From ON Magazine
Dan Ariely is the James B. Duke Professor of Behavioral Economics at Duke University. He is also affiliated with MIT's Media Lab. In his best-selling book, Predictably Irrational, Ariely argues that forces that are ignored by traditional economics, such as emotions and social norms, are important influencers of our economic behavior. Ariely describes in the book his numerous experiments, which highlight our natural tendency to vastly underestimate or completely ignore the influence of these forces.
Can you give us an example of irrational economic behavior that can be predicted?
I did an experiment in which I asked students to write the last two digits of their Social Security number at the top of a piece of paper. Then I showed them a range of products, such as chocolates, books, wines, and computer accessories, and asked them if they would pay that amount for these things. So whether their number was 27 or 87, they had to decide whether any of these items were worth that amount. The students made their decisions and then we held an auction for the products. What we found is that those with higher numbers ended up bidding more for the items than those with lower numbers. Why did they do this? We found that if you consider a higher number like 87 for awhile, it sticks with you, and you end up being more willing to pay more money. What this tells us is that we don't actually know how much things are worth. We use the context in our previous thoughts to try to determine value, rather than some more objective criteria.
Is there a connection between this kind of behavior and our current economic troubles?
What I think happened on Wall Street is that we gave people very bad incentive structures. They were paid a lot of money to see reality in a certain way—chiefly, a way that was more advantageous to them than to investors. Imagine I'm your stockbroker. You're behind for the year in terms of how much money you've made. Your losses don't interest me because I'm only getting paid when you make money. You've told me to maintain a certain risk approach, but I would prefer if you took more risk because unless you do, you'll never make up your losses—and therefore I won't make any money.
Or think about your doctor. You have some illness for which there is Treatment A and Treatment B. A is slightly better for you in terms of your health, but B is slightly better for them in terms of how much they can charge insurance providers. Are they really going to be able to see reality in a way that is good for you? I don't think so. You would never imagine judges getting a cut of what sentences they give—I order you to pay a $50,000 fine, and I get to keep $5,000 of that for myself—yet this is the kind of ridiculous incentives system in which your stockbroker and your physician work.
So what can be done about it?
The tricky thing is that there is only one way to be rational, but many ways to be irrational. One thing that tends to suffer when things are irrational is the concept of trust. We played an experimental trust game that I think has a lot to say about what is going on currently. The trust game works as follows. Player 1 gets $10, and Player 2 gets $10. Player 1 goes first and has two choices. He can either keep the $10 and go home, or give his $10 to Player 2. If Player 2 gets the money, she can either go home with the money she has, or give half the money back to Player 1.
There is one more trick here, which is that the money that Player 1 sends to Player 2 quadruples, so Player 1 will send $10, and by the time it gets to Player 2, it is $40. Now Player 2 has $50, the original $10 and the $40 from Player 1, and can decide to split it $25/$25, or go home with $50. The rational perspective says that Player 2 will never give money back to Player 1 and as a consequence, the prediction is that Player 1 will never send the money in the first place because Player 2 is not expected to send anything back.
As it turns out, people are too nice, too trusting, and too reciprocating relative to rational economic theory. Based on our observations, there is in fact a good chance that Player 1 will give the money to Player 2 and that Player 2 will reciprocate and split the money with Player 1. What is even more interesting are those times when Player 2 decides to walk away with the $50. Then we say to Player 1, "Look, you just lost $10, but for every dollar you give me, I will take $2 away from Player 2. If you give me $3, I'll take $6. If you give me $11, I'll take $22, etc." Again, rationally why would somebody who just lost money want to lose even more money just to punish somebody else? The reality is that people often do. They spend the money to express revenge, even though revenge is irrational in the sense that it's not something a rational person should do.
Now let's go back to Wall Street. I think in many ways this trust game is the kind of game we as investors and people with 401(k) accounts and mortgages have played with Wall Street. We gave them our retirement funds. We gave them our mortgages, and they walked away with our $50. As a consequence, we feel betrayed, and I think that unless we understand that a big part of what is going on in the market has to do with the loss of trust, it's not going to get better. The bailout alone is not enough; people need a reason to trust again, and that could be done with new regulations, policies that create more transparency and remove conflicts of interest, and maybe some real consequences for the people who betrayed our trust.
How do you anticipate that the economic crisis will affect our behavior in the long term? Will our buying, selling, and saving behaviors become more or less predictable or irrational? Will we forget all about this pain in time and go back to our usual patterns?
We are largely creatures of habit. We assume that what we've done before is sensible and we keep on doing it. The times when we attempt to revise those decision strategies are times of incredible pain and frustration, like now. But whatever new habits we come up with right now, we'll probably stay with them for a while.
Are these going to be good habits or bad habits? It's hard to know. I've seen people who are deciding to save more, saying, "What we've done before is not viable. We don't want to have such a big mortgage. We don't want to carry such big credit card debt." But I've also seen the opposite. I got a letter from someone who said, "I've been saving for years. I've deprived myself. I didn't buy myself a new bike, I didn't buy a new car, and I managed to save $40,000. Now half of it is gone. If I hadn't saved anything, at least I would have had the things I wanted." That sentiment may not work for everyone, but it's true that the economy won't improve until people start spending more.
So I think it's a very crucial time to see what happens, to see if people are going to change as a reaction to this meltdown.
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