Behavioral economics explains why we procrastinate, buy, borrow, and grab chocolate on the spur of the moment.
by Craig Lambert
Like all revolutions in thought, this one began with anomalies, strange facts, odd observations that the prevailing wisdom could not explain. Casino gamblers, for instance, are willing to keep betting even while expecting to lose. People say they want to save for retirement, eat better, start exercising, quit smoking—and they mean it—but they do no such things. Victims who feel they’ve been treated poorly exact their revenge, though doing so hurts their own interests.
Such perverse facts are a direct affront to the standard model of the human actor—Economic Man—that classical and neoclassical economics have used as a foundation for decades, if not centuries. Economic Man makes logical, rational, self-interested decisions that weigh costs against benefits and maximize value and profit to himself. Economic Man is an intelligent, analytic, selfish creature who has perfect self-regulation in pursuit of his future goals and is unswayed by bodily states and feelings. And Economic Man is a marvelously convenient pawn for building academic theories. But Economic Man has one fatal flaw: he does not exist.
When we turn to actual human beings, we find, instead of robot-like logic, all manner of irrational, self-sabotaging, and even altruistic behavior. This is such a routine observation that it has been made for centuries; indeed, Adam Smith “saw psychology as a part of decision-making,” says assistant professor of business administration Nava Ashraf. “He saw a conflict between the passions and the impartial spectator.”
Nonetheless, neoclassical economics sidelined such psychological insights. As recently as 15 years ago, the sub-discipline called behavioral economics—the study of how real people actually make choices, which draws on insights from both psychology and economics—was a marginal, exotic endeavor. Today, behavioral economics is a young, robust, burgeoning sector in mainstream economics, and can claim a Nobel Prize, a critical mass of empirical research, and a history of upending the neoclassical theories that dominated the discipline for so long.
Framing a New Field
Two non-economists have won Nobel Prizes in economics. As early as the 1940s, Herbert Simon of Carnegie Mellon University put forward the concept of “bounded rationality,” arguing that rational thought alone did not explain human decision-making. Traditional economists disliked or ignored Simon’s research, and when he won the Nobel in 1978, many in the field were very unhappy about it.
Then, in 1979, psychologists Daniel Kahneman, LL.D. ’04, of Princeton and Amos Tversky of Stanford published “Prospect Theory: An Analysis of Decision under Risk,” a breakthrough paper on how people handle uncertain rewards and risks. In the ensuing decades, it became one of the most widely cited papers in economics. The authors argued that the ways in which alternatives are framed—not simply their relative value—heavily influence the decisions people make. This was a seminal paper in behavioral economics; its rigorous equations pierced a core assumption of the standard model—that the actual value of alternatives was all that mattered, not the mode of their presentation (“framing”).
Framing alternatives differently can, for example, change people’s preferences regarding risk. In a 1981 Science paper, “The Framing of Decisions and the Psychology of Choice,” Tversky and Kahneman presented an example. “Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease which is expected to kill 600 people,” they wrote. “Two alternative programs to combat the disease have been proposed.” Choose Program A, and a projected 200 people will be saved. Choose Program B, and there is a one-third probability that 600 people will be saved, and a two-thirds probability that no one will be saved. The authors reported that 72 percent of respondents chose Program A, although the actual outcomes of the two programs are identical. Most subjects were risk averse, preferring the certain saving of 200 lives. The researchers then restated the problem: this time, with Program C, “400 people will die,” whereas with Program D, “there is a one-third probability that no one will die, and a two-thirds probability that 600 people will die.” This time, 78 percent chose Program D—again, despite identical outcomes. Respondents now preferred the risk-taking option. The difference was simply that the first problem phrased its options in terms of lives saved, and the second one as lives lost; people are more willing, apparently, to take risks to prevent lives being “lost” than to “save” lives.
“Kahneman and Tversky started this revolution in economics,” says Straus professor of business administration Max Bazerman, who studies decision-making and negotiation at Harvard Business School. “That 1979 paper was written on the turf of economics, in the style of economists, and published in the toughest economic journal, Econometrica. The major points of prospect theory aren’t hard to state in words. The math was added for acceptance, and that was important.” In 2002, Kahneman received the Nobel Prize in economics along with Vernon Smith, Ph.D. ’55, of George Mason University, who was honored for work in experimental economics. (Tversky, Kahneman’s longtime collaborator, had died in 1996.)http://harvardmagazine.com/2006/03/the-marketplace-of-perce.html