Economists and the Crazy Things People Do To Themselves
The following passage from St Paul's letter to the Romans is justly famous:
I do not understand what I do. What I want to do I do not do, but what I hate, I do... I have the desire to do what is good, but I cannot carry it out. I do not do the good I want to do, but the evil I do not want to do—this I keep on doing. In my inner being I delight in God’s law; but I see another law at work in me, waging war against the law of my mind and making me a prisoner of the law of sin at work within me. What a wretched man I am! Who will rescue me from this body of death?
Any one of us who has struggled to improve a bad habit knows how this feels. Human beings are crazy, self-sabotaging creatures. Who would try to deny it? Except economists. They deny it, right?
Maybe not...
The following two quotes go out to all of us who have ever wondered why economists assume that people are rational, even though, well, we aren't:
First, from Ronald Coase:
The rational utility maximizer of economic theory bears no resemblance to the man on the Clapham bus [the British equivalent of the man on the street] or, indeed, to any man (or woman) on any bus. There is no reason to suppose that most human beings are engaged in maximizing anything unless it be unhappiness, and even this with incomplete success...
[W]hatever makes men choose as they do, we must be content with the knowledge that for groups of human beings, in almost all circumstances, a higher (relative) price for anything will lead to a reduction in the amount demanded. This does not only refer to a money price but to price in its widest sense.
Whether men are rational or not in deciding to walk across a dangerous thoroughfare to reach a certain restaurant, we can be sure that fewer will do so the more dangerous it becomes. And we need not doubt that the availability of a less dangerous alternative, say, a pedestrian bridge, will normally reduce the number of those crossing the thoroughfare, nor that, as what is gained by crossing becomes more attractive, the number of people crossing will increase.
The generalization of such knowledge constitutes price theory. It does not seem to me to require us to assume that men are rational utility maximizers. On the other hand, it does not tell us why people choose as they do. Why a man will take a risk of being killed in order to obtain a sandwich is hidden from us even though we know that, if the risk increases sufficiently, he will forego seeking that pleasure.
-- The Firm, The Market, and the Law, pp 3-4
Next, from Friedman. No, not Milton Friedman, but David Friedman, spawn of Milt (ichthyology joke!):
The fundamental assumption of the economic approach, to law and everything else, is that people are rational. A mugger is the mugger for the same reason I am an economist: Given his tastes, opportunities, and abilities, it is the most attractive profession open to him...
Rationality does not mean that a burglar compiles an elaborate spreadsheet of costs and benefits before deciding whether to rob your house. An armed robber does not work out a precise analysis of how shooting his victim will affect his odds of being caught, whether it will reduce the chance by 10 percent or by 20. But if it is clear that will reduce the odds of being caught without increasing the punishment, he is quite likely to pull the trigger.
Even in this weaker sense people are not always rational. I, for example, occasionally take a third helping of spaghetti when a careful calculation of my own long-run interests would lead me to abstain. I am well acquainted with my own irrationality and can take steps to deal with it. Having discovered that bowls of potato chips located within arm's reach empty themselves mysteriously, I at least sometimes take the precaution of putting the bowl somewhere else.
But I do not know other people -- the vast masses of other people to whom economic analysis of the law is intended to apply -- well enough to incorporate their irrationalities into my analysis of the effects of legal rules on their behavior. What I do know about them is that they, like me, have purposes they wish to achieve and tend, albeit imperfectly, to correctly choose how to achieve them. That is the predictable element in human behavior, and it is on that element that economics is built.
--Law's Order, pp 8-9
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Apr '12
Re: Economists and the Crazy Things People Do To Themselves
A lot of confusion arises from the difference between the psychological sense of "rationality" and the economic sense. Friedman and Coase admit they don't know another man's thought process, but believe that his observed behavior can reveal his preferences, and that these are similar enough in the generality of people that some predictions can be made about groups (but not so much about individuals). Thus, we can predict (generally) how many fans will leave a baseball game early when the home team is behind by 5 runs; what hours of the day traffic will be heavy; that an increase in expected punishment will lead to a reduction in crime, etc.
I agree with Friedman that giving the death penalty for, say, the rape of a child may or may not be just, may or may not be constitutional, but from an economic perspective it likely leads the "rational" rapist to consider that murdering the child decreases the chance of capture without increasing the severity of punishment. Hence, more murders of child victims.
