A COURSE IN HOW

to read a brain scan might soon become a requirement in business school. Developments in neuroscience particularly a burgeoning offshoot of that field called neuroeconomics promise to help explain the real motivations behind people's everyday decisions to buy, sell and save.

Classical economic theory holds that people make decisions that will serve their best interests. But recent brain studies by George Loewenstein, an economics and psychology professor at Carnegie Mellon University in Pittsburgh, suggest otherwise.

Using a brain scanning technique called functional magnetic resonance imaging, or fMRI, Loewenstein found that when subjects were considering whether to purchase, say, a box of Godiva chocolates, they weren't doing a cost-benefit analysis in their heads, as traditional economists have long believed. Rather than weighing the current gratification of the chocolate against future alternative uses of the money, he found, the subjects weighed the immediate pleasure of owning the item with the immediate pain of forking over hard-earned cash to buy it.

Loewenstein thinks credit cards encourage

It might sound Brave New World-ish, but there's no doubt that neuroscience will become an increasingly important ingredient of understanding economic behavior, according to Loewenstein. And once we better comprehend how the brain processes information, he says, scientists may even be able to help people make better financial decisions.

SmartMoney.com: How have your studies changed the way you view consumer behavior?

George Loewenstein: The standard view of consumer choice is you're trying to decide whether to buy some item or go out to dinner. You're thinking about how much I would enjoy the purchases at hand and how much I would enjoy alternative uses of the money in the future. That's what scientists call the "approach-approach conflict," the choice between desirable items.

We published a study called "The Red and the Black." It was a mental accounting of purchasing and savings. We argued that's not the way consumers do it. They're not weighing the current gratification vs. future gratifications. They experience an immediate pang of pain [when they think of how much they have to pay for something]. That perspective has a lot of implications. For example, it helps to explain why credit cards encourage people to spend; they anesthetize the pain. Paying with a credit card makes you feel like you're not really spending money when you buy something.

It helps to explain why so many people have trouble spending money. In our studies, we hear from a lot of people who can't get themselves to spend money because they experience that pang of pain. We do a lot of surveys looking at spendthrifts and tightwads. We find that there are more people who report they have trouble spending money, that they don't spend money when they should, as opposed to people who spend a lot. They get more media attention.

It also explains why AOL switched from pay-per-hour Internet service to pay-per-month. When they did that, they got a flood of subscribers. They were caught totally by surprise by the overwhelming consumer demand. Why do people love to prepay for things or pay a flat rate for things? Again, it mutes the pang of pain. The worst-case alternative is when you pay for sushi and you're paying per piece. Or watching the taxi meter; you know how much every inch of the way is costing you.

SM: How did this theory pan out in your recent study published in the journal Neuron, where you examined how people make purchasing decisions?

GL: This idea that the spending decision is more of weighing an immediate pain has a lot of implications. We didn't have any proof that's what's really going on in people's minds [before]. And along comes neuroeconomics, in its limited capacity to look inside people's brains.... We teamed up with Brian Knutson at Stanford for a study where we scanned people's brains while doing tasks that involve money. We designed a shopping task. We allowed subjects to shop while lying down in the scanner. We first show people a product, then the price, then the option to buy it or not. We do it 80 times. And the thing we were looking for was when people saw the price and especially when the price would be too high that the region of the brain associated with pain processing would activate. And that's what happened. That area activated when people saw the prices, and particularly when they saw prices too high. So you can predict if they'd decide to buy the item by how much of that region of the brain was activated.

SM: Don't we already know that people don't like paying a lot for something? How surprising is it that making a purchase is often associated with pain?

GL: Well, my first response to that is almost nothing is surprising after you hear it. And it may not seem surprising to you, but it is surprising to social scientists and economists who study buying behavior. And it's always nice to get corroboration for one's ideas.

SM: How can all this apply to making investment decisions in particular?

GL: I'm particularly interested in the role of emotion in economic behavior. This investigation was about how immediate emotions play a role in purchasing decisions. I have the same view of investor behavior. Investors are heavily driven by emotions fear and greed and so on. Again, I've been doing a different type of neuroscience research examining that issue. The "equity premium puzzle" is this idea that stocks have historically had a higher rate of return than bonds, adjusting for risk. It's a big mystery [why people don't buy more stocks and less bonds]. Normal people are pathologically risk-averse. They hate losing money. Even if in the long run they make money, they get very upset when their investments decline. We had the idea that part of what's going on in the puzzle is the emotion of fear. We used patients with brain lesions [to test the theory]. We created an investment task, where people are given a dollar at a time, 20 times in a row. They have a choice: Pocket it or stake it on a gamble, which gives a 50% chance of paying $2.50, and a 50% of losing the dollar.

We tested the behavior of normal people, and people with brain lesions, where the area of the brain associated with fear processing was damaged, as well as people with lesions in nonemotion-related regions. We found that the people with emotion brain lesions played the gamble all the time; they kept playing whether they won or lost. The other two groups, if they lost a few times, they stopped playing. And if they won a few times in a row, they were afraid their luck would run out, so they cut back on playing. The people with the brain damage ended up making more money. So fear seems to play a role in risk taking. It supports the idea that the equity premium puzzle is in part due to the extent people experience fear when risk taking.

SM: Are we getting to the point we'll have neuro everything?

GL: I do think neuroscience is going to play increasingly diverse roles. There's no question that scanning someone's brain is going to indicate lie detection better than if the person was sweating. It is going to revolutionize diverse aspects of life types of ads we're exposed to, the type of information marketers get from us. But a lot of those developments are pretty far in the future. When people hear you can scan someone's brain and see pictures of the colors and the brain lighting up, it almost looks like you can read someone's mind. It's easy to forget that those images are averaged over many trials.... It's like the Internet in the 1990s. Everyone knew the Internet would be revolutionary for our society, but no one can predict how it can revolutionize society or economics. It certainly will be revolutionary, but I wouldn't listen to anyone's prediction now.

The dominant model in economics now is people rationally pursue their goals. My take is that neuroscience is going to produce a different foundational model of behavior, one that takes into account what we know about the brain. And I don't think the brain is a rational maximizer.

SM: How do you see the application of your findings in real-world settings?

GL: I wouldn't advocate this but I suppose you could use the technology to decide how to display prices, or how to give people financing options that mute the pang of pain. There are things done now like this, like presenting the price as a discount or pricing something at $9.95 instead of $10. There are a lot of methods of muting the pain that haven't been discovered.

On the one hand, it would be nice for consumers to enjoy their goods without experiencing the pain they do. But on the other hand, they would buy things they don't need. I could also imagine scanning people paying with credit cards vs. paying with cash could lead to some kind of regulation of the credit-card industry. When people are paying with a credit card, they're not really weighing the cost and benefit of the purchase.