Experimental economics

“A science that claims to interpret demand fails every time it explains consumer behaviour as irrational”

Douglas, M., and Isherwood, B., 1979, The World of Goods (1996, Routledge, p.xvi)

The danger of trying to eradicate any and all behavioural anomalies is that we might be underestimating the evolutionary reasons for why they might exist.

Consider the basic insight of prospect theory – that we care more about losses than gains. This makes perfect sense when you consider that organisms are more likely to survive if they treat threats as more urgent than opportunities.

“I don’t like giving something up unless I know its value.”

Bill Buchanan, 24

And even when we consider each anomaly in isolation, they may not be so foolish. In an episode of 24, Bill Buchanan, the head of the fictional Counter Terrorism Unit (CTU), was being asked to hand over a prisoner. His colleagues didn’t believe the prisoner was of value, and were happy to comply. But Buchanan was reluctant. He said, “I don’t like giving something up unless I know its value.”

When put in these terms, maybe the ownership bias doesn’t seem so irrational. I once caught a bus to Golders Green and needed to find the underground station. Since I didn’t have a map I decided to follow where the majority of the passengers were going. In some circumstances, following the crowd (i.e. herding) is a sensible strategy.

Entrepreneurs are renowned for having more confidence in their abilities than objective data may suggest, and without them we’d have no innovation. Indeed Daniel Kahneman refers to over- confidence as “the engine of capitalism”.

According to The Economist, “inventors and entrepreneurs must often ignore legions of naysayers. That requires self-belief that borders on self-delusion.” But of course the selection bias means that we tend to only see successful entrepreneurs, for whom the self-belief turned out to be valid. What we don’t see is the millions of failures, who failed because of their overconfidence.

Most of the anomalies we’ve looked at are “discovered” in an isolated laboratory setting. Many of these studies have small sample sizes and cannot be replicated. This has led to serious doubts being cast on the validity of the findings, especially since some of the early work on psychological framing effects (i.e. “priming”) turns out to have been fraudulent. The Economist says:

“Over the past few years various researchers have made systematic attempts to replicate some of the more widely cited priming experiments. Many of these replications have failed.”

Trouble at the lab. The Economist, 19 October 2013

Tests for behavioural anomalies more generally are undoubtedly interesting studies, but perhaps they are trivial. Maybe we only really teach them because they are fun, and engaging.

The problem with this is that it can ignore the extent to which (i) in the real world different anomalies can offset each other; (ii) in the real world we have institutions to help us. As John Kay has argued,

“the Wason test is a meaningless card game used by experimental psychologists. Most participants fluff it when it is simply presented as a card game. Faced with the same problem in a practical, social context, most people master it easily.”

John Kay

[I]t might be “costly” to have self-consistent preferences. The design of the human mind entails complex trade-offs. Survival often requires us to make quick decisions without complete knowledge of the problem. The mind is presumably optimized for mostly accurate hunches and an improvisatory approach that constructs desires and beliefs on the fly.

William Poundstone

Ultimately we should seek to understand our decision-making process and decide if the biases and heuristics that are inevitably used are a help or a hindrance. Perhaps they served us well in an evolutionary sense, but the question is whether we expect them to still be applicable in a modern context. Things like the reflection effect and the certainty effect are not examples of irrational behaviour – they are part of a richer model of how humans actually behave.

Daniel Kahneman won the Nobel prize in 2002, but so did Vernon Smith. Here’s his Nobel lecture, where he makes a distinction between constructivist and ecological rationality. You don’t need to watch the whole thing, but you should!