Today we have a dark story about the very controversial topic of end of life decision making that demonstrates what we in decision making studies call the “endowment effect.” Again, this wonderful story is written by another one of my undergraduate behavioral economics students at Duke. Hope you enjoy it! You can find it here.

Ever since the financial meltdown, and throughout this recession, people keep asking me if I’m optimistic about our future. I think people are actually asking two questions: Where does one naturally fall on the optimism spectrum? And is there a place for optimism in our present circumstances?

One of the most basic findings in behavioral economics is what’s called the “optimism bias,” also known as the “positivity” illusion.

The basic idea is that when people judge their chances of experiencing a good outcome–getting a great job or having a successful marriage, healthy kids, or financial security–they estimate their odds to be higher than average. But when they contemplate the probability that something bad will befall them (a heart attack, a divorce, a parking ticket), they estimate their odds to be lower than those of other people.

This optimism bias transcends gender, age, education, and nationality–although it seems to be correlated with the absence of depression. Depressed people tend to show a smaller optimism bias. They also have a more accurate take on reality–perceptions more in line with what actuaries figure to be their real chances of divorcing, suffering a heart attack, and so on.

UNDERESTIMATING RISK

It is interesting to ponder the utility of over-optimism. It’s not a simple matter, because it can both hurt and help us. Individuals often suffer because of an overly bright outlook. They wind up dead, or poor, or bankrupt because they underestimated the downside of taking a certain path. But society as a whole often benefits from behavior spurred by upbeat outlooks.

It’s the inverse of “the paradox of thrift,” which holds that saving money (instead of consuming) may be good for an individual but is bad for an economy trying to grow.

Overoptimism works the other way. Imagine a society in which no one would take on the risk of creating startups, developing new medications, or opening new businesses. We know most new enterprises fail in the first few years. Yet they crop up all the time, sometimes jump-starting entirely new sectors. A society in which no one is overly optimistic and no one takes too much risk? Such a culture wouldn’t advance much.

So are there objective reasons for optimism in the current recession? There are. Amid the countless half-empty glasses strewn about at the moment, there are many that could be viewed as half-full. Most important, there are lessons we can absorb–insights that point to ways we can improve things. And what’s more optimistic than believing in the possibility of improvement?

This recession has delivered a huge lesson in how far human folly and irrationality can lead us astray–into conflicts of interest, extrapolating long-term projections from short-term trends, putting too much trust in economic advisers, and so on. I don’t anticipate that the downturn will change human nature. We aren’t better, more thoughtful people now. And we’re unlikely to become phoenixes rising from our fiscal ashes. But I am hopeful that if we take these painful lessons to heart (and mind), we might create lasting changes.

There are signs we are doing so, sometimes because there’s no other choice. From my perch as a professor, I see undergraduates turning to volunteering, startups, and the pursuit of all kinds of dreams. And for the first time in many years, Americans are starting to save money. (This might not quicken the recovery, but it’s good for the economy long term.) Manufacturers are building smaller, more sustainable homes and cars. And some banks (banks!) are thinking about how to help consumers become more financially responsible.

Finally, it looks as if there are advances in banking regulations that will endure–those mandating clearer disclosures of mortgage rules, for instance, and those making banks more accountable. Changes like these are unlikely to prevent all future financial shenanigans. But I’m optimistic about their ability to prevent some of them.

This reflection first appeared in Businessweek

Dear Irrational,

I recently met a great guy – let’s call him George – and now I can’t stop thinking about him. Though we’ve only been on a couple dinner dates, he’s officially won me over.

Now here’s my problem: Smitten as I am, I’m ready to hop into bed with George this very minute, but I’m not sure that’s the best idea. After all, there must be some reason that all those books and magazines (not to mention my mother) champion the make-him-wait rule. But does it really work? I’ve never followed it in the past, but then, I can’t say I have the best dating track record either.

What do you think? Should I play hard to get, or no? Help!

Sincerely,

Unsure

——

Dear Unsure,

Your mother is right: making the guy sweat a little (no, not like that) is in your best interest if you want to maximize the chances f a long term relationship. The reason lies in cognitive dissonance, which refers to what we do when our beliefs and actions misalign: Can’t change the cold, hard facts? Then change your beliefs!

