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When I think of “economic theory” I recall high school lectures in Econ class that included discussions of Supply and Demand lines along with faint memories of marginal utility curves. The history of economic theory led to an abundance of optimization problems that solved for the ideal methods rational humans used to make decisions. However, until the 1970s, economic theory focused increasingly on the equations and not the beings behind them: Humans. In Misbehaving: The Making of Behavioral Economics, Richard H. Thaler describes the journey to make economic theory more human.
Misbehaving walks us through the beginning of behavioral economics, joining Thaler as a graduate student. Thaler first notices a few discrepancies in human behavior that contrast with normative economic theory (by normative I mean economic theory that involves equations and no consideration of human psychology). Thaler begins keeping note of these discrepancies in what he called “The List”. An example from “The List” that stood out to me most:
- A woman goes to buy something at a convenience store for $45. The cashier says that if the woman drives 10 minutes to a different store, she will get the same item for a discounted price of $35. Is the woman willing to make the trip?
- However, if the item she was purchasing was $495 and she was offered to drive 10 minutes to buy the product for $485, she is much less likely to make the drive
Here, we see a distinction between what economic theory predicts for the woman, and what normal humans actually do. An Econ, Thaler’s term for someone who strictly follows economic theory, would answer both scenarios in the same way. Whether she chooses to drive or not, an Econ values time the same amount, either 10 minutes is worth $10 or it’s not, it doesn’t matter what the original item price is. However, as a normal Human, I would probably drive the 10 minutes in the first case, but not care too much about the discount in the second case since I’m spending so much money anyways. My choice as a human is a contradiction to what traditional economic theory predicts I would decide. The further discovery of these discrepancies led Thaler to believe that economic theory could be improved to be more descriptive of human behavior.
While amalgamating “The List”, Thaler begins to present his findings to economists who, at the time, were entrenched in the traditional theory. Not surprisingly, he faced a slew of backlash which he labeled the “Gauntlet”, the critiques of his theories that explained away the discrepancies in his findings. Prominent arguments against behavioral economics stated how the “stakes” of the situation weren’t high enough. Since the woman in the example above only has $10 on the line, she doesn’t behave as an Econ would, but as the stakes increase, she will start to behave more “rationally”. Another argument stated that the behavior of people varies randomly, but the differing actions of humans “cancel” each other out leaving to an overall optimal environment described by normative economics. Thaler continued to describe counterarguments for each of the “Gauntlet” statements throughout the rest of the book.
Thaler does an amazing job of engaging the reader with his amazing stories and sense of humor. A clear example of this was his detailed description of the 3Com stock price during the Internet Bubble. 3Com was a networking company whose stock price, throughout the bubble, had been flat. 3Com, however, acquired a publicly popular company, Palm, that sold a handheld computer. In an effort to generate interest in the company, 3Com planned on divesting 5% of Palm stocks, an announcement that more than doubled 3Com’s stock price in the months leading to the IPO. Thaler describes how the divestment, along with the outrageous hype of internet stocks led to a negative stock price for 3Com, an outcome that normative economic theory described as impossible.
The book dived into how prevailing economic theory treated humans as Econs, a non-existent species that optimized for every choice they face. Instead, Thaler pushed, economic theory should be built on an understanding of Humans and our recurring biases in decision-making. Thaler details how understanding human behavior can allow economists to create policies that “nudge” people towards making better long-term decisions for themselves. Misbehaving outlines economic theory through a psychological lens, making the field seem much more… human.