1.2 Module 19: Behavioral Economics

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How People Make Economic Choices

Most economic models assume that people make choices based on achieving the best possible economic outcome for themselves. Human behavior, however, is often not so simple. Rather than acting like economic computing machines, people often make choices that fall short—sometimes far short—of the greatest possible economic outcome, or payoff. Why people sometimes make less-than-perfect choices is the subject of behavioral economics, a branch of economics that combines economic modeling with insights from human psychology. Behavioral economics grew out of economists’ and psychologists’ attempts to understand how people actually make economic choices in real life (instead of in theory).

It’s well documented that people consistently engage in irrational behavior, choosing an option that leaves them worse off than other available options. Yet, as we’ll soon learn, sometimes it’s entirely rational for people to make a choice that is different from the one that generates the highest possible profit for themselves. For example, Ashley Hildreth, who we read about in Module 18, may decide to earn a teaching degree because she enjoys teaching more than advertising, even though the profit from the teaching degree is less than that from continuing with advertising.

The study of irrational economic behavior was largely pioneered by Daniel Kahneman and Amos Tversky. Kahneman won the 2002 Nobel Prize in economics for his work integrating insights from the psychology of human judgment and decision making into economics. Their work and the insights of others into why people often behave irrationally are having a significant influence on how economists analyze financial markets, labor markets, and other economic concerns.

Rational, but Human, Too

If you are rational, you will choose the available option that leads to the outcome you most prefer. But is the outcome you most prefer always the same as the one that gives you the best possible economic payoff? No. It can be entirely rational to choose an option that gives you a worse economic payoff because you care about something other than the size of the economic payoff. There are three principal reasons why people might prefer a worse economic payoff: concerns about fairness, bounded rationality, and risk aversion.

Concerns About FairnessIn social situations, people often care about fairness as well as about the economic payoff to themselves. For example, no law requires you to tip a waiter or waitress. But concern for fairness leads most people to leave a tip (unless they’ve had outrageously bad service) because a tip is seen as fair compensation for good service according to society’s norms. Tippers are reducing their own economic payoff in order to be fair to waiters and waitresses.

Bounded RationalityBeing an economic computing machine—choosing the option that gives you the best economic payoff—can require a fair amount of work: sizing up the options, computing the opportunity costs, calculating the marginal amounts, and so on. The mental effort required has its own opportunity cost. This realization led economists to the concept of bounded rationality—making a choice that is close to but not exactly the one that leads to the highest possible profit because the effort of finding the best payoff is too costly. In other words, bounded rationality is the “good enough” method of decision making.

Retailers are particularly good at exploiting their customers’ tendency to engage in bounded rationality. For example, pricing items in units ending in 99¢ takes advantage of shoppers’ tendency to interpret an item that costs, say, $2.99 as significantly cheaper than one that costs $3.00. Bounded rationality leads them to give more weight to the $2 part of the price (the first number they see) than the 99¢ part.

Risk AversionBecause life is uncertain and the future unknown, sometimes a choice comes with significant risk. Although you may receive a high payoff if things turn out well, the possibility also exists that things may turn out badly and leave you worse off. So even if you think a choice will give you the best payoff of all your available options, you may forgo it because you find the possibility that things could turn out badly too, well, risky. This is called risk aversion—the willingness to sacrifice some potential economic payoff in order to avoid a potential loss. Because risk makes most people uncomfortable, it’s rational for them to give up some potential economic gain in order to avoid it.

Irrationality: An Economist’s View

Sometimes, though, instead of being rational, people are irrational—they make choices that leave them worse off in terms of economic payoff and other considerations like fairness than if they had chosen another available option. Is there anything systematic that economists and psychologists can say about economically irrational behavior? Yes, because most people are irrational in predictable ways. People’s irrational behavior typically stems from six mistakes they make when thinking about economic decisions. The mistakes are listed in Table 19-1, and we will discuss each in turn.

Misperceptions of Opportunity CostsAs we’ve seen, people tend to ignore nonmonetary opportunity costs also known as implicit costs. These are opportunity costs that don’t involve an outlay of cash. Likewise, a misperception of what exactly constitutes an opportunity cost (and what does not) is at the root of the tendency to count sunk costs in one’s decision making. In this case, someone takes an opportunity cost into account when none actually exists.

