Perhaps the methods and mindset of psychology will rescue economics from ignominy.
By SHLOMO MAITALDan Ariely speaking at TED(photo credit: Wikimedia Commons)
WHAT HAPPENS when economics, known for over two centuries as the dismal science, meets psychology, whose practitioners are often called “shrinks”? Economics becomes a whole lot less dismal and a great deal more useful and interesting.A whole truckload of powerful insights emerges, useful in daily life for all of us.And a new discipline, behavioral economics, is born, largely shaped by three Israeli scholars – Daniel Kahneman, his friend the late Amos Tversky and Dan Ariely – all psychologists, none of whom ever got degrees in economics.A recent study showed an eightfold rise in scholarly papers on behavioral economics since the year 2000. In 2002, Kahneman, a Princeton University professor, won the Nobel Prize for Economics. I believe Ariely will win a Nobel one day, too. Sadly, according to Kahneman, Tversky would have shared his Nobel but died in 1996 of cancer; he was only 59. Kahneman and Tversky began a 30-year collaboration at the Hebrew University of Jerusalem in the 1960s. Tversky’s widow Barbara said, “It was an amazing synergistic collaboration.They spent hours talking on the phone every week. They wrote every word together. It was a real intellectual high to watch them.”My own appreciation of behavioral economics is deeper than that of a bystander. In 1967, I married Sharona, a psychologist, and quickly realized she knew more about economics than I did because she understood people and their behavior, while I only understood the mathematics that purportedly (but badly) portrayed behavior.We wrote a book together on behavioral economics, published in 1982, called “Minds, Markets and Money,” though the publisher inexplicably chose not to include her as co-author. Later that same year, I co-founded a behavioral economics organization, the Society for the Advancement of Behavioral Economics, though I missed the inaugural meeting when our third child was born.It is said that behavioral economics is psychology’s most important export. Two major shifts in thinking occurred when the three Israeli psychologists focused their research on economic behavior. First, rationality – they showed that people are “predictably irrational,” a title of one of Ariely’s books.Second, methodology. They showed that the best way to truly understand economic behavior is to observe it through guided controlled experiments, a technique economists largely eschewed for centuries. Significantly, American Prof. Vernon Smith shared the Nobel with Kahneman for his development of what is today known as experimental economics.The origins of Kahneman, Tversky and Ariely’s breakthroughs lie in two surprising places: the Israel Air Force and a disastrous explosion and fire.
Flight instructors As colleagues at the Hebrew University Department of Psychology in 1968, Tversky and Kahneman taught IAF flight instructors. They were fascinated by how the instructors used rewards and punishments to motivate their pilot trainees. The instructors refuted psychologists’ stock-intrade that reward is far more powerful than punishment.They claimed this carrot-over-stick policy got bad results because in their experience “...good execution of complex maneuvers, when reinforced by reward, typically results in worse performance on the next try!” Sticks beat carrots, the flight instructors claimed.But why? Why did reward (positive reinforcement) not work? Economists and psychologists both think it must. The answer to the riddle lies in the concept of “regression toward the mean.”In flight maneuvers, Kahneman and Tversky observed, performance is not perfectly reliable and progress is quite slow. It is likely that pilots who did well on one trial will deteriorate on the next. This is called “regression to the mean.”Flight instructors wrongly attributed this “regression” (backsliding) to the detrimental effect of their positive reinforcement.The concept of regression is “counterintuitive and difficult to apply,” Kahneman and Tversky note. The reason: “Regression effects typically violate our intuition” that better performance should follow good.Kahneman and Tversky’s research revealed a common human foible known as “attribution error – attributing outcomes to the impact of human action and intervention, rather than to the randomness of life, a saddening aspect of the human condition,” they note.Investment funds are a good example.They trumpet their success in a good year, claiming it was their brilliant strategy when, in fact, it was likely random luck.The next year, of course, they are mute when their performance plummets (regresses to the mean).