The classic experiment here comes from psychologists Leon Festinger and James Carlsmith, who had participants perform a boring task and then paid them either $20 or $1 to convince someone else that the task had been great fun. Everyone then rated the task, with the result that the $1 participants rated the task more positively than did the $20 crew. While the $20 group could explain away the dissonance between their action (“I told someone the task was riveting”) and their belief (“It actually bored me to tears”) via money (“I was paid to promote the task”), the $1 individuals could not because they could not justify misleading others for such a small amount of money– so they changed their initial belief (“I must really like the task, to have promoted it”) and they ended up rating the task more positively.

To give you an example that is closer to our social life, look at fraternities: loyalty to frats increases with the amount of hazing, since pledges tell themselves, “I did a lot of embarrassing stuff for my frat – it must really matter to me.”

So, going back to your dilemma, Unsure, cognitive dissonance suggests that if you really want a guy, you have to create a dissonance for him, so that he will say, “Wow, if I put in all this effort for the woman – I must love her.”

This means that instead of putting out early, you have George pursue you. Instead of splitting the check, you let him pick up the entire tab. Instead of calling him up and suggesting dates, you leave the calling and planning up to him. In other words, make him work, and he will rationalize it by deciding he loves you.

Good luck.

Irrationally yours,

Dan

p.s please don’t tell George about my advice, and who gave it to you

Here is a video dedicated to the start of a new academic year.

Today we all have good intentions but what will come of these intentions in the future?

Happy semester

We usually accept without argument the notion that man is at the top of the animal hierarchy. After all, only mammals have a neocortex – the most recently evolved part of the brain and the center of higher mental functions – and ours is the most advanced variation, so it makes sense that we’d be at a higher stage of development.

But is this true? Does the neocortex always make us more rational than other animals?

Most of the time, the answer is yes. For instance, it’s thanks to our neocortex that we are able to plan for the future, something that animals have a hard time doing. (They are even worse at saving than we are!)

Still, this isn’t always the case, as the following chimpanzee experiment suggests. In “Chimpanzees are rational maximizers in an ultimatum game,” researchers Keith Jensen, Josep Call, and Michael Tomasello looked into how chimps fare at one of the classic tests of human rationality, the ultimatum game.

In the human version of this game, a “proposer” is handed some money, say $10, and must suggest a division of the sum for himself and another participant. This other person, the “responder,” can then either accept or reject the offer. If he chooses to accept the division, both participants receive their share; if he opts to reject it, neither gets compensated.

Now, if we were to go by the traditional economic model of man as a self-interested rational maximizer, we would suppose that the proposers would always suggest a division that maximized his self-interest (an $9/$1 division) and that the responders would always accept a nonzero offer ($1 may not be $9, but it’s still better than nothing).

Except, this is not what happens. Research has shown that we human beings not only consider how best to maximize our compensation, but we also factor in such notions as cooperation and fairness when we make our decisions. For example, responders in the ultimatum game will often reject a monetary division that is particularly unfair for them (such as a $8/$2 division) – even when this comes at their own cost (they lose the $2, after all). This behavior is of course wonderfully human — but it is not part of the standard rational model.

Chimpanzees, however, go about the ultimatum game (which involves divisions of raisins in their case) without giving fairness any thought. In this experiment, the researchers found that the chimp responders tended to accept any nonzero offer, however unfair. And conversely, the chimp proposers rarely suggested a fair division, choosing instead to maximize their own share.

In this case, then, animals are more rational than we are. Whereas we’re willing to lose a couple bucks so that the other guy gets punished for his inequitable offer, chimps only act according to what will guarantee them the most raisons.

This curious turning-of-tables suggests that we might want to think differently about the neocortex. Overall, we’re better off having it, as without our sense of right and wrong, we would lack empathy and the ability to reinforce societal rules. Yet, in certain contexts, the neocortex can cause us not to maximize our self-interest. Evolution, then, is a mixed blessing: it makes us better some things, and worse at others.

It’s time for another Predictably Irrational Short Story! This one is a love story the beautifully demonstrates some of the principles of discussed in Predictably Irrational about decision making applied to dating, again written by one of my students at Duke. It’s called “The Dating Game” and you can find it here.

The New York Times and Time Magazine have recently posted interesting articles about two new books that discuss consumer behavior: Chris Anderson’s Free and Ellen Ruppel Shell’s Cheap (see links in The New York Times and Time Magazine).

Both books reference our Hershey’s Kiss experiment that is described in Chapter 3 of Predictably Irrational. If you recall, in one trial of one study we offered students a Lindt Truffle for 26 cents and a Hershey’s Kiss for 1 cent and observed the buying behavior: 40 percent went with the truffle and 40 percent with the Kiss. When we dropped the price of both chocolates by just 1 cent, we observed that suddenly 90 percent of participants opted for the free Kiss, even though the relative price between the two was the same. We concluded that FREE! is indeed a very powerful force.

