One Reason Why Psychology Matters: $BILLIONS$

The most recent edition of the Atlantic (January/Feburary 2008) included a brief blurb about a curious result from a Cornell Johnson Business School research paper. This paper found that sellers can make buyers perceive that a cost is smaller than it is by replacing zeroes with numbers. The authors suggest that this comes about because we use precise numbers to measure small quantities, and rounded numbers to measure large quantities - consequently, a number like 391,534 will seem smaller than 390,000. Examining 27,000 real-estate transactions on Long Island and in South Florida, they found that having at least one zero lowered the sale price by about 0.72% compared to houses listed at a similar price. Three zeroes lowered it by 0.73%, and each additional zero lowered it by 0.39%.

I can think of a couple other reasons that might be the case (For example, buyers might understand that sellers would likely round up rather than round down. Or, sellers might believe that the more precise number reflects careful pricing and analysis and is more reliable than the rounded number.) Whatever the reason, this result is an example of the success and value of behavioral economics.

Behavioral economics is a recent effort spearheaded by psychologists and economists to incorporate the results from social psychology into microeconomics models. in turn, features these microeconomic models are being incorporated into macroeconomic theory.

The recent wave of foreclosures provides another example of behavioral economics at work. The NYTimes has an article titled "A Reality Check for Home Sellers" (Sept 23, 2007, available at http://www.nytimes.com/2007/09/23/business/yourmoney/23view.html). Home buyers experience loss aversion ; that is, they feel losses more strongly than gains.

One consequence of this is that they will leave homes on the market at or above the price they paid for it, even after it is clear that their home is no longer worth as much. This is deemed "irrational" by classical economics, which states that the price a rational consumer offers ought to simply be whatever the market price is for the home. Another consequence is that an unsold home can prevent an individual from moving and taking a better-paying job elsewhere. (This may be particularly important if the drop in housing prices is in part due to the closure of a local employer.)

Studies show that individuals typically feel losses more strongly than gains by a factor of 2 to 2.5 to 1. This means that, all other things being equal, the average person would wager $100 on a coin toss only if she would win $200-$250 if she called it correctly. The ancients were right when they said, "A bird in the hand is worth two in the bush."

The strength of Behavioral Economics is growing, as evidenced by another NYTimes article ("Calculating the Irrational in Economics, Jan. 14, 2008) http://query.nytimes.com/gst/fullpage.html?res=9407E1DC1F3BF93BA15755C0A9659C8B63) and the popularity of the book Freakanomics. It was by far one of the most interesting and valuable courses I have taken in my life (and I've been in school for 19 of my 24 years). Check it out - even if it doesn't make you a fortune, it might explain why you aren't socking away money in your 401(k), or why you waste so much money on gym memberships, or why procrastination hurts so good.

Speaking of which, I've got some work to do...