The Sandpit

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This blog is dedicated to finding and extolling smart psychology/behavioral science books with an emphasis on judgment & decision making. I publish a few essays each month that typically feature new and classic titles. Why “The Sandpit?” Read the introduction essay here.

What Makes Us Tick? A Writer and a Behavioral Scientist Talk about Behavioral Economics

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This conversation also appears on “There Are Free Lunches,” a blog on PsychologyToday.com written by Diogo Gonçalves.

Diogo Gonçalves is a PhD student who tries to translate what he learns about human decision making in simple stories. We met in a airport because of a book that one of us was reading, the same the other had recently read. The conversation was so stimulating, that we decided to continue it online, and share it with their readers. We both believe this will be the first of an endless series of talks about the subject—what makes people tick?

McNerney:

Hi Diogo,

I recently watched the Israeli historian Yuval Noah Harari talk about his new book Sapiens: A Brief History of Humankind. He spoke about how humans expanded out of the savannah, formed civilizations, invented science, and created modern society. When explaining our rapid expansion, Harari rules out the usual candidates including language, intelligence, and even collective behavior.

The distinguishing trait that underpins our success, Harari says, is our obsession with imagined reality. Like all animals, we’re sensitive to events that happen in the real world, but we spend most of our time thinking about things that don’t exist—things like human rights, nation states, gods, and money. You could never convince a chimpanzee that if he gives you a banana, he will go to heaven for his good deeds.

I think this distinction nicely captures one big difference between economists and psychologists. Economists tend to treat things like price and value as if they exist in objective reality. Psychologists, by contrast, better appreciate the idea that since these constructs only exist in imagined reality, they are highly sensitive to anchors, social norms, and the perception of fairness.

Gonçalves:

Sam,

I think that what you said is probably the most compelling, precise, and beautiful definition of behavioral economics I ever heard—and a great start for our conversation.

In fact, I believe the main contribution of psychology to economics, which originated with the emergence of behavioral economics, is the idea that the human brain doesn’t measure absolute values. When economists were treating preference, price, and value as stable and absolute, Kahneman, Tversky, and other psychologists argued that in the human mind, everything is relative and depends on context. And when we say everything we really mean everything, from judgments of physical attractiveness to judgments of preference, price, and value. Almost all human judgments are made in relation to a reference point.

George Loewenstein—probably the researcher that most brilliantly integrates psychology with economics—recently framed the idea like this: “Our perception of, and reaction to, reality is subjective. How you feel about products, or even about your life, is at least as important, and probably much more important, than the product or your life’s objective characteristics.”

This idea, which looks simple but feels counter intuitive, has profound implications on the way we look at policy, society, and ourselves. I would say it represents a paradigm shift that challenges many assumptions: Can we rely on free markets? Should we use financial incentives to drive behavior? Are objective economic measures (such as GDP) the metrics that should guide society?

McNerney:

Loewenstein perfectly captures the idea that behavioral science isn’t just about outlining a few trivial mental quirks that occasionally distort how we think. It is revealing the more groundbreaking notion that how we understand the world is a subjective interpretation. As Rory Sutherland puts it, we feel like we’re making objective calculations about reality when most of the time we’re just “punting.” His point, I think, is that the brain didn’t evolve to perceive reality as it is. It evolved to make approximations that are reliable.

Let’s talk a little bit about one concept from behavioral science that I’m especially interested in, coherent arbitrariness, which William Poundstone brilliantly explores in his book Priceless: The Myth of Fair Value (and How to Take Advantage of It).

Gonçalves:

Coherent arbitrariness is the idea that a wealthy man is someone who earns $100 more than his wife’s sister’s husband. There is coherence because there is an orderly pattern between the two salaries—one is more than the other—but the man’s “wealth” is arbitrary because it is not based on an absolute value. The salary of the wife’s sister’s husband does not have any logical relation to the man’s salary, yet it strongly influences how he perceives his wealth.

Coherent arbitrariness tells us that absolute preferences are volatile, but relative preferences are stable. This creates an illusion of order that disguises the largely arbitrary nature of how we value things. (Imagine a man whose wife’s sister’s husband is Roman Abramovich compared to a man whose wife’s sister’s husband is a poor PhD student like me.)

