The Rich Science of Economic Choice

Good Prospects

In 1979, APS Fellow Daniel Kahneman and Amos Tversky published findings from a series of experiments that would, 24 years later, lead to the Nobel Prize in Economics and open the door to the emerging, interdisciplinary field of behavioral economics. What made their work different from traditional economic theory was its basis in empirical observation. In a series of studies on human behavior, Kahneman and Tversky disproved the assumption that people are motivated primarily by material incentives and make decisions in a rational way. In one of their original experiments, Kahneman and Tversky asked subjects to choose between an 80 percent chance of winning $4,000 and a 20 percent chance of winning nothing versus a 100 percent chance of receiving $3,000. Even though the riskier choice would yield a larger reward ($3,200), 80 percent of the subjects chose the certain $3,000. Kahneman and Tversky then offered a choice between an 80 percent chance of losing $4,000 and a 20 percent chance of breaking even versus a 100 percent chance of losing $3,000. With only this slightly different perspective on the original scenario, 92 percent of the respondents chose the gamble, even though its potential loss of $3,200 was, once again, larger than the certain loss of $3,000. The suggestion that still reverberates throughout the economic world is that despite our desire to lock in a sure gain, we will take bold risks in the face of economic loss.

The science of economic choice seems to be at a critical juncture. It has long since shrugged off the confines of behaviorism, in favor of psychological realism. Now, studies are showing that, for better or worse, our feelings, motivations, social expectations, and loyalties also play a profound role in shaping our economic decisions. What’s more, our economic choices and predicaments — and even simply handling money — reshape emotional experience and self-identity in surprising ways.

Recently, interest in how behavioral factors color economic decisions has spilled over into the biological realm. A subfield of “neuroeconomics” has emerged (see “Mind Over Money”). A number of collaborations among psychologists, neuroscientists, and economists have sprung up, and although the field is still in its infancy, many researchers predict that probing how the brain navigates economic choices will yield valuable theoretical and practical insights.

Money is better than poverty, if only for financial reasons. — Woody Allen

From their beginnings, psychology and economics have shared a fundamental interest in understanding how people think and feel and act and choose. But in the 1920s, the two disciplines parted ways. Economists embraced a “rational-choice” model of decision making, assuming that people coolly and selfishly calculate financial decisions to maximize their monetary gain. Psychological principles were almost completely expunged from economic thought.

The rational-choice model was not seriously challenged for more than half a century. In 1979, APS William James Fellow Daniel Kahneman, Princeton University, and the late Amos Tversky published a theoretical framework — prospect theory — that used cognitive psychological principles to understand why people so often make irrational choices, particularly when they are on uncertain terrain.

The article, published in the technical journal Econometrica, was enormously influential, in part because it was published in an economics journal and spoke the mathematical language that economists favor. In 2002, six years after Tversky’s death, Kahneman was awarded the Nobel Prize in economics for the team’s work on decision making under uncertainty. Followed shortly by the pioneering work of economists Richard Thaler, University of Chicago; APS Fellow George Loewenstein, Carnegie Mellon University; and Colin Camerer, California Institute of Technology, prospect theory planted the seeds for a reunion of economics and psychology. Soon, the fledgling field of behavioral economics exploded.

“In 1980, it was virtually impossible to publish a good, psychologically informed paper in a good economics journal,” Loewenstein recalled. Today, he said, although many traditionalists continue to reject applications of psychology to economics, behavioral economists regularly win prestigious prizes in economics and get the best jobs in economics departments.

The number of collaborations between psychologists and economists has grown rapidly in the past several years, as has the number of scientific conferences, journal articles, and seminar series focused on the intersection of the two disciplines. And a few years ago, Carnegie Mellon University established the first undergraduate “decision science” major, which requires students to learn fundamental concepts in both disciplines.

The reunification benefits both disciplines. For economists, psychology offers realism: a textured appreciation for the limits of human reason and the cognitive and emotional processes that govern behavior. For psychologists, economics offers problems with real-world consequences, precise mathematical models that make clear-cut predictions, and access to massive datasets. In short, said APS Fellow David Dunning, Cornell University, “Economics has research paradigms that are a joy to explore.”

It also has not escaped psychologists’ notice that it is economists who have the public ear.

