but let's think about...let's suppose I want to put this ball in this pocket.
Now, I know the trigonometry; I've got to get the angles right and so forth.
An expert would have no problem with it, but for me, this is a pretty hard shot.
Ooh! Close!
Most of the time, we're not expert billiards players.
When people face hard problems, they make mistakes.
At the center of all the rational models lies an unflinching belief in free markets.
The idea is to keep regulation and government interference to a minimum,
in both the every day consumer market and in the giant money markets of Wall Street.
Rational economists believe that the increase in wealth, worldwide, over the last 30 years,
is a triumph for free markets.
GARY BECKER: It lifted maybe a billion people out of real poverty, and I mean real poverty,
but they had one dollar a day or two dollars a day.
That's real poverty. And it lifted those people above those limits.
ARCHIVE AUDIO NEWS CLIP: What in the world is happening on Wall Street?
Then comes the crash of 2008.
ARCHIVE AUDIO NEWS CLIP: Investment traders say they've never seen anything like it.
The stock market drops over 40 percent...
ARCHIVE AUDIO NEWS CLIP: The Dow traders are standing there,
watching in amazement, and I don't blame them.
ARCHIVE AUDIO NEWS CLIP: Traders here, working the phones,
say a lot of their customers are freaked out, waiting to see how low the Dow will go.
...and apparently irrational financial behavior becomes the order of the day.
ARCHIVE AUDIO NEWS CLIP: Let's talk about the speed with which we're watching this market
deteriorate.
Fourteen-trillion dollars of wealth invested by Americans is destroyed.
ARCHIVE AUDIO NEWS CLIP: This has truly been a manic Monday on Wall Street.
Fear grips the markets.
ARCHIVE AUDIO NEWS CLIP: The stock market suffered one of its worst days in years.
And financial experts are forced to imagine the once impossible:...
ARCHIVE AUDIO NEWS CLIP: We haven't seen anything like this since the Great Depression.
...the global economy coming to a halt.
LEO MELAMED (Chicago Mercantile Exchange): I shudder to think if all of that stopped.
The consequences are beyond imagination: there would be hunger; there would be war;
there would be strife; there would be total unemployment.
ARCHIVE AUDIO NEWS CLIP: We're having an electronic run on the banks.
LEO MELAMED: It would put the world back a hundred years, maybe more.
The chaos seems to undermine decades of economic thinking.
GARY BECKER: Economists as a whole didn't see it coming.
So that's a black mark on economics, and it's not a very good mark for markets.
ARCHIVE AUDIO NEWS CLIP: This market took five years to go higher; it's now down 40
percent; this was in one week.
With the crash, the rift in economics widens between the rationalists and the behavioralists.
ARCHIVE AUDIO NEWS CLIP: We are talking about financial Armageddon.
JENNIFER LERNER: The crash really matters, because much of the behavior that led up to
the crash is unexplained by the discipline of economics.
JOHN COCHRANE: I'm sorry, that's such an empty argument.
That's just an insult, a pointless insult.
EUGENE FAMA: I don't see this as a failure of economics,
but we need a whipping boy, and economists have always, kind of, been
whipping boys, so they're used to it.
It's fine.
So which side is right? Are we rational about money,
or do our emotions and psychology play a much bigger role than previously realized?
ZACH BURNS: Okay, everyone, we're going to start off with a game.
Take the auction of the 20-dollar bill that sold for 28.
ZACH BURNS: Do I hear one dollar?
BIDDER ONE: One, one dollar.
ZACH BURNS: How about two?
BIDDER TWO: Two, two dollars.
In the rational model, a person should never pay 28 dollars for a
20-dollar bill.
ZACH BURNS: Six? How about six?
BIDDER SIX: Six.
Paying more than something is worth cannot be in anyone's best financial interest.
The auction is a key experiment of behavioral economics.
RICHARD THALER: It's designed to be a trap, and it's a trap that,
if you don't think more than a couple steps ahead, you fall into.
ZACH BURNS: Eleven? Eleven. Twelve.
Do I hear 13?
It's the emotional desire to win that drives bids up.
ZACH BURNS: Fourteen? Fourteen! Fifteen.
Do I hear 20? Twenty dollars.
And fear of being the loser drives them even higher.
