"Leaders have to be ready to adapt, to move, to forget yesterday." Tom Peters
As a behavioral economist, Dan Ariely studies how people actually act in the marketplace, as opposed to how they should or would perform if they were completely rational. His interests span a wide range of daily behaviors such as buying (or not), saving (or not), ordering food in restaurants, pain management, procrastination, dishonesty, and decision making under different emotional states. His experiments are consistently interesting, amusing, and informative, demonstrating profound ideas that fly in the face of common wisdom. Dan is the James B. Duke Professor of Behavioral Economics at Duke University and a visiting professor at MIT. He is author of the New York Times bestseller Predictably Irrational: The Hidden Forces that Shape Our Decisions, which he discusses with Erik for our Cool Friends interview.
You can use this link to download an MP3 with Three Things from Dan Ariely.
[Bio adapted from his website: PredictablyIrrational.com.—CM]
tompeters.com asks ...
So, Dan, what's Predictably Irrational all about?
DA: Predictably Irrational is a book about my research over the last 20 years. Each chapter describes one irrational behavior. I observe behaviors around me in the real world, then take them into the lab and do some experiments. I study the extent to which the behavior is rational or irrational, as the case may be. What causes it? What are the underlying factors? And what does it mean for our lives?
I think you call this behavioral economics.
DA: That's right.
DA: Freakonomics is, in a sense, the opposite of my book. By the way, it's a fantastic book. It's about people being rational in cases where you wouldn't necessarily expect them to be rational. So, for example, in one of the chapters, Levitt and Dubner showed that, while you might think teachers are honorable people, when given the opportunity to cheat, they do. And while you think that real estate brokers are representing you, well, they are largely representing themselves. Freakonomics basically shows you how statistical information can reveal insights about how our behavior is in line with the economic principles of selfish maximization.
My book is more like the evil-stepbrother of Freakonomics. It examines scenarios where people do not act as rationally as we might expect. It also takes a look at scenarios where we expect people to behave one way, but they actually behave another. With Freakonomics, there's almost nothing you can do to change the subjects that you read about. It's a fantastic, interesting, and entertaining book. But there's nothing you can change in your personal life, business life, or policy in order to make things better. This is just how people are; they're selfish.
On the other hand, in my book, although I present multiple ways in which we're irrational, and the consequential mistakes we make, I also believe that if we understand those mistakes, we can actually improve our behavior. That's the interesting conflict between standard economics and behavioral economics. In standard economics, people are rational and the world is optimal because everybody behaves rationally. In behavioral economics, people make mistakes all the time. We're myopic, vindictive, emotional, and so forth. It's a sad perspective of human beings, right? We're less like Superman and more like Homer Simpson. But we aren't without hope, we can fix these mistakes and change our behavior.
I find it strange that when we do things in the physical world, we understand our limitations, but this is not so in the mental category. In the physical world, we build products for real people—shoes, chairs, cars, and pens—that fit our physical limitations; we don't design these products for Superman. But when it comes to products in the mental category; things like insurance policies, retirement plans, healthcare—or even things that are a combination of physical and non-physical products like homes and mortgages—we suddenly assume that people are perfectly rational, which is not in accordance with reality. As a consequence, without understanding where people fail in the cognitive domain in the same way that we understand our failings in the physical domain, we build products that are bad for us. The best example is the sub-prime mortgage crisis. We trusted people to be rational, and they were not.
Let's look at "interest-only mortgages." For standard economics, interest-only mortgages are wonderful things. Every month, people can decide to pay only the interest or to pay toward the principal based on other expenses that month. Sometimes you need to use your money for something else, like paying down your credit card debt. And because mortgages are generally cheap, interest-only mortgages provide great flexibility. But they only work if people are perfectly rational.
Now, what happens when people are not rational? What happens if people don't know how much they should borrow, and how much they should spend on a house? When you're trying to get a mortgage, nobody helps you figure out how much you should borrow. They help you figure out the maximum you can get, but not what's optimal.
Now, if I had the choice between borrowing $300,000 with a regular mortgage or $600,000 with an interest-only mortgage, this flexibility would only work to my advantage if I could actually afford to borrow the larger amount. But because people have such a hard time figuring out how much they should borrow, given this option, they borrowed the maximum amount. Housing prices went up accordingly because people could, and did, borrow more—creating more competition on the market. Since everyone stretched themselves to their limits, it created a situation where, if anything went wrong, which it did, they found themselves in a real mess. And that's what we're seeing now.
