Misbehaving

The Birth of Behavioral Economics

Richard Thaler discovered early in his teaching career that human reactions often defy the logic of traditional mathematics. He once gave a difficult exam where the average score was 72 out of 100. Even though he curved the grades so that the students still received high marks, they were angry about the low numerical score. To fix this without making the test easier, Thaler changed the total possible points to 137. On the next exam, the average score rose to 96. Even though 96 out of 137 is only 70 percent—a lower percentage than the previous exam—the students were thrilled. This reaction makes no sense in standard economic theory, which assumes a person should only care about their actual grade and the percentage of correct answers. This gap between how people are expected to act and how they actually act serves as the foundation of behavioral economics.

Standard economic theory is built on the idea of perfectly rational beings known as Econs. These fictional creatures are never overconfident and always make the best possible choice to maximize their well-being. In contrast, real people are simply Humans, who have limited time, energy, and mental capacity. Economists often ignore factors they consider irrelevant, such as the way a choice is described, but for real people, these factors are often the most important parts of a decision. For decades, economics relied on optimization and equilibrium, assuming people always choose the best option and markets naturally balance out. However, these premises are often flawed because people carry natural biases and face incredibly complex problems. Because traditional models ignore these traits, they often fail to predict major events like the 2008 financial crisis.

To track these predictable flaws, Thaler started keeping a list on his office blackboard of behaviors that seemed irrational. For instance, he noticed that people treat money differently depending on whether they have already spent it. Two friends might refuse to drive through a blizzard for a basketball game if the tickets were free, but they would risk the dangerous trip if they had paid a high price for them. According to traditional theory, the money spent in the past is a sunk cost and should not influence a current decision, yet it clearly does. Another quirk involved how people perceive savings. A person might drive ten minutes across town to save ten dollars on a forty-five-dollar clock radio but would refuse to make the same trip to save ten dollars on a five-hundred-dollar television, viewing the discount relative to the total price rather than as an absolute value.

A major breakthrough occurred when Thaler discovered the work of psychologists Daniel Kahneman and Amos Tversky. They proposed that because humans have limited time and mental energy, they rely on simple rules of thumb, known as heuristics, to make judgments. While these mental shortcuts are often helpful, they lead to systematic errors. For example, people often judge how common an event is by how easily they can remember an instance of it, which explains why many wrongly believe homicides are more frequent than suicides. This insight was revolutionary because it suggested that human mistakes are not just random accidents, but predictable patterns that can be studied and understood.

When Thaler began presenting this evidence to the academic establishment, he faced a formidable task in proving that human behavior deserved a place in economic theory. Traditional economists used a set of deeply entrenched arguments to dismiss human irrationality. One common dismissal was the as if argument, which suggested that even if people are not math experts, they behave as if they have solved complex equations to reach an optimal decision. Thaler countered this by pointing out that while a professional billiard player might play flawlessly, a typical person at a bar often misses the easiest shots. He argued that if we want to understand how people actually save for retirement or buy groceries, our models cannot assume everyone is a grandmaster of logic.

Another hurdle was the argument that people would sharpen their focus and make rational choices if real money were on the line. However, research showed that when researchers repeated tests with large cash prizes, mistakes actually became more frequent. Critics also argued that irrational people would be driven out of business or corrected by the competitive market, an idea Thaler called the invisible handwave. Thaler pointed to the long-term survival of poorly managed companies to show that market forces are often slow and inefficient. He realized that for behavioral economics to be taken seriously, he needed to produce hard evidence showing how these human patterns directly impact the real-world economy.