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Thursday, May 21, 2009

Predictably Irrational: The Hidden Forces that Shape Our Decisions

As the title suggests, Predictably Irrational is another offering on behavioral economics. The overriding theme is that people not only tend to behave irrationally, but they do so in systematic and predictable ways. Thus our lapses from rational behavior reinforce each other rather than cancelling out. The evidence for this comes largely from experiments which find people making decisions that deviate from what one would expect from the standard economic models of rational self-interest (for example, giving less weight to opportunity costs than to out-of-pocket costs). The robustness of some of these experiments is controversial in some academic circles, but for purposes of this review I accept the results as reported by Ariely (who teaches behavioral economics at Duke’s Fuqua School of Business) and other experimental economists. My concern is with what Ariely sees as the implications of these deviations from rationality.

Ariely’s book is more interesting than most on behavioral economics because of the bold claims he makes. Most behavioral economists see their findings as suggesting some qualifications to utility maximization as the basis for describing economic behavior. But most are cautious in concluding that the irrationalities they observe make a case for relying more on government to direct economic decisions. One suspects that some behavioral economists favor more government direction, but they typically argue for what they see as a benign government role. (The best example is the argument Richard Thaler and Cass Sunstein make for “libertarian paternalism.”) Ariely shows no such restraint, saying that he wants more government regulation because irrationality renders markets unable to work properly.

Ariely’s chapter “The Fallacy of Supply and Demand” begins with the story of an entrepreneur who took black pearls of “dubious worth” and turned them into a high-priced luxury item. He then discusses some experiments that he interprets as showing that “initial prices are largely ‘arbitrary’” and influence “not only the immediate buying decision but many others that follow.” In other words, if businesses can get us to pay high prices initially then we, as irrational as we are, continue to find those prices acceptable.

But even if consumers are as irrational as Ariely would have us believe, they are still protected by private-sector competition that has driven down the real prices—while improving the quality—of televisions, electronic calculators, digital cameras, personal computers, life-saving medications, and a host of other products. If Ariely has given the effect of competition any thought, he keeps it to himself. Instead, he concludes that if we cannot depend on markets “to help us maximize our utility, then we may need to look elsewhere [meaning government]. This is especially the case with society’s essentials, such as health care, medicine, water, electricity, education and other critical resources.”

Even if people are irrationally willing to continue paying the prices they initially pay for a product, that hardly makes a case for more government intervention. Would anyone argue that the Post Office (or Amtrak or Social Security) does a better job of providing consumers, irrational or not, with lower costs and increasing quality than private firms? Markets clearly do far better than governments at revealing the cost of goods and services and thereby enhancing rational choices.

Ariely emphasizes how consumers are misled by what he calls “decoy” prices, and other types of private-sector pricing. But market pricing, even at its most deceptive, reveals information on costs far more accurately and understandably than government pricing. Does anyone know how much Social Security costs (including its effect on wages), or the cost of public education, or the ethanol in the gasoline they buy? Ariely has an entire chapter on the high cost to consumers of being convinced by businesses they are getting something for nothing. Nowhere, however, does he mention the free-lunch political promises that end up increasing the cost of the “free” goods.

One of the most interesting of Ariely’s chapters is on the importance of social norms and how they contrast with market norms. He does an admirable job pointing to the serious problems of applying market norms in situations involving families and close friendships. The problem is that he’s sympathetic to applying social norms to the extended and impersonal relationships in business transactions. Ariely’s concern with moving in the direction of treating businesses like a family is that businesses will fail to adhere to their social-norm responsibilities by laying off workers, cutting benefits, and reverting to market norms. He remains optimistic, however, that by doing it right, businesses can benefit from more reliance on social norms, citing Google as an example.

Ariely’s book would have been better, though probably not as popular, had he balanced his discussion of irrationality in markets with some Public Choice implications of perverse political behavior.

  • Dwight R. Lee is the O’Neil Professor of Global Markets and Freedom in the Cox School of Business at Southern Methodist University.