The Compromise Effect

. . . And the New Thinking About Money Is That Your Irrationality Is Predictable

Chances are you know someone who sells his stocks only if they have gone up, never if they have gone down.

Or the person who regularly runs up credit card debt but would never think of dipping into her savings account.

Or maybe the guy who refuses to pay $15 to have someone else mow his lawn but wouldn't dream of mowing anyone else's lawn for $15.

And what about those folks who flock to all-you-can-eat buffets and cell-phone plans with unlimited minutes?

According to traditional economic theory, such people shouldn't exist. People aren't supposed to careen through life systematically making bad bets, leaving money on the table, assigning different values to the same products and paying too much for things they don't really want. Homo economicus is supposed to make intelligent, rational choices that maximize his or her wealth and financial well-being.

Reality, of course, turns out to be quite different from theory. As economic actors, people are as likely to be governed by their emotions as by reason, by prejudices as by careful cost-benefit analysis. Their rationality is bounded by limits on their time, intelligence and the information at their disposal.

Take the bargain hunters in the headline above. They get so excited about the 50 percent discount on that sweater they don't realize it's just as worthwhile for them to drive across town to get a 1.3 percent discount on a $750 chair. Ten dollars is ten dollars, any way you slice it.

Or that investor who won't sell a falling stock, because that would mean admitting a loss. He would be better off deciding which stocks to hold on to based solely on his expectation of their future performance, regardless of what happened in the past.

And by what logic should people be buying things for prices that are vastly different from what they are willing to sell them for, such as their time (mowing lawns) and their money (the high interest rates paid on credit cards compared with the low rates earned on savings deposits)?

As for folks with unlimited calling plans, they get so enchanted with all the extra long-distance calls that seem as if they are free, they don't focus on the fact that their monthly bills are higher.

In recent years, a growing cadre of economists and psychologists has begun to challenge the economic orthodoxy. Relying on clever laboratory experiments and data from businesses and financial markets, they have not only documented how irrational people become around issues of money and prices, but also demonstrated how predictably irrational they are.

"A lot of problems we have in real life come from our inability to deal with money," explained psychologist Daniel Ariely at the Sloan School of Management at the Massachusetts Institute of Technology. "Money is an abstract concept that we, as human beings, don't understand. How much money is it worth to eat sushi? Economists used to think we could calculate that, but it is really impossible. At any moment in time I may be able to say that I prefer sushi to a banana. I may even have a notion of how many bananas I would trade for one piece of sushi. But how much money are they worth? I have no idea."