Edited by Erwann Michel-Kerjan

Edited by Paul Slovic

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Of the twenty most costly catastrophes since 1970, more than half have occurred since 2001. Is this an omen of what the 21st century will be? How might we behave in this new, uncertain and more dangerous environment? Will our actions be rational or irrational?

A select group of scholars, innovators, and Nobel Laureates was asked to address challenges to rational decision making both in our day-to-day life and in the face of catastrophic threats such as climate changes, natural disasters, technological hazards, and human malevolence. At the crossroads of decision sciences, behavioral and neuro-economics, psychology, management, insurance, and finance, their contributions aim to introduce readers to the latest thinking and discoveries.

The Irrational Economist challenges the conventional wisdom about how to make the right decisions in the new era we have entered. It reveals a profound revolution in thinking as understood by some of the greatest minds in our day, and underscores the growing role and impact of economists and other social scientists as they guide our most important personal and societal decisions.

ec·o·nom·ics (ĕk‘ə-nŏm’ĭks) - noun

1. a study of mankind in the ordinary business of life (Alfred Marshall, 1890)

2. the social science that analyzes human behavior as a relationship between the production, distribution, and consumption of goods and services.

NOTE TO THE READERS

There is a clear tendency to view our own thoughts, words, and actions as rational and to see those who disagree as irrational.

Introduction

An Idea Whose Time Has Come

ERWANN MICHEL-KERJAN AND PAUL SLOVIC

All the forces in the world are not so powerful as an idea
whose time has come.

—Victor Hugo

OUR DANGEROUS AND INTERDEPENDENT WORLD

At a time of immensely consequential choices, it has never been more important to make the right decisions. But how can we be sure we are not making fatal mistakes? How can we be sure we can trust the tools, models, and methods we use to make our decisions?

The Irrational Economist aims to shed light on some important developments in decision making that have occurred in economics and other social sciences over the past few decades, including some of the most recent discoveries. Quite surprisingly, much of the knowledge developed in these fields has yet to be translated from research into actionable decisions in the real world. Our goal in this book is simple: to provide this knowledge in a condensed fashion to help people make better decisions in a world that seems to become more and more uncertain—if not more dangerous—as time passes.

This last statement may seem controversial. Conventional wisdom holds that crises and catastrophes are not new and that the world has seen many great dangers before. The twentieth century alone witnessed one of the deadliest five-year periods in human history: Between 1914 and 1918, World War I killed over 15 million people. And as the war ended, the 1918-1919 influenza pandemic (commonly referred to as the Spanish flu) spread to nearly every part of the world. The flu killed over 50 million, more than the toll of the Black Death in the fourteenth century. Wars and natural disasters have indeed devastated many parts of the world throughout history. Since the industrial revolution, new types of technological risks and deadly weapons have also emerged.

But one of the hallmarks of the twenty-first century will likely be more and more unthinkable events, previously unseen contexts, and pressure to react extremely quickly, even when we cannot predict the cascading impact our actions might have.

That is because the world has been evolving at an accelerating speed. Physical frontiers between economies are disappearing, as described by Thomas Friedman in his best-selling book, The World Is Flat. Increasingly widespread social and economic activities have turned our planet into an interdependent village. Communication costs are close to zero, goods and people travel faster and more cheaply than ever before, and knowledge is shared with unprecedented ease on the Internet and through emerging social networks. There are many benefits to this process.

Yet the flip side of this extraordinary transformation has been somewhat underappreciated: Actions taken or risks materializing 5,000 miles away can affect any of us very soon thereafter. Viruses fly business class, too! The financial turmoil that started in 2008 is another example; this blew up the theory of decoupling long supported by many theorists who thought a reduction in the United States’ or China’s economic growth would not severely affect the rest of the world. Well, as we now know, it did—with profound consequences. We are all interconnected.

The litany of global interdependent risks is almost endless. Events that have surfaced prominently on the social, economic, and political fronts in many countries just since the beginning of 2001 are eye-opening: terrorist attacks; financial crises; global warming; scarcity of water and other resources; hurricanes, floods, tsunamis, heat waves, droughts, earthquakes, and wildfires unprecedented in scale and recurrence;¹ failures of our aging critical infrastructures; ² repeated genocides and local wars; nuclear threats; pandemics and new illnesses.

