by Tyler Cowen
on February 27, 2006 at 2:35 pm
This article is a good introduction. Beneath the fold you will find an excerpt with an interesting example of the power of photographs…
I would say that the article rather overstates the role that Harvard has
played in the development of behavioral economics, and the claim that
Harvard has the greatest concentration of behavioral economists, even
among the top five schools or so, is overdone. Berkeley for one probably
beats Harvard, and lower down there are quite a few places that beat it,
including George Mason. While Laibson and Bohnet and Glaeser are
important, and Mullanaithan is a new and rising star, the idea Shleifer
and Summers played some big role in all this is ridiculous.
Shleifer has had a very significant impact on behavioral finance (cf. survivial of noise traders, limits to arbitrage). So it is not as ridiculous as you think, at least as far as Shleifer is concerned.
I say these folks need to ask any online marketing on behavior marketing and multivariate testing. Being in the field, there are countless examples of how changes in the layout, color and photo (superfical things) can have a dramatic impact on getting a person to sign up for a service or buying a product.
Here’s one company that does this:
There are countless others.
I am not disputing that Shleifer has written good and useful and
important papers on finance. What I am disputing is that they were
or are key papers in the development of behavioral finance. Yes,
the noise trader paper and the one on the limits to arbitrage are
not fully EMH ratex papers, but I would view them as more on the
periphery of behavioral finance and far from being the centerpieces
of its development. Obviously this is a matter of judgment.
Capital One Financial has made $billions using the same techniques as described in the example.
The article gave an example from Laibson on exercising that doesn’t add up. Here it is:
“Consider a project like starting an exercise program, which entails, say, an immediate cost of six units of value, but will produce a delayed benefit of eight units. That’s a net gain of two units, “but it ignores the human tendency to devalue the future,† Laibson says. If future events have perhaps half the value of present ones, then the eight units become only four, and starting an exercise program today means a net loss of two units (six minus four). So we don’t want to start exercising today. On the other hand, starting tomorrow devalues both the cost and the benefit by half (to three and four units, respectively), resulting in a net gain of one unit from exercising. Hence, everyone is enthusiastic about going to the gym tomorrow.”
This is wrong. Starting an exercise program tomorrow incurs a benefit today of only 2, not 4 (because the agent would discount twice). So today the agent would choose not to start exercising tomorrow. In technical terms, Laibson is saying here that discounting in this way is not dynamically consistent. This is not true. Perhaps Laibson was just trying to explain hyperbolic discounting (which is not dynamically consistent) simply (but incorrectly) so as not to confuse the average reader of Harvard Magazine (who should be able to understand the concept).
I am not arguing against hyperbolic discounting (I think it is quite intriguing). And I know Laibson understands the concept very well. However, if you were to have described hyperbolic discounting this way on a test in Laibson’s class, I’m sure you would have gotten it wrong.
Another note: politically, this behavioural economics is a bit unpleasant. A lot of old economists have defended the rationality-hypothesis as a noble lie, as well as a simplification device, and as a bold conjecture. It’s a noble lie because our politics & culture is based on the sovereignty of the individual: that your preference is your preference, and it won’t be second-guessed.
The behavioural economists are scoring easy points, by attacking the problems which other economists had had a gentleman’s agreement not to attack.
They don’t give much information about the profiles of the recipients of the loan offers. As an American ex-pat in Johannesburg, I’m pretty confident that a lot of the bank customers weren’t even clear on what the interest rate meant.
South Africans are also unusually accepting of high-interest variability and paying high-percentages of income for matters like this. It’s not atypical for a South African to spend 30-40% of monthly income on a car payment. And they follow this pattern even as income increases, which is why every 5th car on the road is a BMW, and there’s a car dealership every 5 km or so.
People in Sales have known that framing changes purchasing tendecies for hundreds of years. Every insurance salesman knows that you sell larger policies when you state the premium in per month dollars as opposed to annual cost. Likewise, telling people that they can feed a child for “pennies a day” generates much more contributions then asking people for a few hundred dollars a year.
Most people are too stupid to know how to maximize their economic situation.
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