Via Arts & Letters Daily: A bunch of Harvard eggheads have figured out a truth known to every real estate agent who ever wore a miniskirt while holding an open house: People make economic decisions that are not necessarily in their best interest, for reasons that are not rational.
The study of "behavioral economics" supposedly turns neoclassical economics on its head and calls into question the belief that markets always or even frequently produce rational results. I'm not an expert, but I question how revolutionary this concept was, since the idea was that markets generate efficient pricing models on balance, not that every transaction is completely rational or that the market is never out of whack. (As the University of Chicago economist says in the old chestnut, "Nonsense, my boy; if there were a five-dollar bill on the ground, somebody would have picked it up already.") But some of the research takes in market-level issues (why the price of shares in the same company varies between Amsterdam and London, how closed-end mutual funds sell at more than the value of their portfolios, etc.) that raise interesting questions. The economist Sendhil Mullainathan draws behavioral econ into a fascinating variety of areas:
"We tend to think people are driven by purposeful choices," he explains. "We think big things drive big behaviors: if people don't go to school, we think they don't like school. Instead, most behaviors are driven by the moment. They aren't purposeful, thought-out choices. That's an illusion we have about others. Policymakers think that if they get the abstractions right, that will drive behavior in the desired direction. But the world happens in real time. We can talk abstractions of risk and return, but when the person is physically checking off the box on that investment form, all the things going on at that moment will disproportionately influence the decision they make. That's the temptation element—in real time, the moment can be very tempting. The main thing is to define what is in your mind at the moment of choice. Suppose a company wants to sell more soap. Traditional economists would advise things like making a soap that people like more, or charging less for a bar of soap. A behavioral economist might suggest convincing supermarkets to display your soap at eye level—people will see your brand first and grab it."
Mullainathan worked with a bank in South Africa that wanted to make more loans. A neoclassical economist would have offered simple counsel: lower the interest rate, and people will borrow more. Instead, the bank chose to investigate some contextual factors in the process of making its offer. It mailed letters to 70,000 previous borrowers saying, "Congratulations! You're eligible for a special interest rate on a new loan." But the interest rate was randomized on the letters: some got a low rate, others a high one. "It was done like a randomized clinical trial of a drug," Mullainathan explains.
The bank also randomized several aspects of the letter. In one corner there was a photo—varied by gender and race—of a bank employee. Different types of tables, some simple, others complex, showed examples of loans. Some letters offered a chance to win a cell phone in a lottery if the customer came in to inquire about a loan. Some had deadlines. Randomizing these elements allowed Mullainathan to evaluate the effect of psychological factors as opposed to the things that economists care about—i.e., interest rates—and to quantify their effect on response in basis points.
Find out what results they got here.
The conclusion of the article mentions the question of how we can "manage" markets with these irrational factors in mind, but doesn't specify anything. But the catalogue of irrational factors involved in making financial decisions, from excitement to altruism to instant gratification to a desire to take revenge, may bring up some painful memories for most readers. (For me, it was a real walk of shame down my sad history of fucked-up financial decisions.)