Sunday, December 18, 2011

Predictably Irrational: Chapter 4

Dan Ariely is a behavioural economist who refutes the idea that we are fundamentally rational. Through empirical data, experiments and anecdotes, he illustrates that our irrationality can actually be predicted. He then presents ways in which we can make more rational decisions, both as investors and as people.

Human behaviour changes based on whether we view a situation as a social one or a market one. In a social context, it makes sense to help someone without requiring immediate reciprocation. In a market context, however, we expect immediate payment for our efforts. Sometimes, we can be manipulated by counterparties (who are interested in profit) into thinking we should be behaving in a social context when we should be thinking in a market context.

Ariely ran and cited a number of experiments illustrating this dichotomy. They showed that humans are more willing to work for free (i.e. as a social favour) than they are for small amounts of money (a market transaction that would make them better off). They are also willing to work harder (i.e. more work gets done) when they work for free versus when they work for little.

The experiments also show that once market norms enter a social context, the social context is nearly destroyed; from then on, market norms take over. For example, a daycare used to have a certain number of parents picking up their kids late. When they instituted a charge for lateness, people felt more comfortable coming late and so the late numbers rose. When the charge was removed, the late numbers stayed elevated. Ariely interprets this to mean the social contract (the feeling of guilt at arriving late) was irreparably obliterated when market norms entered the fray.

Gifts on the other hand, are seen as within the context of social norms. So while someone might not do you a favour for fifty cents cash, they will do so for a fifty-cent gift...unless you mention the price of the gift, that is! Once people even start thinking of things in a market context, the social norms go out the window!

Many companies apply these concepts successfully, both with their customers and their employees. Gifts (instead of cash) and efforts that stress social, rather than financial, contracts make customers/employees more loyal and more productive than those who simply think in terms of market benefits. Ariely notes that there is a risk here for companies, for when market norms do enter the fray, it can result in anger and hurt feelings as the social contracts are obliterated.

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