Mind over money

Behavioral research may explain why people spend and save the way they do

In the world of traditional economics, people are rational actors who dispassionately pursue their self-interest, logically assessing the value of goods and services, and paying accordingly.

Then how do you explain $4 cups of coffee?

Traditional economics really can't, since it assumes purely rational consumers wouldn't pay high prices for a product that is so widely available and easily substituted. But a new research center at the Boston Federal Reserve Bank is hoping to find an answer to the coffee question, and many others, and in doing so create a framework for more effective economic policy.

The Fed's center specializes in behavioral economics, an emerging field that combines economics with psychology to better understand how people -- passionate, irrational, and sometimes downright silly -- act in the marketplace. To help gain this understanding, behavioral economists are pushing the boundaries of economic research, conducting experiments that range from offering shoppers free samples to making monkeys pay for food.

This relatively young field has produced insights that challenge accepted economic principles. For example, traditional economics teaches that choice is good, and the more choices the better. But behavioral economics has shown too many choices can confuse people and ultimately prove ineffective.

In one experiment, behavioral economists set out six samples of fruit jams at a grocery store, enticing 30 percent of shoppers to buy jam. The researchers then increased the samples to 24. According to established theory, that should have led to more purchases. Instead, jam buyers fell to 3 percent of shoppers.

Another economic principle holds that people always seek to maximize returns. But behavioral economics suggests avoiding loss is a more powerful motivator, and could, via evolution, be deeply ingrained in human nature.

At Yale University, Keith Chen, an economist, and Laurie Santos, a psychologist, taught Capuchin monkeys to buy food with metal chips. The monkeys were given a choice: They could buy one grape, with a 50-50 chance of winning a second grape, or get two grapes at the same price, but with a 50-50 chance of losing one.

In other words, the chances of ending up with just one grape were the same. Researchers expected the monkeys to simply buy the most food presented to them. But three out of four times, the monkeys chose to buy a single grape. The explanation: The monkeys didn't want to risk a loss.

''When we behave irrationally, are we just making a mistake, or is it hardwired into our nature?" said Chen. ''We are trying to address which aspects of our economic behavior are innate, and which ones we learn from the market."

Viewed as an offbeat specialty as recently as a decade ago, behavioral economics is rapidly moving into the mainstream. The specialty is generating some of the most intriguing research in economics, not by focusing on complex mathematical analysis that dominates the social science today, but rather by exploring how people react to snow shovel prices, performance incentives, and even the alarm buzzer.

Still, the big question for behavioral economics remains, ''So what?"

That's the question the Boston Fed's behavioral economics center hopes to answer. The goal of the center, established earlier this year, is to discover if these insights into individual behavior can lead to a better understanding of how the economy works, and eventually to the more effective use of policy tools, such as interest rates, taxes, and regulation.

Jeff Fuhrer, research director at the Boston Fed, said it's still unclear whether jam-buying habits or fear of losses have much effect on broad economic movements. Nonetheless, Fuhrer said, behavioral economics, by providing a ''richer description of the circumstances in which people make decisions," offers a promising avenue of inquiry into key economic forces, such as consumer spending, pricing, and inflation.

Already, the specialty is influencing public and private policies on saving. Behavioral economics has found that people put off saving for much the same reason they hit the alarm snooze button: Immediate rewards trump future rewards.

Other research has shown this propensity can be overcome by automatically enrolling people into savings plans, then leaving it up to them to opt out. One study found participation in a company 401(k) plan jumped to 86 percent with automatic enrollment from 37 percent when employees enrolled themselves.

As a result, many companies are switching to the opt-out model, while Congress is considering legislation to encourage more to adopt automatic enrollment for retirement savings plans.

''This is the most dramatic example of behavioral economics influencing public policy," said Peter Orszag, a senior fellow at the Brookings Institution in Washington, who is studying ways to increase savings.

Boston Fed officials say they hope their research center will provide other examples. Dan Ariely, the center's visiting scholar and an MIT professor, is examining why people might pay prices greater than the intrinsic value of a good or service, which could have implications for policies that rely on market forces to deliver equitable results.

Ariely's research shows people often don't have a good idea of what something is worth, which makes them susceptible to manipulation. He calls it ''Tom's law," referring to the Mark Twain character, Tom Sawyer, who convinces friends to pay for a chance to do what would otherwise seem an unpleasant chore, whitewashing a fence.

''People's willingness to pay is not always determined by supply and demand," Ariely said. ''Sometimes, they just don't know what to pay."

Which perhaps explains $4 coffees.

Robert Gavin can be reached at rgavin@globe.com.