Another important point to mention here is that economists sometimes admit that people make mistakes. But they say that these mistakes will cancel each other out in the market. I think that's clearly wrong. In fact, the mistakes would aggregate themselves in the market. The reason we have this catastrophe right now is because so many people in the market made the same mistake of over-borrowing.
Another contributing factor to the sub-prime mortgage crisis is the 2/28 loan. With this loan, people get two very cheap years followed by 28 very expensive years. Interestingly enough, about half the people who took these loans were eligible for a prime rate mortgage. So they could have got a much better rate, but they were tempted by the two inexpensive years instead.
You know, temptation is something that we encounter day-in and day-out in all aspects of life. You go to a restaurant and swear you'll watch your diet. And then the dessert tray comes with a delicious smelling soufflé. You're tempted to focus on the short term in the same way people are tempted by two years of a low interest rate. You ask yourself, "Should I go to the gym?" That's good for the long term. "Or should I stay home and watch basketball on television?" That's good for the short term.
We fall prey to these conflicts time after time, day after day. We were tempted with the very alluring sub-prime mortgage. A lot of people took it when they really shouldn't have. They are now paying incredible amounts, taking huge risks, and, as a consequence, are failing. Now, if we understand how people are likely to fail, we could actually design better products that won't fail us when our natural inclinations kick in.
DA: If it were me, I would apply very strong restrictions to interest-only mortgages. I would create a mortgage calculated to help people understand how much the optimal amount is that they can afford to borrow. Currently, they're being told the maximum amount that they can borrow. Nobody wants their house to go into foreclosure. If people can't figure out what to do, they'll just do whatever the bank tells them. I would also eliminate these very dangerous 2/28 mortgages.
You said earlier that regular economics supposes that everyone is rational. Yet, the point you make over and over again in your book is that no one is actually rational. Banks seem to encourage people to borrow more than they can afford. You're suggesting regulation and legislation to fix this?
DA: Right. There's one way to be rational, but there are many ways to be irrational. In a sense, the market preys on our irrationality. This time, they over-preyed on it. The people in the sub-prime mortgage market wanted us to borrow too much, but they didn't think it would get this crazy.
Nobody thought about it in those terms. It seems as if nobody looked at the downside to this. If they did, somebody somewhere said, "Holy crap, if this all comes home to roost we're screwed."
DA: That's right. I had a position at the Boston Federal Reserve Bank where I argued with a local economist about the interest-only mortgages. I basically said that they were a bad idea and we would end up with too many people over-extending themselves because they couldn't compute how much they should borrow.
Now, I think it's very hard to create the optimum solution on our own. We just bought a house recently and figuring out the optimum amount to borrow and how much money we should spend on the house turned out to be very complex. But I think that if we understand the pitfalls, we can at least be careful and make a better decision. Maybe not optimal, but better.
You need a lot of help. You can't figure this out on your own. You can't rely on the bankers, because they want to make money. As you mentioned earlier, you can get some help from your broker. I remember when my wife and I bought our house, we thought the broker was working for us. We realized after going through the whole process that the broker was working for the seller. Nobody tells you any of these things upfront; you only learn it through discovery.
DA: That's right. We can't fix all irrationalities. Let me give you another one that's parallel to the broker. Think about physicians. Your physician, who I'm sure is a great person, is being placed in a very severe conflict of interest. Sometimes the medication they prescribe results in a kickback from the drug company or they test you on equipment that they own (when it's not necessarily the best equipment for the testing), resulting in profit for them.
Now, I'm not saying that your physician is a bad person. What we find is that when we put people in a situation with a conflict of interest, it changes the way that they view reality. Imagine that you are a physician and you see somebody that should receive one of two treatments. Should you put them on treatment A or treatment B? You would get $5,000 if they went on treatment A. And nothing if they went on treatment B. Can you really see reality from a natural perspective? It turns out you can't.
We all think that we can be objective, but we're not capable of that. Yet, we tell ourselves that we are.
DA: That's right. Part of what's interesting about irrationality is that we are blind to it. Let me give you a quick story about one experiment. I approached people in a pub and said, "Here are two small glasses of beer. Try them both and tell me which you prefer." I gave them one glass of regular beer and one glass of regular beer with balsamic vinegar. It turned out that when people didn't know about it, they liked the one with balsamic vinegar more. Balsamic vinegar apparently adds quality to the taste of beer.
