Book Unmasks 'Rational Actor' as Impulsive Animal

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MIKE PESCA, host:

If you've ever taken econ 101, you've come across the phrase "the rational actor." Maybe you glossed over it to get to the good part about the demand curve. But for years, few economists ever stopped to ask, just who is this rational actor? And why are we basing our knowledge on him? This is all changing. According to a new wave of economists, faith in the rational actor is neither durable nor good.

RACHEL MARTIN, host:

That's funny.

PESCA: Little econ joke there. Yeah, yeah. Dan Ariely is at the crest of this wave. Ariely teaches behavioral economics at Duke University and MIT. He's the author of a new book, "Predictably Irrational." He devises ingenious experiments that reveal the impulses that drive much of our economic behavior. I asked him about one of his experiments to figure out why different people can look at the same item and see two different prices.

Dr. DAN ARIELY (Behavioral Economics, Massachusetts Institute of Technology; Author, "Predictably Irrational"): One year, Duke went to the Final Four, and obviously, all the students wanted to go the game, but they didn't have enough tickets. So they had this week-long camping event where the students had to stand outside in the rain for a week, you know, in tents and so on, and at the end, only the survivors would get the tickets. I guess this was kind of maybe the early version of "Survivor," or one of these television shows.

And - but at the end of the week, there were too many students who remained. So now they did a lottery, and some students who spent the whole week got the tickets, and some students who spent the whole week didn't get the tickets. Now, we called them up, and we tried to understand, how does the mere fact of ownership changes how they look at the tickets?

So, the people who didn't have tickets, we called them up and said, hey, we might have a deal for you. We might be able to sell you a ticket. How much would you be willing to pay for one? And we tried to bargain them up. And the average price there was about 170 dollars. Then we called the people who had tickets, and we tried to buy the tickets from them. Hey, you know, we might have a buyer for you, how much would you sell me the ticket? And we tried to bargain them as lower as we could, but they wanted about 2,400 dollars for it.

PESCA: Right.

Dr. ARIELY: Now, here is the interesting thing. It was a random allocation. Some people get it and some people don't, but a day later, the people who had the ticket thought they were wonderful, exciting. In fact, when they talked about them, they talked about the Duke basketball game as being the defining moment of their life at Duke, something they will tell their children and grandchildren about.

Whereas the people who didn't have it thought very differently about it. They said, well, we could watch the game on television. We could get some beer with some friends. It's not such a big deal. The mere fact of becoming an owner somehow dramatically changes how people look at the world.

PESCA: Interesting. Another example of where it should be - everything should be equal and people just don't perceive it as is. You gave your class some deadlines, or you gave them the option to have a deadline. You had three different classes, and with one, you said papers will be turned in whenever you want, and with one, you said papers have to be turned in at this week, and then the next week, and then the third week.

And with the last class, you said - and this was really interesting - you get to name your own deadline. It can be as late as you want, but you have to stick to the deadline that you named. What were you looking to find out in that experiment? And what did you find out?

Dr. ARIELY: So the big issue, of course, is self-control and procrastination, and we often have things where we have very different long-term hopes for ourselves, in terms of our health, and saving, and exercising, and eating, and procrastination, but at the moment, we're tempted to behave differently.

Now, I'm experiencing a lot of procrastination in university, of course. In the beginning of the semester, all the students are excited and they think they'll be ahead of their work, and they'll do well, and they come with clean notebooks and so on, and by the end of the semester, they always come up with excuses of, you know, dead relatives, and illnesses, and all kinds of stuff like that.

So what I was trying to do in there is to create a mechanism where the students can force themselves to behave better. So imagine the following. If you're in the condition where I said you could decide when you want to submit your grade. If you are rational - when you submit your paper, if you were rational, you would say, I will submit everything in the last day of class. After all, you could always submit papers early. It's just that submitting them late costs you something.

But if you were irrational, and you knew it, if, for example, the semester ends on May 2nd, and you knew that without an early deadline, you would start working on May 1st, you will work through the night and produce crummy outcome. You might be willing to take a costly deadline and say you know what? I'll submit one paper in March, one in April, one in May, and this deadline.

