by Dan Ariely, June 25, 2010 10:17 AM
Money is an integral part of modern life. We constantly make decisions about whether we're willing to pay for different products and, if so, how much we are willing to pay. In fact, we make decisions about money so often that we consider money to be a natural part of our environment.
However, money is a relatively recent invention, and despite its incredible economic usefulness it does come with its own set of problems. In particular, it turns out that decisions about money are often non-intuitive and, in fact, quite difficult. Consider the following situation as an example: You are thirsty, tired, and annoyed and just want a cup of coffee. You see two coffee shops across the street from each another. One is a specialty coffee shop that sells handcrafted, designer coffee and the other is Dunkin' Donuts which sells standard, decent coffee. The price difference between the two options is $1.75 for your cup-a-joe. Now, how do you decide if the benefit of the handcrafted coffee drink is worth the additional $1.75?
What you should do (if you wanted to be rational about it) is consider all of the things that you could buy with that $1.75, now as well as in the future, and decide to buy the expensive coffee only if the difference between the two coffees is more valuable than all of those other possibilities. But of course this computation would take hours, it is incredibly complex, and who even knows all the possible options to consider?
So what do we do when we need to make decisions but making them "correctly" is too time consuming and difficult? We adopt simplifying rules, which academics call heuristics, and these heuristics provide us with actionable outcomes that might not be ideal but they help us to reach a decision. In the case of coffee and other, similar decisions, one of the heuristics we often use is to look at our own past behaviors and if we find evidence of relevant past decisions, we simply repeat those. In the case of coffee, for example, you might search your memory for other instances in which you visited regular fancy coffee shops. Assess which one of those two behaviors is more frequent and then you tell yourself "If I've done Action X more than Action Y in the past, this must mean that I prefer Action X to action Y" and as a consequence, you make your decision.
The strategy of looking at our past behaviors and repeating them, might seem at first glance to be very reasonable. However, it also suffers from at least two potential problems. First, it can make a few mediocre decisions into a long-term habit. For example, after we have gone to a fancy coffee shop three times in a row, we might reason that this is a great decision for us and continue with the same strategy for a long time. The second downfall is that when the conditions in the market change, we are unlikely to revise our strategy. For example, if the price difference between the fancy & standard coffee shop used to be 25¢ and over the years has increased to $1.75, we might stay with our original decision even though the conditions that supported it are no longer applicable.
In light of our current financial situation, many people these days are looking for places to cut financial spending. Once we understand how we use habits as a way to simplify our financial decision-making, we can also look more effectively into ways to save money. If we assume that our past decisions have always been sensible and reasonable then we should not scrutinize our long-term habits. After all, if we've done something for five years, it must be a great decision. But if we understand that long-term, repeated behaviors might reflect our habitual decision-making in the face of complex financial decisions more than they reflect what is truly best for us, we might first examine our old habits and carefully consider whether they indeed make sense or not. We can examine our subscription to the ESPN Sports Package, our annual subscription to the opera, our yearly Disneyland vacation, or our monthly visit to the hairdresser. By examining these habits, and quitting them when it makes sense to do so, we might actually discover ways in which we could reduce our spending on a long-term basis.
Yes, money is complex, and it is incredibly difficult for us to carefully examine every purchasing decision we make. But the advantage of examining our habits is that it might lead us to create good ones that will benefit us for a long time
by Dan Ariely, June 24, 2010 11:25 AM
I personally find fruit and vegetables to be not only healthy, but also delicious. I enjoy cooking and preparing them, and try to eat them often. Sometimes I wind up spending egregious amounts of money getting the freshest local organic produce. Still, even when I empty my wallet at the farmer's market, some of my fruit and veggies inevitably end up wilting or rotting in the fridge, leaving a fairly unpleasant sludge. A number of things could contribute to this waste — but I'd like to point out a few simple design flaws that I think we can fix.
