Monday, May 5, 2008

Are we rational or predictably irrational?

If you ask Tim Harford, author of “The Logic of Life” (2008), he would say that we can generally be expected to make rational decisions. According to Harford, people do the things they do largely as a result of rational choices.

If you ask Dan Ariely, author of “Predictably Irrational” (2008), he would say that we are generally far less rational than we think we are. According to Ariely, while we like to think of ourselves as sitting in the driver’s seat, with ultimate control over the decisions we make, we are actually pawns in a game whose forces we largely fail to comprehend. We tend to make the same mistakes over and over because of the basic wiring of our brains.

After reading these books I felt that both authors made some good points. Is it possible that both could be right?

Harford adopts the time-honoured economic method of seeking to explain how various phenomena could be a consequence of rational individual behaviour. He refers to research studies explaining a wide variety of things in these terms that are often thought of as symptoms of irrationality. The list includes crime, addictions, divorce, provision of astronomical remuneration to some chief executives, racial segregation and the growth of large cities.

Ariely approaches the subject as a behavioral economist. His research methodology is more akin to experimental psychology than economics. He uses his experiments to illustrate that human behavior is influenced by a list of factors other than rational choice. This list includes price anchors, the power of gifts, social norms, the influence of arousal, the problem of procrastination, the tendency to over-value the things we own, the effect of expectations and the influence of ethical codes on integrity.

It seems to me to be possible for both Harford and Ariely to be right because they use different definitions of rationality. Harford’s definition of rationality is simple: rational people respond to incentives (p 8). Ariely views rationality as involving much more. In his terms, to be rational implies “that we know all the pertinent information about our decisions, that we can calculate the value of the different options we face, and that we are cognitively unhindered in weighing the ramifications of each potential choice” (p 239). Rationality involves making “logical and sensible decisions” and “if we make a wrong decision from time to time we will quickly learn from our mistakes (p 239).

That might make it possible for Harford to say that a person’s behaviour in some situation was rational whereas Ariely could say that it was predicably irrational. There is not a great deal of overlap between the things that Harford and Ariely have written about, but what they have to say about self-control in relation to spending and saving decisions can be used to illustrate this point. Harford would argue that when we have self-control problems the warring parties within us are both rational - it is just that one party is impatient and the other party is willing to wait for larger rewards in the future (pp 56 -66). Ariely implies that a person with such problems is having difficulty behaving rationally (p 122-3). Both acknowledge the potential to resolve problems by making strategic decisions e.g. placing your credit card in a glass of water in the freezer, so that you have to wait for the ice to thaw before you can use it.

The definition of rationality may have some importance to the extent that it is used as an anchor in public discussion. When we define rationality so broadly that foolish behaviour can be rational, some foolish people may think that this implies approval. Similarly, when we define rationality too narrowly some foolish people may think that the existence of irrational behaviour by individuals provides an open and shut case for more government regulation.

While adopting a broad definition of rationality, Tim Harford acknowledges that individual rationality can produce undesirable social outcomes. For the most part Dan Ariely suggests that the best way for individuals to deal with their irrational tendencies is to be aware of them. Sometimes, however, he slides quickly (too quickly in my view) from identifying irrationality to suggestions for government intervention.

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