The End of Economic Man, or, Buy Gold Now!
Via Arts & Letters Daily: A bunch of Harvard eggheads have figured out a truth known to every real estate agent who ever wore a miniskirt while holding an open house: People make economic decisions that are not necessarily in their best interest, for reasons that are not rational.
The study of "behavioral economics" supposedly turns neoclassical economics on its head and calls into question the belief that markets always or even frequently produce rational results. I'm not an expert, but I question how revolutionary this concept was, since the idea was that markets generate efficient pricing models on balance, not that every transaction is completely rational or that the market is never out of whack. (As the University of Chicago economist says in the old chestnut, "Nonsense, my boy; if there were a five-dollar bill on the ground, somebody would have picked it up already.") But some of the research takes in market-level issues (why the price of shares in the same company varies between Amsterdam and London, how closed-end mutual funds sell at more than the value of their portfolios, etc.) that raise interesting questions. The economist Sendhil Mullainathan draws behavioral econ into a fascinating variety of areas:
"We tend to think people are driven by purposeful choices," he explains. "We think big things drive big behaviors: if people don't go to school, we think they don't like school. Instead, most behaviors are driven by the moment. They aren't purposeful, thought-out choices. That's an illusion we have about others. Policymakers think that if they get the abstractions right, that will drive behavior in the desired direction. But the world happens in real time. We can talk abstractions of risk and return, but when the person is physically checking off the box on that investment form, all the things going on at that moment will disproportionately influence the decision they make. That's the temptation element—in real time, the moment can be very tempting. The main thing is to define what is in your mind at the moment of choice. Suppose a company wants to sell more soap. Traditional economists would advise things like making a soap that people like more, or charging less for a bar of soap. A behavioral economist might suggest convincing supermarkets to display your soap at eye level—people will see your brand first and grab it."
Mullainathan worked with a bank in South Africa that wanted to make more loans. A neoclassical economist would have offered simple counsel: lower the interest rate, and people will borrow more. Instead, the bank chose to investigate some contextual factors in the process of making its offer. It mailed letters to 70,000 previous borrowers saying, "Congratulations! You're eligible for a special interest rate on a new loan." But the interest rate was randomized on the letters: some got a low rate, others a high one. "It was done like a randomized clinical trial of a drug," Mullainathan explains.
The bank also randomized several aspects of the letter. In one corner there was a photo—varied by gender and race—of a bank employee. Different types of tables, some simple, others complex, showed examples of loans. Some letters offered a chance to win a cell phone in a lottery if the customer came in to inquire about a loan. Some had deadlines. Randomizing these elements allowed Mullainathan to evaluate the effect of psychological factors as opposed to the things that economists care about—i.e., interest rates—and to quantify their effect on response in basis points.
Find out what results they got here.
The conclusion of the article mentions the question of how we can "manage" markets with these irrational factors in mind, but doesn't specify anything. But the catalogue of irrational factors involved in making financial decisions, from excitement to altruism to instant gratification to a desire to take revenge, may bring up some painful memories for most readers. (For me, it was a real walk of shame down my sad history of fucked-up financial decisions.)
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In the department of ‘duh’, incentives matter at the margins, and summed marginal decisions make up markets. Global rationality for each actor is not an essential piece of the puzzle when you are looking at any particular decision.
Also, utility can be broadly defined to include things like status so as to confuse the otherwise clear picture of what is rational and what is not.
Been there, Tim. When I think of the money I’ve wasted on hit men for the momentary thrill of revenge. Sure, the funerals were fun, but afterwards what have you got? A big fat nothing. Now when someone cuts me off in the supermarket I just pick up an extra pack of Ho-Hos and keep on walking. It’s so much easier.
Me personally, I literally paid off today the last of my financial obligations to a bad decision I made in 2002. Good timing.
I always liked that old quote by English soccer great George Best. It went something like “I have spent a lot of money on booze, birds and fast cars and the rest I just wasted I guess.” Perhaps what these eggheads consider irrational is quite rational when you factor in the short run goal of having a good time. Perhaps not everyone is so concerned with doing what four out of five dentists say we should.
I’d be more likely to borrow money if the Reason Pillow Girl was lending it.
The part about how the form designs and psychological impact of approaching what should be a no-brainer rational decision made a lot of sense to me. Jakob Nielsen makes a lot of similar points on his http://www.useit.com website.
The bank also randomized several aspects of the letter. In one corner there was a photo?varied by gender and race?of a bank employee. Different types of tables, some simple, others complex, showed examples of loans. Some letters offered a chance to win a cell phone in a lottery if the customer came in to inquire about a loan. Some had deadlines. Randomizing these elements allowed Mullainathan to evaluate the effect of psychological factors as opposed to the things that economists care about?i.e., interest rates?and to quantify their effect on response in basis points.
In other words, they did the exact same thing direct marketing companies have been doing for many, many years.
I think Jason Ligon nailed it in one. Who cares if not every single economic decision ever made is rational? Who ever claimed it was? What bugs me, though, is the number of people who basically claim
1. People act irrationally in their economic decisions,
2. Rational decisions are much better than irrational decisions,
3. Therefore, we/the government/the philosopher-king should be making decisions for people.
So how would further controlling the economy decrease the “irrationality” of some decisions? So bureaucrats can’t be irrational? This is why we shouldn’t pay any attention to data-crunching eggheads who think they can exact higher truth by looking at statistics.
Equating better with more rational is an easy mistake, but a mistake none the less.
Does this
http://www.context.org/ICLIB/IC32/Gilman.htm
get it any better is the (a) question…
At least it takes more factors into consideration, but I think it still assumes “rational” actors. It opens them up to more dimensions of choice, however.