1) I suspect that one of the main culprits is the produce drawer in the refrigerator. Most refrigerators have a special drawer designed to hold produce, usually located at the bottom of the fridge. The drawer is often just barely opaque and for some reason difficult to open. Because of these "features," when you open the fridge door, you look straight ahead, to the leftover lasagna or apple pie (and their convenient position) come to mind, leaving the carrots and nectarines hidden and forgotten in the vegetable drawer. If the design of the produce drawer is one of the barriers for eating the fruit and vegetables we have already purchased, what can we do about it? For one, instead of using the crisper to store fruit and vegetables, we could put them on a higher shelf so that they are more inviting when that door is opened. We'll smile and say to ourselves: "Oh, right, I now remember I have blueberries and I want to eat some of them."
2) Another obstacle that keeps us from eating our vegetables before they've gone rancid is the sense of immediacy and gnawing hunger that compels us to open the fridge in the first place. We usually go to the fridge when we are already hungry, and are looking for something to pop in our mouths right away. Because there are usually a few steps between raw vegetables and ready to eat food, we shy away from them in favor of something faster and more convenient. One way to solve this would be to wash, cut or cook them in advance so that they are already prepared at the pivotal moment of hunger.
3) In addition, these perishables don't come with any indication of an expiration date. Until we discover the point-of-no-return, it is hard to tell how far the produce are from the end of their useful lives. We know that when we buy fish, we should eat it within the next couple of days. With milk, there is a date stamped right on the container, undisputable and in plain sight. Because we are averse to losing money (even money already spent), these expiration dates compel us to make sure that we use that pound of Mahi Mahi, eat that yogurt, and finish the milk. By leaving the produce's expiration date ambiguous, it is hard for us to plan when to eat our produce, and we often discover that we have missed the expiration date after it's too late. If we were to make our own expiration dates and stick them on our celery sticks, we would be more likely to use them before they've turned into a mushy mess.
This type of waste worries me because I think that it also prevents us from future purchases of fruit and vegetables. Imagine this scenario: You buy a bag of grapes for $7.50, throw them in the crisper drawer, and forget about them. A couple weeks later, you open the crisper on a whim and are alarmed to find that the former bag of grapes has now turned into a moldy pile of muck. You feel awful, not only because you have to clean up the mess, but because you paid seven dollars and fifty cents for this. You grumpily go for the sponge and think to yourself, "Well, I'll never do that again."
My general point is this: There are all kinds of reasons why we eat badly, but some are more fixable than others if we only look at our behavior and undercover the nuanced forces guiding our actions. Instead of throwing the bag of grapes into the dark drawer in the bottom of the fridge, we can save that drawer for the cupcakes and instead put some grapes in a tray on the top shelf with some mixed greens and pecans, ready to grab and go. The rest of the grapes can be prewashed and stamped with a homemade expiration sticker. If we make plans to eat them within a few days and mark them as such, we are more likely to stick to our goals. This way, we can eat more fruit and veggies and avoid wasting money or creating a mess — benefits all
by Dan Ariely, June 23, 2010 10:21 AM
From a standard economic perspective, gifts are a waste of money. Imagine that you invite me over for dinner one day and I decide to spend $50 on a bottle of wine. There are a bunch of problems: To start, I am not sure what wine you would like the most. And besides, maybe you'd prefer something else, like a book, a DVD, or a blender. This means that the bottle of wine that cost me 50 dollars might be worth, at most, 25 dollars to you.
If gift-giving were rational I would come to dinner and tell you, "Tom, thanks for inviting me for dinner. I was going to spend $50 on a bottle of wine, but realizing that this might provide you with only $25 of benefits, here is the cash instead and you can decide how best to spend it."
(Or even better, maybe I would split the cost and offer Tom $37.50, making both of us better off.)
But, despite the realization that gifts are economically inefficient, I don't suspect that many people will follow this advice. Why? Because even though a cash gift is more economically efficient, it will in no way endear you to your host.
For example, if the day after the dinner party you find yourself in a bind and need some help moving a sofa, the odds are that a host that you gave a gift to will step in to help. But what about the host that you gave the efficient cash gift to? Wouldn't his logical response to your request for help be, "How much are you offering me for my time?"
