Do You Even Act Rationally Bro?

If you have taken an introductory economics class, you learn that the world is made up of rational human beings trying to allocate scarce resources. In essence, people demand goods that have a limited supply. Where demand meets price is where we get the equilibrium quantity and price. What this classic model fails to notice is that people are fucked. It also fails to recognize that people are sometimes irrationally good. In the three sections of this article, I will discuss the areas where the classic view of economics is not sufficient. In essence, this article is a quick overview of some basic concepts in behavioral economics.

That’s Not Ethical, Man

If you solely accept the simple principle of supply and demand as your over-arching market compass, you may be a giant dick. Under this view, you would be okay with a hardware store increasing the price of snow shovels the morning after a large snowstorm. In that, the snowstorm increased demand and due to that increase, price should shift upward. Behavioral economists Daniel Kahneman, Jack Knetch, and Richard Thaler proposed this scenario in a survey to individuals asking if it was fair. 82% of respondents answered that the price hike was unfair. So although theoretically the storm increased demand for snow it did not increase peoples willingness to pay because they see the price increase as unjustified and therefore unfair.

So, if it isn’t just simple supply and demand that dictates price and profit, then what does? The answer involves a little sociology my friends, in that social norms dictate community standards of fairness. Ernst Fehr believes a social norm has three parts:

• It is a behavioral regularity; that is
• Based on a socially shared belief of how one ought to behave; which triggers
• The enforcement of the prescribed behavior by informal social sanctions.

So what have us wealth thirsty capitalists defined as fairness in the application to price, rent and wage setting? “A relevant precedent that is characterized by reference price or wage.” Da Fuq?!?!? No, it really is quite simple and is known as the principle of dual entitlement. The basic idea is that, transactors have an entitlement to the terms of the reference transaction and firms are entitled to their reference profit. This means a firm is not allowed to increase its profits by arbitrarily violating the entitlement of its transactors to the reference price, rent, or wage. So raising the price of snow shovels after a storm is arbitrary, but raising the price of snow shovels because of an increase in cost for the firm would be fair. What are the possible sources of reference transactions? Price, posted price, and previous transactions between a firm and a transactor.

What happens if a firm or transactor violates the reference transaction? The firm or transactor may start seeking alternatives. Also, an aggregate of unfair behavior will hurt a businesses’ reputation leading to transactors avoiding exchanges with the offending firm. This is part of the reason quasi monopolies like utility companies, or cable companies are such assholes. “Oh did we hike up your rates for no reason? Well if you are unsatisfied due to our unfair violation of the reference price you can cancel your service and seek an alternative” ::maniacal cackling::

People are Fucked

Scholars like Mankiw want you to think that market actors are purely rational, always thinking at the margin. I don’t know if he has ever met any real humans, but most the people I know do stupid stuff all the time thinking it’s the smart thing to do. This of course includes myself. I REALLY THOUGHT THESE BEANIE BABIES WERE GOING TO BE WORTH MORE BY NOW. Dammit.

People will even go out of their way to act irrationally. This is often found in ultimatum games. In the ultimatum game, two subjects are paired together, one receives an amount of money. The subject who has the money gets to divvy the money up between him and the subject. However, the other subject can deny the offer, which will result in no monies being awarded to either side. Under the view that market actors are completely rational, one would believe the subject who gets to accept/decline the offer would accept anything over $0, for that even if they are offered $1 the subject will be “better off” than by rejecting the offer. But ultimatum games find that recipients almost always reject offers that are between 0-20%. Wow my head just exploded, people will turn down free money? Kant was right intentions do matter. So even if a respondent would be financially better off by accepting the low offer, they decline out of a notion of unfairness. OH YEAH SUCK IT MANKIW.

People are also incredibly self-centered. The self-serving bias is when an individual conflates what is fair with what benefits themselves. Self-serving bias emerges out of ambiguity, which reference points can be. In their paper “Explaining Bargaining Impasse: the Role of Self-Serving Biases,” Babcock and Loewenstein offer three ways that self-serving biases can impede negotiations. First, negotiators estimate the value of the alternatives to negotiated settlements in self-serving ways. Second, if disputants believe that their notion of fairness is impartial and shared by both sides, then they will interpret the other party’s aggressive bargaining as an exploitative attempt to gain an unfair advantage. Third, negotiators will almost never settle even slightly below the point they view as fair.

People aren’t that unreasonable, are they? I feel like I can put the shoe on the other foot, I can see your angle, I see what you’re laying down, I just used a possessive pronoun five times in this paragraph to explain how unbiased I am, dammit again! Okay whatever, prove it. Babcock and Loewenstein do through a series of studies known as the “Texas Tort Experiments.” In brief, the study law students were randomly assigned to the role of plaintiff or defendant and attempt to negotiate a settlement. Subjects first receive a page explaining the experiment, the sequence of events, rules for negotiating and the costs they face if they failed to reach an agreement. Both subjects then receive the same 27 pages of materials from the original legal case in Texas. The study found that the plaintiffs’ predictions of the judge averaged $14,527 higher than the defendants’ and plaintiffs’ fair settlement values averaged $17,709 higher than defendants. Lastly, when the subjects did not learn their roles until after they read the case and made their assessments of the judge and fair settlement values, only 6 percent of the negotiated were resolved by the judge, compared to 28 percent when the subjects knew their roles initially.

Market Irrationality Can be a Good Thing

Aline Sullivan estimates that 89% of Americans donate to charity. John List found that on average, households gave about $2,120 to charity in 2004. That doesn’t sound so rational. Why would a household give a gift to a cause that doesn’t directly benefit them? In my mind there are four main reasons offered by academia. Two are good, two aren’t bad but they aren’t so great.

The good:

• Altruism, the belief in or practice of selfless concern for others well-being; and
• Inequity aversion, which is the preference for fairness and resistance to incidental inequalities.

The not so great include:

• Warm glow, which is an internal self-reward or guilt reduction. “Wow I feel so good for donating that money, Mr. Police Officer was wrong I am NOT a selfish delinquent”; and
• Invidious distinction, which is an external signal that I am fuckin BALLER, as in “yeah they named that library after me because I’m so rich and h3tty.”

No matter the reason (suck it Kant) people will irrationally donate their money for a good that doesn’t directly benefit them. The line is somewhat blurred with invidious distinction and warm glow, but I would argue that it is still not a purely self-interested move.

In Closing

Old school supply and demand doesn’t explain everything.

People are not rational and will punish themselves to punish others that they think are acting unfairly. An additional layer to that is that people are self-biased so their notion of fairness may be skewed. Lastly people will act irrationally to benefit others at their own expense.

Pretty crazy shit huh?