Are We All Predictably Irrational? Or Just the “Behavioral Economists”?

Posted by & filed under CGR Staff, Rochester Business Journal.

Kent GardnerThe following is based on a book review I delivered on behalf of the Rochester Public Library’s “Books Sandwiched In” series.

Dan Ariely’s Predictably Irrational comes from a field called “behavioral economics,” a branch of cognitive psychology focused on economic decision-making. Folks in the field attempt to figure out why apparently rational people behave irrationally so much of the time.

That markets are influenced by irrational behavior is easily demonstrated. Let’s consider recent trends in oil prices. When oil was trading at over $140 per barrel, relatively few oil industry experts would defend the price on the basis of pure supply and demand. Sure, some would cite rising demand in China or the number of cars added to the road every day in Mumbai. Many authoritative voices had been saying for months that they while they could rationally explain a spot price around $100 per barrel, the arithmetic simply didn’t justify $140 per barrel. So why were apparently smart people betting big dollars on a higher price? How did the price get to $147 per barrel? Largely because they believed that other people believed that prices were going to rise. And they believed that they were smart enough to buy when prices were rising and to sell before the bubble burst.

I’ve a friend who bought Florida real estate in 2000—the stereotyped townhome on a golf course. She bought as an investment: Fifteen years from retirement, she didn’t actually expect to retire there anyway. When we talked about it in late 2005 there were abundant signs that the boom in real estate prices was unsustainable, particularly in Florida. I asked her if her neighbors were all retirees or people retiring soon. “No, they’re all investors like me.” So everyone in the neighborhood was buying real estate because they were hoping for an increase in prices, NOT because they needed a place to live! I don’t do this often, but I urged her to sell—NOW! She didn’t, of course, and has lost most of the paper profits about which she’d been so gleeful.

Daily stock price fluctuations also fly in the face of rationality. Say what they will about “market fundamentals,” many, many Wall Street trades are made not based on the judgment of the company, but the trader’s judgment of other traders, that is, whether other traders think the stock price is likely to go up or down. What happens in the short term on the stock market is better grist for psychologists than economists.

Practitioners of “cognitive economics” are fond of challenging economic orthodoxy. In his introduction, Ariely asserts that “[i]n conventional economics, the assumption that we are rational implies that, in everyday life, we compute the value of all the options we face and then follow the best possible course of action.” The key debate between economists and the psychologists working in this field is this: To what extent is irrational behavior normative? If irrational behavior is normative or at least, common, to what extent is policy based on the presumption of rationality invalid?

Before I address these questions, let me summarize portions of the book. Ariely reports on a number of clever experiments that demonstrate our irrationality and interprets these as propositions:

  • Context influences decision making: a)We are influenced by the opinions of others: What we order in a restaurant or bar varies when we hear what others are ordering. b)Our perception of a “fair price” is affected by the alternatives: The television you purchase or the vacation you choose is influenced by the others on offer.
  • We’re bad at math: We’ll choose to spend 15 minutes to save 25% of the cost of a pen but not to save 1% of the cost of a suit—even though the dollars saved are identical.
  • Expectations play an important role in decision-making: a)We are suckers for a priori price signals, e.g. the “MSRP” (manufacturer’s suggested retail price): He reports a number of experiments in which our minds fix on an “anchor” price—even a value that is wholly unrelated to the product on offer. b) In a special case of the same phenomenon, he devotes an entire (fascinating—or possibly depressing) chapter to the power of FREE, reporting an experiment showing that subjects assigned different relative values to Hershey’s kisses and Lindt truffles when the kisses were offered for free. c)Our perception of quality (thus our willingness to pay) depends on presentation: In one experiment, coffee drinkers rate identical coffee as better quality because the accompaniments are presented in silver instead of Styrofoam. d)In another coffee experiment, Ariely doctors coffee with vinegar and found that the same coffee was rated lower by coffee drinkers who had been warned. e)In an interesting version of the placebo effect, he shows that more expensive pills are more effective than cheaper pills.

Ariely also “proves” a few things that hardly need evidence: Young men are less rational when sexually aroused (Now THAT explains a few things—it’s a shame parents haven’t been aware of this in previous generations. Isn’t research wonderful?). Also, humans have a problem with delayed gratification, e.g. saving for retirement or dieting.

So this is a well-written and entertaining book and should be required reading for anyone in marketing. But do we really learn anything that a good salesman didn’t already know? And will fathers look at their daughter’s dates with any more scrutiny? More importantly, does “behavioral economics” erode the fundamental assumptions of conventional (dare I say “real”?) economics?

Hardly. The key insight of economics is that individuals respond to incentives. Is it rational to smoke? Of course not. But given their addiction, smokers still respond to price incentives. Higher taxes on cigarettes reduce smoking. Economists don’t claim or believe that every person is perfectly rational all of the time or that everyone is good at math. The notion of “economic man” or homo economicus that Ariely disproves is but a caricature. Moreover, Ariely’s “policy prescriptions” are either common sense or seem only tangentially related to his experimental data.

If you are interested in the application of economics to ordinary affairs, I encourage you to read the work of Steven Leavitt and Stephen Dubner, the guys who wrote Freakonomics, or Tim Harford from the Financial Times who wrote The Undercover Economist and, most recently, The Logic of Life: The Rational Economics of an Irrational World.

Kent Gardner, Ph.D. President & Chief Economist
Published in the Democrat & Chronicle September 19, 2008