“Economics has cornered the market on policy,” said Jennifer Lerner, Carnegie Mellon University. “We don’t have a psychological advisor to the president, but we have an entire board of economic advisors. If we think the country is not being run right in terms of maximizing human welfare, this is an opportunity to come to the policy table.”

Anger makes dull men witty, but it keeps them poor. — Queen Elizabeth I

During the 1980s and ’90s, most psychological treatments of economic decisions focused on heuristics, memory biases, and other cognitive limits to rational choice. Working from this narrow cognitive focus, researchers gave little attention to the role of emotions in economic decisions. But more recently, paralleling a renaissance of interest in emotions in psychology and neuroscience, decision researchers have begun to probe how emotions are woven into economic behavior.

“The implicit view of emotions and decision making was that the arousal of intense emotional states really derails higher level cognitive functioning,” said Leaf Van Boven, University of Colorado.

More recent analyses, he said, reveal a more complicated picture, showing that emotions can also provide important reward cues. Increasingly, some researchers are moving beyond simply cataloging instances when emotions affect decisions, casting emotions as either hero or villain in the decision-making drama, or describing emotional effects in terms of global mood states. Many say a more nuanced approach is needed to uncover how, why, and under what circumstances different emotions shape decisions.

One hallmark feature of economic choice is what is known as the endowment effect — people’s inclination to inflate the value of items that they already own. This seemingly irrational tendency is one of the most robust departures from what rational-choice models would predict. Yet a study published in Psychological Science in 2004 showed that lingering emotions — unrelated to the economic choice at hand — can wipe out or reverse the endowment effect.

In the study, Lerner, Loewenstein, and graduate student Deborah Small, now at the Wharton School, University of Pennsylvania, compared the buying and selling decisions of people who had either been given a set of highlighter pens or were given an opportunity to buy the pens. They found that when experimentally prompted to feel disgusted, both sellers and buyers valued the pens less than did those in a neutral group.

Why? Lerner’s group hypothesizes that disgust triggers an urge to purge — little inclination to acquire more stuff. If that means selling your own stuff at a loss, so be it. Sadness appears to act differently, perhaps because it makes people want to change their situation, whatever it takes. In Lerner’s study, sad sellers were willing to offload the pens dirt cheap, and sad buyers were willing to pay inflated prices to get the pens.

The findings are notable, Lerner said, both because they show that passing emotions can subvert a powerful decision-making tendency and because they indicate that different emotions — even though both are negative — had different effects on behavior.

Anger appears to exert yet a different effect, as graduate student Roxana Gonzalez, working with Lerner and two other Carnegie Mellon researchers, has found. Their results indicate that anger makes people earn less money in negotiations and make more errors in perceiving both their own and the other party’s interests. Yet angry people emerge from these miserable encounters more satisfied than people who are not angry.

So what’s going on? Lerner and Gonzalez believe that anger numbs people to risk and triggers a calming sense of individual control and certainty. Fear, she predicts, has an opposite effect. She said new physiological data, not yet published, support that notion.

Another way that emotions can skew decisions is by making people insensitive to differences in the magnitude of numbers, observed Christopher Hsee, University of Chicago. That’s the process, he argued, that leads to people’s exaggerated precautions against very low-probability risks, such as the risk of dying from the SARS virus. In a 2004 study, Hsee and colleague Yuval Rottenstreich, now at Duke University, demonstrated that when people rely on feelings to guide their behavior, they are sensitive only to the presence or absence of an event, rather than to variations in scope. For example, when people let their feelings do the talking, they view five CDs as being equal in value to 10 CDs. Or, as another experiment showed, they pledge the same amount of money to rescue four endangered pandas as to rescue just one. The reason, Hsee argued, is that “emotion is qualitative, not quantitative. When emotions are aroused, it’s easy to identify ourselves with individual people, and when we do so, we become insensitive to the numbers.” In other words, it does not matter how many pandas need saving — what’s salient and important is that there are pandas.

For all its power in the moment, intense emotion can recede quickly from memory. Recently, Van Boven and colleagues have found that people tend to judge current emotional experiences as more intense than previous ones. Van Boven suggests that this “intensity bias” stems, in part, from the fact that we simply have more information — such as access to the facts concerning the new crisis; or a thumping heart and tears running down the face — about current emotions than we do about earlier emotions.

