A recent issue of The New Yorker has some lengthy coverage of the rise of neuroeconomics by business writer John Cassidy. A few interesting excerpts:

Trust plays a key role in many economic transactions, from buying a secondhand car to choosing a college. In the simplest version of the trust game, one player gives some money to another player, who invests it on his behalf and then decides how much to return to him and how much to keep. The more the first player invests, the more he stands to gain, but the more he has to trust the second player. If the players trust each other, both will do well. If they don’t, neither will end up with much money.

Fehr and his collaborators divided a group of student volunteers into two groups. The members of one group were each given six puffs of the nasal spray Syntocinon, which contains oxytocin, a hormone that the brain produces during breast-feeding, sexual intercourse, and other intimate types of social bonding. The members of the other group were given a placebo spray.

Scientists believe that oxytocin is connected to stress reduction, enhanced sociability, and, possibly, falling in love. The researchers hypothesized that oxytocin would make people more trusting, and their results appear to support this claim. Of the twenty-nine students who were given oxytocin, thirteen invested the maximum money allowed, compared with just six out of twenty-nine in the control group. “That’s a pretty remarkable finding,” Camerer told me. “If you asked most economists how they would produce more trust in a game, they would say change the payoffs or get the participants to play the game repeatedly: those are the standard tools. If you said, ‘Try spraying oxytocin in the nostrils,’ they would say, ‘I don’t know what you’re talking about.’ You’re tricking the brain, and it seems to work.”

… and this…

The results provide further evidence that reason and emotion often compete inside the brain, and it also helps explain a number of puzzling phenomena, such as the popularity of Christmas savings accounts, which people contribute to throughout the year. “Why would anybody put money into a savings account that offers zero interest and imposes a penalty if you withdraw cash early?” Cohen said. “It simply doesn’t make sense in terms of a traditional, rational economic model. The reason is that there is this limbic system that produces a strong drive. When it sees something it likes, it wants it now. So you need some type of pre-commitment device to make people save.”

Laibson and Brigitte Madrian, an economist at the Wharton School, have studied one such “pre-commitment device” for 401(k) plans, which deduct part of an employee’s earnings each month and invest them in stocks and bonds. Because the plans are often optional, many people fail to join them, even when their employers offer to match a portion of their contributions. Laibson and his colleagues have called for people to be automatically included in the plans unless they choose to opt out. At companies that have adopted such a policy, enrollment rates have increased sharply.

Reforming 401(k) plans is an example of “asymmetric paternalism,” a new political philosophy based on the idea of saving people from the vagaries of their limbic regions. Warning labels on tobacco and potentially harmful foods are similarly intended to keep subcortical structures in check. Neuroeconomists have suggested additional policies, including warning buyers of lottery tickets that their chances of winning are practically nonexistent and imposing mandatory “cooling off” periods before people make big-ticket purchases, such as cars and boats. “Asymmetric paternalism helps those whose rationality is bounded from making a costly mistake and harms more rational folks very little,” Camerer, Loewenstein, and three colleagues wrote in a 2003 issue of the University of Pennsylvania Law Review. “Such policies should appeal to everyone across the political spectrum.”

The results provide further evidence that reason and emotion often compete inside the brain, and it also helps explain a number of puzzling phenomena, such as the popularity of Christmas savings accounts, which people contribute to throughout the year. “Why would anybody put money into a savings account that offers zero interest and imposes a penalty if you withdraw cash early?” Cohen said. “It simply doesn’t make sense in terms of a traditional, rational economic model. The reason is that there is this limbic system that produces a strong drive. When it sees something it likes, it wants it now. So you need some type of pre-commitment device to make people save.”

Laibson and Brigitte Madrian, an economist at the Wharton School, have studied one such “pre-commitment device” for 401(k) plans, which deduct part of an employee’s earnings each month and invest them in stocks and bonds. Because the plans are often optional, many people fail to join them, even when their employers offer to match a portion of their contributions. Laibson and his colleagues have called for people to be automatically included in the plans unless they choose to opt out. At companies that have adopted such a policy, enrollment rates have increased sharply.

