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How economists think differently from other humans

June 25, 2015 at 6:25 PM EDT
In economics, a theory has long prevailed that markets are based on people making rational choices. But behavioral economist Richard Thaler is seeking to prove that there is far more randomness to our financial decisions. Economics correspondent Paul Solman talks to Thaler to find out why we buy and to discuss Thaler’s new book, “Misbehaving.”
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GWEN IFILL: Economics correspondent Paul Solman spends a lot of time trying to explain and assess why markets, individuals, consumers, and businesses behave the way they do. But there’s a growing school of thought that says the traditional answers to those questions may not be the correct ones.

Paul caught up with one of the leading thinkers changing the way we look at economic behavior, as part of his series Making Sense, which airs every Thursday on the NewsHour.

PAUL SOLMAN: In Chicago’s Millennium Park, Richard Thaler, an academic revolutionary, who thinks his field, economics, has a weirdly distorted view of human behavior that we’re all rational maximizers, mathematical machines, who use our unusually big brains to wisely calculate every decision as we strive to get to the top, thus creating perfect markets to make us better off.

Yet, says Thaler:

RICHARD THALER, Economist, University of Chicago: After the ’87 crash, when the market fell 20 percent in a day, and the Internet bubble, when the Nasdaq went from 5000 to 1400, and then the real estate bubble, which led to a financial crisis from which we’re still trying to extricate ourselves, the idea that markets work perfectly is no longer tenable.

PAUL SOLMAN: Thaler is running his revolution from inside the belly of the beast, the University of Chicago, which boasts 28 Nobel laureates practiced in traditional economics.

Collectively, they have created what’s known as the Chicago School, predicated on the perfect efficiency of markets, in which prices rationally reflect all available information. But at a lunch with star students, Thaler offered his latest favorite example of markets behaving badly, a closed end stock fund called the Herzfeld Caribbean Basin Fund.

RICHARD THALER: Ticker symbol CUBA. Now, needless to say, it cannot and doesn’t invest in Cuba. That’s against the law.

(LAUGHTER)

RICHARD THALER: And there wouldn’t be anything to buy anyway. There are no traded securities in Cuba.

PAUL SOLMAN: Now, typically, the shares of closed end funds, which simply own a basket of stocks, shouldn’t be worth more than the stocks themselves. Otherwise, you could save money by just buying the stocks yourself.

RICHARD THALER: Nevertheless, the day that President Obama made an announcement that relationships with Cuba would be eased, this fund shot to a 70 percent premium, and is now selling at about a 40 percent premium.

PAUL SOLMAN: Now, to be fair, the fund does invest in firms likely to benefit from economic development throughout the Caribbean, including Cuba, but that doesn’t explain why shares of the fund are now worth a whopping $140 for every $100 worth of actual stocks in the fund.

RICHARD THALER: Cuba, good, price goes up.

(LAUGHTER)

RICHARD THALER: Would you say that’s consistent with a rational, efficient market?

PAUL SOLMAN: Thaler started noticing such market anomalies early in his career as an economist.

RICHARD THALER: The market would be up in January. It would go up on Fridays, down on Mondays. It would go up on the day before holidays. None of this made any sense.

PAUL SOLMAN: So he began challenging economic orthodoxies. Today, his version of economics, behavioral economics, has finally taken hold, a story that he tells in his new book, “Misbehaving.”

It’s a hit even here in orthodox Chicago, where the book’s very price is an example of economic irrationality.

RICHARD THALER: My book is 30 percent off, and people love deals. They can be driven to purchase things that they don’t really want if the deal is good enough.

PAUL SOLMAN: By contrast, Chicago School economists long argued that if someone chooses to buy Thaler’s book, say, or anything else, that’s proof enough that they want it at the price being paid, deal or no deal. All human behavior, says Thaler, was reduced to similar absurdities, usually accompanied by mathematical equations.

RICHARD THALER: Marry the optimal wife. Get divorced when the utility of being married turned negative.

PAUL SOLMAN: But it was only when Thaler began doing experiments and publishing them that doctrinaire economists, whom he calls e-cons, began to admit some of the error of their ways.

