Having read the books Nudge (2009) and Misbehaving (2015) by Richard H. Thaler, I decided to get a copy of his book The Winner’s Curse: Paradoxes and Anomalies of Economic Life recently. At first sight, the book seems a bit dated because it was already published in 1992. Yet, the content of the book is as relevant today is it was in the nineties.
The title of the book already implies that it is about economics anomalies, where Thaler defines an anomaly as a “fact or observation that is inconsistent with the theory” (p.2). In order to come across a cogent anomaly, Thaler argues that one needs:
- A theory which allows for clear predictions and
- Observations of actual human behaviour which are inconsistent with the predictions of the theory.
With these two basic ingredients Thaler succeeded in composing a book of 13 anomalies in total. His main intention at the time of writing was to raise awareness of economics anomalies. His vision, however, went beyond this: he envisioned the development of an improved economic theory which is consistent with actual human behaviour. For him, the cornerstones of this new theory would need to comprise optimising behaviour coupled with bounded rationality and social preferences. In Thaler’s words:
This new theory will retain the idea that individuals try to do the best they can, but these individuals will also have the human strengths of kindness and cooperation, together with the limited human abilities to store and process information. (p.5)
In the introduction to the book, Thaler gives a good overview on the model of rational choice on the one hand and actual choice on the other hand. Rational choice models are based on the assumptions of (1) rationality and (2) self-interest. This allows for the well-known ‘homo economicus’ (rational man) in standard economic theory. He (or she) maximises his (her) utility by making optimal choices, knowing his (her) preferences and planning well ahead. Then there is actual human choice with anomalies like the winner’s curse, under-saving for retirement or a significant gap between the willingness to accept (WTA) and the willingness to pay (WTP) for a good.
Despite considerable evidence for the incompatibility of rational choice and actual human choice, proponents of the rational choice model provide a range of reasons for why rational choice should be retained. Thaler lists the following four as examples:
- People act ‘as if’ they possessed the knowledge necessary for making a rational choice.
- The shortcomings of the rationality and self-interest assumptions do not matter (“it does not matter if the assumptions are wrong if the theory still makes good predictions” (p.4)).
- The mistakes of individuals cancel out in aggregate.
- Strong incentives for optimal choice, for example transaction costs, will induce people to behave rationally and in self-interest.
Having described the proponents’ strongest arguments for rational choice models, Thaler continues to refute each of them. For example, mistakes are unlikely to cancel out in aggregate because they are likely to be in the same direction. This might be due to confounding factors. Imagine that the individuals in an economy base their investment decisions on the news and forecasts available to everyone. Then, over-optimistic or over-pessimistic news will likely bias individuals in the same manner. As a result, individuals as collective will likely be over-optimistic or over-pessimistic in their investment decisions. Hence the argument that mistakes are irrelevant to aggregate behaviour in the economy and therefore the conclusion that rational choice is the golden rule for economic theory is rather weak.
I am in the midst of reading Thaler’s book. However, the inspiration and motivation behind The Winner’s Curse as well as Thaler’s vision of economic theory in the future makes me keen to read more on the 13 anomalies. I love his writing style; it is engaging and challenging your mind at the same time. It also makes you aware of your own biases and from an economist point of view, it challenges your conventional training. In sum, if you enjoyed Thaler’s books Nudge and Misbehaving as much as I did, then you should not miss out on The Winner’s Curse.
Many thanks for reading,
Thaler, R.H. (1992). The Winner’s Curse: Paradoxes and Anomalies of Economic Life. Princeton: Princeton University Press.
Sunstein, C.R., Thaler, R.H. (2009). Nudge: Improving Decisions About Health, Wealth and Happiness. London: Penguin Books.
Thaler, R.H. (2015). Misbehaving: The Making of Behavioral Economics. New York: W.W. Norton & Company.