Review: Misbehaving - The Making of Behavioral Economics

Misbehaving is Richard Thaler's memoir of how Behavioral Economics went from being a backwater of economics to becoming mainstream enough that he got to win the Nobel Prize. It's a great read and much deserving of your time.

First of all, you get all the references to Daniel Kahneman and Amos Tversky's work on psychology that revealed the fundamental short-cuts that human brains tend to use whenever it's confronted with complicated problems. The result is that humans don't resemble anything close to the "rational man" so frequently assumed in economic theory and analysis.

Thaler's a characteristically modest academic, not given to blow his own horn. This is great, and he discusses his difficulty in convincing the general community that the anomalies he discovered were of note and impacted policy that mainstream economists were prescribing. So for instance, retirement plan policy are largely focused on tax incentives, but not about how easy it is to sign up for a retirement plan and whether or not to prescribe a correct strategy.

Sometimes the invisible handwave is combined with the incentives argument to suggest that when the stakes are high and the choices are difficult, people will go out and hire experts to help them. The problem with this argument is that it can be hard to find a true expert who does not have a conflict of interest. It is illogical to think that someone who is not sophisticated enough to choose a good portfolio for her retirement saving will somehow be sophisticated about searching for a financial advisor, mortgage broker, or real estate agent. Many people have made money selling magic potions and Ponzi schemes, but few have gotten rich selling the advice, “Don’t buy that stuff.” --- Page 52

Furthermore, the  idea that the competitive marketplace would punish mismanagement of corporations or businesses and drive them out of business fails in that businesses have gotten very good at manipulating market structure and the political environment to preserve themselves:

In my lifetime, I cannot remember any time when experts thought General Motors was a well-run company. But GM stumbled along as a badly-run company for decades. For most of this period they were also the largest car company in the world. Perhaps they would have disappeared from the global economy in 2009 after the financial crisis, but with the aid of a government bailout, they are now the second largest automobile company in the world, a bit behind Toyota and just ahead of Volkswagen. Competitive forces apparently are slow-acting. (Pg. 52)

He notes that frequently, many company CEOs want to  increase risk-taking, while employees are risk averse. Thaler makes a great observation: if you tie compensation to results, rather than the reasoning that leads to funding the risky project, then managers would generally try to only fund projects that are guaranteed to make them look good.

Whenever there is a time lapse between the times when a decision is made and when the results come in, the boss may have trouble remembering that he originally thought it was a good idea too. The bottom line is that in many situations in which agents are making poor choices, the person who is misbehaving is often the principal, not the agent. The misbehavior is in failing to create an environment in which employees feel that they can take good risks and not be punished if the risks fail to pay off. I call these situations “dumb principal” problems. (Pg. 190)

I hope the above quotes give you an idea of how great a book this is. If you're involved in business in anyway,  you should read this book. If you want a good understanding of how much of a death-grip the Chicago school of economics and the rational expectations assumptions had on policy prescriptions and economics thinking, this book also provides a fantastic history of how hard it was to change the paradigm.

There are too many reasons to read this book. Go find a copy and read it. Highly recommended.