We can accept that we will never know everything for sure, and that sometimes our models will fail, but at least we will get good approximations which to most are better than nothing. Huh, heuristics at its best.
Imagine sitting next to the sea, on a beach in the Hawaii. Suddenly you get thirsty and decide to look for a place that sells beer. You find a shabby-looking local store, where the beer costs $7. It’s too pricey, so you move on and enter a five-star hotel. Luckily, it also sells beer, and also at $7! You happily buy the beer at the hotel, and you’re back at the beach, enjoying your summer.
Wait, didn’t you say that seven dollars for a beer was a bit too much? What changed? Clearly, it was the location at which you bought your drink. But why? The product is exactly the same in both places. Given that you’re a reasonable customer, seeking to maximise your utility, if you consider it too expensive at the local store, you should also view it as too expensive at the hotel.
This scenario doesn’t make sense…unless you abolish the assumption of rationality, and factor in things such as your personal values and emotions. For instance, you may consider it unjust for the small store to charge the same price as the friendly hotel; although this opinion may be relative, it still influenced your decision.
Situations like these have inconvenienced the followers of the homo economicus model a lot. They profess that people are driven solely by rationality and utility-maximisation, and that non-measurable factors do not have place in the study of economics. However, because of how markets have acted in the last few decades, economics is focusing more and more on the not-so-reasonable human ways.
Animal spirits in action
In fact, the concept started circulating around when Keynes came up with the idea of ‘animal spirits’. As the name suggests, Keynes pointed out that markets are not just influenced by the ‘invisible hand’. Instead, actions of economic actors are “a spontaneous urge to action rather than inaction, and not (…) the outcome of a weighted average (…)”. Keynes used this to explain investment; we all know that it is driven by confidence, but when you think about it, confidence and trust are hardly set-in-stone rational givens.
On why you make bad decisions
Although Keynes’ idea was not very popular in the 60s through to 80s, it bounced back in the last 15 years or so. Strange, seeing that as we develop more and more, we should get better at being rational. So what are some of the reasons why we aren’t?
First of all, we have all sorts of hidden biases that influence our decisions, but in order to be completely rational, we would need to be completely objective. Consequently, we have a natural tendency to look for and notice examples that confirm our existing beliefs and hypotheses. Whenever a weather anomaly happens, it is cited as evidence for climate change by environmentalists, even if experts claim that the two are unrelated. We are also biased in how we interpret evidence, e.g. you are more likely to buy a product after you hear a positive review from a friend, than after you read a few positive reviews online.
The second major obstacle to rationality is the concept of fairness. It’s useful to look at the ultimatum game to understand this concept best. Two players are given $100. Player 1 is to divide the sum between themselves and the other player. Player 2 then decides whether or not to accept the offer; if they don’t accept, both players walk away with nothing. Rationally speaking, Player 1 could take $99 and leave a dollar to Player 2, because Player 2 would still be $1 better-off than before. However, two strange things happen when actual people are asked to play the game. Either Player 2 rejects the $1 offer, or the money is not even split that unevenly in the first place; in a lot of cases Player 1 offers a 70/30 or a 60/40 divide, which is still unfair to some, but is far more egalitarian than the most rational split.
Finally, we use heuristics – rules of thumb. We take very complex problems, and turn them into simpler ones, so that people find it easier to grapple with them. We use heuristics to make best use of limited information, or lack of understanding of certain issues, and while it may be the best option for us, the results of our decision-making still end up irrational.
Why does it all matter?
Either way, given all this information, you might ask why we bother studying economics, which is largely based on the assumption of rationality. The answer to that lies in modelling. We can accept that we will never know everything for sure, and that sometimes our models will fail, but at least we will get good approximations which to most are better than nothing. Huh, heuristics at its best.