This list is long but hardly exhaustive: We trust that if you think for a moment about what is going wrong today, what you are afraid of, or you simply watch news TV, you shall soon add to this list. And as challenging as it is today on a planet with nearly 7 billion people, it is likely to be even more so as the population continues to grow; ever greater concentrations of people and assets at risk set the stage for truly devastating events to happen.

At the heart of the work that led to this somewhat unusual book is this question: Is the series of untoward events that have occurred since 2001 an omen of what the twenty-first century has in store for us? If so—as we believe—it is time to think about the future in a fundamentally different way. What does this mean for us, as individuals and families, private companies, government authorities, and organizations? How might we behave in this new, uncertain, and more dangerous environment? Will our actions be rational or irrational? And what does this last question actually mean?

ARE WE RATIONAL ACTORS OR RATIONAL FOOLS?

We sought the answer to these questions from a group of internationally recognized experts who had worked with or were influenced by the economist Howard Kunreuther, who pioneered the field of decision making and catastrophe management (see the Acknowledgments section). Their work in The Irrational Economist examines human decision making from a variety of perspectives and documents the rich and subtle complexities of the concept “rationality.” These contributors’ perspectives are the result of an important evolution in theory and applied research that has occurred during the past half-century and is now accelerating.

Many mainstream economists in the second part of the twentieth century developed sophisticated mathematical treatments that attempted to model human behavior. But most of these were founded on a very simplistic concept of rationality. Indeed, early views on rationality were dominated by the concept of homo economicus: The idea here is that we can all be represented by an economic man who is assumed to be completely informed, perfectly responsive to economic fluctuations, and rational in the sense of having stable-over-time , orderly preferences that maximize economic well-being and are independent of the actions and preferences of others.

Slowly, psychologists and other behavioral scientists began testing this presumption of rationality, which, as noted by Herbert Simon, one of the most influential social scientists of the twentieth century, permitted economists to make “strong predictions . . . about behavior without the painful necessity of observing people.”³

Simon, both an economist and a psychologist, drew upon empirical research on human cognitive limitations to challenge traditional assumptions about the motivation, omniscience, and computational capacities of “economic man.” He introduced the notion of “bounded rationality,” which asserts that cognitive limitations force people to construct simplified models of how the world works in order to cope with it. To predict behavior “we must understand the way in which this simplified model is constructed, and its construction will certainly be related to man’s psychological properties as a perceiving, thinking, and learning animal.”⁴

About the same time that Simon was documenting bounded rationality in the 1960s and 1970s, another psychologist, Ward Edwards, began testing economic theories through controlled laboratory experiments to examine how people process information central to “life’s gambles.” Early research confirmed that people often violate the assumptions of economic rationality and are guided in their choices by noneconomic motivations. For example, one series of studies showed that slight changes in the way choice options are described to people or in the way they are asked to indicate their preferences can result in markedly different responses. In short, we behave very differently depending on how the information is presented to us, on the nature of the decision-making environment, even on what period of life we are in. Moreover, in many important situations we do not really know what we prefer; we must construct our preferences “on the spot.”⁵

Not surprisingly, as often happens with new ideas, economists of the 1960s and 1970s were divided on how to interpret them. Many, rather than trying to understand the psychology, embarked on studies designed “to discredit the psychologists’ work as applied to economics.”⁶ Evidence against the rationality of individual behavior tended to be dismissed by those economists on the grounds that in the competitive world outside the laboratory, rational agents would survive at the expense of others. In this way, the study of irrationality could be downplayed as the study of transient phenomena.

At the same time, and despite very important advances in economic theory that were made possible by the traditional view of economic man,⁷ there was a growing sense of unease among the general public and other social scientists as well as among policy makers that many economists had been unrealistic in their attempts to always rationalize how people, enterprises, and markets function.

Fortunately, the story did not stop there. Stimulated by creative conceptual, methodological, and empirical work by the more senior authors in The Irrational Economist and many others, including Amos Tversky, Daniel Kahneman, and Richard Thaler, the trickle of studies challenging traditional economic assumptions of rationality became a torrent. Nobel prizes in economics awarded to Herbert Simon in 1978, to George Akerlof in 2001, and to Daniel Kahneman and Vernon Smith in 2002 for their contributions toward understanding the behavioral dynamics of economic decisions further contributed to what has become a revolution in thinking.

