From Homo Economicus to Homo Sapiens Richard H. Thaler University of Chicago

1. From Homo Economicus to Homo Sapiens Richard H. Thaler University of Chicago

2. Economics and Behavioral Economics • Economics is the study of markets and people. • Models of markets have been gradually enriched by relaxing simplifying assumptions. • Less work has been done enriching the models of the people for various reasons, some good and some not.

3. Outline of Talk • Four key areas: • Bounded Rationality • Bounded Self-Interest • Bounded Willpower • Bounded Arbitrage • New Direction: Prescriptive Economics

4. Bounded Rationality • Simon’s original concepts: • Bounded Rationality • Satisficing • Quandary for economists: • How do boundedly rational satisficers differ from rational optimizers? • Are errors just random noise? • Breakthrough: Kahneman and Tversky introduced the idea of systematic bias. Theories of systemic error.

5. What are the Dimensions of these Table Tops?

6. Enter the ratio for the left table now! X = (longer / shorter side) X press 3 1 + 2.67 2 2.33 3 2 4 1.33 5 1 6 10 0 15 5 20

7. Enter the ratio for the right table now! X = (longer / shorter side) X press 3 + 1 2.67 2 2.33 3 2 4 1.33 5 1 6 15 0 5 10 20

9. Answer

10. Question Compare yourself to everyone else attending this lecture. How would you rate yourself in terms of “sense of humor”? 90+ means top 10 percent.

11. Enter Your Rating Now!! 3 10 1 2 4 5 6 7 8 9 + 5 10 15 20 0

13. Biased Beliefs • The heuristics and biases paradigm offers a coherent alternative to rational expectations. • Non-Bayesian forecasting • When does news get too much weight, or too little? • Memory biases • Salient events are more memorable. • Forecasts are remembered as being accurate (hindsight bias). • Overconfidence and Optimism • Necessary to understand excess trading in financial markets.

14. Elements of Preferences • Rational choices are consistent (transitive) and satisfy common sense axioms that lead to expected utility theory. • Actual choices violate these axioms • Preference reversals • Framing • Loss Aversion • Mental Accounting

15. How Should Economists Cope? • Three kinds of theories: • Normative: how a rational agent should behave (e.g., EU, Life-cycle, max profits). • Descriptive: how agents do behave. • Prescriptive: how to help agents come closer to normative ideal.

16. Bounded Willpower • A basic tenet of economic theory is that we choose what is in our best interest. • But self-control problems are a fact of life. • The first step is to acknowledge these problems exist.

17. Models of Bounded Willpower • The second step is to try to model bounded willpower. • Two key components: • “Present-biased preferences”. • Some, but imperfect, self-knowledge. • One approach: the planner and the doer.

18. Bounded Self-Interest • Many economic models portray agents as unboundedly unprincipled, unscrupulous, and dishonest with no regard for others (except possibly family members and friends): e.g., models of public goods, agency, etc. • Thankfully this is wrong. • Better model:

20. Lessons From the Fruit Stand • Enough people are willing to pay for what they take to make it worth while to maintain the stand. • Someone will take the money if you leave it on the table. • Thus, no extreme model of saints or sinners will do.

21. Bounded Arbitrage • A long oral tradition, attributed to Friedman, suggests that many of these issues do not matter in markets. • Why not? • Smart agents will jump in and …??? • Careful analyses have shown that this argument does not hold.

22. Limits to Market Discipline • Suppose I save too little for retirement, choose the wrong career, marry the wrong spouse, or buy the wrong car. How can you profit? • Markets give signals (incentives), but incomplete markets prevent arbitrage if agents do not process the signals properly.

23. Irrationality Catering Services • Markets sometimes react to irrationalities by catering to them, rather than eliminating them. • Insurance and extended warranties cater to small stakes risk aversion . • During the bubble, internet brokerage ads. “Own your own island!” • In bubbles, the very smart money may jump on the bandwagon, exacerbating rather than correcting the problem.

24. Guess-the-Number Game • Each player must submit an integer between 1 and 100. • Call these submissions Xi. • Compute the mean Xi and call this M. • The winner is the person whose guess is closest to 2/3M. • Example: Three players submit bids of 25, 50, and 75. • M=50 2/3M=33.3 • The player who submitted 25 would win.