Take the concept of sunk costs, time and money already spent. An e-con assumes everyone knows when to quit, cut their losses, move on. This group of Cameroonian students at first seemed to get that.

RICHARD THALER: Let’s suppose you bought tickets to go to a concert over here at this fancy bandshell 40 bucks each. And the group is OK, but then it starts to rain. How long do you think you’re going to stick around this concert?

MAN: Not much.

PAUL SOLMAN: Not much?

RICHARD THALER: Not much.

MAN: Not much.

PAUL SOLMAN: But what if the sunk costs suddenly swell?

How many of you would have a different decision about staying or leave leaving, if it was $500, as opposed to $40? Every single one of you.

MAN: I have to make my money worth it.

PAUL SOLMAN: You have to make your money worth it.

MAN: Yes.

PAUL SOLMAN: And your point here?

RICHARD THALER: Well, economists would say how much you paid for the ticket, tough luck, if it’s $40 or $500.

PAUL SOLMAN: Doesn’t matter.

RICHARD THALER: You should just decide whether the music is worth the annoyance of the rain.

PAUL SOLMAN: Then there’s the way most people value their time, as when Riley Gaunt is shopping for a $40 pair of shoes learns they’re on sale for $30.

RICHARD THALER: But it’s another store 10-minute drive away.

RILEY GAUNT: OK.

RICHARD THALER: Would you go?

RILEY GAUNT: Probably.

RICHARD THALER: OK.

PAUL SOLMAN: But what if she’s shopping for a $200 dress that she learns another store is selling for $190.

RICHARD THALER: Do you think you would go?

RILEY GAUNT: No.

PAUL SOLMAN: But you see the point, right? If 10 minutes is worth $10 to you, it doesn’t matter how you’re saving the $10, no?

RILEY GAUNT: Yes, I mean, that makes sense.

PAUL SOLMAN: Now that you have heard this explanation, would you change your answer?

RILEY GAUNT: No, probably not.

RICHARD THALER: So, Charlie…

PAUL SOLMAN: Her boyfriend, Charlie Ellis, had his own distinctly non-e-con approach to personal finance.

RICHARD THALER: Are you pumped about the finals?

CHARLIE ELLIS: I’m so pumped. I’m ready.

PAUL SOLMAN: We taped this on the eve of the Stanley Cup Finals, eventually won by the Chicago Black Hawks.

RICHARD THALER: Suppose I told you I have two tickets to the first home game about 10 rows behind the penalty box.

CHARLIE ELLIS: I would be so excited.

RICHARD THALER: Now let’s suppose I gave you those two tickets.

PAUL SOLMAN: How much would he demand to sell those tickets?

CHARLIE ELLIS: Whew, man, maybe $500, if I could get that.

RICHARD THALER: Five hundred each?

CHARLIE ELLIS: A pop, yes.

PAUL SOLMAN: And how much would he pay if he had to buy the tickets?

CHARLIE ELLIS: Maybe $200.

RICHARD THALER: OK, so, about half.

CHARLIE ELLIS: Yes.

PAUL SOLMAN: Now, an e-con would say the price to buy or sell should be about the same, but not a human, and not our cameraman, a die-hard Black Hawks fan himself who had heard the entire previous exchange, and then gave exactly the same answers.

MAN: I wouldn’t pay as much as I’m going to sell it for.

PAUL SOLMAN: And this is after he has heard you do this already.

RICHARD THALER: Yes, you know, teaching the principles doesn’t make people do it.

PAUL SOLMAN: After nearly four decades of trying to prove just how crazy economics can be, Richard Thaler is now running the asylum, as president of the American Economic Association.

His behavioral economic theories have been put into practice by governments around the world, including ours, in so-called nudge units, based on his previous bestseller. Not bad for a guy who thought he’d never get tenured for such unconventional work.

And how does he now feel about being called the inventor of behavioral economics?

RICHARD THALER: One guy can’t create a field, but you can get people thinking.

PAUL SOLMAN: And so he has.

This is Paul Solman reporting for the PBS NewsHour from ever more sensible and unorthodox Chicago, Illinois.

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