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The Empirical Economist

Robert Langreth
This article is more than 10 years old.

If you carry balances on several credit cards with varying interest rates, you should pay back the one with the highest interest rate first. But that is not what happens in real life, if the results of a new loan game devised by behavioral economist and bestselling author Dan Ariely are to be believed.

In the online experiment volunteers pay off loans of various sizes and interest rates. In each of 25 rounds they receive income and decide how to allocate the money to pay off the loans. The goal is to maximize how much money is left at the end.

So far nearly 1,000 volunteers (mostly students) have tried the game, and almost no one has managed to stick to the optimal strategy. People are constantly tempted to pay back the small loans first. Closing loans makes people feel good, even when the right thing to do is to keep all the loans open. The researchers add to this temptation by occasionally giving people a "bonus" just big enough to pay off a couple of the low interest rate loans. "We have this incredible desire to feel we are making progress," says Ariely. "The satisfaction we get from fewer loans opened overwhelms our decision of what is the right thing to do."

Ariely, 43, a professor of psychology and behavioral economics, is among the most creative of a new breed of social scientists charting the numerous ways our psychological quirks cause us to deviate from rational behavior. He conducts simple experiments to show how people cheat, procrastinate, overvalue objects they made themselves, take free things they don't need, insist upon keeping their financial options open even when it means losing money and otherwise behave contrary to their interests.

His second book, The Upside of Irrationality, comes out in June. In one chapter he describes experiments suggesting that large bonuses won't improve executive performance. He teamed up with Carnegie Mellon economist George Loewenstein and others to test 87 residents of a poor village in India on a variety of tasks involving memory, fine motor skills and creativity. Some were promised a few hours or few weeks of pay if they did the tasks well. Others could get much larger bonuses--the local equivalent of six months of pay. Performance plummeted when people knew they were in the big-bonus pool. "The way to understand it is we are rediscovering choking with money," Ariely says. "For some reason nobody ever thought this applies to bonuses with executives."

Behavioral economics takes aim at the classic economics assumption that humans behave rationally when it comes to financial and other matters. Starting in the 1970s, psychologists Daniel Kahneman and the late Amos Tversky did groundbreaking studies suggesting otherwise. The psychologists showed that people take mental shortcuts that cause them to veer from rational behavior. They weigh losses greater than corresponding gains. They don't adjust for sample size in calculating probabilities. They go out of their way to get a $10 discount on a $20 product but can't be bothered to shop around for the same discount on a $500 product. Disturbing corollaries: Stock markets aren't necessarily efficient. Prices don't always obey the laws of supply and demand. Speculative real estate bubbles sometimes happen.

Ariely says textbook economics is a fine approximation of the world--perhaps half of the time. The problem is that "we take economics too seriously as a society" and assume it works all the time. The world, he says, would be better off if economists spent more time in the field. "In every other field of science data is worth more than theory," he says. Unlike some behavioral economists who focus on high finance, Ariely looks broadly at everyday decision making. He has a knack for taking a complex phenomenon and encapsulating it in a simple experiment. One set of experiments shows that college students are more likely to cheat on a task with financial rewards when they know a confederate from the same university is doing it and getting away with it. If they know someone from a rival school is cheating, they are less likely to cheat.

Ariely grew up in a middle-class family in Israel and majored in psychology at Tel Aviv University, before getting doctorates in cognitive psychology (the University of North Carolina) and business administration (Duke University).

He credits a freak bomb explosion when he was 18 with transforming his outlook on life. The explosion burned 70% of his body, mangled his right hand and put him in the hospital for three years. Many of the hospitals' procedures seemed irrational to him. When it came time to change his bandages, the nurses would rip them off quickly even though this produced excruciating pain. They were confident it was the right way to do it, despite an utter absence of evidence. (He later showed patients generally perceive less pain if bandages are removed slowly.) When patients exhausted their daily morphine rations, sometimes nurses would give them placebo injections and they would quickly fall asleep. The expectation of pain relief produced real pain relief in the absence of medicine.

His book-writing career began with a failed attempt to write a cookbook. Nobody would publish it, but a book agent pushed him to write about his research. He reluctantly agreed. The resultant 2008 book, Predictably Irrational, has sold 136,000 copies, according to Nielsen BookScan. It is a chatty romp through our imperfect decision-making processes. One chapter, "The Fallacy of Supply and Demand," focuses on how the initial price of a product can have an undue influence on what people are willing to pay. In one experiment (with Loewenstein and a third colleague) Ariely asked people to write down two digits of their Social Security numbers. He asked them if they would be willing to pay that much for various products, including a bottle of wine and a cordless keyboard. When volunteers bid on the same products, those with high numbers were willing to pay significantly more. "He is a star of the field, one of the most productive people in his age group," says Princeton University's Kahneman, who won the 2002 Nobel Prize in economics.

Ariely, who is married with two young children, gives 150 speeches a year to a bewildering variety of audiences. They include high school students (encouraging them to go into social science), doctors (arguing that letting sick, ill-informed patients choose between treatments shirks responsibility) and nonprofits (suggesting they do more experiments assessing whether their methods work). Wall Street types are the most skeptical of his message. When he speaks to them, he sometimes asks them how many have sent text messages while driving. Most hands go up. "For some reason they are willing to put their lives at risk because their phone vibrates for a second, but when it comes to money all of a sudden they think people are perfectly rational," he says.

Standard economics, Ariely argues, provides few solutions to the world's problems because it assumes people are making perfect decisions. "People are making mediocre decisions. If you get them to make better decisions, you might have a better world."

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