The point is that while gifts are financially inefficient, they are an important social lubricant. They help us make friends and create long-term relationships that can sustain us through the ups and downs of life. They are, in fact, efficient because they help us create the social fabric we so depend on.
It turns out that sometimes a waste of money is worth a lot
by Dan Ariely, June 22, 2010 10:47 AM
What would you think if someone told you: Do the right thing because your life may depend on it? Or more accurately, that you better start making better decisions because it is a matter of life and death. This may sound like something an overprotective parent would tell their child, but in reality it's the way most of us should start to think about our day-to-day decisions and their potential to lead to harmful habits and fatal consequences. It is hard to believe that this is true, but recently, researchers have done some interesting analyses on this topic and the results support the idea that personal decisions, and often fairly mundane ones, are a leading cause of premature death in the United States (and I suspect that similar numbers are also the reality in the rest of the developed world).
One of the most interesting analyses on the ways in which our decisions kill us is one by Ralph Keeney (Operation Research, 2008), where Ralph puts forth the claim that 44.5% of all premature deaths in the US result from personal decisions — decisions involving, among other things, smoking, not exercising, criminality, drug and alcohol use, and unsafe sexual behavior. In his analysis, Ralph carefully defines the nature of both the type of personal decision and what is considered premature death. For instance, dying prematurely in a car accident caused by a drunk driver is not considered premature in this framework because the decision to drive somewhere is not one that can logically be connected to the premature death. Unless, of course, the person who dies is also the drunk driver, in which case this counts as a premature death caused by a bad personal decision. This is because the decision to drive drunk and dying as a result are clearly connected. In this way you can examine a large set of cases where multiple decision paths are available (the drunk driver also has the option to take a cab, ride with a designated driver, or call a friend), and where these other decision paths are not chosen despite the fact that they won't directly result in the same negative outcome (i.e., fatality). As other types of examples, consider the decisions to smoke (when not smoking is an option), to overeat (when watching our weight is an option), or for people with long term medical conditions to skip taking insulin or asthma medication when these are important to their ongoing health.
Using the same method to examine causes of death in 1900, Keeney finds that during this time only around 10% of premature deaths were caused by personal decisions. Compared to our current 44.5% of premature deaths caused by personal decisions, it seems that on this measure of making decisions that kill ourselves we have "improved" dramatically (of course this means that we've actually gotten much worse) over the years. And no, this is not because we've become a nation of binge-drinking, murderous smokers; it's largely because the causes of death like tuberculosis and pneumonia (the most common causes of death in the early 20th century) are far more rare these days and our temptation and ability to make erroneous decisions (think about driving while texting) has increased dramatically.
What this analysis means is that instead of relying on external factors to keep us alive and healthy for longer, we can (and must) learn to rely on our decision-making skills in order to reduce the number of dumb and costly mistakes that we make.
The question then becomes how to help people become better decision-makers. Or at least better at making decisions where their health is concerned. If nearly half of premature deaths in the U.S. can be avoided by making better decisions, it is clear to me that it would be worthwhile to spend much more time and effort to disseminate the knowledge we have gained in social science about the main ways in which people fail to make good decisions. It is, of course, over-optimistic to expect that just helping people to see what mistakes they are likely to make will fix the problem, but personally I would be happy even if it only slightly reduced the number of catastrophic decisions. The next step we need to take is to expand upon the research that examines what kind of methods encourage healthier decision-making and conduct much more research in areas that could help us limit our mistakes. For example, based on research about how people make different decisions when they are sexually aroused we might concentrate on providing comprehensive sexual education that teaches teenagers how to make decisions while in the heat of the moment. Similarly, by understanding how people think we might be able to teach people to enjoy eating fruit and vegetables; how to make exercise part of their ongoing lifestyle; and develop effective smoking cessation programs. And it would also help to remember, in light of this, that every decision
by Dan Ariely, June 21, 2010 11:44 AM
My interest in the irrationality of human behavior started many years ago in hospital after I had been badly burned. If you spend three years in a hospital with 70 percent of your body covered in burns, you are bound to notice several irrationalities. The one that bothered me in particular was the way my nurses would remove the bandage that wrapped my body. Now, there are two ways to remove a bandage. You can rip it off quickly, causing intense but short-term pain. Or you can remove it slowly, causing less intense pain but for a longer time.
