What stops people making good decisions?

Young Daniel McFadden met a young lady named Beverlee and married her three months later. The two are happy together to this day. It’s no surprise his studies on behavioral economics teach us about questions such as when to marry, where to work and where to live. His work on 'discrete choice' was only the starting point in analyzing people’s behavior. McFadden’s research predicted not only conditions for use of public transportation, but also focused on the state of the elderly in society, housing, financial diversification, and health services. His own biography underlines his economic reputation: he grew up during the Great Depression in a family growing peanuts, despite being deprived of running-water. Today, McFadden grows grapevines in his Napa Valley vineyard.

Daniel L. McFadden

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (shared), 2000

At a glance

Born: 1937, Raleigh, North Carolina

Field: Behavioral Economics

Prize-winning work: Theory and methods for analyzing discrete choice

Early engagements: Started a civil rights petition at high school and got suspended

Decision skills: He got married three months after the first date with his future wife

Self-confidence: He thought the call from the Nobel Committee was a prank

Bad at: Dancing

Stalkers: One. His dog, Odi, follows him around everywhere

Meeting the man who helps us predict the future

Daniel McFadden offers composed confidence in an interview, holding a handsome yet steady, wistful smile. He’s quick off the mark, usually firing off the right answer before the question is fully asked. That said, he never does so without empathy, his colleague and good friend Kenneth Train agrees. He remembers meeting for the first time. During a job interview, when McFadden spoke about his Conditional Logit Model, Train (the applicant) interrupted to correct McFadden’s pronunciation. “I corrected him on the model he was developing. He didn’t even say anything - he just let me go ahead,” Train says with a laugh.

We meet him in Russell Hill, San Francisco. Here, McFadden started applying his work on the Logit Model, which helped determine future demand for a new urban subway system.

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How can we foresee people’s decisions?

When we meet McFadden in Napa Valley, he remembers these early issues. People, as he points to the basic economic idea, behave in their own self-interest. They have preferences, and these preferences can be measured. “You call it utility and you say the people are maximizing utility. For some people, the utility of having a red car is high, for others the utility of having a red car is low. When you describe these random preferences, you can characterize how the population will behave. If you trace out the proportion of people that will buy a car and plot it against the price of the car, what you’ll see is some kind of curve: the car is very inexpensive, lots of people will buy it. If it gets more expensive, then fewer will buy it.”

How can we prevent people from making harmful decisions?

McFadden’s model gained prominence in many areas of economics, as it successfully predicts behavior. At the same time, McFadden brings to light that one of the big lessons of behavioral economics is that people often don’t consider the long term when making financial decisions. He suggests that more instruments are needed to help people spend their money wisely, alongside help with saving and planning for retirement to prevent poverty in old age.

McFadden highlights that this is a policy issue. For example, he suggests another form of insurance that prevents people from “outliving” their pensions. He urges young people to think about their distant future. “Building up some assets starting young would put you in a much better position towards the end of your life.” Even though everyone should live and spend every day as if it were their last, which might be the maxim of the recent Generation Y, McFadden cautions that “balance is needed.”

He speaks from experience. During the Great Depression of the 1930s, his parents were forced to move to a farm without running water or electricity. In this environment, Daniel McFadden’s social life mainly consisted of the characters he met in books, as he was an ardent reader from a young age. “If you asked me anything when I was ten years old, I pretty much knew about everything,” he reminisces with a smile.

Why do people fear trade and investments?

Although McFadden himself is a child of the Great Depression, he doesn’t understand why people fear trade and investments. Of course, from a psychological and behavioral economics perspective, it makes sense. “You’re being thrown into an interpersonal interaction, with someone you’re not sure you can trust, and that creates stress,” he analyzes. “A set of questions tends to bother people: is this person going to pay me? Does he or she know something that I don’t?

“If you decide something and it turns out to be a bad choice, you beat yourself up about it. What then happens psychologically is that people often say: why bother with it at all? I’m okay where I am. Maybe I’d be a little bit better off if I made this trade, but perhaps I will make myself unhappy, so I’ll simply avoid it.” He emphasizes again that it’s important to be cautious about savings. But to his mind, avoiding investments and trade isn’t the answer.

What are systematic mistakes in decision making?

Anxiety towards risk and avoiding, for example, “putting your eggs in different baskets” isn’t the only problematic aspect of making bad decisions that affect our entire lives. Political events in particular show a much wider perspective. “I think it’s reported that the main two Google searches in the days after the Brexit vote were, 1) What is Brexit? and 2) What is the EU?” says McFadden, pointing to systematic mistakes people make when processing information. “Concentrating too much on what’s going to come right now without looking into the future to see what the consequences will be, or paying too much attention to the things that are so easy to see, the shiny parts of the car and not the stuff that’s under the bonnet, all those things are systematic biases in the way people, in general, make decisions.”

Do we learn from making bad decisions?

In McFadden’s opinion, when making bad decisions, people are driven by fear on many levels. For example, fear of immigrants becomes an engine for populism and right wing-parties. When people make decisions, they don’t consider the long-term benefits. “When you have immigrants coming into a nation,” he says, “they bring economic activity, which generates income. In most cases, these immigrants end up adding to the economy and even employing other people.”

Research and economic evidence could help not only citizens but also policy makers to take a “moderate view”, McFadden claims. “There’s a way to pursue policies which seek to help assimilate refugees, providing impetus for entry to the workforce, enabling many to contribute to the economy.”

What McFadden has learned from his research is that people don’t learn as well as they should from their own bad decisions. A popular response people tend to adopt when something goes wrong is to blame someone else. “There’s a cultural failure to take responsibility for your own actions and to try to learn from your own mistakes,” McFadden explains. He states that we’re all responsible for what happens. In his opinion, we’ll go on making systematic errors unless we recognize them and do our best to correct them in our behavior.

His advice to the young? “One would hope that in future, young people won’t sit on the sidelines, but rather think seriously about the kind of future they want for themselves, and try to achieve it.”

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