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Behavioral economics and the irrational mind

Stop-and-go traffic on the 405? Skyrocketing housing prices? Blame it on the illogical and inefficient thinking of humans, two Nobel winners say.

October 14, 2002|Mary McNamara | Times Staff Writer

The next time you're stuck in traffic, consider this: If Caltrans had been paying any sort of attention to the work of recent Nobel Prize winners Vernon L. Smith and Daniel Kahneman, you might be home by now.

While the Nobels awarded in other areas -- literature, medicine, occasionally peace -- often resonate at some level with the average person -- most of us can read, after all, and take medicine, and peace, well, who doesn't want a little peace? -- the economics category can leave one cold. So often the work done in that field bears little resemblance to our challenges of maxed-out credit cards.

But when reports of this year's winners stressed the cross-pollination of economics and psychology, there seemed a chance that this was something the layperson would be able to understand. After all, the award -- shared by Smith, a professor of economics and law at George Mason University in Virginia, and Kahneman, a professor of psychology and public affairs at Princeton University -- highlights the emerging field of "behavioral economics," a term that sounds more Dr. Phil than John Maynard Keynes.

Smith and Kahneman were a bit too busy to bother with questions that might be found in "The Idiot's Guide to Award-Winning Economic Theory," but Ross M. Miller, author of "Paving Wall Street: Experimental Economics & the Quest for the Perfect Market," most patiently obliged.

And so he broke it down to freeways. According to Miller, the formulas that California officials use when deciding when, where and how to build a freeway are based on traditional cost-benefit models. A major assumption of these models is that humans think, and act, logically, like computers. "But the way people choose the path they take to work is not rational," says Miller. "People get in habits; they have misperceptions; they do not always choose the most efficient route."

This is one of the main findings of Kahneman's work -- that people do not always act in the most logical or efficient manner. One of his studies found that while folks will go out of their way to save five bucks on a $15 calculator, they won't to save the same five-spot on a $125 jacket. Perception -- the greater the percentage of saving, the greater the actual savings -- blurs the facts.

Smith, on the other hand, has concentrated on how people behave in groups, in the marketplace. Much of his work has concentrated on re-creating and explaining bubbles and crashes. In a perfect market, says Miller, who also runs a risk-management company in upstate New York, "a depressed value should be bid up to appropriate value and stop there. But it often doesn't stop there. Momentum itself distracts people from the real value of what is being sold." And prices, like those of California's housing market, skyrocket.

"People get carried away," he says. "They forget that 'This isn't worth this and, at that price, I don't need it anyway.' Conversely, when a crash begins, it sometimes doesn't stop at a reasonable level but goes on and on. It's almost magical, why and when it stops."

Kind of like traffic on the 405.

So, can our flawed freeways and ever-increasing commute times be blamed on obsolete economic theory?

"Probably," Miller says. "I have no doubt that if the ultimate rulers of how freeways were built were run by Smith and Kahneman, things would look a lot different. For one thing," he adds with a laugh, "it is economically inefficient to have a 'free' freeway when there is so much congestion. But then I live in the East now, the land of the toll road and the EZ pass."

Although he is happy to have explained economics in terms of transportation, Miller refuses to take the analogy any further. Because the work of the prizewinners is not really about freeways or even consumerism. It's about markets, and talking about Smith and Kahneman in terms of "how will it affect me?" is a little like asking Bill Gates to come fix your hard drive.

Kahneman has focused on what motivates an individual to buy or sell at a certain price. For centuries, economists have assumed people made economic decisions based on rational information -- was the price good? was it worth the effort? Kahneman discovered that this assumption is just wrong -- people's buying and selling behavior may be predictable, but only if their odd habits, weird motivations and misperceptions are taken into account.

All this might seem like the first Nobel Prize in Traveling Salesmanship. But to boil it down to that would be a mistake, says Miller. This is less about the pricing of merchandise and more about keeping the lights on and the water coming out of the taps.

For decades, Smith has constructed controlled experiments to figure out why and when and for how much people and governments and companies buy things -- pork bellies and electricity, houses and gold. Smith believes the glitches that lead to bubbles and crashes in the systems we all rely on can be explained, often foreseen and possibly avoided.

"Vern is very big-picture," says Miller.

Economists should test new markets, or new rules and mechanisms, Smith believes, before unleashing them on the public. Had California properly tested its power market, says Miller, the blackouts might have been prevented.

And that is something almost anyone can understand.

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