Piet Keizer on Dan Ariely on Irrationality

Introduction

More than 50 years ago Herbert Simon criticised the neoclassical idea that the orthodox economic analysis, which is based on the assumption of the economic and rational homo oeconomicus, is a sound theoretical foundation for empirical research. Simon was a cognitive psychologist, and offered an alternative foundation, based on the assumption that cognitive capacities are limited. It means that in the process of decision-making people do not endlessly search for relevant information, but stop searching as soon as they have the idea that the marginal search benefits are not higher than the marginal search costs. In other words, they are satisfied with the information collected so far. It implies that actors are regularly making mistakes, and the question is whether people are inclined to make particular mistakes systematically.

Simon’s critique has had a very important influence on the way (business) economists approach the problem of decision-making. This approach is called behavioural economics, and even today there is not much methodological difference between Simon’s work and the way prestigious scientists in this field are operating now. There is, however a huge problem!! In this text I discuss the second edition of the book “Predictably Irrational” by Dan Ariely (2009), since this book is highly praised in prestigious circles.

Methodology

When Ariely was a psychology student, he assisted a professor neuro-science in his research on the effect of brain stimuli on human behaviour. He learned from his professor that science is an empirical endeavour. When Ariely began his own research he designed many experiments to show to economists that human persons are predictably irrational. He used the orthodox-neoclassical model as his point of reference. Unfortunately he does not explicitly formulate this model – actually he compares the results of his experiments with his (economic) intuition. Experiments show that the choices are systematically different from what is economically expected.

If Ariely would have formulated the orthodox-economic analysis explicitly, he could have seen that the model results from introspection, and is based on the economic motive only. In other words, they recognise just the economic motive as driver, and ignore the psychic and the social drive on purpose. When doing experimental and empirical research we ought to develop a psychological and a sociological analysis first, and integrate them with the economic model. Now his psychology is one without a psyche, and sociology does not even exist! We will discuss two experiments to show the misinterpretations that result from a lack of a multidisciplinary economic analysis.

Experiments

The first experiment shows a situation, in which a person is at the point of buying a pencil with a price of $14. Then a fellow customer whispers in his ear that in another shop the price of exactly the same pencil is $7.The shop is on a 15 minutes-walk distance. It appears that most persons decide to go to the cheaper shop. In another situation a customer is at the point of buying a suit for $488. Again a whisperer tells him that exactly the same suit can be bought for $481 in a shop on a 15 minutes-distance walk. Just a small minority takes the walk and buys the cheaper copy. Ariely explains this result in terms of a cognitive failure: people tend to calculate in terms of percentages, even when absolute numbers is the rational use of our cognitive capacities. When interpreting the result in a more realistic way we must acknowledge that humans are driven by more motives than just the economic one. When the other motives are ignored the interpretation of experiments and empirical research is necessarily flawed.

When I asked myself and a couple of friends to give their answer plus motivation to the questions concerning the purchase of the pencil and the suit, completely different interpretations appeared. One person said that the price difference in case of the pencil might reflect an abnormal profit margin – “I don’t want to support this behaviour”. Another person said that in the case of the  suit you never know for sure that the quality is similar – “I don’t to go up and down the street to find out what is the best suit for just $7”. A third person’s choice, which was in line with the choice of the majority of the persons, who participated in the experiment by Ariely, and she motivated it as follows. If I waste an amount of $7 for a purchase of $14 already, than I’m not optimising my allocation of scarce resources. But a waste of the same amount in case of a purchase of several hundreds of dollars – that’s  not so bad. We see that the last person has apparently developed a rule, which says that he should be more cautious in case of cheap goods – you buy them so often! Penny wise does not necessarily mean pound foolish. [this idea of waste is quite similar to the so-called X-inefficiency rule of Harvey Leibenstein(1966)].

A second experiment is about an employer and an employee. The salary is $100.000 per year and the employee is happy with it. Then he discovers that his colleague, who is perfectly identical to her in terms of education, experience and performance earns a salary of $120.000. The outcome of the experiment shows that most employees go to their boss and ask for explanation. Ariely interprets this behaviour as irrational, which is a cognitive failure as we saw. When we apply a multidisciplinary economic analysis of the situation, however, we interpret this behaviour as socially motivated. In Europe the action of the employee would be interpreted as justified and in line with the generally accepted norm ‘equal pay for equal output’. According to European cultural standards the employer discriminates. He might be a sexist, a racist or a nationalist; in that case he is rational according to his own standards. But according to European standards he is immoral. To call the behaviour  of the employee irrational is completely beside the point.

Lessons

Empirical research can only be conducted by researchers who dispose of a sophisticated multidisciplinary economic analysis of the situation under scrutiny. So with experimental research. Even if we want to collect empirical data – by means of a questionnaire, for instance – we need such a theoretical foundation. The book by Ariely – extremely popular in the Anglo-Saxon world – illustrates why so much empirical and experimental work is still premature. Gamma-scientists should focus their attention to significant improvements of the theoretical foundation, so as to make it more realistic. Theory-free interpretations make no sense.

Dr. Piet Keizer

Utrecht University School of Economics

p.k.keizer@uu.nl

www.pietkeizer.nl

12-02-2014

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