Economic theory must change to accommodate irrational, inconsistent and altruistic behavior

Traditional economics is based on three key assumptions: (1) rationality, (2) consistency, and (3) self-interest. It assumes a cold, calculating, rational choice by each individual based on a stable set of preferences. It frequently doesn’t work out to be that simple, because social factors intervene.

We are all highly interdependent. Automobiles, cell phones, even breakfast cereals are created collectively. Stock market and housing bubbles are evidence of important contagion effects. Aliens from outer space may not see us as individuals at all, but rather as cells in a collective body that is spreading across the face of our planet. Economic theory needs drastic revision to better incorporate our collective interdependence.

Economists tried to devise methods of aggregating individual preference functions into a community-wide preference function, but finally had to accept economics Nobel prize laureate Kenneth Arrow’s Impossibility Theorem that said that under somewhat general circumstances no such aggregation of individual preferences could produce a legitimate community-wide preference function. Thus, no formal, mathematical proof has been forthcoming of Adam Smith’s idea that our collective, economic well-being as a nation can be improved from each individual pursuing their own economic self-interest, as expressed in his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations.

Instead economics detoured into game theory which provides many interesting results but does not solve the fundamental problem. Moreover, the outcome of any particular game tends to be sensitive to its own, game-specific assumptions. A more general economic theory is needed that is robust to a wider range of assumptions in general and allows for our collective interdependence in particular.

A good beginning for thinking about developing an economic theory of our collective interdependence is the 1976 book by Fred Hirsch called Social Limits to Growth published by Harvard University Press.

A new branch of economics called behavioral economics tests these assumptions by performing scientific experiments to determine how people actually behave. Behavioral economists have recorded numerous situations where people do not behave rationally.

For example, advertisers have long understood that people will go to great expense to get something for “free.” One professor set up an auction system that caused his students to bid more than $20 for a $20 bill. An irrational sense of commitment leads people to tenaciously hold on to stocks they already own, but otherwise would not be willing to purchase. These are not just trivial irregularities. There are a wide-range of situations where people behave irrationally from the point of view of traditional economics.

From its beginning, economics has had to fend off evidence of irrationality. Giffen goods that defy the law of demand by responding positively to price increases and negatively to price cuts were dismissed as special cases with little importance for overall economic policy. When some individual consumers and investors made foolish choices, economists employed the law of averages to try to reaffirm rational market outcomes. The term rational expectations was coined when this was extended to the behavior of monetary and fiscal policy makers.

Is it enough to simply dismiss irrationality by throwing it into the error term, or could it sometimes be the main effect? Bounded rationality depicts decision making in a restricted context where information is incomplete and available choices are limited. Such analysis provides the dismal science with a new basis for moving away from excessively optimistic forecasts.

The hedge fund Long Term Capital Management collapsed in 2000 when the market did not move back toward equilibrium in a reasonable amount of time. Such unexpected events are described by Nassim Taleb in his book The Black Swan: The Impact of the Highly Improbable.  Are markets ultimately efficient in the long run or is the long run just too far off? After all, it was John Maynard Keynes, the father of macroeconomics, who pointed out that “in the long run we’re all dead.”

The Achilles heel of traditional economics was uncovered when researchers found that irrationality is often predictable. Dan Ariely’s 2008 book Predictably Irrational is a recent popular contribution while the 2004 compendium volume Advances in Behavioral Economics provides a more extensive coverage from the professional literature. Also see The Paradox of Choice by Barry Schwartz, Sway by Ori and Rom Brafman, and Free Market Madness by Peter Ubel.

Economists such as Nobel prize laureate Gary Becker led the extension of economics into the social realm in studying such things as the economics of marriage and drug addiction. Becker and his followers showed how economics can influence social behavior. The new economics is showing how social considerations can impact economics. The Nobel prize in economics was won in 2009 by Elinor Ostrom and Oliver Williamson for research that showed how organizational factors can affect economic outcomes. Social factors can have an even bigger impact on the day-to-day decisions of all of us.

For example, if you ask a friend to help you move, she may be willing to sacrifice a few of her precious Saturday hours to help out. If instead, you offer her $10 a hour to help you, she may turn you down flat. How can it make sense to be willing to work for nothing, but not be willing to do that same work for money? The answer is that social relationships are quite different from economic relationships. As soon as you make it a monetary transaction, you have changed the nature of the relationship.

An important irrational distortion occurs when a person takes possession of an item. A study randomly sorted an equal number of people into two groups. In one group each person was given a coffee mug. In the other group everyone got a candy bar. They were immediately given an opportunity to exchange the item they received for the other item. Since membership in the two groups was random, on average the ratio of people with candy bars to coffee mugs should turn out to be the same in the two groups after the final exchange. To the surprise of the researchers, the proportion of candy to mug lovers turned out to be quite different in the two groups. Each group tended to hold on to its initial gift much more than traditional economics would predict.

Decision making is more than just taking into account time and money. We also must consider the mental energy necessary to make decisions. Behavioral economists have unearthed substantial evidence of omission bias in economics. The stock market provides a perfect example. Researchers have found that people who own stock A which turns out to be a loser but could have purchased stock B which ultimately turns out to be a winner have much less regret than a person who initially owned stock B and then sold it to buy stock A. Even though both people end up with the losing stock A, they feel much different about it. A recent decision to hold onto a loser is not considered anywhere near as bad as the decision to buy that loser even when the monetary loss turns out to be exactly the same.

The desire to be a winner frequently distorts economic outcomes and not just when an item is offered for “free.” A study offered people either $100 for sure or, alternatively, a chance to win $200 or nothing with a fifty-fifty probability. Since the expected value of the two alternative offers is the same, researchers expected about half of the people would take the $100 and the other half would try the gamble. A large proportion of the people chose the $100 with certainty. The $100 is enough to make the person a winner while the chance to get an additional $100 was not as important as the possibility of getting $0 and losing the winner status. The opposite was found when people were given a choice to lose $100 with certainty or lose $200 or $0 with a fifty-fifty probability. Most people chose the gamble since a loss of $0 was the only way to avoid being a loser.  Traditional economics does not provide a mechanism for understanding such an irrational inconsistency.

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Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone
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