Misbehaving: The Making of Behavioral Economics (39 page)

I began by reminding everyone that standard law and economics assumes that people have correct beliefs and choose rationally. But suppose they don’t? How should law and economics change? Our paper offered an illustrative example based on a new policy that had been adopted by the Chicago police department. Parking tickets had traditionally been placed on a car’s front windshield, held down by the wiper blade. The new policy was to issue tickets that were printed on bright orange paper and were attached by some sticky substance to the driver’s side window, where they were highly visible to drivers passing by. We pointed out that such a policy was smart from a behavioral perspective, since it might increase the perceived probability of getting a ticket, thus discouraging illegal parking at almost no cost.
†
This example may not seem either profound or controversial, but remember that part of the received wisdom in law and economics is that people have correct beliefs, including about the probability of getting caught committing some crime, and base their decisions about whether to commit a crime, from illegal parking to robbing a bank, by calculating the expected gains and losses. If it were possible to change the perception of the chance of getting caught by just changing the color and location of parking tickets, without changing the actual probability of being caught, then it might be possible to do the same for more serious crimes. This thought was pure heresy.

Judge Posner remained quiet for about five minutes, but then he could no longer contain himself. Why, he asked out of the blue, were we ignoring evolution? Didn’t evolutionary biology explain many of the odd behaviors discussed in the paper, such as turning down small offers in the Ultimatum Game, or ignoring sunk costs? Couldn’t evolution explain these and all our other “cognitive quirks” (a slyly deprecating term he insisted on using)? His thought was that if humans had evolved to pay attention to sunk costs, or resist unfair offers in the Ultimatum Game, then such behavior must be good for us, in some sense, and therefore rational. Problem solved.

I assured him that I was not a creationist and accepted evolution as a scientific fact. I added that there was no doubt that many of the aspects of human behavior that we were talking about had evolutionary roots. But, I argued, accepting the theory of evolution as true does not mean that it needs to feature prominently in an economic analysis. We know people are loss averse; we don’t need to know whether it has an evolutionary explanation. (Amos used to joke that there once were species that did not display the endowment effect, but they are now extinct.) Furthermore, the real point of behavioral economics is to highlight behaviors that are in conflict with the standard rational model. Unless we change the model to say that people pay attention to sunk costs, the model will make poor predictions. At this point Posner was completely exasperated. “You are completely unscientific!” he cried, in utter despair. I had resolved to remain calm so I just smiled at this outburst, said, “Okay then,” and moved on. There was much more contentious material still to come, and I was determined not to get into a shouting contest, especially with a federal judge!

The biggest fight was about something called the Coase theorem. The Coase theorem is named for its inventor, Ronald Coase, who had been a faculty member at University of Chicago Law School for many years. The theorem can be easily stated: in the absence of transaction costs, meaning that people can easily trade with one another, resources will flow to their highest-valued use.
‡

The logic is easy to explain. I will follow Coase’s lead and explain it with a simple numerical example. Suppose that Alexa and Julia are college roommates. Julia is quiet and studious, but Alexa is boisterous and likes to play loud music while she studies, which disturbs Julia. Julia complains to the dorm resident advisor, Hallie, who is empowered to settle disputes like this. Hallie can choose one of two alternatives: she can give Alexa the right to play her music as loud as she likes, or she can give Julia the right to quiet during certain hours. The Coase theorem makes a strong and surprising prediction: Hallie’s decision will have no effect on how much music Alexa will play. Rather, that will depend simply on whether Alexa likes her music more than Julia hates it.

The result is surprising but the logic is simple. Suppose Alexa is willing to pay $5 per night to blast her music, and Julia is willing to pay $3 a night for silence. If Julia is awarded the right to silence, then, according to the Coase theorem, Alexa will pay Julia some amount between $3 and $5 for the right to play her music, an amount Julia will accept. Both will be happier this way than if Alexa couldn’t play her music but no money changed hands; that is, after all, why they’re both agreeing to the transaction. And if Alexa wins the right to play her music, Julia will be unwilling to pay her enough to stop, since her value of silence is less than Alexa’s joy of music. Either way, Julia will have to find somewhere else to study if she wants quiet.

