Post No.: 0435
Almost every decision in life is a gamble with varying odds – including eating that sandwich, crossing that road or deciding to stay in or go out tonight (even if there wasn’t a pandemic!) – with both a risk of loss and an opportunity for gain. Few, if any, long-range forecasts or significant decisions in particular have perfectly 100% certain outcomes.
Both classical and neoclassical economists may assume that all agents who make decisions in economic contexts are rational, purely selfish and their tastes never change – but more modern behavioural economists empirically understand that real-life agents are neither fully rational nor completely selfish and their tastes are anything but stable. Real people are swayed by emotions and intuitional cognitive shortcuts that are fallible, they are sometimes generous (especially towards the group(s) to which they’re attached), their view of the world is limited depending on what ‘system one’ currently has to mind, their preferences are inconsistent and they often have little idea of what they’ll like the next year or even tomorrow.
The hyper-rational, self-interested (perhaps psychopathic?) ‘Homo economicus’ or ‘Econ’ of neoclassical economic theory won’t even have true friends. They wouldn’t allow emotional attachments or loyalty to affect their behaviour – only utility maximisation. But of course real humans do have friends who aren’t just there to be used for selfish gains. The rational model of expected utility theory is sufficiently predictive a lot of the time but the assumption that economic agents are infallibly rational and don’t make (predictably) foolish mistakes when money is involved is patently false. Real humans are frequently short-sighted and irrational – they tend to be guided more by the immediate emotional impacts of gains and losses, not by the long-term prospects of wealth or overall utility, even though the latter is what most people want.
People’s choices aren’t always based on the expected cash values or utilities but on the psychological values or utilities of outcomes. If offered a choice between a gamble and a sure amount that’s equal to the gamble’s expected value, most people will take the sure amount when it should be 50:50. Most people will even take a sure amount that’s less than the gamble’s expected value!
This is why, for instance, when there’s, say, a £1,000 box and a £1 box remaining in a game of Deal or No Deal (which means each box has an expected value of £500.50) – most contestants will take a £450 sure offer instead of carrying on with the game (and the banker seems to recognise this peculiarity of humans and so exploits it by offering less than the expected value every single time), thus proving that people do not naturally evaluate gambles or uncertain prospects according to rational expected value calculations. (Most people don’t even pick boxes in that game as if they understand that it’s essentially random unless it’s rigged – they instead choose them based on some emotional ‘feeling’ or intuition!)
So most people weight a ‘sure gain’ disproportionately highly, suggesting that most people dislike risk or the chance of receiving the lowest possible outcome in a gamble. In effect, people are willing to pay a premium to avoid uncertainty. Casinos and underwriting (buying insurance is essentially a form of gambling) are thus great businesses to be in.
When people haggle, they’ll fight more to knock off £100 from a new mobile phone than to knock off an extra £500 when purchasing a property. The difference in utility between £0 and £100 is not treated the same as between £1,000 and £1,100 i.e. £1 is, inconsistently, not always the same in utility as another £1!
Due to loss aversion, a loss of £5 feels more affecting than a gain of £5. Marginal subjective value gains decrease the more of something one gains or expects to gain, and marginal subjective value losses decrease the more of something one loses or expects to lose.
People also don’t normally think of relatively small outcomes in terms of how they’ll affect their total current state of wealth when making a gamble – people see each individual gamble or set of related gambles as either a gain, loss or neutral independently, due to ‘mental accounting’, rather than them all coming from and going to essentially the same pot of total personal wealth. This can, for instance, lead to people putting money into savings accounts even though they have bad, non-interest-free credit card debts to pay off; where the outgoing interests payable on debts are typically far higher than the incoming interests receivable on savings i.e. in most cases, they should rationally concentrate on paying off these bad debts before they concentrate on trying to stash any money away (albeit do account for any early repayment penalties). Having an ‘emergency fund’ even in these circumstances feels emotionally comforting though.
It’s not to say that our immediate psychological well-being isn’t important because it is, but it can conflict with serving what’s rational for us financially, and in turn what’s best for our long-term psychological well-being.
People think in terms of changes of wealth rather than ultimate states of wealth. People think in terms of relative wealth (such as compared to their immediate peers) rather than absolute wealth. This is why inequality is psychologically a major problem in society, even if no one were personally struggling to find their next meal. Although higher GDPs correlate with higher average life satisfactions when comparing low and high GDP countries – happiness levels have remained flat or have even declined even though levels of GDP have increased amongst high GDP nations. This is in large part due to the widening level of wealth inequality.
Less inequitable nations tend to be the happiest. Education equity is only a part of it. We make decisions based on making comparisons between whatever information is currently brought to mind. And so what’s heavy or light, smart or stupid, bright or dark, depends primarily on what we’re comparing to rather than its own absolute value, and this applies to feeling rich or poor, powerful or powerless, too, and its effect on our subjective well-being. Nations should routinely measure subjective well-being (amongst other things that matter for our health and the environment), not just GDP, and should do more to increase the well-being of citizens, because well-being – not its proxies – is ultimately what we all live for. After all, people want to be richer because they think it’ll ultimately make them happier i.e. happiness is the true long-term goal rather than being rich per se.
Anyway, rational ‘Econs’ live in the land of neoclassical economic theory, whereas real people, with internal inconsistencies and logical incoherence, live and act in the real world. More examples of illogical behaviours were illustrated in Post No.: 0418. Real humans can be reasonable but cannot be rational (according to the economic definition) because humans evolved to be susceptible to biases such as priming, anchoring and narrow framing. People might believe that their sports team will win – not because they infer this from their own betting preferences (i.e. they may choose outcomes that they wouldn’t bet on, and vice-versa) but because they hold many beliefs based on emotion (‘heart’) rather than rationality (‘head’). People often hold incompatible beliefs yet are unperturbed by this, such as they may understand that a fair coin has no memory of its previous tosses yet may nonetheless believe in the ‘gambler’s fallacy’ (e.g. a coin has just tossed a head 3 times in a row thus the next toss is believed to have a >50% chance of being a tail, when a rational person would believe that the chance will remain exactly 50% again). People may be entitled to their own preferences and views – but they should be at least internally consistent with themselves!
Sometimes an established theory – in this case either the classical or neoclassical economic theory – becomes entrenched for reasons of being taught it in school and it’s what your respected teachers said. It’s perhaps what everyone in your field has always believed and one has heard and used it for many years. Rather than the theory proving wrong, there may be assumptions that oneself must be mistaken somewhere or there’s a missing but perfectly good explanation if one meets an observation that doesn’t fit the theory, thus if something isn’t accommodated by the theory then it can get dismissed. There’s confirmation bias, giving the theory the benefit of the doubt and trusting the community of experts who’ve accepted it for decades because no one else has (bothered to) call it wrong before (but here everyone else is thinking and behaving in the same dismissive ways towards disconfirming evidence). But probably the biggest reason is that most people in this field (ironically emotively) want to (continue to) believe that it’s robust and true because it serves their worldviews, beliefs and agendas – in this case, believing that their economic activities are based on infallible rational behaviours and so the system can therefore self-regulate in a free market to attain optimal outcomes for the economy, society and world without need for external interference.
This effect is exacerbated if an entire powerful, financial community is involved too, who will lobby and resist calls for change as hard as they can. People usually start with a desired and therefore biased conclusion first (in this case wanting no/little government interference) then they’ll try to find theories and arguments to confirm these biases (in this case the rational-agent model that shows, on paper, with a multitude of fragile assumptions, that self-regulation will result in optimal economic and welfare outcomes). These groups are rich, powerful and influential and so they’ll manage to convince many other people and politicians to believe in their beliefs too.
This confirmation bias skews their perception of the facts and evidence towards their own desired conclusion. It therefore often takes an independent ‘outsider’s view’ to question the beliefs inside a community (e.g. psychologists looking at economics, which has led to the relatively new and growing field of behavioural economics). Disbelieving, disconfirming or scepticism is also hard mental work and a function of ‘system two’, which gets easily tired.
And especially in the more ‘fuzzy’ or ‘chaotic’ social sciences, such as economics, it can take much more than one or two contradictory findings for an established theory to be questioned seriously compared to in the relatively ‘concrete’ world of the hard sciences (where e.g. finding just one legitimate faster-than-light event would call into question entire long-established theories!) ‘Fundamental’ everyday human behaviour involves countless variables (e.g. whether someone had a bad-hair day, their coffee was lovely, they had an itch under their ear, they heard some pleasant comments from a stranger, etc.) and there are often huge variances along all of these different variables between different people, times and places (plus genetics and environments constantly evolve too). Meanwhile, a muon neutrino will behave reliably like another muon neutrino and the relevant and notable variables that affect muon neutrinos are relatively small in number. This all means that amateur or professional economists can (in their own minds at least) easily explain contradictory findings away or cast doubt on them in this field where we cannot expect perfectly tidy experiments, clean results or absolute or immutable ‘laws of behaviour’. Yet it’s itself irrational to not heed the evidence presented by economic crashes.
At the end of the day, humans would have to transform into a completely different animal species (or perhaps robots) to be considered a rational species. That’s what I personally think. Not that I’m saying that dogs are rational creatures either!
Woof. I guess it’s down to how rational an animal must be before it’s considered rational? Humans certainly aren’t totally irrational but they certainly aren’t the perfectly rational ‘Homo economicus’ that the neoclassical economic theory relies upon either. I suppose you can use the Twitter comment button below to tell us whether you personally regard humans as rational animals or not?