Money: Crazy about our cash

By MARK FRYER

Imagine you're basking on a tropical island. The sun is beating down and you haven't had a drink all day. Then someone offers to take a boat to the expensive hotel on the next island to buy a few cold beers.

How much would you pay? $10 a bottle? Maybe $20?

What if the beer came from a scruffy bottle store instead of the ritzy hotel? Would that make a difference to the price you'd be willing to pay?

That's one of the questions US economist Richard Thaler poses to illustrate his approach to economics.

Assuming we're talking about the same brand of beer, conventional economics says the price you're prepared to pay should be the same, regardless of where it comes from. After all, the beer's origins make no difference to how well it quenches your thirst.

But when he asked test subjects that question, Thaler found they would pay more for the beer from the hotel than they would for the identical beer from a less exclusive source.

Welcome to the world of "behavioural" economics, where theories are often illustrated with folksy examples like this one, and where economists borrow heavily from disciplines such as psychology and anthropology to explain the way we make, spend, save and invest our money.

This is economics based on a blindingly obvious proposition: when it comes to money, people behave like - well, like people.

This is radical stuff, as economics has traditionally assumed we tend to behave rationally. Faced with choosing among different ways of spending our limited money, we supposedly weigh up the options and go with the one that most improves our wellbeing.

Behavioural economists see things differently. Far from being consistently rational, they argue, most of us are prone to error, irrationality and emotion, and frequently make choices which don't maximise our financial wellbeing.

Another favourite example is the "ultimatum game." In this game, one player is given some money, say $10, and told to offer part of it to the other player.

The second player can accept the offer, in which case the two split the $10 accordingly. If the second player rejects the offer, no-one gets anything.

If economic reward is all that matters, it always makes sense for the second player to accept the offer - even 1c is better than nothing. In practice though, players often reject low offers; apparently, indignation and the desire to get back at the person making the low offer can be more important than the desire for financial gain.

Borrowing from psychological experiments like the ultimatum game is not a completely new approach for economics.

Thaler, a University of Chicago professor and one of the best-known behaviouralists, has been developing his ideas since the 1970s.

Other heavyweights who have used the behavioural approach include Harvard's Lawrence Summers, who was Bill Clinton's last treasury secretary, and Yale's Robert Shiller, who wrote the book Irrational Exuberance, about the "irrational" rise in the US sharemarket in recent years.

Their work has sometimes sparked hostility from the more established approach to economics, known as the "neoclassical" school, which has dominated the field for the past 50 years or so.

Traditionalists tend to dismiss the behaviouralists' examples of our irrationality as amusing tales which do nothing to disprove the argument that we generally make rational economic choices.

Thaler himself says the neoclassical model is misleading only when it is used to explain everything.

People aren't crazy, he says - it's just that their rationality is limited.

The two schools of thought seem to be coming to a compromise: we're trying as hard as we can to be rational, but we still keep making the same mistakes over and over again.