RelativeResourceManager5.pdf

The problems with perfect people: Where economics breaks down  Three key assumptions underlie the study of consumer decision making in economics. First, people know what they like. Second, they know what is available. Third, they choose rationally to maximize their own ?utility?. (Utility is an imaginary concept that we might think of as enjoyment, pleasure, happiness, or well-being.) It is easy enough for economists to make changes to their models when the first two rules are violated. When one of the first two rules is violated, it simply reflects a deficiency of information. To fix the problem, all we have to do is give appropriate information. If people don?t know what they like, economists can adjust models for learning and experimentation. If people don?t know what is available, economists can incorporate imperfect information, marketing, and advertising costs. Thus, our perfectly rational consumer is easily put back onto the track of maximizing utility. Violating the first two rules is not a major problem. Violating the third rule is different. If people do not make rational, utility- maximizing decisions, then the wheels fall off. Standard, neo-classical economic models simply do not function without the third rule. Yet, how often do we see people making decisions that do not rationally maximize their well-being? People become addicted and wish they hadn?t. Addicts wish they could stop, but still don?t. People get angry, greedy, or lustful and do stupid things. We feel regret over a past decision ? even when we knew at the time exactly what the consequences would be. We read studies about the benefits of exercising more or eating healthier, but somehow our rational understanding doesn?t change our behavior. It seems that our behavior is often far from the economic model of the cool, calculated, rational individual advancing his well-being with mathematically precise choices. In a classic display of behavior inconsistent with pure rationality, we see a variety of circumstances where people pay to remove choice options. We would certainly think it strange if a weight loss camp included sugary and fatty food options in its cafeteria. And, who would expect an alcohol rehabilitation program to offer a full bar? The truth is that people will pay to have choices removed from their set of options. For example, a recovering alcoholic might pay for a prescription to Antabuse (disulfiram) which causes alcohol to be nauseating. Others might choose to take a longer route home to avoid being tempted by doughnuts, alcohol, pornography, or other options. In all of these examples, the common theme is that people will pay money or expend effort to remove a choice option. This behavior, however, requires irrational choice. If the person could simply choose not to consume the item, then paying to remove the option is irrational. Alternatively, if paying to remove the option is rational, it is only because the person would have behaved irrationally in the presence of the choice option. Either way, the practice requires the existence of non-maximizing choice behavior. If the reality of human behavior does not fit the assumptions of the economic model, why is it so important in economic analysis? Where did this idea of the perfectly rational, utility maximizing, homo economicus originate? The most common starting point for this idea is John Stuart Mill who, in 1836, described it as ?an arbitrary definition of man, as a being who inevitably does that by which he may obtain the greatest amount of necessaries, conveniences, and luxuries, with the smallest quantity of labour and physical self-denial with which they can be obtained.? 1 This idea first became critically important to economics when, later in the century, economists began working on a mathematical model of an entire economy. Production choices were easy to model, based simply upon the idea of profit maximization. Consumption choices, on the other hand, were far too messy. People bought things for many different reasons. People worked for many different reasons. But, the complications of real human decision-making didn?t fit into an equation. People were messy and their messiness messed up the math. To make the messiness go away, economists adopted the idea of homo economicus. People were modeled as little factories. Real factories ran to maximize profit; people ran to maximize ?utility.? If the dissatisfaction from working an extra hour was less than the satisfaction from buying more things with the extra pay, then a person would work an extra hour. If product ?A? gave more utility than product ?B,? then a person would buy product ?A?. The exciting mathematical result of this approach was that economists could simply copy the models developed for profit-maximizing factories and apply them to human behavior. This mathematical ?breakthrough? allowed for the increasing dominance of consumer economics by mathematical models. In the late 19 th century, economists such as Francis Edgeworth and Vilfredo Pareto built mathematical models of consumer well- being based upon these assumptions. Today, such mathematical