Reforming 401(k) plans is an example of “asymmetric paternalism,” a new political philosophy based on the idea of saving people from the vagaries of their limbic regions. Warning labels on tobacco and potentially harmful foods are similarly intended to keep subcortical structures in check. Neuroeconomists have suggested additional policies, including warning buyers of lottery tickets that their chances of winning are practically nonexistent and imposing mandatory “cooling off” periods before people make big-ticket purchases, such as cars and boats. “Asymmetric paternalism helps those whose rationality is bounded from making a costly mistake and harms more rational folks very little,” Camerer, Loewenstein, and three colleagues wrote in a 2003 issue of the University of Pennsylvania Law Review. “Such policies should appeal to everyone across the political spectrum.”

Read more: Mind Games: What neuroeconomics tells us about money and the brain

The March-April 2006 issue of Harvard Magazine features some excellent and inspiring coverage of of behavioral economics. Here’s a few highlights…

On intertemporal choice (or what the article poetically calls “the seductive now-moment”):

A national chain of hamburger restaurants takes its name from Wimpy, Popeye’s portly friend with a voracious appetite but small exchequer, who made famous the line, “I’ll gladly pay you Tuesday for a hamburger today.” Wimpy nicely exemplifies the problems of “intertemporal choice” that intrigue behavioral economists like David Laibson. “There’s a fundamental tension, in humans and other animals, between seizing available rewards in the present, and being patient for rewards in the future,” he says. “It’s radically important. People very robustly want instant gratification right now, and want to be patient in the future. If you ask people, ‘Which do you want right now, fruit or chocolate?’ they say, ‘Chocolate!’ But if you ask, ‘Which one a week from now?’ they will say, ‘Fruit.’ Now we want chocolate, cigarettes, and a trashy movie. In the future, we want to eat fruit, to quit smoking, and to watch Bergman films.”

Laibson can sketch a formal model that describes this dynamic. Consider a project like starting an exercise program, which entails, say, an immediate cost of six units of value, but will produce a delayed benefit of eight units. That’s a net gain of two units, “but it ignores the human tendency to devalue the future,” Laibson says. If future events have perhaps half the value of present ones, then the eight units become only four, and starting an exercise program today means a net loss of two units (six minus four). So we don’t want to start exercising today. On the other hand, starting tomorrow devalues both the cost and the benefit by half (to three and four units, respectively), resulting in a net gain of one unit from exercising. Hence, everyone is enthusiastic about going to the gym tomorrow.

On 401(k) contributions and procrastination:

Take 401(k) retirement plans, which not only let workers save and invest for retirement on a tax-deferred basis, but in many cases amount to a bonanza of free money: the equivalent of finding “$100 Bills on the Sidewalk” (the title of one of Laibson’s papers, with James Choi and Brigitte Madrian). That’s because many firms will match employees’ contributions to such plans, so one dollar becomes two dollars. “It’s a lot of free money,” says Laibson, who has published many papers on 401(k)s and may be the world’s foremost authority on enrollment in such plans. “Someone making $50,000 a year who has a company that matches up to 6 percent of his contributions could receive an additional $3,000 per year.”

The rational model unequivocally predicts that people will certainly snap up such an opportunity. But they don’t—not even workers aged 59 1/2 or older, who can withdraw sums from their 401(k) plans without penalty. (Younger people are even more unlikely to contribute, but they face a penalty for early withdrawal.) “It turns out that about half of U.S. workers in this [above 59 1/2] age group, who have this good deal available, are not contributing,” says Laibson. “There’s no downside and a huge upside. Still, individuals are procrastinating—they plan to enroll soon, year after year, but don’t do it.” In a typical American firm, it takes a new employee a median time of two to three years to enroll. But because Americans change jobs frequently—say, every five years—that delay could mean losing half of one’s career opportunity for these retirement savings.

I’ve read alot of the research on the behavioral biases that effect people’s participation (or lack thereof) in corporate retirement plans, but this last fact still amazed me. Someone who is 59 1/2 or older and works for a company which matches employee retirement contributions has no reason not to participate. A one dollar contribution, plus the employer’s matching dollar, can be immediately withdrawn, doubling the employee’s money with hardly any effort. And yet half the people in that situation don’t take advantage of it. This is powerful evidence against the conventional rational choice model in economics.

Yet it gets worse:

Laibson has run educational interventions with employees at companies, walking them through the calculations, showing them what they are doing wrong. “Almost all of them still don’t invest,” Laibson says. “People find these kinds of financial transactions unpleasant and confusing, and they are happier with the idea of doing it tomorrow. It demonstrates how poorly the standard rational-actor model predicts behavior.”