My nurses believed in the quick method. It was incredibly painful, and I dreaded the moment of ripping with remarkable intensity. I begged them to find a better way to do this, but they told me that this was the best approach and that they knew the best way to remove bandages. It was their intuition against mine, and they chose theirs. Moreover, they thought it unnecessary to test what appeared (to them) to be intuitively right.
After leaving the hospital, I started doing experiments that simulated these two ripping methods. And I found that the nurses were wrong: quick ripping turned out to be more painful than slow ripping. In my experiments, I discovered a collection of approaches that could have been used to lessen the pain or manage it more effectively. For instance, they could have started from the most painful part of the treatment and moved to less painful areas to give me a sense of improvement; they could have given me breaks in between to recover.
Over the years I have examined many topics related to the mistakes we all make when we make decisions, and my two books (Predictably Irrational and The Upside of Irrationality), describe some of these in more depth. There are great lessons to be learned from such experiments, lessons that apply to economics, markets, policymaking, and even our personal lives. But before we examine some of these mistakes, let me first describe for you my view on behavioral economics:
1) What is behavioral economics? How is it different from standard economics?
In general, both standard and behavioral economics are interested in the same questions and topics. The choices people make, the effects on incentives, the role of information, etc. However, unlike standard economics, behavioral economics does not assume that people are rational. Instead, behavioral economists start by figuring out how people actually behave, often in a controlled lab environment in which we can understand behavior better, and use this as a starting point for building our understanding of human nature. As a consequence of this different starting point, behavioral economists usually come to different conclusions about the logic and efficacy of almost anything, ranging from mortgages to savings to health care, in both the personal and business realms.
2) Even if consumers make mistakes from time to time, wouldn't the market fix these?
I always found the appeal to the market gods a bit odd. Why would the market fix mistakes instead of aggravating them? When the Chicago economists sometimes (reluctantly) admit that people make mistakes, they claim that people make different types of mistakes that will eventually cancel each other out in the market. Behavioral economics argues that, instead, people will often make the same mistake, and the individual mistakes can aggregate in the market. Let's take the subprime mortgage crisis, which I think is a great example (but a very sad reality) of the market working to make the aggregation of mistakes worse. It is not as if some people made one kind of mistake and others made another kind. It was the fact that so many people made the same mistakes, and the market for these mistakes is what got us to where we are now.
3) Isn't this a depressing view of human nature?
It is true that from a behavioral economics perspective we are fallible, easily confused, not that smart, and often irrational. We are more like Homer Simpson than Superman. So from this perspective it is rather depressing. But at the same time there is also a silver lining. There are free lunches!
Take the physical world, for example. We build products that work with our physical limitations. Chairs, shoes, and cars are all designed to complement and enhance our physical capabilities. If we take some of the same lessons we've learned from working with our physical limitations and apply them to things that are affected by our cognitive limitations — insurance policies, retirement plans, and health care — we'll be able to design more effective policies and tools that are more useful in the world. This is the promise of behavioral economics — once we understand where we are weak or wrong we can try to fix it and build a better world.
Take again the sub-prime mortgage crisis. Imagine that we understood how difficult it is for people to calculate the correct amount of mortgage that they should take, and instead of creating a calculator that told us the maximum that we can borrow, we created one to help us figure out what we should be borrowing. I suspect that if we had this type of calculator (and if people used it) much of the sub-prime mortgage catastrophe could have been avoided. This, of course, is one idea to fix one problem, and there are many ways to think about how to improve our lives along many of the decisions we make every day. This is why I think that behavioral economics is so optimistic, useful, and important for our personal life and for society.