June 8, 2015


The Mischievous Science of Richard Thaler : a review of MISBEHAVING: The Making of Behavioral Economics, by Richard H. Thaler (CASS R. SUNSTEIN, 6/08/15, The New Rambler)

Thaler has a mischievous mind. At the same time that he was producing his math-heavy dissertation, he started asking people two questions. The first: How much would you pay to eliminate a mortality risk of 1 in 100,000? The second: How much would you have to be paid to accept a mortality risk of 1 in 100,000? According to standard economic theory, people's answers to the two questions should be essentially identical. But they weren't. Not close. The answers to the second question were much higher (often in the range of $500,000) than the answers to the first (often in the range of $2000).  In fact some people responded to the second question, "there is no amount you could name."  According to economic theory, that's serious misbehaving.

Thaler showed his results to Rosen, who told him to stop wasting his time, but Thaler was hooked.  As he eventually demonstrated, the disparity in people's responses to the two questions reflects the "endowment effect," which is now a centerpiece of behavioral economics: People value goods that they have more than they value exactly the same goods when they are in the hands of others. If you are asked to give up a right (say, to be free from a risk), you'll demand a lot more than you will pay to get that same right. The endowment effect can be found for countless things, including coffee mugs, candy bars, lottery tickets, environmental amenities (such as clean air), and legal protection of many different kinds.

It would be an overstatement to say that behavioral economics was born with this little survey, but Thaler started to collect anomalies, often involving the misbehavior of his friends, and resulting in what he called the List. As he explains it here, the List captures a series of differences between Econs (an imaginary species much discussed by economists) and Humans (our actual species). Here's one example: "Stanley mows his lawn every weekend and it gives him terrible hay fever. I ask Stan why he doesn't hire a kid to mow his lawn. Stan says he doesn't want to pay the $10. I ask Stan whether he would mow his neighbor's lawn for $20 and Stan says no, of course not." But Thaler didn't know what to do with his List, thinking that no one would want to publish an academic paper called "Dumb stuff people do."

In 1976, serendipity struck. Along with Rosen, Thaler went to a conference in California, where he met a young Israeli psychologist named Baruch Fischhoff, who told him about two psychologists unknown in economic circles named Daniel Kahneman and Amos Tversky. That led him to read a paper of theirs the next day, cataloguing systematic departures from the standard predictions of economic theory. As he read the paper, his "heart started pounding the way it might during the final minutes of a close game. The paper took me thirty minutes to read from start to finish, but my life had changed forever." (In the last decades, a lot of people have had that reaction to reading Kahneman and Tversky, and Thaler as well.)

What particularly impressed Thaler, and where Kahneman and Tversky went beyond the social science of the time, was in demonstrating that people's errors are not random but predictable. Economists of course knew that people made mistakes but believed the mistakes occurred randomly, and so canceled each other out, leaving intact predictions based on the rational actor model. Kahneman and Tversky showed that this assumption was wrong. For example, Kahneman and Tversky showed that in assessing risks, people use the "availability heuristic." This is a mental shortcut, in which we assess risks not by engaging in statistical analysis but instead by asking whether we can easily think of events in which the relevant risks came to fruition. If you can think of recent thefts in your neighborhood, you might have a grossly inflated sense of the danger - and if you can't, you might be far too complacent. The availability heuristic plays a big role in individual lives and in public policy, sometimes leading to both excessive and insufficient precautions.

Kahneman and Tversky also emphasized the importance of "framing." Suppose that your doctor asks you to consider whether to have some operation for a serious illness, and he tells you that of 100 people who have that operation, 90 are alive after five years. You might well ask him to go forward. But suppose he tells you that of 100 people who have the operation, 10 are dead after five years. You might well hesitate. The influence of "frames" shows the pervasive impact of supposedly irrelevant factors (in Thaler's shorthand, SIFs), which economic theory deems immaterial, but which can have a large effect on what people end up doing. 

Importantly, Kahneman and Tversky did not claim that people are "irrational." On the contrary, they urged that our heuristics, or rules of thumb, usually work well. But in some contexts, they fail us, which can lead to systematic mistakes. Pressing this claim with skeptical economists, Thaler repeatedly encountered an argument that he calls "the invisible handwave." The basic idea is that even if individuals blunder, competitive markets and invisible hands will cure the problem and eventually set them right. Thaler says that economists cannot ever finish this argument with both hands remaining still. "Handwaving is a must because there is no logical way to arrive at a conclusion that markets transform people into rational agents" (p. 52). To be sure, he is aware of the more sophisticated argument that because of market pressures, prices might turn out to be fully rational even when individuals are not - an argument he deems "certainly plausible, perhaps even compelling. It just happens to be wrong" (p. 53).

Posted by at June 8, 2015 4:06 PM

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