The reason this result is important for the law is that judges often decide who owns a certain right, and the Coase theorem says that if transaction costs are low, then what the judge decides won’t actually determine what economic activities will take place; the judge will just decide who has to pay. The article that includes this result, entitled “The Problem of Social Cost,” is one of the most cited economics articles of all time.

The argument I have sketched up to this point crucially depends on the stated assumption that the costs involved in the two parties coming to an efficient economic agreement are small to nonexistent. Coase is upfront about this. He says: “This is, of course, a very unrealistic assumption.” Although many applications of the Coase theorem ignore Coase’s warning, we wanted to show that the result was wrong, even when it could be shown that transaction costs were essentially zero. To do so, we presented the results of the mug experiments that were discussed in
chapter 16
, the results of which are summarized in figure 17.

Recall that the first stage of the experiments involved tokens that were redeemable for cash, with each subject told a different personal redemption value for a token, meaning the cash they could get for it if they owned one at the end of the experiment. The Coase theorem predicts that the students who received the highest personal valuations for their tokens would end up owning them; that is what it means to say that resources flow to their highest valued use. And that is what happened. The market worked perfectly, just as the theory predicted, which also meant that transaction costs must not be inhibiting trade in any meaningful way.

But the Coase theorem is not meant to be limited to tokens for which people are told their personal values. It says that the same thing should happen when we replace the tokens with real goods, such as coffee mugs. So when we gave every other student a coffee mug, the Coase theorem predicts that the students who liked the mugs most should end up owning them, and since the mugs were randomly assigned, about half the mugs should trade. Yet we found that trading volume was much lower than that: resources were not flowing at the rate predicted. And the reason was the endowment effect: people given mugs valued them about twice as much as people not given the mugs. How goods were allocated
did
affect who would end up owning the mugs. In other words, the Coase theorem worked in theory, when trading for tokens redeemable for cash, but it did not work in practice, when trading for real-world objects like coffee mugs. Questioning the Coase theorem at a law and economics workshop! That was high treason.

One of the unfortunate aspects of the University of Chicago at that time, one that is thankfully no longer the case, was that there was an undue tolerance for scholars who would spout the Chicago School traditional lines, loudly and frequently. One example was the economist John Lott, who had strung together a series of visiting appointments allowing him to be at the university for several years. Lott is most famous for writing a book entitled
More Guns, Less Crime
. As the title suggests, the thesis of the book is that if we just made sure every American was armed at all times, no one would dare commit a crime, a claim that other researchers have strongly disputed.
§
Lott was a frequent attendee and active participant at workshops. His style resembled that of a pit bull.

At this workshop, Lott was present and looking annoyed, so I hoped he was not packing a gun. His wife, Gertrude (also an economist), was in the crowd as well and asked a question about the mugs study. Couldn’t the low trading of the mugs be explained by transaction costs? I explained that the tokens experiment had ruled out this explanation—after all, the tokens had the same transaction costs as the mugs, and the tokens did trade as much as the theory predicted. She seemed satisfied, but then Lott jumped in to “help.” “Well,” he asked, “couldn’t we just call the endowment effect itself a transaction cost?” I was shocked by this comment; transaction costs are supposed to be the
cost
of doing a transaction—not the
desire
to do a transaction. If we are free to re-label preferences as “costs” at will so that behavior appears to be consistent with the standard theory, then the theory is both untestable and worthless. So instead of trying to reason with Lott, I turned to Posner and asked him whether he would now concede that I was not the
least
scientific person in the room. Posner smiled, nodded his agreement, and everyone in the room who could see him laughed. But Posner was not in Lott’s line of sight, so I saw him angrily asking people around him what had happened. I quickly moved on to another topic.