25. Enter your guess now! For example: for “3” press: + 3 For “46” press: 0 5 10 15 20 + + 4 6 For “100” press: + + + 1 0 0

27. Analysis of the Number Game • Level 0: “I have no idea what to do, its random, I’ll guess 50.” • Level 1: “Most of these other players are bozos. They will guess 50. I’ll guess 33.” • Level 2: “Most of these players think that they are pretty smart, but they think that everybody else is a bozo, so they will probably guess 33. I’ll guess 22.” • Level 3: “Most of these other players will figure out how this game works. They will think that most people will guess 33, and will guess 22. Therefore, I should guess about 22*2/3=15.”

28. J.M. Keynes General Theory Ch.12 “Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole: so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth, and higher degrees.”

29. Contest in Financial Times • FT rules: only integers, tiebreaker: best justification, prize: two business class tickets London-NY. • 1382 entries. • The average guess was 18.91, two thirds of which is 12.6. • 31 entries with winning guess of 13.

30. Results of Financial Times Contest

31. Are Prices in Financial Markets “Right”? • Arbitrage is easier in financial markets. • Costs are lower. • Shorting markets often exist. • Are prices always “right”? • How would we know? • Excess volatility. Price should be the present value of future cash flows. Shiller showed that prices move much more than the present value of dividends.

32. Violations of the Law of One Price • Royal Dutch Shell • Current company formed in 1907 as an alliance between Royal Dutch (Netherlands) and Shell Transport (UK). • All interests are shared on a 60/40 basis.  • Until recently, Royal Dutch traded primarily in Netherlands and NYSE and was part of the S&P 500 Index. • Shell traded primarily in London and was part of the Financial Times Stock Exchange Index. • Did the two stocks trade at a price ratio of 1.5?

33. Recent Royal Dutch/ShellPrice Differential

34. How Can This Mispricing Happen?Why Doesn’t Arbitrage Work? • LTCM and other hedge funds did try betting on convergence. • But, in August of 1998 the price difference was at record highs, and widened! 

35. Conclusions About Bounded Arbitrage in Financial Markets • If the market cannot get these simple cases right, then it is possible that other prices can be very wrong, e.g., irrational exuberance. • After the bubble, NASDAQ lost $5 trillion in value! • Prices can be very wrong although there is still no way to make money. • This in no way implies that anyone has figured out a better way to allocate capital. • The presumption that markets and institutions produce rationality is wrong.

36. What’s Next?Prescriptive Economics • Having a better model of behavior allows for better advice about what to do. • Do not guess 0 in the beauty contest game. • Since more variables “matter” in behavioral economics, there are more tools in the economist’s tool kit.

37. Prescriptive Economics:Increasing Retirement Savings • In many countries, retirement savings decisions are made by workers, not firms. • Many workers save too little. How to help?

38. Prescriptive Approaches • Standard economics offers little help. • People are already saving the “right” amount. • Raising (after-tax) interest rates and employer matches has ambiguous effects (income and substitution effects). • Behavioral economics offers more tools because more things “matter” (e.g., framing).

39. Psychological Principles to Keep in Mind • Many people want to save more, but lack the self-control. • Choi et al. find that 2/3 of 401(k) participants think their savings rate is “too low”. • Self-control restrictions are easier to accept if they take effect in the future. • Money diverted to a special retirement savings “mental account” is less likely to be spent.

40. One Prescription: Automatic Enrollment • The default option is changed. Participants are enrolled into the plan unless they explicitly opt out. • Good news: enrollments jump. In one company studied by Madrian and Shea, enrollments of new employees go from 49% to 86%.

41. Down Side of Auto Enrollment • Bad news: whatever default options are selected by the plan administrators are taken as “suggestions” by employees. • In Madrian and Shea’s firm, most employees adopt the 3% savingsrate (and 100% allocation to money market fund).

42. The Save More Tomorrow Plan (SMarT) • People pre-commit to saving more in the future. • Saving increases are synchronized with salary increases. • People remain in the plan unless they drop out.

43. The SMarT Program works! • In the first company to adopt the SMarT program, savings rates nearly quadrupled. • The plan is now being offered by thousands of employers in the US and elsewhere.

44. The First SMarT Program (cont.) • Participants precommit to increase their saving rate by 3% per year • Saving increases are synchronized with pay raises • The increases continue unless the participant opts out or hits the plan max

45. Lessons from Save More Tomorrow • Simple behavioral economics principles and good framing can produce large changes in behavior. • The same tools could be used in other contexts, e.g., economic development.

46. Conclusions • Behavioral economics is not a radical departure, just another enhancement of in the tools of economic theory. • Progress in cognitive psychology has enabled us to begin to model less than fully rational behavior. • Progress in economics has enabled us to begin to understand when and where such behavior matters. • Since more things “matter” in behavioral economics, there are more tools to use in designing economic programs.