Predictably Predictable about Irrationality

Noah has been reading Dan Ariely’s bestseller Predictably Irrational recently. It’s one of the more successful books of a popular new subgenre in pop science: the one that claims that we are evolutionarily wired to get certain things wrong. There isn’t a name for this yet, so let me suggest “Anthropological Relativity.”

I’m not a big fan of Anthropological Relativity books – the main reason being the obvious: establishing to a scientific certainty that people are irrational in predictable ways begs the question of how the scientists who established this managed to avoid the trap themselves. And the answer to the begged question is equally obvious: since this irrationality is predictable, the behaviors associated with it can be identified and avoided. Much the way we learn to avoid having our anger buttons pushed as we get older, actually. So in theory, the Anthropological Relativity subgenre is like the Self-Help book’s RICH cousin – the one that actually has good advice about how to get a leg up on other people. But in practice, the authors of these books tend to fall into a particular pattern – that of assuming that overcoming these weaknesses is hopeless, and that this somehow justifies more government intervention in our lives, as though carrying a government badge has the magic power to render someone immune to these weaknesses that the rest of us are supposedly hopeless to overcome on our own (or that if it did, that the government agents can somehow be trusted not to exploit this power to take advantage of the rest of us).

Noah confirms that Predictably Irrational has this slant. And in fact I already knew that, because Alexis read it last year and reported the same finding.

Noah’s biggest bone to pick so far comes from the second chapter, The Fallacy of Supply and Demand, in which the author (apparently, I haven’t read the book myself) strongly hints that the market system is broken in the important sense that market forces cannot be trusted to reach the “correct” (aka the market clearing or equilibrium) price on a given class of good because people can only assess relative value and have no independent basis for setting a starting point. The argument is that people tend to “peg” their expectation of how much something should cost at the initial price they saw associated with a good of that class, and forever after they assess things priced more highly than that initial price as “expensive” and lower as “cheap.” To show that this initial price is arbitrary, the author cites some research (actually, I think it’s mostly research he himself performed?) to the effect that two groups were given different initial starting prices for some kind of bauble and then asked whether they would buy similar baubles at price x or price y, and invariably the people in the group with the lower initial price were less likely to buy at the higher price y than the people in the group with the higher initial price. Conclusion: OHMIGOD there are NO SUCH THINGS AS ABSOLUTE PRICES!!!

And that’s basically the content of Noah’s objection: that the idea that there are no such things as absolute prices – i.e. no sense in which there is a “correct” price for anything – is not something that needed to be proven by experiment, and so this is not revealing. The author is burning a straw man in saying that Free Market Capitalism believes in absolute prices for things that the market will eventually reach. Free Market Capitalism asserts no such thing.

Noah is mostly right – Free Market Capitalism doesn’t make this exact claim. But I still think this isn’t the best critique of this chapter – because in truth, while Free Market Captialism doesn’t assert exactly that thing, it does make a highly similar claim – namely that markets will converge on an equilibrium price for a good, and this equilibrium price will in some sense be “ideal.” The difference between what Free Market advocates (such as myself and Noah) claim about this equilibrium price and what Mr. Ariely thinks we claim about it is NOT that there isn’t “one such price” (at a given time in a given context) – because there IS. It’s that Mr. Ariely seems to think that Free Market Fundamentalism claims that the market will reveal the BEST such price that operates in everyone’s best interests, however defined. And that it clearly does not (though it does claim to do a better job than most of the proposed alternatives, more on which later). And the reason it does not is because we Free Market Fundamentalist types do not, as a general rule, claim to know better than anyone what is in his best interests and, more to the point, we are highly skeptical of people from the government making the same claim. Actually, we’re downright suspicious of the government making that claim – one of the many reasons for which is that the government by and large uses the same mechanisms the market uses, only more crudely. (So, for example, in an ideal world in which prices operated to encourage people to do things in their own interests and avoid things that were not in their interests, the price labels on alcohol bottles would show higher numbers for people who drink too much and lower numbers for people who don’t drink so much (what you might call perfect price discrimination), and the legal blood alcohol content for driving would be high for people who function well with a lot of alcohol in their systems and low for those who don’t. But the government doesn’t take these kinds of approaches. When it taxes to try to make alcohol expensive, it taxes all people equally, and when it imposes regulations on driving while intoxicated, it imposes the same regulation for everyone. And it tends to get these numbers wrong because it accumulates less total information than the market does, and tends to filter what information it gets though an ideological alternator besides. So the government does what the market does, only in a less flexible and less informed manner.)

