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Pittsburgh Tribune-Review: “Irrational us?”

In my column for the December 29th, 2006, edition of the Pittsburgh Tribune-Review, I took a look at behavioral economics. If you’re rational, you’ll want to read the column, which is beneath the fold.

Irrational us?

Behavioral economists have uncovered a good deal of evidence that, as individuals, we human beings often are not “rational” in the ways that economics textbooks assume us to be.

Would you pay $250 for a vintage bottle of fine champagne? Most of us would not. Suppose that you’re among those for whom that price is too steep. You might adore bubbly, but quite sensibly reason that you have better uses for $250 worth of your hard-earned money than to spend it on a bottle of carbonated intoxicant.

Now suppose that you unexpectedly win such a bottle in an office raffle. Would you sell it for $250?

An intrepid band of researchers over the past few decades has asked questions such as this one and has done experiments that test how people behave in different situations. Its findings are fascinating.

These researchers sail under the banner of “behavioral economics” (although Eric Wanner, president of the Russell Sage Foundation and an influential supporter of this approach to economics, prefers the name “cognitive economics.”)

Behavioral economists (whose ranks include psychologists, such as Wanner, in addition to economists) have uncovered a good deal of evidence that, as individuals, we human beings often are not “rational” in the ways that economics textbooks assume us to be.

For example, if you refuse to pay $250 for a bottle of champagne, this fact “reveals” (as economists say) that you value this bottle of champagne at something less than $250. So, it should follow that if you find yourself unexpectedly owning such a bottle of bubbly, you’ll sell it to someone who offers you $250. That is, your willingness to accept as payment for what you own should be consistent with your willingness to pay for what you don’t already own. If you’re not willing to pay $250 for a certain bottle of champagne, you should be willing to sell such a bottle for $250 if you happen to own one.

But behavioral economists find that people’s willingness to sell is frequently different from people’s willingness to pay. Behavioral economists call this “the endowment effect.” The endowment effect suggests that people aren’t rational. After all, if you refuse to sell a bottle of champagne for $250, you are saying to the market that you value your bottle by more than $250 — but when you refuse to buy an identical bottle at that price, the message that you send to the market is the opposite.

So what’s the market to think? Or rather, what are we to think about market outcomes? If the values that people attach to things depend heavily upon the somewhat arbitrary current pattern of ownership of those things, then we cannot be confident that the commerce in free markets moves goods and services from persons who value them less to persons who value them more.

At a deeper level, if each of us doesn’t really know how much we value specific goods and services, what can it mean to say that the market promotes the satisfaction of our wants?

And the endowment effect is just one of several behavioral anomalies uncovered by behavioral economists. These researchers also find, relatedly, that individuals are biased to favor the status quo, that individuals often imagine (wrongly) that current trends will continue for no reason other than that these trends are the current ones, and that the ways options are presented — or “framed” — to decision-makers strongly influence which options people choose. These are just a few examples of behavioral economics’ findings.

To the extent that behavioral economists have it right, standard Econ 101 textbooks get off to a lousy start by assuming that individuals generally do not act in these anomalous ways. And it’s not far from this suspicion that standard economics misses something vitally important about human reality to the conclusion that economics’ famous trust in markets to promote human well-being is misplaced.

As the University of Chicago’s Richard Thaler — a leading behavioral economist — bluntly says, “There’s no reason to think that markets always drive people to do what’s good for them.” From this observation, in turn, it seems a short step to the conclusion that government intervention, after all, promises great benefits.

Other researchers, including my Nobel Prize-winning colleague Vernon Smith, have challenged some of the findings of behavioral economics by arguing that the behavioralists’ research methods are flawed or that they’ve misread the data. No doubt some such research errors have occurred. But there’s a deeper issue that behavioral economics exposes — one that standard economists would do well to take heed of and one that, when all is said and done, reveals more surely than ever that markets will generally outperform even the best-intentioned government regulators.

In my next few columns I’ll explain why I believe that behavioral economics does not, in fact, strengthen the case for government regulation or weaken the case for the market.