models dominate consumer economics. For example, a relatively simple model of consumer utility in purchasing minivans would begin with a formula such as [If your want to know how these define consumer utility in minivans, feel free to consult Petrin, A. (2002). Quantifying the benefits of new products: The case of the minivan. Journal of Political Economy, 110(4), 705-729.] Without question, modeling consumers as rational ?utility factories? allows for the construction of an enormous edifice of mathematical models. Economists can produce models that are sophisticated, complex, and internally consistent. However, the advancement of such model building has a significant problem. Economics is a social science. Such models are intended to model human behavior. Thus, while it is possible to have enormously complex models that are logically consistent and agree with each other, these models are not particularly useful if they don?t reflect actual human behavior. Nevertheless, learning how to create and translate such mathematical models takes years of training and requires the intimate involvement of graduate-level faculty and educational institutions. Questioning the basic assumptions of these models is, consequently, an approach guaranteed to ruffle a few feathers. In economics, the new field of study that departs from modeling individuals as rational maximizers is known as behavioral economics. The full recognition of this emerging new field in economics can be dated to the awarding of the 2001 Nobel Prize to Daniel Kahneman and Vernon Smith. Both Kahneman and Smith brought techniques of experimental psychology to the study of economic behavior. Kahneman?s early work on prospect theory (how we treat potential gains and losses inconsistently) remains a fundamental part of behavioral economics today. However, this point of international recognition for behavioral economics probably resulted from an earlier fight over one of the more famous characters in economics, John Nash. Thanks to Russell Crowe?s portrayal of John Nash in the movie ?A Beautiful Mind,? many people are familiar with the life of John Nash. However, the movie did not include the part of the Silva Nasar?s original book about the controversy surrounding Nash?s Nobel Prize in Economics. To begin with, John Nash was not an economist. He was not a social scientist. He was purely a mathematician. His award did not result from a lifetime of achievement in the field of economics. His only contributions came as a graduate student when he solved a mathematical problem in modeling multi-person games. As described in Nasar?s book, the decision about his nomination caused a tremendous fight within the Nobel committee. The purely mathematical economists supported his nomination. But, those who saw economics as more of a social science were infuriated by the idea of awarding the Nobel prize for a single contribution by a mathematician who had neither taught or nor studied economics. The compromise reached in the end allowed Nash to receive the prize. In exchange, several of the purely mathematical representatives agreed to leave the awarding committee and be replaced by those with a broader, social science view of economics. In this way, Nash?s award in 1994 set in motion the Nobel committee?s personnel changes that would ultimately lead to the 2001 award of the prize to Daniel Kahneman and Vernon Smith and the recognition of behavioral economics. Behavioral economics is the new field of study in economics that specifically rejects the third principle. In behavioral economics, people do not always rationally maximize their own utility. Human rationality, while it does exist, is ?bounded.? Sometimes we rationally maximize our own well-being. Sometimes we do not. In standard economics, humans are modeled as being, essentially, perfect. Homo economicus is perfectly rational, holds all information about himself and his options, and makes precise, utility-maximizing choices. Instead of homo economicus, the behavioral economic model may be Homer economicus, as in Homer Simpson. Behavioral economics views humankind as messy, emotional, forgetful, prone to errors, and potentially self-destructive. Yet, it is because of this view that behavioral economics holds the promise of improving human decision-making. (Standard economics cannot aim to improve such decisions, because it assumes that decisions are already perfectly rational.) The goal in behavioral economics is to discover those areas where people do not behave according to the rational maximizing model. With these discoveries, we can see where people consistently make mistakes. By understanding the causes of these mistakes, we can also explore how to avoid similar mistakes, and ultimately how to improve human decision making.                                                              1  Mill, John Stuart. "On the Definition of Political Economy, and on the Method of Investigation Proper to It," London and Westminster Review, October 1836. Essays on Some Unsettled Questions of Political Economy, 2nd ed. London: Longmans, Green, Reader & Dyer, 1874, essay 5, paragraph 48. FACS