MARKET FAILURE AS PEOPLE FAILURE

(h/t Paul Kedrosky)

Elizabeth Kolbert in the New Yorker reviews two books about behavioral finance, which is the study of how we are not rational economic actors as the Free Market Fairy assumes. The first book is “Predictably Irrational: The Hidden Forces That Shape Our Decisions” (Harper; $25.95), byt Dan Ariely, a professor at M.I.T. He has an interesting little study on the irrationality of prices:

In one example, Ariely and a colleague asked students at M.I.T.’s Sloan School of Management to write the last two digits of their Social Security number at the top of a piece of paper. They then told the students to record, on the same paper, whether they would be willing to pay that many dollars for a fancy bottle of wine, a not-so-fancy bottle of wine, a book, or a box of chocolates. Finally, the students were told to write down the maximum figure they would be willing to spend for each item. Once they had finished, Ariely asked them whether they thought that their Social Security numbers had had any influence on their bids. The students dismissed this idea, but when Ariely tabulated the results he found that they were kidding themselves. The students whose Social Security number ended with the lowest figures—00 to 19—were the lowest bidders. For all the items combined, they were willing to offer, on average, sixty-seven dollars. The students in the second-lowest group—20 to 39—were somewhat more free-spending, offering, on average, a hundred and two dollars. The pattern continued up to the highest group—80 to 99—whose members were willing to spend an average of a hundred and ninety-eight dollars, or three times as much as those in the lowest group, for the same items.

This effect is called “anchoring,” and, as Ariely points out, it punches a pretty big hole in microeconomics. When you walk into Starbucks, the prices on the board are supposed to have been determined by the supply of, say, Double Chocolaty Frappuccinos, on the one hand, and the demand for them, on the other. But what if the numbers on the board are influencing your sense of what a Double Chocolaty Frappuccino is worth? In that case, price is not being determined by the interplay of supply and demand; price is, in a sense, determining itself.

The second book is “Nudge: Improving Decisions About Health, Wealth, and Happiness” (Yale; $25), by Richard H. Thaler and Cass R. Sunstein, and it offers practical advice for bypassing our irrationality:

They share with Ariely the belief that, faced with certain options, people will consistently make the wrong choice.Therefore, they argue, people should be offered options that work with, rather than against, their unreasoning tendencies. These foolish-proof choices they label “nudges.”