IRRATIONAL
ECONOMIC BEHAVIOR
If what you hear doesn’t make sense to you, you are not
alone. We hear about JP Morgan Chase announcing $5 billion profit in its second
quarter of 2012 despite its London trade losses of equal amount. We hear of
Iran’s nuclear ambitions despite international sanctions and the lunacy of
dropping such a bomb on a close-by neighbor, Israel. Gas prices at the pump are
rising despite the double-dip recession and the infamous laws of supply and
demand.
The world around us makes no sense, and no rational
economic models of rational consumers can provide a clear road-map in this
turbulent market. No worries, reassure us some behavioral economists, like Dan
Ariely, because your irrationality is in fact “predictable”. If he is right, mapping
deviation from rational behavior is possible by analyzing probabilistically our
common mistakes.
So, what can psychologists really teach economists? The
first lesson is to give up on the idealized model of rational participants in
the marketplace. No matter how evolved, humans still react emotionally to
triggers whether in the marketplace or their kitchen. They have urges and
instincts, and their “fast” thinking overtakes any “slow” rational deliberation,
according to the Noble Laureate Daniel Kahneman.
The second lesson is that economics is not a science like
physics, but rather a complex system (like biology) in which environmental cues
affect marketplace behavior. Sometimes the impact is so great that we choose contrary
to our self-interest (poor people voting for tax cuts for the rich). Sometimes
the external impact is unpredictable as seen after 9/11 (shopping) or the
Walden Canyon Fire (robberies).
The third lesson is that if we study human behavior in
its broadest context, we might learn how to protect ourselves from preventable
mistakes. Among the many “fallacies” and “illusions” that Kahneman enumerates,
the “sunk-cost fallacy” may be useful for our local utilities establishment.
According to Kahneman, “a rational decision maker is
interested only in the future consequences of current investments. Justifying
earlier mistakes is not among the Econ’s concerns.” This is termed the “narrow
framing” of the situation by the decision-maker, preferring to ignore the past
and the costs associated with earlier decisions. Such framing leads to costly
mistakes about future plans.
The ongoing debate about the future of coal burning at
CSU, the implementation of the Neumann system, and the elimination of the Drake
plant are among such mistakes. The reason to think about them as mistakes is
not because earlier decisions look bad in hindsight—all businesspeople must
admit that they overshot or undershot at some point in their business careers,
just as all Venture Capitalists admit that their success rate is inversely
related to insisting on potential success when none is forthcoming.
The point is that financial decisions are always informed
guesses. We hope the “informed” part is greater than the “guesses” part, but
it’s impossible to quantify this ratio with precision. Any quantification
depends on the definition we assign to what it means to be informed to begin
with, and what we believe are guesses rather than sure things.
But once financial decisions have been made, once
investments have been committed, one must observe their results. And if they
turn out to be “misses” rather than “hits,” one should change course as fast as
possible. Though this is sound financial advice, it is a difficult psychological
feat to accomplish.
Pride and humiliation stand in the way of rational
choice: admitting to a mistake and trying a different venue is relatively easy
financially speaking—the “sunk cost” is already lost and can never be
recovered, but difficult psychologically—how can a large organization like CSU
make big mistakes with public funds?
Kahneman observes that “All too often a company afflicted
by sunk costs drives into the blizzard, throwing good money after bad rather
than accepting the humiliation of closing the account of a costly failure.”
Instead of losing more money, he suggests walking away from previous mistakes
and starting over in a new direction.
He also reports that teaching this fallacy to economic
and business students has the good effect that graduate students are more
likely to walk away from mistakes than undergraduates—they have learned
something valuable in school.
One wonders if CSU’s leadership will ever go back to
school, the school of real life (if not the academic one), and be humiliated
just a bit for the sake of a better future for all of us. This is a small price
to pay for the well-being of the community.
If admitting mistakes is psychologically too difficult
for them, let them all resign now, and a new leadership can take credit for changing
course. Even President Morsi has learned this lesson in Egypt!
Raphael
Sassower is professor of philosophy at UCCS. He can be reached at rsassower@gmail.com See
previous articles at sassower.blogspot.com
