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Here’s a fascinating "Sunday read" from Harvard Magazine on behavioral economics. The article is long (about 6,000 words), but I think you'll enjoy it.

Instead of looking at how the world ought to work in theory, behavioral economists study how people really go about making economic decisions. They've found that how decisions are "framed" can have a dramatic impact on what decisions are made.

For example, people have a very difficult time internalizing risk. David Laibson summaries the phenomenon:

"There's a fundamental tension, in humans and other animals, between seizing available rewards in the present, and being patient for rewards in the future," he says. "It’s radically important. People very robustly want instant gratification right now, and want to be patient in the future. If you ask people, 'Which do you want right now, fruit or chocolate?' they say, 'Chocolate!' But if you ask, 'Which one a week from now?' they will say, 'Fruit.' Now we want chocolate, cigarettes, and a trashy movie. In the future, we want to eat fruit, to quit smoking, and to watch Bergman films."

Laibson can sketch a formal model that describes this dynamic. Consider a project like starting an exercise program, which entails, say, an immediate cost of six units of value, but will produce a delayed benefit of eight units. That’s a net gain of two units, "but it ignores the human tendency to devalue the future," Laibson says. If future events have perhaps half the value of present ones, then the eight units become only four, and starting an exercise program today means a net loss of two units (six minus four). So we don’t want to start exercising today. On the other hand, starting tomorrow devalues both the cost and the benefit by half (to three and four units, respectively), resulting in a net gain of one unit from exercising. Hence, everyone is enthusiastic about going to the gym tomorrow.

Broadly speaking, "People act irrationally in that they overly discount the future," says Bazerman. "We do worse in life because we spend too much for what we want now at the expense of goodies we want in the future. People buy things they can’t afford on a credit card, and as a result they get to buy less over the course of their lifetimes." Such problems should not arise, according to standard economic theory, which holds that "there shouldn't be any disconnect between what I’m doing and what I want to be doing," says Nava Ashraf.

Economics isn't like chemistry or physics, it's a social science. As a result, numbers can sometimes fool us. In finance, a 10% gain and a 10% loss aren't symmetrical. People fear loss more than the value gain.

The article has this interesting quote from Sendhil Mullainathan:

"We tend to think people are driven by purposeful choices," he explains. "We think big things drive big behaviors: if people don’t go to school, we think they don’t like school. Instead, most behaviors are driven by the moment. They aren't purposeful, thought-out choices. That’s an illusion we have about others. Policymakers think that if they get the abstractions right, that will drive behavior in the desired direction. But the world happens in real time. We can talk abstractions of risk and return, but when the person is physically checking off the box on that investment form, all the things going on at that moment will disproportionately influence the decision they make. That's the temptation element—in real time, the moment can be very tempting. The main thing is to define what is in your mind at the moment of choice. Suppose a company wants to sell more soap. Traditional economists would advise things like making a soap that people like more, or charging less for a bar of soap. A behavioral economist might suggest convincing supermarkets to display your soap at eye level—people will see your brand first and grab it."

Here's a well-known example of behavioral economics. Suppose you're in a roomful of people, and you're told to choose any integer from zero to 100. All participants are told that a large cash price will go to the person who chooses closest to two-thirds of the average of everyone else’s number. So what number would you choose?

Thirty-three, right? Wait...everyone else will say that. I know: Twenty-two? No…hold on. Everyone else will....

*Thinking*

I got it! The theoretical answer is zero.

In the real world, studies have shown that the average guess is 18.91, so the winning answer is about 13. This of course makes no sense whatsoever. Remember that next time you buy a stock.

Posted by edelfenbein at March 19, 2006 10:15 AM