This spacing deadlines would cause me to start working early and actually provide better results. And the outcome we had from that experiment is that the students realized their procrastination tendencies, and given this mechanism, they actually did better, so they got better grades.

PESCA: A lot of people say, yes, I impose deadlines on myself. I even set my watch 15 minutes early, but - you know, so I won't be late. But you say let's actually expand it into something much more important for society, and that's healthcare.

Dr. ARIELY: So we're testing now the following idea. Imagine that I schedule a colonoscopy for you for July 15th. What's the chances that you'll wake up July 15th, and feel that today's a good day for a colonoscopy? Right? Not very high. And so you will find other things to do. You would feel a little sick. You would make some excuse.

But what about today, when I schedule this colonoscopy, I said, look, here's a deal. Of you give me a check now for 500 dollars, I will keep it in trust, and if you don't show up on July 15th on time, I will deposit that check. But if you show up on time, the check is yours to take back.

Now, on July 15th, you will still not feel like colonoscopy - who would ever feel like having a colonoscopy? - but you would also not feel like having - like losing 500 dollars, and as a consequence, you might actually show up for the exam. And this is the general idea, is that if we understand our shortcomings, the things that we might not be good at, we might create mechanism that later on will force us to behave better.

PESCA: So behavioral economics, why not just go into psychology or some social science? Why are you looking at this through an economics lens?

Dr. ARIELY: For me, the importance of economics is that economics have become the factor, the input for policy, and for law, and for businesses. And if you want to influence policy, law and businesses, one approach is to basically get people to think more carefully about the economics that they apply to their everyday decisions.

PESCA: So basically, if you could convince someone it's a smart business move, it's shorthand for just it's a smart move.

Dr. ARIELY: That's right. And you know, I actually don't want to change economics. I think economics is a wonderful profession. People have a great insight. And without going back and saying what economists say often it is, economics is the only thing you need to study, or to listen to, or use as an input, I would have no qualms with economics. But when we come to make policies, I want us to consider other inputs.

And I'll just give you a simple example. Recently, the U.S. government gave us a tax rebate worth approximately 153 billion dollars. My question is, how do you give that incentive? And it turns out that very small differences could make a huge impact on how people choose to spend it. For example, how would people react differently if they got it as a check from the government, versus got it in direct deposit into their checking account, versus if they got a prepaid debit card with the government's logo, and a statement that said spend the government's money?

The idea is that all of those things will have dramatic influence on how people decide to spend their money. And now the government is assuming that money is fungible. It is perfectly fungible. It doesn't matter how much you give it to people, how - in what way. But if we understand the ways in which people will treat money differently, depending on the format in which they get it, we might actually be able to extract much more value from this incredible tax incentive.

PESCA: So this goes back to, what does the government want us to do with the money? Does it want us to save the money? Or does it want us to spend the money as a stimulus?

Dr. ARIELY: That's right. So the government wants us to spend it, and we can argue whether that's right or wrong, but assuming that it's the right thing for us to spend it, the question is, how do you take such an expensive tool and optimize it so that people would spend it?

If you wanted to save it, you could have, how do you - the question of, how do you get people to optimize saving it? But in any case, the idea is that when you come to implement something in the real world, you should think about people, how they're going to think about it, how they're going to react to it, and try to optimize the incentives to fit your goal.

PESCA: So, to get people to spend the money, I guess a prepaid debit card would be the smartest way.

Dr. ARIELY: That's right.

PESCA: And depositing it in people's bank accounts would be the dumbest way?

Dr. ARIELY: That's right.

PESCA: Where would you say is the biggest area, where just assuming a rational actor is a recipe for a disaster/ that you've come up with?

Dr. ARIELY: I think that the recent event in the sub-prime mortgage is probably the best example. Here is the problem. If you go to get a mortgage, it's incredibly hard for you to figure out what's the right amount of mortgage you should be taking. So what do people do, they go to the bank, and the bank tells them, we would lend you 30 percent of your income.

