ECONOMICS

Putting a Human Face on Economics
Why do people put off saving? Matthew Rabin can
answer that

For more than two decades, behavioral economists
such as Richard Thaler, Andrei Shleifer, Daniel
Kahneman, and the late Amos Tversky have been
pointing out all the ways in which people diverge from
the hyperrational behavior that is assumed by
conventional economics. They procrastinate on saving
for retirement. They shop for hours to save pennies,
then make snap decisions on big-ticket items. They run
up huge credit-card debts even when they have ample
savings to pay them off.

Behavioral economics says real people act like this
because most of us lack the farsightedness or the
willpower to do what the textbooks say we should.
Makes sense, right? But even though it does a better
job of describing reality, behavioral economics isn't
part of the average economist's toolbox. One reason:
Its psychological insights were never put into a formal
language that economists could understand and work
with. ''The math was too complicated,'' says Colin F.
Camerer, a business economist at the California
Institute of Technology.

Now, behavioral economics is getting the mathematical
rigor it needs to enter the mainstream of economics,
where it can influence forecasting and policy decisions.
That's thanks in large part to the formulations of
Matthew Rabin, a 36-year-old economist at the
University of California at Berkeley. Rabin, who wears
tie-dyed T-shirts every day and does some of his best
work at the counter of a San Francisco coffee shop, is
considered a mathematical wizard by his colleagues.
This year, Rabin won a $500,000 John D. & Catherine
T. MacArthur Foundation ''genius'' fellowship in
recognition of his work on formalizing behavioral
economics.

Rabin wins high marks from some of the top names in
the field. Says the University of Chicago's Thaler:
''Much of the swagger economists show in relation to
their colleagues in other social sciences is based on the
belief that theories have to have symbols. Matthew has
provided the symbols.'' Says Carnegie Mellon
University economist George F. Loewenstein:
''Matthew is like Pac-Man. He gobbles up psychology
and leaves a trail of economic theory behind.''

LOSS LOATHING. A bedrock assumption of
standard economics is that people attempt to maximize
their well-being, using all available information and
always acting with their long-term self-interest in mind.
From this starting point, economists build models of all
economic activity, from how people respond to price
changes to what careers they pursue. In general, the
assumption works pretty well. But not always. Rabin's
goal is to improve the predictiveness of conventional
economic models by plugging into them more realistic
formulas for how people actually behave.

Take, for example, the exploding field of behavioral
finance. Thaler, author of The Winner's Curse:
Paradoxes and Anomalies of Economic Life, uses
behavioral theories to explain what economists call the
''equity premium puzzle'': the odd fact that the
long-term returns on equities are much higher than
those on bonds--even more than their higher volatility
would seemingly call for. Thaler says the answer to the
puzzle is that people hate losses much more than they
enjoy gains. So investors demand higher returns from
stocks to compensate for their dread of losses.
Likewise, sports fans who would not pay more than
$200 for a Super Bowl ticket wouldn't sell one they
own--i.e. ''lose'' it--for less than $400.

Rabin has made big contributions in the study of
fairness. Imagine there's a drought. The more others
conserve water, the more water a self-interested
person could use without causing the reservoir to run
dry. In fact, though, people are fair; they tend to
conserve more when they see others conserving. That's
what Rabin built into his formal model. Says Rabin:
''People reciprocate public-spiritedness in others rather
than counteract it.'' His model also takes into account
that perceptions of unfairness breed retaliation, even
when the cost of retaliating is very high.

DELAYING TACTICS. Rabin's work on
self-control problems such as procrastination is
catching on most quickly. Cornell University economist
Ted O'Donoghue and Rabin demonstrate that there's a
good reason why many people put off the chore of
financial planning--it takes a lot of work, and there's an
insignificant cost of delaying the work until tomorrow.
The difficulty comes from the fact that the same is true
every day--and those small daily losses eventually add
up to a tremendous sum. Rabin should know: He
admits to having his own ''severe procrastination
problem.'' Rabin adds that people procrastinate longer
on the most important things because the up-front effort
is usually greatest.

O'Donoghue and Rabin recommend policies to fight
procrastination, such as automatic enrollment in
employee retirement plans, transaction deadlines, and
on-the-job seminars on retirement planning.
Economists once assumed such measures were
unnecessary. But Thaler, who offers similar
recommendations, says the steps ''are designed to take
into account people's humanness.''

Rabin envisions a day when all economics is so infused
with the findings of psychology that behavioral
economics loses much of its distinctiveness. His own
procrastination problem, however, may be more
difficult to conquer. He admits that he has kept an
average of more than $20,000 in his checking account
at less than 1% interest for the past 10 years. Might his
work on procrastination affect how promptly he'll
invest the MacArthur prize? Answers Rabin: ''Not a
chance.''

By Charles J. Whalen in New York

BUSINESSWEEK ONLINE : JULY 31, 2000 ISSUE
 
 
 

ECONOMICS

How People Really Behave
 

Behavioral economists explain what's seemingly irrational

CONVENTIONAL               BEHAVIORAL

People focus on            People compartmentalize their
overall assets.            finances. Households with large
                           savings often run up high-interest
                           credit-card debt.

Stocks should barely       People go to great lengths to avoid
outperform bonds.          losing money. Since stocks are
                           riskier than bonds, investors in
                           stocks demand much higher returns
                           from them to compensate for the dread
                           of losses.

People act on the basis    People match their behavior to that
of pure self-interest.     of those around them. This explains-
                           why people make sacrifices volun-
                           tarily--and why those who feel mis-
                           treated may retaliate even if the
                           personal cost is great.

In daily life, people      Procrastination on important matters
focus on the long term.    is rampant. That's why many people
                           leave large sums in low-interest
                           checking accounts and put off saving
                           for retirement.