Three questions on Behavioral Economics
1.) What is behavioral economics? How is it different from standard economics?
In general, both standard and behavioral economics are interested in the same questions and topics. The choices people make, the effects on incentives, the role of information etc. However, unlike standard economics, behavioral economics does not assume that people are rational. Instead, behavioral economists start by figuring out how people actually behave, often in a controlled lab environment in which we can understand behavior better, and use this as a starting point for building our understanding of human nature. As a consequence of this different starting point, behavioral economists usually come to different conclusions about the logic and efficacy of almost anything, ranging from mortgages to savings to healthcare in both the personal and business realms.
2.) Even if consumers make mistakes from time to time, wouldn’t the market fix these?
I always found the appeal to the market gods a bit odd. Why would the market fix mistakes instead of aggravating them? When the Chicago economists sometimes (reluctantly) admits that people make mistakes, they claim that people make different types of mistakes that will eventually cancel each other out in the market. Behavioral economics argues that, instead, people will often make the same mistake, and the individual mistakes can aggregate in the market. Let’s take the subprime mortgage crisis, which I think is a great example (but a very sad reality) of the market working to make the aggregation of mistakes worse. It is not as if some people made one kind of mistake and others made another kind. It was the fact that so many people made the same mistakes, and the market for these mistakes is what got us to where we are now.
3.) Isn’t behavioral economics a depressing view of human nature?
It is true that from a behavioral economics perspective we are fallible, easily confused, not that smart, and often irrational. We are more like Homer Simpson than Superman. So from this perspective it is rather depressing. But at the same time there is also a silver lining. There are free lunches!
Take the physical world for example. We build products that work with our physical limitations. Chairs, shoes, and cars are all designed to complement and enhance our physical capabilities. If we take some of the same lessons we’ve learned from working with our physical limitations and apply them to things that are affected by our cognitive limitations—insurance policies, retirement plans, and healthcare—we’ll be able to design more effective policies and tools, that are more useful in the world. This is the promise of behavioral economics – once we understand where we are weak or wrong we can try to fix it and build a better world.
Take again the sub-prime mortgage crisis. Imagine that we understood how difficult it is for people to calculate the correct amount of mortgage that they should take, and instead of creating a calculator that told us the maximum that we can borrow, it helped us figure out what we should be borrowing. I suspect that if we had this type of calculator (and if people used it) much of the sub-prime mortgage catastrophe could have been avoided. This of course is one idea to fix one problem, and there are many ways to think about how to improve our lives along many of the decisions we make every day. This is why I think that behavioral economics is so optimistic, useful, and important for our personal life and for society.
Irrationally yours
Dan Ariely
The Upside of Irrationality, explores some positive and some negative ways that irrationality plays out in our lives.
My question about behavioral economics is how can you be confident it will work more efficiently than standard economics?
If behavioral economics acknowledges that humans aren’t rational, doesn’t that imply that economists also aren’t rational?
“Imagine that we understood how difficult it is for people to calculate the correct amount of mortgage that they should take, and instead of creating a calculator that told us the maximum that we can borrow, it helped us figure out what we should be borrowing. I suspect that if we had this type of calculator (and if people used it) much of the sub-prime mortgage catastrophe could have been avoided.”
You need to understand how the Federal Reserve works. Since a mortgage is a credit purchase, it’s the interest rate set by the Fed that dictates how much people “should” borrow. The Fed was the cause of the mortgage bubble. If you want to prevent future bubbles, study the likes of Robert Rubin, Alan Greenspan, and Ben Bernanke.
One comment I would add to the market section… one could argue that if you take a longer time frame, say the period right after the sub-prime crisis hit, that the resulting correction is the balance to the over-exuberance of the preceding bubble. With this argument, people were rational to take advantage of a market that was grossly misregulated and that those who failed to exit the market ‘while the getting was good’ paid the price that balances the money made by the people who started the bubble.
That said, I tend to think that both your argument and the one I presented provide valid insight into not only people but markets as a whole. I do think your point about markets being just as likely to make matters worse as they are to make things better is very accurate.
