What if on your next coffee run, you discover that Starbucks has started running on the honor system? All the baristas are gone, and in their place, you find Tupperware filled with coins and bills. Would you pay for your daily soy Latte? Or would you “forget” to shell out the five bucks? Be honest.

This, of course, is only a thought experiment, as I doubt Starbucks will be adopting the honor policy anytime soon. But in another part of the world, it’s a real question that residents are facing on a daily basis. As the New York Times recently reported, the attorney general’s office in Indonesia has been opening thousands of “honesty cafes” as part of its anticorruption campaign.

The idea is that these cashier-free cafes will teach people to be honest and curb the country’s corruption problem (which pervades business, politics, and education) by inducing residents – especially the young – to get into the habit of practicing honesty. As the Times reports, “…the cafes are meant to force people to think constantly about whether they are being honest and, presumably, make them feel guilty if they are not.”

It’s a laudable plan, and a lovely feel-good idea, but will it work? I have my doubts.

First I think that people will also cheat to a certain extent in these honesty cafes (as they do in our experiments). In fact, according to one Indonesian student, they already do: “Some of my friends don’t pay the right amount.”

But that’s not the worst of it. I worry that these cafes won’t just fail to discourage cheating – they will actually lead to more of it. In some of our research, we found that cheating on one occasion makes it easier for people to cheat again on a later task, because it alters their self-concept. (Think of dieting as an analogy: once you break your diet once, it’s that much easier to say, “Oh what the hey, cut me a slice of that chocolate cake; I’ll count calories again tomorrow.”)

With honesty cafés widespread, residents will have more temptations to cheat, more occasion to cheat, and maybe this will make it such that they will find it easier to cheat again in other contexts.

Maybe these cafes are a good idea, maybe it will not have any effect, but I worry that it might make things worse.

Our prehistoric ancestors spent much of their waking hours foraging for and consuming food, an instinct that obviously paid off. Today this instinct is no less powerful, but for billions of us it’s satisfied in the minutes it takes to swing by the store and pop a meal in the microwave. With our physical needs sated and time on our hands, increasingly we’re finding psychological outlets for this drive, by seeking out and consuming concepts.

Conceptual consumption strongly influences physical consumption. Keeping up with the Joneses is an obvious example. The SUV in the driveway is only partly about the need for transport; the concept consumed is status. Dozens of studies tease out the many ways in which concepts  influence people’s consumption, independent of the physical thing being consumed. Here are just three of the classes of conceptual consumption that we and others have identified.

Consuming expectations. People’s expectation about the value of what they’re consuming profoundly affects their experience. We know that people have favorite beverage brands, for instance, but in blind taste tests they frequently can’t tell one from another: The value that marketers attach to the brand, rather than the drink’s flavor, is often what truly adds to the taste experience. Recent brain imaging studies show that when people believe they’re drinking expensive wine, their reward circuitry is more active than when they think they’re drinking cheap wine – even when the wines are identical. Similarly, when people believe they’re taking cheap painkillers, they experience less relief than when they take the same but higher-priced pills.

Consuming goals. Pursuing a goal can be a powerful trigger for consumption. At a convenience store where the average purchase was $4, researchers gave some customers coupons that offered $1 off any purchase of $6, and others coupons that offered $1 off any purchase of at least $2. Customers who received the coupon that required a $6 purchase increased their spending in an effort to receive their dollar off; more interestingly, those customers who received the coupon that required only a $2 purchase to receive the dollar off actually decreased their spending from their typical $4, though of course they would have received their dollar off had they spent $4. Consuming the specific goal implied by the coupon – receiving a savings on a purchase of a designated amount — trumped people’s initial inclinations. Customers who received the $2 coupon left the store with fewer items than they had intended to buy.

Consuming memories. One study of how memories influence consumption explored the phenomenon whereby people who have truly enjoyed an experience, such as a special evening out, sometimes prefer not to repeat it. We might expect that they would want to experience the physical consumption of such an evening again; but by forgoing repeat visits, they are preserving their ability to consume the pure memory – the concept – of that evening forever, without the risk of polluting it with a less-special evening.

