Misbehaving

Thaler explores the concept of fairness in economic transactions through experimental games. Thaler, along with colleagues Danny Kahneman and Jack Knetsch, created the Ultimatum Game to understand if people would punish unfair behavior. In this game, one player (the Proposer) offers a portion of a sum to another (the Responder), who can accept or reject the offer. If rejected, both players get nothing. Contrary to economic predictions, they found offers below 20% of the total amount were often rejected, indicating a willingness to punish unfairness.

Thaler’s team also designed the Dictator Game, where one player unilaterally divides a sum of money. Surprisingly, most participants chose to split the money evenly. They further tested the concept with the Punishment Game, where players could choose between sharing money with a “fair” or “unfair” allocator from the Dictator Game. A majority preferred to share with the fair allocator, even at a personal cost.

These experiments showed people are not always selfishly rational and often value fairness over maximizing personal gain. The Ultimatum Game, for instance, had consistent results worldwide, with proposers often offering close to half of the total amount to avoid rejection.

The chapter also highlights cooperative behavior through games like the Prisoner’s Dilemma and the Public Goods Game. These games demonstrate that while people don’t always cooperate, a significant number do, contrary to pure economic self-interest. Cooperation rates in these games tend to decline with repeated play as players learn about the behavior of others.

Thaler concludes that human behavior in economic transactions is complex, balancing self-interest with fairness and cooperation. This nuanced view of human nature, as he suggests, is more realistic and should be adopted by economists for a better understanding of economic interactions.

Thaler recounts his involvement in a conference at the University of Pittsburgh, where he and Danny Kahneman represented the behavioral wing of the experimental economics community. The discussion focused on the endowment effect, a phenomenon where people value items they own more highly than items they do not own. Thaler’s colleagues, Vernon Smith and Charlie Plott, were skeptical of the endowment effect’s empirical evidence.

To address this skepticism, Thaler, Kahneman, and their colleague, Jack Knetsch, designed an experiment to demonstrate the endowment effect in a market setting. They used Vernon Smith’s “induced value” methodology, where subjects are assigned a personal value for tokens, which they can trade in the experiment. The theory predicted about half of the tokens would change hands, matching buyers and sellers based on their assigned values.

The experiment was first conducted with tokens, resulting in several trades close to the predicted amount, proving that subjects understood the task. Next, they repeated the experiment using real goods: coffee mugs and pens. Contrary to the theoretical prediction that half of the items would be traded, significantly fewer trades occurred. Owners of the mugs and pens demanded about twice as much to give them up as buyers were willing to pay. This difference in valuation between buyers and sellers confirmed the endowment effect, showing loss aversion and status quo bias play significant roles in people’s reluctance to trade possessions they own.

Thaler reflects on a pivotal period in the development and recognition of behavioral economics. After eight years of dedicated work in this field and having secured tenure at Cornell, Thaler found himself part of a significant event that brought behavioral economists and traditional economists together for a debate at the University of Chicago. This event marked a turning point in bringing behavioral economics into the broader academic discourse.

The conference, organized by Robin Hogarth and Mel Reder, aimed to scrutinize whether behavioral economics warranted serious consideration. The event featured influential figures like Herbert Simon, Amos Tversky, Daniel Kahneman, and Kenneth Arrow, representing the behavioral side, and notable traditional economists, like Robert Lucas and Merton Miller.

Kahneman presented their work on decision-making inconsistencies, such as the Asian disease problem, which demonstrated how framing effects could lead to different choices despite identical outcomes. Thaler discussed fairness in economic transactions, highlighting results from the Ultimatum and Dictator Game experiments that contradicted traditional economic predictions.

Kenneth Arrow, in his talk, argued rationality was neither necessary nor sufficient for sound economic theory. He criticized the overreliance on rationality assumptions and stressed the need for theories incorporating non-rational behaviors.

Merton Miller’s presentation addressed the dividend puzzle in finance, acknowledging that behavioral models best explained why firms pay dividends despite tax inefficiencies. However, he maintained rational models were still viable.

Robert Shiller, in response to critiques of his work on market efficiency, suggested behavioral insights could enhance, rather than replace, efficient market models. This debate marked the beginning of a longstanding discussion between behavioral and traditional finance, with both sides feeling confident in their positions.

Thaler discusses the significance of anomalies in scientific paradigms, particularly in economics. Drawing on Thomas Kuhn’s model of scientific revolutions, Thaler reflects on the role of anomalies in challenging and potentially shifting established paradigms. He suggests that for a paradigm shift to occur in a field like economics, a series of unexplained anomalies must accumulate, each requiring its own unique rationalization within the existing framework.

