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Thinking Fast and Slow and Poorly and Well

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In December 1979 the actor Steve McQueen was diagnosed with a severe cancer. In October 1980 his doctors advised him that his tumor was inoperable -- that his heart could not withstand surgery. McQueen turned to Dr. William Kelley -- an orthodontist -- who promised him that he would be completely cured and return to normal life. He had the tumor removed and -- as predicted by his U.S. doctors -- died of cardiac arrest shortly after surgery.

There is nothing mysterious about not wanting to hear bad news: McQueen is neither the first or the last distressed person to turn to a quack. Today with the economic crisis we are all in that boat. The impact on young people facing an uncertain job market is as traumatic for us -- their parents -- as for them. The message of economists -- that we sold our children's future to the Chinese in order to live well -- is not the message we want to hear. Is it surprising that we turn to charlatans?

That is the best explanation I can give as to why Danny Kahneman's book Thinking Fast and Slow is a best-seller. It is a tedious book to read. I can't do much about that, but I can tell you about the intellectual substance of the book. The theme is that people are full of biases -- that economists believe otherwise and so are full of it. I imagine this is a popular message.

The book is remarkably smug, and has some strange historical oversights. One chapter is devoted to choice under uncertainty. Kahneman gives a nice history of expected utility. He also discusses his discovery with Amos Tversky in 1979 that the theory is wrong. Yet the key flaw was discovered by another Nobel Prize winning economist -- Maurice Allais -- in 1953!

The world is full of strange behavior. It is natural to theorize this is due to irrational biases. But often apparently strange behavior is the right solution to a complex problem. A good example of this is in biology. Economists think that people behave relatively rationally because we learn from our mistakes. Biologists think that organisms behave relatively "rationally" because those that do not get dead. How then to explain odd behavior? You probably didn't know that Pandalid shrimp start life as a male then switch to female when they get older. Isn't that strange and irrational? Not at all: Ghiselin in 1969 explained that when large size is important for females -- so they can produce more eggs -- then this is just the right thing to do. Economics and psychology are full of examples like this.

The central feature of the theories of bias that Kahneman promotes is the idea of the "reference point." The idea is that people evaluate losses and gains relative to what they have. Unfortunately to build a theory based on the reference point is to build on foundations of sand. One of the key pieces of evidence for the reference point is the "endowment effect." For example, if you give people a coffee mug and ask them how much, they will sell it back to you for, they state a high price, while if you keep the mug and ask how much they will pay for it, they state a low price. That's not so surprising: we all know to buy low and sell high. But researchers are cleverer than that: the bidding rules are constructed so that you do best by stating your true value in both cases -- hence the conclusion that people like the mug more if they have it than if they don't. But do people really have an "endowment effect?" Or do they give a confused answer to a confusing question?

Two economists Tim Cason and Charlie Plott looked into this. They went around with real money and handed out cards. The cards said:

This ticket is worth $2.00 to you. You can sell it. Name your offer price [there is a blank place on the ticket to write the price]. Located under the tape on the other side of this card is a posted price. The posted price was drawn randomly between: $0.00 and $8.00. If your offer price is below the posted price on the back of the card then you sell your ticket at the posted price. If your offer price is above the posted price on the back of the card then you do not sell your ticket but you do collect the $2.00 value of the ticket. You can view the posted price after you have named your price.

What would you bid? In the study 17 percent of the subjects chose offers within five cents of the $2 value of the card while a greater fraction of subjects chose to sell high, making bids near $3 and $4.

However, the rules are constructed so that you do best by stating the true value of $2.00. Most people know not to try to sell a $2.00 card for less than $2.00. But why not state a high bid, $3.00 say, in an effort to get more? According to the rules this won't work. If the posted price is $3.00 it is true by bidding $3.00 you get $3.00 for the card. But: if you bid $2.00 you also get $3.00 -- reread the rules. On the other hand if the posted price is $2.50 and you bid $3.00 you only get $2.00 while if you had bid $2.00 you would get $2.50. The rules are designed so that you maximize your opportunity to earn money if you bid what the card is actually worth. It isn't that easy to figure it out -- but people eventually do, and once they do they stop making mistakes. There is no endowment effect -- just a wrong response to a complicated question.

So what then is Kahneman's theory useful for? For marketers who want to fool us? To help us avoid Nigerian scammers? To clue us to deception by politicians? Yet we are all aware of these things -- and there are many and many better books written explaining how to mislead the public to market your product.

In his conclusion Danny Kahneman writes: "My intuitive thinking is just as prone to overconfidence, extreme predictions and the planning fallacy as it was before I made a study of these issues." While our economic theories allow for people such as Danny Kahneman it is fortunate that most of the rest of us do not blindly repeat our same mistakes over and over again.

Kahneman is celebrated as a founding father of behavioral economics. That school has often followed him in its excesses. Yet not all economics is good, nor is all behavioral economics bad. I wrote my own book about that: Is Behavioral Economics Doomed? It probably won't be a best-seller -- but I promise you it is a lot more fun to read than Thinking Fast and Slow.