Joe: Alright Lewis, before we dive in, quick-fire question. When you hear the term 'behavioral economics,' what's the first image that pops into your head? Lewis: Honestly? I picture a bunch of economists in a lab, poking a guy with a stick to see if he'll buy a second toaster he doesn't need. Just... weird human experiments. Joe: That's... not entirely wrong! And that's exactly what we're talking about today, through the lens of a book that basically chronicles the birth of that entire, slightly weird, field. We're diving into Misbehaving: The Making of Behavioral Economics by Richard H. Thaler. Lewis: Ah, Thaler. I know that name. Didn't he win a Nobel Prize for this stuff? It’s funny, because the book was apparently quite controversial among traditional economists when it came out. It was even shortlisted for a major business book award, which is rare for something so... academically rebellious. Joe: Exactly. He was the ultimate renegade. And the title, Misbehaving, is this brilliant double entendre. It’s about how we, as normal people, "misbehave" according to the perfect models of traditional economics. But it's also about how Thaler himself "misbehaved" by daring to challenge the orthodoxy of his entire profession. Lewis: I like that. A professional troublemaker. So, where does this story of economic misbehavior even begin? Joe: It begins with Thaler noticing these tiny, seemingly insignificant quirks in human behavior that economics just couldn't explain. Things that, on the surface, make absolutely no sense.

Joe: For example, early in his teaching career, Thaler gave his students a tough midterm. The total possible score was 100, and the class average came out to 72. Now, the grades were curved, so the final letter grades were fine—A's, B's, C's, the usual. But the students were furious. They felt like they had failed. Lewis: Yeah, I can definitely relate. Seeing a 72 on a paper feels bad, no matter what the curve is. It’s a C- in your soul. Joe: Exactly! So, for the next exam, Thaler did something ingenious. He made the exam slightly harder, but he changed the total number of points to 137. The average score this time was 96. Lewis: Wait a minute. 96 out of 137 is... let me do the math... that's only 70 percent! That's a worse score than the first exam. Joe: Precisely. But the students were ecstatic! They loved it. They felt smart. Thaler was so amused by this that he started putting a note in his syllabus: "Exams will have a total of 137 points... This scoring system has no effect on the grade you get in the course, but it seems to make you happier." Lewis: That is hilarious. And it perfectly captures this idea that we aren't cold, calculating machines. We're driven by feelings, by perceptions. But does this apply to things that actually matter, like money? Joe: Oh, absolutely. This is where Thaler's work gets really profound. He tells this fantastic story about a mentor of his, an economist named Richard Rosett, who was also a serious wine collector. Rosett had bottles in his cellar that he'd bought years ago for, say, $10. Now, those same bottles were selling at auction for over $100. Lewis: A nice little investment. Joe: A very nice investment. But here's the puzzle. Rosett would happily drink one of those $100 bottles on a special occasion. However, he confessed that he would never, ever pay $100 for a bottle of wine. He just wouldn't do it. Lewis: Hold on. That doesn't make any sense. If he drinks the bottle, he's giving up the $100 he could have gotten by selling it. Economically, drinking it is the same as buying it for $100. Joe: You, my friend, are thinking like an Econ. An Econ is the perfectly rational, logical being that lives in traditional economic models. For an Econ, the opportunity cost of drinking the wine is exactly the same as the out-of-pocket cost of buying it. But for a Human, they feel completely different. Lewis: So what is this phenomenon called? Joe: Thaler calls it the Endowment Effect. The simple act of owning something makes it more valuable to you. Once that bottle is in your cellar, it’s your bottle. To give it up feels like a loss, and we humans are wired to feel losses much more intensely than we feel equivalent gains. Thaler and his colleagues proved this with simple experiments, like giving half a class a coffee mug. Lewis: What happened? Joe: The people who got the mugs wouldn't sell them for less than, say, $5. But the people who didn't get a mug were only willing to pay about $2.50 to buy one. Same mug, but ownership doubled its perceived value. It's not about the mug; it's about the feeling of ownership. Lewis: Wow. So my garage full of old junk I can't bring myself to throw away... that's the endowment effect in action. It's not junk, it's my junk! Joe: It's your priceless, sentiment-infused junk. And that simple, powerful idea—that we aren't Econs, we are Humans who misbehave in predictable ways—is the foundation of everything Thaler built.

