It is good to have friends who not only point you towards interesting books but actually mail order the book and get it delivered to you. This one landed in my doorstep thusly. :-)
Book chronicles the birth and development of the field of behavioral economics via interesting stories, anecdotes, experiments and personal experiences. Richard Thaler, who is the author of the book was awarded a Nobel in Economics in 2017 for his contributions to the development of this field. It is amusing to hear the story from his perspective since he and few other economists noticed faults in the traditional economic models and proposed alternate models decades back just to prove their points. It has since evolved into this huge field now. Book's language and contents are very accessible as there is nothing too technical or complicated.
As you may know, in the traditional school of economics, individuals are always seen as very rational entities that are not swayed even an iota by emotions, pressures, or social/environmental influences. The falsity of this notion is illustrated by a simple example. Let us say you go to a departmental store to buy a toaster that costs $20. If the store clerk says there is a sale starting tomorrow and so if you come back tomorrow and buy the same toaster, it will cost you only $10, most of us will skip the purchase that day, return the next day and pick it up for half the price thus saving $10. But if you are in the store to buy a $1000 TV, and the store clerk tells you that if you come back and buy the same TV tomorrow, it will cost you only $990, most people just shrug and buy the TV that day itself. This is because the human mind while working with a price tag of $20 finds a $10 discount a big one (50%!) that justifies going home empty handed and making the trip next day to buy it for $10 less. But while working with the $1000 price tag, same $10 discount doesn't look that important to make another trip to the store the next day.
While this thought process may be easy to understand from a normal human behavior point of view, traditional economics uses models of human beings that will consistently make the second trip to save $10 or always ignore it and go for the purchase the same day, irrespective of the price of the item. Logically this is the correct behavior since whether a second trip to the store is worth $10 or not should not be influenced by other Supposedly Irrelevant Factors (SIFs) like the price of the item you are trying to buy. But we are all not Spock from Star Trek and so easily get influenced by SIFs. This is basically the bone of contention. Traditional economists refused to take this into considerations and kept pushing back with anyone of the following arguments:
- This observed odd behavior will all iron out when the stakes are really high.
- When all individual behaviors are added up to compute the big picture, it will even out.
- Even individuals will behave very rationally and consistently across all the activities if you look broadly on all their activities. So focusing on one behavior to find fault is not right and so on.
People like Thaler and even Daniel Kahneman have proven this notion wrong time and again. Book is organized chronologically and so starts off with the 1970-80's related experiments in this domain. So, notions like endowment effect and mere ownership paradigm make their first appearances. Then he talks about the conceptualization of acquisition and transaction utilities. Acquisition utility is the value you derive from a purchase. Let us say you buy a bottle of cold water for $2. If you are really thirsty, you think it is worth the price. This is all the standard economic model considers. But in reality human beings also associate a transaction utility, because of which they feel great about buying that bottle of water for $2 if they got it from an expensive resort or restaurant since they expect to pay more for it. But if the same bottle (brand, temperature, quantity) of water was purchased from roadside, it feels like a rip-off since people expect to pay less than a dollar for it on the road side. While it is irrational, this is how the world works. In the following chapters we encounter sunk costs, mental accounting (where money that we rationally know is fungible is treated as not fungible), marshmallow experiments and quasi hyperbolic discounting. Each one of these terms are worth looking up as they are all good topics for party conversations. :-)
Second half of the book has several interesting real world case studies where these notions of behavioral economics are applied to improve business or people's behavior. For example, when credit cards were being introduced, gas stations wanted to charge customers using credit cards a surcharge to cover the fee they need to pay to credit card companies. Naturally CC companies hated this idea since it will make it look like their customers are being penalized for using the card and wanted the gas stations to include the fee as part of the standard gas price. After some consultation, gas stations (who did want the increase in sales CC will bring due to the ease of funds availability) decided to list the standard price with CC fee included and then give a "discount" for customers paying with cash. Mathematically & rationally there is absolutely no difference between surcharge and discount. But customers started viewing the discount as an advantage and were willing to go with "standard" price when they wanted to use the CC. Everyone was happy! There is a more elaborate example of how using such techniques Thaler helped turn a failing ski-resort business into a profitable one. There are also several negative examples like his interaction with NFL, GM and Uber that looked at his input but decided to discard them or didn't understand the importance to deploy the ideas to their own peril as per his recounting. He does list few academics by name, who fought against his ideas and lost as per his narration. I am sure those professors will remember the events differently. :-)
In the 90's the field had started getting traction with papers being published, conferences being organized and students starting to routinely working with him. In this phase there is also a large section that deals with finance and stock market that is quite interesting. There is an amusing complete chapter on how his colleagues who are all professors at the Booth School of Business in the University of Chicago went around picking offices in a new building they were moving into. Apparently it resulted in such a tense contest with emotions and competitiveness running quite high but in the end many missing important aspects of office selection (e.g. view) and focusing on aspects that turned out to be not so important (e.g. bigger office with ten more square foot space in the building plan that was hardly noticeable in the real office). Chapters on NFL player salary, TV game show analysis are all quite entertaining and help illustrate the span of domains where behavioral economics ideas will be applicable.
Book wraps up with how these notions were applied to help improve employees save more in their retirement savings account (nudge them by making savings the default option instead of expecting employees to opt-in), and even working with Governments in other countries (U.K. for example) to promulgate these ideas to improve governance.
Major complaints I had with the book fall into two categories. One is that in several chapters author is dropping too many names of colleagues, graduate students, professors he worked with to run experiments or write papers. It might be amusing or very nice for those individuals to see their names in the book. Thaler might be paying his dues to his collaborators in this manner as well. But when too many of these names appear in some sections, it feels like some irrelevant insider information that is too distracting. Second one is related to my own exposure to many of the studies, experiments and papers since they have been discussed in the mainstream media often over the years (e.g. how due to endowment effect, people will value a coffee mug they owned just for an hour more than what it is actually worth). So, while the prose is very light and easy to read, several sections didn't have a lot of new information for me. Still it was fun to go through the discussion again. Do give it read if you haven't already.
-sundar.
