving like “Econs” (Thaler’s term for the fictional hyper-rational agents assumed in traditional economics).
• “Incentives”: Results from experiments could only be expected to mirror reality if the stakes were sufficiently large. This called into question the validity of the findings from behavioural studies that leveraged small incentives to bring about behavioural change.
• “Learning”: Experiments in decision making were one-shot games, and not reflective of the repetitive nature of real-life decisions.

Thaler’s reaction was to offer example after example rebutting the “as if”, “incentives”, and “learning” arguments, assuaging any junior academic wary of going against the orthodoxies championed by their seniors.

Perhaps the most memorable term in the whole book comes from Thaler’s account of the “invisible handwave”. This is the assertion that markets trump in all situations: that markets can discipline people’s misbehaviour, and that non-optimal individual choices somehow disappear in a competitive marketplace. A tongue-in-cheek reference to Adam Smith’s “invisible hand”, Thaler makes short shrift of that counter-argument with a number of examples, one of which reads:

“Suppose you pay attention to sunk costs, and finish a rich dessert after a big dinner just because you paid for the dessert. What will happen to you? If you make this mistake often you might be a bit chubbier, but otherwise you are fine.” (p. 52)

Clearly, markets do not inevitably correct irrational behaviours. In this instance, they do nothing to change the customs of the misbehaving individuals who fail to ignore the sunk costs of their dessert.

The Behavioural Revolution in Economics

As with many institutions, paradigm changes in academic fields do not come about by simply piling up evidence, although that is a necessary condition. More importantly, there needs to be constant conversation. In the second half of the book, Thaler highlights how the debate began in 1985, when the University of Chicago Graduate School of Business, a vaunted bastion of the hyper-rational Econs, organised a two-day workshop bringing behaviourists and rationalists together for serious sparring. Among the many eye-catching and fascinating anecdotes is the account of a presentation by Kenneth Arrow (who passed away in February 2017 at the age of 95). Arrow, the youngest ever recipient of the Nobel Memorial Prize in Economics, made the case that rationality is neither necessary nor sufficient for good economic theory. It was a revolutionary concept then, which clearly had an impact on the debate at that conference, as well as debates and policymaking for the next three decades.

Misbehaving and Challenges to Public Policy Design

Thaler also spends time tracing the influence of behavioural economics on other fields, from law to finance. Behavioural concepts have by now made their way into the realm of policy innovations: notably the UK government’s Behavioural Insights Team, which has among its stated goals to “encourage, support and enable people to make better choices for themselves”. In Singapore, public agencies are also applying behavioural insights more systematically to improve policy design and implementation.

Not surprisingly, once theory is put into practice, complexities arise. To Thaler’s credit, he does not shy away from them. Behavioural solutions are often context-dependent: interventions that work in one cultural setting might not translate well, or may not be fully scalable, in another context. This makes the policy applications of behavioural findings less straight forward than might have been hoped.

Another challenge of applying behavioural approaches to policy is the complexity of problems faced. A behavioural intervention may need to be multi-faceted to adequately address public issues. Thaler describes how the use of defaults alone in encouraging savings for retirements could be counter-productive and could lead to lower savings. In his example, when a company adopted an automatic enrolment plan with 3% savings rate as the default, employees who would otherwise have chosen to save at 6% were now only saving a 3%. The inertia against taking action to change the default rate in this case helped some but hurt others. Thaler suggests that an automatic enrolment plan coupled with automatic escalation of savings rate would lead to higher savings, because people tend to have less problem with self-control when it comes to decisions about the future rather than the present (i.e., the present bias). In Thaler’s “Save More Tomorrow” plan, savings rate increases are tied to future salary raises. This also mitigates loss aversion, as increases in savings are only taken away from future gains. Through examples like “Save More Tomorrow”, Thaler highlights the importance of thinking more deeply about how best to apply behavioural theories, and adapting them to the context of the issue being addressed.

At a more philosophical level, there are sometimes ethical considerations with a paternalistic approach to policymaking. Since behavioural nudges are not meant to tell people what to do (they are meant to help people to choose better for themselves), they are not useful in situations where we do not know what people want. After all, a better choice for one person may not be the case for another. In such situations, it could be better for the government to make it mandatory for people to make a choice, rather than to set a default.Despite such limitations in the use of nudges, behavioural economics has greatly impacted our understanding of how people make decisions. Given the clarity and levity in which Misbehaving provides the reader with insights into these developments, there is clearly one optimal choice for both academics and practitioners: read this book.