MisBehaving

By Richard Thaler

Richard H. Thaler is an American economist and the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business. He is a theorist in behavioral economics, and collaborated with Daniel Kahneman, Amos Tversky and others in further defining that field.

The book describes Thaler’s journey into founding the field of Behavioural Economics, and the resistance against it, along with many additional contributors.

Hindsight Bias

Thaler introduces the idea of Hindsight bias, also known as the knew-it-all-along effect or creeping determinism, is the inclination, after an event has occurred, to see the event as having been predictable, despite there having been little or no objective basis for predicting it.

Thaler describes how this is highly prominent in the corporate world where CEOs would like to encourage risk taking among management. However, managers know that if there ideas fail, the CEO will look back at the idea as if it was stupid to begin with and blame the manager as in hindsight everything appears clear.

Thaler describes how humans are bounded by three distinct counts — bounded rationality, bounded willpower (limited self-control) and bounded self-interest (a concern for the well-being of others) with this deviating from the standard econ model.

Bounded Rationality

The idea that the cognitive, decision-making capacity of humans cannot be fully rational because of a number of limits that we face. These limits include:

• Information failure — there may be not enough information, or it may be unreliable, or maybe not all possibilities or consequences have been considered
• The amount of time that we have to make our decisions
• The limits of the human brain to process every piece of information and consider ever possibility — “lack the cognitive ability to solve complex problems”.
• The impact of emotions on decision making.

As a result people use heuristics, to make decisions with these heuristics causing people to make predictable errors.

Prospect Theory

Prospect theory holds that people tend to value gains and losses differently from one another, and, as a result, will base decisions on perceived gains rather than on perceived losses. For that reason, a person faced with two equal choices that are presented differently (one in terms of possible gains and one in terms of possible losses) is likely to choose the one suggesting gains, even if the two choices yield the same end result.

Organisms that placed more urgency on avoiding threats than they did on maximising opportunities were more likely to pass on their genes. So, over time, the prospect of losses has become a more powerful motivator on your behaviour than the promise of gains. Whenever possible, you try to avoid losses of any kind, and when comparing losses to gains you don’t treat them equally.

Prospect theory suggests that losses hit us harder. There is a greater emotional impact associated with a loss than with an equivalent gain. As an example, consider how you may react to the following two scenarios: 1) you find $50 lying on the ground, and 2) you lose $50 and then subsequently find $100 lying on the ground. If your reaction to the former scenario is more positive than to the latter, you are experiencing the bias associated with prospect theory.

Utility

Thaler formulates that consumer’s spending choices are led by 2 different types of utility:

• Acquisition Utility — This is the same as consumer surplus and is equal to the utility on the purchase-the opportunity cost of the purchase.
• Transactional Utility — This is the perceived quality of the deal. It is the difference between the current price and the price one would expect to pay.

People make purchases simply because there is a high transactional utility even if there is a negative acquisition utility! i.e. if the deal is to good to pass up on. As a result sellers have the incentive to create a high reference price. One example is the “suggested retail price” of a product. This explains why Ron Johnson’s J.C. Penney strategy did not work as consumers were missing out on lots of “transactional utility”.

Sunk Cost Fallacy

Your decisions are tainted by the emotional investments you accumulate, and the more you invest in something the harder it becomes to abandon it.

Many people believe that the US continued its futile war in Vietnam because it had invested so much into it.

Thaler stipulates that this is what makes Costco so successful. Costco makes all members pay $50 for a membership card to be able to shop there. Consumers see this as an investment and due to the sunk cost want to shop at Costco in order to recoup this investment.

The Issue Of Self-Control

The idea of self-control is paradoxical unless it is assumed that the psyche contains more than one energy system, and that these energy systems have some degree of independence from each to other.

In the theory of Moral Sentiments, Adam Smith expounded on self-control. He portrayed the topic as a struggle or conflict between our passions and what he called our impartial spectator.

The issue is that our passions are short-sighted. As Arthur Pigou said “Our telescopic faculty is defective… and we therefore see future pleasures, as it were, on a diminished scale”. We are therefore Present Biased.

Present bias occurs when individuals place a greater value on goods/income achieved in the present moment — rather than receiving same goods/income in the future.

It suggests that people can be time inconsistent — making decisions that their future self may regret.

“Casual observation, introspection, and psychological research all suggest that the assumption of time consistency is importantly wrong. It ignores the human tendency to grab immediate rewards and to avoid immediate costs in a way that our “long-run selves’ do not appreciate.”

Commitment Strategy

A commitment strategy is one way in which we trick ourselves into overriding our urge to make myopic choices.

The example that Thaler gives of this is Odysseus in the Odyssey. Odysseus would like to hear the Siren’s call but does not want to be lured to them and his eventual destruction. As a result, he gets his men to put in earwax and to then tie him to the sail so that he can hear the Siren’s song without being lured to them.

Rebates vs Sales

Thaler discusses the use of rebates versus sales. He describes how GM had a car with a list price of $14,800. Reducing the price to $14,500 does not seem like a lot. However, issuing a rebate of $300 encourages the user to view this separately which results in it appearing as a great deal.

The Endowment Effect

The endowment effect is the hypothesis that people ascribe more value to things merely because they own them.

A group of students were asked whether they preferred $3 or a lottery ticket. They were then at random given either $3 or a lottery ticket. Of those who began with a lottery ticket, 82% decided to keep it, whereas of those who started out with the money, only 38% wanted to buy the ticket. This means that people are more likely to keep what they start with than to trade it, even when the initial allocations are done at random. It is in-part due to loss-aversion as once a person owns an item, forgoing it feels like a loss, and humans are loss-averse. It is also due to inertia with this being dubbed the status-quo bias.

Confirmation Bias

Confirmation bias, also called confirmatory bias or mysidebias, is the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses. It is a type of cognitive bias and a systematic error of inductive reasoning.

For example, imagine that a person holds a belief that left-handed people are more creative than right-handed people. Whenever this person encounters a person that is both left-handed and creative, they place greater importance on this “evidence” that supports what they already believe.

Narrow Framing

In finance, an investor is said to suffer from narrow framing if he seems to make investment decisions without considering the context of his total portfolio.

An investor may get excited about the shares of a particular tech stock and purchase that stock without recognising that his portfolio is already overweight in tech stocks.

False Consensus Effect

In psychology, the false-consensus effect or false-consensus bias is an attributional type of cognitive bias whereby people tend to overestimate the extent to which their opinions, beliefs, preferences, values, and habits are normal and typical of those of others