Behavioral Economics #3: Change

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Change happens very slowly, then all at once.

This seems to have been the case for behavioral economics as well. Traditional economics/economists didn’t exactly roll out the red carpet for these noisy newcomers and certainly weren’t enthusiastic about what ended up being a seismic shift in the profession.

The biggest problem was that, aside from our engagement with the experimental economics community, Amos [Tversky], Danny [Kahneman], and I were mostly talking to one another. That state of affairs was about to change.
— Richard Thaler (Page 157 of "Misbehaving: The Making of Behavioral Economics")

To be taken seriously though, behavioral economics had to overcome a crucial hurdle: isolation. If it remained in a silo, it would never win the respect of the mainstream economics community and would forever remain in infancy.

In Chapter 19 of his book Misbehaving: The Making of Behavioral Economics, Richard Thaler laments the fact that “behavioral economics has turned out to be primarily a field in which economists read the work of psychologists and then go about their business of doing research independently.” Psychologists, so crucial to the progress of behavioral economics were rarely invited to contribute. He describes three reasons for this unfortunate lack of collaboration.

First, given that most of the findings of behavioral economics were blatantly obvious to psychologists — of course people struggle with self-control! — they didn’t think it was particularly interesting to spend to much time investigating it. Second, and connected to this, was the fact that the findings that behavioral economics borrowed from psychology weren’t exactly cutting-edge, further adding to psychologists feeling of “yeah, so what?” Thaler likened it to how uninterested economists would be if psychologists used basic supply and demand curves in their research.

Lastly, and perhaps most importantly, the study of applied problems in psychology has generally been ignored. Government officials invite economists to the table when they’re forming policy, not psychologists.

Economic theory, the design of markets, public policy making, and a lot more depended on theories about how people made decisions. But psychologists — the people most likely to test these theories and determine how people actually made decisions — hadn’t paid much attention to the subject.

[Psychology professor at Johns Hopkins, Ward] Edwards wasn’t setting himself, or his field, in opposition to economics. He was merely proposing that psychologists be invited, or perhaps invite themselves, to test both the assumptions and the predictions made by economists.
— Michael Lewis (Page 103 of "The Undoing Project: A Friendship That Changed Our Minds")

So behavioral economics not only had to become respected by traditional economics, but also had to convince psychologists to join the team, much in the way that Nick Fury had to recruit the Avengers in the Marvel movies/comics. In this post, I’ll focus on the first part of that challenge, leaving the second part for the next part of the series.

Note: The research for this post came from Chapters 17 through 19 of Richard Thaler’s book Misbehaving: The Making of Behavioral Economics.

If you’re new to my Behavioral Economics Series, make sure to read parts 1 and 2 by clicking the buttons below.

The Kuhn Cycle

Before I get into the main body of this post, I think this is the right time to describe a model that will be useful for you as you read this post and think about behavioral economics’ fight to become accepted as a legitimate academic profession. In his seminal 1962 book The Structure of Scientific Revolutions, the American philosopher of science Thomas Kuhn described the cycle of progress in a scientific paradigm. The steps are as follows:

1. Pre-Science

At this stage, there is not yet a model of understanding that is strong enough to solve the field’s main problems or make major advances in it. In other words, there’s not yet a “real” science that has sufficiently strong predictive power.

2. Normal Science

A paradigm is formed and a model of understanding is created. In this case, we’re talking about the traditional economics that believes in a world of Econs.

3. Model Drift

Over time, the profession discovers new questions that its current model of understanding cannot answer (many of which were described in Part 2 of this series). The established model becomes weaker as more of these anomalies (or "violations of expectations") are found.

4. Model Crisis

Ah, the dreaded “c”-word. Once scientists in the field can no longer reconcile the growing number of anomalies, a critical mass of model drift is reached and a crisis occurs. While some of these were discussed in Part 2, I failed to mention the crisis of confidence that the economics profession experienced when it failed to predict the Great Recession of 2008. Economics lost a lot of respect in that period.

When we hit our lowest point, we are open to the greatest change.
— Avatar Aang (in the show "The Legend of Korra")

5. Model Revolution

And now the much-cherished “r”-word! This can also be described as the “out-with-the-old, in-with-the-new” phase. In our example, this is where behavioral economics challenges traditional economics and offers a different/better explanation for the failings of the old paradigm. This is also probably the point where the newcomers have to break past the egos of the incumbents, who obviously don’t want to hear that the work they’ve spent decades working on had some seriously glaring errors.

6. Paradigm Change

The all-important final phase of the performance. If this is successfully completed, the old paradigm is officially discarded and the new one becomes the accepted standard and taught to current- and new academics in the field. We’ll discuss this phase and all other phases of this model in more detail in a future part of this series.

