A Basic Economic Illustration
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Economics has a giant problem. It models the world as it should be not how it is, and while instructive, is very often wrong. This is because it models a world in which everyone acts rationally, or at least with rational self interest.
You don’t need to be a PhD Rocket-Surgeon-Genius to know that this is most definitely not the case. It’s remained a constant thorn in general economics for a long time, until the best ideas from another social science was brought into the study of this “dismal” social science. Psychology.
Behavioral economics, far from modifying economic models, set about showing that people are fundamentally irrational, and tried to learn why. This means, with all the best plans laid, economists can diagnose problems with their predictions and implementers can find ways to perhaps induce desired behavior.
If you take a basic behavioral economics course, there’s a simple case used to begin to illustrate how irrational people can be. Or rather, the split between the perfect rationalist response, and the typical human response. My last post about Sunk Costs reminded me of this.
Two Choices
Imagine you discover a burger place near you. In-n-out Burger perhaps. They have the best burger you have ever eaten in your life. It is your favorite, and it costs $10. One day you discover there’s another burger joint five minutes away.
Just five minutes from In-n-Out Burger is Good Burger, home of the good burger. Turns out this burger tastes just as fantastic. In fact, it’s the same recipe except it only costs $5. The same fantastic recipe, taste, and quality at HALF the price and just five minutes away. Is it worth it?
The answer is yes. Of course it’s worth it. Just five extra minutes and I can get this amazing burger at half the price. Why on earth wouldn’t I do it? If it was across town, half an hour or an hour away, that’s a different story, but just five minutes? That’s close enough to not be a burden for, and I repeat, HALF OFF.
Now imagine you have to buy a new TV. You can purchase this TV for $1,000 at a particular store. However, if you go to another store that is 5 minutes away from this one, you can get it at $995. Is that extra trip worth the “discount?”
To most people, the answer of course, is no. Clearly no. Adding five minutes to your trip for just 0.5% discount is stupid. I mean, with the first example, by traveling just five extra minutes, you get to save $5. But in the TV case, by traveling an extra five minutes, you only get to save $5… wait…
Economic Rationalists
So what happened here? To an economic rationalist, if adding five extra minutes to your trip to save $5 is worth it in one situation, then it is worth it in just about every situation. That’s still five extra dollars in your pocket for just adding five minutes to your trip regardless. To a pure rationalist, both situations would be literally equally worth it.
This is the answer or the world that economic theory assumes exists. And this is the reason a lot of economic theories fail. Because this is clearly not what happens. Humans, beautifully though shoddily engineered as we are, are full of bad code in the form of biases and fallacies and intellectual blind spots.
We may rationally understand that $5 savings for five extra minutes to the trip are worth it, but with the more expensive TV scenario, it simply doesn’t feel like it. In fact, the more expensive the item, the less that $5 feels worth it. The $5 doesn’t actually change in physical value.
*incidentally, this is why the question “is it worth it for Bill Gates to pick up a penny?” is sort of weird. Yes it is. Unless the act of him picking up the penny restricted him from making his regular money in the usual ways. But if that’s still happening regardless, a penny is still a penny. That is, a penny is worth more than no-penny. A penny is literally worth one penny more than zero pennies. That’s a 100% increase in pennies currently in my hand, acquired without cost. I can’t retire with it, but that’s still one penny more than I had a moment ago.
A more interesting question than “Should he?” is “Would he?” I think we can all agree that would be a pretty solid “lolno.”*
This is one of the earliest types of illustrations used to show that people behave irrationally in economic terms. Being rational isn’t always easy. It often requires us to think and act in counterintuitive ways. We can probably blame evolution for that, but that’s beyond this topic.
I just wanted to show a basic illustration. There are many like it. In fact, you sometimes start feeling like “okay, fine, we’re all stupid and we’re garbage. How do we fix this?” I’ve just gotten in the habit of starting from the standpoint that, I’m really not smart at all and everything I think is wrong. It’s just easier that way.
In fact, it might be worthwhile to talk about “the fallacy fallacy,” “the Wikipedia/Search effect,” and the value of skeptical empiricism. If I ever get around to it (I also start from the standpoint that I’m lazy :) ).
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