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Irrational Economics

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Irrational Economics

swstephe
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Posted 04/25/09 - 09:32 PM: Subject: Irrational Economics	#1
In many threads, I've argued against humans being rational. Everything I read, as a hobby, about psychology and human behavior has lead me to this conclusion. We are emotional, irrational, creatures -- who only jump onto rational ideas when they serve our emotional needs. When confronted with evidence that contradicts our emotional values, we reject the evidence, then the rules of logic and finally appeal to the emotion of the other person. Economics is a nice subset to study. It encapsulate a rational, logical system, but depends on people acting rationally and logically, in their own interests. If people are not rational, then the premise is flawed. I came across a nice article describing 3 experiments which demonstrate how people will act irrationally in every case: http://www.financialjesus.com/2008.../3-experiments-with-money/ To summarize, quickly, (so you don't have to read the article): Experiment #1: Give one person $100. They have to divide it between themselves and another person. If the other person accepts, they both keep the money. If the other person rejects the offer, they both lose the money. The Result? People offered anything less than $30 will reject the offer. They would rather lose a small amount than feel they were not getting something fair. Experiment #2: Earn $100,000, but twice as much as other people or earn $200,000, but half what everyone else earns. The Result? People would rather earn more than others, ($100,000), than earn more money, ($200,000), even though salaries don't affect price. Experiment #3: You can win $100 for being the millionth person, or win $150 for being the millionth-and-first person after the person in front of you earned 10 times as much. The Result? People would rather be the biggest winner than win more money. I conclude that people are irrational and emotional. They depend more on emotional rewards and social status compared to others than any objective values. This means that economic models based on resources, supply and demand are always irrational and flawed. Solutions with better values will be rejected for irrational reasons. Even in the recent economic crisis, the model nearly broke down because of greed and competitiveness between people, than seeking a rational goal as an alternative. I think the ultimate evolution of economics will require an external, unbiased, arbitrator rather than relying on individual needs and desires. This is why the current solutions to the problem appear socialist, (regulation and government injection of cash) -- it is to compensate for human behaviors.
Ethics is the measuring of morality. Morality is the measuring of good. Good is the measuring of benefit. Benefit is the measure of values.

Banno
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Posted 04/25/09 - 10:01 PM:	#2
Check out http://www.abc.net.au/rn/allinthemind/stories/2008/2198214.htm
Davidson: We make maximum sense of the words and thoughts of others when we interpret in a way that optimizes agreement. Russel Morris: There's a meaning there, but the meaning there doesn't really mean a thing... Ned: Such is life

Aetixintro
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Posted 04/26/09 - 02:10 AM:	#3
Nice, swstephe, I consider economics the way you do, perhaps not totally the same. The question in experiment #2 is given to a limited set of business people if I'm not wrong. I'd say there is something wrong with it. To say that price is unaffected by salaries is plain wrong if it applies to everyone in a given system, say a particular country. After the labour unions and the employer unions have set the new salaries standard for the next year, it doesn't take long before there is a reaction in the market. I think it may be right to choose to earn twice as much as absolutely everyone else. Surely, something must happen inflation wise in such cases. I think it's very rational to seek a labour union if you're engaged with blue collar work. Even white collar labour unions have some guide lines in the interest of their members. The way with unions on both sides of the working situations has proven quite stable and good, I think, with increased safety and better working environment where it applies. I hope this system gets applied everywhere. Speaking of the economic crisis, there is something insane going on when people fail to get paid for risks when their only goal is exactly this task, as with the risk of sub-prime mortgages. It doesn't get any better when the successor of Alan Greenspan who has been known for allowing interest rates to be set quite low, is Ben Bernanke who figures he's going to be the nice schoolboy and all of a sudden shifts focus to protecting the value of the dollar with a subsequently steep rise in interest rates so that the market which has bet on steady, low rates goes BUST! Well done, Bernanke! Now you can really defend the dollar. However, mostly I find the economic systems very good and contributing to the development of the whole world. Eventually, the planet's population is more or less earning the same (in two hundred years?) and the differences will lie in resources, cultural streaks and creativity of entrepreneurs. The future is good if it is managed properly by alert democracies.
Efficacy of "for since it is at present manifest to me that even bodies are not properly known by the senses nor by the faculty of imagination, but by the understanding alone" - Descartes, Meditation II I'm always wanting more, Anything I haven't got, Everything, I want it all, I just can't stop - The Cure, Want

swstephe
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Posted 04/26/09 - 04:31 AM:	#4
I think experiment #2 was artificially rigged, but it is valid for anyone receiving a salary. It was more important to be richer than other people than to have a higher salary and being poorer. The value for this question was weighed toward comparing yourself to others, not on actual value. When interests rates were low, and real estate loans had even lower entry rates, people behaved irrationally, seeking out short term gains despite potential long-term consequences, (which everyone generally knew when they signed on the dotted line). Now they are paying the consequences and demanding regulations to prevent the greed. People want their cake, to eat it, and to have a built-in weight-loss system. The rational goal is moderation, but the irrational goal is short term gains with long term loss.
Ethics is the measuring of morality. Morality is the measuring of good. Good is the measuring of benefit. Benefit is the measure of values.

