THE TEACHING ECONOMIST - William A. McEachern                 

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Issue 49, Fall 2015

William A. McEachern, Editor

BEHAVE YOURSELF!

Behavioral scientists argue that we humans routinely overestimate what we know. Our preferences at times seem inconsistent. We are not very good at figuring out what we’ll want in the future. And getting more or better information doesn’t necessarily improve our decisions. In making choices, we often ignore facts at odds with our desires. We focus on irrelevant information, see patterns not there, and are swayed by passing but extraneous emotions. Even after we make a decision, we have trouble sticking with any choice that takes willpower. We value things that we have more than what we lack to a degree that seems odd. And we have an intense interest in “fairness,” even at a personal cost. In short, behavioral scientists argue that we don’t seem to be the rational, utility maximizing, economic decision makers that populate conventional economic theory.

Thomas Kuhn argued decades ago that scientific breakthroughs begin with anomalies. Only after a significant number of empirical anomalies have undermined the conventional theory, will that theory get modified or replaced. Richard Thaler, in his new book, Misbehaving: The Making of Behavioral Economics (Norton, 2015), takes us on his personal journey as he and his behavioral-economics colleagues chip away at assumptions and implications of conventional economic theory. Their professed goal is to modify rather than to replace that theory.

Thaler, a professor of behavioral science and economics at the University of Chicago, outlines two opposing descriptions of economic actors: Econs, the rational maximizers of conventional economic theory, and Humans, who, in Thaler’s view, behave like real people. But to the extent that Humans do not act like Econs, they are misbehaving—hence, the book’s title. A second take on the title may be that Thaler and other behavioral economists are misbehaving by challenging conventional theory.

Thaler documents the many ways that Humans do not behave like Econs, largely because of bounded rationality, bounded willpower, an asymmetry between the effects of gains versus losses, and an inordinate interest in fairness. Whereas traditional economists view their models as descriptions of how the world works, behavioral economists view some traditional models more as descriptions of how the world should work—that is, as normative descriptions of behavior.

Financial economics takes the biggest knock in the book, especially the bedrock theory of that discipline, the efficient market hypothesis. For years the efficient market hypothesis (EMH) seemed unassailable as a description of how the stock market worked. According to the EMH, it’s impossible to “beat the market” in any systematic way because share prices already capture all relevant information. Thus, stock price movements reflect a random walk. Thaler argues that the EMH boosted the stature of financial economists, moving them from a sleepy, backwater discipline, into a respected and highly paid one.

Thaler has fun poking holes in the EMH by reporting a number of contradictory anomalies. For example, even after adjusting for differences in risk, portfolios of small corporations outperform those of large ones, “cheap stocks” (based on price-earnings ratios) subsequently outperform “expensive stocks,” and recent losers subsequently outperformed recent winners by a wide margin. These findings and others reflect a reversion to the mean, but this violates the random-walk predicted by the EMH. Even more fun for Thaler are the many disclaimers and qualifiers that financial economists have come up with in their efforts to shore up the EMH.

I could detail Thaler’s long list of the ways that Humans misbehave, but that would take our focus off teaching economics. You are here because of an interest in teaching. Although Thaler has little to say about teaching per se (teach, teacher, or teaching does not appear in the index), I'll underscore four primary tenets of behavioral economics then speculate how they could help us become more effective teachers.

1. Bounded Rationality: An economic theorist may toil for months to derive the optimal solution to some complex economic problem, but then easily assume that the agents in this model behave as if they are capable of solving that same problem. What’s more, Econs are assumed to get smarter as the models get more sophisticated. Thaler quotes Kenneth Arrow as noting “We have the curious situation that scientific analysis imputes scientific behavior to its subjects” (p. 161). Of course conventional economists have ready answers for these challenges and others, a list that Thaler calls “the Gauntlet,” such as that a theory should be judged not by the realism of its assumptions but by the accuracy of its predictions. Thaler says he usually must run that Gauntlet, countering such objections, whenever he presents his work.

Teaching Implications: Not only are economic actors constrained by bounded rationality, so are our students. We can’t simply add more complexity to a course and expect our students to absorb it. In this case, we can’t simply pile behavioral economics atop conventional economic theory. I tend to agree with the 2002 Nobel Prize winner in Economics and behavioral scientist, Daniel Kahneman, who observed in Thinking Fast and Slow, "The basic concepts of economics are essential intellectual tools, which are not easy to grasp even with simplified and unrealistic assumptions about the nature of economic agents who interact in markets. Raising questions about the assumptions even as they are introduced would be confusing, and perhaps demoralizing. It is reasonable to put the priority on helping students acquire the basic tools of the discipline" (p. 286). To the extent behavioral issues are introduced at the introductory level, I believe they should become a natural extension of the discussion, not a jarring departure.

2. Bounded Willpower: Many humans eat and drink too much, exercise too little, and procrastinate in ways that would appear to make them worse off. Thaler argues that problems of bounded willpower and self-control, though ubiquitous in the real world, get little attention in conventional economic theory. Still, market and non-market mechanisms offer commitment strategies to help cope with self-control issues. For example, academics (including Thaler) commit themselves to present papers still in progress to boost incentives to finish them.

