Richard Thaler is already known in the business world for his theory of nudges, as well as his work with Daniel Kahneman and Amos Tversky on the way individuals evaluate risk. The main idea is that real people – as opposed to members of the mythical species homo economicus – are sensitive to framing effects, like the existence of a default option, or if something is considered a gain or loss. In Thaler’s new book, he reviews the whole history of behavioral economics
-in which he played an large role. Thaler coins terms like “Invisible Handwave,” for the belief – without supporting data – that markets solve all problems, and “SIF,” which stands for supposedly irrelevant factors.
In a Freakonomics podcast, Thaler helps show why acting like an Homo Economicus is probably best way to go through life, anyway. This is for a couple reasons. First, it is impossible for an actual human endowed with “bounded rationality” to constantly update a metaphorical (or actual) spreadsheet of all possible actions to find the optimal course of action. Second, many social conventions (like not auctioning subway seats) explicitly or implicitly hinder individuals from acting like compete sociopaths.
Empirical Economics definitively shows that people do not make decisions rationally. So why does the myth of Econs persist? Like physics without friction, utility-maximizing, omniscient Econs provide a convenient starting point for models, since the math is tractable, but they remain models. The main theme of Misbehaving is that the conventional theory of economics did not go quietly. Each time “anomalies” were found by Thaler et al, defenders of the old guard rushed to find new ad hoc explanations to save the view that people act like Econs. Taking models too seriously might have been a major factor in the housing collapse. Emanuel Derman titled his book “Models.Behaving.Badly.: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life.”