Monday, August 16, 2004

The Rationality Fallacy

MSNBC runs a piece by Jerry Adler of Newsweek International headlined "Mind Reading". Adler is quick to repeat a common misunderstanding about economics:
For all its intellectual power and its empirical success as a creator of wealth, free-market economics rests on a fallacy, which economists have politely agreed among themselves to overlook. This is the belief that people apply rational calculations to economic decisions, ruling their lives by economic models.
Balderdash and hogwash! Economics says that individuals try to maximize their satisfaction, as they understand it. Maximizing satisfaction isn't always the same thing as maximizing wealth, which is apparently the measure of rationality being used in the article; viz.:
Economists have many ways of demonstrating the irrationality of their favorite experimental animal, Homo sapiens. One is the "ultimatum game," which involves two subjects....Subject A gets 10 dollar bills. He can choose to give any number of them to subject B, who can accept or reject the offer. If [B] accepts, they split the money as A proposed; if [B] rejects A's offer, both get nothing. As predicted by the theories of mathematician John Nash (subject of the movie "A Beautiful Mind"), A makes the most money by offering one dollar to B, keeping nine for himself, and B should accept it, because one dollar is better than none.

But if you ignore the equations and focus on how people actually behave, you see something different....People playing B who receive only one or two dollars overwhelmingly reject the offer. Economists have no better explanation than simple spite over feeling shortchanged. This becomes clear when people play the same game against a computer. They tend to accept whatever they're offered, because why feel insulted by a machine? By the same token, most normal people playing A offer something close to an even split, averaging about $4. The only category of people who consistently play as game theory dictates, offering the minimum possible amount, are those who don't take into account the feelings of the other player. They are autistics.
Such experiments may prove something about wealth maximization, but they prove nothing about rationality because they fail to take into account the dynamics of human interaction. Being offered only one of 10 dollars is an insult, and accepting an insult isn't worth a dollar, to most people. When someone who is holding 10 dollars offers you only one dollar, that person is sending you a signal about your worth in his or her eyes. It's like approaching a panhandler with a fan of five-dollar bills in your hand and plucking out one of those bills for the panhandler -- who might take it, refuse it, spit in your face, or grab all the bills. If your purpose is to give the panhandler five dollars, without insulting the panhandler, you approach the panhandler with a single five-dollar bill in your hand and give that bill to the panhandler -- who will accept it with thanks. (By the way, why do some people give money to panhandlers? After all, it's not a way to maximize one's wealth. That's right, it's a way to maximize one's satisfaction. Those who give money to panhandlers feel better about themselves.)

There is simply a lot more to maximizing satisfaction than maximizing wealth. That's why some people choose to have a lot of children, when doing so obviously reduces the amount they can save. That's why some choose to retire early rather than stay in stressful jobs. Rationality and wealth maximization are two very different things, but a lot of laypersons and too many economists are guilty of equating them.