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.