While concepts can influence people to consume more physical stuff, they can also encourage them to consume less. Offering people a chance to trade undesirable physical consumption for conceptual consumption is one way to help them make wiser choices. In Sacramento, for example, if people use less energy than their neighbors, they get a smiley face on their utility bill (or two if they’re really good) – a tactic that has reduced energy use in the district and is now being employed in Chicago, Seattle, and eight other cities. In this case, people forgo energy consumption in order to consume the concept of being greener than their neighbors.

We suggest that examining people’s motivations through the lens of conceptual consumption can help policy makers, marketers, and managers craft incentives to drive desired behavior – for better or for worse.

by Dan Ariely and Michael I. Norton

The full paper on which this article is based is available here.

Derek Bok, the 25th President of Harvard, famously said: “If you think education is expensive, try ignorance.” What we need is more business education, not less!

There are recent debates about the value of MBA education and I have to say that I find the notions of scrapping management education somewhat odd.  It is not that I think that management education is perfect, far from it, but its importance in my mind has only increased due to this financial crisis. Does anyone really want to suggest that the people who are running our institutions and companies do not need to learn more? That they don’t need to have specific knowledge to better guide their companies and our economy? For example, is there anyone who doesn’t think these days that executives need to have a much better understanding of accounting, and that they need to know how to read accounting statements?

From my perspective, the main lesson from this economic meltdown is that despite our confidence – we actually know very little about the operation of the financial world around us.  Moreover, it is clear that such lack of understanding, together with high confidence and reliance on the opinions of others (presumably experts) can have devastating consequences. If anything I suspect that this meltdown shows exactly how important it is for executives to have a better understanding of the world in which they operate.

Of course, like many others, I believe that it will be very useful to change the curriculum of the MBA program so that it is more useful — but if anything I would make it mandatory for executives to keep on learning throughout their careers in the same way that we require physicians to keep on improving and learning.

In terms of the actual curriculum for management education, my own view is very simple-minded: The world is incredibly complex, it changes all the time, and we should not even hope that we could create a general model that accurately describes the world in all its possible states. Instead I proposed that management education and practice should become much more experimental and data-driven in nature — and I can tell you that it is amazing to realize how little business know and understand how to create and run experiments or even how to look at their own data!

We should teach the students, as well as executives, how to conduct experiments, how to examine data, and how to use these tools to make better decisions.  For example, over the past five years or so we have learned from experimental evidence a lot about the tricks that conflicts of interests can play on us, and these findings help us understand financial catastrophes from Enron to the recent market failures (for my take on this see TED).  Given this new understanding, and we lean more and more all the time, I think it is crucial to transfer this knowledge to business executives so that they can take this new understanding into account.

Disasters are usually a good time to re-examine what we’ve done so far, what mistakes we’ve made, and what improvements should come next. If the lesson from all of this will be to blame the MBA programs than I think we would have not gained much. However if we will seriously consider how to keep on exploring and understanding the complex world we live in, and make this an inherent part of management education, perhaps the future version of our world would look better.

Imagine that it is the last day of the month and you have $20 in your checking account. Your $2,000 salary will be automatically deposited into your bank later today.  You walk down the street and buy yourself a $2.95 ice cream cone. Later you also buy yourself a copy of Predictably Irrational for $25.95, and an hour later you treat yourself to a $2.50 cup of café latte. You pay for everything with debit card, and you feel good about the day – it is payday, after all.

That night, sometime after midnight, the bank settles your account for the day.  Instead of first depositing your salary and then charging you for the three purchases, they do the opposite – qualifying you for an overdraft fee.  You would think this would be enough punishment, but the banks are even more nefarious. They use an algorithm that charges you for the most expensive item (the book) first.  Boom, you are over your available cash and charged a $35 overdraft fee.  The ice cream and the latte come next, each with its own $35 overdraft fee.  A split second later, your salary is deposited and you are back in the black – only $105 poorer.