OverconfidenceIt’s a function of ego: we tend to think we know more than we actually do. And even if alerted to how widespread overconfidence is, people tend to think that it’s someone else’s problem, not theirs. (Certainly not yours or mine!) For example, a 1994 study asked students to estimate how long it would take them to complete their thesis “if everything went as well as it possibly could” and “if everything went as poorly as it possibly could.” The results: the typical student thought it would take him or her 33.9 days to finish, with an average estimate of 27.4 days if everything went well and 48.6 days if everything went poorly. In fact, the average time it took to complete a thesis was much longer, 55.5 days. Students were, on average, from 14% to 102% more confident than they should have been about the time it would take to complete their theses.

Overconfidence can be bad for your financial health.

Jack Watts/Alamy

Overconfidence can cause trouble by having a strong adverse effect on people’s financial health. Overconfidence often persuades people that they are in better financial shape than they actually are. It can also lead to bad investment and spending decisions. For example, nonprofessional investors who engage in a lot of speculative investing—such as quickly buying and selling stocks—on average have significantly worse results than professional brokers because of their misguided faith in their ability to spot a winner. Similarly, overconfidence can lead people to make a large spending decision, such as buying a car, without doing research on the pros and cons, relying instead on anecdotal evidence. Even worse, people tend to remain overconfident because they remember their successes and explain away or forget their failures.

Unrealistic Expectations About Future BehaviorAnother form of overconfidence is being overly optimistic about your future behavior: tomorrow you’ll study, tomorrow you’ll give up ice cream, tomorrow you’ll spend less and save more, and so on. Of course, as we all know, when tomorrow arrives, it’s still just as hard to study or give up something that you like as it is right now.

Strategies that keep a person on the straight-and-narrow over time are often, at their root, ways to deal with the problem of unrealistic expectations about one’s future behavior. Examples are automatic payroll deduction savings plans, diet plans with prepackaged foods, and mandatory attendance at study groups. By providing a way for someone to commit today to an action tomorrow, such plans counteract the habit of pushing difficult actions off into the future.

Counting Dollars UnequallyIf you tend to spend more when you pay with a credit card than when you pay with cash, particularly if you tend to splurge, then you are very likely engaging in mental accounting. This is the habit of mentally assigning dollars to different accounts, making some dollars worth more than others. By spending more with a credit card, you are in effect treating dollars in your wallet as more valuable than dollars on your credit card balance, although in reality they count equally in your budget.

A dollar is a dollar, whether it’s in your wallet or on your credit card balance.

discpicture/Alamy

Credit card overuse is the most recognizable form of mental accounting. However, there are other forms as well, such as splurging after receiving a windfall, like an unexpected inheritance, or overspending at sales, buying something that seemed like a great bargain at the time whose purchase you later regretted. It’s the failure to understand that, regardless of the form it comes in, a dollar is a dollar.

Loss AversionAn oversensitivity to loss, leading to an unwillingness to recognize a loss and move on, is called loss aversion. In fact, in the lingo of the financial markets, “selling discipline”—being able and willing to quickly acknowledge when a stock you’ve bought is a loser and sell it—is a highly desirable trait to have. Many investors, though, are reluctant to acknowledge that they’ve lost money on a stock and won’t make it back.

Although it’s rational to sell the stock at that point and redeploy the remaining funds, most people find it so painful to admit a loss that they avoid selling for much longer than they should. According to Daniel Kahneman and Amos Tversky, most people feel the misery of losing $100 about twice as keenly as they feel the pleasure of gaining $100.

Loss aversion can help explain why sunk costs are so hard to ignore: ignoring a sunk cost means recognizing that the money you spent is unrecoverable and therefore lost.

Status Quo BiasAnother irrational behavior is status quo bias, the tendency to avoid making a decision altogether. A well-known example is the way that employees make decisions about investing in their employer-directed retirement accounts, known as 401(k)s. With a 401(k), employees can, through payroll deductions, set aside part of their salary tax-free, a practice that saves a significant amount of money every year in taxes. Some companies operate on an opt-in basis: employees have to actively choose to participate in a 401(k). Other companies operate on an opt-out basis: employees are automatically enrolled in a 401(k) unless they choose to opt out.