Dear Luke, I’m wkoirng on genetic models for explaining GWAS results, andhave found this entry very interesting.May I ask how was the disease risk distribution you’ve plotted computed?So my best guess is that for each of the 3 papers, you extracted for each SNP both its population frequency and it’s odd ratio for getting the disease.So for example for chron’s disease, you’ve got 30 loci and you know their frequencies. Now you can sample genotype vectors with these 30 loci, and for each such genotype you need to compute the disease risk – so what is your assumption when computing this? do you just multiply the odds ratio, i.e. assume a multiplicative model? or are there any other assumptions? I guess without knowing the true genetic architecture and without further assumptions you cannot really know the distribution of disease risks. Any clarifications would be greatly appreciated.Best,Or
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Hi Dan,
You had mentioned about the Controlled Lab Experiments. To what extent the results we see in a completely controlled lab experiment same compared to the natural context in which we behave in our day to day life. Doesn’t the experiment becomces artificial and makes people behave in a different way. I had this question after reading your Predictably Irrational.
“once we understand where we are weak or wrong we can try to fix it and build a better world.”
This is where I get worried about the claims being made for behavioural economics. Are you not in danger of replacing ‘the market gods’ with ‘political gods’?
Take your example of the sub-prime market Dan. I understand there were three parties to that market: politicians (supporting mortgages for low income voters); the financial industry (implicitly supported/guaranteed by government); and the borrowers themselves.
As best I can tell, two of them – politicians and Wall St – acted in a very standard economics, rational way: the former wanted votes, the latter risk-free profits. Together they exploited the irrationality of sub-prime borrowers.
Which begs the question: who are ‘we’ who are going to ‘build a better world’? I don’t have any pat answers myself, but maybe the best we can expect from behavioural economics in the short run should be to better understand the real motives of all the parties to a decision, and to protect the more vulnerable parties accordingly.
@Robin
One of the things Prof Ariely points out in his book, Predictably Irrational, is that even with his expertise and awareness of human irrationality, at times he falls victim to it himself.
@GaryD
You wrote: “You need to understand how the Federal Reserve works. Since a mortgage is a credit purchase, it’s the interest rate set by the Fed that dictates how much people “should” borrow.”
The Fed’s rate doesn’t dictate what people *should* borrow. Though by way of changes in the rate, lenders will tell consumers what they *can* borrow. Two very different things. Prof Ariely’s suggestion, while purposely oversimplified, seems spot on.
@ted
Borrowing (by way of credit) more than you can afford is, more often than not, irrational. The end result is probably not going to be good. Gross misregulation may have made borrowing as easy as taking candy from a baby, but let’s not confuse easy with rational.
@Gerard
I could not agree more. And I suspect education is the key, not layer upon layer of government regulation. Perhaps educators can help consumers understand their tendency to act irrationally and ways they might curb irrational behavior. While I doubt it’ll eliminate such behavior completely, perhaps it’ll help. Especially if such knowledge is shared beginning in our earliest formative years. For example, I do not recall anyone explaining the basics of saving and spending when I was in elementary school.
Behavior must take into consideration a great deal more than individuals if considering systemic crises. I’ve studied many such crises– the S&L crisis for example set the stage for the national financial crisis in RE by realizing moral hazard, essentially communicating (teaching a very hard lesson to those with ethics and considered entire system integrity in their decisions) to the entire real estate and banking sector that the federal government will bail out those who abuse the system, and in fact many who did intentionally turned right around and acquired the assets at a deep discount, but only after intentionally reducing values by poor management and lack of maintenance — entire towns, regions.
Fraud was wide spread, systemic, and throughout the ecosystem — those who did not participate paid for a generation. The RTC didn’t reform until most of the plums were cherry picked by offenders, and only then when many of us pounded on Congress.
Very similar social dynamics occur in other systemic crises — internal disincentives at the FBI and between agencies certainly enabled 9/11 — leading to several trillion and thousands of lives lost; agency turf battles and structural misalignment caused unnecessary loss of life with Katrina– not terribly different than the conflicts on Wall Street from poorly designed incentive programs.