So it adds a hint of sweetness.
DA: Bitterness, actually. It adds a kind of robust bitterness.
DA: To other people, I said, "Here are two small glasses of beer. One has balsamic vinegar in it, and one doesn't. Try them and tell me which one you like more." They think the one with balsamic will be disgusting. That's their expectation, and it colors their perception.
What this tells me is that our preconceived notion of how we're going to see reality affects our reality so much that no matter how much beer with vinegar we taste, we can't possibly see it as better than the regular beer. Our expectations about the world change the way we objectively see the world. Objectivity is very strange, because it's not just based on what we experience; it's based on what we expect to experience. What we expect to experience could be very different depending on what we may profit from, what we think about balsamic vinegar before tasting it, what advertisements we see before buying something, things like that.
In your book, I think you have an example of two guys watching football. They're fans of opposing teams. There's a close call. Is the receiver out of bounds? The guys perceive reality according to the team they favor. One sees the receiver as out of bounds, the other doesn't. They actually perceive the same event differently.
DA: That's right. To the point that they'd bet money on it. You can expand this. I'm Israeli. Think about the Israeli-Palestinian issue. As an Israeli, can I see reality from the perspective of a Palestinian? Well, maybe I could if I were Russian. But I think it's impossible for me as an Israeli. That's one of the reasons these terrible fights continue. Both sides believe that they have the right version of reality. In fact, neither side does.
I'm of Norwegian heritage, and it brings to mind the Oslo Accords. We think that bringing in a third party will somehow enable these two conflicted parties to see things rationally or objectively. But that's not the case.
DA: The Oslo Accords, while very important, didn't help the two sides see things differently. But I think it's the only way out. If you say, "Look, my version of reality is wrong, and your version of reality is wrong, let's get a party we both agree on, who is uncolored by expectation, to make this decision for us." What is the role of a third party? If you really understand your biases, you might be willing to relinquish some control, and therefore really reach a solution.
We say we know we're biased, we think we can look beyond our bias, but we're so biased that it's hopeless.
DA: That's right. Imagine that the next time you have an argument with your wife, you tell her, "Honey, I realize this is what you think happened and this is what I think happened. We're just not going to agree on what really happened. Let's just not fight over this." It's very hard to say that. When you experience something, you really have a high certainty that you own the real version.
Yes. Maybe you should become a family counselor.
DA: The emails I get from people who've read this book have been fascinating. One guy said, "I just finished listening to the illegally downloaded version of your audio book." He told me how much he liked it. And then he said, "That's my business, I sell illegal content. I reflected on my profession after reading your book." I never imagined that somebody would reflect on an illegal profession as a result of my work.
What he said was tremendously interesting. He said that three years ago he tried to get a legal job, but he missed his customers too much. He said that in the regular retail business, people don't really get attached to their customers; it's just business. But in the illegal retail business, because of the mutual need for trust inherent in the situation, they become like family. So he went back.
It seems that I've struck a chord with people. People email me about the lessons they've learned from the book as they relate to everything from public service to raising kids. I even got a call from a person diagnosed with cancer who had questions about the best way to tell her family. It's an unbelievable range of issues.
You cover a lot of territory. I'd like to touch briefly on the topic of education. You put what's happening as a result of No Child Left Behind and "teaching to the test" in terms of social norms and market norms.
DA: Yes. First of all, let me give an example of a social norm and a market norm. Imagine that I ask you for a favor, "Would you help me change a tire on my car?" Chances are, you think I'm a reasonable guy and you will help me. What if I promised you two dollars to do it? Would you tell yourself, "Gee, I get to help plus I get two dollars?" Of course not. In fact, the two dollars would not be an added benefit; it would subtract your social motivation. "Oh, this is a job? I don't do anything for two dollars. Offer me one hundred dollars and we'll talk." You would not do something for two dollars that you would otherwise do for free.
We basically live in two worlds. One is the social world, in which we do things for other people for mainly unselfish reasons. And then we live in a financial world in which we do things because we are paid to do them. We think about those two worlds very differently. Now, think about teachers. They're really not getting paid as much as they should. Part of the motivation to teach is the social mission—that what they do is important for society.
