'Predictably Irrational'

As a group, economists have traditionally believed that people are rational actors, essentially commercial beings who are motivated by reason and who respond predictably to monetary incentives. But in recent years, a growing number of practitioners of the dismal science have come to understand that the insights of Sigmund Freud can be as useful as the insights of Adam Smith. The burgeoning subdiscipline of behavioral economics has led more economists to tap into the subconscious, to plumb the ways in which human nature can affect markets. In fact, the phenomenon of "Freakonomics"—economist Steven Levitt's mega-best seller—has helped launch a slew of books that aim to popularize the field. Among them, Dan Ariely's "Predictably Irrational: The Hidden Forces that Shape Our Decisions" stands out for its intelligence, curiosity and wit.

Ariely's book examines how tough-to-measure factors—emotions, expectations, contexts, social norms—play an important role in the economy. If you want to know why you always buy a bigger television than you intended, or why you think it's perfectly fine to spend a few dollars on a cup of coffee at Starbucks, or why people feel better after taking a 50-cent aspirin but continue to complain of a throbbing skull when they're told the pill they took just cost one penny, Ariely has the answer. "Predictably Irrational" deftly straddles the worlds of economics and psychology. Ariely is an experienced straddler himself. Born and raised in Israel, he now lives in the United States. He has Ph.D.s in both economics and business. He holds a joint appointment at the Massachusetts Institute of Technology's Sloan School of Management and at its Media Laboratory. He spoke with NEWSWEEK's Daniel Gross at Davos in January, and on the phone last week. Excerpts:

NEWSWEEK: What do you mean when you say people are predictably irrational?
Dan Ariely: I mean that we have built-in ways of looking at the world and processing information that causes us to make the same mistakes over and over again. The mistakes we make in the market aren't random, but they have a systemic element that is predictable and repeatable.

Doesn't this fly in the face of the bedrock assumption behind economics, namely that people are rational actors who respond in predictable ways to incentives?
It does. And the work of behavioral economics has chipped away at the consensus, but not enough. If you think about economics, it's not just a topic of study. It's the main influence on law, policy and for business decisions. While at the individual level, we can recognize irrationality. When it comes to making big decisions, the intensity of the irrationality has not yet been recognized. Whether it's No Child Left Behind, or tax rebates, or business decisions or retirement planning—the only input is economics. I think we understand a little bit more that there are some irrationalities feeding into these decisions, but we haven't integrated it into the product design. Economics has the audacity to pretend it is exclusive of everything. And that's the frustrating part. People in the U.S. aren't saving enough and don't take care of their health. And yet we have this idea that people are behaving rationally.

You start your book off with an example of an offer for a subscription from The Economist that advertised an online subscription for $59, a print subscription for $125 and a print and Web subscription for $125. What's so telling about this?
Obviously, the $125 for the print and the Web subscription emerges as the best choice. But that's only because of what it's arrayed next to. The big idea there is that we don't know how much exactly we want to pay for different things, and context helps us figure it out. Our decisions are made on these relative local contexts that are available at the moment we make the decision. We go around feeling that we make decisions based on our preferences, but there's another big force there--the things that are next to those options. I think salaries are a good way to think about it. How much of your happiness with your salary is based on the absolute amount of money you earn, and how much is based on the amount you earn compared with how much you made last year, or compared to others in your profession? The moment you reflect on it, you realize it has less to do with the raw amount, and more to do with what you made last year and what other people around you are making.