Irrational Decisions vs Irrational Expectations

Mapping human behavior and understanding why people do what they do has been a cornerstone in different schools of philosophy. If asked to participate in a $50 coin toss on a regular Tuesday afternoon, a consumer caught off-guard is likely to decline the offer but may go on to spend over $500 next Friday at the casinoㅡwhere there is a lower probability of winning.

A decision of this kind is clearly not in line with the utility maximization theory which refers to the idea that individuals and firms strive to make economic decisions that give them maximum satisfaction. This satisfaction, however, is often equated to merely monetary gains and is hence unable to incorporate the true behavior of all actors in the market. People have been known to derive satisfaction from acts of altruism which directly contradicts traditional “rational consumer behavior” since making donations reduces monetary gains. Can non-monetary means of achieving satisfaction be categorized as irrational?

Markets need to update and enhance their definition of a “rational consumer’’ to allow for the several variables that contribute to the satisfaction derived by actors from their economic decisions. However, encompassing these minute details that motivate people’s economic decisions would make it virtually impossible to build a single mathematical model or theory. Nonetheless, researchers are performing real-time experiments and observing human behavior in various situations: an experiment published in the Harvard Business Review reduced the prices of two chocolates by 1¢ each, making one of them 14¢ and the other free. The results showed that 42% more people opted for the free chocolate after the price change even though they would save 1¢ in either case. This showed the consumers’ temptation towards a “free” product. Such studies can be used to better understand the human thought process that guides decisions and maximizes satisfaction.

Although all the factors influencing decisions cannot be accounted for, suboptimal decision making is largely visible when people experience cognitive biases or are unable to consider alternatives thoroughly. Consumers’ overly optimistic or pessimistic expectations of a decision’s outcome can lead to irrational behavior. For example, some consumers tend to underinvest in fear of losses while others build “castles-in-the-air” and keep losing a lot of invested money in hopes that a poorly performing stock will eventually do well. When a consumer reviews their investment portfolio and sees a certain company’s stock skyrocket, they feel satisfied by the gains that could be insignificant in front of their entire portfolio. They form a mental account and may fail to change their investment strategy even though the portfolio as a whole is not doing well. If a significant fraction of investors make this irrational decision, the prices of stocks in the market will cease to be an accurate representation of their value. This could be further exacerbated by attention anomalies in the market when consumers start following the masses and invest without self-analyzing the stock. If overpriced stocks were to return to their real value, consumers would lose large sums of money and the economy could also experience market failure.

This is, experts argue, precisely what caused the 1930s stock market crash. Buyers became overconfident about their investments’ performances in the “Roaring Twenties” and not only invested large amounts of their savings but also began “buying on margin” with minimal down payments of 10%. The stocks were so overpriced that when the bubble finally burst, investors panicked, and everyone tried to withdraw their money from the market simultaneously. Unfortunately, the extreme overconfidence meant that even banks did not have the funds to return the consumers’ money, leading to a dire situation.

The impact of such sub-optimal consumer decisions can be decreased by enabling all information regarding individuals’ investments to be easily accessible to them. The elimination of “conventional wisdom” would empower individuals to stop relying on agents behaving as “middlemen” and follow the true economics at play. This would help them understand the value of the investment and make an informed decision as to whether it is the right place to allocate their resources. Financial literacy should also be integrated into public education to reduce inequity and prevent common people from becoming a party to an economic bubble. If consumers are provided a reliable means of analyzing the various alternatives and are qualified to understand the data provided to them, they are less likely to depend on popular opinions.

As American author, Harriet Beecher Stowe once said: “Human nature is above all things lazy.” Often, individuals lack the motivation to ensure that they are attaining the best possible deal. The costs in the market of reviewing the immense amount of information are often higher than that of making a sub-optimal decision. According to the 1971 economics Nobel Laureate Herbert Simon, consumers don’t necessarily seek an optimal outcome but rather a satisfactory one. For example, when we plan to purchase a new pair of shoes and identify a store selling them for $250, we continue searching for a better deal. On stumbling upon the same pair of shoes for $200, we feel a surge of satisfaction of saving $50 and proceed to buy the pair. Although the pair may have also been available for $175 in the market, we have anchored our mind to the initial $250 price. We are content with our decision and prioritize the saved time over the additional $25 we could have saved.

In today’s world, the debate of whether time precedes money as a priority or vice versa is a continuing one, but the unfortunate effect on the market is stark: a firm X selling well-marketed and easily accessible products can achieve higher revenue than a firm Y selling more optimal products. If firm Y were to increase the distribution of its products, consumers would immediately cease to buy from firm X bringing its inflated stock back to real value. Once again, this could cause a shock in the market that would eventually harm individuals. If markets can limit the extent of exaggerated advertising and advocate the importance of thorough comparison, the magnitude of such misvaluation could be minimized.

Individuals’ inability to weigh all possible options against each other also means that firms can influence consumers by using choice architecture and nudges. Buyers are more likely to choose the default option at hand than opt-out which means that firms can hold on to customers through misleading schemes and plans. However, this tendency can also be used to extract more socially desirable outcomes from people without restricting choice. Vanguard, an American investment company, for example, reported in 2017 that the participation in retirement plans almost doubled when new employees were registered automatically. Whether this is ethical largely depends on the way these nudges are used and communicated to the audience. Hence, governments should set down comprehensive regulations to ensure that nudges are not misused by the market to deceive the public into making sub-optimal decisions.

While it can be seen that incomplete information, opportunity cost, and financial illiteracy limit the effectiveness of a consumer’s rational calculations一producers and firms are not subject to such drawbacks on a large scale. Yet they too, unknowingly or as a part of a well thought out strategic plan, take decisions that don’t necessarily equate to immediate profits. Oftentimes, firms endure higher production costs to fulfill their corporate social and ethical responsibilities. For instance, Nike is known for using renewable energy in production as well as minimizing textile waste by reusing all its off-cuts. This leads to higher costs for Nike and since it doesn’t directly align with the profit maximization objective of firms, it can be categorized as a sub-optimal decision. Nonetheless, these decisions have helped Nike and similar firms establish customer loyalty and build a positive brand image that as a result has increased their long-term revenue. Taking brand loyalty, employee satisfaction, and humanitarian decisions into account while making policies for the rational producer would make predictions more accurate and schemes more efficient.

Upon reviewing the issues of consumer and producer irrationality, the undeniable question arises: are individuals really making irrational decisions, or is the idea of optimal behavior an irrational expectation? Answering this question will pave the path for future measures that either try to decrease inefficiencies in the market by growing a more rational community or accepting human behavior for what it is and creating policies around it. Maybe, the solution lies in trying to achieve a little bit of both. Policymakers must bear in mind that money is not always the sole factor for attaining satisfaction but at the same time try to ensure that individuals are not losing this monetary satisfaction due to their irrationality.

To further illustrate this point, I leave you with a quote from Nobel Laureate Richard Thaler: “We do not have to stop inventing abstract models that describe the behavior of imaginary Econs. We do, however, have to stop assuming that those models are accurate descriptions of behavior, and stop basing policy decisions on such flawed analyses.”

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