“We normally reinforce others when their behavior is good and punish them when their behavior is bad,” Kahneman and Tversky wrote. “By regression alone, therefore, [people] are most likely to improve after being punished and most likely to deteriorate after being rewarded. Consequently, we are exposed to a lifetime schedule in which we are most often rewarded for punishing others, and punished for rewarding.”Armies of school psychologists are needed to repair the devastation this misanthropy causes in schools.In numerous brilliant experiments, Kahneman and Tversky used subjects expert in probability, psychology or statistics.They showed that judgment biases (nonrationality) are rarely mitigated by education or experience. We are all human, they show, and make mistakes – even statistics professors.But, how in the world do you get economists to abandon their cherished assumption that human beings are perfectly rational? Because, if they are not, you cannot use mathematics to model their behavior.Kahneman and Tversky did this brilliantly, with two weapons. First, they designed simple experiments that everyone could try, even on themselves. Second, they spoke to economists in their own language – mathematics. In 1977, they published a path-breaking paper in a highly mathematical economics journal, Econometrica, and provided a mathematical appendix that explained their findings, prospect theory, in a way economists understood and in a way that quantified their approach.Here is an example of one human bias the two scholars found.Would you prefer: A) a 50 percent chance to win a three-week tour of England, France and Italy or B) a 100 percent certain oneweek tour of England? Most people choose B, the certain prize.Would you prefer: C) a 5 percent chance to win a three-week tour of England, France and Italy or D) a 10 percent chance to win a one-week tour of England? Most people who choose B also choose C.A “bird in the hand” is best, they reason, but if both ‘birds’ are risky, well, go for the big one. Rationality requires us to be consistent, and choose B and D or A and C. Kahneman and Tversky call this “certainty bias.”Simply put, we perceive that 100 percent certain is a whole lot better than 99 percent, even though they are essentially the same.Kahneman and Tversky went on to discover a vast number of similar biases in how ordinary people behave under uncertainty.Here are a few, with some useful prescriptions.● “People have undue confidence in early trends.” When you invest your money, avoid believing that a swallow makes a summer.● “Alternate descriptions of a decision problem give rise to different preferences.”If you tell someone they have a 3 percent chance of dying in surgery, they may decline. But if you tell them they have a 97 percent chance of surviving it, they accept.Avoid this “framing” bias. Advertisers manipulate our choices all the time in this manner.● “Forecasts of future outcomes are often anchored on plans and scenarios of success...and are therefore overly optimistic.”Beware of experts’ forecasts. They are far less certain than the experts would have you believe.● “Low probabilities are commonly over-weighted.” One in a million chance of winning the lottery? Save your money.● “Losses have greater impact on preferences than gains.” We tend to avoid risks when it comes to gains, but take big risks to avoid losses. Beware of gamblers’ ruin – doubling your bets to recoup losses. It’s human nature but disastrous.In 1994, Kahneman reframed the question of whether people are rational. He wrote, “The time has perhaps come to set aside the… question of whether or not people are rational... allowing research to be focused instead on what are the most important ways in which people fail to maximize their outcomes (i.e. err)? And how can this be changed?” And amazingly, economics, the dismal science, did a U-turn.Ideas born in fire As a teenager, Dan Ariely was burned severely in a home explosion and fire. He tells his story in clinical fashion on his website.For three years, he suffered hospitalization, severe pain (“more intense and longer lasting than almost any other medical condition,” he notes) and emotional turbulence.The burns left his face disfigured and some of the pain still remains. “There is still not a day in which I do not feel pain,” he notes.“During my first year in college,” Ariely recalls, “I was still wearing my Jobst suit, a head-to-toe elastic cover designed to create pressure on the recovering tissue and which covered me completely with a brownish elastic panty hose-like material leaving only holes for my eyes, ears and mouth… [I looked] somewhere between a Martian and a bank robber.”During this trial by fire, Ariely says it “sparked many of my research interests.”How? He writes that “the range of treatments in the burn department, and particularly the daily ‘bath’, made me face a variety of irrational behaviors that were immensely painful and persistent. Upon leaving the hospital, I wanted to understand how to better deliver painful and unavoidable treatments to patients so I began conducting research in this area.