Thaler’s involvement in documenting economic anomalies began after a conversation with Hal Varian at a conference. Varian was an advisory editor for the new Journal of Economic Perspectives, and together they conceptualized a regular feature for Thaler to write about economic anomalies. This opportunity allowed Thaler to explore and publicize various findings that were inconsistent with standard economic theories.

In his columns, Thaler presented a range of anomalies, from stock market calendar effects to betting behaviors at racetracks. These anomalies demonstrated inconsistencies in economic behavior that traditional models struggled to explain. For instance, he noted peculiar patterns in stock market returns related to specific days or months and the inefficient expected returns from betting on horse racing, where favorites offered better returns than longshots.

Thaler’s goal was to broaden the understanding of economic phenomena by incorporating empirical facts that didn’t align with theoretical predictions. While he didn’t always have behavioral explanations for these anomalies, highlighting them was essential in challenging the conventional economic wisdom.

After writing regularly for The Journal of Economic Perspectives for several years, Thaler’s column was eventually retired. The editor at the time, Andrei Shleifer, felt that the columns had achieved their purpose, marking an end to Thaler’s formal role in documenting economic anomalies. This work, however, had a lasting impact, contributing to the broader recognition and acceptance of behavioral economics within the academic community.

Thaler reflects on the growth of behavioral economics and his efforts to develop the field alongside other pioneers. Recognizing the need for a collaborative approach to advance this emerging discipline, Thaler emphasizes the role of forming a team to explore the intersection of psychology and economics.

Thaler recounts the beginnings of behavioral economics, which, at the time, was a niche area with only a few key figures, including George Loewenstein, Robert Shiller, and Colin Camerer. Camerer, a prodigious talent, contributed significantly by developing behavioral game theory and, later, neuroeconomics.

The growth of the field gained momentum with the support of Eric Wanner, a psychologist with a strong interest in economics. Wanner, who moved from the Sloan Foundation to the presidency of the Russell Sage Foundation, was instrumental in fostering behavioral economics. He organized meetings between psychologists and economists, although these interdisciplinary interactions didn’t yield the expected results. It became clear behavioral economics would primarily involve economists applying psychological insights rather than a fully collaborative effort between the two disciplines.

To cultivate a new generation of researchers, Wanner and Thaler established the Behavioral Economics Roundtable and organized summer institutes, or “summer camps,” for graduate students. These camps, starting in 1994, were intensive training programs that played an important role in encouraging young scholars to enter the field of behavioral economics. Prominent economists and psychologists, including Nobel laureates, participated as faculty members.

The summer camps were highly successful in attracting talented students, many of whom went on to become leading figures in behavioral economics. This initiative significantly contributed to the field’s development, transforming behavioral economics from a fringe subject into a significant part of mainstream economics. The success of these camps and the growth of the field owe much to the foresight and support of individuals like Wanner, who recognized the potential of combining economic and psychological perspectives.

Thaler explores how “narrow framing” affects decision-making, focusing on two distinct projects undertaken during a year spent at the Russell Sage Foundation by Thaler, Danny Kahneman, and Colin Camerer. Narrow framing refers to the tendency to evaluate risks or decisions in isolation rather than as part of a broader context.

Thaler and Kahneman, along with their assistant, Dan Lovallo, investigated how managerial decision-making is influenced by narrow framing, leading to bold forecasts but timid choices. This issue arises from the natural tendency of managers to be loss-averse and conservative in their decision-making due to the fear of negative consequences of risky choices. An example Thaler discusses involves executives at a media company who were reluctant to undertake individually profitable projects due to the fear of potential losses.

Another aspect of narrow framing is discussed in Thaler’s collaboration with Shlomo Benartzi. They examined the “equity premium puzzle,” which questions why people invest heavily in bonds despite stocks historically offering higher returns (213). Their hypothesis, “myopic loss aversion” (214), suggests investors’ frequent evaluation of their portfolios leads to an exaggerated perception of risk and, consequently, a preference for safer but lower-yielding investments like bonds.

Thaler’s work on narrow framing extends to a study of New York City taxi drivers, conducted with Camerer and Babcock. They found that many drivers set a daily income target and would stop working once this target was reached, regardless of how quickly it was achieved. This behavior was counterintuitive to economic theory, which would expect workers to work longer hours on days with higher earning potential. However, more experienced drivers tended to work longer hours on lucrative days, suggesting that learning and adaptation occur over time.