Behavioral Economics

Calls for increasing financial literacy have grown louder recently, as the soaring costs of health care and education, high unemployment, and the effects of the Great Recession all converge to strain the budgets of governments, businesses, and individuals. Many agree that financial education benefit those who participate, but the results have been underwhelming. According to a recent column in The Economist, not only is financial literacy a major stumbling block for most people, but interest in—and success in teaching—financial education is incredibly low, regardless of age or life circumstances. Last September, the SEC released its own report on financial literacy among Americans, and its results of which were fairly discouraging. Some argue that the main problem is the ability to engage students in the material, but as we’ve written before, the problem may be more fundamental than that.

In their paper “Misunderstanding Savings Growth,” published in the RSF-funded Journal of Marketing Research, Craig McKenzie and Michael Liersch argue that the failure to begin saving early for retirement—or to reach retirement savings goals—comes down not just to a lack of financial knowledge, but also to gross misunderstandings of how savings grow over time. Conventional economic wisdom holds that people are able to “[calculate] future values and [make] trade-offs with present values.” However, through a series of experiments, McKenzie and Liersch notice that not only do people systematically underestimate how much retirement savings grow exponentially, but that understanding how compound interest works doesn’t always help to motivate them to save earlier.

In fact, what helps the most in motivating people to save is demonstrating the effects of exponential growth. Offered a graphical representation of how compound returns accumulate over time (see below), participants were markedly better able to determine whether early saving would prove beneficial over the course of a career. Not only that, but they were better able to think their way out of the fallacy that saving twice as much later might yield the same returns at the point of retirement. This finding was successful without any interventions that told participants explicitly what compound interest was or how it could be calculated. Interestingly, this approach increased motivation in participants at different stages of their careers. McKenzie and Liersch did experiments with undergraduate students as well as employees at a Fortune 100 company, and found that workers’ reactions to exponential savings growth were similar to those of the undergraduate sample. As the authors point out, this finding indicates that it isn’t an understanding of compound interest that motivates people, but demonstrations of its effects over time.

Nicholas Barberis, a member of RSF's Behavioral Economics Roundtable, has published a new paper that examines how researchers have tried to apply prospect theory in economic settings. Here is the abstract:

In 1979, Daniel Kahneman and Amos Tversky, published a paper in Econometrica titled "Prospect Theory: An Analysis of Decision under Risk." The paper presented a new model of risk attitudes called "prospect theory," which elegantly captured the experimental evidence on risk taking, including the documented violations of expected utility. More than 30 years later, prospect theory is still widely viewed as the best available description of how people evaluate risk in experimental settings. However, there are still relatively few well-known and broadly accepted applications of prospect theory in economics. One might be tempted to conclude that, even if prospect theory is an excellent description of behavior in experimental settings, it is less relevant outside the laboratory. In my view, this lesson would be incorrect. Over the past decade, researchers in the field of behavioral economics have put a lot of thought into how prospect theory should be applied in economic settings. This effort is bearing fruit. A significant body of theoretical work now incorporates the ideas in prospect theory into more traditional models of economic behavior, and a growing body of empirical work tests the predictions of these new theories. I am optimistic that some insights of prospect theory will eventually find a permanent and significant place in mainstream economic analysis.

Late last year, the Russell Sage and Alfred P. Sloan Foundations sponsored a competition to solicit proposals for smart disclosure demonstration projects. "Smart disclosure" policies aim to improve consumer markets by providing decision-makers data about their their personal use patterns or histories. Here are some details on the winning proposals:

1. Efficient Web-Based Credit Markets

While the consumer credit market has grown dramatically in the past two decades, consumers find it difficult to systematically compare credit offers (many of which arrive in the mail). Consumers know that their credit score may be downgraded by repeated applications for credit, but a bigger challenge is sorting through lengthy contracts, complicated reward programs, and interest rates. This research project will investigate the potential of a recent policy shift in Sweden, where consumers can "shop" for credit using an online intermediary. When they submit their information -- for example, the amount of credit they seek and their credit score -- the online intermediary supplies their application to participating banks, which can decide to offer a bid to the consumer. The web intermediary standardizes all financial contracts, reduces search costs, and allows consumers to see competing bids in an accessible manner.

2. Doctor Finding Service

Finding a healthcare provider can be difficult: comprehensive information about a doctor -- that is, including malpractice history, patient feedback, outcomes -- is rarely available in one location, and websites often present data using arcane terminology and complicated designs. This research project aims to develop and test a smart disclosure service that captures information local area health care providers and provides consumers an easy to understand interface for finding and comparing health care resources.

In the December issue of the Journal of Economic Literature, RSF author Andrei Shleifer discusses the insights and ideas from Daniel Kahneman's latest book, Thinking, Fast and Slow. Published in 2011, the book summarizes Kahneman's innovative research on decision-making and human rationality; his work with Amos Tversky is widely believed to have played a pivotal role in the rise of behavioral economics. "The broad theme of [Kahneman and Tversky's work] is that human beings are intuitive thinkers and that human intuition is imperfect," Shleifer writes, "with the result that judgments and choices often deviate substantially from the predictions of normative statistical and economic models." He then summarizes prospect theory, heuristics, biases such as loss aversion, and possible future paths for behavioral economics, a relatively novel field that the Russell Sage Foundation has sponsored for more than two decades.