Overdraft plans connected to checking accounts are common at most major financial institutions, and the Center for Responsible Lending estimates that this practice costs consumers about $17.5 billion in fees every year. Given these numbers, it is perhaps not very surprising that most financial institutions currently enroll their account holders into this expensive method of covering overdrafts without the customer’s consent or knowledge and that when consumers try to get out of these programs they find it incredibly difficult.  When I called the few banks I have accounts with last week and tried to un-enroll from these programs, the most common response I got was that it was impossible. Similarly, one New Jersey columnist reported that his own daughter was charged a $35 overdraft fee for a debit card purchase of less than $2, even when he had accompanied her to open her account and asked that transactions that would overdraw the account be denied. (Paul Mulshine, ‘Courteous’ bankers in for a rude awakening, The Newark Star-Ledger, June 7, 2007, at 15)

With the current financial challenges, I suspect that the people at the lower Social Economic Status (SES) are carrying a large part of the general financial crisis in terms of jobs and housing, as well as a large part of the overdraft fees related to overdraft protection plans.  Given this, it is a good sign that the Feds are finally looking at this issue.  The first thing that the policymakers are considering is whether to require banks to let their customers opt-out of the default overdraft system.  This sounds like a no-brainer.  A far better version of the rule would require banks to obtain explicit permission from their customers before enrolling them in this program, the “opt-in rule”. So when you sign up for a bank account, you are not enrolled in this program unless you decide that you want the bank to approve debit purchases you make even if you have no money in your account.  Given what we know about defaults and behavioral economics (that most people adapt the default option as their choice, and they see it as an implicit recommendation), I suspect that with the opt-out requirements, the vast majority of consumers will become part of the program and will keep on paying these high penalties, while the opt-in approach would make consumers much less likely to join these programs. Presumably, the banks know this, which is why they are arguing for the right to put all their customers into this expensive system of overdraft coverage without asking.

But of course, this is just the first step. In addition to the pending Federal Reserve regulatory proposal, Representative Carolyn Maloney (D-NY) has introduced legislation that, in addition to requiring that banks get explicit “opt-in” permission, would require warnings at the checkout counters and ATMs to allow customers to cancel a transaction before incurring a fee. It would also stop banks from clearing transactions from the highest to the lowest in order to increase their fees.  These are useful reforms that are much needed to prevent banks from taking advantage of their customers.

The banks of course are very worried about losing this income stream, but I suspect that changing the bankers’ mindset from business as usual to one where they are actually going to start seeking their customers’ trust and products that would actually appeal to their clients is in everyone’s best interest.  Adopting such programs might in fact push the banks to further improve their overdraft protection programs so that they are truly valuable for their consumers.  For example, banks might start giving consumers better access to competitively priced short- term loans, better connections between saving and checking accounts, or at least they can start alerting consumers using SMS when they are in danger of overdrawing their account. In the meantime, the Federal Reserve Board’s “opt-in” rule would be a step in the right direction.

The first chapter of the Bernie Madoff fiasco has come to a close, with Madoff pleading guilty to 11 charges of fraud yesterday.

Madoff’s massive Ponzi scheme was horrific on many levels. But while we watch the next phase of the scandal, it’s important to ask: What lessons are we going to learn from this? I can see three lessons that relate to my work studying human irrationality — and in particular, some non-useful lessons we might learn.

One lesson that individuals and foundations are likely to take from the Madoff scandal is that in addition to diversifying their portfolio across several investments (stock, bonds, equity, cash), they also need to diversify their investments among several advisors. While the idea of diversifying among advisors has some merit — and it could reduce the exposure risk of another Madoff scandal — it will also make the task of managing portfolios much more difficult and much less efficient. Imagine that you have $1,000,000, split among four advisors. You will need a whole new level of coordination among them so they can have the right amount of cash, bonds, stocks etc., across all of your assets.

