The Irrational Consumer: Why Economics Is Dead Wrong About How We Make Choices

A new paper reviews how psychology, biology, and neurology are ganging up on economics to prove that, when it comes to making decisions, people are anything but rational

Reuters

Daniel McFadden is an economist. But his new paper, "The New Science of Pleasure," shows the many ways economics fails to explain how we make decisions -- and what it can learn from psychology, anthropology, biology, and neurology.

The old economic theory of consumers says that "people should relish choice." And we do. Shopping can be fun, democracy is better than its alternatives, and a diverse and fully stocked grocery store ice cream freezer is quite nearly the closest thing to heaven on earth. But other fields of science tell a more complicated story. First, making a choice is physically exhausting, literally, so that somebody forced to make a number of decisions in a row is likely to get lazy and dumb. (That's one reason why stores place candy near the check-out aisle: They suspect your brain is too zonked to resist.) Second, having too many choices can make us less likely to come to a conclusion. In a famous study of the so-called "paradox of choice", psychologists Mark Lepper and Sheena Iyengar found that customers presented with six jam varieties were more likely to buy one than customers offered a choice of 24.

If you've read the work of Dan Ariely or Daniel Kahneman, you know exactly how far from perfectly rational we are when faced with a decision. Many of our mistakes stem from a central "availability bias." Our brains are computers, and we like to access recently opened files, even though many decisions require a deep body of information that might require some searching. Cheap example: We remember the first, last, and peak moments of certain experiences. So when we make a choice about how to spend a certain amount of time -- say, by going to Six Flags -- we forget that most of the time at an amusement park is spent waiting around doing nothing. Instead, we remember the thrill of the roller coaster. (This has been previously used to explain why people sometimes go back to disappointing old romantic partners, but that might be for another article.)

The third check against the theory of the rational consumer is the fact that we're social animals. We let our friends and family and tribes do our thinking for us. In a fascinating example, McFadden presents a study that shows Korean peasant women within the same village tend to use the same contraception -- even though there is "substantial, persistent diversity across villages." This pattern could not be explained by income, education, or price. Word-of-mouth explained practically all the difference.

In another corner of the ivory tower (or, more likely, across campus in a glassy lab), neurologists are finding that many of the biases behavioral economists perceive in decision-making start in our brains. "Brain studies indicate that organisms seem to be on a hedonic treadmill, quickly habituating to homeostasis," McFadden writes. In other words, perhaps our preference for the status quo isn't just figuratively our heads, but also literally sculpted by the hand of evolution inside of our brains. 

A final example to show how other fields of science are ganging up on classical economics: The popular psychological theory of "hyperbolic discounting" says people don't properly evaluate rewards over time. The theory seeks to explain why many groups -- nappers, procrastinators, Congress -- take rewards now and pain later, over and over again. But neurology suggests that it hardly makes sense to speak of "the brain," in the singular, because it's two very different parts of the brain that process choices for now and later. The choice to delay gratification is mostly processed in the frontal system. But studies show that the choice to do something immediately gratifying is processed in a different system, the limbic system, which is more viscerally connected to our behavior, our "reward pathways," and our feelings of pain and pleasure.

And there's much more. To explain it, here's Daniel McFadden himself. The following transcript of our email conversation has been very lightly edited for clarity.

Let me try to sum up your paper for readers, because it covers a lot of ground. Classical economists used to posit that, since consumers are rational, we make decisions to maximize our pleasure, end of story. But your paper reviews all the ways we know that consumers aren't in fact rational but prone to all sorts of biases and habits that pull us from any strictly rational view of the consumer. Is that alright?

This is a good summary, but I think the final message is that neither the physiology of pleasure nor the methods we use to make choices are as simple or as single-minded as the classical economists thought. A lot of behavior is consistent with pursuit of self-interest, but in novel or ambiguous decision-making environments there is a good chance that our habits will fail us and inconsistencies in the way we process information will undo us.

Choices are good. Trade is good. That's the view of neoclassical consumer theory. But it turns out that people don't really like making decisions. We have habits, we like thinking automatically. So sometimes we avoid making choices altogether because it stresses us out. Why is that? And how might, say, a company use that superior understanding of consumer theory to make consumers behave a certain way?

