Irrational economic behavior

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If what you hear doesn’t make sense, 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. 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, some behavioral economists, like Dan Ariely, reassure us, 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 Nobel 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 Waldo 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 Utilities, the implementation of the Neumann system, and the elimination of the Drake plant are among such examples. 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. 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 — 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 step aside, and a new leadership can take credit for changing course.

Raphael Sassower is professor of philosophy at UCCS. He can be reached at rsassower@gmail.com. See previous articles at sassower.blogspot.com