Why We're '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.

In one of your studies, you asked college students two times to answer a series of questions relating to their interest in certain sexual activities—first while imagining they were sexually aroused, and then again when they were actually sexually aroused. You had them answer questions like: would you always use a condom if you didn't know the sexual history of your partner? What was the point there?
The broader takeaway was to determine to what extent we become different people under emotional states. And when they were aroused, students were more likely to give different answers. If we were like Jekyll and Hyde and understood that when we're aroused, we behave differently, we would know how to deal with the consequences. But people don't estimate correctly the extent to which they will change. I think of it as intra-empathy gaps. Empathy is how much I understand you. Intra-empathy is how much we understand ourselves. The results show very clearly that we don't understand ourselves very well. By the way, there are some interesting mistakes we make based on this. Nobody will say they want an unwanted pregnancy, or to get a sexually transmitted disease. But when the moment comes, their behavior changes.

In another study, you told students you'd auction off sets for a reading of Walt Whiman's "Leaves of Grass." Before you asked them to bid, you asked half the students if, hypothetically, they'd be willing to pay $10 to hear a 10-minute recitation, and the other half to write down if, hypothetically, they'd be willing to listen to you recite poetry for $10? Why?
This was about measuring the effect of the initial decision on later decisions. The basic idea is that if we make a particular decision, if we remember we made it, it can influence our next decision, and the next one. So I asked people to engage in a hypothetical thought process, and then wanted to see if doing so would change their behavior when they had to bid. And it did. The ones whom I had asked if they'd be willing to pay were willing to pay about $3 to hear me recite poetry. The others said I'd have to pay them $4.80 to make them listen to me. Nobody knew if it was good or bad to listen to me, but once the first decision was made for them, it influenced the next decision. It's like the scene in "Tom Sawyer" where he gets the kids to help him paint the fence.

Can we school ourselves to recognize when we're being irrational?
I think we can sometimes. It's hard. We can also learn to bypass. Lets say you know that every time you go to the supermarket hungry, you buy too much food. You can bypass that by deciding never to go to the supermarket when you're hungry. The challenge for government is to provide tools that will help us behave better, to help us bypass the irrationality we all succumb to.