But as for equilibrium prices, I think Free Market Fundamentalists (and I am one, so I should know) DO make something like the claim that Mr. Ariely is saying we do: we do claim that there is an equilibrium price that the market will eventually find. Now, Noah’s right that this equilibrium price can change as attitudes and needs change with time, so he’s right in one sense that there’s no “correct” price for everything across times and contexts. But he’s wrong in thinking that the Market Advocates such as myself (and himself too, actually, though I suspect he’s somewhat less of a fundamentalist about it than I am) do not believe in a “correct” price of sorts for a given time and population, because we do. And we think that all other things equal, the market will find it. And yes, I’m here saying that Mr. Ariely’s “fallacy of supply and demand” is a red herring – in the following way.

It’s probably true enough that people take arbitrary fixed starting points of comparison for their pricing – but these pricing points will only stay abritrary on unimportant goods, or else goods shielded from competition. The more important a good, the more quickly the market price will converge to equilibrium. And in fact Alexis confirms that Ariely’s experiments mostly deal with baubles, which is why he’s able to sustain the illusion.

The difference between baubles and actual goods – like gasoline – is that people can afford to throw money away on baubles but can’t similarly afford to throw money away on gasoline. And of course the science of ECONOMICS is only interested in and makes claims about the LATTER type of good, the one that, if you’ll pardon the not-so-pun, they have to economize over. The trouble with Mr. Ariely’s experiments is that they disconnect these purchasing decisions from the real world. Put differently, Mr. Ariely, like so many others, is fetishizing money.

In the real world, prices represent tradeoffs. Money has no value independent of the total economy – it is merely a medium of exchange. It’s as though Mr. Ariely has never even heard of inflation; he certainly doesn’t seem to have done much reading about it. But in the real world, there is inflation, and that’s what happens when there’s too much money relative to actual goods and services available floating around. Printing more money doesn’t have the magic power to create new goods and services, so what happens instead is that prices on the existing goods and services rise to absorb the excess money supply. Money expands or contracts to reflect how much actual “stuff” and “demand for stuff” there is in the world. Put differently, prices rise or fall to make sure that they continue to represent the percentages of everyone’s budgets that they’re actually willing to dispose for those goods.

When people spend money, they aren’t doing so under experimental conditions. Their spending represents tradeoffs. If I buy a bottle of wine for $30, then that’s $30 that I don’t have available to spend on other things. But there’s nothing about the number 30 itself that means anything here. 30 is just an arbitrary score, and it only means something in the context of the equally arbitrary scores attached to all those other things that I would like to buy with my 30. Put differently, 30 only matters as a percentage of my budget taking into account what percentages of my budget are required to obtain other things that I want. If I pocket $30,000 a year, after taxes, then I can buy exactly 1,000 bottles of wine – BUT I WOULDN’T, because of course if I did that I wouldn’t be able to eat, or drive, or sleep under a roof. I’m limited in how much wine I can purchase and how much I am willing to spend on such wine as I do purchase by all those other things that I also need to buy.

Mr. Ariely strikes me as being similar to all those people who thought, two years ago, that the oil companies were free to just keep raising prices on gasoline indefinitely. They’re not, you see, because at some point gas gets to be so expensive that people HAVE to find ways to economize on it. And even those people who “can’t” economize on it (because, they have a 50mile commute every day or whatever) will eventually HAVE TO if the price gets high enough. And the reason they HAVE TO is because there are other things besides gasoline that are necessary to their survival. Oil companies can comfortably raise prices to a certain extent, granted. But when you push people beyond a certain point, then raising prices actually hurts their profits, because people HAVE TO economize on gas once gas becomes a certain critical percentage of their budget, and at that point they buy less of it. And if enough people buy enough less of it, which at a certain price level will definitely happen, then the oil company loses money even though the price is higher just from the lower volume of sales. The oil company would, of course, like to sell you as little oil as it can at as high a price as it can, but there’s only so much it CAN do to achieve this.

OK, Mr. Ariely would presumably say, but doesn’t the oil company still want to reach as high a point on that curve as it can before everything busts? Isn’t it going to devote as much time and research energy as it can to finding that point? Well yes, and why shouldn’t it? The point is that everyone else is doing that too. So the oil company’s efforts in this regard are offset by the watchmakers’ efforts, and the pharmacists’ efforts, and the breadmakers’ efforts, etc. Everyone would like to reach that sweet spot – and an open market as good as guarantees that they keep trying until they do.