This intensity bias, Van Boven believes, helps explain why we so quickly drop our humanitarian support for the victims of one disaster, only to be caught up in the next.

And there is another way in which numbers can overwhelm: Research shows that one reaction to having too many options — in consumer purchases or retirement savings plans, for instance — is to just walk away from the decision.

While foregoing a minor purchase might not matter much, Sheena Iyengar, Columbia University, has found a more disturbing trend: The more retirement savings plan options people have, the more likely they are to choose nothing at all. In related work, economists Thaler and David Laibson, Harvard University, have shown that it is possible to manipulate people’s savings habits simply by manipulating companies’ default retirement savings plan.

Whenever people say, ‘We mustn’t be sentimental,’ you can take it they are about to do something cruel. And if they add, ‘We must be realistic,’ they mean they are going to make money out of it. — Brigid Antonia Brophy

Of course, economic decisions are not made in a social vacuum. In negotiating a pay raise, bargaining over the price of a used car, or trading stocks, our ability to understand other people’s goals and emotional states is critical to calibrating our own behavior.

But this is a hard skill to master, especially when the two parties in a negotiation are on different emotional planes. In a series of studies, Van Boven, Dunning, and Loewenstein examined participants’ intuitive understanding of the endowment effect. On the principle that ownership is in itself an emotional state — one of attachment — they gave some participants a commodity, such as a coffee mug, and observed selling and buying prices.

The researchers have found that in this “hot” emotional state, sellers projected their own feelings about the mug onto buyers, and thus could not understand buyers’ lowball offers. Likewise, buyers, being in a “cold” state, failed to understand the impact of sellers’ “greedy” asking prices. The result was a standoff: Selling prices exceeded buying prices by more than three to one.

This “hot-cold empathy gap” is fundamentally egocentric, said Van Boven. “What everyone misses is that if they were in a different state, they too would act differently.” That emotion-driven egocentricity means that “we don’t steer clear of situations where we might lose control, because we don’t appreciate the power of affective states that we aren’t currently experiencing,” Loewenstein added. “When we’re in a hot state, it feels like we will want whatever we want at that moment forever.”

Another aspect of emotional perspective-taking involves trust. In a recent experiment, Dunning and Detlef Fetchenhauer, University of Cologne, gave research participants $5 to either keep or give to another participant. If they gave it away, the $5 became $20, and the other person could then decide to share it evenly or keep it all. The participants cynically — and incorrectly — predicted that few others would share the $20. Even so, most gave up the $5.

The research illustrates a puzzling aspect of economic discourse, Dunning said. “People trust each other and behave honorably. They aren’t as cynical or selfish as rational economic models would predict.” He speculates that in addition to wanting to preserve our reputations, people experience a sense of moral obligation — and a strong desire to maintain our self-image as moral people — that makes us both trust others and honor others’ trust.

It’s a kind of spiritual snobbery that makes people think they can be happy without money. — Albert Camus

As a culture, we claim an inalienable right to the pursuit of happiness. That would seem to indicate that we know intuitively that our emotional outcomes matter. Yet often we fail to maximize our own happiness, even when we have the opportunity to do so.

One reason, theorize Hsee and colleague Jiao Zhang, also at the University of Chicago, is that in making decisions, people take into consideration factors that do not really matter to their future happiness. In addition, Hsee said, “Even if people could make expert predictions, people do not always base their decisions on their predictions.”

Instead, Hsee maintained, we second-guess ourselves, wrongly choosing what we think should, logically, make us happy. In a recent study, Hsee asked people to predict whether they would prefer to eat a small, cheap, heart-shaped chocolate or a large, expensive, cockroach-shaped chocolate. No fools, his subjects predicted that they would be disgusted by the chocolate cockroach, yet that is what they decided to buy — after all, it is only rational to want to score the biggest, best chocolate.

Recently, researchers have begun to form a more comprehensive picture of how factors like expectations, reference points, and social comparisons influence our emotional reactions to gains and losses.

Economic models of utility predict that happiness is a direct function of monetary gain. Yet there are times when a gain can feel an awful lot like a loss — pity the soul who makes it onto “Who Wants to Be a Millionaire” only to come home with $100. Correspondingly, a loss can masquerade as a gain, if we narrowly escaped losing more, or if a friend came out even worse. Further, as APS Charter Member Barbara Mellers, University of California, Berkeley, and colleagues have recently shown, wins or losses that take us by surprise are emotionally amplified.