Lewis: Okay, so we're irrational about things we own. I get that. But what about our future selves? I feel like I'm in a constant battle with myself. Part of me wants to be healthy and save money, and the other part wants to order a pizza and buy a new video game. Joe: That's a perfect description of the next big piece of the puzzle. Thaler argues that we have a kind of internal civil war going on. He calls it the Planner-Doer model. Inside each of us, there's a long-term, goal-oriented "Planner" and a short-term, impulsive "Doer." Lewis: The Planner is the guy who sets the alarm for 6 a.m. to go to the gym. The Doer is the guy who smashes the snooze button nine times. Joe: Exactly. The Planner is your better angel, thinking about your retirement and your cholesterol levels. The Doer lives entirely in the present and just wants what feels good right now. The ancient Greeks understood this perfectly. Think of the story of Odysseus and the Sirens. Lewis: Right, the Sirens' song was so beautiful it would lure sailors to their deaths on the rocks. Joe: Odysseus, the Planner, knew this. He knew his future self, the Doer, would be powerless to resist the song. So what did he do? He made a commitment. He had his crew tie him to the mast of the ship and, crucially, plug their own ears with wax so they couldn't hear his pleas. He created a situation where his future, impulsive self was physically unable to make a bad decision. Lewis: He literally restrained his Doer. That's a brilliant way to think about it. But we can't all tie ourselves to a mast every time we pass a donut shop. Are there more practical, modern examples? Joe: There are. Thaler tells a simple one about hosting a dinner party. He puts out a bowl of cashews before the meal. Everyone starts munching on them, and soon they've eaten half the bowl. They know they're spoiling their appetite for the main course, but they can't stop. The Doer is in control. Lewis: I've been there. The hand just keeps going back to the bowl. Joe: So Thaler, the Planner, takes the bowl away and hides it in the kitchen. And what happens? Everyone thanks him! They were happy to have the option removed. This violates a core economic principle that more choice is always better. Sometimes, for Humans, less choice is a relief. Lewis: That's a great little hack. But what about bigger problems, like saving for retirement? That feels like the ultimate Planner-Doer battle. Joe: It is. And this is where Thaler and his collaborator Shlomo Benartzi came up with one of the most powerful ideas in behavioral economics: the Save More Tomorrow plan, or SMarT. Lewis: Okay, how does that work? Joe: It's designed to perfectly outsmart the Doer. They approached employees at a company who said they couldn't afford to save more. Instead of asking them to save more now, which the Doer would hate, they asked them to commit to saving more in the future. Specifically, they'd agree to increase their retirement contribution by a small amount every time they got a pay raise. Lewis: Oh, that's clever. So it never feels like a cut in your take-home pay. Joe: Exactly. It sidesteps loss aversion. Your paycheck never goes down. And second, it leverages inertia. Once you're in the plan, you stay in it automatically. You have to actively choose to opt out. It turns our natural laziness from a bug into a feature. Lewis: It’s a financial commitment device that works with our irrationality instead of fighting it. What were the results? Joe: They were staggering. In the first company they tried it, the employees who joined the SMarT plan nearly quadrupled their savings rate over about three years, going from 3.5% to 13.6%. It's been adopted by millions of people and has dramatically increased retirement savings. It’s a perfect example of using these small insights about our 'misbehavior' to create massive positive change.

