“Hand waving is required because there is nothing in the workings of markets that turns otherwise normal human beings into “Econs” (Highly intelligent beings that are capable of making the most complex of calculations but are totally lacking in emotions.). For example, if you choose the wrong career, select the wrong mortgage or fail to save for retirement, markets do not correct those failings…
…In fact, quite the opposite often happens. It is much easier to make money by catering to consumers’ biases than by trying to correct them.”, Richard H. Thaler, “Unless You Are Spock, Irrelevant Things Matter in Economic Behavior”, The New York Times
“Pre 2008 financial crisis, my entire career was focused on the easy path of catering to consumers’ (investors, and well-intended governments’) biases. My prospective home buyer application is going to try to correct them. I am even toying with the idea of calling the application “Don’t BUY and Borrow” or something like that, as the seller/home builder, Realtor, mortgage lender, and home appraiser all don’t get paid unless you BUY and Borrow!!!!”, Mike Perry, former Chairman and CEO, IndyMac Bank
Unless You Are Spock, Irrelevant Things Matter in Economic Behavior
By RICHARD H. THALER
Early in my teaching career I managed to get most of the students in my class mad at me. A midterm exam caused the problem.
I wanted the exam to sort out the stars, the average Joes and the duds, so it had to be hard and have a wide dispersion of scores. I succeeded in writing such an exam, but when the students got their results they were in an uproar. Their principal complaint was that the average score was only 72 points out of 100.
What was odd about this reaction was that I had already explained that the average numerical score on the exam had absolutely no effect on the distribution of letter grades. We employed a curve in which the average grade was a B+, and only a tiny number of students received grades below a C. I told the class this, but it had no effect on the students’ mood. They still hated my exam, and they were none too happy with me either. As a young professor worried about keeping my job, I wasn’t sure what to do.
Finally, an idea occurred to me. On the next exam, I raised the points available for a perfect score to 137. This exam turned out to be harder than the first. Students got only 70 percent of the answers right but the average numerical score was 96 points. The students were delighted!
Credit Emily Cross
I chose 137 as a maximum score for two reasons. First, it produced an average well into the 90s, and some students scored above 100, generating a reaction approaching ecstasy. Second, because dividing by 137 is not easy to do in your head, I figured that most students wouldn’t convert their scores into percentages.
Striving for full disclosure, in subsequent years I included this statement in my course syllabus: “Exams will have a total of 137 points rather than the usual 100. This scoring system has no effect on the grade you get in the course, but it seems to make you happier.” And, indeed, after I made that change, I never got a complaint that my exams were too hard.
In the eyes of an economist, my students were “misbehaving.” By that I mean that their behavior was inconsistent with the idealized model at the heart of much of economics. Rationally, no one should be happier about a score of 96 out of 137 (70 percent) than 72 out of 100, but my students were. And by realizing this, I was able to set the kind of exam I wanted but still keep the students from grumbling.
This illustrates an important problem with traditional economic theory. Economists discount any factors that would not influence the thinking of a rational person. These things are supposedly irrelevant. But unfortunately for the theory, many supposedly irrelevant factors do matter.
Economists create this problem with their insistence on studying mythical creatures often known as Homo economicus. I prefer to call them “Econs”— highly intelligent beings that are capable of making the most complex of calculations but are totally lacking in emotions. Think of Mr. Spock in “Star Trek.” In a world of Econs, many things would in fact be irrelevant.
No Econ would buy a larger portion of whatever will be served for dinner on Tuesday because he happens to be hungry when shopping on Sunday. Your hunger on Sunday should be irrelevant in choosing the size of your meal for Tuesday. An Econ would not finish that huge meal on Tuesday, even though he is no longer hungry, just because he had paid for it. To an Econ, the price paid for an item in the past is not relevant in making the decision about how much of it to eat now.
An Econ would not expect a gift on the day of the year in which she happened to get married, or be born. What difference do these arbitrary dates make? In fact, Econs would be perplexed by the idea of gifts. An Econ would know that cash is the best possible gift; it allows the recipient to buy whatever is optimal. But unless you are married to an economist, I don’t advise giving cash on your next anniversary. Come to think of it, even if your spouse is an economist, this is not a great idea.