Now, that's not a question people should ask themselves. People should ask themselves, how much risk should I take? But the bank tells them, we would lend you 30 percent of your income. So people said, well, I guess that's what I'll borrow. OK. So that's the first thing. A few years ago we created something else called interest-only mortgages. These mortgages basically allowed people to borrow more money, and pay every month either the interest only or the interest and some principle.

Now, from an economic, rational perspective, this is a wonderful thing. I also have a position in the Federal Reserve Bank, and one of my friends in the Fed found out that people with higher credit-card debt were more likely to take interest-only mortgages, and he interpreted it is as being evidence of rationality. He said, look, here are smart people who are stuck with this bad credit-card debt, and they're going to take this more flexible mortgage, which is also cheaper in terms of interest rate, and they're going to use the extra money to pay off their credit-card debt.

But from my perspective, this relies on the very important assumption. It relies on the fact that people would not borrow to the max, that they will borrow less than they can, and use the extra money to pay off their credit card bill. But if you have a very hard time figuring out the right amount to borrow, maybe people would borrow the max.

They can pay again, they can borrow again, but only this time they would really create a huge risk for themselves, in terms of how much they're stretching themselves. And of course, I didn't expect this huge tragedy in the market, but it happened, and I think it's a classical example of us, as society, as bankers, relying very heavily on people's rationality.

PESCA: OK. Total 180, if caviar and peanut butter swapped scarcity, so if peanut butter were as scarce as caviar, would they also switch price?

Dr. ARIELY: Yes, great example, and the idea is that we have a very hard time figuring out how much we translate enjoyment to money. And the example I usually like to think about is wine and milk. You know, with wine, we have all these connoisseurs, and we taste it, and we look at it, and we have wine from a single type of grape, and I can imagine the same thing happening with milk, like single-cow milk.

(Soundbite of laughter)

Dr. ARIELY: Right, that the whole milk comes from one cow, and you compare Jersey cows to some other cows, and cows that eat this and cows that eat that and people - if you think about it, wine is just grape juice. Milk needs to be refrigerated. It needs to be processed. I mean, why are we willing to pay so much for wine, and so much for the variance of wine, and milk is such a commodity?

I don't think it's inherent to wine or inherent to milk, and I can imagine a universe in which things would have developed differently, much like your peanut butter and caviar example. But the problem is that when we make these decisions about how much we're willing to pay, and how much we enjoy, they are based on social convention, on past experiences, and to some degree, on just random starting points.

PESCA: If everyone took your book to heart and stopped behaving so economically irrationally, wouldn't that really hurt the economy? I mean, isn't the economy largely fueled by unnecessary, luxury items, and keeping up with the Joneses?

Dr. ARIELY: I think there's a big part of it which the American economy right now is designed to take advantage of all this extreme spending, but I'm not sure it's sustainable over the long run. So, if everybody started tomorrow to behave very differently, and started spending less and saving more, I think we will bring on the recession. But even if we had a recession, it's not clear that we would be worse off 20, 30, 40 years from now. So, as a general issue, the short term could be devastating, but the long term could be much more beneficial.

PESCA: Dan Ariely is the author of " Predictably Irrational: The Hidden Forces That Shape Our Decisions." Thank you, Dan.

(Soundbite of music)

PESCA: See, that last question I asked Dan about crazy spending, that's why I believe the government should fund HBO's "Sex and the City." I mean, they didn't have to, but just think of all the Manolo Blahniks that were sold because that show is on the air? All the leather belts. I mean, it would turn - if you exceeded it... .TEXT: MARTIN: Economic stimuli.

PESCA: They give money to NPR. What do we do? You know, we're - yeah, we teach you to be smart and stuff, but, like, we convince you not to buy bad toys made in China. How's that going to help the economy? I say...

MARTIN: It might save your kids' life.

PESCA: Yeah. OK. Fine, OK, example, but what I'm saying is, it's keeping up with the Joneses that keeps this economy humming along.

MARTIN: You heard it. That's the word from Mike Pesca. And you know what? That does it for this hour of the BPP, but we don't go away online. We are there all the time at npr.org/bryantpark. I'm Rachel Martin.

PESCA: And I'm Mike Pesca. This is the Bryant Park Project from NPR News.

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