Teaching Implication: Think about the good intentions students may have about your course, and how you can introduce rules and enforcement mechanisms to “nudge” them in the right direction. Thaler lays out three criteria for fair and effective nudges, which I’ll adapt here for teaching: (1) instructors should have a good reason to believe that many students will benefit from the nudged behavior; (2) students must agree that a nudge is desirable; and (3) the policy is relatively easy for you to administer and is not especially onerous on students. Homework, quizzes, deadlines, contracts, reading assignments, asking students questions in class, even attendance policies, all can nudge student willpower in the course. As instructors, we want to influence students in a way that will make them better off, as judged by themselves.

3. Asymmetry of Gains Versus Losses: Because of the endowment effect, people feel any loss much more sharply than they enjoy a gain. Roughly speaking, losses hurt you about twice as much as gains make you feel good. According to Thaler, this has become the single most powerful finding in the behavioral economist’s arsenal. Thus, an incentive framed as avoiding a loss is more powerful than one framed as experiencing a gain.

Teaching Implication: How might the endowment effect be used to motivate students? How about giving each student a given number of “bonus points” at the beginning of the term? That bonus will carry to the end of the term as long as the student follows through with specified assignments—such as attendance, online assignments, following through on a course contract, and the like. Based on the endowment effect, students will be more motivated to keep the bonus points they already have rather than work for extra points they do not yet have. I know, one sounds like the mirror image of the other, and any difference is an illusion. But go tell that to the teachers who responded much more to a cash bonus awarded at the beginning of the year, which then could be reduced based on performance, than did the teachers who worked towards a year-end bonus.

4. Special Concern with Fairness: Humans do not seem to pursue self-interest as single-mindedly as the conventional model assumes. People appear to have an inherent sense of fairness and are willing to exact revenge in response to unfairness, even if the personal cost of doing so seems irrationally high.

Teaching Implication: After decades of teaching, I believe that students have an intense regard for fairness in a course. As teachers, we should be scrupulously fair. If an injustice occurs, try to correct it. If you can't, apologize for it and say you will try to do better. We should also do all we can to prevent cheating, as this is unfair to other students and undermines the integrity of your course.

Behavioral economics has taken hold, with articles in all the top journals. And specialty journals in the field proliferate, such as theJournal of Behavioral Economics and Finance, Journal of Economic Behavior and Organization,International Journal of Applied Behavioral Economics, Review of Behavioral Economics, Journal of Risk and Uncertainty, and Games and Economic Behavior. Behavioral economics has invaded other fields too with journals such as Behavioral Science and Policy and Journal of Economic Psychology. The Oxford Handbook of Behavioral Economics and Law, published last year, fills 840 pages.

Behavioral economics has been working its way down the food chain into basic textbooks. I am most acquainted with my own principles book, Economics: A Contemporary Introduction, first published in 1988 and just now appearing in an 11th edition. Here are some behavioral topics I have introduced over the years in chronological order, beginning with my first edition: bounded rationality, animal spirits, behavioral theories of the firm, principal-agent problems, sunk cost, winners curse, problems arising from asymmetric information, the lemons problem, moral hazard, adverse selection, efficiency wages, sticky wages and fairness, liar loans, bounded willpower, commitment strategies, the behavioral life-cycle hypothesis, and neuroeconomics.

Behavioral economists are held in high regard within the discipline and in the wider world. Sendhil Mullainathan, Matthew Rabin, and Colin Camerer have all won MacArthur Foundation “genius” grants. Several behavioral economists have also won the John Bates Clark Medal as the best U.S. economist under forty. Nobel Prizes in Economics have been won by Herbert Simon in 1978, Daniel Kahneman in 2002, and Robert Shiller in 2013. Kahneman’s book, Thinking Fast and Slow (discussed here in Issue 42), remains on the New York Times best-bestseller list today, four years after its initial publication. Thaler is the 2015 president of the American Economic Association. Robert Shiller becomes president in 2016.

Shiller, the author of Irrational Exuberance and the canary in the mineshaft chirping before the housing bubble burst, best reflects the posture of behavioral economists with respect to conventional theory. Three decades ago, Shiller wrote “I could teach the efficient market models to my students with much more relish if I could describe them as extreme special cases before moving to the more realistic models” (quoted by Thaler, p. 168).

In Misbehaving: The Making of Behavioral Economics, Thaler cleverly uses his own career as a narrative arc to describe the development of behavioral economics more broadly. Along the way, he lets the anomalies speak for themselves. I believe that both Econs and Humans will find his book engaging. But I have two tiny quibbles: Chip Case, of the Case-Shiller home-price index fame, spent his career at Wellesley, not Tufts. And I found it odd that Dan Ariely, of MIT and Duke, who since 2008 has authored three interesting and popular books in the field (discussed here in Issues 35, 40, and 43), warrants not a single mention in Thaler’s 415 page book. Why the snub? Did Ariely misbehave in some way?

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