While some exceptions exist, generally speaking academia is not the appropriate well of knowledge to seek truth in overcoming these kinds of challenges — rather it requires deep experience based on real world cases. Untested theory and misplaced ideology combined with political activism and fraud, has in fact contributed greatly to the series of systemic crises the U.S. in particular has suffered over the past 20 years, beginning in my experience with the S&L crisis, through studying the Asian contagion, Dotcom bubble, 9/11, Katrina, the financial crisis and many other smaller events throughout.
So while it is very interesting to play around with intellectual curiosity, the danger with behavior economics is that we’ll follow the same process, allowing ideology, theory, and limited lab testing instead of in some cases common knowledge from experts in the field.
A great example of this is the academic isolation in the FRB, where Greenspan was absolutely convinced based his ideology — that he finally admitted was wrong — one I shared prior to studying the S&L crisis with far more depth in the field — that Wall Street firms and financial institutions would perform the necessary due diligence for counter party risk, and that individuals would perform their fiduciary duty.
If only that were true, we’d live in a much different world. None of the professionals who actually audited events agreed with that ideology — those I knew were well aware of the political activism whereby individuals purposely used the often insured assets of institutions to make house ownership easier, and became personally wealthy doing so.
That said — regulation is equally flawed for reasons that have been made brutally obvious with the Gulf tragedy, which followed the financial meltdown — at the heart is a dysfunctional and corrupt political core– sad as it is, the evidence is crushing.
Behavioral economics has some great people involved, and they are studying these issues, but until we question our fundamental assumptions about who is expert and who isn’t — and hardwire accountability into the system, systemic crises will continue. That isn’t theory– every single major crisis was preventable with state-of-the art systems. They aren’t adopted because fraudulent cultures don’t want accountability.
To suggest that even a majority of mortgage applicants and the entire industry ecosystem wasn’t fully aware that the applicants could not afford the mortgages — is simply a false assumption based not on the realities on the ground, or human nature. I and others screamed fire the entire time, refused to participate, and we are now paying for the dysfunctional ideology of others, and very poor assumptions based on research that often contained bias with a predetermined outcome — across the spectrum of political ideology.
Thank you so much for this post. Regarding the “depressing” view of human nature in behavioral economics, I actually think it is just the opposite! As a student, learning about homoeconomicus, we are basically taught that the economic man is a self-regarding, perfectly calculating, sociopath. To me, this is a depressing view! However, when taking a course in behavioral economics, we read things like Fehr and Schmidt and learn that sometimes, many times, people are other-regarding and not so selfish. In fact, I think a lot of the research on other-regarding preferences, trust, “warm glow”, and other not so depressing topics (especially when it comes to public goods), is a very uplifting humanist view of the world.
Not to mention, the world would not be a very fun place if we were all so smart and rational. =)
“However, unlike standard economics, behavioral economics does not assume that people are rational.”
Rationality in economics means that a person’s choices can be described as if they were the product of best satisfying some preferences. But those preferences are the primitive of the system and can be anything: the focus on rationality as a source of fundamental difference is tilting at windmills.
For any pattern of observed choice there exist preferences and a utility function that “rationalize” that pattern. This means that no choice pattern can be designated irrational. This is not such an absurdity as it sounds, but rather is a virtue of economics; we are never forced to restrict the preferences of the “rational” agents in an economic model, but can instead discover what those models suggest for a range of different, equally valid preferences.
This applies equally well to the behavioral school. It is interesting to ask what economic models predict when our assumptions on the motivations of people more closely conform to observed human behavior. This is not and need not be portrayed as a radical departure from existing economics.
Appealing to rationality versus irrationality invents a gap between behavioral and “standard” economics that does not necessarily exist. Since rationality in economics is a methodological concept that places no restriction on acceptable data, it cannot be used to attack the status quo. Any distinction denoted “rationality” is a distinction only of semantics.
Excellent points David
To say that economic behavior is relative (which is what David appears to be saying) and therefore always rational in-context is, frankly, bunk.
Discussions about rational versus irrational economic behavior are quite similar to classic philosophical debates about moral absolutism versus moral relativism.
Relativism is self-contradictory. Absolute rational behaviors do exist even in economics.
