Cognitive Biases and Rational Behavior

By Dr. Hassan Shirvani—As you might have heard, the 2017 Nobel Prize in Economics was awarded to Richard Thaler for his pioneering work in the field of behavioral economics, a school of thought dedicated to the application of psychology to economics.  The main point of this school is that humans are subject to too many cognitive biases or suffer from too many personal flaws to be capable of making rational judgments.  As a result, there is a need for various remedial private and public “nudges” to steer them towards their correct decisions.  The fact that the adoption of many of these nudges may interfere with the sacrosanct principle of the freedom of individual choice so dear to many modern economists seems to have been largely ignored.  Equally ignored has been the danger that some of these nudges may be used by some businesses and governments not to help consumers but rather to further their own narrower and more self-serving ends.

 

Irrational Behavior?

To many critics, much of the so-called irrational behavior underlined by behavioral economists is nothing more than rational responses to situations characterized by less than full information.  That is why many consumers with insufficient knowledge about the qualities of the products they are interested in simply follow the herd and purchase the most popular brands.  Still, these critics must entertain the possibility that, as emphasized by behavioral economists, many economic agents are in fact plagued by a host of ingrained cognitive deficiencies which can result in questionable economic decisions.  To resolve this issue, it is therefore incumbent upon behavioral economists to support their assertions of irrational individual behavior through satisfactory explanations of the reasons behind such behavior.  Otherwise, it will be difficult to pass judgment on whether humans do indeed make decisions that can only harm their own best interests.

 

Cognitive Biases

Unfortunately, behavioral economists have generally failed to provide such support.  Following the lead of psychologists, many behavioral economists have only managed to offer a long list of tautological labelings of different personality types.  For example, an impatient (present-biased) individual is said to place greater emphasis on immediate gratification, while an individual with this characteristic is then termed impatient.  This is, of course, similar to psychologists defining, say, a pessimist as someone who always expects the worst, and then characterize someone with this trait as a pessimist.  Such circular classifications of the sets of observed behaviors clearly fail to provide any real insights into what makes humans behave the ways they do.  The case of psychology providing guidelines to economics is, therefore, not unlike the case of the blind leading the blind.

 

The Linda Problem

To make the preceding point more clearly, follow this link to a list of some 150 different types of cognitive biases defined by psychologists, many of which have been regularly applied by behavioral economists to account for “anomalous” economic and financial behaviors.  Some of these biases are frankly too ridiculous to be taken seriously.  However, even if legitimate, most can be easily justified on rational grounds.  To cite just one example, consider the so-called Linda Problem, popularized by psychologists to illustrate the prevalence of cognitive errors.  Suppose Linda is a young college graduate who is very bright, conscientious, and highly active in social causes.  Given this information, the question is then raised as which of the following is more likely:

1) Linda is a bank teller, and

2) Linda is both a bank teller and a feminist.

 

On purely statistical grounds, clearly the first option is more likely, simply because it is less restrictive.  After all, not all bank tellers are necessarily feminists.  Despite this fact, most people consider the second option as more likely, indicating that they presumably suffer from erroneous judgments.  However, as some critics such as Berit Brogaard have observed, this answer is not necessarily wrong, if we consider the fact that humans have the valuable skill of reading between the lines of any semantically straightforward question.  That is why when we are asked if we have already had lunch, we know immediately that the reference is to today’s lunch rather than yesterday’s.  Likewise, most respondents to the Linda question are really trying to see which of the following two options is more likely:

1) Linda is a bank teller only and not a feminist, and

2) Linda is both a bank teller and a feminist.

 

Given her background, it is only natural that most will choose the second option.

In addition, even if present, there is no evidence to indicate that such biases will necessarily prevent their holders from achieving their best possible results.  After all, if it were true that, say, impatient persons generally made poorer investors, or pessimists poorer spouses, then we should have found disproportionately more of the former broke and more of the latter divorced.  In reality, of course, I am not aware of any serious research which conclusively tends to support any of these conjectures.

 

Conclusion

Instead of wasting their times on such obsessive banalities as how psychological glitches influence human economic and financial behaviors, may be it is high time for economists to delve more deeply into the dynamics of market forces and their associated institutional changes that truly drive most modern economies.  In the process, they may be able to find more effective fixes for such important and seemingly intractable issues as lack of economic and financial transparency, increasing financial fragility due to excessive leverage and risk-taking, rising inequality, deteriorating healthcare and educational affordability, growing protectionism, and intensifying immigration and climate change challenges.  Put differently, behavioral economists must be careful not to mistake the individual trees for the forest.  Otherwise, the growing global populist revolts against what is perceived to be the failures of the stewards of society and their economic advisors to exercise more effectively their economic and social responsibilities can only darken the future prospects for all of us.

 

Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics

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