4 Ways We Are Not Rational And How It Affects Economics

At the core of economics (especially economics teaching) is the idea that people are fundamentally rational, self-interested, utility maximising individuals who make decisions after logically considering all the relevant facts. As these people know best what’s best for themselves, these decisions are optimal for society. However, one of the newest and fastest growing school of thought is the Behavioural School which uses the insights of psychology to show that this simply is not the case. These insights are sometimes viewed only in isolation or glossed over as minor trivia. However, when you put all the different pieces together, you see that the conclusions are far reaching for how the economy operates.

  1. Priming

We like to believe that we are fully aware of everything that is occurring around us and make decisions based solely on the facts. Most people would laugh at the idea that they are influenced by advertising. Those thousands of ads simply bounce off them without having any impact. It doesn’t matter how attractive a model or how catchy a jingle they use, why would that make them want to buy the product anymore? If we do something it s because we made a conscious decision to and felt that the benefits outweighed the costs, right?

Wrong. In a sense we have two brains (not really but it’s a good metaphor). There is the emotional fast brain which makes unconscious reflex decisions, often following habits and is essential for things such as sport. Then there is the logical slow brain which we use for making conscious decisions based on their cost and benefit. Both are useful, as without the fast brain we would be unable to do unconscious acts like breathing and moving, while without the slow brain, we would be no better than animals unable to make rational decisions. Your typical economist thinks only about the logical brain that carefully decides each action but forgets about the emotional brain which does things for reasons even it doesn’t understand.

There are many studies on this topic. Showing people images from the business world makes them more competitive and greedy. The crucial part is that when asked after why they behaved as they did, none of the participants mentioned the business items, instead they spoke about their concept of fairness or their impressions of the other people they were dealing with. In another experiment participants had to unscramble words that were either polite, neutral or rude. When it came time to hand up the test, participants found the examiner having a conversation with another person (this was the real test). People who had been primed by the rude words were far more likely to interrupt than those who had been primed by the polite words. When interviewed after about how long they had to wait, none of the participants realised that their behaviour had been influenced.

The entire advertising industry is based upon taping into the emotional brain and bypassing the logical side. Think about it, when was the last time you saw an ad that discussed the details of the product or compared it to its competitors? It’s far more common to see ads that remind you of home  or having fun or being cool. Our logical brain thinks there’s no way that having a sexy model will make us buy that product but our emotional brain is making a connection and the next time we’re in the shop we end up buying the product without being fully aware why. You could fill a book about priming (and many have). Businesses use priming in the colours they use, the layout of their shops (ever wondered why supermarkets always seem to be laid out in the same pattern?), their words,

An excellent example of priming is the term “free market”. How can you not be influenced by a word like that? Not only does everyone love getting things for free but freedom is probably the most important value we have. How can anyone be against freedom? With this bit of priming, no wonder so many people want to keep government intervention out of the free market (even though the market could not exist without the state). Imagine if instead we called it the “wild market”. We still have the core concept of a market without rules but know we have connotations with weeds, chaos and dangerous animals. In both cases our logical brain is indifferent but our emotional brain is strongly influenced.

  1. Anchoring Effect

It is impossible to judge anything or make any decisions without reference to the world around us. The only way we can decide whether something is cheap or expensive is by reference to the price of other goods. However, what many people don’t realise is that they are unconsciously influenced by the options around them. For example you might think that $70 for a product is too expensive. However, if the same product had a regular price of $100 but was on sale for $70, you might be happy to buy it. A rational consumer would see no difference between the two scenarios, but a real consumer has just been subject to the anchoring effect.

The anchoring effect is when we latch onto a certain number and judge everything relative to it. So if we latch onto 100, then everything below that seems cheap. On the other hand, if we latch onto 50, then everything above that seems expensive. A good salesperson gets their customers to latch onto a high number, which is why car prices can usually be haggled down; they’re not actual prices, just high anchors. Likewise, technology shops always have the newest, state of the art piece of technology in the centre of their shop with a massive price tag. It doesn’t matter whether anyone actually buys it, its role is to act as a high anchor and make everything else look cheaper.

Dan Ariely did some interesting experiments on the topic. The best is one where he brought students to an auction but before they bid they had to write down the last two digits of their social security number and were asked if they would bid that much for the item. Then they placed real bids. Now surely something as random as that that couldn’t possibly influence something as serious as money? Incredibly, people with high social security numbers bid three times as much as those with low social security numbers.

Perfect competition as taught in economic textbooks is a good example of a high anchor. Many economists will tell you that they don’t really believe it describes the real world and they adjust their views accordingly. However, the anchor has been set at perfection and so undoubtedly many economists and students have a far more positive view of the markets than otherwise. Imagine if the standard economics textbook described the economy as a complete monopoly and economists adjusted their views from this point. They would probably be influenced into having a much more negative view based on this low anchor.