Suggested reading:
http://www.allaboutphilosophy.org/absolute-truth.htm
“Why would the market fix mistakes instead of aggravating them?”
Incentives and profits.
Mistakes are costly and cause disutility. Helping people avoid such mistakes is profitable.
Not all mistakes will be avoided, but more than in other economic systems and as many as humanly possible.
The reason the mortgage crisis is a bad example of compounding mistakes in the market is that government intervention was responsible for creating perverse incentives, thru below-market-level interest rates, policies and institutions to encourage home ownership, and risk-inducing insurance programs.
Government, not the market, create the large cluster of errors.
That said, I this behavioral economists are right to make more realistic assumptions about people. But frankly, Austrian economists are ahead of the curve in that regard. Also, unlike behavioral economists, they actually define what rational means, because claiming that some behavior is irrational.
The market doesn’t make “mistakes.” The market sometimes causes effects that turn out poorly for many (or even most) people, but to characterize these as “mistakes” is like characterizing an earthquake as a “mistake” of nature. Behavioral economists think they can find the answer by learning how people really think and act and building a model around these data. Are we to assume this approach will be “mistake” free? I doubt it.
Don,
You write as if “the market” is a separate entity. The market comprises people and people make mistakes.
Unfortunately, few people consider the consequences of their decisions/actions in a larger context…whether it’s about energy consumption, the environment, or finances. Their myopic perspective only serves to exacerbate the problem at a macro level.
Science will never have all the answers, nor will it be free of error and miscalculation. But without it rest assured the world as we know it, and the conveniences we enjoy, would not exist.
Behavioral economics may not
Dear Robin,
We assume that the data will tell us what is right.
Dear Hariharan Ragunathan,
I think that controlled lab experiments are a great way to start research and understand what in general is going on.
But then, it is important to take the next steps and figure out if there are any limitations, extensions, variations etc. And this is what we try to do.
I should also point out that over the years we had a few attempts to examine cultural and and age differences — and so far the differences are not that large…
Dan
I agree with you that controlled lab experiments are a good start, but (and of course you knew a but was coming) I also question controlled lab experiments as sometimes being too simplistic. For example, in some group behaviour, expert/novice, and problem solving literature, we have come to suspect that the nature of the problems that were used as the basis of the experiment were faulty. Some group performance research which at first seemed to suggest that the group rarely did better than the highest-scoring member seemed to go against the “common-knowledge” of groups being better than individuals. A closer look at the lab research shows the groups together for a very short time and working on a non-meaningful/non-relevant or trivial task. Later research examining groups together for longer periods and engaged in work within authentic contexts found that groups do indeed more frequently outperform the individual. (See Michaelsen’s Team Based Learning literature). Similar problems exist with problem-solving literature.
I guess my point is that I too have concerns as to whether having participants play games can be generalised to how they would behave if they were engaged in a task for which they had developed some expertise and/or were more authentic and complex tasks. (See Johnassen’s breakdown of kinds of problem-solving tasks, and one can see that many of the problem-solving experiments have participants doing activities that rank low on the problem-solving typography)
Your research provides much food for thought. Thanks.
Dear Gerard O’Neill,
I am not sure I understand your issue.
Here is an example: Take conflicts of interests. They are real and powerful yet people don’t recognize how they work on them.
Once we understand these based on research we can hope that people in positions of power will realize their effects and take measures to minimize them.
Irrationally yours
Dan
Hello Mr. Ariely,
I didn’t know the appropriate place or manner to do this, but I wanted to thank you for your wonderful book Predictably Irrational. I am only 15 years old and reading this book has given me great insight into how people behave and why our society functions like it does. This has also lead me on to discovering what I’d like to do as a career choice (Human Factor Design). I hope to one day understand people to the degree that you do and be able to prove it through experiments but then also move forward and solve design issues through the newfound knowledge.
Your work has also given me so much to reference when having debates in the classroom or elsewhere, though most of the people here (in Arizona) are very traditional. I just wish everyone would read up on Behavioral Economics and what problems could be solved through relatively easy solutions.
I hope to read more about your work and the field and in the future make a difference through knowledge.
