Misbehaving : the making of behavioral economics

The author related that his friend and collaborator, Amos Tversky, received a terminal cancer diagnosis in early 1996. Tversky chose to handle his final months privately, focusing on work, such as editing a book with Daniel Kahneman, Choices, Values, and Frames, and spending time on personal interests like watching basketball, rather than devoting himself to the role of a dying man. Tversky famously eschewed painful and likely futile medical treatments, suggesting that what was bad for the tumor was not necessarily good for him. The author noted that Tversky’s advice to transmit history and wisdom through anecdotes and stories influenced the style of this book.

In a separate anecdote, the author recalled a 2001 phone interview Daniel Kahneman gave to a journalist about the author’s work. To the author’s surprise, Kahneman identified the author’s single best quality as his laziness. Kahneman explained that this sloth was an asset, ensuring that the author only pursued research questions that were compelling enough to overcome his default tendency to avoid work.

The author introduces Humans as deviating from the rational Econs of traditional economics. Early observations highlighted Supposedly Irrelevant Factors (SIFs), which influence decisions irrationally. Key concepts developed include the endowment effect, where ownership increases perceived value, and Prospect Theory, which focuses on gains and losses relative to a reference point, demonstrating diminishing sensitivity and loss aversion, the profound dislike of losses.

This section explores mental accounting, how individuals categorize and evaluate money. It introduces transaction utility, explaining why people enjoy "bargains" and feel pain from "rip-offs" based on reference prices. The irrational influence of sunk costs is discussed, where past expenditures drive future behavior. Furthermore, people employ mental "buckets and budgets," violating fungibility and leading to suboptimal financial decisions.

This section addresses the challenge of self-control, a concept absent in traditional economics. It delves into the Planner-Doer model, an internal conflict between a long-sighted planner and an impulsive, present-focused doer. The discussion highlights time inconsistency and present bias, where individuals prioritize immediate rewards over future ones, often leading to commitment strategies to manage their future selves.

This interlude provides practical examples of behavioral economics in action. It details a pricing strategy at the Greek Peak ski resort that leveraged mental accounting and transaction utility to boost revenue. Additionally, it examines General Motors' successful low-interest loan promotion, illustrating how psychological appeal often outperforms economically superior cash rebates, showcasing real-world behavioral insights.

This section chronicles the early clashes between behavioral and traditional economists, addressing critiques like the "as if" argument, incentives, learning, and the disciplining force of markets. It highlights the establishment of the "Anomalies" column, which systematically documented market behaviors inconsistent with rational economic theory, such as stock market calendar effects and racetrack betting patterns.

This section describes the pivotal role of the Russell Sage Foundation in nurturing the nascent field, particularly through its "summer camps" for graduate students. It introduces narrow framing, where individuals make decisions in isolation rather than considering the broader portfolio, impacting managerial risk-taking and explaining the equity premium puzzle as a result of myopic loss aversion.

Challenging the Efficient Market Hypothesis (EMH), this section examines how investor overreaction leads to mean reversion in stock prices, validating value investing. Robert Shiller's work demonstrated excessive stock market volatility, suggesting prices are often "wrong." Anomalies like closed-end fund discounts and the 3Com/Palm paradox revealed blatant violations of the law of one price, highlighting the limits of arbitrage.

This section details applying behavioral economics for societal good, exemplified by the Save More Tomorrow (SMarT) program, which leverages inertia, loss aversion, and present bias to boost retirement savings. It introduces libertarian paternalism and the concept of "nudging," advocating for policies that guide individuals toward better choices without restricting freedom, as implemented by government "nudge units."

The conclusion reflects on behavioral economics' journey from a marginal pursuit to a mainstream field. It emphasizes the need for behaviorally realistic macroeconomics and evidence-based policy across all domains, advocating for more randomized control trials (RCTs). The author presents three foundational lessons: observe the real world, collect systematic data, and courageously challenge authority to foster better decision-making.