Can behavioural economics help markets to work better?

By Winton Bates, on March 31st, 2011

In his book, ‘The Upside of Irrationality’, Dan Ariely claims to have identified a market failure in the online introductions market. He refers to a survey indicating that people participating in that market spent on average 5.2 hours per week searching profiles and 6.7 hours per week emailing potential partners for a payoff of 1.8 hours actually meeting them.
The Upside of Irrationality: The Unexpected Benefits of Defying Logic at Work and at Home
He comments:
‘Talk about market failures. A ratio of 6:1 speaks for itself. Imagine driving six hours in order to spend one hour at the beach with a friend (or even worse, with someone you don’t know and are not sure you will like)’.

When I read that my first thought was that it would not be particularly uncommon in Australia for young people to drive three hours to spend an hour with a friend and then drive for another three hours back to where they came from.

I think the term market failure is thrown around too loosely. The situation described clearly involves high transactions costs, but that doesn’t mean the market has failed. The existence of high transactions costs in a market should not be viewed as a symptom of market failure unless we can point to some reason why the market cannot function efficiently.

In this instance the market seems to be working well because evidence relating to the existence of high transactions costs has induced some enterprising people to consider what innovations might be introduced to reduce those transactions costs. The fact that the innovators were a university professor and his associates suggests to me that university staff may be becoming more entrepreneurial.

I think Dan Ariely has done a good job of demonstrating the potential for behavioural economics to help entrepreneurs to design innovations that may reduce transactions costs. He considers survey and experimental evidence which suggests that the high transactions costs associated with online introductions stem from the attempt to reduce humans to a set of searchable attributes. The problem is that the searchable attributes convey little information about what it might be like to spend some time with particular individuals.

Ariely and his associates developed a virtual online dating site that enabled participants to engage anonymously in instant message conversation about various images e.g. movie clips and abstract art. They found that participants were about twice as likely to be interested in a real date after meeting in person following the virtual date than following a conventional online introduction. It seems that when we experience something with another person we gain much more information about compatibility than when we just look at searchable attributes. He has discussed his research here.

It is too soon to know whether Dan Ariely and his associates have prompted a market innovation that will help large numbers of people to live happier lives. However, I think Ariely has demonstrated that behavioural economics may be able to help markets work better. As he points out, there is potential for firms to do a better job of satisfying consumer demand by conveying to consumers what it might actually be like to have the experience of using their products. I think that means, among other things, that if retail stores didn’t exist already they would probably need to be invented to give consumers the opportunity to experience goods before they buy them.

Coming back to market failure, does the fact that some consumers buy goods cheaply online after visiting a retail outlet constitute a market failure? I don’t think so, even though such behaviour is evidence of positive spillovers associated with retailing. Manufacturers will work out before long that retailers provide them with a useful service by enabling consumers to experience their products in real life and think up some way to encourage ongoing provision of that service.



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Secrets of the Moneylab

By Claus Vistesen, on September 10th, 2010

Kay-Yut Chen and Marina Krakovsky have earned their colours as behavioural economists at Hewlett Packard in the HP Labs and in in their new book Secrets of the Moneylab they present the gist of their research over the past 20 years. The book is a run-through of the most salient aspects of behavioural economics and its applications and since behavioural economics is all about designing (clever) experiments, the book oftentimes presents itself as an experimental handbook of their main results. As such, this is not an academic book but more so a how-to guide for business practitioners on how to implement lessons (and even experiments) of behavioural economics in a business context. Yet, the book never descends to the lower levels of the 10 Steps to Business Success type of books and always steers clear of making pretentious profit promises for the eager business man. This is a welcome plus and means that the stories are presented in a credible way.

