Misbehaving: The Making of Behavioral Economics by Richard H. Thaler Read Free Book Online

ignored. I soon had another list: reasons why economists could safely ignore behaviors such as those on the List. Among friends I would call this series of questions the Gauntlet, since any time I gave a talk about my work it felt like running a medieval gauntlet. Here are a few of the most important ones, along with the preliminary responses I had worked up at the time. To some extent people are still arguing about these points; you will see them reappear throughout the book.
    As if
    One of the most prominent of the putdowns had only two words: “as if.” Briefly stated, the argument is that even if people are not capable of actually solving the complex problems that economists assume they can handle, they behave “as if” they can.
    To understand the “as if” critique, it is helpful to look back a bit into the history of economics. The discipline underwent something of a revolution after World War II. Economists led by Kenneth Arrow, John Hicks, and Paul Samuelson accelerated an ongoing trend of making economic theory more mathematically formal. The two central concepts of economics remained the same—namely, that agents optimize and markets reach a stable equilibrium—but economists became more sophisticated in their ability to characterize the optimal solutions to problems as well as to determine the conditions under which a market will reach an equilibrium.
    One example is the so-called theory of the firm, which comes down to saying that firms maximize profits (or share price). As modern theorists started to spell out precisely what this meant, some economists objected on the grounds that real managers were not able to solve such problems.
    One simple example was called “marginal analysis.” Recall from chapter 4 that a firm striving to maximize profits will set price and output at the point where marginal cost equals marginal revenue. The same analysis applies to hiring workers. Keep hiring workers until the cost of the last worker equals the increase in revenue that the worker produces. These results may seem innocuous enough, but in the late 1940s a debate raged in the American Economic Review about whether real managers actually behaved this way.
    The debate was kicked off by Richard Lester, a plucky associate professor of economics at Princeton. He had the temerity to write to the owners of manufacturing companies and ask them to explain their processes for deciding how many workers to hire and how much output to produce. None of the executives reported doing anything that appeared to resemble “equating at the margin.” First, they did not seem to think about the effect of changes in the prices of their products or the possibility of changing what they paid to workers. Counter to the theory, they did not appear to think that changes in wages would affect either their hiring or output decisions much. Instead, they reported trying to sell as much of their product as they could, and increasing or decreasing the workforce to meet that level of demand. Lester ends his paper boldly: “This paper raises grave doubts as to the validity of conventional marginal theory and the assumptions on which it rests.”
    The defense team for the marginal theory was headed up by Fritz Machlup, who was then at the University of Buffalo but later joined Lester at Princeton, perhaps to continue the debate in person. Machlup brushed Lester’s survey data aside on the grounds that economists are not really interested in what people say they are doing. The theory does not require that firms explicitly calculate marginal costs and marginal revenues, he argued, but their actions nevertheless will approximate those predicted by the theory. He offered the analogy of a driver deciding when to pass a truck on a two-lane highway. The driver will not make any calculations, yet will manage to overtake the truck. An executive, he argued, would make decisions much the same way. “He would simply rely on his sense or his ‘feel’ of