McNerney:

I’m reminded of a study showing that people would prefer a salary of $60,000 when their co-workers are making $55,000 over a salary of $70,000 in a company full of people making $75,000. The numbers are absolute—$70,000 is more than $60,000—but our sense of wealth is not.

It’s a great piece of research because it shows how much imagined reality influences what we prefer to receive in reality. To any other species on Earth, more is usually better. I can’t imagine that my dog would prefer to play with other dogs just because they eat less generously than he does. And while there is a growing body of research showing that some animals have a rudimentary sense of fairness—Capuchin monkeys get especially upset when they see other monkeys receive tastier threats for performing the same task—humans are especially sensitive to what other people receive.

Coherent arbitrariness raises fundamental questions about how evolution and culture shape our valuations and social instincts. But I’m wondering: How does it challenge neoclassical economics?

Gonçalves:

If we accept coherent arbitrariness, we should dismiss (or at least discourage) the idea that market price is solely determined by a balance between demand and supply. Just like the valuation of the man’s wealth depends on his wife’s sister’s husband, his willingness to pay for a product depends on his perception of fairness, not a cold calculation of what the product should be worth based on its market price. The behavioral economist would argue that even though market price is not entirely arbitrary—no one could get away with selling a six-pack of beer for one thousand dollars—how prices are framed and the context of the purchase significantly influence our willingness to pay.

Let me give you the example of Renova, a company from my country (Portugal) that recently launched a new product: black toilet paper. This toilet paper is considerably more expensive than other toilet paper, but people still buy it. Why? It’s hard to believe that consumers perform a complex computation of the trade-offs and make a rational decision, as conventional economics would suggest.

A more compelling explanation for the success of black toilet paper is that Renova was able to differentiate it enough (through advertisement, packaging, or other marketing strategies) in order to create a new price anchor. The new anchor changed the consumer’s willingness to pay for toilet paper (the same way that decreasing the wife’s sister’s husband salary would increase the man’s sense of wealth). Thus, the toilet paper market was capable of inducing consumer’s demand instead of simply reacting to it.

McNerney:

What a great example. It’s fascinating because if you think about it, even something like color does not exist in objective reality. Blackness is something the brain “does.”

It reminds me of a famous study conducted by Joe Huber and Christopher Puto originally published in The Journal of Consumer Research. In an initial experiment most participants preferred a $2.60 “premium beer” over a $1.80 “bargain beer.” In a follow-up experiment, in which participants selected among three beers—the premium beer, the bargain beer, and a cheap beer priced at $1.60—their preferences shifted. Nobody in the second experiment preferred the super-cheap beer, yet the proportion of people who opted for the bargain beer to the premium beer changed dramatically. As Poundstone puts it, “The existence of the super-cheap beer legitimized the bargain beer.”

There are a few ways to interpret this finding. We’ve already discussed the first, which is that price is relative. The second interpretation is that high and low anchors make us feel like we’re deciding rationally, even though we’re probably just responding to social pressures and loss aversion—we don’t want to be perceived as cheap, but we don’t want to get ripped off, so we opt for the middle option.

Perhaps the most provocative implication of the beer study is that expensive items that don’t sell change what does. Could you talk a little bit about that?

Gonçalves:

Before I answer your question, let me go back to the black toilet paper example. When you say that Blackness is something the brain “does,” it makes me think that it’s really all about that. It is our super developed cognitive apparatus that make us more prone to this kind of phenomena than any other animal. Recently, psychologists interested in the evolutionary origins of this phenomena studied by behavioral economists investigated behavioral biases in monkeys. The psychologists showed that the human heuristic “expensive equals good,” which occurs even when the price of the good is arbitrary, might not exist in monkeys. These results suggest that pricing effects depend on sophisticated cognitive capacities unique to us. These capacities allow us to understand market forces and signaling, but they also make us prone to a suite of judgment and decision making biases.

