Standard economic theory assumes that humans behave fully rationally and are able to objectively calculate the value (or cost) of the different choices they are presented with. In fact, we pride ourselves on our rationality. Different from the animals, we humans have the unique capacity for logical thought and rational decision making. Or do we?
According to behavioral economist Dan Ariely, we should be less proud of ourselves. In his entertaining book Predictably Irrational, Ariely describes many case studies of every-day irrational human behavior. His simple but clever scientific experiments often require nothing more than a box of chocolates. However, subtle differences in the way these chocolates are offered to people can cause large and completely irrational differences in the way we behave. Moreover, these irrational behaviors fly square in the face of what conventional economic theory, based on rationality, would predict.
Research into behavioral economics has shown, for example, that our assessment of what something is worth to us can be directly, and predictably, influenced. Or how we fall for the illusion of a free lunch, even when economic theory would clearly suggest a more valuable option (but at a small cost). Ariely also beautifully elucidates how we sometimes operate on social norms, and at other times on market norms. The difference is in whether there is a price attached to something. If a friend invites you over for dinner, and you bring a nice bottle of wine along (social norms), she will probably appreciate it. However, if instead you slap $20 --the price of a nice bottle of wine-- in cash on the table and say "thanks for a lovely dinner" (market norms), she would most likely be offended. Mixing social norms and market norms inappropriately often lead to irrational behavior, and possibly even to conflict or misunderstanding.
Our irrational behavior is not just random though. The scientific experiments are repeatable, and each time we are faced with a similar situation, we tend to behave in a similar irrational way. So, next to the bad news that we are not nearly as rational as we might have thought (or hoped), there is also good news in that we can understand and predict our irrational behavior, at least to some extent. And this, in turn, can help us improve our decision making and change our behavior for the better. In other words, we can try to be more rational about our irrationality.
In short, behavioral economics shows us when and how we behave in irrational ways. However, it does not explain why we behave irrationally in the first place. For this, we have to look at another emerging scientific area that focuses on human behavior: evolutionary psychology. A book with that title by researchers Dunbar, Barrett and Lycett provides a wonderful introduction.
Evolutionary psychologists try to explain human behavior as the result of our species' long evolutionary history. During most of the existence of modern humans (roughly the past 200,000 years), and even before, we lived as hunter-gatherers in relatively small family groups where certain social interactions were crucial for survival and reproduction. Natural selection has shaped our brains and behaviors to cope with these social demands. In contrast, market-driven and money-oriented economies emerged only very recently, as a cultural phenomenon. Cultural evolution happens at a much faster pace than genetic evolution, and as a consequence, our inborn social behaviors are not (yet) fully adapted to this modern way of life. This is also wonderfully illustrated, in the context of modern diseases, in the book Mismatch by Gluckman and Hanson.
So, this explains much of our irrational behavior, also outside of the context of economics. For example, the sight of spiders and snakes induces a deep-rooted fear in most of us. The sight of a drawn gun does not produce nearly such a fearful reaction. Yet, these days many more people die from gunshots than from spider and snake bites combined. So why this irrational difference in fear response? It seems the logical explanation is an evolutionary one, where spiders and snakes have been a realistic threat throughout most of human history, while guns are only a very recent phenomenon. Our brains have not (yet) been wired by evolution to respond in the same way.
Moreover, evolution is largely a blind force that acts without foresight or deliberate design. It just works with whatever it has available at any given time, and tinkers with that by means of small (random) changes. In some cases, this leads to improvements which are then favored by natural selection over less successful variants. As a consequence, the "products" of evolution are not always the most perfect or efficient. This includes our own brain, which still leaves plenty of room for irrational behavior.
So, what does all this have to do with economic theory? Recall that the standard theory assumes that people behave fully rationally. It argues that in a free market, prices will automatically converge to an optimum where supply and demand are balanced out and the market is in equilibrium (Adam Smith's "invisible hand"). However, as behavioral economics shows, in many situations, our behavior is far from rational. Demand for a product, the choices we make, or the price someone is willing to pay, can all be easily influenced. Furthermore, evolutionary psychology shows that much of this irrational behavior is a consequence of our evolutionary history, which is often at odds with the modern money-driven society we now live in.
What this implies, is that an economic system based only on market norms and assuming full rationality is clearly incomplete, or even invalid. History has shown time and again that societies acting mostly according to market norms and short-term monetary gains often cause their own decline (read Collapse by Jared Diamond). Homo Economicus is perhaps nothing more than an illusion. Instead, the mirror that behavioral economics and evolutionary psychology put in front of us shows us our real selves, social norms and irrational behavior included. It is imperative that our economic theory, and the policies and practices that are derived from it, reflect this reality, even if only to protect ourselves from our own imperfect and irrational behavior.
Header image by Christopher Dombres / Flickr.