It’s not that we are utterly helpless against procrastination. Laibson worked with a firm that forced its employees to make active decisions about 401(k) plans, insisting on a yes or no answer within 30 days. This is far different from giving people a toll-free phone number to call whenever they decide to enroll. During the 30-day period, the company also sent frequent e-mail reminders, pressuring the staff to make their decisions. Under the active-decision plan, enrollment jumped from 40 to 70 percent. “People want to be prudent, they just don’t want to do it right now,” Laibson says. “You’ve got to compel action. Or enroll people automatically.”

When he was U.S. Treasury Secretary, Lawrence Summers applied this insight. “We pushed very hard for companies to choose opt-out [automatic enrollment] 401(k)s rather than opt-in [self-enrollment] 401(k)s,” he says. “In classical economics, it doesn’t matter. But large amounts of empirical evidence show that defaults do matter, that people are inertial, and whatever the baseline settings are, they tend to persist.”

The article goes on to describe some fascinating research on borrowing behavior done by Sendil Mullainathan, which again is completely at odds with the behavior traditional economics would predict.

Mullainathan worked with a bank in South Africa that wanted to make more loans. A neoclassical economist would have offered simple counsel: lower the interest rate, and people will borrow more. Instead, the bank chose to investigate some contextual factors in the process of making its offer. It mailed letters to 70,000 previous borrowers saying, “Congratulations! You’re eligible for a special interest rate on a new loan.” But the interest rate was randomized on the letters: some got a low rate, others a high one. “It was done like a randomized clinical trial of a drug,” Mullainathan explains.

The bank also randomized several aspects of the letter. In one corner there was a photo—varied by gender and race—of a bank employee. Different types of tables, some simple, others complex, showed examples of loans. Some letters offered a chance to win a cell phone in a lottery if the customer came in to inquire about a loan. Some had deadlines. Randomizing these elements allowed Mullainathan to evaluate the effect of psychological factors as opposed to the things that economists care about—i.e., interest rates—and to quantify their effect on response in basis points.

“What we found stunned me,” he says. “We found that any one of these things had an effect equal to one to five percentage points of interest! A woman’s photo instead of a man’s increased demand among men by as much as dropping the interest rate five points! These things are not small. And this is very much an economic problem. We are talking about big loans here; customers would end up with monthly loan payments of around 10 percent of their annual income. You’d think that if you really needed the money enough to pay this interest rate, you’re not going to be affected by a photo. The photo, cell phone lottery, simple or complicated table, and deadline all had effects on loan applications comparable to interest. Interest rate may not even be the third most important factor. As an economist, even when you think psychology is important, you don’t think it’s this important. And changing interest rates is expensive, but these psychological elements cost nothing.”

Finally, we get this sketch of an economics profession which can step away from the differential calculus long enough to engage itself with the messy, hopeful details of the real world. Behavioral economics holds the real power to improve people’s lives, and I’m excited to see these paths explored.

Mullainathan is helping design programs in developing countries, doing things like getting farmers to adopt better feed for cows to increase their milk production by as much as 50 percent. Back in the United States, behavioral economics might be able to raise compliance rates of diabetes patients, who don’t always take prescribed drugs, he says. Poor families are often deterred from applying to colleges for financial aid because the forms are too complicated. “An economist would say, ‘With $50,000 at stake, the forms can’t be the obstacle,’” he says. “But they can.” (A traditional explanation would say that the payoff clearly outweighs the cost in time and effort, so people won’t be deterred by complex forms.)

Economists and others who engage in policy debates like to wrangle about big issues on the macroscopic level. The nitty-gritty details of execution—what do the forms look like? what is in the brochures? how is it communicated?—are left to the support staff. “But that work is central,” Mullainathan explains. “There should be as much intellectual energy devoted to these design choices as to the choice of a policy in the first place. Behavioral economics can help us design these choices in sensible ways. This is a big hole that needs to be filled, both in policy and in science.”

This article presents a fantastic overview of the rise of the behavioral faction within economics over the last few decades as well as striking details about recent research, suggesting inspiring avenues for future work. Strongly recommended!

Read more: The Marketplace of Perceptions: Behavioral economics explains why we procrastinate, buy, borrow, and grab chocolate on the spur of the moment