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The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social science from the principles of psychology. —VILFREDO PARETO, 1906
To this day, Danny insists it was a high compliment. My laziness, he claims, means I only work on questions that are intriguing enough to overcome this default tendency of avoiding work.
To an economist, no one should be happier about a score of 96 out of 137 (70%) than 72 out of 100, but my students were. And by realizing this, I was able to set the kind of exam I wanted but still keep the students from grumbling.
Compared to this fictional world of Econs, Humans do a lot of misbehaving, and that means that economic models make a lot of bad predictions, predictions that can have much more serious consequences than upsetting a group of students.
of all the social scientists, economists carry the most sway when it comes to influencing public policy.
The core premise of economic theory is that people choose by optimizing.
There is, however, a problem: the premises on which economic theory rests are flawed. First, the optimization problems that ordinary people confront are often too hard for them to solve, or even come close to solving.
Second, the beliefs upon which people make their choices are not unbiased.
We don’t have to stop inventing abstract models that describe the behavior of imaginary Econs. We do, however, have to stop assuming that those models are accurate descriptions of behavior, and stop basing policy decisions on such flawed analyses.
The field has become known as “behavioral economics.” It is not a different discipline: it is still economics, but it is economics done with strong injections of good psychology and other social sciences.
My objective is to explain what my colleagues and I learned along the way, so that you can use those insights yourself to improve your understanding of your fellow Humans.
Unlike the sick girl, the typical domestic public policy decision is abstract. It lacks emotional impact.
As Schelling noted, the right question asks how much the users of that highway (and perhaps their friends and family members) would be willing to pay to make each trip they take a tiny bit safer.
Economic theory has a strong prediction about how people should answer the two different versions of these questions. The answers should be nearly equal.
Answers varied widely among respondents, but one clear pattern emerged: the answers to the two questions were not even close to being the same. Typical answers ran along these lines: I would not pay more than $2,000 in version A but would not accept less than $500,000 in version B. In fact, in version B many respondents claimed that they would not participate in the study at any price.
These examples all involve what economists call “opportunity costs.” The opportunity cost of some activity is what you give up by doing it.
even economists have trouble equating opportunity costs with out-of-pocket costs. Giving up the opportunity to sell something does not hurt as much as taking the money out of your wallet to pay for it. Opportunity costs are vague and abstract when compared to handing over actual cash.
Of course, the credit card industry hated this practice; they wanted consumers to view the use of the card as free. As the case wound its way through the regulatory process, the credit card lobby hedged its bets and shifted focus to form over substance. They insisted that if a store did charge different prices to cash and credit card customers, the “regular price” would be the higher credit card price, with cash customers offered a “discount.” The alternative would have set the cash price as the regular price with credit card customers required to pay a “surcharge.” To an Econ these two
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people valued things that were already part of their endowment more highly than things that could be part of their endowment,
“hindsight bias.” The finding is that, after the fact, we think that we always knew the outcome was likely, if not a foregone conclusion.
What makes the bias particularly pernicious is that we all recognize this bias in others but not in ourselves.
Humans have limited time and brainpower. As a result, they use simple rules of thumb—heuristics—to help them make judgments.
using these heuristics causes people to make predictable errors.
In case you are wondering about the order of the names in their papers, early on Amos and Danny adopted the highly unusual strategy of alternating whose name would go first as a subtle way of signaling that they were equal partners. In economics, alphabetical order is the default option, but in psychology the order of names usually is meant to indicate relative contributions.
With prospect theory, Kahneman and Tversky set out to offer an alternative to expected utility theory that had no pretense of being a useful guide to rational choice; instead, it would be a good prediction of the actual choices real people make. It is a theory about the behavior of Humans.
Kahneman and Tversky focus on changes because changes are the way Humans experience life.
People think about life in terms of changes, not levels. They can be changes from the status quo or changes from what was expected, but whatever form they take, it is changes that make us happy or miserable.
The difference between losing $10 and $20 feels much bigger than the difference between losing $1,300 and $1,310.
