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Best Business Books 2004: Behavioral Economics

The Not-So-Dismal Science

(originally published by Booz & Company)

When I'm asked at a party, "What do you do?" the reply "I'm an economist" is, I've always found, a conversation killer. After all, the public persona of the profession is a gray suit spouting jargon on financial news programs. Most professional economists have a difficult to nonexistent relationship with clear prose, perhaps because so often they bring bad news. The academics disdain attempts to popularize their work, and most of the popularizers are dull, too. (I exclude myself here, of course.) But I'm optimistic about becoming less of a social outcast, because economics is reaching out beyond its conventional narrow boundaries and getting more interesting.

Just as science and history have found popular audiences, three new books suggest economics could do the same: The Economy of Esteem: An Essay on Civil and Political Society, by Geoffrey Brennan and Philip Pettit (Oxford University Press, 2004); The Paradox of Choice: Why More Is Less, by Barry Schwartz (Ecco, 2004); and The Company of Strangers: A Natural History of Economic Life, by Paul Seabright (Princeton University Press, 2004). None is a straight popularization of a conventional part of economic knowledge. Instead, each is an example of how economists are taking an interdisciplinary approach to their research and writing, which is helping make their work more accessible and relevant. Some of the best economists have always done this: Think of past winners of the Nobel Prize in economics, such as Herbert Simon, for his insights into how real-life businesses make economic decisions; or Gunnar Myrdal and Friedrich August von Hayek, for their insights into the ways social and economic institutions shape each other.

Today, economists are increasingly making links to history, law, urban studies, biology, anthropology, and psychology. This is a change since the mid-1980s, when most academics worked in the neoclassical tradition of abstract models of profit- or income-maximizing rational individuals. So strong has the trend been that the borders of the subject are becoming mainstream.

Stuck with Choice
In The Paradox of Choice, Barry Schwartz, a professor of social theory at Swarthmore College, draws on a growing body of research into how psychology affects economic outcomes -- and how economic outcomes affect our psychology -- to address two questions: Do the facts of human psychology mean that, contrary to a basic postulate of economic theory, we do not make choices rationally? And does prosperity actually make us happy?

The answers provided by this very readable and stimulating book are, in brief, yes and no, respectively. According to economic theory, more choice is inevitably better. People can always look at the alternatives, figure out what benefits they expect to derive, and decide whether or not to buy. But even aside from the time taken to assess all the choices, our psychology means we don't evaluate the alternatives in this purely objective way. There is increasing evidence that people's choices diverge in quite systematic ways from the rational ideal of economic textbooks. For example, most of us prefer small, reasonably sure gains to large but uncertain ones, even if the expected outcomes (the size of the gain multiplied by the probability of its occurrence) are the same. Most people fear losses more than they desire gains. And all our choices depend on what we start with and how we think about or "frame" them: A discount off a high price for paying cash and a surcharge on a low price for paying on credit are perceived very differently even if the final price is the same in both cases.

The implication is that more choices can actually make us worse off. A Sony CD player is on offer at $99, a great price. Researchers cited by Schwartz found that 66 percent of the people they surveyed would buy it without searching any further and 34 percent would not buy. Yet offered a choice between the Sony at $99 and a top-of-the-line Aiwa at $169, 27 percent would buy the Sony, 27 percent would buy the Aiwa, and 46 percent would wait. Faced with a trade-off between price and quality, nearly half the potential customers would avoid a purchase altogether. Schwartz comments: "When people are presented with options involving trade-offs that create conflict, all choices begin to look unappealing."

Another example concerns the proliferating choices of investment options in retirement plans. Studies find that, typically, employees simply divide their money equally among their options. If there are four options -- for example, one low-risk and three with higher risk -- people tend to put 25 percent of their funds in each. As the book points out, a manager offering this choice to employees is actually subtly handing over the responsibility for the individual's retirement security. It's fair to ask, however, whether most people have the expertise to make wise choices in this important financial decision (and in fact this is being asked in the U.S. in the policy debate over the future of Social Security).

This analysis seems to lead logically to the conclusion that there are too many brands of cereal on the shelves for our psychological well-being. It taps into an important new literature on economics and happiness arguing that people in rich countries are happier than people in poor countries. But beyond a certain level of development, extra economic growth does not increase people's happiness. Economists are taking seriously this question of how economic growth is related to our well-being. Schwartz's message will also resonate with many people uneasy with modern capitalism, including environmentalists.

There are some real difficulties with his argument, though. The psychological evidence is clear, but its implications are not. Consider other areas of choice: book titles, say, or charities. In both, there has also been an explosion of choice in recent times. But few of us would be so willing to accept the argument that there's too much choice in these cases. Whatever the psychological stresses, we recognize the great merits of alternatives. But who's to say when the benefits of choice outweigh the costs? Economists? Professors of social theory? Government officials? Journalists? Or do we say it ourselves?

Trade-offs are part of the human condition. Every course of action has an opportunity cost (an essential insight of economics). Is it better not to make the trade-offs explicit, for the sake of our peace of mind? Surely not. For this reason, it's hard to recommend a reduction in choice, and so the book ends with several chapters of rather banal advice on how to avoid the stress, such as not overindulging in shopping and reminding yourself to be grateful for everything you have. Halfhearted self-help aside, this is a thought-provoking treatment of some of the most exciting new ideas emerging from the study of economics.

