New Yorker on behavioral economics

Elizabeth Kolbert reviews two recent books on behavioral economics. She even notes the negative consequences of "irrationality" for democracy.

NewYorker: ...Over the years, Tversky and Kahneman’s initial discoveries have been confirmed and extended in dozens of experiments. In one example, Ariely and a colleague asked students at M.I.T.’s Sloan School of Management to write the last two digits of their Social Security number at the top of a piece of paper. They then told the students to record, on the same paper, whether they would be willing to pay that many dollars for a fancy bottle of wine, a not-so-fancy bottle of wine, a book, or a box of chocolates. Finally, the students were told to write down the maximum figure they would be willing to spend for each item. Once they had finished, Ariely asked them whether they thought that their Social Security numbers had had any influence on their bids. The students dismissed this idea, but when Ariely tabulated the results he found that they were kidding themselves. The students whose Social Security number ended with the lowest figures—00 to 19—were the lowest bidders. For all the items combined, they were willing to offer, on average, sixty-seven dollars. The students in the second-lowest group—20 to 39—were somewhat more free-spending, offering, on average, a hundred and two dollars. The pattern continued up to the highest group—80 to 99—whose members were willing to spend an average of a hundred and ninety-eight dollars, or three times as much as those in the lowest group, for the same items.

This effect is called “anchoring,” and, as Ariely points out, it punches a pretty big hole in microeconomics. When you walk into Starbucks, the prices on the board are supposed to have been determined by the supply of, say, Double Chocolaty Frappuccinos, on the one hand, and the demand for them, on the other. But what if the numbers on the board are influencing your sense of what a Double Chocolaty Frappuccino is worth? In that case, price is not being determined by the interplay of supply and demand; price is, in a sense, determining itself.

...A few weeks ago, the Bureau of Economic Analysis released its figures for 2007. They showed that Americans had collectively amassed ten trillion one hundred and eighty-four billion dollars in disposable income and spent very nearly all of it—ten trillion one hundred and thirty-two billion dollars. This rate of spending was somewhat lower than the rate in 2006, when Americans spent all but thirty-nine billion dollars of their total disposable income.

According to standard economic theory, the U.S. savings rate also represents rational choice: Americans, having reviewed their options, have collectively resolved to spend virtually all the money that they have. According to behavioral economists, the low savings rate has a more immediate explanation: it proves—yet again—that people have trouble acting in their own best interests. It’s worth noting that Americans, even as they continue to spend, say that they should be putting more money away; one study of participants in 401(k) plans found that more than two-thirds believed their savings rate to be “too low.”

...Like neoclassical economics, much democratic theory rests on the assumption that people are rational. Here, too, empirical evidence suggests otherwise. Voters, it has been demonstrated, are influenced by factors ranging from how names are placed on a ballot to the jut of a politician’s jaw. A 2004 study of New York City primary-election results put the advantage of being listed first on the ballot for a local office at more than three per cent—enough of a boost to turn many races. (For statewide office, the advantage was around two per cent.) A 2005 study, conducted by psychologists at Princeton, showed that it was possible to predict the results of congressional contests by using photographs. Researchers presented subjects with fleeting images of candidates’ faces. Those candidates who, in the subjects’ opinion, looked more “competent” won about seventy per cent of the time.

When it comes to public-policy decisions, people exhibit curious—but, once again, predictable—biases. They value a service (say, upgrading fire equipment) more when it is described in isolation than when it is presented as part of a larger good (say, improving disaster preparedness). They are keen on tax “bonuses” but dislike tax “penalties,” even though the two are functionally equivalent. They are more inclined to favor a public policy when it is labelled the status quo. In assessing a policy’s benefits, they tend to ignore whole orders of magnitude. In an experiment demonstrating this last effect, sometimes called “scope insensitivity,” subjects were told that migrating birds were drowning in ponds of oil. They were then asked how much they would pay to prevent the deaths by erecting nets. To save two thousand birds, the subjects were willing to pay, on average, eighty dollars. To save twenty thousand birds, they were willing to pay only seventy-eight dollars, and to save two hundred thousand birds they were willing to pay eighty-eight dollars.

What is to be done with information like this? We can try to become more aware of the patterns governing our blunders, as “Predictably Irrational” urges. Or we can try to prod people toward more rational choices, as “Nudge” suggests. But if we really are wired to make certain kinds of mistakes, as Thaler and Sunstein and Ariely all argue, we will, it seems safe to predict, keep finding new ways to make them. (Ariely confesses that he recently bought a thirty-thousand-dollar car after reading an ad offering FREE oil changes for the next three years.)