Irrationality

One assumption that economic theorists have been weirdly fond of is the idea that as consumers, and investors, people are "rational actors." We'll put the investor aside for the time being and just consider ourselves as consumers -- people who buy stuff with money. (We also consume a lot that we don't pay for but that's for another day.)

 

The idea of rationality in this context means, first of all, that our desires for goods and services that might be on sale are quantifiable in units called utiles, an idea which has always been kind of vague, but basically it means that I can say that three tomatoes right now will give me as much satisfaction as one carrot, and a dinner at Delmonicos is worth as much to me as 167 tomatoes, or something like that. Supposedly we go through life weighing up all of these possible utiles and allocating our spending so as to give ourselves the highest possible amount of utility.*

 

It shouldn't take a lot of deep thought to see that this is essentially absurd. For one thing, our instinctual mathematics isn't good enough. We overly discount the future, we commit gambler's fallacies. Notably, we pay much more attention to the percentage of the price of an item than to the absolute price. People will go out of their way to save 10 cents on a gallon gas, i.e. less than two bucks on a fill up. But they pay little attention to a price difference of $2,000 between two new cars, or $10,000 or $20,000 on a house. Obviously, I could fill up a thousand times at the more expensive gas station if I bought the cheaper car, but I just don't think about it as hard.

Also, we just don't know ourselves very well. We think we'll really enjoy some new trinket or toy, we get it home, and it just doesn't interest us after all and it goes into the closet. We are swayed by advertising, and fashion, and our peers. And basically, trying to figure out how to allocate our money to maximize our utility is just too much work. We can't be bothered. We buy on impulse, as merchants well know. Where products are placed on the shelf has a big effect on how well they sell. I could go on about this for a long time but you get the idea. This isn't actually the most important reason that Economics 101 is bullshit, but once you pull one string, the whole thing starts to unravel. As we shall see.

*The famous economist Mancur Olson used this theory to write a book, The Logic of Collective Action: Public Goods and the Theory of Groups, in which he used calculus to prove that many of the most notable events in human history were impossible. These would include, for example, the French and Chinese revolutions, most wars, democratic elections . . . A lot of people like this book.