Brilliant autobiography blended with economic theory. Thaler draws on decades of misbehaving evidence to show how people systematically deviate from standard economic assumptions. He does a great job combining both academic research with his own stories. Fair to say that his contribution to behavioral economics rivals that of Kahneman.

My Notes

Origins

As a young teacher, Thaler developed an exam model to discriminate between the best and average students. He soon realized that they were unsatisfied with having an average score of 72, so he had the bright idea to grade out of 137 instead of 100. As such, grades were often closer to 90 (which sounds better) but had no real difference in terms of percentage.

Students were happier when they got 96/137 (70%) rather than 72/100.

This is misbehaving: individuals’ behavior are inconsistent with the idealized behavior of a rational agent. One way to start realizing that individuals misbehave is by taking account what Thaler calls supposedly irrelevant factors (SIFs).

The Endowment Effect: people value things that they already own (part of their endowment) more than things they don't

Imagining a young girl dying is emotionally worst than hearing about thousands of lives unrescued at the hospital. As such, less consideration is granted to the latter.

• statistical life: the hospital, where data are far and blurry
• identified life: vivid and clear in our mind, just like the young girl

One way to use this distinction in policy-making is to stimulate emotion relative to the identified life.

Value Theory

Mental Accounting

Mental accounting refers to different ways we think about money.

For Econs, there is only acquisition utility. For Humans, utility from transaction should be considered as well.

Acquisition utility is based on standard economic theory and represents consumer surplus.

Transaction utility is the perceived quality of the deal, which represents the difference between the price you effectively pay and the price you would expect to pay (reference price). Buying a sandwich at a sporting event for $15 if it costs you $5 at the supermarket means that the deals stinks: transaction utility is negative.

• Positive transaction utility → bargain
• Negative transaction utility → rip-off

Transaction utility helps to understand why people rarely buy once-in-a-lifetime experiences. Considering the deal bad prevent people from overpaying.

Reciprocally, buying useless goods is extremely common because people seek to make bargains.

Consumption

Briefly outlining some important theories of consumption.

• Irving Fisher: Intertemporal Choice Model
  • Time preference depends on an individual's level of income, with the poor being more impatient than the rich
• Paul Samuelson: Discounted Utility
  • Consumption is worth more to you now than later (e.g. a great dinner this weak or one year from now)
• Keynes: Theory of Consumption
  • A household receiving some incremental income would consume a fixed proportion of that extra income (marginal propensity to consume, or MPC)
  • MPC varies across socioeconomic classes: lower for the rich, higher for the poor
• Milton Friedman: Permanent Income Hypothesis
  • Households have the foresight to smooth their consumption over time
• Franco Modigliani: Life Cycle Hypothesis
  • Instead of short periods of time (a few years), Econs make choice based on their lifetime income
  • People would determine a plan when young about how to smooth consumption over time
• Robert Barro: Ricardian Equivalence
  • Individuals have an infinite time horizon, meaning that each individuals care for its children or grandchildren
  • A tax cut financed by government bonds is anticipated by individuals to repay them later, so they won't increase their consumption.

Fairness

Along with Kahneman, Thaler conducted many experiments to evaluate the importance of fairness in economic transactions.

Some important conclusions:

• The endowment effect influence one's perception of fairness.
• A company that raises its prices right after a temporary spike in demand is very likely to harm its reputation.
• For example, if a hardware store raises the price of snow shovels after a blizzard, many customers perceive this as unfair, even though from a economic theory standpoint, it is perfectly rational.
• Market norms are not social norms. Although theory suggests that prices should adjust freely to reflect supply and demand, people usually fairness from businesses, especially in emergencies.
• Another way to understand it through loss aversion. People develop reference points for the "normal" prices. A sudden price increase is seen as a loss relative to this reference point.
• Fairness norms apply to employment as well. During a recession, it is harder for businesses to lower wages than to layoff. This is mainly because workers perceive wage cuts as unfair.
• A convenient way for a business to lower wages is through inflation (by lowering real wages). This could have been better done by central banks in 2008 to increase employment.
• In public goods games, a large portion of people cooperate to enhance the public good albeit that it is not in their most selfish interest. Conclusion: Humans are not Econs.
• Humans are willing to lose money to “punish” others whom they feel are behaving unfairly.

A purely economic man is indeed close to being a social moron.

Finance

The efficient market hypothesis (EMF) states that the price of a stock reflects its intrinsic value, which represents the value of future dividends. The theory has obvious limitations, which explains some of the irrationality observed in financial markets.

• People tend to overreact to irrelevant news.
• Split companies, like Palm and 3Com in 2000, can end up be valued at a negative price.
  • After Palm's IPO, its market capitalization was higher than that of 3Com (though Palm owned 3Com)
  • Mathematically, this made no rational sense!
• In a perfectly rational world, there is no need for high volumes of trading.

Nudging

The (only) tool governments use to encourage saving is tax breaks.

But, in some cases, lowering taxes on retirement savings, say in the case of someone who is already saving at their target rate, and does not want to save more, could result in such a person saving less.

How to effectively nudge people into saving more?

1. Allow taxpayers to use their income tax refund to make a contribution that counts on the return currently being filed.
2. Increase withholding. People tend to save more from windfalls, and they see tax refunds as windfalls. So increase the tax refund by increasing withholding.
3. When onboarding new employees, make signing up rather than not the default for 401(k) participation.
4. Offer employees Save More Tomorrow: sign up to automatically have your saving percentage increased for their next 4 pay raises.

The 3rd suggestion was tried, and it did improve savings greatly. The 4th suggestion was taken by 78% of employees, after 75% of them had refused an immediate savings rate increase.

Initially, Thaler coined the term libertarian paternalism to refer to plans trying help people in subtle but smart ways (nudges).

• paternalism: trying to help people achieve their own goals
• libertarian: without restricting choices

The goal is to influence choices in a way that make choosers better of, as judged by themselves.

Reducing errors is a one of the most famous types of nudges.

The most famous example comes from the Schipol International Airport in Amsterdam, where someone came up with the idea of displaying an etched image of a housefly near the drain of the urinal. Airport management reported that installing these flies reduced "spillage" by 80%.

Nudges are SIFs that influence our choices in ways that make us better off.

When it comes to organ donations, most countries have an opt-in policy, whereby donors have to take some positive step such as filling in a form in order to have their name added to the donor registry list.

However, European countries such as Spain have adopted an opt-out strategy called "presumed consent". You are presumed to give your permission to have your organs donated unless you explicitly take the option to opt out and put your name on a list of "non-donors".