As a CIO, you’re familiar with the following scenario:

You’ve sunk $900,000 into a forecasting system that’s expected to cost $1 million but has yet to deliver on its promises. In hindsight, you’ve realized that all that money would have been better spent on a sales-force automation (SFA) system. Nevertheless, you’ve still got $100,000 in your coffers, so instead of scrapping the forecasting system and starting anew with SFA tools, you sink the remainder of your money into the forecasting system and hope for the best.

A foolish mistake? Perhaps, but not at all unusual, according to Dan Ariely, the Luis Alvarez Renta professor of behavioral economics at MIT’s Sloan School of Management and director of the MIT Media Lab’s e-rationality research group. As a behavioral economist, Ariely studies how people make decisions in real life and why their decisions often deviate from classical economic models, which assume that people act rationally and in their own best interests.

Ariely, 36, takes a self-described "armchair" approach to that discipline.

"I look at how I behave. When I find something curious or bizarre about myself, I tend to look at it in more detail," he says.

For example, Ariely’s own tendency to procrastinate led him and a colleague to study different measures for overcoming procrastination. They found that people are willing to set their own deadlines so that they don’t wait until the last minute. Yet while self-imposed deadlines help people improve their performance, they are not as effective as deadlines set by others.

Ariely, with his self-examining style, is one of a handful of academics challenging the intellectual foundation of economics. For years, classical economists

maintained that individuals make decisions based on their own self-interests. Ariely’s research on procrastination, how people value goods, how they perceive pain and the effects of female physical beauty on the male brain reveals the exact opposite: Individuals make irrational decisions that are not in their best interests.

What may interest CIOs most are Ariely’s investigations into how people value goods and how people’s experiences of physical and psychological pain affect their decisions. CIO Senior Writer Meridith Levinson caught up with Ariely at his home in Cambridge, Mass., where he explained his research, discussed it in the context of the irrational decisions CIOs make and shared his thoughts on what CIOs can do to make more rational financial decisions.


CIO: Your research shows that people, including CIOs, don’t know how to value or set prices for various goods. How did you come to that conclusion?
Dan Ariely: We [Ariely and fellow researchers Drazen Prelec and George Loewenstein] conducted a second-price auction in class. We sold MBA students keyboards, [computer] mice, bottles of wine, DVDs, books and chocolate. We explained the procedure for a second-price auction where the highest bidder pays the second highest bidder’s price. We described each of the products and said to the students, "Before you tell us your bids, please tell us the last two digits of your Social Security numbers and translate those last two digits into a dollar figure." So if your last two digits are 44, that’s $44. Then we asked them to tell us whether they would pay the amount of money indicated by the last two digits of their Social Security numbers for the various products.


What did you find?
The people with the highest Social Security numbers, in most cases, bid 100 percent more than people with the lowest Social Security numbers.


In that experiment, you were also testing a concept called coherent arbitrariness. Can you explain what that is?
It’s the idea that people do not know how much to pay for anything. They will rely on their own arbitrary judgments to generate a value, and the value they generate will be coherent in the sense that it will be based on the value of a similar item. For example, when we sold a large box of chocolates and a small box of chocolates everybody said, "We’ll pay $X more for the big box than the small box." Once the price of a product [in this case, the small box of chocolates] was fixed, the prices of similar products were set in a relative manner.


How does that research apply to prices that CIOs pay for IT?
Imagine that an organization is thinking of creating a database. Why does it care what Oracle thinks [the database] should cost? Theoretically, the company should be able to say, "How good is this [database] for us?" Often it relies on prices that it or others have paid for similar products in the past. "That database was $2 million. This database is twice as big so we should be able to pay at least $4 million." It’s hard to figure out the value of an IT investment. If what you’re willing to pay is a function of what you paid before, that’s a problem because it means you don’t know what it’s worth.


Is hardware an exception to what you’ve found, since its price decreases every year?
The fact that the cost of hardware decreases every year is an additional factor people take into consideration when estimating a price. They still set prices in a relative manner. They begin with the starting level price?what they paid last year?then they adjust it based on factors that seem relevant. In the case of hardware, you’re expecting prices to go down.


How should CIOs evaluate the value of a database or any other IT investment?
They should not compare databases to databases. They should compare the database with all possible IT investments. People have a tendency to make decisions in silos. We think about whether or not to invest in a new database or to allocate salaries separately. It’s better to think across categories to find out where the best value is. Should we update software? Hardware? Move to a new operating system?


Can you explain why people rely on those apples-to-apples comparisons to determine or rationalize what they’re spending?
It’s so simple. It’s seductive. It appears rational.