Aetixintro
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Posted 04/26/09 - 05:01 AM:	#5
Has Ben Bernanke been irrational? Come on, swstephe, don't be shy! I think Bernanke has been stupid in the past, but he may have been learning after that. I hope the economy gets the best in the end. Edit: Is there anyone who knows where to access a historical overview of the interest rates of the Fed? I believe I've tried the Fed itself, but there is no way in that jungle. Edited by Aetixintro on 04/26/09 - 05:21 AM
Efficacy of "for since it is at present manifest to me that even bodies are not properly known by the senses nor by the faculty of imagination, but by the understanding alone" - Descartes, Meditation II I'm always wanting more, Anything I haven't got, Everything, I want it all, I just can't stop - The Cure, Want

swstephe
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Posted 04/26/09 - 07:11 AM:	#6
My premise is that people will tend to act irrationally in an economy. If Bernanke realizes this, then it would be rational for him to manipulate people's emotions for the sake of the economy. If Bernanke follows most economic schools, that people are rational agents, then he would manipulate them based on rational behaviour. The fact that there is an economic crisis shows that he assumed people would be rational and regulate themselves, and didn't recognize the mistake until it was too late, or overly optimistic over short-term gains. I don't think Bernanke is any less intelligent than anyone else. Everyone assumes the other person is rational, but the reality may be that nobody is. Even when we realize it, we tend to forget. Manipulating emotions just feels very unethical.
Ethics is the measuring of morality. Morality is the measuring of good. Good is the measuring of benefit. Benefit is the measure of values.

Aetixintro
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Posted 04/26/09 - 08:26 AM:	#7
I sense a rather dark view on the possibility of rational people here, swstephe, but so be it. Don't you think that the activity of people doing science points in a different direction? I have great hopes of science, perhaps also the science of economy.
Efficacy of "for since it is at present manifest to me that even bodies are not properly known by the senses nor by the faculty of imagination, but by the understanding alone" - Descartes, Meditation II I'm always wanting more, Anything I haven't got, Everything, I want it all, I just can't stop - The Cure, Want

ssu
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Posted 04/26/09 - 10:43 AM:	#8
Swstephe, it isn't actually irrationality. That is a far too easy answer. People try to be rational when making financial decisions, they don't just loose their minds and surrender totally to their "animal spirits". The irrationality, which we now can see, comes from the fact that people did not understand the true risks involved. Especially if an economy goes up due to a credit bubble for a long time (and economists all talk about a Goldilocks-economy), the risks are staggering, but nearly invisible to the vast majority of investors. Actually, the majority of them do not even understand that they are risk takers and speculators. They just think that the boom times are the new economic reality. And even if they did understand that they are living inside a boom, would it be rational to jump off? Let me give two examples. Would you say that somebody that did get away with "house-flipping" before the summer of 2006 was irrational? Some did find a buyer, even if the buyer was this famous greater fool. Where these sellers irrational? I think not. How about a person that has seen how bad everything is now in the economy (and isn't so stupid to believe Bernanke that the economy will possibly turn in the fall), puts his life savings in US treasury bonds. Would he be defined as being irrational? Well, if one believes that hyperinflation is coming, it is the last thing to put your money, so obviously he or she is truly irrational, nearly crazy. However, if one believes in Japan-style deflation outcome, it would seem rational. With historical hindsight we can say, what economic choices were rational and what were not. Hence it is only with our future knowledge that we can define what is rational and what isn't. (And by the way, my view is that the deflation is just temporary before inflation) Now I would say that people TRY to be rational. But if they do not understand the true risks involved in their financial decisions, the decisions can truly be irrational. Perhaps a form of that famous irrational exuberance, what Alan Greenspan talked about and Robert Schiller used as the name of his book. When we look at for instance this crisis, which was caused by the massive credit bubble, the mispricing of risk in epic portions that has had catastrophic consequenses can be clearly seen. What is the earlier pricing (and actually selling) of huge amounts of Credit Default Swaps anything other than direct evidence, a smoking gun, of this? So I don't think the problem is that economics assumes people to be rational. No, the problem is that economics has been totally incapable of understanding speculative bubbles. Modern economics, perhaps except the Austrian School, has been totally ignorant of this crucial economic phenomenon. In mainstream economics there has not been any rational nor scientific understanding of how speculative bubbles appear. In short: there has been no mathematical model for them. No math form, not reality! Speculative bubbles were thought to be nonexistent in modern economics and only historical oddities. Bubbles were thought to form from "people just loosing their minds in a frenzy". This is what economics got wrong. I think that what happens in a speculative bubble is a huge mispricing of risk. This mispricing happens when people are either ignorant or simply do not use the historical data or historical precedents that would show the risks involved in a similar economic situation. This leads people not to understand the risks they are taking. And then we have the boom ending with a crash that the majority did not see coming at all.

wuliheron
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Posted 04/26/09 - 11:39 AM:	#9
You argument assumes that someone who values fairness and social status as well as money is irrational, and that those who value personal gain above all else are rational. If you place this in an evolutionary context it is nonsensical. Evolutionarilly speaking, we are social animals which explains why we value fairness and social status as well as personal gain. It would be irrational or, at least, contrary to their nature for a social animal to not place a high value on fairness and social status. It all just depends upon the context in which you wish to interpret the data. My favorite evolutionary example of this sort is male homosexuality. At first glance it might seem irrational for any animal to be homosexual, but on an evolutionary scale there can be perfectly rational reasons. Among humans, male homosexuals tend to have a number of older brothers and by them being homosexual they help to prevent inbreeding. The same kind of argument could be made for why people stress fairness and social status as well as personal gain. By doing so they protect the genetic heritage that makes us social animals.

Incision
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Posted 04/26/09 - 12:14 PM:	#10
I'm tempted to agree, swstephe. Have you read Ariely's Predictably Irrational? (Ariely is the author mentioned in Banno's link.) One problem with behavioral economics, I imagine, is that it's hard to determine empirically how people will act in each possible case. If people are at least approximately rational in many situations, then "traditional" economics will give roughly the right answer much of the time.

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