Predictably Irrational (2 page)

Although a feeling of awe at the capability of humans is clearly justified, there is a large difference between a deep sense of admiration and the assumption that our reasoning abilities are perfect. In fact, this book is about human
irrationality
—about our distance from perfection. I believe that recognizing where we depart from the ideal is an important part of the quest to truly understand ourselves, and one that promises many practical benefits. Understanding irrationality is important for our everyday actions and decisions, and for understanding how we design our environment and the choices it presents to us.

My further observation is that we are not only irrational, but
predictably irrational
—that our irrationality happens the same way, again and again. Whether we are acting as consumers, businesspeople, or policy makers, understanding how we are predictably irrational provides a starting point for improving our decision making and changing the way we live for the better.

This leads me to the real “rub” (as Shakespeare might have called it) between conventional economics and behavioral economics. In conventional economics, the assumption that we are all rational implies that, in everyday life, we compute the value of all the options we face and then follow the best possible path of action. What if we make a mistake and do something irrational? Here, too, traditional economics has an answer: “market forces” will sweep down on us and swiftly set us back on the path of righteousness and rationality. On the basis of these assumptions, in fact, generations of economists since Adam Smith have been able to develop far-reaching conclusions about everything from taxation and health-care policies to the pricing of goods and services.

But, as you will see in this book, we are really far less rational than standard economic theory assumes. Moreover, these irrational behaviors of ours are neither random nor senseless. They are systematic, and since we repeat them again and again, predictable. So, wouldn't it make sense to modify standard economics, to move it away from naive psychology (which often fails the tests of reason, introspection, and—most important—empirical scrutiny)? This is exactly what the emerging field of behavioral economics, and this book as a small part of that enterprise, is trying to accomplish.

A
S YOU WILL
see in the pages ahead, each of the chapters in this book is based on a few experiments I carried out over the years with some terrific colleagues (at the end of the book, I have included short biographies of my amazing collaborators). Why experiments? Life is complex, with multiple forces simultaneously exerting their influences on us, and this complexity makes it difficult to figure out exactly how each of these forces shapes our behavior. For social scientists, experiments are like microscopes or strobe lights. They help us slow human behavior to a frame-by-frame narration of events, isolate individual forces, and examine those forces carefully and in more detail. They let us test directly and unambiguously what makes us tick.

There is one other point I want to emphasize about experiments. If the lessons learned in any experiment were limited to the exact environment of the experiment, their value would be limited. Instead, I would like you to think about experiments as an illustration of a general principle, providing insight into how we think and how we make decisions—not only in the context of a particular experiment but, by extrapolation, in many contexts of life.

In each chapter, then, I have taken a step in extrapolating the findings from the experiments to other contexts, attempting to describe some of their possible implications for life, business, and public policy. The implications I have drawn are, of course, just a partial list.

To get real value from this, and from social science in general, it is important that you, the reader, spend some time thinking about how the principles of human behavior identified in the experiments apply to your life. My suggestion to you is to pause at the end of each chapter and consider whether the principles revealed in the experiments might make your life better or worse, and more importantly what you could do differently, given your new understanding of human nature. This is where the real adventure lies.

 

And now for the journey.

CHAPTER
1
The Truth about Relativity

Why Everything Is Relative—Even
When It Shouldn't Be

O
ne day while browsing the World Wide Web (obviously for work—not just wasting time), I stumbled on the following ad, on the Web site of a magazine, the
Economist
.

I read these offers one at a time. The first offer—the Internet subscription for $59—seemed reasonable. The second option—the $125 print subscription—seemed a bit expensive, but still reasonable.

But then I read the third option: a print
and
Internet subscription for $125. I read it twice before my eye ran back to the previous options. Who would want to buy the print option alone, I wondered, when both the Internet and the print subscriptions were offered for the same price? Now, the print-only option may have been a typographical error, but I suspect that the clever people at the
Economist
's London offices (and they are clever—and quite mischievous in a British sort of way) were actually manipulating me. I am pretty certain that they wanted me to skip the Internet-only option (which they assumed would be my choice, since I was reading the advertisement on the Web) and jump to the more expensive option: Internet and print.

But how could they manipulate me? I suspect it's because the
Economist
's marketing wizards (and I could just picture them in their school ties and blazers) knew something important about human behavior: humans rarely choose things in absolute terms. We don't have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly. (For instance, we don't know how much a six-cylinder car is worth, but we can assume it's more expensive than the four-cylinder model.)

In the case of the
Economist
, I may not have known whether the Internet-only subscription at $59 was a better deal than the print-only option at $125. But I certainly knew that the print-and-Internet option for $125 was better than the print-only option at $125. In fact, you could reasonably deduce that in the combination package, the Internet subscription is free! “It's a bloody steal—go for it, governor!” I could almost hear them shout from the riverbanks of the Thames. And I have to admit, if I had been inclined to subscribe I probably would have taken the package deal myself. (Later, when I tested the offer on a large number of participants, the vast majority preferred the Internet-and-print deal.)

So what was going on here? Let me start with a fundamental observation: most people don't know what they want unless they see it in context. We don't know what kind of racing bike we want—until we see a champ in the Tour de France ratcheting the gears on a particular model. We don't know what kind of speaker system we like—until we hear a set of speakers that sounds better than the previous one. We don't even know what we want to do with our lives—until we find a relative or a friend who is doing just what we think we should be doing. Everything is relative, and that's the point. Like an airplane pilot landing in the dark, we want runway lights on either side of us, guiding us to the place where we can touch down our wheels.

