I gave this talk several years ago, but you know what? It’s still pretty decent.

Irrationality in Economics  

The title is misleading. Like many of my titles, it’s meant to grab attention rather than be exactly correct.

I was trying, with this talk, to convince college freshmen to switch from Philosophy to Economics. And you know, Philosophers are always talking about Rationality — is there even such a thing, and if so what does it consist of? Econ provides more than one concrete prescription for Rationality — more on that below.

 

“We are recorders and reporters of the facts—not judges of the behavior we describe.” —Alfred Kinsey 

I actually think that economists and psychologists could do more to prescribe healthy, effective behaviours and thought-strategies for people to follow. But the recommendations should be based on empirics, e.g.

  • "buy experiential goods, not durable goods";
  • "purchase with cash instead of plastic";
  • "beware these 4 common investing mistakes made by novices";
  • put crisps and fudge in a drawer, not in plain sight”

—not on a general model of “optimal” behaviour.

Theorists, though, don’t have the necessary understanding to make normative evaluations. Not yet, at least. But they can approach the deep Utility Theory questions in the spirit of the above quotation. They can model behaviours and thoughts, and inquire as to how they are internally structured — without the prejudice of inherited mathematical aesthetics.

What do I mean by ‘inherited aesthetics’ ? One example is substituting the mathematics of probability for a separate theory of human figuring.

 

I SHOULD HAVE SAID IT LIKE THIS IN THE SLIDES

One parsimonious shortcut economists tried, which didn’t work out, was to use probability mathematics to explain how people think about the future. If we can conceive of people’s beliefs as mathematical probabilities, then regular microeconomics + more maths = a new, better theory of behaviour.

For example, curved preferences over wealth would manifest themselves in probabilistic situations such as lotteries, insurance, betting, investing, employment in risky jobs, and love & sex risks.

But. People don’t think that way. They don’t make accurate calculations about Poisson distributions, Beta distributions, Bayesian priors, Aumann agreement theorems, and so on. I guess evolution either built us for something different or else we’re just misshapen clay with limited resources to Bayes our way to rationality.

I speculate that the way people think about probability — dubbed “subjective probability” by Leonard Savage — is shaped very differently from what mathematicians usually consider “natural” axioms — transitivity, commutativity, reflexivity, independence of irrelevant alternatives, monotonicity, and so on. But who knows? The correct theory doesn’t exist yet.

 

NOT ACTUALLY IRRATIONAL

The word “irrationality” I definitely ab-used.

Economists come up with a theory of how people behave and say it’s “ideal” or “rational”. People don’t actually think like that, so then we say they’re “irrational”? That doesn’t make sense. The theory was just wrong; an incorrect description. They perform sub-optimally according to some guy’s theory of the world, of their value system, and of how they should think. But since we don’t really know how people really think, how they experience the results of their choices, or how we should evaluate discrepant self-reports of how good a decision was, we can’t say what’s rational.

Like so, although it took the Ellsberg Paradox, Allais Paradox, and other results to disprove the accepted theory which naïvely united Probability and Utility, those results are not the point. The point is that we have to conceive a more realistic model of people’s mental models before Economics can draw valid conclusions about what people “should” do.

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