The fact that we experience diminishing sensitivity to changes away from the status quo captures another basic human trait—one of the earliest findings in psychology—known as the Weber–Fechner Law. The Weber–Fechner Law holds that the just-noticeable difference in any variable is proportional to the magnitude of that variable.
People will be risk-averse for gains, but risk-seeking for losses,
Roughly speaking, losses hurt about twice as much as gains make you feel good.
The fact that a loss hurts more than an equivalent gain gives pleasure is called loss aversion. It has become the single most powerful tool in the behavioral economist’s arsenal.
Recall from chapter 4 that a firm striving to maximize profits will set price and output at the point where marginal cost equals marginal revenue. The same analysis applies to hiring workers. Keep hiring workers until the cost of the last worker equals the increase in revenue that the worker produces.
Friedman argued that it was silly to evaluate a theory based on the realism of its assumptions. What mattered was the accuracy of the theory’s predictions.
My main point was that economics is supposed to be a theory of everyone, not only experts. An expert billiard player might play as if he knows all the relevant geometry and physics, but the typical bar player usually aims at the ball closest to a pocket and shoots, often missing. If we are going to have useful theories about how typical people shop, save for retirement, search for a job, or cook dinner, those theories had better not assume that people behave as if they were experts.
Apparently economists don’t mind survey data as long as someone other than the researcher collected it.
Psychologists tell us that in order to learn from experience, two ingredients are necessary: frequent practice and immediate feedback.
Notice the trend. We do small stuff often enough to learn to get it right, but when it comes to choosing a home, a mortgage, or a job, we don’t get much practice or opportunities to learn.
my lifetime, I cannot remember any time when experts thought General Motors was a well-run company. But GM stumbled along as a badly-run company for decades. For most of this period they were also the largest car company in the world. Perhaps they would have disappeared from the global economy in 2009 after the financial crisis, but with the aid of a government bailout, they are now the second largest automobile company in the world, a bit behind Toyota and just ahead of Volkswagen. Competitive forces apparently are slow-acting.
Recall from the discussion of the endowment effect that all economic decisions are made through the lens of opportunity costs. The cost of dinner and a movie tonight is not fully captured by the financial outlay—it also depends on the alternative uses of that time and money. If you understand opportunity costs and you have a ticket to a game that you could sell for $1,000, it does not matter how much you paid for the ticket. The cost of going to the game is what you could do with that $1,000. You should only go to the game if that is the best possible way you could use that money.
Thinking like that is a right and proper normative theory of consumer choice. It’s what Econs do, and in principle we should all strive to think this way most of the time.
These results show that people are willing to pay different prices for the same beer, consumed at the same spot on the beach, depending on where it was bought. Why do the respondents care where the beer was bought? One reason is expectations. People expect prices to be higher at a fancy hotel, in part because the costs are quite obviously higher. Paying seven dollars for a beer at a resort is annoying but expected; paying that at a bodega is an outrage! This is the essence of transaction utility.
Getting a great deal is more fun than saving a small and largely invisible amount on each item.
It might well be true that consumers were not paying any more under the new regime, but they were missing out on lots of transaction utility. They even lost that tiny pleasure of paying just “under” a given dollar amount, e.g., $9.99 rather than $10.
For businesses, it is important to realize that everyone is interested in a good deal. Whether it is via sales or genuine low prices, the lure of a deal will attract customers.
many people, even if they understand the concept in principle, can find it difficult to follow the advice to ignore sunk costs in practice.
Marketing professors John Gourville and Dilip Soman conducted a clever study at a health club to demonstrate this point. This club bills its members twice a year. Gourville and Soman found that attendance at the club jumps the month after the bill arrives, then tails off over time until the next bill arrives. They called this phenomenon “payment depreciation,” meaning that the effects of sunk costs wear off over time.
There is an old expression that money burns a hole in your pocket, and cash on hand seems to exist only to be spent.
Gambling when behind in an effort to break even can also be seen in the behavior of professional investors. Mutual fund portfolio managers take more risks in the last quarter of the year when the fund they are managing is trailing the benchmark index (such as the S&P 500) to which their returns are compared.
