The End of Rational Economics

Standard economic theory assumes that human beings are capable of making rational decisions and that markets and institutions, in the aggregate, are healthily self-regulating. But the global economic crisis, argues Ariely, has shattered these two articles of faith and forced us to confront our false assumptions about the way markets, companies, and people work. So where do corporate managers—who are schooled in rational assumptions but run messy, often unpredictable businesses—go from here?

Once an understanding of irrationality is embedded in the fabric of an organization, a behavioral economics approach can be applied to virtually every area of the business, from governance and employee relations to marketing and customer service.

How Behavioral Economics Differs from Traditional Economics

All of economics is meant to be about people’s behavior. So, what is behavioral economics, and how does it differ from the rest of economics?

Economics traditionally conceptualizes a world populated by calculating, unemotional maximizers that have been dubbed Homo economicus. The standard economic framework ignores or rules out virtually all the behavior studied by cognitive and social psychologists. This “unbehavioral” economic agent was once defended on numerous grounds: some claimed that the model was “right”; most others simply argued that the standard model was easier to formalize and practically more relevant. Behavioral economics blossomed from the realization that neither point of view was correct.

The standard economic model of human behavior includes three unrealistic traits—unbounded rationality, unbounded willpower, and unbounded selfishness—all of which behavioral economics modifies.

Nobel Memorial Prize recipient Herbert Simon (1955) was an early critic of the idea that people have unlimited information-processing capabilities. He suggested the term “bounded rationality” to describe a more realistic conception of human problem-solving ability. The failure to incorporate bounded rationality into economic models is just bad economics—the equivalent to presuming the existence of a free lunch. Since we have only so much brainpower and only so much time, we cannot be expected to solve difficult problems optimally. It is eminently rational for people to adopt rules of thumb as a way to economize on cognitive faculties. Yet the standard model ignores these bounds.

An example of suboptimal behavior involving two important behavioral concepts, loss aversion and mental accounting, is a mid-1990s study of New York City taxicab drivers (Camerer et al. 1997). These drivers pay a fixed fee to rent their cabs for twelve hours and then keep all their revenues. They must decide how long to drive each day. The profit-maximizing strategy is to work longer hours on good days—rainy days or days with a big convention in town—and to quit early on bad days. Suppose, however, that cabbies set a target earnings level for each day and treat shortfalls relative to that target as a loss. Then they will end up quitting early on good days and working longer on bad days. The authors of the study found that this is precisely what they do.

Consider the second vulnerable tenet of standard economics, the assumption of complete self-control. Humans, even when we know what is best, sometimes lack self-control. Most of us, at some point, have eaten, drunk, or spent too much, and exercised, saved, or worked too little. Though people have these self-control problems, they are at least somewhat aware of them: they join diet plans and buy cigarettes by the pack (because having an entire carton around is too tempting). They also pay more withholding taxes than they need to in order to assure themselves a refund; in 1997, nearly ninety million tax returns paid an average refund of around $1,300.

Behavioral Economics 101

Drawing on aspects of both psychology and economics, the operating assumption of behavioral economics is that cognitive biases often prevent people from making rational decisions, despite their best efforts. (If humans were comic book characters, we’d be more closely related to Homer Simpson than to Superman.) Behavioral economics eschews the broad tenets of standard economics, long taught as guiding principles in business schools, and examines the real decisions people make—how much to spend on a cup of coffee, whether or not to save for retirement, deciding whether to cheat and by how much, whether to make healthy choices in diet or sex, and so on. For example, in one study where people were offered a choice of a fancy Lindt truffle for 15 cents and a Hershey’s kiss for a penny, a large majority (73%) chose the truffle. But when we offered the same chocolates for one penny less each—the truffle for 14 cents and the kiss for nothing—only 31% of participants selected it. The word “free,” we discovered, is an immensely strong lure, one that can even turn us away from a better deal and toward the “free” one.

For the past few decades, behavioral economics has been largely considered a fringe discipline—a somewhat estranged little cousin of standard economics. Though practitioners of traditional economics reluctantly admitted that people may behave irrationally from time to time, they have tended to stick to their theoretical guns. They have argued that experiments conducted by behavioral economists and psychologists, albeit interesting, do not undercut rational models because they are carried out under controlled conditions and without the most important regulator of rational behavior: the large, competitive environment of the market. Then, in October 2008, Greenspan made his confession . Belief in the ultimate rationality of humans, organizations, and markets crumbled, and the attendant dangers to business and public policy were fully exposed.

Experimenting with Behavior

Behavioral economics experiments that get to the bottom of people’s decisions and actions are very different from the kinds of tests companies traditionally use to try out new product ideas and marketing concepts or to discover opportunities. The difference is not in the research methodology itself but in the process of selecting ideas to be tested.

The standard business approach to experiments is similar to an engineering project. A behavioral economics approach, in contrast, is more like a science project: We search simultaneously for the governing principles and how to implement them. Consider, for example:


I don’t know whether Apple’s executives were conducting a behavioral economics experiment when they introduced the iPhone at a price of $600 and then quickly discounted it to $400, but that move revealed something important about human behavior. By imprinting the price of $600 in people’s minds, Apple was able to make consumers think that $400 was a real bargain. In a standard approach to price setting, the people running Apple’s pricing group might have asked focus groups about various price points for the phone, and based on participants’ feedback, picked the price they thought would maximize profits ($400). But if Apple had set the initial price at $400, consumers would have had no basis for comparison, since they’d never seen such a product before.

Adopting a behavioral economics perspective, Apple might have started by questioning the assumption that people would know how to value the pathbreaking product and so set up various pricing experiments. In this type of test, the goal is not simply to find out the optimal price but also to discover how people arrive at a decision to buy at that price.

Product launches.

Behavioral economists might also look at the roles of habit and trust in consumer choice. Take a manufacturer who is planning to sell a triple-concentrated detergent, on the theory that environmentally conscious consumers would prefer to eliminate waste. Given shoppers’ almost automatic impulse to reach for the same detergent, should the manufacturer package the concentrate in the standard-size bottle and charge more for it? Or should the manufacturer try to break consumers’ force of habit and package the concentrate in a bottle one-third the size of the original? And what about trust? If consumers don’t trust the manufacturer to deliver a more concentrated product, given that the product smells and looks the same as before, will they be willing to pay for it? How can the manufacturer overcome this hurdle?


A variety of companies now use a behavioral economics approach to more closely examine customer and employee behavior. For example, one automobile insurer discovered that most people, when filling out forms that ask how many miles they’ve driven in a year, claimed that they drove less than they actually had. Building on the discovery that people are less inclined to cheat after being reminded of their own ethical standards, the company moved the signature line to the top of the form. Applicants who signed the form at the top reported driving an average of 2,700 more miles a year than those who signed at the end.

Once the understanding of irrationality is embedded in the fabric of the organization, a behavioral economics approach can be applied to virtually every area of the business, from governance and employee relations to marketing and customer service. It is probably most useful in the areas that we know the least about—such as the relationships between compensation and performance, risk and reward, loyalty and consumer habits, and pricing and purchasing behavior. As companies become more willing to question their assumptions, discover something about their stakeholders’ predilections, and share the results of their learning, they will no doubt become a good deal wiser.


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