Thank you,
Ethan Bond
Hi Dan.
Thank you for your blog entries. I actually find them encouraging, just as we find them informative.
As I read this, I began to wonder if all people should take time out to conduct studies in their own neighbourhoods, and various places. I think that a lot of us would get wrong results and tainted data, but it would probably bring us a step closer to the truth, because we would have experience, and we could learn from our mistakes.
Thanks.
–
Sincerely, and with thanks,
Eugene T.S. Wong
Hi Ethan,
I can’t tell you how delighted I am that you find the book useful.
All the best
Dan
After nearly 15 years in business (to include the sale of one I grew from its infancy), I’m routinely amazed at how often people over-estimate their capacity to remain rational in the decision-making process.
Of course, this awareness can be used to great advantage in business.
After listening to the 6 cd’s, I must confess you have found a new disciple. Bravo!
“Rational market” theory assumes vested interest and ownership. This is not the case with managers of “other people’s money”, OPM, who work for fees.
The human qualities that make one attractive to be an OPM manager – sociability, charm, conversation skills – are more attributable to people with weak analytical skills and poor independent thought. Hence, you have a situation where trillions of assets are managed by sub-intelligent lemmings.
David Brooks in the NYT had a wonderful column on the subject yesterday.
Dan, I recently picked up your book. I have started reading it.
I agree that people don’t always think and act that would make economic sense for them. Desires, wants, and thinking/perceiving the world around us to what we think it should be, or what we want it to be play a huge role. And I think that’s where our vulnerabilities and also potential factor in.
So, I agree that understanding people’s behavior and motives help, and behavioral economics add huge value.
I enjoyed reading this post.
-Deven
What behavior is rational when irrationality is what’s being rewarded by the market? We see this time and time again with bubbles.
In the mortgage crisis, you had appraisers rubber stamping valuations to get deals done. The more deals that they approved, the more business banks and real estate agents sent their way. Taking a long time to do an appraisal or otherwise refusing to go along would hurt you economically.
Lenders didn’t care about the risk of loans (esp. liars loans) as long there were others waiting to buy them.
Likewise, no one in the banks at the time was going to be rewarded for saying, “Hey, wait a minute. This is all a house of cards.” All the financial incentives were to keep perpetuating the system.
In these scenarios, is it more rational to play along or to buck the trends and lose out on the financial rewards? (Assuming, of course, that you don’t have big gobs of money to short the whole thing like a few players did.)
“It is not as if some people made one kind of mistake and others made another kind”
The claim is made that the market is a “random walk” – if that were true, wouldn’t the DOW, despite fluctuations, be the same place as it was 20, 30, or 50 years ago? Some may say that the economy has grown – but not all economies grow. I remember reading that the GDP of South Korea and ?Congo? were the same in 1960, but since than have diverged greatly.
So my point is that people as a whole are making progress or mistakes, but some more than others…and this happens as a group.
If we know (and obviously we do) what cheating is, we surely know, deep down, what counts as fair. I hope to see more experiments into the ways and means of eliciting and enabling fair interactions.
My thoughts for now:
Might it be the case that the more you’re paid, the more you feel owned? Might it be the case that earning, via transactions with others, a subsistence level income is a good enough balance? What we subsist on is digested and disappears, not to be encountered next time the sun rises; it’s the living we need to eat and keep warm or cool and to rest easy. Excess, however, the baubles and trappings, are there day after day to remind us of our human indebtedness. When too much is too much, might we not feel we have to keep earning it? And why is it that the things I’ve made feel like things I’m expected to give away?
While I’m here, I may as well contribute this drop in the bucket –
My prime beef with any semblance of corporate-controlled health care is that they get to say, “Do what we tell you and we’ll let you live.”
i have to give a class presentation on behavioral economics .i have have asked to explain how behavioral economics ans stock market are related.the ppt has to be for 15 minutes can you give me ample about of examples to explain the same.
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I would like to know examples of how behavioural economics could solve social or economical problems, current ones in particular.
I love your work particularly your videos on youtube and TED. YOu explain these concepts simply, eloquently and not without the occasional witty joke. <3