Thinking Like an Economist: A Guide to Rational Decision Making
Thinking Like an Economist: A Guide to Rational Decision Making is on our May 2018 book club reading list. While it might not be so plausible to always think like an economist, knowing the tools to be able to think like one is obviously both interesting and beneficial. Randall Bartlett is a professor of economics. His book easily teaches lay person the main principles and concepts essential to the foundations of economical decision making.
Bartlett starts the book/lecture by introducing the six principles.
One. People respond to incentives. If you don’t like the examples of dogs reacting to food as incentives, the increases and reduction of taxes and jail time are typical incentives that people respond to in making their decision. It could also mean that lectures generally don’t count as effective parenting tools, and child abusing has far more psychological and behavior influences.
Two. There is no such thing as free lunch in this world of scarcity. The world is ever changing, and most likely a particular opportunity knocks but once. When you concentrate on something else, like to get a free lunch, this particular opportunity is forever lost. The underlying theory is that time and chance are scarce. Unfortunately, not many people are aware of that, and waste a big chunk of life on things of very low priority that neither derive achievements nor happiness. The Road Less Travelled is a beautiful poet as it elicits a feeling of lost chance. This is the literature example of opportunity cost. You can’t step into the same river twice. This saying is but a philosophical expression of the economical principle of opportunity cost. So next time you see someone interrupts others’ endless small talks and left abruptly, don’t judge him as impolite. Maybe he just deeply understands that time is so scarce. Maybe his alternative way of spending the same time could be more constructive and awarding.
Three. Nothing is just one thing; there are always at least two sides to every interaction. You spend money, another person makes money. In China, there is this ancient saying “A person in Chu Lost a bow. Another person in Chu gets a bow” （楚人失弓，楚人得之）. Interestingly it is against traditional Chinese thinking that thrift is a virtue and spending is a waste.
Four and five. The law of unanticipated influences and unanticipated consequences. It’s called butterfly effect, meaning one matter could have very reaching effects on unforeseeable people far away. Unanticipated consequences could mean that good intentions have totally surprising bad consequences beyond foreseeability. This reminds me of the Chinese story of Sai Weng who lost his horse（塞翁失馬焉知非福）. Sometimes misfortune is a blessing in disguise However, this story has its limits, as it fails to considers the unforeseeable effects on people at large. Interestingly, the Chinese literature and philosophy usually shows a predictable preaching style, with causations shown as very direct and obvious. They somehow manage to have failed in showing that they could fail, to anticipate that quite often something is un-anticipable, to foresee that it is not usually foreseeable. In summary, they fail to see its limit as they are not aware of their limits.
Six. No one can be in absolute control. Adding the above five principles we could see that our knowledge is nothing but limited and the causation and reactions are too complicated. It also means that economists recognize that their tools are limited and all theories have major limitations.
Bartlett then explains three core concepts, i.e., rationality, marginal analysis and optimization. Basically, these three concepts mean that rational people, before making a decision, will gather information, calculate the opportunity costs, and make the decision that gets the highest net payoff. An example of marginal analysis is that when a child already has three teddy bears, the next teddy bears he receives will not give him the same satisfaction and happiness as the first ones he gets.
Marginal analysis is an analysis of value. The highest net payoff is also about value. However, there is no absolute value as to anything. True value is a myth. Value is a personal thing, it is constantly changing when the marginal value to a specific person’s unique circumstances changes all the time. One easy example is that a person in the desert is willing to pay so much more for a cup of water than a person sitting in his home. Is a kiss still a kiss in Casablanca? It all depends. Communicating and negotiations, economists believe, will lead to the best resource ending up in people most need it, who value it most.
Then Bartlett goes on to examine the limitations of the efforts to make best choices through communications and negotiations. There are time, resource and other costs associated with gathering information and conducting negotiations, which are called transaction costs. Time is limited and the marginal value of gathering more information and conducting more negotiations are decreasing. No one is in absolute control.
The prisoner’s theory is an example of failed optimization. What makes sense to each individually, however, could lead to a disaster to all when the flow of information and negotiations are not possible. This happens a lot to China when factories pour polluted water into the river to reduce their own costs while creating an environmental disaster. It happens because the polluters are neither penalized by law nor paid the actual costs of pollutions. The market gives the polluters incentives to pollute.
Experiments show that if we take many independent estimates and average them, they can yield information better than any one participant can generate. With that, economists prescribe that market provides an inexpensive, accurate, and valuable way to take a lot of information. To individuals, the prescription is slightly different. If the stakes are high and wrong decision is costly, individuals should invest more to gather information and turn to expert to reduce the cost of ignorance, while bearing in mind the conflict of interests and information asymmetry.
Bartlett emphasizes the time value of money in a whole lecture. Similarly, when drafting contract there is usually a term called “Time is of essence to this contract”. Failing to finish a duty on time is material breach of contract.
Bartlett goes on the examine the reasons people have irrational behaviors. Using the example of purchasing extended warranty, he sees through it that the company selling the warranty, like selling insurance, as a business, would always make money. However, even rational people would want to feel safe, especially risk averse people.
People could also act not so rationally when the feeling of fair or other emotions are invoked. That’s why a person would be willing to accept five dollars with no string attached but might refuse to accept the same five dollars when he knows that the other person had opted to get ninety-five dollars out of one hundred, leaving him only five dollars. The price of feeling fair is an interesting phenomenon, and it greatly increases the transaction costs when people act irrationally.
Endowment effect is another interesting factor that influences people’s behavior in a way seemed not so rational. Once the grass is mine, it is greener than others. People will charge a much higher amount of money to be willing to lose or sell something they already own, than the amount of money to acquire them. There is a Chinese saying 敝帚自珍，a person cherishes something as little value as his worn broom simply because it is his own.
Another psychological way of twisting the value is the status quo effect. Once people had made a decision, they rationalize their choices and stick with it. It’s then quite difficult to get them to change the habit. Bartlett then invites people to the idea of proactively change their own incentives by reaching into agreements with partners, so that better behaviors, like more exercises, could be acquired.
May 27, 2018