Man is a rational animal who always loses his temper when he is
called upon to act in accordance with the dictates of reason.
Oscar Wilde
His thesis was on “The Value of Life”, but it seemed the ongoing economic theory did not help him solve the puzzle of life. His Ph.D. advisor summarized his assessment of him by saying “We did not expect much of him”. The man had doubts about the theory he was told to use. Either it was flawed, or he did not understand it. Even though he had M.A. and Ph.D. degrees in Economics, he consistently objected to the idea of a rational and optimizing man, which forms the basis of economic theory. According to mainstream theory, the human is assumed to be optimizing and finding the best solutions to all daily problems, including choosing the best mortgage, finding the best credit card, and consuming optimal amounts each day. This seemed counterintuitive to him. His preoccupation centered on several counterexamples of irrational behaviors of the human. He called these irrationalities "anomalies". He criticized the theory; started writing about these anomalies. But he was swimming against “the tide”. He tried to collaborate with people from psychology, organized seminars summer schools. He was trying to discover how human behaviors influence and contribute to the reformulation of the economic theory. He thought economists should discover and unearth the unknowns of the human interaction with the economic environment. That is what exactly he did for many years after his Ph.D. He and several other colleagues, who of whom believed the same thing, developed a field called behavioral economics. In 2017, he received the Nobel Prize in Economics[1]. That was Richard Thaler.
Thaler legitimated this theory with two important examples showing how investors sometimes act irrationally or even in a foolish way. The first example discusses a stock market event in the 2000s. The value of the company Palm was about twice the value of the company 3Com. What made this phenomenon irrational was 3Com owns 94 percent of Palm. How could a company be more valuable than the company owning it? To illustrate, assume you are the owner of "Chicago Tacos" which has ten branches in greater Chicago area. Assume again the market value of your company is 10 million dollars but the market value of your branch in Rockford is 15 million dollars. If this were true, the value of your other nine branches would have been -5 million dollars. This exemplifies roughly the case for 3Com. If this were possible, the value of 3Com's other companies would have been negative. However, that was what happened. Thaler tells a story of one of his students who bought a sports car by simply short selling the expensive stock and buying the cheap one.
The second example belongs to a closed-end mutual fund, CUBA. Closed-end mutual funds raise money from investors first, then make an investment using that money in the shares traded on the stock exchanges. CUBA was traded on Nasdaq. For the sake of understanding this point, you can think CUBA as a publicly traded company; the name “closed-end mutual fund” is not of great importance at this point. Even though the name sounds so, this fund could not invest in Cuba, the country, because US companies were prohibited to invest in Cuba since the 1960s. The company’s investments were heavily in US stocks and had zero investments in Cuba. However, the similarity in the names CUBA and Cuba influenced the market.
On December 18, 2014, something weird happened. President Obama announced his decision to relax several restrictions against on Cuba. On that same day, the price of CUBA jumped to $12.7 from $6.2. There was no overnight change in fund's profits or assets and it had no investments in Cuba. Despite this, good news about Cuba, doubled its share price. This was an irrational excitement within the markets. You may think ask “Isn’t it possible that everybody was confused at that day (this includes the giant investment companies)?”, but the prices did not recover the next day, nor the day after. It took almost a year for the prices to come back to the $6 levels. According to Thaler, this phenomenon pointed out how irrational the investors were behaving and the market sometimes fails to correct these irrationalities.
Thaler was claiming the markets, hence the investors can sometimes behave absolutely irrational, and thus he tried to embed the psychology into the economic models. Thaler recognized people’s psychology affected their economic and financial decisions, and these decisions could sometimes end up being very foolish. This was the basic idea behind the foundation of behavioral economics. Behavioral economics does not assume people are rational and instead it models human behavior with imperfections and inconsistencies, thus providing related solutions. If you assume the human is rational, then there is nothing to correct, given that the human is supposed to make no mistakes.
Thaler was among the founding fathers of behavioral economics and contributed a lot to this field. Some of his contributions stand out. The "sunk cost" is one of those. Here is a simple experiment[2] showing how it works: Assume you were planning to go on a ski trip, found one in Michigan for $200 and bought it. Later, you found a better deal in Wisconsin for $100 and bought this one too. Imagine now, they happened to be exactly on the same day, and the tickets could not be resold or refunded. Which trip would you go? Michigan or Wisconsin? Most of the people choose to go Michigan because if they do not do so, they will feel as if they are losing $200. But in the Wisconsin case, they feel they are losing $100. The more you spent on something, the more difficult it is to abandon. People cannot decide without thinking about the “sunk cost” they already paid. But the money is already gone, no matter what.