The Battleground

In October 1985, Robin Hogarth (a psychologist) and Mel Reder (an economist) of the University of Chicago Graduate School of Business organized a conference at their university. As Richard Thaler describes it in his book Misbehaving, Hogarth and Reder invited ‘rationalists’ — “defenders of the traditional way of doing economics” — and ‘behavioralists’ — behavioral economists — to the conference in order to “sort out whether there was really any reason to take psychology and behavioral economics seriously.”

You have to understand just how important this conference was for the behavioralists. If real change was to occur in the field of traditional economists, the behavioralists had to show that they could win an intellectual battle against the powers-that-be. Moreover, this two-day conference was a crucial opportunity for them to step out of their silo. Thaler states that, unsurprisingly, every seat in the auditorium was taken.

The teams were composed as follows:

  • Behavioralists Team: Herb Simon, Amos Tversky, Daniel Kahneman, and Kenneth Arrow, with Bob Shiller, Richard Zeckhauser, and Richard Thaler given speaking roles as discussants.

  • Rationalists Team: Robert Lucas and Merton Miller, with Eugene Fama and Sherwin Rosen as panel moderators.

Note: these individuals will be discussed in detail in the next part (#4) of the Behavioral Economics series.

Day One

The first day proceeded without too much fuss as the behavioralists took the stage. First, Tversky presented the paper that he and Kahneman had recently completed in which they investigated the Asian Disease problem (discussed in part 2). Then, Kahneman discussed some work on fairness, mainly through the famous Ultimatum and Dictator Game experiments.

Kenneth Arrow, whose mind operates even faster than his surname suggests, gave the most interesting talk of the day. He took aim (last pun, I promise) at the idea that rationality (i.e. optimization) was necessary for good economic theory and argued that it is “neither necessary nor sufficient [in order] to do good economic theory.”

He found it strange that an economist, “who toils for months to derive the optimal solution to some complex economic problem”, assumes that the people in his models behave as if they’re capable of solving such difficult problems all the time (an argument which was also explored in Part 2 of this series).

Day Two

The rationalists got their turn on day two. Merton Miller, who had worked together with Nobel Prize winner in Economics (1985) Franco Modigliani, explained the Miller-Modigliani irrelevance theorem that the two of them had created. This theory was important because it centered on a key assumption: the fungibility of money. To explain this assumption in normal English, let’s say you have three jars filled with equal amounts of money. The jars are labeled “rent”, “groceries”, and “clothes.”

If I move $10 from my rent jar to my groceries jar, my wealth has not changed. I’m not suddenly poorer because I have $10 less in my rent jar, “cannot afford my rent”, but have a surplus in grocery money. All three jars are my money. A dollar in one jar is the exact same as a dollar in another jar (at least, if you’re an Econ). This may sound insultingly simple, but it has important implications in corporate finance and mental accounting (this article by Jessica Sier explains it nicely).

Anyway, Miller was tasked with defending the rationalists’ perspective by explaining yet another case of people (or, in this case, corporations) misbehaving. According to the Miller-Modigliani theorem, under a very strict set of assumptions, “it would not matter whether a firm chose to pay a dividend or instead use that money to repurchase their own shares or reduce their debts.” However, a 1984 behavioral finance paper by Hersh Shefrin and Meir Statman offered…

...a behavioral explanation for an embarrassing fact. One of the key assumptions in the Miller-Modigliani irrelevance theorem was the absence of taxes. Paying dividends would no longer be irrelevant if dividends were taxed differently than the other ways firms return money to their shareholders. And given the tax code in the United States at that time, firms should not have been paying dividends. The embarrassing fact was that most large firms did pay dividends... So the puzzle was: why did firms punish their tax-paying shareholders by paying dividends?
— Richard Thaler (Page 164-165 of "Misbehaving: The Making of Behavioral Economics")

According to Shefrin and Statman, some shareholders, especially retirees, mentally categorized the inflows of dividends as income “so that they don’t feel bad spending that money to live on.” This was a clear error of mental accounting and obviously makes no sense to an Econ. Rationally, a person should buy shares in companies that do not pay dividends, sell a portion of those holdings periodically, and live off of those proceeds (that are taxed less than dividends).

Similar to the concept of spending house money in poker, however, people think that it’s better to spend the income from a (winning) bet and leave the principal alone, which might explain why these shareholders preferred getting dividends even though they’re taxed at a higher rate.

The rationalists obviously did not like concepts from behavioral economics being used to explain such an anomaly, and Miller was certainly not a fan. However, in a confusing display of indecision, Miller seemed to both strongly dislike this behavioralist explanation and admit that it was probably true.

Specifically, he agreed that most firms should not pay dividends, even though most did. And yet he also agreed that the model that best explained this peculiarity was one created by the financial economist John Lintner, which was one that Miller himself labeled behavioral! “This sounds like a paper written by someone who has come to praise behavioral finance, not bury it,” Thaler states on page 166 of his book Misbehaving.

