As a follow-up to my last blog about General Motors, I wanted to add some thoughts about economics in general. This is not because I know all that much about the subject, but because recent events have forced us all to question the part economic theory plays in our lives, and whether or not it makes sense. A recent BBC documentary by Adam Curtis called “The Trap”, for instance, pointed out that particularly since the Reagan presidency, a notion has taken root suggesting that political solutions by governments are no longer necessary; just let the genius of the free market determine everything. This would mean, assuming it were fully implemented, the dominance of corporations and those who head them—something which, up until a year or two ago, essentially prevailed. Money and markets and the lobbyists for both have been all-pervasive and all-powerful in determining not just who gets elected, but how lives are lived, how products are grown, mined, produced, marketed, and disposed of, and how the planet is managed. The result has been a growing sense of things out of control, of imbalance, exploitation, looming catastrophe.
The heart of this idea to “let markets and economists run things” lies in the standard economic model that assumes that humans who make economic decisions are rational actors. This model runs on the notion that we know all the relevant information about the decisions we make, that we can figure the value of different options, and that we can intelligently weigh the implications and results of each of our choices. It is on the basis of such assumptions that economists draw conclusions about consumer trends, laws that govern economic behavior (and by implication, all behavior), and policies made by governments. A recent book by behavioral economist Dan Ariely, “Predictably Irrational” (HarperCollins: 2008), provides evidence that such assumptions are false. Even the law of supply and demand, Ariely maintains, is false, because “what consumers are willing to pay can easily be manipulated, and this means that consumers don’t in fact have a good handle on their own preferences and the prices they are willing to pay for different goods and experiences.” Ariely describes some of his own experiments to prove this.
Take the “decoy effect.” Marketers have learned to always include a high-priced decoy offer in the range of choices they make available to consumers. This is designed to get the customer to choose what appears to be the “cheaper” option, when, in reality, it’s the choice the marketer wanted him to make in the first place. Ariely cites as an example an offer to buy the Economist magazine. Consumers are offered three “choices”: a) an internet-only subscription for $59; b) a print-only subscription for $125; c ) a print-and-internet subscription for $125. Most people go for the $125 offer that gives them both print and internet (it seems like a bargain—nevermind whether it’s needed or not—compared to the $125 for the print-only option.) The con is revealed when the $125 print-only option (the decoy) is eliminated; in this case, fewer take the print-and-interent option at $125, and more choose the internet-only offer at $59. Why? Because there is no “decoy” to persuade them of the “good deal” they’re getting. This same decoy effect can be observed again and again.
Ariely explains this via his concept of “arbitrary coherence.” The idea is simple: the initial price we are willing to pay for an item is in large part arbitrary. But once that price is fixed in our minds, it will determine not just how much we’ll pay for that item today, but also in the future. That is, the price becomes a coherent standard, or anchor. Even more astonishing, experiments show that just getting subjects to think of a high number (as for instance, asking them to write their social security number) “establishes a median price in their minds.” Then when asked how much they’d pay for a bottle of wine, those with higher social security numbers were willing to pay more than those with lower social security numbers! The completely irrelevant social security number became the “anchor” for what people were willing to pay. Ariely’s conclusion: most of have no idea what most things are worth, so we depend on some “anchor” to guide us. And who usually provides the anchor? You guessed it: the one trying to sell us the goods.
Ariely then makes his astonishing claim: the hallowed law of supply and demand, which says that the supply of a thing measured against how many people want it (demand) determines prices, is false. In the real world, anchoring (the price we use as a standard of a thing’s worth) is manipulated by the marketer: manufacturer’s suggested retail price, advertised prices, promotions, product introductions, and so on. “Instead of consumers’ willingness to pay influencing market prices (demand), the causality is somewhat reversed and it is market prices themselves that influence consumers’ willingness to pay.” One can test this with gasoline prices: a few years ago, paying $2 per gallon seemed outrageous. Last year, with prices steadily increasing, most of us found ourselves lining up if a station advertised unleaded at $3.75 a gallon, and thinking it was a bargain!
Ariely also investigates the influence of belief on our willingness to pay. For example, if a pain reliever called “Veladone” (really Vitamin C) is priced at $2.50 per pill, subjects who receive an electric shock report considerable pain relief from the pill. But if the “Veladone” is priced at 10 cents a pill, only half the patients report relief. The “placebo effect” is the common name for the mechanism at work here. The idea is that in experiments, a certain percentage of subjects are given placebos—useless pills, often sugar. Yet many of those given sugar pills heal just as well as those given the real medicine. Ariely cites a 1993 study showing that even in surgeries like arthroscopic knee surgery, the placebo had its effect: of 180 patients with osteoarthritis, the placebo group (no surgery) got equal relief from pain and the ability to walk as those who got the actual surgery. One of the study’s authors, Dr. Nelda Wray, questioned “whether the $1 billion spent on these procedures might be put to better use.” According to Ariely, two mechanisms are at work in placebos: 1) belief, i.e. our confidence in the drug or doctor; 2) conditioning, the expectancy built up in the body after repeat experience, which releases chemicals to prepare us for the future (this latter is a bit like the saliva released in Pavlov’s dogs by a bell announcing food).
Ariely concludes: “we are all far less rational in our decision-making than standard economic theory assumes. Our irrational behaviors are neither random nor senseless—they are systematic and predictable. We all make the same types of mistakes over and over, because of the basic wiring of our brains.”
It is interesting to note, incidentally, that John Nash (of “A Beautiful Mind” fame), the man who invented game theory (one of the most highly respected economic theories of recent years, based in rational decision-making) did so when he was a paranoid schizophrenic. As a coda to this debunking, it is interesting to note that the only people who have been found to consistently make rational economic decisions are economists themselves, and schizophrenics. And lest we are inclined to wish that somehow we could all become as rational as Spock, it might be well to remember what brain researcher Antonio Damasio has found: our emotions are necessary for decision-making. Patients with brain damage that incapacitates their emotions but leaves their reasoning ability intact find it impossible to make decisions.
In sum, we would all do well to understand both how our own economic decisions are made, and what clever hucksters do to influence them. What Ernest Hemingway once said about the necessary equipment for a writer is equally applicable to any potential consumer: come equipped with a 100% built-in shit detector.