Why is traditional economics outdated? Why are behavioral economics important in everyday life?<\/p>\n\n\n\n
In Misbehaving<\/em>, Richard H. Thaler says that the theories of traditional economics<\/a> rest on a faulty foundation. Traditional economics assumes that consumers act rationally and that financial markets reflect securities’ true values.<\/p>\n\n\n\n Read below for a brief overview of Misbehaving<\/em>.<\/p>\n\n\n\n\n\n\n\n In his 2016 book, Misbehaving<\/em><\/a>, Richard H. Thaler instead argues that consumers frequently behave irrationally by the standards of traditional economics<\/strong>, making suboptimal economic decisions<\/a>, and financial markets may under- or over-value securities such as stocks and bonds. To show as much, he traces the historical development of behavioral economics<\/em>, which explores how consumers actually <\/em>behave in economic situations, not just how they should<\/em> behave.<\/p>\n\n\n\n Thaler is the 2017 recipient of the Nobel Prize in economics<\/a> and one of the founding fathers of behavioral economics. He coauthored the 2009 bestseller Nudge<\/em><\/a>, which recommends practical applications from behavioral science. <\/p>\n\n\n\n Before discussing the arguments that Thaler marshals against traditional economics, it\u2019s helpful to understand the foundations of traditional economic theory. To that end, we\u2019ll begin by discussing the two key components of traditional economics: the premise of constrained optimization and the efficient market hypothesis<\/a>.<\/p>\n\n\n\n Thaler explains that the first foundational principle of traditional economics is the premise of constrained optimization<\/em>, which contends that consumers with a limited budget always make decisions that optimize it<\/strong>. In other words, they act rationally, and their decisions always maximize economic value based on their available budget.<\/p>\n\n\n\n To see how this works in practice, imagine that you were purchasing groceries on a $100 budget. According to the premise of constrained optimization, every item that you purchase will guarantee that you\u2019re getting the most bang for your buck. For example, if you were choosing between a $10 name-brand item and an $8 value-brand item with identical nutritional values and flavor profiles, you would always choose the $8 item to maximize your budget.<\/p>\n\n\n\n Thaler explains that the premise of constrained optimization implies that noneconomic factors are irrelevant to consumers\u2019 decision-making<\/a> process<\/strong>. For example, the fact that one brand of bread has more aesthetic branding than another won\u2019t influence your decision, since the factor is economically irrelevant. But, as we\u2019ll see later, Thaler argues that many purportedly irrelevant factors are, in fact, very relevant.<\/p>\n\n\n\n While constrained optimization concerns individual consumers, the next foundational component of traditional economics\u2014the efficient market hypothesis<\/a> (EMH)\u2014concerns financial markets on the whole. As Thaler relates, the efficient market hypothesis consists of two claims: Financial markets always accurately price securities, and it\u2019s impossible to consistently earn above-market returns. <\/strong><\/p>\n\n\n\n As for the first claim, Thaler explains that the EMH dictates that financial markets always price securities according to their intrinsic value<\/em>\u2014roughly, the fair value that a given security is worth. According to EMH advocates, markets accurately price securities because they immediately incorporate all publicly available information into securities\u2019 prices, meaning these prices fairly reflect all relevant information. For example, as soon as Tesla releases a quarterly earnings report, the relevant information from this report is factored into Tesla\u2019s share price.<\/p>\n\n\n\n As for the second claim, Thaler clarifies that it follows from the first: If securities are always fairly priced, then financial markets will never include the bargains necessary to consistently beat the market. In other words, while investors could accurately predict that bargain securities typically increase in price, they cannot reliably predict what will happen to fairly priced securities since these securities are already trading at their fair value. <\/p>\n\n\n\n Having examined the foundation of traditional economic theory, Thaler discusses the arguments from behavioral economics that undermine this foundation. He focuses on arguments against the premise of constrained optimization, highlighting three types of counterexamples to this premise that show the salience of noneconomic factors in our decision-making process\u2014namely, examples of mental accounting, examples of the importance of fairness, and examples of present bias.<\/p>\n\n\n\n While Thaler\u2019s examples from mental accounting show more mundane ways that consumers often act irrationally according to traditional economic theory, other experiments reveal more specific situations in which we consider allegedly irrelevant factors in our economic decision-making. Thaler\u2019s second argument against the premise of constrained optimization is that consumers are concerned with fairness and cooperation<\/strong>, even when these concerns conflict with budget optimization\u2014as shown by two experiments: the ultimatum game and the prisoner\u2019s dilemma.<\/p>\n\n\n\n Thaler\u2019s third argument holds that we exhibit a <\/strong>present bias<\/em><\/strong>\u2014a preference toward smaller immediate rewards over larger future rewards\u2014that conflicts with the premise of constrained optimization <\/strong>because it decreases our long-term economic utility. To show as much, he examines how this bias manifests itself in children as well as adults. <\/p>\n\n\n\n Thaler first examines psychologist Walter Mischel\u2019s famous experiment testing children\u2019s willpower in a laboratory setting. In Mischel\u2019s experiment, children are given the choice between one marshmallow now and two marshmallows in 15 minutes, with the caveat that they have to spend these 15 minutes in a room with access to the single marshmallow. Thaler relates that, on average, children couldn\u2019t last the 15 minutes: They lasted an average of 11 minutes before eating the single marshmallow. If children rationally maximized economic utility, however, they would wait 15 minutes, since two marshmallows are clearly worth more than one.<\/p>\n\n\n\n According to Thaler, adults likewise exhibit present bias\u2014that is, they irrationally place more weight on short-term economic gains than equivalent long-term gains. He argues that adults often fall victim to a specific form of present bias known as hyperbolic discounting<\/a><\/em>, in which they prefer immediate rewards to future rewards, but they don\u2019t differentiate between comparable rewards at different dates in the far future. For example, if you\u2019re offered tickets to the Superbowl either for this year or 10 years in the future, you\u2019ll likely prefer the tickets to this year\u2019s Super Bowl. By contrast, if you\u2019re offered the choice between tickets to the Super Bowl 10 years in the future or 11 years in the future, you\u2019ll likely lack the strong preference for the earlier tickets. <\/p>\n\n\n\nMisbehaving<\/em> by Richard H. Thaler<\/strong><\/h2>\n\n\n\n
The Foundations of Traditional Economics<\/strong><\/h3>\n\n\n\n
The Premise of Constrained Optimization<\/strong><\/h4>\n\n\n\n
The Efficient Market Hypothesis<\/strong><\/h4>\n\n\n\n
Arguments Against the Premise of Constrained Optimization<\/strong><\/h3>\n\n\n\n
Argument #2: People Care About Fairness and Cooperation<\/strong><\/h4>\n\n\n\n
Argument #3: People Exhibit Present Bias<\/strong><\/h4>\n\n\n\n
Arguments Against the Efficient Market Hypothesis<\/strong><\/h3>\n\n\n\n