So it seems that a key player of the rationalists team was conceding that his team had just lost an important battle, right?

Absolutely not. In Miller’s words:

The purpose of this paper has been to show that the rationality-based market equilibrium models in finance in general and of dividends in particular are alive and well — or at least in no worse shape than other comparable models in economics at their level of aggregation.

The framework is not so weighed down with anomalies that a complete reconstruction (on behavioral/cognitive or other lines) is either needed or likely to occur in the near future.
— Merton H. Miller (in his 1986 paper "Behavioral Rationality in Finance: The Case of Dividends"

An admirable defense, but Thaler admits that he “had trouble keeping track of which side of the case Miller was arguing.” Not only that, but he was also unconvinced by his flip-flopping between the two sides. “So, the strongest statement Miller could muster,” Thaler states on page 167, “was to say that the standard rational model of financial markets… was not quite dead.”

All in all, at the end of the conference it was hard to tell whether the event was a victory for the behavioralists or a successful defense by the rationalists. At the very least, it seems like behavioral economics made a very respectable case for itself and shown that it was ready to escalate the battle.

As usual after such meetings, or after debates between political candidates, both sides were confident that they had won. The debate between behavioral finance researchers and defenders of the efficient market hypothesis was just beginning, and has been continuing for the last thirty years, but in some ways it all began that afternoon in Chicago.
— Richard Thaler (Page 168 of "Misbehaving: The Making of Behavioral Economics")

Summer Camp

While important reputational progress was made at that conference in Chicago, behavioral economics had to sustain this momentum. It had to keep up the pressure by creating and encouraging the new, young scholars to join the field.

A key player in this process was the Russell Sage Foundation. In 1992, the foundation brought together a group of researchers, which it called The Behavioral Economics Roundtable, gave them a budget of $100,000 per year. The group had one simple objective: foster growth in behavioral economics (Note: The foundation and the members of the Roundtable will be discussed in more detail in the next part of the series).

The Roundtable decided to start with cultivating the next generation of (young) behavioral economists. The team organized two-week, intensive summer training programs for graduate students (held in the summer to avoid conflict with university courses) and called these trainings the Russell Sage Foundation Summer Institutes in Behavioral Economics, or the Russell Sage Summer Camps for short.

On page 183 of his book, Thaler states that the team wanted to “increase the likelihood that some of the best young graduate students in the world would seriously consider the idea of becoming behavioral economists” and to “provide them with a network of like-minded economists they could talk to.”

The first camp, held in Berkeley in the summer of 1994, was a huge success. Over 100 students applied and a group of 30 was picked to participate. Some of the most notable graduates of this camp were:

  • Sendhil Mullainathan: Professor of Computation and Behavioral Science at the University of Chicago Booth School of Business, winner of the famous MacArthur Foundation “genius grant”, co-founder of the first behavioral economics nonprofit think tank called ideas42 (fun fact: I actually applied for a job there a few years ago. Unsurprisingly, I didn’t get it), and co-author of the book Scarcity: Why Having Too Little Means So Much.

  • Terrance Odean: The Rudd Family Foundation Professor of Finance at Berkeley Haas, a highly-respected behavioral finance scholar, and the person who, as Thaler states, “essentially invented the field of individual investor behavior.”

  • Chip Heath: Thrive Foundation for Youth Professor of Organizational Behavior in the Stanford Graduate School of Business and co-author of the 2007 best-selling book Made to Stick: Why Some Ideas Survive and Others Die.

  • Linda Babcock: James M. Walton Professor of Economics and former Acting Dean at Carnegie Mellon University's H. John Heinz III School of Public Policy and Management. She is the founder and faculty director of the Program for Research and Outreach on Gender Equity in Society (PROGRESS) and, best of all, current member of the Russell Sage Foundation’s Behavioral Economics Roundtable.

  • Christine Jolls: The Gordon Bradford Tweedy Professor at Yale Law School and Director of the Law and Economics Program at the National Bureau of Economic Research (NBER). Also served as a law clerk at the Supreme Court of the United States. 

Not bad for a first camp.

Behavioral economics was well on its way to gaining reputation as a profession and cultivating talented new leaders to join the charge. The camps continue till this day, so if you or someone you know is interested in attending, give it a shot!

Next up: Meet the Troublemakers

In the next part, we’ll get to know the individuals and organizations that spearheaded the attack on traditional economics. While many of their names have already been mentioned in this and previous parts of the Behavioral Economics series, in the next part we’ll take a closer look at who they were, how (in the cases that they did) they ended up working together, and what motivated them to begin this daring assault on such an established profession.

Stay tuned!

See you, Space Cowboy.