And I think that people will begin to over-diversify across investors. Why? Because when we have one large and salient instance in our minds, it can be so powerful that we overemphasize it. This same effect is very apparent in what we call “the identifiable victim effect,” and it is the reason that we overemphasize the risks of a shark attack, and underestimate the risks of riding a bike without a helmet. In general, what we find when there’s one single vivid event is that people overweight it — we focus on it too much. So that’s the first lesson: We’re going to learn from the Madoff scandal, but we are going to overdo it.

Another non-useful lesson that I think we will adopt is to start searching with more vigor for other bad apples. On one hand, it is clearly important to prevent more Madoffs, but at the same time I worry that as a consequence of searching for bad apples, we won’t pay enough attention to other financial behavior that might not be as badly wrong but that can actually have larger financial consequences.

In our research on dishonesty, we found that when we give people the opportunity to cheat, many of them cheat by a little bit, while very few cheat by a lot. In our experiments, we lost about $100 to the few people who cheated a lot — but lost thousands of dollars to the many people who each cheated by a bit. I suspect that this is a good reflection of cheating in the stock market, where the real financial cost of the egregious cheating by Madoff is actually a tiny fraction of all the “small” cheating carried out by “good” bankers.

The risk here is that if we pay too much attention to chasing bad apples, we might pay too little attention to the situations where the small dishonesties of many people can have large consequences (such as paying slightly higher salaries to cronies, making small changes to financial reports, doctoring documents, being slightly dishonest about mortgage terms), and in the process neglect the real economic source of the trouble we are in.

A third bad lesson that I think people will take from this concerns the way we define acceptable levels of cheating. In a study that may parallel Madoff’s egregious dishonesty, we again gave the participants the opportunity to cheat, while solving a puzzle quiz — but this time we hired an actor. This actor, posing as a fellow participant, stood up at the start of the session and declared that he had solved all the puzzles. Now the question is how his behavior would influence the other participants in the room — the ones who were watching him.

What we found is that when the actor wore a plain T-shirt, which made him part of the student group, cheating increased. On the other hand, when the actor wore a T-shirt of the rivaling university, cheating decreased. What this means is that when someone who is part of our own social group cheats, we find it more acceptable to cheat, but when people who are not part of our social group cheat, we want to distance ourselves from these people and cheat less.

Madoff was part of the financial elite — part of an in-group of our financial leaders. Think of all these people who were in his house, who knew him well. So now, when other people in this circle see him cheating, think about the long-term consequences: Would these other people in this financial industry now be more likely to take the immoral path? It doesn’t have to be another Ponzi scheme. It just means that, now that they have been exposed to this extreme level of dishonesty, they might adopt slightly lower moral scruples. Maybe they will start not letting their clients know exactly what they own and what they don’t own, or change a little bit the interest rate that they’re charging them … I don’t think that those in his circle will necessarily become more Madoff-like people, but I do suspect that they will get a substantial relief from their moral shackles. Sadly, that’s his legacy.

So, Chapter One of the Madoff scandal is over, but I worry that the negative downstream consequences of this experience are just starting …

In the wake of all this public anger over bankers’ salaries, and within weeks of taking office, Barack Obama is proposing “common sense” executive pay guidelines—at least in companies receiving government money. These measures call for executive salaries not to exceed $500,000; any further compensation could only be in the form of stocks, which can’t be sold until the government is paid back. No doubt this makes us feel better to some extent, but the question is, will it work?

I think not, and here’s why: if we were designing the stock market from scratch and offering people $500,000 a year plus stock incentives, I’m sure we would get lots of qualified people who would kill for this job, and not only for the salary but also as an important civil service to maintain the financial system on which we depend. But this is if we started from scratch, which we are most assuredly not. Instead we’re dealing with existing bankers who are accustomed to millions a year plus millions in stock options. These people have made up, over the years, a multitude of reasons why this is the least that they deserve for their efforts and skills (how many people can admit to being paid much more than they’re worth?). This is a problem of relativity. To these bankers, in view of their “normal” pay, it looks like an offensive and irresponsible offer. My guess is that they will not accept these conditions, or if they do, they’ll find other tricks to pay themselves what they think are “right” and fair wages, which is what they earned heretofore.