Today, young scholars, and even those not so young, have become convinced that the secret to improving economic decision making lies in the careful empirical study of how we actually make decisions. New multidisciplinary fields have now emerged—many represented in this book by those who pioneered them—including behavioral economics, economic psychology, behavioral finance, decision sciences, and neuroeconomics, to integrate theories and results from economics, psychology, sociology, anthropology, biology, and brain sciences. Applied fields such as management, marketing, finance, public policy, and risk management and insurance are using this new knowledge today in significant ways.

We now recognize that the question “Are people rational or irrational?” is ill-formed. As human beings, we have intuitive and analytic thinking skills that work beautifully, most of the time, to help us navigate through life and achieve our goals, individually and collectively. But sometimes our thinking skills fail us.

The very modes of thought that are highly rational most of the time can get us into big trouble when the nature of the environment surrounding us, or the time horizon on which we make decisions, changes. We are also fundamentally influenced by short-term rewards, by what others do, and by what is at stake and how we feel when we make these decisions. Our emotions (known to economists as “affective feelings” or “affects”), including fear, anxiety, love, trust, and confidence, all of which help us assess risk and reward, are processed swiftly in our minds. These feelings form the neural and psychological substrate of what is important to us and guide many decisions, what economists refer to as “utility.” In this sense, reliance on feelings enables us to be rational actors in many important situations. For instance, if you were to see a venomous snake on your vacation trip, you would not pause to calculate the mathematical utility of all the possible harmful consequences multiplied by their associated probability (hard to calculate anyway) in order to decide what to do. Upon seeing the snake, you would act rationally: You would move away fast.

More generally, reliance on our gut feelings works when our experience enables us to anticipate accurately the consequences of our decisions—that is, when we have a good knowledge of the situation and (think we) fully understand our reactions today and in the future. But it fails miserably when the consequences turn out to be very different from what we expected—which is likely to happen quite often in an uncertain world. In the instance of surprise, the rational actor often becomes, to borrow the words of 1998 Nobel Laureate Amartya Sen,⁸ the rational fool.

This brings us back to two of our original questions: How might we behave in this new, uncertain, and more dangerous environment? Will our actions be rational or irrational? Our answer is: It depends. Part One of this book—“Irrational Times”—addresses a series of behaviors that many might consider irrational. Yet, when we look at them more closely and try to understand the rationale behind them, they often make sense: Our actions are driven by our feelings, incentives, and the nature of the environment in which we make decisions.

The challenge before us now is to better understand when and how rationality fails in this modern world. The chapters in Part Two—“Are We Asking the Right Questions? Economic Models and Rationality”—consider the growing menu of tools we have at our disposal today to meet this challenge. Part Three—“Individual Decisions in a Dangerous and Uncertain World”—looks at the individual decision processes that arise when people are confronted with small and catastrophic risks, and at how experience, uncertainty, and different time horizons can radically threaten rationality. By understanding these processes and thus avoiding the failures of rationality that sometimes result, people can make better decisions for themselves, and also better decisions for others in our society. Part Four—“Managing and Financing Extreme Events”—analyzes how individual behavior can translate into very good or very poor collective decisions by enterprises, markets, and governments. Natural disasters, climate change, terrorism threats, and financial crises are cited as illustrative examples of uncertain and dangerous environments.

WHAT ROLE FOR THE ECONOMIST? FROM THE IVORY TOWER TO THE CIRCLE OF POWER

In many ways, the transformation of economics as a discipline that now includes more realistic behavioral models is similar to what happened over the course of several centuries in physics, chemistry, biology, and medicine. Established paradigms evolve with new knowledge, the discovery of which is fueled, at least in part, by the collective desire to explain more accurately the world we live in, and by the aspiration to make it better. Economics is still a young discipline. To mature, it needs to transform itself into one that not only can better represent human behavior in the real world (the normative approach) but also can propose better remedies to societal issues the world faces (the prescriptive approach).