BIDDER EIGHT: 23.
BIDDER SEVEN: 24.
BIDDER EIGHT: 25.
RICHARD THALER: And now it's a game of chicken.
ZACH BURNS: Twenty-six!
BIDDER EIGHT: Twenty-seven.
ZACH BURNS: Twenty-seven going once...
BIDDER SEVEN: Twenty-eight.
ZACH BURNS: Twenty-eight!
Twenty dollars sold for $28 to this gentleman.
BIDDER SEVEN: What a deal.
ZACH BURNS: And you owe me $27, as well.
RICHARD THALER: Nobody will want to play that game twice.
The auction may seem far removed from everyday life,
but do people outside of the classroom behave just as irrationally?
We asked shoppers in a Chicago mall if they would prefer $100 in a year's time or $102
in a year and a day.
MALL SHOPPER ONE: I'll take the $102 in a year and one day.
MALL SHOPPER TWO: A hundred and two dollars.
MALL SHOPPER THREE: Year plus a day.
MALL SHOPPER FOUR: I mean, I can wait that extra day for it, the $102.
MALL SHOPPER FIVE: It really wouldn't make any difference.
MALL SHOPPER SIX: I would do the 102 a year and a day from today.
They all made the rational decision...
MALL SHOPPER SIX: What's one day after a whole year of waiting?
...and chose the bigger amount. Then they were asked if they would prefer
$100 today or $102 tomorrow. The larger amount is still the rational choice.
So what did they say?
MALL SHOPPER ONE: I'll take $100 right now.
MALL SHOPPER SIX: I would take $100 today.
MALL SHOPPER FOUR: I would prefer the $100 today.
MALL SHOPPER THREE: Today.
MALL SHOPPER FIVE: I'm taking the $100 today.
The desire for a quick reward....
MALL SHOPPER SIX: One hundred dollars today.
...trumps their rational self-interest.
RICHARD THALER: There's something called "present bias," that if we have the option of something
right now, it's very tempting to go for it.
According to behavioral economists, this bias may explain why we save less than
we should.
And there are other psychological forces that impact our decisions.
AUCTIONEER: ...a bottle of wine.
In this experiment, students are asked to bid for a bottle of wine.
Rational economics suggests they will carefully calculate what it's worth to them,
but before the bidding begins, they're asked to write the last two digits
of their Social Security number on their bid sheet.
Astonishingly, the people who bid the highest for the wine
were those who had the highest Social Security numbers.
Unwittingly, they have been influenced by a completely irrelevant number.
RICHARD THALER: It is a great illustration of anchoring.
People are anchored on some number they were given,
even when they constructed it at random, like the last two digits of their social security
number. It's an almost irresistible force.
Do experiments like these expose flaws in the assumptions underlying rational economics?
GARY BECKER: They're dealing with people in the lab.
Economists are dealing with people in the real world,
and there's a difference between the lab and the real world.
JOHN COCHRANE: These experiments are very interesting,
and I find them interesting, too. The next question is,
to what extent does what we find in the lab translate into how people...understanding
how people behave in the real world...and then make that transition to,
"Does this explain market-wide phenomenon?"
For economists like Cochrane, it doesn't matter if individuals sometimes
go against their financial self-interest, as long as most of us act rationally about
money most of the time.
Nowhere is that idea more important than here: the New York Stock Exchange,
where traders buy and sell corporate stocks. Their decisions move prices up and down,
creating wealth for some investors and financial loss for others.
Richard Rosenblatt's been trading here for 30 years.
RICHARD ROSENBLATT (New York Stock Exchange): When I started, the technology was electric
lights and telephones. And yet it's still the same job: trying to
anticipate where the stock is going to move over the next few seconds or minutes
and judge your trading decisions accordingly. And if I'm right,
and I buy a stock in anticipation of other people deciding that this stock is underpriced,
then I'll realize a profit.
Now, the stock exchange is one small cog in a vast global machine that is the financial
markets. Technology means trading can take place anywhere.
KNIGHT CAPITAL GROUP TRADER ONE: Trading on two bucks on earnings; we've got 15.
Buy.
At Knight Trading, one of the biggest private dealing floors in the world,
traders buy and sell everything from stocks and currencies to commodities like oil and
gold