What would I have done if I’d been the financial czar in this situation? I would try to turn over a new leaf; incentivize the creation of new banks with a new pay structure; promote the idea that bankers are not greedy bastards but have a crucial social responsibility so that a whole new generation would take this approach and want these positions. The “old bankers” who feel they needed millions of dollars to do their jobs well could try and compete in this new market, but we’d see who actually wanted to bank with them when the alternative is a new bank with more idealistic underpinnings and a better, more realistic, and more transparent, salary structure.

Recently I had an interesting experience being poor. It didn’t last too long but it was quite distressing and I learned how difficult this is. The story is as follows. I was out of the country for a month and during that time my car insurance expired. When I got back I called my insurance agent and I asked them to renew my policy. “No, no, no, ” they said, “If your insurance has elapsed you can’t do it over the phone and you have to come to our office in person.” Well at that time I was living in Princeton and my insurance agency was 300 miles away in Boston.  So I took the train up, got to the insurance office on time and I was ready to hand them a check and renew my insurance.
Well, here again, I was wrong. It turns out I could not do it by check. The insurance company would not take a check from me because, after all, I have shown I am financially irresponsible. “Will a credit card do?” I said. “Of course not. Only cash.” The limit I can take out with my ATM card is $800 a day and the insurance was almost $3,000 (needless to say they also increased my premium). So I could not solve it this way. “Luckily” the insurance agent had a solution at hand that was designed for this very particular problem.  There is another company they told me that would finance my insurance fee. Interestingly enough, the cost of this financing included 20%  interest rate on the loan itself plus a $100 fee just to enroll in this program.
I had no choice but to take this particular loan. So I paid the $100 fee, I paid the 20% in interest, and I got my insurance. I took the train back to Princeton. A few days later, of course, I canceled this terrible loan and paid it off. But here is what I learned from this distressing lesson, the moment you make one financial mistake the chances that you will be hit with all kinds of fines, all kinds of difficulties, all kinds of financial obstacles, are much, much higher.
If I was on the verge of financial difficulty there is no question that this particular incident would have pushed me over the edge, making my financial life much more difficult and maybe even impossible. I think that this is, in fact, what we do to people with financial constraints all the time. We impose substantial penalties on the people who violate financial responsibilities, not taking into account their viability and therefore make their lives much, much worse.
How can we get over this issue? I think we have to reconsider the punitive systems all the financial institutions use (insurance, banks, credit cards, etc.), and think more carefully about how we want to share responsibility and payment across people.  After all when someone goes bankrupt, they of course suffer, but so does the whole system around them.  From this perspective, it is easy to see how the punitive systems we are using are not only bad for the individuals but they can be very damaging for the whole society.

Today was an interesting customer service day. First, our cable (phone, internet and TV) stopped working. I got on the neighbors network and requested a technician from Time Warner. I was told that someone would come the next day and that they would call 30 minutes before they arrived and if we did not answer the phone they would not show up and we would have to call to reschedule the service visit. I tried to point out that the reason I need someone is that I don’t have a working phone, but this was lost on them.

When I got to the office I called the mortgage company. Our mortgage was just sold from one bank to another, and I called to make sure that they applied the first payment correctly. Yes, they got the payment but they did apply it to the mortgage. Why? I have no idea and they did not know either – so they asked me to call back in a few days to see if something had changed. Reluctantly I agreed, and then the customer service person asked me if all my questions were answered. “Are you joking?” I asked. “I had one question and you told me to call back.” You are correct,” she said, “did I answer all your questions?” “What do you think” I asked. “I guess we didn’t.” she said.

I am sure looking forward to calling them again in a few days.