It’s important to note that we have carried out lots and lots of studies on the effect of FREE!, many of which are detailed in Predictably Irrational. Describing them all, however, would be too much for those who are trying to make just one point abut this effect, so naturally we see authors making choices about which experiments to describe and which ones to leave in footnotes, or not to mention at all. But, some  kinds of omissions are made as well — ones that are important for understanding the complexity of the effect.

For example, in one study of FREE!, we tried lowering the price from 2 cents to one cent on the Kiss to see if we observed that same level of increase in demand in the Kiss. We didn’t. In another study we also tried seeing what would happen if we lowered the price from FREE! to negative one cent, and we also didn’t see a difference in behavior. We also tried the experiment on a broad demographic–not just college students, but also on children and older adults.
Personally, I think it is perfectly fine for people to take the main point from some experiments and build on it, but as readers (and writers) we should realize that often there is more complexity to the picture and that before criticizing particular findings, or citing them as supporting evidence, we should keep in mind the nuances.

Someone should remind Michael Bloomberg that free does not always mean free lunches.

The billionaire New York City mayor recently rolled out a transit proposal that sounds too good to be true – probably because it is.

In order to speed up the pace of Manhattan’s famously slow crosstown buses, mayor Bloomberg suggested eliminating the $2.25 fare on a few of the buses, as it would put an end to all the time passengers spend fumbling for their MetroCard and cash at the bus door. It would mean free bus rides for all, but without much additional cost to the city, he reasoned, since the majority of crosstown passengers are already riding for free, using their MetroCards to transfer from the subway. If we aren’t charging folks anyway, it’s not a big money loss, is the gist of his claim.

In short: win-win.

Except, there’s a flaw to his argument.  If bus fare falls to zero, it’s likely that more people (many more people) will start riding the bus, which will lead to even worse congestion and potentially require the city to spend on introducing more buses.

In other words, mayor Bloomberg is harboring under the assumption that demand for the cross town bus will not change as the price drops. In all likelihood, however, the number of bus-riders will go up dramatically because free is exciting. In fact, according to our research on free, such a change will cause many people who now walk a few blocks, to switch their ways and hop on the free bus.

Motivating people is an extremely difficult and delicate task as anyone who’s ever taught, managed, collaborated with or given birth to someone knows. In business, as opposed to say, child-rearing, the debate is slightly less daunting, though not always much clearer. For instance, offering incentives to employees for improved performance is a fairly common approach to encouraging higher sales —though surprisingly unproven by data.

For the most part, the effectiveness of incentives is supported by intuition and some anecdotal evidence. Wouldn’t everyone work at least a little harder for a $100 bill on top of their usual paycheck? Certainly it can’t hurt. But one important open question is whether monetary or tangible (spa retreat, ipod, dinner for two, etc) rewards more efficacious motivators?

Those who advocate for monetary incentives claim they have the greatest appeal given that the winners can do anything with them; what if someone needs an ipod like they need another hole in their head? On the other side, those in favor of tangible incentives argued that money lacks the emotional appeal of, say, a weekend for two at a romantic country inn or swank hotel. But either way, there was nothing to back up either camp.

Thankfully, there is some data on this debate.  A few years ago Goodyear Tire & Rubber Company decided to test which method was more successful in an effort to improve sales of a new line of Aquatred tires. Their plan was simple and elegant: first they ranked their 60 retail districts according to previous sales, then divided them into two groups of equal performance and assigned one group to receive monetary incentives and the other to receive tangible incentives of equal value to the first group.

The results were very interesting; it turned out that the tangible-reward group increased sales by 46% more than the monetary-reward group. They also improved in terms of the mix of products sold by 37%. One explanation, and it seems to me a fairly good one, is that we can visualize tangible rewards (imagine yourself on a Hawaiian beach), which creates an emotional response. Money, on the other hand, is not accompanied by images as often (aside from maybe Scrooge McDuck swimming in piles of it), and lacks the emotional pull that tangible rewards have, so they’re less effective in motivating employees. I guess it’s called “cold, hard cash” rather than “future beach vacation cash” for a reason.

In a follow-up to the much acclaimed “Pinch of Saffron” , this latest Predictably Irrational Short Story is a thrilling Wall Street tale of overpricing CDOs, again written by one of my Behavioral Economics students, Andrew Holmberg. It’s entitled, “Fixed Income”, and you can find it here.