Kindness of Strangers
In The Company of Strangers, Paul Seabright, professor of economics at the University of Toulouse in France, also draws on the accumulated evidence from human psychology, evolution, and anthropology to explore the everyday miracle of coordination in the modern global economy. It is only for the past 10,000 years -- just a blink on the evolutionary timescale -- that humans have had regular nonviolent contact with people other than their genetic relatives. Prior to that, a meeting with a stranger would probably end fatally -- humans are the most violent of the apes. And yet the degree of specialization that has made economic growth possible means we now depend on the efforts of many strangers for our lives.

In these days of terror and conflict, Seabright's stunning exploration of this human social experiment is timely. He points out that there has never been less violence in human history than there is now: Only 1 percent of deaths are due to violence, compared with up to 40 percent in preindustrial times. More people commit suicide than are killed by others. You are 20 times more likely to die from an infectious disease caught from a stranger on a suburban train than from a terrorist. Yet we are all, rightly, wondering about the fragility of the social order.

The Company of Strangers argues that self-reinforcing institutions sustain prosperous societies; these institutions originated during the transition from a hunter-gatherer existence to settled agriculture. Economic specialization rests on trust, as it is rare to exchange goods and services simultaneously, like the exchange of hostages in an old-fashioned spy thriller. Usually there's a gap in time, and the transaction is mediated by symbols such as paper currency or electronic records.

The trust among billions of people that makes our global economy function can be sustained only thanks to the institutions that make it worth everybody's while to participate. "Modern political institutions temper their appeals to the deep emotions, to family and clan loyalty, with just enough abstract reasoning to help Homo sapiens, the shy murderous ape, emerge from his family bands in the savanna woodland in order to live and work in a world largely populated by strangers," Seabright writes. Money is a good example of such an institution.

Seabright argues that this mutual consent to trust one another is based partly on rational calculation that we'll be better off by being trusting, and partly on our psychological inclination toward reciprocity. "Tit for tat" has a firm foundation in evolutionary psychology.

The book ends by asking whether the logic of economic organization could undermine the social institutions that underpin it. Can the openness and flexibility needed by a modern industrial society coexist with the need to trust strangers on an ever-greater scale? The answer -- "who knows?" -- is not exactly comforting. Our safety and prosperity depend on how fast we can evolve our social and political institutions. This is a book every concerned citizen should read, along with anybody in business who ever has to tangle with government regulations or the law, and who wants to understand why those relationships are so complex.

The Intangible Hand
Seabright's emphasis on the importance of institutions for economic success is becoming a common theme in economics. This is a revival of the subject's early tradition found in the work of pioneers such as Adam Smith and David Hume. Smith's The Theory of Moral Sentiments is far less well known than his later The Wealth of Nations, but he regarded it as providing the philosophical scaffolding for his analysis of the economy, and his conclusions about how the benign results of the market rest on virtuous behavior. Smith's "moral sentiments" are the subject of The Economy of Esteem, by Geoffrey Brennan, an economist at the Australian National University, and Philip Pettit, a political philosopher at Princeton University. They argue (in a book slightly more technical than the other two) that there are three fundamental human drives: drives for property, for power, and for esteem, defined as the good opinion of others.

Social scientists have long studied property (the invisible hand) and power (the iron fist), but the desire for esteem as a motive in human society has been overlooked. The authors apply the methods of economic analysis to this missing driving force and consider the part it plays in the institutions of the economy. Mobilizing the "intangible hand" of esteem, they say, can help support desirable social norms and institutions.

Why? Because esteem is mutually reinforcing. As David Hume put it in his Treatise of Human Nature: "Tho' fame in general be agreeable, yet we receive a much greater satisfaction from the approbation of those whom we ourselves esteem and approve of, than of those whom we hate and despise. In like manner, we are principally mortified with the contempt of persons upon whose judgment we set some value, and are, in great measure, indifferent about the opinions of the rest of mankind." Esteem is a compliance mechanism. For example, the recycling of household waste started out as an unusual activity, an ostentatious signal of virtuous concern for the environment. This warm glow of virtue attracted others to recycle their trash as well. This trend steadily reduced the special kudos of being ultra-green, and in the end recycling has become normal. Now only those who want to make a strong statement of their anti-environmentalism will never use recycling centers.

Of course, the bandwagon effect of the esteem economy is not always beneficial. Think of the emergence of a social norm among corporate executives to base their mutual esteem on the large size of their pay and options packages. As in any self-reinforcing process, there are many possible outcomes in the development of such norms. But understanding the nature of the process is essential if we hope to steer the outcomes.

This is very far from the kind of economics so many of us suffered through in Econ 101. As Brennan and Pettit note, until recently the rise of economics as a conventional academic subject meant the eclipse of the traditional concern of political economy. But markets are not abstractions. Economies consist of relationships between people -- usually strangers -- within a framework of specific institutions. The analytical rigor of conventional economics needs to be combined with a rich understanding of the human context. Fortunately, that is what more and more economists, including the authors of these three books, are doing.

Author profile:

Diane Coyle ( is an economic consultant, author, and visiting professor at the University of Manchester. Professor Coyle is a former economics editor at the Independent, and has been a commentator on BBC radio. Her latest book is Sex, Drugs & Economics: An Unconventional Introduction to Economics (Texere, 2002).

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