This month we want to share with you the summary of the book titled FREAKONOMICS. This is a book published in 2005 by Steven Levitt, an economist at the University of Chicago and Stephen J. Dubner, a journalist for the New York Times. It is a book that has sold more than four million copies globally and the main theme of the book is how the economic decisions that humans make in our daily lives are largely irrational, largely influenced by factors that we do not understand entirely, and related to other hidden factors that add complexity to the analysis. The book draws heavily on a series of articles published by Levitt in the New York Times in the 1990s and argues that, in the end, the study of economics is the study of the incentives that cause human behavior to change one way or another.
The authors define incentives as rewards that make people do more of a good thing or less of a bad thing. These incentives can be of three types: Economic incentives are those that have a direct impact on people’s pockets, for example, a price discount is an incentive to buy more of something. Social incentives are those related to the perception of the individual within the community, for example, paying back a loan on time so as not to affect the reputation of the group. And moral incentives are those related to the individual’s perception of good and evil, for example, returning a wallet full of money.
The best incentives are those that combine a little of these three factors, undoubtedly something that must be kept in mind by companies when thinking about how to influence employee behavior, how to build a robust model of internal controls and how build mechanisms to prevent fraud.
The problem with incentives is that many times the result achieved is very different from the planned result, and small changes in the environment can cause large unforeseen changes in the result. The authors comment on the case of a kindergarten in Israel where a penalty of three dollars was established to try to reduce the number of parents who came to pick up their children late. A week after implementing this penalty, the number of parents who were late for their children not only did not reduce, but doubled. Which was the reason? Different parents reacted differently to the incentive. For some, paying the three-dollar penalty removed the moral burden of not being there on time. For others, the three-dollar cost was less than the opportunity cost of doing another activity at that time. And for others, the small cost of three dollars sent the signal that being late for their children was not such a serious issue, since the penalty was not that high.
Another interesting factor in relation to incentives is that people’s response can vary when external conditions change, or even the same people can have different responses due to the simple passage of time. The authors comment on the case of Paul Feldman, a small businessman who sold bagels and coffee for offices. Feldman’s business model was based on the honesty of his customers: In the morning he would stop by and leave his coffee and bagels in the offices, and at evening he would pick up the left overs as well as the money from his sales. Each customer was responsible for drinking the coffee and bagels they needed and for making their payment directly in a transparent box. By monitoring the behavior of his customers for more than ten years, Feldman began to notice some interesting behavior patterns: For example, his customers paid better and even tipped better in the spring and summer, and particularly on days when there was excellent weather. His clients paid less during stressful times like Christmas or the end of the year. He also observed that people paid better in offices where he could perceive a “happy” work environment and less where people seemed to be angry or stressed all the time. Finally, in the weeks following 9/11, Feldman saw an unprecedented improvement in his sales and tips, perhaps stemming from an overall increase in empathy and a sense of community. In summary, external factors such as the weather or work environment can have a significant effect on how individuals process incentives.
The role that fear and anxiety play as dark incentives to make decisions is also discussed. Fear and anxiety start with ignorance: lack of information, little interest in learning, or simply the profound ignorance of the other. Fear and anxiety cause our rational decision-making process to be depressed and emotions that take control of our decisions. This can lead us to buy things that we do not need, or to buy them at a price that is not convenient, or to elect a bad politician as president. We need to embed processes since our early age to help us understand the impact that fear and anxiety have on our decision-making process.
Although this book was written more than 15 years ago, the authors very clearly foresaw the risks and opportunities of the Internet. On one hand, they anticipated the Internet would be a tool to democratize access to data, reducing what they call Information Asymmetry. They give us as an example the way in which the costs of life insurance in the United States fell dramatically in the late 1990s, mainly due to the Internet pages that gave consumers the possibility to quickly compare prices between various competitors. The same could be argued about the price of airline tickets, hotels and other commodities, which have been falling as the Internet makes it easier to compete and compare options. But on the other hand, the Internet can also amplify the spread of information that is not true and that can impact our decision-making. This has profound implications even for our Western model of democracy, which by definition is based on millions of personal decisions when people go to vote.
Often we assume that there is a direct relationship between two variables or two phenomena that occur simultaneously, although in reality there is no direct relationship. Sometimes we assume that the relationship between two variables is causal, that is, that one variable causes the other, when in reality there is only a correlation, that is, that the two variables move in a similar way but are not necessarily consequence of each other. This phenomenon is evident when we see that not always the product that spends the most on advertising sells better, or that not always the candidate who spends the most on their campaign gets elected, or that not always the people who have the most money is happier. The popular belief is that there is causality between these variables, although in reality there is only a distant correlation.
Human nature inclines us to give greater importance to the immediate relationship that exists between two variables, and not to see as easily the relationship that may exist between them in the long term. And this is where the authors make one of the most controversial statements in the book. When talking about the reduction of crime in the United States in the 1990s, they comment that many of the explanations that economists and sociologists gave to this phenomenon revolved around access to better economic opportunities, better gun control laws, increases in the quantity and quality of police, or in faster and more effective judicial processes. However, the authors argue that several studies have shown that all of these factors actually have little impact on reducing crime, and that there is another longer-term factor that may have been ignored: the 1973 decision of the Supreme Court to legalize abortion. They argue that two of the factors that induce young people to commit crimes are growing up in disintegrated families and growing up in the midst of poverty, which are precisely two factors that would lead a woman to consider having an abortion. Thus, hundreds of thousands of women who decided to terminate their pregnancies in the 1970s were also unknowingly eliminating an entire generation that would have had ample chances of becoming criminals in the 1990s, which is just when the decrease in this statistic is recorded. This point was highly controversial at the time and even ended in lawsuits against the authors by groups opposed to abortion in the United States.
This is the summary of this interesting book that tells us about the complexity of human decisions, the role of incentives on our behavior, and the unexpected effects that escape the explanations of traditional economic theory.
Managing Partner of Nuricumbo + Partners. His work as a consultant has focused around CFO services and challenges, in companies of all sizes, both in Mexico and abroad. He began his career at PWC. Later, he held the position of internal audit manager for Young & Rubicam and The Interpublic Group, two international advertising groups, working for five years in New York City and performing audit projects in many countries.