Shleifer also highlights some of Kahneman and Tversky's path-breaking questions and experiments that show part of the human mind to be "nonstatistical, gullible, and heuristic." Try the following puzzle:

An individual has been described by a neighbor as follows: “Steve is very shy and withdrawn, invariably helpful but with very little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.” Is Steve more likely to be a librarian or a farmer?

Shleifer explains the results:

Most people reply quickly that Steve is more likely to be a librarian than a farmer. This is surely because Steve resembles a librarian more than a farmer, and associative
memory quickly creates a picture of Steve in our minds that is very librarian-like. What we do not think of in answering the question is that there are five times as many farmers as librarians in the United States, and that the ratio of male farmers to male librarians is even higher (this certainly did not occur to me when I first read the question many years ago, and does not even occur to me now as I reread it, unless I force myself to remember). The base rates simply do not come to mind and thus prevent an accurate computation and answer, namely that Steve is more likely to be a farmer.

This year, the Society of Labor Economists presented Marianne Bertrand, a professor of economics at the University of Chicago, the Sherwin Rosen Award "for outstanding contributions in the field of labor in economics." A member of the Foundation's Behavioral Economics Roundtable, Bertrand's research has covered a a variety of topics, including racial discrimination, household finance, and the effects of regulation on employment.

The announcement of the award cited a number of Bertrand's highly cited papers, including one on CEO pay funded by the Foundation and co-authored with Sendhil Mullainathan:

One particular labor market where the connection between product market performance and compensation is particularly important is the market for corporate executives. Bertrand has written a number of highly influential papers on this topic. For instance, her Quarterly Journal of Economics (2001) paper with Mullainathan, "Are CEOs Rewarded for Luck? The Ones without Principals Are," empirically examines two competing views of CEO pay. The contracting view of CEO pay assumes that pay is used by shareholders to solve an agency problem. Simple models of the contracting view predict that pay should not be tied to luck, where luck is defined as observable shocks to performance beyond the CEO's control. Using several measures of luck, they find that CEO pay in fact responds as much to a lucky dollar as to a general dollar. A skimming model, where the CEO has captured the pay-setting process, is consistent with this fact.

In late 2011, Allianz Global Investors and TED organized a daylong conference on behavioral finance. Several members of the Russell Sage and Sloan Foundations' Consumer Finance Working Group discussed their research and how behavioral economics can illuminate and possibly improve consumers' decisions. You can watch videos of the lectures by clicking on the links below. You can also find other TED Talks on behavioral economics here.

Late last year, we announced the release of a special issue on consumer finance from the Journal of Marketing Research. The issue, funded by the Russell Sage and Alfred P. Sloan Foundations, features 14 articlesthat provide new insights on how to improve consumers' financial decisions. We previewed some of the articles in these blog posts, but now, we have received permission to post the entire issue for free. Browse through the links and abstracts below to download the papers.

Misunderstanding Savings Growth: Implications for Retirement Savings Behavior
Authors: Craig R.M. McKenzie and Michael J. Liersch
Abstract: People systematically underestimate exponential growth. This article illustrates this phenomenon, its implications, and some potential interventions in the context of saving for retirement, where savings grow exponentially over long periods of time. Experiment 1 shows that a majority of participants expect savings over 40 years to grow linearly rather than exponentially, leading them to grossly underestimate their account balance at retirement. Experiment 2 demonstrates that this misunderstanding leads to underestimates of the cost of waiting to save, which makes putting off saving more attractive than it should be. Finally, Experiments 3-5 show that highlighting the exponential growth of savings motivates both college students and employees to save more for retirement. Making clear to employees the exponential growth of savings before they make crucial decisions about how much to save may be a simple and effective means of increasing retirement savings.

Earmaking and Partitioning: Increasing Saving by Low-Income Households
Authors: Dilip Soman and Amar Cheema
Abstract: This research examines the effects of earmarking money on savings by low-income consumers. In particular, the authors test two interventions that are designed to enhance the effects of earmarking: a) using a visual reminder of the savings goal and b) dividing the earmarked money into two parts. Consistent with prior research which suggests that partitioning increases self-control, individuals save more when earmarked money is partitioned into two accounts versus pooled in one account. In addition, the presence of the visual reminder increases the savings rate. The authors conclude with implications for consumers’ welfare and a discussion of directions for further research.

Increasing Saving Behavior Through Age-Progressed Renderings of the Future Self
Authors: Hal E. Hershfield, Daniel G. Goldstein, William F. Sharpe, Jesse Fox, Leo Yeykelis, Laura L. Carstensen, and Jeremy N. Bailenson
Abstract: Many people fail to save what they will need for retirement. Research on excessive discounting of the future suggests that removing the lure of immediate rewards by precommitting to decisions or elaborating the value of future rewards both can make decisions more future oriented. The authors explore a third and complementary route, one that deals not with present and future rewards but with present and future selves. In line with research that shows that people may fail, because of a lack of belief or imagination, to identify with their future selves, the authors propose that allowing people to interact with age-progressed renderings of themselves will cause them to allocate more resources to the future. In four studies, participants interacted with realistic computer renderings of their future selves using immersive virtual reality hardware and interactive decision aids. In all cases, those who interacted with their virtual future selves exhibited an increased tendency to accept later monetary rewards over immediate ones.