Of course, most economists know that the people with whom they interact do not resemble Econs. In fact, in private moments, economists are often happy to admit that most of the people they know are clueless about economic matters. But for decades, this realization did not affect the way most economists did their work. They had a justification: markets. To defenders of economics orthodoxy, markets are thought to have magic powers.
There is a version of this magic market argument that I call the invisible hand wave. It goes something like this. “Yes, it is true that my spouse and my students and members of Congress don’t understand anything about economics, but when they have to interact with markets. …” It is at this point that the hand waving comes in. Words and phrases such as high stakes, learning and arbitrage are thrown around to suggest some of the ways that markets can do their magic, but it is my claim that no one has ever finished making the argument with both hands remaining still.
Hand waving is required because there is nothing in the workings of markets that turns otherwise normal human beings into Econs. For example, if you choose the wrong career, select the wrong mortgage or fail to save for retirement, markets do not correct those failings. In fact, quite the opposite often happens. It is much easier to make money by catering to consumers’ biases than by trying to correct them.
Perhaps because of undue acceptance of invisible-hand-wave arguments, economists have been ignoring supposedly irrelevant factors, comforted by the knowledge that in markets these factors just wouldn’t matter. Alas, both the field of economics and society are much worse for it. Supposedly irrelevant factors, or SIFs, matter a lot, and if we economists recognize their importance, we can do our jobs better. Behavioral economics is, to a large extent, standard economics that has been modified to incorporate SIFs.
SIFs matter in more important domains than keeping students happy with test scores. Consider defined-contribution retirement plans like 401(k)’s. Econs would have no trouble figuring out how much to save for retirement and how to invest the money, but mere humans can find it quite tough. So knowledgeable employers have incorporated three SIFs in their plan design: they automatically enroll employees (who can opt out), they automatically increase the saving rate every year, and they offer a sensible default investment choice like a target date fund. These features significantly improve the outcomes of plan participants, but to economists they are SIFs because Econs would just figure out the right thing to do without them.
These retirement plans also have a supposedly relevant factor: Contributions and capital appreciation are tax-sheltered until retirement. This tax break was created to induce people to save more. But guess what: A recent study using Danish data has compared the relative effectiveness of the SIFs and a similar tax subsidy offered in Denmark. The authors attribute only 1 percent of the saving done in the Danish plans to the tax breaks. The other 99 percent comes from the automatic features.
They conclude: “In sum, the findings of our study call into question whether tax subsidies are the most effective policy to increase retirement savings. Automatic enrollment or default policies that nudge individuals to save more could have larger impacts on national saving at lower social cost.” Irrelevant indeed!
Notice that the irrelevant design features that do all the work are essentially free, whereas a tax break is quite expensive. The Joint Economic Committee estimates that the United States tax break will cost the government $62 billion in 2015, a number that is predicted to grow rapidly. Furthermore, most of these tax benefits accrue to affluent taxpayers.
Here is another example. In the early years of the Obama administration, Congress passed a law giving taxpayers a temporary tax cut and the administration had to decide how to carry it out. Should taxpayers be given a lump sum check, or should the extra money be spread out over the year via regular paychecks?
In a world of Econs this choice would be irrelevant. A $1,200 lump sum would have the same effect on consumption as monthly paychecks that are $100 larger. But while most middle-class taxpayers spend almost their entire paycheck every month, if given a lump sum they are more likely to save some of it or pay off debts. Since the tax cut was intended to stimulate spending, I believe the administration made a wise choice in choosing to spread it out.
The field of behavioral economics has been around for more than three decades, but the application of its findings to societal problems has only recently been catching on. Fortunately, economists open to new ways of thinking are finding novel ways to use supposedly irrelevant factors to make the world a better place.
RICHARD H. THALER is a professor of economics and behavioral science at the Booth School of Business at the University of Chicago. He is the author of “Misbehaving: The Making of Behavioral Economics,” from which this article is adapted, and which will be published this month by W.W. Norton.
A version of this article appears in print on May 10, 2015, on page BU1 of the New York edition with the headline: The Importance of Irrelevance .