Daniel Kahneman, in his great "Thinking Fast and Slow" shows a hundred ways that people are not rational utility maximizers, but without contradicting Coase and Friedman.
Edited on June 19, 2012 at 4:09amMay '10
Re: Economists and the Crazy Things People Do To Themselves
I was an econ major as an undergrad. When I got my first career job I found myself doing enrollment projections for the University of California. These included overall projections, as well as projections for subdivisions of the campus. As it happened, I developed a great model and had pretty remarkable accuracy. The secret? While individuals are, indeed, irrational the Law of Large Numbers means that the group is rational.
Reducing the price of a widget will not cause every individual to increase their demand. But it will affect most people in fairly predictable ways.
As as far as the irrational ones among us: they are the ones who keep life interesting.
Nov '10
Re: Economists and the Crazy Things People Do To Themselves
Even Coase is too optimistic. Sometimes raising the money price of X can actually increase demand for X. This is so for at least two reasons.
First, everyone knows that the quality of X generally correlates with the price of X. Where the quality of X is known imperfectly, the price of X can serve as a guide to it. Hence, too low a price--by conveying an impression of fishiness--will dissuade someone from buying X rather than persuade them to buy it. Would you buy a diamond ring for $100?
Second, the expensiveness of X means something to symbolic creatures such as ourselves. For example, if P1 bought P2 a diamond ring for $100,000, P2 may be happier than if P1 bought it for $100. Accordingly, if P1 values P2's happiness, P1 may disdain the cheaper ring.
But don't worry: the praxelogically valid rules of economics are not being violated. In both cases, the loss of demand is the result of X's subjectively evaluating the cheaper version less favorably on balance, despite its lower monetary cost. Obviously, there is nothing necessarily irrational about being either a canny consumer or a generous lover.
Aug '10
Re: Economists and the Crazy Things People Do To Themselves
As Coase was a canny guy, I'm gonna guess that he qualified his statement
because he had stuff like what you mention in mind. As you say, there are costs to ending up with much shoddier merchandise than you wanted or making the effort to investigating what's likely "too good to be true".
Engagement rings appear to have become popular during a period when premarital sex was becoming more common, yet could still ruin a woman's reputation, especially if the man didn't marry her, and courts stopped recognize breach-of-promise for marriage. If it's true that an engagement ring therefore served "as a performance bond for the promise to marry" (Law's Order, p179), there'd be reason for a gal to be miffed by a cheap bond.
Edited on June 19, 2012 at 5:03pmAug '10
Re: Economists and the Crazy Things People Do To Themselves
I, for one, found Coase's frank pessimism refreshing :-)
May '11
Re: Economists and the Crazy Things People Do To Themselves
Freud explained all of this. The desire for immediate gratification (the "id"), is at odds with the rational calculation of long-term best interests (the "ego"). We have a conscience and morals (the "superego") to help us overcome the powerful desire for immediate gratification. Our morality is the thumb on the scale, that gives our rational selves a fighting chance against the childish but powerful feeling that "I want what I want, and I want it now." Surely economic models can deal with that fact.
Oct '10
Re: Economists and the Crazy Things People Do To Themselves
Do you have any idea how much time I spend on Ricochet (and NRO and WSJ Online) when I know I should be working instead??
Aug '10
Re: Economists and the Crazy Things People Do To Themselves
That your model rocks is evidence that for your purposes you could assume the Law of Large Numbers, but why assume it's always safe to apply the Law of Large Numbers to human beings?
We can always assume that human beings are independent and identically distributed random variables known well enough that we know all possible outcomes?
Now, I may not have the knowledge to prove that it's not true, but who can prove it's always true? Seems like one of those things that's true until your model breaks.
I find Friedman's argument
more convincing -- more honest about what is not known.
Edited on June 20, 2012 at 2:31amDec '11
Re: Economists and the Crazy Things People Do To Themselves
Midget Faded Rattlesnake I find Friedman's argument
more convincing -- more honest.
One of Milton Friedman’s most famous contributions to economics was his 1953 essay The Methodology of Positive Economics. Friedman argues that the realism of assumptions used in an economic model doesn’t matter. What matters is that the model produces valid predictions.