Why do so many Americans receive such a big tax refund? Every year, the IRS sends a check of around $3,000 to Americans who paid more taxes than they should. The excess withholding is a puzzle: why do consumers prefer to give the U.S. government an interest-free loan? Wouldn't a quick trip to the payroll administrator be worth the effort if it meant a bigger paycheck? Michael Barr, an editor of the RSF volume Insufficient Funds, spoke to the Wall Street Journal last week about his research on the problem:

"People want to have a ready way to save," says Michael Barr, a University of Michigan law professor and a former Obama and Clinton Treasury official. "For some families, tax time is a good time to do so."

In the mid-2000s, Mr. Barr and colleagues surveyed about 650 low- and moderate-income families in the Detroit area who had filed tax returns in 2003 or 2004. About 82% received refunds—either because they had overpaid or because they qualified for the federal Earned Income Credit, a federal cash bonus to low-wage workers that is paid through the IRS. [...]

In fact, Mr. Barr and co-author Jane Dokko of the Federal Reserve Board, found these folks don't want smaller tax refunds. In the survey, researchers offered them choices: Withhold $100 a month more and get a bigger refund (an option favored by 35%), withhold the same amount and get the same refund (46%) or withhold less and get a smaller refund (only 19%.) This and other survey findings appear in a coming Brookings Institution book, "No Slack: The Financial Lives of Low-Income Americans."

The Wall Street Journal profiled economist Yale psychologist Laurie Santos and her work on the origins of human irrationality. Santos, who co-published a study funded by the Russell Sage Foundation, conducts experiments with Capuchin monkeys in her lab to observe if systemic decision-making errors like loss aversion extend beyond the human species. Her research has produced some surprising results:

In one experiment, they gave each monkey a wallet filled with 12 flat aluminum tokens, monkey money that the animals could trade for food. Right away, the scientists saw the similarities to human behavior. When researchers slashed the price on certain foods, the monkeys sought out the best deal. They also typically spent all their cash at once and didn't bother to save.

Then researchers decided to test a more complex economic theory which shows that people do not judge price in a vacuum. Sitting with the team at the coffee shop, Dr. Santos could see how the concept worked in her own life. Many days, she feels guilty about spending $2.20 on a cup of coffee. But when she looks up at the chalk board listing drink prices, the Nutella Latte goes for $3.85 and the Ginger Snap is $4.15. "My $2 cup doesn't seem as expensive anymore," she said.

Monkeys make similar assessments. In one experiment, a researcher showed a monkey two pieces of apple but handed over one in exchange for a token. A second researcher showed one piece of apple and gave the slice to the monkey for the token. The monkeys strongly preferred to trade with the second researcher. They did not like being offered two apple pieces and then only getting one.

For more information on this line of inquiry, see Santos' RSF-funded study: "How Basic Are Behavioral Biases? Evidence from Capuchin Monkey Trading Behavior." Here is the abstract:

As we discussed in this post, the Russell Sage Foundation played an instrumental role in the development of behavioral economics. Readers looking for a quick introduction to the discipline can find a series of articles below from the field's leading scholars. As with our reading list on inequality and mobility, this list is not meant to be exhaustive; users looking for more advanced research should see these reading lists, as well as the Foundation's behavioral economics program page, which lists our current research initiatives.

GENERAL INTRODUCTION

"A Short Course in Behavioral Economics." The Edge.org. October 1 2008. Web. March 23 2012.

Camerer, Colin. 1999. "Behavioral economics: Reunifying psychology and economics." Proceedings of the National Academy of Sciences 96 (19): 10575-10577.

Kahneman, Daniel. 2003. "Maps of Bounded Rationality: Psychology for Behavioral Economics." American Economic Review 93 (5): 1449-1475. (PDF)

Laibson, David and Richard Zeckhauser. 1998. "Amos Tversky and the Ascent of Behavioral Economics." Journal of Risk and Uncertainty 16 (7): 7-47. (PDF)

Lambert, Craig. 2006. "The Marketplace of Perceptions." Harvard Magazine. Online. March 23, 2012.

Mullainathan, Sendhil and Richard Thaler. 2000. "Behavioral Economics." MIT Working Paper 00-27.

Rabin, Matthew. 1998. "Psychology and Economics." Journal of Economic Literature 36 (1): 11-46. (PDF)

Rabin, Matthew. 2002. "A Perspective on Psychology and Economics." U.C. Berkeley Working Paper E02-313.

Thaler, Richard and Cass Sunstein. Nudge: Improving Decisions about Health, Wealth and Happiness. New Haven: Yale University Press, 2008.