To put this in a context that the economically uninformed like Mr. Ariely can understand: let’s indulge in a hypothetical about his arbitrary price point. So, assume wine is 30/bottle out here in the real world. But for the summer we all go to an island resort town where wine is more like 55/bottle on average, because there’s only the one store on the island. At first this will seem expensive, but if Mr. Ariely is right, we’ll soon adjust and 55/bottle will come to seem reasonable. Now, when we “treat ourselves,” we might spend 80 for a bottle. This would have seemed completely outrageous at home, but since 55 is our point of comparison, 80 for something really nice seems acceptable. So Mr. Ariely’s point is made, right?

No, not exactly. He’s right that 80 can come to seem reasonable for a nice bottle of wine. But he’s wrong about two much more important things. The first is that while the acceptability of 80 as a price for a bottle of (nice) wine may have changed, our wine budget has not. There’s still only so much money that we can afford to spend on wine before we have to start giving up other things that we’d like (cheese, say), and this will necessarily limit how much wine we’re willing to purchase. We may come to find 80 a normal number to see on a wine tag, but we may also find ourselves drinking less wine – or at least find ourselves drinking worse wine. The other is that this new wine price is only sustainable to the extent that we’re on an island where there is imperfect competiton in wine. If someone else opened another wine store next door and priced his wine at 45/bottle on average, then this would seem cheap to us on the island (even though it’s still expensive by the standards we’re used to at home), and we would tend to buy more wine from him, and eventually his competitor would have to lower his prices too. Now it’s 45 that comes to seem normal for wine rather than 55, and of course it’s easy to see that if there were free competition in wine on the island then the price would reach the 30 we’re used to at home. And this is so because Mr. Ariely is forgetting that it’s not just from the purchaser’s point of view that the starting point is arbitrary, it’s also from the seller’s point of view. The original seller on the island thought of 55 as a normal price for a bottle, bt he, like everyone else, adjusts in the face of changes. And the market works for THAT reason – because there are two sides negotiating, not just one setting prices at which the other has to buy. It doesn’t matter that the purchasers can’t see for themselves that wine merchants can afford to sell at 30 rather than 55 – the wine merchants themselves will reveal this by undercutting each other’s prices. And yes, of course there’s a lower limit on how low prices can go, and that’s because wine merchants have budgets like everyone else – things they want to buy – and if the profit margin gets too low in the wine business then wine merchants will find other things to do.

So sorry, Mr. Ariely, but the market only fails to reach equilibrium in your artificial experiments over inconsequential goods. In the real world, where we do this with currency rather than monopoly money, it does reach equilibrium. Indeed, one of the most powerful arguments I’ve heard in favor of markets is that they aggregate information in a way that central planners can’t. People individually may suffer from the irrational bias that Mr. Ariely has identified, but as a group they do not. Mr. Ariely’s experiment is like playing someone who’s never heard music punk and stadium rock and asking him to declare himself a fan of one or the other, and then taking him to a record store and noting that he avoids the classical section and calling this insight!

It’s true enough that people can only make comparisons on the basis of the options in front of them. What is completely ludicrous is using the fact that people can only make choices on the basis of the options in front of them as an argument for limiting the options in front of them, as Mr. Ariely is apparently doing. Quite the contrary – what Mr. Ariely has in fact established is that it is extremely dangerous to allow the government to have this kind of power. It is why, for example, the people of North Korea think they’re well off when in fact they’re dirt poor. Compared to their parents’ generation, of course, they are actually somewhat well off. But they’re much less well off than citizens of most other countries in the world, and the ONLY reason the illusion of prosperity persists for them is because they’re not allowed to see any other options.

Mr. Ariely’s experiment is analogous in a rough way. Now, it’s true enough that Mr. Ariely’s subjects still have some concept of how much money they have available to spend, and this is informing their intuitions about how much they’d be willing to spend on his baubles. Nevertheless, he has removed an important component of real markets – that of the competitor’s freedom to undercut the big seller. It’s true enough that people in one group may consider the same price “high” that people in the other group consider “reasonable;” what’s artificial is that it would ever happen in the real world that these two groups would remain separate. The fact that the members of the one group consider the price “high” is what gives merchants an incentive to lower their prices, and what guarantees that they WILL lower their prices eventually. Wal Mart, after all, is not an illusion or a figment of anyone’s imagination. It’s a real chain that really competes with Mom and Pop stores and puts them out of business by finding ways to undercut their prices. And it’s possible only because that component that’s missing from Mr. Ariely’s experiments – the motivation to show people who are not otherwise aware that they are overpaying for something that they are overpaying for it – is very real. The merchant who sets the initial price peg may have no motive to make things comfortable for his customers, but his competitors do. And the market reaches equilibrium for this reason – i.e. exactly when the government isn’t limiting people’s freedom to price things.