Lewis: This is all fascinating for personal finance and self-help, but surely this doesn't happen in the big leagues, right? I mean, Wall Street traders, NFL General Managers... they're supposed to be the ultimate 'Econs,' aren't they? There's too much money and competition on the line for this kind of foolishness. Joe: That is the ultimate question, and it's the battleground where behavioral economics had to prove itself. If these biases disappear when the stakes are high, then it's just a collection of cute stories. But Thaler and others found that not only does misbehavior exist in high-stakes markets, it can create billion-dollar absurdities. Lewis: Like what? Give me the best example. Joe: The best, clearest example is the story of 3Com and Palm from the height of the dot-com bubble. 3Com was a solid, if boring, tech company. But they owned Palm, the maker of the super-hot PalmPilot, the must-have gadget of the late 90s. Lewis: I remember those! Everyone had one. Joe: Right. So, investors were going crazy for Palm, but they weren't as excited about 3Com's other businesses. To unlock Palm's value, 3Com decided to spin it off. They sold just 5% of Palm's shares to the public in an IPO, with the plan to give the remaining 95% to existing 3Com shareholders later. For every share of 3Com you owned, you'd get 1.5 shares of Palm. Lewis: Okay, so the price of a 3Com share should be, at a minimum, 1.5 times the price of a Palm share, right? Plus the value of all of 3Com's other businesses. Joe: That is what an Econ would say. That is the law of one price. But on the first day of trading, Palm's stock went through the roof. It closed at $95 a share. At the same time, 3Com's stock fell to $82. Lewis: Wait... run that by me again. Joe: You could buy one share of 3Com for $82, which entitled you to 1.5 shares of Palm. At the same time, you could buy 1.5 shares of Palm on the open market for about $142. The market was essentially saying that the rest of 3Com—a profitable, multi-billion dollar company—was worth negative $60 per share. The total implied value was minus $23 billion. Lewis: That is completely insane. You're telling me you could buy a dollar for less than eighty cents, and nobody fixed it? Where were the arbitrage guys? The 'smart money'? Joe: They were there! They saw the opportunity. They tried to do what's called arbitrage: buy the cheap asset (3Com) and short-sell the expensive one (Palm). But there was a problem. The demand to short Palm was so high that there were no shares left to borrow. The irrationality of the 'noise traders'—the regular investors caught up in the hype—was so powerful that it overwhelmed the smart money. Lewis: So the market can stay irrational longer than the smart guys can stay solvent. Joe: That's the famous line, and it's exactly what happened. This wasn't a small anomaly. It was a $23 billion violation of the law of one price, sitting there in plain sight for months. It was the ultimate proof that the 'price is not always right.' Even in the most sophisticated market in the world, Humans can and do misbehave, spectacularly.

Joe: And that really brings all these ideas together. We see this 'misbehavior' isn't just a funny quirk in a classroom exam. It starts with how we perceive value, like with the wine or the coffee mugs. It shapes our deep internal struggles with self-control, the constant battle between our Planner and our Doer. And it scales all the way up to create these mind-bending absurdities in what are supposed to be the most rational markets on earth. Lewis: It's like the book is giving us a new lens. Once you stop looking for the perfectly rational Econ and start seeing the predictably irrational Human, you see these patterns everywhere. It's not that people are dumb; it's that we're wired in a specific way, and traditional economics just ignored the instruction manual. Joe: That's a perfect way to put it. Thaler's work wasn't about calling people stupid. It was about making economics more human, more empirical, and ultimately, more useful. And the most powerful takeaway for me is how we can use this knowledge to help ourselves. Lewis: So what's the one thing people can do after listening to this? Joe: I think it's simple. The next time you're faced with a big decision—whether it's about spending, saving, or even eating that piece of cake—just pause and ask yourself: is my long-term Planner making this choice, or is my short-term Doer in the driver's seat? Just asking the question can be enough to tip the balance. Lewis: I love that. It’s a small nudge for your own brain. We'd love to hear your own 'misbehaving' stories. Where have you seen your inner 'Doer' take over, or how have you outsmarted it? Let us know on our socials. It's a conversation we all need to be having. Joe: This is Aibrary, signing off.