About the beer study, I would say the finding is like the visual illusion where the same circle appears large when surrounded by small circles but small when surrounded by large ones. You can obtain the same effect with the price of beer, which violates the normative theory of choice, which classical economics was built up on. This theory assumes that the addition of a new alternative should not increase the probability that customers will choose an item in the original set.

The beer study shows that we can actually change consumer preference between two initial beers (and potentially any product) when we introduce an alternative beer that no one prefers. As you said, when participants selected among three beers—the premium beer, the bargain beer, and a cheap beer priced at $1.60—their preferences shifted. This change strongly suggests that we don’t really know what we want and that marketers have the power to shape what we buy, just “like pulling the strings on a marionette” as Poundstone puts it.

And pulling the string can mean diminishing the size of the circles or increasing them, so to speak. This maneuver is particularly apparent in the luxury trade where expensive items that don’t sell change what does. Thus, if a retailer wants to sell a pair of shoes that cost $100, they should put them next to a pair of shoes that cost $150. That way, the retailer will activate the trade-off contrast principle, which says that if item X is clearly better than item Y consumers will tend to buy X, even when X is only better relative to Y—and potentially worse than comparable items.

Neoclassical economic models predict that customers weigh all the options rationally. In reality, when we encounter too much choice—just like we would in a shoe store—we tend to opt for items that we can justify. We talk ourselves into X because it looks better than Y.

The fashion industry exploits this principle relentlessly. The most expensive luxury brand articles are very costly, uncomfortable, and sometimes aesthetically shocking. Very few people can afford them. As a result, most customers choose something that’s relatively more comfortable, economical, and discrete. The most expensive, uncomfortable, and shocking articles—which a small minority buy—determine the patterns of choice for the remaining customers. It’s not a huge departure from the XVII century, where the clothes the king worn determined what the rest of the cutting vest.

McNerney:

I’m glad you mentioned the study involving monkeys. It’s interesting because it raises a fundamental question about the human mind. Our imagination is an unrivaled piece of mental hardware. With it, we’ve contemplated the origins of the universe and our place in it. It underpins the philosophy of Socrates and Nietzsche; it forms the foundation of art and poetry; it drove centuries of research in science. Over time, our imagination has come to define us. It is, as Yuval Noah Harari puts it, what makes us human.

And yet, our ability to think abstractly can lead us astray. It happens often, but we rarely notice it. That’s the devilish problem with cognitive biases. They are not like a broken limb—something to fix and forget—but short term memory loss: they won’t go away and we rarely notice them. Marketers are all too familiar with this hidden side of human irrationality, which is why we are frequently seduced into buying overpriced watches and wine. Price, as Proundstone puts it, is not an answer to a math problem. It’s a guess about what other human beings will do.

I think a good way to conclude is to talk about the future of behavioral economics. You’re a Ph.D candidate in Behavioral Economics. I’m a freelance writer with a focus on behavioral science. As recent as a decade ago this would have been an unlikely dialog. There were not as many people working at the intersection of economics and psychology; there were probably fewer people writing about it. Yet this topic is significantly influencing governments and private companies. Where do you see the field going?

Gonçalves:

I think that the answer to your question “Where do you see the filed going?” is that it’s already going. Since 2010, when UK Prime Minster David Cameron created The Behavioral Insights Team (aka, the Nudge Unit), the application of behavioral science in policy has become a reality that has since spread to other countries (US, Denmark, Australia, France) and institutions (European Commission, World Bank).

Private companies have been using behavioral science for decades. Marketing departments claim that they try to anticipate consumer preference, but most of the time they influence or even create preference. That’s why many people believe behavioral economics is about recognizing that marketing exists, and that companies can make a lot of profit from exploring our biases and weaknesses.

I think that behavioral science and its application to policy through the emergence of behavioral economics will continue to shape how governments approach public policy in the next decade. I believe that the effectiveness and progress of these applications will depend on how well economists, psychologists, and other social scientists work together. Every field of social science offers a different behavioral angle, and the precision of this angle will depend on how academics and practitioners from different fields collaborate. The more precise the angle, the easier it will be to find ways of “making it easier for people to do the right thing”.