Are You Irrational? Behavioral Economics Explains Decision-Making

Do you consider yourself an irrational person? Most people would say no, they're highly rational. This is because we usually don't like to perceive ourselves in a seemingly negative light. Rationality is defined as "the quality of being based on or in accordance with reason or logic". However, we are human and with that comes human thoughts, emotions, and behaviors. So surprisingly, we sometimes seemingly act rationally less of the time than we do irrationally according to Behavioral Economics.

Everybody makes decisions that are logically bad for them. Sometimes it's unknowingly, but there are plenty of times when you do something with 100% clarity that that decision is bad for you. For example, I know I could be spending time writing a paper or getting work done, but instead I'll "accidentally" sit and watch Netflix or YouTube videos for 3 hours. This is in part due to my lack of self-control, but also in part due to the algorithms that encourage you to go down the rabbit hole with suggestions of other videos you might like. Now you don't even have to click on the video, they'll just play the next one for you!

Anyway, my point with that example is that it's irrational for me to spend most of my productive hours focusing on things that won't inherently net me any tangible value or worth if I'm concerned with minimizing loss and maximizing gains. Traditional economic models are all about how humans will always try to minimize loss and maximize gains. This is what it means to be a rational actor to traditional economists. While yes, it's true that minimizing losses and maximizing gains are integral to economic – and really just human success – minimizing losses is actually substantially more important to us than maximizing gains.

This is called Loss Aversion, which I wrote an article about that you can read here. Loss Aversion is a concept in Behavioral Economics that means the pain of losing something has a substantially higher value, a substantially larger psychological weight, than the potential pleasure of gaining something of equal value. I'll give you a quick example to demonstrate this. Let’s say you're at work and you're minding your own business filing papers or whatever it is you do at your job. Your HR manager walks by and you overhear them saying they're going to raise your salary by $500 a month. Wow! $500 is great! That can be used for a lot of different things you could use and do. Now let’s say you're in the same setting and you hear your HR manager say they're going to cut your salary by $500 a month. Which one are you more likely to confront your boss about?

Most people would say they would confront their boss about losing $500 a month, because that's peoples' rent, car payments, student loans, etc. They need that $500 to survive. However traditional economic theory dictates that this is irrational, and that people should have an equal chance of talking to their boss about either gaining or losing $500 a month because it's the same dollar amount. However due to Loss Aversion (and other social factors) that pain of losing something is substantially greater than the pleasure of gaining something of equal value.

Richard Thaler, professor at the University of Chicago's Booth School of Business, in an interview with Charles Rotblut, CFA published in 2017 by the American Association of Individual Investors, sites many other ways humans are irrational. One in particular he sites is something known as the Sunk Cost Fallacy. This is basically when money that you've already spent influences you to stick with whatever you spent your money on, even when a better option arises.

Thaler gives a great example in the interview: Let's say you got tickets to a sold-out concert and spent a lot of money on those tickets. Then your very good friend calls you and tells you they're in town for tonight only and wants to see you (this scenario assumes you're going with someone else to the concert, or that your very good friend would be unable to attend the concert with you). Traditional economics states that money that's already been spent should have no bearing on future decisions, so you should generally prefer spending time with the person you've built a friendship with for years whom you hardly ever get to see. However, because you've already invested resources into the tickets, you don't want that to go to waste, so you'll be more likely to choose to go to the concert instead of seeing your friend. So when your very good friend that you blew off says you're a bad friend, you can just blame economics!

Another great example of how psychology can make people engage in irrational behavior is called the Endowment Effect. This concept basically states that when we have something, we’re going to place a higher value on that thing than someone else will. The classic example that Richard Thaler, along with his colleagues Daniel Kahnemen and Jack Knetsch used in their 1991 study published in the Journal of Economic Perspectives entitled, Anomalies: The Endowment Effect, Loss Aversion and Status Quo Bias, to exemplify this effect involves coffee mugs.

Thaler and his colleagues took a group of college students and asked them to decide how much a mug was worth. They took the students and divided them into three groups: Buyers, Choosers, and Sellers. The Buyers were shown the mug and told they were going to buy the mug and asked how much they thought it was worth. The Choosers (the control group) were just asked how much they thought the mug was worth. The Sellers were shown the mug and told it was theirs, then were asked how much they thought it was worth to sell. The results showed the Buyers and Choosers priced the mug around $2-$3. The Sellers however priced the mug at around $7-8! That huge disparity is due to the Endowment Effect. What I think is really fascinating about this study is that they didn’t even touch or actually have the mug, they just thought they did. When someone thinks they own something, whether or not they actually do, they place a substantially higher value on it than others will. There are so many other telling examples of this you can see every day that don’t necessarily have to do with economics, from politics, to land disputes, to even other people.

Behavioral Economics is an extremely interesting field and gives us much insight into why people make the seemingly irrational decisions they do. What was ostensibly the rational way to do things, may not be as rational to us as we once thought. We want to minimize losses more than we want to maximize gains, we think that if we’ve spent money on something we should follow through with that thing, and when we think we have something, we value it higher than others will. Regardless, knowing that the reasons behind why we make the decisions we do is just as important if not substantially more important than the decisions themselves.

Are these concepts all common sense or rational? Let me know what you think in the comments of this blog, or on whatever social media you found it!