“A bat and a ball cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost?”
Ten cents is the wrong answer, but don’t feel too bad if that was the answer that came to mind: more than
half of more than 3,000 college students selected that option, according to Shane Frederick, an associate professor of marketing at the Yale School of Management, who designed the question in 2005 to test the ability of subjects to think rationally despite incorrect intuitions. The high portion of subjects that select the wrong answer illustrates one of the main findings in contemporary behavioral studies, humanity’s frequent irrationality, said Frederick. Researchers at the Yale School of Management, including Frederick, are at the forefront of the growing field of behavioral economics, which studies the often irrational nature with which people make economic decisions.
Frederick recently completed a roughly nine-year project, which will appear in the Journal of Consumer Research in June 2012, in which he is the first researcher to show what he calls the “X effect” — that humans overestimate by an average of 40 percent how much other people will pay for items ranging from a box of gourmet chocolates to a pill that would increase one’s height by two inches. For example, the average person said they would only pay $191 for a pill to gain two inches of height, but that other people would spend $895. While Frederick said there is little doubt that the “X effect” exists, he said he was frustrated that it was so “stunningly difficult” to figure out why people commit this error.
Drazen Prelec, a professor of management science and economics at MIT, said he knew the “X effect” as the “Shane effect” when Frederick was an assistant professor of management science at MIT from 2002 to 2008, and praised the article for how it dealt with the lack of a definite explanation for the effect.
“What’s really special about this article is that it almost reads like a mystery story, and the mystery is why do people have this illusion,” Prelec said. “The article goes through one suspect explanation after another and more or less dismisses every one. We [only have] some clues about what might be the explanation.”
Others experts in the field found the lack of a definite conclusion more frustrating than Prelec did. Joachim Krueger, a professor of psychology at Brown University, said that while the article describes a “beautiful phenomenon,” its ultimate failure to propose a reason for the bias was “anticlimactic.”
Frederick said one of the possible reasons for the bias could be what his article calls “Asymmetric Salience of Expressions of Liking and Disliking.” In other words, individuals only see the people waiting in line for coffee at Starbucks and not those who go elsewhere for their caffeine drinks, causing the observers to overestimate the percentage of people who would pay $4 for a cup of coffee.
Both Prelec and Frederick also identified the paper as having important practical implications in business negotiations.
“This is an important finding in itself, namely that in negotiations if people think that other people are willing to pay more, when someone is giving you their honest estimate, you will not believe them,” Prelec said.
Frederick’s paper is an example of behavioral economics challenging classical economic theory’s assumption that humans are capable of unlimited rational thought. In the second half of the 20th century, the concept of bounded rationality — that individuals are unable to consider all of the relevant information when making decisions — began to challenge the classical assumption of total rationality, according to Ravi Dhar, a professor of management and marketing at the Yale School of Management. These first advances in behavioral economics came not from economists but from psychologists who identified the common biases and heuristics that humans use to make decisions under pressure.
“Behavioral economics is just an attempt to make our models of economic behavior psychologically more realistic,” said Nicholas Barberis, a professor of finance at the Yale School of Management. “We hope that by doing so we can understand the world better and make smarter predictions about how the world works.”
Researchers at the Yale School of Management focus not only on behavioral economics, but also in the related fields of behavioral finance, which studies how people invest, and behavioral decision theory, a more abstract study of decision making. Both Dhar and Frederick attribute the strength of overall behavior sciences research at the School of Management to the presence of this range of disciplines.
“If you pool across several departments — finance, organizational behavior, marketing, economics — I think it’s arguably the best in the world,” Frederick said. “[We have] the strongest group of behavioral people in many disciplines.”
Echoing Frederick, Prelec said that the School of Management features one of the world’s best groups of behavioral economics researchers.
Barbaris said that behavioral research at the School of Management has taken off in recent years thanks in part by a $1.6 million donation by Yale alum Andrew Redleaf ’78 in 2004. All of the Yale faculty interviewed for this article have either recently completed or are currently undertaking research.
Apart from facilitating behavioral economics research, the Yale School of Management offers related courses open to undergraduate students, including “Foundations of Behavioral Economics,” which Frederick teaches.