Trade is a contest, with a chance of coming out on the short end. Animals in "fight or flee" situations often find it safer to flee. Similarly, people in situations where trade is possible, or even promising, may find it safer to turn away. It takes trust to trade. McDonald's is successful because it has created a brand people trust - they know what to expect. A "30-day free trial" or "satisfaction or your money back" or "bring us a better price and we will refund the difference" are offers by merchants intended to promote the idea that they can be trusted, and that the risk of an unsatisfactory trade is low.

Real estate agents take advantage of people's discomfort with decision-making. Since buying a house is highly consequential and difficult to reverse, rational people should look at a great many options and think them through very carefully. A good agent will show you a few houses that are expensive and not very nice, and then one at almost the same price and far nicer. Many buyers will respond by stopping their search and jumping on this bargain. Our susceptibility to "bargains" is one of the cognitive devices we use to simplify choice situations, and one that companies are conscious of when they position their products.

One of the observations that most struck me was "economic choices can make us uncomfortable." That seems like a very powerful idea. How might I see it in my life?

If two "rational" people meet and disagree on the probability of an event (e.g., the AFC team wins the super bowl, the price of Google stock goes up), then both can gain by wagering on the event. In the real world, however, wagering is the exception, not the rule. On the one hand, you could say that getting someone to bet on an event, pay attention to the outcome, and finally make the payoff, is too much work. But actually, if you ask people why they don't bet often with their friends, they will simply say that it would make them uncomfortable to do so.

I'm a big procrastinator. Why does that fall under the category of "hyperbolic discounting" rather than "rational way to spend a Sunday afternoon"?

Procrastination is a way of avoiding uncomfortable choices. Hyperbolic discounting seems to be related to our subjective perception of time, and to the way the brain parses current and future pleasure-seeking - waiting for an hour right now is more painful than our perception of waiting for an hour in the future.

Here is an example of how hyperbolic discounting works: You go to your car dealer seeking a model that has a sound system you want. He says it will take 3 days to get that exact model, but you can drive away right now with one that has a better sound system and costs $300 more. Most buyers will choose to pay a little more and take their new car now. However, if the dealer said that no car is available right now, and he can get the model you want in 33 days, but a model costing $300 more with a better sound system in 30 days, most buyers will choose to wait the 33 days and get the exact model they want. This is hyperbolic discounting at work. Rational consumers with consistent intertemporal evaluation should treat the trade "$300 for an attractive but unneeded accessory versus 3 days" the same whether it is executed right now or executed in 30 days.

I felt like this sentence at the end of your paper was really important -- "Specialized brain circuitry processes experience in ways that are not necessarily consistent with relentless maximization of hedonic experience" - but I didn't really understand what it meant.

Our brains seem to operate like committees, assigning some tasks to the limbic system, others to the frontal system. The "switchboard" does not seem to achieve complete, consistent communication between different parts of the brain. Pleasure and pain are experienced in the limbic system, but not on one fixed "utility" or "self-interest" scale. Pleasure and pain have distinct neural pathways, and these pathways adapt quickly to homeostasis, with sensation coming from changes rather than levels. Overall, presumably as a product of evolution, our brains are organized well enough to keep us alive, fed, reproducing, and responsive to but not overwhelmed by sensation, but they are not hedinometers.

You make the case that humans are social animals more than economic machines, which sounds right to me. So do social network like Facebook and Twitter help us make better choices?

This is complicated. Social networks are sources of information, on what products are available, what their features are, and how your friends like them. If the information is accurate, this should help you make better choices. On the other hand, it also makes it easier for you to follow the crowd rather than engaging in the due diligence of collecting and evaluating your own information and playing it against your own preferences. In net, the information provided by social networks probably improves choices. The down side is that it may make you a lazy decision-maker. There is also a problem that if social networks encourage herd behavior, then they increase the risk of panics and stampedes that lead to market bubbles and instability.

read more at http://www.theatlantic.com/business/archive/2013/01/the-irrational-consumer-why-economics-is-dead-wrong-about-how-we-make-choices/267255/#.UPhZ40vRYWM.twitter