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Governments rely on economists to tell them whether to increase spending, reduce taxes, or tackle deficits. Economists, in turn, predict how the population’s spending habits will change in reaction to policies. If policymakers act on predictions that are wrong, the economy could go into a tailspin. So building accurate models that reflect how people spend and invest is critical.

Economic models predict such things as price and wage fluctuations. The models can explain, for instance, why demand for a company’s stock rises and its share price jumps when the company announces better-than-expected news. But they cannot explain why investors poured money into Internet companies that had only dim prospects. Psychologists may be as qualified as economists to untangle this phenomenon. And increasing numbers of economists are turning to psychology to model people’s often irrational behavior, giving the relatively new field of behavioral economics legitimacy. Sendhil Mullainathan and Xavier Gabaix, both in MIT’s Department of Economics, and Sloan School of Management psychologist Drazen Prelec are forging into new territory. They are overhauling assumptions from economic models that predict that people act rationally on the basis of perfect information, and the two are helping to pave the way for other behavioral economists by developing new theories to explain people’s actions.

Understanding human behavior and social phenomena from an economic point of view could lead to more effective social policies and a better understanding of what makes people do what they do,  Mullainathan says. In one study that points in that direction, he examined what happened when, in 1992, the South African government dramatically raised pension payments to its elderly black population. Mullainathan used data that the World Bank and South African Development Research Unit collected from 9,000 households in 1993.

Mullainathan’s work confirmed what local newspapers had already reported: in households that included a pensioner, the windfall prompted the prime earners to stop working altogether. “The men sat around while the women continued to work,” Mullainathan says.

“There were lots of ideas, but,” Mullainathan says, “ideas are cheap. A lot of my work is coming up with facts.”

In other research, Mullainathan is looking at how people form categories in their minds and what influences their formation. For example, what makes someone a good job candidate? Experience and education make a difference, Mullainathan says. What constitutes a good investment? Television, newspapers, magazines, books, and friendly advice help people form investment strategies.

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