Economic Irrationality


Popular economic theory is based largely in two unexamined underlying assumptions. Economic theories assume that people make (1) rational, (2) well-informed decisions. However, massive amounts of psychological & anthropological research shows what advertisers already understand: human rarely ever make rational well-informed decisions. Thus, the entire basis of the supply and demand curves is known to be false. Corrections in our economic models are clearly needed.
Here we will look at some of the easy to identify problems with rational well-informed decisions hypotheses.

Draft: April 2012

 

 

Demand Curve Irrationality

The demand curve as it is taught in Econ 101 shows demand monotonically dropping as price rises. If humans were perfectly rational and well informed this would make sense. But real prices don't work that way. $9.99 may be the most common price found in stores. Why? The poorly informed, not-so rational mind sees $9.99 as less than $10.00. Thus stores can increase their sales (demand for their goods) by increasing their prices to $9.99, or to other prices ending in .99.
Similar, well known to marketing departments is a trick called anchoring. Before a product price is seen another unusually high price, typically for similar product is shown. This causes people to accept a higher price as reasonable for the product being sold to them. There are many ways to anchor prices, comparison to an overpriced product, coupons, false discounts, etc. They all have the same outcome: increasing demand for higher priced products.
Possibly the worst case of human irrationality on the demand curve results from the desire for status. (1) Severely overpriced products can easily be sold to people who believe they gain status by purchasing that product. Much of the spam e-mail we all receive attempts to sell us overpriced products that offer nothing more than status.
Supply Curve Irrationality
We strongly believe that financial rewards increase performance and output. But massive amounts of research show that although rewards can increase output for simple repetitive tasks, rewards actually reduce performance for complex tasks (Pinker.) Yet, most businesses are set up to give strong financial rewards to those doing complex tasks and no financial incentives to those doing routine tasks. Other research has shown either an inverse correlation between CEO salary and company performance, or simply no correlation.
This should come as no surprise if we stop to think about it. High rewards for poorly measured outcomes incentivize cheating. People quickly recognize they can get the largest reward for non-productive or even counter-productive behaviors. These can include cornering a market, leveraged take-overs, down-sizings, and undermining colleagues' achievements for personal status gains. (2)
Even under the most rational circumstances the Peter Principal reminds us that those promoted to higher status positions would not achieve the highest outcome. But under real conditions, we frequently see those seeking status playing many image games and counter-productively meddling to give themselves a better place on the ladder. We see executives who have no clue what it takes to produce their product and salesmen who have no idea what their customer really needs; they were never the customer nor the design engineer.
Consequently, we can't trust the supply curve as higher prices do not necessarily result in greater quantity output or higher quality. In fact, higher prices occasionally result in the opposite.

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Local-immediate vs. long-term large-scale & absence of feedback

Even with all our education and all our science and all our access to media, Americans are surprisingly poor at assessing long-term and large scale costs. We persist at making many decisions that have rather high long-term or down-stream costs for short-term gains.
This is most apparent in the news about the federal deficit. All Americans want programs that benefit them. All Americans want tax-cuts. Few Americans recognize that they can't have the programs they demand and still have a tax cut without running a huge deficit. We saw the same problem in the housing bubble. Few Americans recognized that investment costs could not continue to rise faster than real incomes.
We see various forms of this failure to accurately assess long term costs throughout American private choices. In health we see Americans failing to assess the long-term consequences of smoking, excess eating, sedentary life-styles, drinking or texting while driving, etc. In business we see Americans failing to assess the cost to their children of continued down-sizing, greenhouse gas emissions, overdependence on monoculture, antibiotics, nitrogen fertilizers, developing farmland, peak oil, etc. We even see major movements in America to protect people and businesses from the natural costs of their own choices.
If we were to evaluate all the long-term costs that we ignore we would realize that the next generation has huge debts to pay in many forms: federal deficit, personal deficit, loss of employment diversity, pollution, habitat destruction, and resource loss. (3)
We have a similar problem when costs are immediate and local, but benefits are long-term or distributed. Many choices would be good for our children or our retirement, but we feel the costs immediately. The immediate costs may be financial or life impact. For example, investments in renewable energy would have strong benefits for our country's future, our children, or simply reducing our long term energy costs. But the immediate costs are very real. Because of this, very few people or organizations actually invest in renewable energy. The list of choices with positive long term returns, but real immediate costs is very long. But very few Americans consider how a cost realized now will benefit their grandchildren. Most large American companies reward choices in terms of benefits for the current quarter, they don't even have a decade long cost-benefit analysis, let alone a generations-long plan.

Summation

We've looked at some ways that both supply and demand behave irrationally. We've looked at some ways that the absence of immediate feedback leads Americans to make irrationally costly choices. And yet, even though all these examples are obvious or well-known, our media and politicians still tend to discuss economic theories as if they were known truths. We are told that rational models will work even when we can plainly see that they don't.
What we need is new economic theories that accept as a basis well known aspects of the irrationality of human behavior. This page does not tell us how to do that; it just shows that it needs to be done.


Footnotes
(1) Many teachers have seen how desire for status abounds in students' thinking. Many teachers have put forth the question, "if you can buy Nikes in one store for $40 and the same Nikes in another store for $60, what should you do?" The teachers have been horrified to see how many students respond, "go to the store that charges $60." But we actually see this irrational choice throughout our culture: designer clothing, sports cars, etc.
(2) We have all been in situations where we see somebody undermine a colleague for the sake of their own status. (I've probably seen it in every job that I have had.) But this type of counterproductive behavior is a zero-sum game. Our major economic models don't include the real costs of undermining each other for personal status.
(3) Rational choice is not clearly defined when it comes to large scale or long term choices. Is it better to make choices that benefit me now or my children in the distant future? Currently, dominant American thinking, both economic and environmental, is oriented in favor of personal gains now that will be paid for by a future generation. Is that rational or irrational?


 
 

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