TBR: Predictably Irrational
This week’s book is Predictably Irrational, by Dan Ariely. It’s a quick read, but has far reaching ramifications. It’s about how people aren’t as rational as economists think we are. That’s not particularly surprising, but Ariely goes on to argue that people are irrational in systematic– predictable — ways, and to explain the elegant experiments that psychologists and behavioral economists have developed to tease these out. So, let’s look at some of the examples:
- People are hugely biased for the idea of getting something for "free." They’ll take the crappy thing for free over the good thing for a modest cost.
- People don’t know what things are really worth, and so anchor to arbitrary comparisons. People often won’t buy the most expensive thing on the menu, but they’ll buy the next most expensive thing. I was particularly impressed by the studies that showed that if the researchers asked people if a percentage was higher or lower than the last two digits of their social security number, and then had them guess at a concrete number, there was a strong correlation between the guess and those last two digits. Based on this, I’d guess that including a high "buy
it now" price pulls up the value of bids on ebay, even when no one uses
the buy it now option. (Although I don’t know if it would pull them up to offset the increased fee.)
- When you ask people to choose among three things, two of which are similar (but one is clearly better than the other) and one is very different, they’re more likely to choose the better of the two similar choices. It’s hard to tell if an apple is better than an orange, but a fresh apple is clearly better than a rotten apple — and the presence of the rotten apple stand out against the orange.
All this isn’t just entertaining, but has pretty significant policy implications. Orthodox economists — for all their pessimistic reputation — actually tend towards a Panglossian view of the world — that we’re in the very best of all possible worlds, or at least that the world couldn’t be made better for anyone without making it worse for someone else. This is because economists take pretty seriously the idea of revealed preference: the idea that you can tell what agents in a free market prefer by what they chose, given the options that are available to them.
Ariely more or less blows up this idea, by showing studies where given choices A, B and C, no one chose option B, but taking away option B dramatically changes the distribution of choices between A and C. The bad news is that this means that lots of people are making suboptimal choices all the time; the good news is that it means there’s room for improvements without making anyone worse off. The problem is that there’s a lot of resistance — for good reasons — to having public institutions adopt the strategies of direct marketers…
Somewhat related books that I’ve read recently:
- Discover Your Inner Economist, by Tyler Cowan (of Marginal Revolution). While Cowan is much more of a traditional economist than Ariely, I’m not sure you’d be able to tell that by this book. Cowan’s big take-away here is that economics is about scarcity, and so the key is always to figure out what’s the resource that’s scarce (and it’s often attention or time, rather than money).
- Your Money and Your Brain, by Jason Zveig. Specifically focusing in on why we behave irrationally when it comes to investing. I thought the first chapter or two was fascinating, but then it got repetitive, and I didn’t finish the book before it was due back to the library. Maybe a good one to give to your brother who thinks that he’s figured out a way to beat the markets.
May 21st, 2008 at 7:05 am
You’ve probably read this, but he’s british, so there’s a small chance you haven’t – The Logic of Life, by Tim Harford, is a higher level survey of economic work along similar lines (he’s a journalist for the UK Financial Times) – why many decisions which seem irrational on the surface are rational when you unpack all the ramifications of the alternatives. He doesn’t much like behavioural economics in the laboratory – preferring studies which look at real life choices, so would probably disagree with some of the comments above.
May 22nd, 2008 at 1:00 pm
We sold an extra Nintendo Wii on eBay last year (yes, my husband actually managed to get two, somehow), which basically paid for the first Wii. We spent quite a while observing auctions, trying to figure out the best placement strategy.
Based on our observations, high “Buy It Now” and high starting prices resulted in lower selling prices. I *think* that this is because bidders get engaged in an auction when the price is low and they are thinking that they might get a bargain. They then become psychologically locked into that particular auction and continue to bid it up, even when there are other items with high Buy It Now prices that are lower than the current price of the item. Items with high start prices tend to receive fewer bids and therefore miss out on the bidding frenzy. This is also a form of predictable (and collective) irrationality–we see lots of people bidding on something (and willing to keep bidding it up) and our lizard brain tells us that it *must* be worth it, otherwise all these other people wouldn’t be bidding it up (see also: market, housing). I haven’t read the book, but I think this is consistent with his arguments (based on what I’ve read about it).
The revealed preferences problem is a big one. It drives me crazy! I actually had fellow MA students argue to me in an econ class that poor people *prefer* living in polluted neighborhoods because they *prefer* cheap real estate over clean air…hello? Constrained choices anyone?
May 22nd, 2008 at 1:48 pm
I think there’s probably different effective strategies for selling something on eBay when there’s a MSRP that is widely known and provides an anchor price (as for the Wii), and for selling something when the “real value” is unknown (such as a piece of art by a non-famous artist).