By Robert C. Port
Behavioral economics combines insights from psychology, judgment, and decision making, and economics to generate a more accurate understanding of human behavior. This article considers these insights as they relate to the practice of law.
A (very) brief overview of behavioral economics1
Behavioral economics is the study of how people make decisions. In particular, behavioral economics is “a relatively new field that combines insights from psychology, judgment, and decision making, and economics to generate a more accurate understanding of human behavior.”2 Although these insights have significant application to how people make decisions regarding their investments, they have application for a broad range of decision making. This article considers these insights as they relate to the practice of law.
The research demonstrates that decision-making is often not as rational and analytical as traditional economic theory would predict.3 Traditional economic theory—think Adam Smith, “The Wealth of Nations”4 —makes two basic assumptions. First, the person making choices either knows or has assessed all the information relevant to making a decision. Second, the person is rational, and makes decisions that are logical and consistent based on an objective calculation of risk and costs compared to the expected rewards. This is often referred to as “utility theory.”
The problem with utility theory is its limited application in real-world situations. It describes how people should make decisions rather than how they actually make decisions. Real-life decision-making usually employs a variety of cognitive “rules-of-thumb,” called heuristics. Heuristics are unconscious short cuts by which our minds make decisions, sometimes instantaneously or irrationally, rather than engaging in the thoughtful, logical, analytical or rational approach that traditional economic theory suggests.6
“Prospect theory” is the term coined by psychologists to describe the way people actually make real-life economic decisions between alternatives whose outcomes are uncertain.7 The theory suggests that people make decisions based on their intuitive perception of the risk of a loss or a gain rather than a true probabilistic analysis of the likely final outcome.
Behavioral economics challenges the notation that people make thoughtful rational decisions when faced with economic choices: In standard economics, we think—we assume—that people are perfectly rational, which means that they always behave in the best way for them. They can compute everything, they can calculate everything and they can make, always, consistently, the right decisions.
In contrast, behavioral economics doesn’t assume much about people. Instead of starting from the idea that people are perfectly rational, we say we just don’t know, but let’s check it out. So, what we do is we put people in different situations to check how they actually make decisions. And what we find in those experiments is that people often don’t behave as you would expect from a perfectly rational perspective.8
In sum, behavioral economics reveals that we are “predictably irrational.”9
Behavioral economics and securities class action litigation
Without directly using the term “behavioral economics,” it appears that the Supreme Court has recognized its impact in evaluating the proofs and defenses presented in securities class action litigation. In Basic Inc. v. Levinson, the Supreme Court upheld the validity of the “fraud-on-the-market” presumption. That presumption provided that class action investors could satisfy the reliance requirement for proving stock fraud premised on a material misrepresentation because it was assumed that the price of the stock they had purchased or sold occurred in an “efficient market,” one which reflected all public material information, including material misrepresentations.
In its subsequent holding in Halliburton Co. v. Erica P. John Fund, Inc.,11 the Court held that defendants can defeat the Basic presumption at the class certification stage by introducing evidence that the alleged misrepresentation did not affect the stock price. Of particular note is the concurrence by Justices Thomas, Alito and Scalia, which channels behavioral economic theories by stating that the Basic presumption is based on “a questionable understanding of disputed economic theory and flawed intuitions about investor behavior.”12 The concurrence further observed:
Basic based the presumption of reliance on two factual assumptions. The first assumption was that, in a “well-developed market,” public statements are generally “reflected” in the market price of securities. 485 U.S., at 247, 108 S.Ct. 978. The second was that investors in such markets transact “in reliance on the integrity of that price.” Ibid. In other words, the Court created a presumption that a plaintiff had met the two-part, fraud-on-the-market version of the reliance requirement because, in the Court’s view, “common sense and probability” suggested that each of those parts would be met. Id., at 246,108 S.Ct. 978.
In reality, both of the Court’s key assumptions are highly contestable and do not provide the necessary support for Basic’s presumption of reliance. The first assumption—that public statements are “reflected” in the market price—was grounded in an economic theory that has garnered substantial criticism since Basic. The second assumption—that investors categorically rely on the integrity of the market price—is simply wrong.13
The concurrence captures the basic premise of behavioral economics: Contrary to traditional economic theory, which presumes a clear-eyed analytical evaluation of the costs and benefits of a decision, we may not consistently understand or implement probability when making economic decisions, our assessment of the probability of future expected events may be flawed, we regularly act impulsively and with unconscious biases, and we often act without complete information or ignore material information. As one district court has observed, “Because the notion of information efficiency upon which the fraud-on-the-market presumption rests is crumbling under sustained academic scrutiny, the future of securities fraud class action litigation—dependent on this presumption—may be in jeopardy.”14
Behavioral economic concepts in the practice of law
In their work describing why people are “predictably irrational,” behavioral economists have identified a number of common themes—heuristics—in decision making, many of which have application to the practice of law. Some of these are discussed below.
Anchoring describes how exposure to a recent number or exposure to certain environments affects decision-making.
Anchoring is “a behavioral bias in which the use of a psychological benchmark carries a disproportionately high weight in a market participant’s decision-making process.”15 The concept of anchoring focuses on our tendency to attach or “anchor” our thoughts to a reference point—even though that reference point may have no logical relevance to the decision at hand. Behavioral economist Daniel Kahneman describes anchoring as “one of the most reliable and robust results of experimental psychology.”16
To illustrate this bias, in a well-known experiment, subjects are asked to write down the last few digits of their Social Security number. They are then presented with a jar of marbles, and asked to guess the number of marbles in a jar. Subjects with higher Social Security numbers almost always guess high-e r. 17 Similarly, researchers asked participants whether Mahatma Ghandi died before or after the age of nine years or whether he died before or after the age of 140 years. The average of answers given to the two questions differed by 17 years, although these anchors seemed to be obviously irrelevant.18
As a consequence, the starting point at the beginning of the decision-making process has a very real effect on the final result. In a negotiation, anchoring efforts should occur early in the process before the other party has an opportunity to anchor based on their own decision-making processes or other experiences.
Consider the following which might be anchor points for your client: • The first offer made in a negotiation.
• The amount of damages set forth in a complaint.
• Litigation costs already incurred.
• Media reports of similar verdicts or settlements.
• Lawyer advertising as to verdicts and settlements achieved.
• The sale of a similar property or business.
• The highest perceived prior value of a property or...