“After completing this initial research project, I became engrossed with the idea that we repeatedly and predictably make the wrong decisions in many aspects of our lives and that research could help change some of these patterns.”Ariely got his undergraduate degree in psychology from Tel Aviv University and is now a professor at Duke University in North Carolina. His books are bestsellers and describe ingenious experiments that reveal many deep insights into human behavior and the human condition. His books include “Predictably Irrational” (2008), “The Upside of Irrationality” (2011) and “The (Honest) Truth About Dishonesty” (2012). Among Ariely’s interesting findings: ● “Sometimes, we actually behave less rationally when we try harder. So what is the correct way to pay people without overstressing them? One simple solution is to keep bonuses low.” Bank of Israel, take note. Those huge salaries Israel’s bankers pay themselves are doing damage.● “If you thought that crime or dishonesty is driven by a cost-benefit analysis, then you have some very basic solutions – for example, put people in prison. And people who were going to commit a crime would say, ‘Okay, I’ll go to prison, not worth it.’ I’ve been talking to big cheaters, including people who have been to prison, and I tell you, nobody I’ve talked to has ever thought about the long-term consequences of their actions.“How many people who did insider trading thought about the probability of being caught and how much time they would get in prison? The number is incredibly close to zero, maybe exactly zero. What will happen if we increase the prison sentence? Basically nothing, because it’s not part of their mindset.What we need to understand is the process by which people become dishonest.”With American and Israeli prisons filled to bursting, perhaps we need to rethink our understanding of crime and punishment Ariely’s work on honesty can be traced back to his medical treatment for burns. He told Wired magazine that he underwent an incredibly painful treatment. For six weeks, he was told it would be painless. Had he known the truth, he would have undergone emotional torture for six weeks. “At the end of it all,” he says, “I think they were right (not to tell me the truth).”● “We talk about honesty, but the reality is we have lots of human values, and they are not all compatible. We don’t always tell the truth about everything, no matter what the consequences. If you have an internal truth of what you think and you have an external truth of what you say to society, in the social domain it’s called politeness, and in many cases it’s ok.“The problem arises when this becomes commercial rather than personal. If you’re an accountant and you have an internal truth of what’s happening in your company and you have an external truth, you can see where this goes. Honesty is a complex and tricky thing and we don’t want to be honest all the time.”Ariely also found that creative people tend to be more dishonest. Their imaginations stretch the truth.● Ariely found that people find it easier to rationalize stealing when they’re taking things rather than actual cash. His experiment left Coca-Colas in a dorm refrigerator along with a pile of dollar bills. People took the Cokes but left the cash. “This is one of the most worrisome experiments we’ve ever conducted, and it’s again about rationalization [justifying wrongdoing],” Ariely says.● “If we exhaust people mentally, we give them all kinds of complex tasks that they have to suppress their initial instincts, as they do it more and more, they also cheat to a higher degree. Because cheating is one of those things that we have this immediate reward, and as the long-term thought becomes weaker and weaker (it would be nice to be honest) we follow more of our impulsivity.”If mental exhaustion brings more cheating, let’s give our workers longer vacations.I am embarrassed and distressed by the damage my fellow economists and I have done to the world with bad science. But I am greatly encouraged that behavioral economics, in my day regarded as weird and exotic, has today become mainstream.Perhaps the methods and mindset of psychology, and the brilliant insights of three Israelis, will rescue economics from ignominy.Perhaps we dismal scientists, too, will one day be proud to be known as “shrinks.” The writer is Senior Research Fellow at the Samuel Neaman Institute, Technion
