Misbehaving: The Making of Behavioral Economics (9 page)

I call this argument the
invisible handwave
because, in my experience, no one has ever finished that sentence with both hands remaining still, and it is thought to be somehow related to Adam Smith’s invisible hand, the workings of which are both overstated and mysterious. The vague argument is that markets somehow discipline people who are misbehaving. Handwaving is a must because there is no logical way to arrive at a conclusion that markets transform people into rational agents. Suppose you pay attention to sunk costs, and finish a rich dessert after a big dinner just because you paid for the dessert. What will happen to you? If you make this mistake often you might be a bit chubbier, but otherwise you are fine. What if you suffer from loss aversion? Is that fatal? No. Suppose you decide to start a new business because you are overconfident and put your chances of success at 90%, when in fact a majority of new businesses fail. Well, either you will be lucky and succeed in spite of your dumb decision, or you will muddle along barely making a living. Or perhaps you will give up, shut the business down, and go do something else. As cruel as the market may be, it cannot make you rational. And except in rare circumstances, failing to act in accordance with the rational agent model is not fatal.

Sometimes the invisible handwave is combined with the incentives argument to suggest that when the stakes are high and the choices are difficult, people will go out and hire experts to help them. The problem with this argument is that it can be hard to find a true expert who does not have a conflict of interest. It is illogical to think that someone who is not sophisticated enough to choose a good portfolio for her retirement saving will somehow be sophisticated about searching for a financial advisor, mortgage broker, or real estate agent. Many people have made money selling magic potions and Ponzi schemes, but few have gotten rich selling the advice, “Don’t buy that stuff.”

A different version of the argument is that the forces of competition inexorably drive business firms to be maximizers, even if they are managed by Humans, including some who did not distinguish themselves as students. Of course there is some merit to this argument, but I think it is vastly overrated. In my lifetime, I cannot remember any time when experts thought General Motors was a well-run company. But GM stumbled along as a badly-run company for decades. For most of this period they were also the largest car company in the world. Perhaps they would have disappeared from the global economy in 2009 after the financial crisis, but with the aid of a government bailout, they are now the second largest automobile company in the world, a bit behind Toyota and just ahead of Volkswagen. Competitive forces apparently are slow-acting.

To be fair to Jensen, there is a more coherent version of his argument. Instead of arguing that markets force people to be rational, one can argue that market prices will still be rational, even if many individuals are decidedly Human. This argument is certainly plausible, perhaps even compelling. It just happens to be wrong. But how and why it is wrong is a long story that we will take up in Section VI.

For the field of behavioral economics to succeed, we needed answers to these questions. And in some quarters, we still do. But now, instead of snappy one-liners, it is possible to point to studies of real people interacting at high stakes in markets—even financial markets, where the invisible handwave would be expected to be most likely to be valid.

I
t was with the Gauntlet in my mind that I arrived at Cornell, in rural Ithaca, New York, in the fall of 1978. Ithaca is a small town with long, snowy winters, and not much to do. It was a good place to work.

While in California I had managed to finish two papers. One expounded on the List, and the other was called “An Economic Theory of Self-Control.” Writing the papers was the easy part; getting them published was another story. The first paper, mentioned earlier, “Toward a Positive Theory of Consumer Choice,” was rejected by six or seven major journals; I have repressed the exact count. In hindsight, I am not surprised. The paper had plenty of ideas, but little hard evidence to support them. Each rejection came with a set of referee reports, with often scathing comments that I would try to incorporate in the next revision. Still, I did not seem to be making any progress.

At some point I had to get this paper published, if for no other reason than that I needed to move on. Luckily, two open-minded economists were starting a new journal called the
Journal of Economic Behavior and Organization
. I guessed that they were anxious to get submissions, so I sent the paper to them and they published it in the inaugural issue. I had my first behavioral economics publication, albeit in a journal no one had ever heard of.

If I were going to stay in academia and get tenure at a research-focused university like Cornell, I would have to start publishing regularly in top journals. I had returned from California with two ideas at the top of my list of topics to explore. The first was to understand the psychology of spending, saving, and other household financial behavior, what has now become known as mental accounting. The second was self-control and, more generally, choosing between now and later. The next two sections of the book take up those topics.

________________

*
   They favored this hypothesis even though Lichtenstein and Slovic (1973) had replicated their studies for real money on the floor of a casino in Las Vegas. Their dismissal of this evidence might be explained by another of their hypotheses. They also explicitly entertained the possibility that the perverse results were obtained simply because the experimenters were psychologists, who were known to deceive people in experiments. Needless to say, this hypothesis did not sit well with any psychologists who stumbled onto their paper.

II.

MENTAL ACCOUNTING:
1979–85

After our year together in California, Amos and Danny continued their collaboration and I would only see them occasionally at conferences. They were working on follow-up papers to “Prospect Theory” and I continued to think about consumer choice. There was one topic, however, that they and I were both thinking about, mostly independently. In a nutshell it is: “How do people think about money?” Early on I called this process “psychological accounting,” but in a later paper on the topic Amos and Danny changed the name to “mental accounting,” and I followed suit.