“Truly important and significant hypotheses will be found to have 'assumptions' that are wildly inaccurate descriptive representations of reality, in general, the more significant the theory, the more unrealistic the assumptions.”
Models contain things that we can see, prices and quantities, for example, but they also contain assumptions about those things that we can’t see. The unobservables are the assumptions like rationality. So in a sense, we assume (possibly) unrealistic things like rationality in the model. We should use the model to predict, not describe. A model should be judged on whether its predictions are correct and important, and not the realism of its assumptions.
Apr '12
Re: Economists and the Crazy Things People Do To Themselves
Midget Faded Rattlesnake
I find Friedman's argument
more convincing -- more honest about what is not known.
The way I understand Friedman is that when we are trying to predict the behavior of groups their (individually) unpredictable irrationalities likely balance each other out sufficiently that we can safely ignore them.
Aodhan's diamond example doesn't ring true to me. A woman might prefer a $100,000 ring to one that costs $100, but she'd be marrying an idiot if he were willing to pay $100,000 for the same ring he could have purchased for $100. For expensive rings, no one thinks, "It's on sale for $99,000. I won't buy it until they raise the price over $100,000." Sometimes a price rise communicates to prospective purchasers that the price might go up even more, and this is the best time to buy. An increase in mortgage rates could persuade borrowers to get off the fence.
Aug '10
Re: Economists and the Crazy Things People Do To Themselves
Muleskinner
What matters is that the model produces valid predictions.
“Truly important and significant hypotheses will be found to have 'assumptions' that are wildly inaccurate descriptive representations of reality, in general, the more significant the theory, the more unrealistic the assumptions.”
We should use the model to predict, not describe. A model should be judged on whether its predictions are correct and important, and not the realism of its assumptions.
If long and careful experience shows that applying the Law of Large Numbers to human beings produces valid predictions, that's one thing. But then the justification is experience, not the Law of Large Numbers itself, which is about numerical abstractions only.
Models do, of course, often assume something other than reality -- models are models, after all. But how far a model's assumption can be from what we know to be out there in reality depend rather on what you're using the model for, no?
A ballistics model ignoring air resistance that's used to explain the force of gravity to freshmen physics students is not necessarily the same model that engineers would want to use to design a guided missile system.
(1/2)
Edited on June 20, 2012 at 3:08pmAug '10
Re: Economists and the Crazy Things People Do To Themselves
I also wonder whether Friedman had, as a good scientist, an exceptionally fastidious idea of what "wildly inaccurate descriptive representations of reality" are.
Honesty compels us to acknowledge that even very good models often contain unrealistic assumptions. But that doesn't mean good models contain assumptions nearly as wild as they could get. If a model was perfectly predictive, but used assumptions such as a conspiracy of mind-controlling aliens from space or the existence of purple rhinoceros fairies to make its predictions, we would rightly reject it as a good model.
As Michael Polanyi put it, satisfactory models are more than just Rube Goldberg machines that happen to yield accurate predictions. In fact, we rightly find ad-hoc models that have only predictive power, but lack whatever it is we mean by explanatory power, ugly.
(2/2)
Edited on June 20, 2012 at 3:07pmDec '11
Re: Economists and the Crazy Things People Do To Themselves
Midget Faded Rattlesnake: I also wonder whether Friedman had, as a good scientist, an exceptionally fastidious idea of what "wildly inaccurate descriptive representations of reality" are.
As Michael Polanyi put it, satisfactory models are more than just Rube Goldberg machines that happen to yield accurate predictions. In fact, we rightly find ad-hoc models that have only predictive power, but lack whatever it is we mean by explanatory power, ugly.
Friedman did say that more inaccurate assumptions were not preferable in an of themselves. But that tension is part of the reason that generations of grad students have been forced to wrestle with Friedman.
But to a large degree it really depends what you are trying to do. Experience shows that imposing all of the assumed relationships between variables in a model generally results in a model that forecasts poorly. If I'm trying to explain, I use one kind of model. If I'm trying to forecast, I'm not so (or at all) concerned with how well it explains the relationships between variables.
Aug '10
Re: Economists and the Crazy Things People Do To Themselves
Thanks for all the thoughtful replies, Muleskinner. I'm learning a lot from what you say when I talk back to you :-)