In the case of the
Economist
, the decision between the Internet-only and print-only options would take a bit of thinking. Thinking is difficult and sometimes unpleasant. So the
Economist
's marketers offered us a no-brainer: relative to the print-only option, the print-and-Internet option looks clearly superior.

The geniuses at the
Economist
aren't the only ones who understand the importance of relativity. Take Sam, the television salesman. He plays the same general type of trick on us when he decides which televisions to put together on display:

36-inch Panasonic for $690

42-inch Toshiba for $850

50-inch Philips for $1,480

Which one would you choose? In this case, Sam knows that customers find it difficult to compute the value of different options. (Who really knows if the Panasonic at $690 is a better deal than the Philips at $1,480?) But Sam also knows that given three choices, most people will take the middle choice (as in landing your plane between the runway lights). So guess which television Sam prices as the middle option? That's right—the one he wants to sell!

Of course, Sam is not alone in his cleverness. The
New York Times
ran a story recently about Gregg Rapp, a restaurant consultant, who gets paid to work out the pricing for menus. He knows, for instance, how lamb sold this year as opposed to last year; whether lamb did better paired with squash or with risotto; and whether orders decreased when the price of the main course was hiked from $39 to $41.

One thing Rapp has learned is that high-priced entrées on the menu boost revenue for the restaurant—even if no one buys them. Why? Because even though people generally won't buy the most expensive dish on the menu, they will order the second most expensive dish. Thus, by creating an expensive dish, a restaurateur can lure customers into ordering the second most expensive choice (which can be cleverly engineered to deliver a higher profit margin).
¹

S
O LET'S RUN
through the
Economist
's sleight of hand in slow motion.

As you recall, the choices were:

1. Internet-only subscription for $59.

2. Print-only subscription for $125.

3. Print-and-Internet subscription for $125.

When I gave these options to 100 students at MIT's Sloan School of Management, they opted as follows:

1. Internet-only subscription for $59—16 students

2. Print-only subscription for $125—zero students

3. Print-and-Internet subscription for $125—84 students

So far these Sloan MBAs are smart cookies. They all saw the advantage in the print-and-Internet offer over the print-only offer. But were they influenced by the mere presence of the print-only option (which I will henceforth, and for good reason, call the “decoy”). In other words, suppose that I removed the decoy so that the choices would be the ones seen in the figure below:

Would the students respond as before (16 for the Internet only and 84 for the combination)?

Certainly they would react the same way, wouldn't they? After all, the option I took out was one that no one selected, so it should make no difference. Right?

Au contraire!
This time, 68 of the students chose the Internet-only option for $59, up from 16 before. And only 32 chose the combination subscription for $125, down from 84 before.
*

What could have possibly changed their minds? Nothing rational, I assure you. It was the mere presence of the decoy that sent 84 of them to the print-and-Internet option (and 16 to the Internet-only option). And the absence of the decoy had them choosing differently, with 32 for print-and-Internet and 68 for Internet-only.

This is not only irrational but predictably irrational as well. Why? I'm glad you asked.

L
ET ME OFFER
you this visual demonstration of relativity.

As you can see, the middle circle can't seem to stay the same size. When placed among the larger circles, it gets smaller. When placed among the smaller circles, it grows bigger. The middle circle is the same size in both positions, of course, but it appears to change depending on what we place next to it.

This might be a mere curiosity, but for the fact that it mirrors the way the mind is wired: we are always looking at the things around us in relation to others. We can't help it. This holds true not only for physical things—toasters, bicycles, puppies, restaurant entrées, and spouses—but for experiences such as vacations and educational options, and for ephemeral things as well: emotions, attitudes, and points of view.

We always compare jobs with jobs, vacations with vacations, lovers with lovers, and wines with wines. All this relativity reminds me of a line from the film
Crocodile Dundee,
when a street hoodlum pulls a switchblade against our hero, Paul Hogan. “You call that a knife?” says Hogan incredulously, withdrawing a bowie blade from the back of his boot. “Now
this
,” he says with a sly grin, “is a knife.”

R
ELATIVITY IS (RELATIVELY)
easy to understand. But there's one aspect of relativity that consistently trips us up. It's this: we not only tend to compare things with one another but also tend to focus on comparing things that are easily comparable—and avoid comparing things that cannot be compared easily.

That may be a confusing thought, so let me give you an example. Suppose you're shopping for a house in a new town. Your real estate agent guides you to three houses, all of which interest you. One of them is a contemporary, and two are colonials. All three cost about the same; they are all equally desirable; and the only difference is that one of the colonials (the “decoy”) needs a new roof and the owner has knocked a few thousand dollars off the price to cover the additional expense.

So which one will you choose?

The chances are good that you will
not
choose the contemporary and you will
not
choose the colonial that needs the new roof, but you will choose the other colonial. Why? Here's the rationale (which is actually quite irrational). We like to make decisions based on comparisons. In the case of the three houses, we don't know much about the contemporary (we don't have another house to compare it with), so that house goes on the sidelines. But we do know that one of the colonials is better than the other one. That is, the colonial with the good roof is better than the one with the bad roof. Therefore, we will reason that it is better overall and go for the colonial with the good roof, spurning the contemporary and the colonial that needs a new roof.

To better understand how relativity works, consider the following illustration: