Thursday, May 26, 2011

Mind Games and Economic Semantics

Rationality is a significant principle in economics. It is employed to explain how people make choices. This SmartMoney article highlights Dan Ariely, an expert in behavioral economics that has PhDs in cognitive psychology and business. An accomplished and engaging public speaker, Ariely contends that many choices are made on an irrational rather than a rational basis.

An example of Ariely’s contention of general and predictable irrationality mentioned in the SmartMoney article involves mortgage-backed securities that played such a prominent role in the 2008 housing bubble crash.
“Most people, it turns out, are comfortable with a small amount of cheating; if the incentives are in place, they can bend the rules and still consider themselves "good people." That's one reason Ariely is disappointed but not surprised that high bonuses are back in the financial world. "If I pay people $5 million to view mortgage-backed securities as a good product, most people will believe [those securities] are good," says Ariely.”
If this is a good example of irrationality, it is a poor one. In fact, it looks a lot like cases cited to support rational choice theory.

The common use of the term rationality denotes sanity and fact-based emotionless decision making. This appears to be the way the term is used throughout the SmartMoney article. It would seem that this is how Ariely employs the term.

Rational choice theory, on the other hand, defines rationality as making choices based on which option is likely to produce the greatest return at the lowest cost. It applies in all decisions regardless of whether they involve monetary matters or not. It suggests that people respond to the incentives they perceive—all of the incentives, not just those that translate directly into money.

Paying someone “$5 million to view mortgage-backed securities as a good product” creates a huge incentive to adopt such a view. Rational choice theory says that a person receiving such an opportunity would balance the perceived benefits and costs of accepting that view against the perceived benefits and costs refusing to do so.

Maybe the person considers what his neighbors will think of him or what his God will think of him, as well as how his physical lifestyle will improve. Perhaps, like Tevye singing If I Were a Rich Man, they see their neighbors revering them for their wealth and even increased opportunities for worship and doing good.

One of the main points many economists make with respect to rational choice theory is that no one is better suited to make any choice a person faces than the person themselves. While no one has perfect information regarding any choice, each of us brings a unique understanding of the costs and benefits involved to each decision. It would be impossible for anyone else to fully comprehend the number of factors we consider and the weight we apply to each factor when making a decision. Some of these things are so automatic that we probably couldn’t articulate them all if we wanted to.

Whenever someone purports to demonstrate that people make irrational economic choices, it is almost always because they have indulged in the hubris of assuming to know what is best for others. It can be relatively easy to quantify whether someone spends overall less on a cart of similar groceries at store A than at store B. But to then assert that someone that shops at store B is behaving irrationally is extreme arrogance.

How does the outside observer know all of the factors that go into a shopper’s cost-benefit analysis? Declaring emotion to be irrational makes it far easier to study behavior and to declare it irrational. But the fact is that we are emotional beings. It is absurd to attempt to separate people from one of their core characteristics in the name of science.

In the store A, store B example, might it not be possible that some shoppers are willing to pay more to shop in a store with better lighting, more pleasing d├ęcor, or a layout that makes more sense to them? Or maybe it’s a matter of time vs money. They happen to know where things are in store B and their time is more important to them than the savings they would get by going to the unfamiliar store A.

I know people that are deeply religious that choose to shop at a store that is closed on the Sabbath, although, prices are generally higher. I suppose Ariely and his ilk would say that these people are behaving irrationally. But their choices are perfectly rational under rational choice theory. They perceive a greater net benefit from their choices despite the fact that shopping receipts show that they spend more. Spiritual benefits are hard to track through cash register receipts.

In effect, Ariely is simply playing a game of semantics, applying some behavioral economic theories to the common understanding of rationality rather than using the term as employed by most behavioral economists. From the grand living he earns by doing so, it would seem that he is highly incentivized to engage in this deceptive behavior. That too demonstrates rationality.

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