This leads us to ask: What should be the role of those who study or have a special knowledge of economics and other social sciences in ensuring the success of this transformation? Many pioneers of economics not only were advocates of specific theoretical programs but also participated directly in government. One example is Adam Smith, often cited as the father of modern economics. His work on self-interest was largely prompted by a critique of mercantilism and adherence to a moderate free-market policy (even though his earlier work focused on a morality based on sympathy and benevolence).⁹ But he was also one of the leading customs commissioners in Scotland appointed in 1778. Another is James Mill, who made significant contributions to classical British economic theory and was also a high-ranking official of the East India Company that governed India. During the 1830s, he was an influential leader in Parliament. A third is David Ricardo, tutored by Mill; after writing his Principles of Political Economy and Taxation in 1817 he entered Parliament as well. And influential laissez-faire economist Michel Chevalier negotiated the free-trade agreement between the U.K. and France in 1860—the same year he became a senator in the French Congress.

This long history of prominent economists influencing policy has continued. For instance, the Italian economist Vilfredo Pareto made important contributions to the study of income distribution and the analysis of individuals’ choices; but he was also a militant laissez-faire liberal who battled for free trade. And of course John Maynard Keynes, the very influential British economist, served in several key government posts during the twentieth century. Keynes would spearhead a revolution in economic thinking that was essentially pragmatic, rather than theoretical. He wanted his ideas to work in the world.

It is for the same reason that in a rare moment of collective awareness for our profession, Part Five of this book addresses the ultimate question “What Difference Can We Make?” If we are right in saying that the world is becoming more interconnected, that the potential for catastrophes is more widespread than ever before, and that the effects of any single person or group may be, like the proverbial flap of the butterfly’s wing, amplified across the world with potentially vast consequences, then an accurate appreciation of the science of decision making and of catastrophe risk management cannot remain within the ivory towers of universities and specialist institutes. Indeed, this knowledge must be shared—with industries, governments, nongovernmental organizations, philanthropic foundations, investors, the media, and, last but by no means least, all individuals who care to make the best-informed choices to safeguard themselves and their families in this fast-moving, ever-thrilling world that may challenge them with deep adversity and extreme events. This is the goal of The Irrational Economist.

As a way of ensuring that this knowledge is shared and used more broadly, we hope to see more and more behavioral scientists being asked to provide top decision makers with their views, or even to take on high-level positions in the public and private sectors. In doing so, they will assume this dual role of researchers/teachers and influential players in the power circles of business and public policy, as other great minds in economics have done before. But this time, not quite as purely rationally.

PART ONE

IRRATIONAL TIMES

IN THESE FIVE OPENING CHAPTERS, the authors contemplate a patchwork of situations where decisions can be viewed as irrational (i.e., deviating from what economic rationality would seem to dictate). Each chapter, each anecdote, each piece of evidence provides a touch of color representing an aspect of human behavior either in daily life or during extraordinary times. Together, they provide a mosaic of ideas, integral parts of a surprising painting, that will be discussed in detail in the rest of the book.

For example, why don’t many hotels have a thirteenth floor? Or planes a thirteenth row? Should our believing in supra-human forces (superstition and religion) be considered irrational? If so, how do economists study the ways in which it affects human behavior? A cast of remarkable characters—weather forecasters and beautiful people—unexpectedly help us better understand how (misaligned) incentives on Wall Street pushed us into financial chaos. This section will also consider how decisions can be made today about career choices for the next thirty years, given the increasing uncertainties that come with our rapidly changing world. Part One ends with an ounce of behavioral observation about our dangerous world. We ask how compassionate we really are when it comes to helping others in profound distress . . . and learn that caring does not increase proportionally with the number of victims, as economic rationality would suggest, but rather goes in the opposite direction. All the anecdotes and evidence highlighted in Part One give us a sense of how we really make decisions—a consideration that is all the more important to appreciate and acknowledge as we contemplate the extraordinary times that lie ahead. The new risk architecture that is now unfolding brings complex interdependencies among nations, companies, and individuals all over the world. How others behave should matter more to you today than ever: Directly or indirectly, you are linked to them, as they are to you.

Superstition

A Common Irrationality?

THOMAS SCHELLING

The night before the conference honoring Howard Kunreuther’s birthday I stayed in a Philadelphia Hotel. Riding up the elevator I noticed there was no thirteenth floor.

Walking up Madison Avenue in New York recently, for about twenty blocks, I counted more than twenty fortune tellers on one side of the street. I remember that the wife of a president of the United States was reported to have consulted some kind of seer who resided in California. I’ve been told by what I thought a reliable source that air traffic is below normal on a Friday the thirteenth. Several airlines have no thirteenth row. (What could happen to a passenger in the thirteenth row that would not occur in the fourteenth, I can’t imagine.)