The book covers a number of classic results in behavioural economics and especially the chapter on fairness reveal some well known, but often forgotten, truths about human nature. For example; the tendency to punish others so that they don’t get the better deal even though refraining from it would give you the best of two possible outcomes is a result that defies conventional economic logic. The experiment is detailed in Solnick and Hemenway (1998) and involves participants from the Harvard School of Public Health who are asked whether they would prefer one of two options:

1. You earn $ 50.000 and the other earns $ 100.000

2. You earn $ 100.000 and the other earns $ 250.000

Even under the condition of identical price levels in both contexts half the participants chose option 1 which is a result traditional neo-classical economics using homo economicus as the representative agent would have difficulties explaining. Another interesting passage concerns the collective intelligence and how tapping into it can lead to superior forecasts of market performance, demand figures, sales etc. Personally, I believe this is very important and while the collective intelligence is always noisy and contains a lot of dead ends, understanding how to harness it is becoming a key parameter for business success today.

However, all this has a catch.

Experimental economics and the study of human behavior is all well and good, but my feeling is that we still have too small an overall sample size to really be confident of its conclusions. The work of Chen and Krakovsky is of course a step in the right direction here, but does it matter whether you run the experiment above in Denmark or the US, is there a difference across time or age groups of the participants etc. These questions essentially address the robustness of the results and while some of the experiments have indeed been tested in many contexts, the replication of results is something I think is important as we move on from here.

Is it a Buy Then?

Behavioural economics is ultimately about what people do under a given set of controlled circumstances rather than what they should do given an idealized pre-determined model and I think economists would be wise to take this lesson to heart. The economic profession should take due note not only of the actual results, but also the implied shift in methodology which is a consequence of working with behavioural economics.

The nobel prize winning economist George A. Akerlof finishes his preface of the book stating that Secrets of the Moneylab is economics at its best. This is a tall order, but after having read it I am inclined to agree with him. Behavioural economics maps an important alternative way to do economics and Secrets of the Moneylab is a fine representation of this tradition.

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Full Disclosure: If this reads as a plug, it is because it is a plug. However, please note that regardless of whether the book does well, poorly or somewhere in between I have no financial stake in it. The book goes on sale in Europe in October.

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Behavioral Law & Economics

By G.L.C., on July 17th, 2009

When the concept of law and economics came into existence, behavioral economics was a central point of contact. The Coase theorem is the foundation of law and economics. According to the theorem, the outcome is not affected by allocation of legal rights to one party or another if transaction costs are sufficiently low because when the transaction costs are low, the parties are expected to bargain to the efficient outcome under either legal regime.

The Coase theorem’s claim about the domain within which normative analysis of legal rules – whether one set of rules is preferable to another or the reverse – is actually relevant and central to law and economics.

Daniel Kahneman, Jack L. Knetsch, and Richard H. Thaler came out with a study using Cornell University mugs, and the results were direct contravention of the Coase theorem. They referred to this as the endowment effect – the refusal to give up an entitlement one holds initially even though one would not have been willing to pay to acquire that entitlement had one not held it initially. The endowment effect showed that Coase theorem’s prediction of equivalent outcomes, regardless of the initial entitlement, no longer holds. This plays an important role in drafting of legal rules.

Law and economics tries to assess the desirability of actual and proposed legal rules. For this purpose, the endowment effect is more suited than the Coase theorem. In the presence of endowment effect, the value attached to a legal entitlement varies based on the initial assignment of the entitlement.

Context plays an important role in the occurrence of endowment effect. Prior to the Cornell University mugs study, there were many studies which concluded that the Coase theorem was empirically robust in a set of domains. In all these studies, the value of each possible outcome was directly specified in dollar terms by the researchers. These studies found that if the transaction costs are sufficiently low and people are told specifically what each outcome is worth to them, they will generally find their way to a value-maximizing outcome. The Cornell University mugs study proved that if people are not told about the value of the outcome, the results of the earlier studies would be different.

The study of behavioral law and economics examines human limits to means-end rationality. The endowment effect plays an important role in behavioral law and economics. Other features of behavioral economics also pay an important role. Unbounded rationality, unbounded willpower, and unbounded self-interest are considered to be normal traits of humans. For studying behavioral law and economics, humans must be viewed as departing from traditional economic assumptions in three distinct manners: bounded rationality, bounded willpower, and bounded self-interest. The legal system can be influenced by the results of such studies. Using behavioral law and economics, courts can adjust legal reasoning and conclusions accordingly and legislators can design more effective laws.



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