Now add a tiny financial incentive for them to improve their work. What worries me is that this small incentive suddenly shifts them from working in the social domain, partially or mostly, to completely working in the financial domain. I'm a professor; I produce research and hope that everybody enjoys that research. I publish my findings so that everybody can learn something from them. It's incredibly hard work. I work very long hours and sleep very little. I've been doing it for many years. And I get a lot of gratification when other people read about my studies.
So what would happen if every person who read one of my papers paid me a penny, or a fraction of a penny? It would completely change how I view this work. My motivation would largely be eliminated. But if I received $1000 every time somebody read my paper, it would be exciting again. With No Child Left Behind we're offering peanuts. And when we offer peanuts, we're changing the way people think about their role as educators for the worse. That truly worries me.
I don't know all the details, but it seems to play against teachers' creativity as well.
DA: It has a lot of problems. Small incentives are not the only problem. Teachers are being told exactly what to teach. They can't teach in a way that fits each particular class. It's assumed that all kids can actually reach the same level.
There are also all kinds of really strange incentives. For example, if a school has a minority that fails, the whole school fails. How is a minority defined? Twenty kids of the same ethnicity constitute a minority. So guess what they do? The school only accepts 19. If you are the 20th kid of that ethnicity, you will not be accepted to the school, they will move you to a different grade, or they will consider you a different ethnicity.
Another thing I heard from a superintendent, in a district that will remain nameless, is that a school has to get 70 percent of their kids to pass the standardized tests. So a school that has 90 percent of the kids passing, in a sense, wastes 20 percent. So what do they do? They ship them to different schools. A third of the kids in this county were being bused, not to the closest school for them, but to a school that would optimize the success of the whole county.
There are all kinds of really terrible things happening as a result of this plan. Apparently, they just didn't give it much thought.
On a related topic, you point out how a lot of companies are now trying to cross over from a marketing norm, with basic transactional relationships, to the social norm. For instance, Typepad emailed me because my credit card had expired. They say there's been an error. They say because I'm a loyal customer to Typepad, I have seven days to rectify this issue. If I had been disloyal, would I have only had three days to rectify it? You say there are negative consequences in many cases to these strategies.
DA: That's right. When you have a social relationship, it's incredibly helpful, right? In your relationship with your spouse, if you can't do something one day, the spouse forgives you. You hope that things will even out in the long term, but they don't have to even out immediately.
In a market relationship, you don't have that. There's one shot for things to even out and if it doesn't, then it's over. Think about two credit card companies. One tells you, "We're family, we're friends, we'll give you cookies and gifts. We ask you in return to stand with us when things go bad." You might be willing to do that.
But what if they violate the social relationship? What if they suddenly say, "Because you're a loyal customer we're giving you four hours to rectify this"? And the word "rectify"—
DA: This immediately stops you from thinking about them in a social domain, and moves them completely into the market domain. I'll give you an example of this. In an experiment conducted by two economists with a daycare center, they realized that parents were always late to pick up their children and wanted to find a solution. They decided to impose a two-dollar fine for every hour that the parents were late.
What happened? They expected people to be late less often, but instead they were late more often. Why? Before the fine, people felt guilty about being late so they rushed to arrive on time. The teacher would give them a dirty look and they would feel bad about it. But the two-dollar per hour fine was a steal. Keep my kid for another half a day at this rate!
It's lower than what they're paying per hour for the service.
DA: That's right. So it's not that they felt guilt in addition to the fine; the fine replaced the guilt. After six weeks they realized how bad the strategy was so they put a stop to it. But it was too late; they couldn't bring the guilt back. They had already imposed a market exchange, where the fine made it perfectly acceptable to be late so they didn't care as much. That's where the issue is: when you have a social contract and you violate it, it's very, very hard to go back.
I think it's fascinating that you're interested in figuring out ways to counteract our irrationality. You apparently love doing all these experiments that you set up. They sound like great fun, although it sounds like a lot of work. You're interested in the end game for humanity.
DA: That's right. I think we can do better. I think we have this tremendous opportunity. We are designing our own universe, our own world. And the question is: How are we going to design it in the best way? It's something we have to start taking more seriously.
Dan, thank you very much. It's been a pleasure speaking with you. Good luck in your further adventures.
DA: Thank you very much.
Email: dan (at) – predictablyirrational.com