Dan Ariely: Hidden Forces that Shape Our Decisions
You have called Alan Greenspan’s admission to being ‘shocked’ by the failure of the financial system “an important step forward” for Behavioural Economics. Please explain.
For years, my colleagues and I have been conducting experiments about human irrationality. When we present our results, the ‘rational’ economists say, ‘These are very nice experiments that make for great dinner conversation; but when it comes to professionals making decisions that involve money, irrationality simply doesn’t occur’. I never bought this argument: why would the human brain develop two different approaches to decisions that depend upon the importance of the decision? While I allowed that the market could possibly mitigate some irrational behaviour, I also felt that it could increase it.
At the end of the day, we had all this evidence of human irrationality, but we could never really test how it plays out in the market. There was no way to set up two versions of the market -- one with rational people making decisions and one without. In addition, we couldn’t get these hyper-rational beings to participate in our experiments, so we were left without any empirical answers: until the failure of the financial markets in 2008. This was indeed the best thing that has ever happened for Behavioural Economics. That isn’t very nice to say, because so many people were hurt by it (myself included), but perhaps we can take some comfort in the fact that an emerging academic discipline derived some benefit from the crisis. All of a sudden, there was a realization that the irrationalities we had been studying might be much more important -- and prevalent -- than people believed. Maybe we needed to start thinking about human ability in a more humble way, and to acknowledge that lots of avoidable mistakes are being made on a regular basis.
If the so-called ‘rational’ economic approach can’t protect us from ourselves, what model should we be using?
That’s a tricky question. One reason we got sucked into the rational model is that it is so tractable. Outside of a few zealous economists, most people would admit that it is not perfect, but it’s the best model we have. Allow me to make an analogy regarding the rational model. Can you imagine what our highway system would look like if it had been designed by economists? First of all, there would be no shoulder at the side of the road, because why would you ever pave something where nobody is supposed to drive anyway? And those raised ‘bubble lines’ that indicate to a driver that he is leaving his lane? Why would you need those either, because people know they are supposed to drive within the lines. Indeed, we might not have any lanes or speed limits, because why restrict people like that? What I am describing is a situation in which you assume that people are perfectly rational beings who know what they are doing, so you build-in no room for error. While this is an extreme example, this is the basic idea of perfect economic rationality.
What model should we have in place instead? There is no one theory in Behavioural Economics on which a new model could be built: there is only one way to be rational, but there are endless ways to be irrational. We are susceptible to all kinds of mistakes, and these change with time and technology. Again, think about driving: when cars were slow, we couldn’t really hurt ourselves with them. But then we made faster cars, and all of a sudden we needed to create airbags and anti-lock brakes. Next, we created cell phones and text-messaging, and all of a sudden, we need new rules that tell people not to drive and send text messages. In what kind of universe do we have to tell people not to risk their own lives and the lives of others by texting while driving? Sadly, this is the irrational world we live in, and people make these mistakes all the time – even smart people.
The fact is that we are susceptible to all kinds of decision errors, and as we invent new technologies, new financial instruments and other new ways to get ourselves into trouble, we also create more risks. This aspect of ‘progress’ needs to be better managed. I think we should take a more empirical approach to life by saying, ‘Let’s examine what we are good at, what we are bad at, and the sorts of mistakes that we regularly make and don’t make. Where people don’t make many mistakes, we can let them loose -- following the idea of the free market; but where people make lots of mistakes, we should think more about how to prevent them -- or at least, limit them.
You have said that people don’t know what they want, unless they see it in context. What are the repercussions of such ‘relativism’ for decision making?
The term ‘positional good’ refers to the idea that in many cases, people don’t really care how big something is, they just want to have more than the next guy. Take sea lions, for example: they want to be bigger than the other sea lions, because if you’re bigger, you will attract more females. But in the race to become bigger, they tend to get much too big, and many die from health complications. Now think about humankind, and how nice it would be if our collective ‘footprint’ was half the size that it is now: we would use less energy; we would need less resources. In the race to have ‘more’, we have hurt the species – all because we care so much about comparing ourselves to others. Executive salaries fall into this category as well. Many executives make a substantial amount of money. The fact is, nothing would happen to their lifestyle if they made a bit less. But the way they look at it isn’t, ‘How much do I need?’, but, ‘I want more than that guy over there’. It’s not just executives -- we are constantly making these types of comparisons in many domains of life.
You have studied a wide variety of decision-making biases. Which would you say is the most dangerous to good decision making?
I think the one that has the biggest effect is the power of habits. When we come into a new environment, before long, we will have to make a decision of some type. It may be done thoughtfully or not, it might be based on real information or not, but the next time we enter that environment, we will remember what we did the last time. We won’t remember why, but we will remember what we did, and we have a tendency to repeat that decision over and over. I once did some research in a supermarket. When a new juice comes out and it’s half-priced, people say, ‘Hey, I’ll try that’. But what I found is that the next time they come in, they forget that they bought it the first time only because it was half-priced. They just say, ‘This is the juice I bought last time’, and they keep doing it. This tendency can create situations where one mistake becomes a stream of mistakes over a long period of time.
Seeing reality from a self-serving perspective is another pervasive human foible. What can we do to counteract it?
Unfortunately, there isn’t much we can do. If, every time you make a decision, you consciously say to yourself, ‘I will not have a conflict of interest here’ or ‘I will not be overly optimistic’, you might be able to move the needle a little bit -- but not by much. Imagine that you’re a doctor and there are two treatment plans available for your patient: plan A and plan B. Plan A is better for the patient, and plan B is better for you (it takes less effort and input.) Is it possible for you to see this in an objective way? The answer is No. All we can do is try to eliminate situations that foster conflict of interest.