Book SummaryMisbehaving, by Richard H. Thaler

1-Page Summary1-Page Book Summary of Misbehaving

The theories of traditional economics—which assume that consumers act rationally and that financial markets reflect securities’ true values—rest on a faulty foundation, according to behavioral economist Richard H. Thaler. In his 2016 book, Misbehaving, Thaler instead argues that consumers frequently behave irrationally by the standards of traditional economics, making suboptimal economic decisions, 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, which explores how consumers actually behave in economic situations, not just how they should...

Misbehaving Summary The Foundations of Traditional Economics

Before discussing the arguments that Thaler marshals against traditional economics, it’s helpful to understand the foundations of traditional economic theory. To that end, we’ll begin by discussing the two key components of traditional economics: the premise of constrained optimization and the efficient market hypothesis.

The Premise of Constrained Optimization

Thaler explains that the first foundational principle of traditional economics is the premise of constrained optimization, which contends that consumers with a limited budget always make decisions that optimize it. In other words, they act rationally, and their decisions always maximize economic value based on their available budget.

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’re 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.

(Shortform note: Although Thaler...

Misbehaving Summary Arguments Against the Premise of Constrained Optimization

Having examined the foundation of traditional economic theory, we’ll now discuss the arguments from behavioral economics that undermine this foundation. In this section, we’ll focus 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—namely, examples of mental accounting, examples of the importance of fairness, and examples of present bias.

Argument #1: People Perform Mental Accounting

Thaler’s first argument against the premise of constrained optimization is that people perform mental accounting—that is, they think about money in ways that don’t optimize their budgets. And although Thaler lists an array of examples of mental accounting, we’ll focus on three key ones: the endowment effect, the sunk cost fallacy, and common approaches to budgeting.

Example #1: The Endowment Effect

Thaler first explains that many consumers fall victim to the endowment effect: They overvalue their current possessions, even though they accurately value items they don’t own. For example, imagine that a consumer purchased a Cuban...

Misbehaving Summary Arguments Against the Efficient Market Hypothesis

Having seen how consumers often take noneconomic factors into account when making decisions, contrary to the premise of constrained optimization, we’ll now proceed to Thaler’s arguments against the other key thesis of traditional economics—the EMH. And while Thaler agrees with the EMH’s claim that it’s impossible to consistently beat the market, he disagrees with its claim that securities’ prices always reflect their intrinsic value. In this section, we’ll consider three arguments against the thesis that securities are always accurately priced: that investment opportunities from closed-end funds violate the EMH, that stock market overreaction violates the EMH, and that the stock market is too volatile to be perfectly efficient.

Argument #1: Closed-End Funds Violate the Law of One Price

According to Thaler, one argument against the EMH is the violation of the law of one price—the thesis from traditional economics that a security should never sell at two different prices at the same time. Thaler explains that the law of one price follows directly from the EMH’s assumption that securities are always accurately priced. Under this assumption, it’s logically impossible for...

Misbehaving Summary Real-World Applications of Behavioral Economics

Though Thaler’s work may seem to be of primarily theoretical interest, he also clarifies that behavioral economics has important practical implications in everyday life. In this section, we’ll examine how behavioral economics can help influence consumers for good by discussing specific “nudges” that Thaler and other behavioral economists have used to effect change in society.

How “Nudging” Can Improve Consumers’ Decisions

Thaler explains that in his book Nudge, coauthored with Harvard Law professor Cass Sunstein, he argued that insights from behavioral economics can help us “nudge” consumers toward better choices, as measured by their preferences. In other words, behavioral economics can teach us how to help consumers make decisions that they want to make, but struggle to. In this section, we’ll examine two such “nudges” that have been implemented in the real world: Thaler’s Save More Tomorrow plan and his reformulated letters to delinquent taxpayers in the UK.

Nudge #1: The Save More Tomorrow Plan

Thaler’s first nudge addressed a widespread problem in the US in the mid-1990s: Consumers were...

Shortform Exercise: Reflect on Your Budget

Thaler argues that the standard practice of budgeting can lead to irrational behavior when individuals treat budgeting categories as independent of each other. In this exercise, reflect on your own budget and consider ways to avoid budgeting irrationally.

What does your budget look like in a typical month? Write down the different categories within your budget and the money that you allocate to each category.