In his book Misbehaving, Thaler tells a story of one of his friends, Joyce. Joyce bought a new dress for his 6-year-old daughter, Cindy, to wear in school. However, Cindy did not want to wear it as she wanted to wear only pants or shorts. Joyce yelled at Cindy saying she paid so much money for the dress and the money would be wasted if she did not wear it. Her efforts were in vain. She asked Thaler to be a mediator. Thaler told his friend this behavior was not rational. Money was gone; they could not save the money by wearing the dress. Unless she asks for a dress new – which she has indicated she does not want - wearing the dress does not recover the costs.
Even being an expert in a subject cannot save you from making such mistakes. Once, Thaler fell into a similar mistake. He made an advance payment for a holiday and when that day came, his daughter did not want to go because of a birthday party on the same day. When he said, "We paid so much money, it is going to be wasted," he received an economist` answer from his daughter: "There is no point in trying to salvage the sunk cost. It is gone. "
The sunk cost makes people do weird things. It makes you finish the meal even though you are already full. It prevents you from throwing unused items away from home. But this behavior is hardly limited to individuals in domestic settings. Sometimes the individuals working with or in institutions, corporations, and even governments are committing similar silly mistakes. At the extreme, some countries do not end wars because they invested too much to quit.
Thaler's Mugs
We own many things in life: home, car, work, bicycle, table, chair, among other things. All of those items have some economic values. The house is a very expensive, the car is usually cheaper than the house (if you do not own a Ferrari). Some items are very valuable to you, but they may mean nothing to others.
I never saw an estate sale before coming to Rockford. A lady was selling everything she owned including a washing machine, dishwasher, fridge, T-shirts, pants shoes, teacups, and multiple other items. However, it was not herself making the sale. There was an intermediary company. Two or three agents from this company came to the house and dealt with the sale. One was wandering in the house; the other was a cashier at the door. The lady was not present. All the goods in the house had a price tag on it. To me, the prices were amazingly low. Shirts were sold for $ 2-3, shoes for $ 3-4, coats sold for $ 7-8. They were very cheap, no matter how much it was used. Why did the lady not sell the items herself, instead of engaging a company to sell the goods?
I asked this question to the company’s agent: "Why are landowners choosing you to sell the items at home, why do not they do it?" The agent told me everybody has memories in each of the items, resulting in asking for a high price for the goods. When the owner sells the goods the items are not sold. That was something I knew. I read it in one of Thaler’s articles. He mentioned this was a frequent psychological phenomenon.
Thaler together with his colleagues did a quite simple experiment: They bought some mugs with university’s insignia on it. They gave these mugs to a group of students. Another group did not receive anything. Both groups were asked to guess the price of the mugs. Those who owned the mugs valued the mugs far above than those who did not own them. The results of this experiment have been repeated in many countries around the world, and usually with coffee cups having a university insignia on it. Not many people have thought about using another product like a notebook, book, wallet, or others for this experiment. So, at every university where the experiment was held, enough cups were sold to conduct this experiment. Thaler says: "Someone that makes mugs with university insignias owes me dinner."
Thaler's contributions to humanity are not limited to behavioral economics. Behavioral economics “has helped us understand investor behavior, consumer behavior, employee behavior. It’s really altered how we think about the field of economics,” said Harvard Law School Professor Cass Sunstein.[3] He once said, “Make your research about the world, not the literature”[4] when asked what advice he would provide to graduate students in economics.
Thaler says he and his research team had several interviews with families. He mentions the importance of interacting with people to understand them. Thaler reiterates what Adam Smith did two hundred years ago. Smith visited a pin factory to understand how production influenced the economy, making both beneficially operational. He emphasizes people cannot be understood from our Ivory towers. When he received the Nobel prize for that reason, Peter Gardenfors, a member of the Nobel committee famously said, "He has made the economics more human. [5]"
You can see people's irrationalities everywhere but not in economics textbooks. Someone had to do this. Thank you, Thaler ...
[1]The Nobel Memorial Prize in Economic Sciences is commonly referred to as the Nobel Prize in Economics.
[2] Arkes and Blumer 1985.
[3] http://www.chicagotribune.com/business/ct-nobel-prize-economics-richard-thaler-20171009-story.html