Some people think they are worth a lot of money just because they have it. — Fannie Hurst

Agonizing over financial decisions or evaluating gains and losses are not the only scenarios that trigger emotional effects. New research by Kathleen Vohs, University of British Columbia, indicates that simply handling money exerts a powerful effect on our emotions and motivations.

In a recent series of experiments, not yet published, Vohs found that people who were given a large quantity of Monopoly money to handle and count were less helpful to a hapless assistant and were less likely to ask for help in solving a difficult puzzle than were people who were given little or no money. In another experiment, participants who were exposed to a computer screensaver showing floating money were less inclined to work with others on a task than were those who saw fish floating across the screen.

Vohs thinks having money triggers a basic, motivational orientation. “Money changes people at a core, basic level,” she said. “Having money makes people feel less connected and more independent, whereas having little money makes you feel more interdependent with others.”

The value of a dollar is social, as it is created by society. — Ralph Waldo Emerson

We humans are, indeed, an interdependent bunch. Even when we think we are making decisions on our own, we are immersed in a sea of opinion and commentary. It is that social connectedness that has captured the imagination of Chip Heath, Stanford University. He argues that our economic choices and quandaries are, to a large degree, a product of the stories that propagate naturally around us.

Take the ill-fated dot-com boom, for example.

“It’s not that individuals got irrationally exuberant all by themselves,” Heath said. “We were telling ourselves lots of stories and inventing lots of frameworks on the fly, telling ourselves and each other that these businesses couldn’t fail. There was a shared set of stories and examples, like the story of Amazon, or Netscape, that made people feel silly for sitting out an investment in the stock market.”

What determines which ideas and stories thrive? Heath’s research has shown that people give differential weight to stories that pack an emotional punch — whether it be fear, disgust, or gleeful optimism. The same is true for urban legends, Heath has found, as well as in situations where money is at stake. For example, Heath and colleagues found that investment clubs relied more heavily on socially provided reasons for investing in particular companies than did individual investors or fund managers, who are more likely to be jaded by specious stories.

The same process, Heath observed, can just as easily lead to irrational pessimism.

For example, in a field study conducted in France, Heath, Stanford colleague Marwan Sinaceur, and Steve Cole, University of California, Los Angeles, examined beef consumption during the mad cow crisis. The study, published last month in Psychological Science, found that beef consumption dropped after newspaper articles referred to the disease using the emotionally evocative label “mad cow,” but not after articles that used a scientific term for the disease. A subsequent laboratory study confirmed that the “mad cow” label prompted choices based on emotional reactions, whereas a scientific label allowed people to consider their actual likelihood of getting the disease.

The findings, Heath said, bolster the notion that dynamic social forces play an important role in guiding economic decisions.

“When people start telling stories, the information that puts us into these critical emotional states keeps spreading further and faster.”

For decades, economists held fast to one such story of human decision making. With the help of psychologists, a more mature narrative has begun to take form — one rich with emotion and complex plot, one much closer to a beginning than an end.

References

  • Hsee, C.K., & Rottenstreich, Y. (2004). Music, Pandas, and Muggers: On the affective psychology of value. Journal of Experimental Psychology: General, 133, 23-30.
  • Lerner, J.S., Small, D.S., & Loewenstein, G. (2004). Heart Strings and Purse Strings. Psychological Science, 15(5), 337-341.
  • Sinaceur, M., Heath, C., & Cole, S. (2005). Emotional and Deliberative Reactions to a public crisis: Mad cow disease in France. Psychological Science, 16(3), 247-254.
  • Tetlock, P.E., & Mellers, B.A. (2002). The great rationality debate. Psychological Science, 13(1), 94-99.
  • Van Boven, L.V., Loewenstein, G., & Dunning, D. (2003). Mispredicting the endowment effect: Underestimation of owners’ selling prices by buyers’ agents. Journal of Economic Behavior and Organization, 51, 351-365.
  • Kahneman, D. & Tversky, A. (1979). Prospect Theory: An analysis of decision under risk. Econometrica, 47(2), 263-291.


Observer Vol.18, No.4 April, 2005

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