If everyone behaved rationally, then the proportion of employees enrolled in 401(k) accounts at opt-in companies would be roughly equal to the proportion enrolled at opt-out companies. In other words, your decision about whether to participate in a 401(k) should be independent of the default choice at your company. But, in reality, when companies switch to automatic enrollment and an opt-out system, employee enrollment rises dramatically. Clearly, people tend to just go with the status quo.

Why do people exhibit status quo bias? Some claim it’s a form of “decision paralysis”: when given many options, people find it harder to make a decision. Others claim it’s due to loss aversion and the fear of regret, to thinking that “if I do nothing, then I won’t have to regret my choice.” Irrational, yes. But not altogether surprising. However, rational people know that, in the end, the act of not making a choice is still a choice.

Rational Models for Irrational People?

So why do economists still use models based on rational behavior when people are at times manifestly irrational? For one thing, models based on rational behavior still provide mostly accurate predictions about how people behave in most markets. For example, the great majority of farmers will use less fertilizer when it becomes more expensive—a result consistent with rational behavior.

Another explanation is that sometimes market forces can compel people to behave more rationally over time. For example, if you are a small-business owner who exaggerates your abilities or refuses to acknowledge that your favorite line of items is a loser, then sooner or later you will be out of business unless you learn to correct your mistakes. As a result, it is reasonable to assume that when people are disciplined for their mistakes, as happens in most markets, rationality will win out over time.

Finally, economists depend on the assumption of rationality for the simple but fundamental reason that it makes modeling so much simpler. Remember that models are built on generalizations, and it’s much harder to extrapolate from messy, irrational behavior. Even behavioral economists, in their research, search for predictably irrational behavior in an attempt to build better models of how people behave. Clearly, there is an ongoing dialogue between behavioral economists and the rest of the economics profession, and economics itself has been irrevocably changed by it.

“THE JINGLE MAIL BLUES”

It’s called jingle mail—when a homeowner seals the keys to his or her house in an envelope and leaves them with the bank that holds the mortgage on the house. (A mortgage is a loan taken out to buy a house.) By leaving the keys with the bank, the homeowner is walking away not only from the house but also from the obligation to continue paying the mortgage. And to their great consternation, banks have lately been flooded with jingle mail.

To default on a mortgage—that is, to walk away from one’s obligation to repay the loan and lose the house to the bank in the process—used to be a fairly rare phenomenon. For decades, continually rising home values made homeownership a good investment for the typical household.

In recent years, though, an entirely different phenomenon—called “strategic default”—has appeared. In a strategic default, a homeowner who is financially capable of paying the mortgage instead chooses not to, voluntarily walking away. Strategic defaults account for a significant proportion of jingle mail; in March 2010, they accounted for 31% of all foreclosures, up from 22% in 2009. And there is little indication that number will change dramatically: in the spring of 2011, strategic defaults still accounted for 30% of all defaults.

What happened? The Great American Housing Bust happened. After decades of huge increases, house prices began a precipitous fall in 2008. Prices dropped so much that a significant proportion of homeowners found their homes “underwater”—they owed more on their homes than the homes were worth. And with house prices projected to stay depressed for several years, possibly a decade, there appeared to be little chance that an underwater house would recover its value enough in the foreseeable future to move “abovewater.”

© Tom Cheney/The New Yorker Collection/www.cartoonbank.com

Many homeowners suffered a major loss. They lost their down payment, money spent on repairs and renovation, moving expenses, and so on. And because they were paying a mortgage that was greater than the house was now worth, they found they could rent a comparable dwelling for less than their monthly mortgage payments. In the words of Benjamin Koellmann, who paid $215,000 for an apartment in Miami where similar units were now selling for $90,000, “There is no financial sense in staying.”

Realizing their losses were sunk costs, underwater homeowners walked away. Perhaps they hadn’t made the best economic decision when purchasing their houses, but in leaving them they showed impeccable economic logic.

Module 19 Review

Check Your Understanding

How would you determine whether a decision you made was rational or irrational?