Explaining the Irrational

By Julie Diop    November 2002

Economist Sendhil Mullainathan is building better economic models by focusing on the irrational decisions people sometimes make. (Photograph by Daniel Vanackere)

Behavioral economists are building new models to explain why people make illogical economic decisions

Governments rely on economists to tell them whether to increase spending, reduce taxes, or tackle deficits. Economists, in turn, predict how the population’s spending habits will change in reaction to policies. If policymakers act on predictions that are wrong, the economy could go into a tailspin. So building accurate models that reflect how people spend and invest is critical.

Economic models predict such things as price and wage fluctuations. The models can explain, for instance, why demand for a company’s stock rises and its share price jumps when the company announces better-than-expected news. But they cannot explain why investors poured money into Internet companies that had only dim prospects. Psychologists may be as qualified as economists to untangle this phenomenon. And increasing numbers of economists are turning to psychology to model people’s often irrational behavior, giving the relatively new field of behavioral economics legitimacy. Sendhil Mullainathan and Xavier Gabaix, both in MIT’s Department of Economics, and Sloan School of Management psychologist Drazen Prelec are forging into new territory. They are overhauling assumptions from economic models that predict that people act rationally on the basis of perfect information, and the two are helping to pave the way for other behavioral economists by developing new theories to explain people’s actions.

Understanding human behavior and social phenomena from an economic point of view could lead to more effective social policies and a better understanding of what makes people do what they do,  Mullainathan says. In one study that points in that direction, he examined what happened when, in 1992, the South African government dramatically raised pension payments to its elderly black population. Mullainathan used data that the World Bank and South African Development Research Unit collected from 9,000 households in 1993.

Mullainathan’s work confirmed what local newspapers had already reported: in households that included a pensioner, the windfall prompted the prime earners to stop working altogether. “The men sat around while the women continued to work,” Mullainathan says.

“There were lots of ideas, but,” Mullainathan says, “ideas are cheap. A lot of my work is coming up with facts.”

In other research, Mullainathan is looking at how people form categories in their minds and what influences their formation. For example, what makes someone a good job candidate? Experience and education make a difference, Mullainathan says. What constitutes a good investment? Television, newspapers, magazines, books, and friendly advice help people form investment strategies.

Investors often group companies into categories, viewing them as either good or bad. If they see a company as especially good, most people hold onto their shares even when it announces bad news. Mullainathan found, however, that if there is bad news from a company that is just barely in the good category, investors overreact and sell their shares: in their minds, the company has fallen into the bad category. During the Internet boom, companies “tried to get into the Internet category,” redefining their businesses. Mullainathan cites networking company 3Com, which in an effort to boost the price of its stock, issued press releases that aimed to reposition the company. Mullainathan’s research shows that the more knowledge people had about investing, the less likely they were to group 3Com with Internet companies.

Gabaix studies a different but similar set of problems that are related to the way people process information. People face complex problems every day, he says, and they take shortcuts that lead them to make irrational decisions. Gabaix points out that although it’s not unusual for people to have inadequate information about their options, traditional models don’t take this into account.

The tendency to make decisions on the basis of inadequate information and with a limited ability to process it helps explain the volatility of the stock market, Gabaix says. Although a given company looks much the same from one day to the next, its shares may fluctuate wildly as people make ill-informed decisions about buying and selling its stock.

Prelec offers another explanation for stock market volatility. Economists’ assumptions about rationality don’t capture the complexities of decision-making processes. Furthermore, he says that people’s valuations of goods are often not based on the goods’ underlying value.

Building models that explain irrational behavior is a leap forward in economics. But no matter how robust the new models, people will always make decisions that stump economists. After all, people invariably behave in ways that defy models, including ones that explain their irrationality.
Julie Diop is a business journalist who writes pieces for magazines and newspapers.