I have continued to think, write, and talk about mental accounting for the rest of my career. I still find it fascinating, exciting, and incisive; it is a lens that helps me understand the world. The next few chapters are devoted to mental accounting basics, but the topic permeates the rest of the book. Thinking about mental accounting can be contagious. You may soon find yourself blurting, “Well, that is really a mental accounting problem.”

7

Bargains and Rip-Offs

My friend Maya Bar-Hillel was shopping for a quilt to use as a comforter on her double bed. She went to the store and found one she liked that was on sale. The regular prices were $300 for a king size, $250 for a queen size, and $200 for a double. This week only, all sizes were priced at $150. Maya could not resist: she bought the king size.

T
o begin any discussion of mental accounting, it helps to understand the basic economic theory of the consumer. Recall from the discussion of the endowment effect that all economic decisions are made through the lens of opportunity costs. The cost of dinner and a movie tonight is not fully captured by the financial outlay—it also depends on the alternative uses of that time and money.

If you understand opportunity costs and you have a ticket to a game that you could sell for $1,000, it does not matter how much you paid for the ticket. The cost of going to the game is what you could do with that $1,000. You should only go to the game if that is the best possible way you could use that money. Is it better than one hundred movies at $10 each? Better than an upgrade to your shabby wardrobe? Better than saving the money for a rainy day or a sunny weekend? This analysis is not limited to decisions that involve money. If you spend an afternoon reading a novel, then the opportunity cost is whatever else you might have done with that time.

Thinking like that is a right and proper normative theory of consumer choice. It’s what Econs do, and in principle we should all strive to think this way most of the time. Still, anyone who tried to make every decision in this manner would be paralyzed. How can I possibly know which of the nearly infinite ways to use $1,000 will make me happiest? The problem is too complex for anyone to solve, and it is unrealistic to think that the typical consumer engages in this type of thinking. Few people think in a way that even approximates this type of analysis. For the $1,000 ticket problem, many people will consider only a few alternatives. I could watch the game on television and use the money to go visit my daughter in Providence. Would that be better? But figuring out the best alternative use of the money is not something I or anyone is capable of thinking about—not even close.
*

What do people do instead? I was unsure about how to study this and other aspects of consumer decision-making, so I hired a student to interview local families to see what we could learn about what real people do. I concentrated on lower-middle-class households because spending decisions are much more important when your budget is tight.

The interviews were designed to give the participants plenty of time to talk about whatever they wanted. (We paid them a fixed amount to participate but some talked for hours.) The target respondent was the person in the household who handled the money. In married couples, more often than not this responsibility fell to the wife. The purpose of the interviews was not to collect data for an academic paper. I simply hoped to get an overall impression of how people thought about managing their household’s finances. Adam Smith famously visited a pin factory to see how manufacturing worked. This was my pin factory. The interviews grounded me in reality and greatly influenced everything I later wrote about mental accounting.

The first question to deal with was one I had been pondering since the days of the List. “When is a cost a loss?” Although it had long been on my mind, my “discovery” of prospect theory heightened that interest. Recall that the value function displays loss aversion: when starting from zero, it is steeper going down than going up. Losses hurt about twice as much as gains make us feel good. This raises the question: if you pay $5 for a sandwich, do you feel like you just lost $5? For routine transactions, the answer is clearly no. For one thing, thinking that way would make you miserable. Because losses are weighed about twice as heavily as gains, even trading a ten-dollar bill for two fives would be viewed as a loss with this sort of accounting. “Losing” each of the five-dollar bills would be more painful than the pleasure associated with receiving the $10. So what
does
happen when you make a purchase? And what in the world was Maya thinking when she bought that gigantic quilt?

Eventually I settled on a formulation that involves two kinds of utility:
acquisition utility
and
transaction utility
. Acquisition utility is based on standard economic theory and is equivalent to what economists call “consumer surplus.” As the name suggests, it is the surplus remaining after we measure the utility of the object gained and then subtract the opportunity cost of what has to be given up. For an Econ, acquisition utility is the end of the story. A purchase will produce an abundance of acquisition utility only if a consumer values something much more than the marketplace does. If you are very thirsty, then a one-dollar bottle of water is a utility windfall. And for an Econ who owns a double bed, the acquisition utility of a quilt that fits the bed would be greater than one that hangs two feet over the side in every direction.

Humans, on the other hand, also weigh another aspect of the purchase: the perceived quality of the deal. That is what transaction utility captures. It is defined as the difference between the price actually paid for the object and the price one would normally expect to pay, the
reference price
. Suppose you are at a sporting event and you buy a sandwich identical to the one you usually have at lunch, but it costs triple the price. The sandwich is fine but the deal stinks. It produces negative transaction utility, a “rip-off.” In contrast, if the price is below the reference price, then transaction utility is positive, a “bargain,” like Maya’s extra-large quilt selling for the same price as a smaller one.

Here is a survey question that illustrates the concept. Two groups of students in an executive MBA program who reported being regular beer drinkers were asked one of the two versions of the scenario shown below. The variations appear in parentheses and brackets.

You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort hotel) [a small, rundown grocery store]. He says that the beer might be expensive so asks how much you are willing to pay for the beer. He says he will buy the beer if it costs as much or less than what you state. But if it costs more than the price you state, he will not buy it. You trust your friend, and there is no possibility of bargaining with the (bartender) [store owner]. What price will you tell him?