That, it seems to me, is the better critique. Yes, there’s no such thing as an “ideal” price – but that’s only because we don’t know what’s in everyone’s best intersts simultaneously. Neither does the government, or anyone else. The best a standard price can ever do is aggregate these interests, and that won’t work out for every individual. (People who really like fine tea, such as myself, for example, are kind of screwed because tea just isn’t as popular as coffee, and so more of my budget than I would ideally like gets spent on having tea shipped in from Chicago. But that’s on me for having unpopular tastes; I am always free to aquire the taste for coffee if it comes to that.) The question isn’t whether the market can ideally aggregate people’s interests, but whether the government would do any better. It seems obvious to Noah – and I really agree – that the government would do a worse job. But I would go one step further than Noah: Mr. Ariely’s experiment in fact fails to demonstrate what he claims it does, and that’s because it is an unrealistic setup to begin with. Not only does Mr. Ariely NOT answer Noah’s question (i.e. on what basis he believes the government would do a better job aggregating interests and what it is about government that would help it avoid the limitations he seems to think the market suffers from), he doesn’t, to my mind, even establish his original point – which was that markets will fail to reach equilibrium. Quite the contrary – I see every reason to believe that real world markets WILL reach equilibrium – i.e. WILL converge on “the” price for a good – to the extent that this is possible (which is isn’t completely, but it’s certainly a lot more possible than Mr. Ariely seems to credit). It’s the government that won’t – and that’s because only the government can impose the same artificial conditions on economic transactions that exist in Mr. Ariely’s experiments. Mr. Ariely is using a contrived situation to argue that we should mandate the same contrived situation. The remedy is not to turn the real world into a lab. Done!

So no, there isn’t an “ideal” price which is in everyone’s best interests simultaneously – but there IS such a thing as an equilibrium price, and markets WILL tend to reach it. The equilibrium price is NOT arbitrary, but rather represents the best that the system can do to balance the interests of the people seeking to economize on it against the interests of the people seeking to profit by supplying it. What this perfect equilibrium is will change over time as needs and interests change, but it does exist, and the market is the ONLY mechanism I know that has any hope of discovering what it is, even if the market won’t ever hit it exactly on the nose. The government, by contrast, will never even be in the ballpark.

2 thoughts on “Predictably Predictable about Irrationality

  1. Excellent fisking of yet another annoying argument from the champions of statism. The intellectual contortions that this crowd needs to make in order to rationalize and hide the real reasons they believe the way that they do (ideology of course, or just a plain old fashioned lust for power) never cease to amaze me. The notion that it is impossible for any relatively small group of people (read government officials) to identify (much less enforce) conditions that are in everyone’s best interests never seems to impress upon these people. Those among the intelligentsia, (Krugman, Ariely, et.al.) who actually expend gargantuan amounts of effort every day to undermine free market principles, seem to labor under the perpetual (and fallacious) illusion of an absolute standard of value that only they are wise enough to understand and noble enough to fairly enforce. But even allowing for a clustering of some standards due to shared culture and the like, free people disagree to some extent or another on just about everything, which reveals that no such standard of value is possible. Ultimately the best government can do is to attempt to establish (by force) defacto standards of value accepted by various voting blocks, and negotiate an equilibrium among them based on the relative weight each voting block can generate. If you’re on the wrong end of that power struggle, you’re up the proverbial shit’s creek, usually with little recourse within you’re own sphere of influence. I’ll take the free market any day of the week…even if that means it will generate a price I don’t like. In the long run, I am confident that I myself am adequately empowered to negotiate economic terms that are in my own best interests. I have no such confidence that the government can do this for me and my family.

  2. Thanks as always for the comment. I’m not too happy with this article – seems like I missed a lot of points I could’ve made – and you highlight one of them well. Yes, the alternative is establishing an equilibrium among crude voting blocks – which is still an equilibrium of sorts, but when you put it the way you put it it makes it a lot more obvious to the casual reader why that setup is unlikely to work as well as the finer-grained, more flexible market calculation. I may do a followup on this (if I ever get around to actually reading Ariely) and will definitely incorporate that characterization.

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