  1. Just World Fallacy

Most people want to believe that the world is fair. We want to believe that things happen for a reason, that there is order and justice in the universe. The best example of this is in regards to poverty and wealth. Discussions of poverty inevitably involve people blaming poor people for their poverty. There must be a reason for being poor, so maybe the people are lazy or stupid or without the right skills or work ethic. Likewise when we see rich people we presume they must be rich for a good reason. They must be smarter or more skilful or more talented or more imaginative. We feel people must get what they deserve.

The idea that people could be rich or poor for reasons beyond their control is disturbing for some people. The Just World Fallacy gives people a sense of security and control. That good hard working people could be poor or that you can be dishonest and lazy yet still be rich can be unnerving. Deep down we all feel that good deeds deserve to be rewarded and evil must be punished. We want to think that so long as we work hard and be decent to other people we will be safe from poverty and harm. In reality, whether we succeed in life is determined, not just by factors we control, but also by many beyond our control such as the country we are born in, the class we were born into, our race, gender, who we know and simply being in the right place at the right time.

Proponents of the free market frequently fall foul of the Just World Fallacy. Many claim that if a business is successful then this must be because it is making a positive contribution to society. If someone is unemployed then it must be because they don’t have the skills that businesses need. The richest people in society must be the most talented. This is presuming that whatever outcome there happens to be is a fair one, as if we were living in the best of all possible worlds. If we were rational we could logically and dispassionately examine the world as it is, but in reality we are blinded by how we wish the world should be.

  1. Expectation

I spent a large part of college years drawing indifference curves and solving equations about how consumer preferences supposedly worked. It was assumed, that consumers were rational actors who always picked the best option and couldn’t be easily fooled. They would obviously take the quality of the product into account and would not buy it again if it was not good enough. If only it were so.

Instead people are greatly swayed by their expectations of the product which makes them likely to overrate it. In one experiment, wine tasters were asked to describe in detail, two glasses of wine, one red, and one white. Of the 54, tasters not a single one noticed that two wines were identical, one was just dyed red. In another experiment, cheap wine was put in two bottles, one labelled cheap, the other expensive. The expensive wine was rated much higher. In another experiment, students were given a sports drink before an exam at full price while other got it at a discount (the control group didn’t get any). Those who thought the drink cost more answered more questions correctly.

No rational consumer would be fooled by these tricks, but ordinary people are. Eating food in a luxurious room with expensive cutlery shouldn’t make the food taste any nicer but in fact it does. The food and drink industry is based around this concept. This has serious repercussions for how markets work. It is normally thought that if a business charges too much then a consumer will go elsewhere, but these studies show that if the price is higher, consumers will enjoy the product even more. This turns standard economic theory on its head. This is why so many people are willing to pay huge amounts for an iPhone when there are comparable phone far cheaper. Being overpriced isn’t a weakness, it’s a strength. After paying so much, people unconsciously convince themselves that it was worth it and that it lived up to expectations (otherwise they’d feel like a fool for wasting so much money and our brain is wired to protect us from pain).

So there are four reasons why we are not rational. Economics is still taught as if people were unemotional rational actors, unswayed in their quest for maximum efficiency. Meanwhile behavioural economics is still treated as something with a few limited uses but mostly just interesting titbits rather than anything that affects the important parts of economics. I hope I have shown that this is not the case and that when you realise that we are not rational, it has important and far reaching consequences.

(Source for this blog are this and this book. They’re fascinating reads and I’d highly recommend them)


Filed under Economics

5 responses to “4 Ways We Are Not Rational And How It Affects Economics

  1. Instead of poking holes in all of the ludicrous “premises/assumptions” of economics, I issue you a challenge. Since you are one of the most cogent writers on subjects economic on the Internet, this is perfect for you: find one, just one such assumption that is valid.

    I double dare you, as we say in the U.S. And … bet you can’t!

    • I can answer that, Steve, although it’s broader than a simple economic assumption: the golden rule. Sure, its not entirely foolproof, but if we directed our economic policies this way, with this theme underwriting macro/micro economic decision making, the systems we presently endure would look tremendously different.

  2. You’ve omitted a fifth source of irrational economic behaviour from the list – although it is what your blog is essentially all about, so it’s hardly a criticism. This is the widespread belief in ‘economics’ itself.

  3. Considering that both governments and markets are made up of people, don’t these irrationalities also apply to the agents of the government? Thus, wouldn’t it seem insufficient to simply point out these irrationalities to argue that markets are bad? Don’t we need to compare how both political and market institutions overcome these errors in human logic (you know, comparative institutional analysis)?

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