Markets can still efficiently satisfy irrational desires. Retailers will compete to offer you the DVD release of “Red Eye” at low prices, and provide the best service while selling it to you, even though the movie sucked. AMC will do its utmost to select the most tantalizing scents to add to their crappy snacks at the theater, in hopes of getting me to buy the crappy snacks. (And sometimes I do.) And they will try to minimize the costs that they incur while selling me their crappy snacks.
Hell, in college I did a term paper on souveneir prices along Hollywood Boulevard. Every store on the Blvd offers the same crappy souveneirs, but the price depends on proximity to the major attractions. I went to the stores, collected price data, and put the data on a map showing where the major attractions were. Prices were lower if you had to walk farther to get to the store. There’s absolutely no rational reason why people would buy that crap, but the pricing is in keeping with rational models of competition.
Money? It’s a crime.
No new information there, really. As you pointed out, most people would find it to be common sense. That is, their personal anecdotal evidence has long put the lie to the theory that economic decisions are “rational.”
But within that realization lies the seed of future rational behavior. Once we become self-aware, we are capable of counterbalancing impulse with reason.
Sometimes.
Richard Epstein, in Skepticism and Freedom, goes through a nice excercise of showing (1) many irrational economic choices are based in evolutionary psychology and around for good reason; and (2) government intervention costs more than stupid mistakes.
I’d be more likely to borrow money if the Reason Pillow Girl was lending it.
That is exactly what the bank’s customers did. The male ones anyway.
Seems framing does work. I hereby motion that the Libertarian Party (aka the what-did-you-say, the party of free books?) be renamed the Leave Me Alone Party.
Libertarian Utopia, here we come. 😮
And here’s the kicker, once government has made it’s law(s) concerning how we do something, there will be an institutional interest in keeping said law alive, no matter how bad/irrational it is.
So even though I may buy the Dragon Ball Z dvd set, my friends and/or parents (ha! you think someone who buys that has a girlfriend) can tell me not to be such a douche and stop wasting money on that crap, government usually gets off on the most atrocious of boondoggles, like EVERYONE knows ag subsidies are crap and yet we still PAY MORE SUBSIDIES!
Mr. Pink,
Money? It’s a gas…
There’s another element promoting macro-rationality in the market, and that’s natural selection: The more irrational financial decisions you make, the less you’ll be able to participate in the market at the same level as people who make smart decisions (e.g., I walked away from a house purchase in L.A. in 2004, and the property has appreciated by about 30 percent since then; I’m now priced out of that market–culled from the herd, in effect).
Cavanaugh,
You’re saying survival of the fittest equals the rich get richer.
Now that I see my comment “took,” here’s another I tried to post while the server squirrels were on smoke break:
Has a study been done to see how close to starvation a person would have to be before he or she would spend zero on bling bling?
I have been an economist for many years and I have never given any advice to any business about how to sell more of their products. I think that academics in the field of marketing study such things and they train marketers to give suggestions.
If these various other factors work in such a way that the law of demand doesn’t apply, then prices won’t coordinate independent decisions and so the “invisible hand” won’t work.
And that is what economics is all about. It really isn’t of much practical use. The only question we answer is “what sort of system is better to have?” And a little bit of, “what government interventions might do more good than harm?” And further, “what government interventions are absolutely crazy.”
Of course, what the behavioral economists have to offer may be more valuable to individual market actors than what econonomists have traditinally provided. But I remain puzzled as to why the chose to misrepresent what economists have sought to do and offer.
Hey, George Best quotes! I like it. My favourite George Best story was the one where a hotel room-service waiter come into George’s room, finds him in bed with three lovely women, a pile of coke on the coffee table, and empty champagne bottles scattered around. He looks at George sadly and asks, “George, where did it all go wrong?”
Bill Woolsey,
Why are economists like democrats and republicans while mathematicians are like the Chairman of the Federal Reserve Board… respected on all sides?
A minor point to consider: governments also make irrational and emotional decisions. At least when I spend the rent money on a new bass, millions of people don’t have to pay for my choice.
You need a louder amp.
These critics of neoclassical economics and markets use the equivalence that rationality = maximizing dollar value received and minimizing dollar vale spent allowing for what ever time preference. But sometimes folks have values and desires in their economic decisions that cannot be quantified in terms dollars. Beware of people who want to use the government to fix something, especially when it’s not broken.
I eat only cage free eggs cuz I feel sorry for chickens, even though they cost more. Now wouldn’t these wrong headed critics of free markets count this as a “non-rational” economic decision on my part?
(For me, it was a real walk of shame down my sad history of fucked-up financial decisions.)
Aw, don’t be so hard on yourself. Maybe you need to go the traditional route, like hiding sacks of silver coins under the floorboards. All this modern financial stuff just makes people dizzy.
Jeebus, no one ever claimed markets were perfect, only that they are much better at allocating resources and encouraging efficiency than any alternative discovered to date.
Most claims that markets are flawed or failing start by mischaracterizing the efficient markets hypothesis as the “perfect” market hypothesis, which (like most straw men) is then easily demolished.
Generally as the prelude for calling for more political control of some aspect of your life.
I like the last section, wherein the authors claim that marketing — or, rather, framing — can make trade into a zero-sum game.
Not quite. If the seller gets the buyer to purchase something he doesn’t really want, it is much more likely a negative-sum game. The buyer now has some junk he didn’t want and is not in the position to sell for the same price the original seller could have gotten from the next buyer, who may actually have wanted it.
But then “negative-sum” is not commonly found in the lexicon. “Zero-sum” is much better known and elicits a much more visceral reaction. That is, it has better framing potential.
As the article says…
So did the authors of this piece recognize the irony? Or did they embrace it…