Misbehaving

The Flaws of Traditional Economic Theory

Richard Thaler discovered early in his teaching career that human reactions often defy the logic of traditional mathematics. He once gave a difficult exam where the average score was 72 out of 100, which made his students incredibly angry despite a generous grading curve. To fix this without making the test easier, Thaler changed the total possible points to 137. On the next exam, the average score rose to 96, and even though this was a lower percentage than the previous exam, the students were thrilled. This reaction makes no sense in standard economic theory, which assumes a person should only care about their actual grade and the percentage of correct answers.

Standard economic theory is built on the idea of a fictional creature often called an Econ. These Econs are perfectly rational, never overconfident, and always make the best possible choice to maximize their well-being. In contrast, real people are simply Humans, who have limited time, energy, and mental capacity. Economists often ignore factors that they consider irrelevant, such as the way a choice is described, but for Humans, these supposedly irrelevant factors are often the most important parts of a decision. Because traditional models ignore these human traits, they often fail to predict major events, such as the 2008 financial crisis.

When Thaler began his tenure at Cornell in 1978, he faced the formidable task of proving that human behavior deserved a place in economic theory. He had to defend his ideas against deeply entrenched arguments used to dismiss human irrationality, a process he called running the Gauntlet. One common dismissal was the "as if" argument, which suggested that even if people are not math experts, they behave as if they have solved complex equations to reach an optimal decision. Thaler countered this by pointing out that economics should describe everyone, not just experts, because a typical person often makes predictable mistakes when buying groceries or saving for retirement.

The tension between traditional rationality and behavioral reality came to a head at a 1985 conference at the University of Chicago. During the debate, psychologists Daniel Kahneman and Amos Tversky presented evidence that people’s choices are easily manipulated by how a problem is framed. When a medical solution was framed in terms of lives saved, people chose the safe option, but when the exact same outcome was framed in terms of lives lost, people suddenly became gamblers. This inconsistency proved that humans are not the logical Econs that traditional models assume, as our decisions are frequently swayed by emotion and presentation.

To bring these inconsistencies to light, Thaler began documenting specific instances where real-world behavior violated the standard expectations of economic theory. He gathered data showing that stock prices behave in ways that have nothing to do with logic, and that racetrack bettors consistently make poor financial choices by overvaluing unlikely outcomes. By sharing these findings with thousands of colleagues, Thaler helped move the conversation away from abstract math and toward the messy reality of human life. He eventually built a community of researchers and launched summer programs to train the next generation of scholars, transforming behavioral economics into a respected part of mainstream science.