And this morning’s newspaper carried this advice in the horoscope for (my birth month) Aries:

Old problems surface. Make progress in this regard so you can avoid sharing the all-too-familiar chorus of your discontent. That tune is tired and loved ones will thank you for not playing it.

I recall that the oracle at Delphi had a reputation for prophecies sufficiently ambiguous to avoid her being proved wrong. (Now that I think of it, I’ve never checked whether the horoscopes in different newspapers provide similar advice, or whether they are sufficiently specific that their similarity can be judged.)

Before many states succumbed to the temptation to use lotteries to enhance their revenue, illegal lotteries, known as “numbers rackets,” met the demand and were able to charge higher prices for “lucky” numbers—particular numbers that, unlike one’s birth date, were not peculiar to an individual but were widely regarded as somehow blessed.

There is a well-known, and much-studied, “gamblers’ fallacy”—actually two of them. One is that if a tossed coin comes up heads four times in a row, it has “exhausted” its heads inventory and is likely to come up tails. The other is that it’s on a “roll,” and is likely to come up heads again. (If the experimenter pulls a new coin out of his pocket, after the four heads, the new coin is viewed as neutral, offering a 50-50 chance.) My statistically sophisticated colleagues dismiss these expectations with the rhetorical question, “Does the coin remember, does the coin care?” I think the believers must answer, “Someone up there does!”

Many years ago, while driving a son to school with the radio on, I would hear the advertisement of the Massachusetts Lottery Commission urging us to consider that if we concentrated hard enough we might just do better than chance with our ticket. I never knew whether the Commission meant we might predict the winning numbers or we might determine the winning numbers. (Not all of us, I’m sure, because not all of us could concentrate on the same number!) I marveled that the Commonwealth of Massachusetts would promote extrasensory perception to sell tickets. The market analysis must have led the Commission to believe that some of us could be conned. (Or did the Commissioners believe it themselves; did they even buy tickets themselves and concentrate?)

There are experiments in which people given a modest gift, a coffee mug or a sweatshirt, decline to trade it for some equally “valuable” gift that they might instead have been given. Something happens to “attach” the gift to the recipient. Similarly, people who receive lottery tickets at the door to some event have been found unwilling to trade their tickets for “equally” valuable tickets. (See the work of Ellen Langer, psychologist, Harvard University.) One explanation is that if it’s “their” day to win, they don’t want to confuse the decision by switching tickets!

In the Theory of Games it is held that in “games against nature,” such as deciding whether the weather will turn cold, or rain may ensue, nature is neutral, in contrast to games with human subjects who will act strategically. My impression is that for many people nature is not neutral. I’ve known someone whose auto collision insurance expired while he was traveling, and he wouldn’t drive until his renewed insurance was confirmed. I asked him how many collisions he’d had in some decades of driving, and the answer was none. What’s the expected value of the risk of auto damage if you drive, I asked, thinking he could give a statistical answer that would contradict his decision not to drive. Instead he smiled and said, “That’s just the day that I’d have the accident!” I think the same goes for driving without one’s license: “That’s the day I’d get stopped by a cop!”

(Maybe it is not a truly superstitious belief that if I drive without a license I’ll be stopped by an officer. It may be that if I drive without a license I cannot stop thinking I have no license, and cannot stop looking in the mirror for a police car. It’s my imagination I cannot control, not my logic.)

Genre:

Joseph Stiglitz
“The Irrational Economist challenges conventional wisdoms, overturns traditional economic models, and brings to light new discoveries in decision sciences: The result is a profound revolution in thinking. This book will help us cope better with the myriad of important decisions under uncertainty that we face.”

Richard M. Smith, Chairman, Newsweek
“In The Irrational Economist some of the world’s foremost economists and decision scientists analyze how we make decisions under pressure—and offer thought-provoking ideas about how to improve the process. The result is important and remarkably timely.”

Martin Feldstein, Professor of Economics, Harvard University; President Emeritus of the National Bureau of Economic Research
“Dealing with extra-ordinary situations that cannot be quantified on the basis of past experience is one of the key problems facing investors, business executives, and government officials. Michel-Kerjan and Slovic brilliantly rally insights from an outstanding group of authors: There is something here for any reader.”

On Sale: Jan 5, 2010
Page Count: 336 pages
Publisher: PublicAffairs
ISBN-13: 9780786746262