The Economic Theory of Relativity [Repost]

This is not a post about Einstein.

I briefly attempted to wiki Einstein’s General Theory; and realised, from the second line, that even the phrase “out of my depth” would be inappropriate – because it implies that I may have “some” depth when it comes to physics.

If anything, I have anti-depth.

We’re not rational

But yes – what this post is actually about is irrationality.

The “Rational Man” and the “Rational Investor” are the very foundation of traditional economic theory. They are the approximate assumption – meaning that even if we exhibit short-term irrationality, we are rational over time. And also, if we’re not rational by choice, then we’re made rational by force – because the rest of the market will sweep in and persuade us otherwise, or dwarf us into becoming insignificant outliers.

I present these:

Most of us have seen these and know that the orange ball, the line and the monster are all the same size.

But if you’re honest, when you say “I know they’re the same size“, what you actually mean is “My eyes are telling me otherwise, but I’ve been told that they’re the same size so I have to believe it even though I can’t see it.”

And we should probably all stop for a moment and reflect on that, because:

If a simple optical illusion can continue to cause consternation even when we know that it’s just an illusion (ie. knowing that it’s an optical illusion doesn’t mean that we see clearly once it’s been pointed out),
And optical illusions are just tricks played by the brain,
And rationality is dependent on the brain’s ability to “see” clearly,
Then is it such a leap to suggest that irrationality, or logic blindness, might be the long-term status quo?

Irrationality Number 1: Our Truth Is Always Relative

Obviously, you get the hipsters that sit around and swill cheap brandy while reflecting on the vagaries of life and the subjectivity of truth. But deep down, for most of us, truth is absolute. Or, at least, we believe it is. Truth such as “I like ribs” and “Taxi drivers are malicious and selfish on the road” and “You’re an idiot”.

In relative reality, however:

You’ll only like ribs that are cooked properly in a nice basting sauce and provided that you’re hungry and not ill. Take away any of those, and you don’t like ribs (although it’s usually phrased: “Oh no – I just don’t like those ribs”).
Taxi drivers are carrying twenty to thirty people in their minibus, all trying to get to work. If they cut you off, and you end up a few minutes late, then that’s one person late for 30 that are on time. Sounds like a moral imperative to me… Also – if you were a taxi driver, and you drove all day every day, then I think you too would feel some ownership over the roads and resentment toward the thousands of amateur non-working drivers that suddenly emerged onto the road for an hour in the mornings and an hour in the evenings, ruining your peak work time, costing you money, and arrogantly assuming that they should have full right of way over you in your work place.
You’re probably not an idiot. “Idiots”, being a not-very-nice-name for the intellectually-disabled, are biologically incapable of operating at a certain level of thought. You were likely just distracted from the very important task of meeting my expectations.

Because life operates in a relative way, we act in a relative way, and our choices are relative.

But because of above absolutist illusion/delusion (“I’m always rational!”), we believe that we’re making rational and absolute choices.

So Let Me Give You An Example Of A Study

Okay, but first, a confession: this post has been fully inspired by Chapter 1 of Dan Ariely’s book “Predictably Irrational”, which I’m about to plagiarise heavily.

Here’s the opener:

The Print subscription and the Print & Web subscription cost exactly the same price ($125). Which makes it seem pretty obvious that whatever you choose, you’re not going to choose the plain Print subscription, right?

Don’t worry – you’re not about to be surprised. When Mr Ariely handed the subscription out to 100 MIT students (fairly clever and presumably rational individuals), he had the following responses:

16 opted for the Web only subscription
0 opted for the Print only subscription
84 opted for the Print and Web subscription (get the Print subscription, and get the Web one free!).

So far, so rational.

Alright – so seeing as no one wanted the Print only subscription, then it should make no difference at all if it’s removed from the option list. I mean – we’re assuming rationality here. When you made the original decision, you were choosing between web and print editions. The whole bit about Print vs Print & Web is just saying that there was one print option better than the other.

So Dan removed the middle option from the advert, and handed it to another 100 MIT students. This time:

68 people opted for the Web only subscription.
32 people opted for the Print & Web subscription.

IRRATIONAL.

Why though?

Well here’s the theory:

The Economist subscription is asking us to make a choice between relative unknowns. We’ve never had a subscription to the Economist before, so we’re not sure what actually constitutes a good deal.
ie. is the Web subscription at $59 a better deal than a Print subscription at $125? I mean – how would we know that before we’ve tried out both?
But one thing is clear: a Print & Web subscription at $125 is definitely a better deal than a Print only subscription at $125.
And that immediately biases our decision-making in favour of the Print & Web subscription.
Such clever economists at The Economist.

How That Impacts Real Life

When I go out to eat, I usually forget to buy a bottle of wine before I head out. So I ask for the wine list. Here are my unspoken rules:

The most expensive wine is too expensive;
The cheapest wine is a bad one, and I don’t want to appear cheap; so
Let’s go with middle of the range.

My choice now has nothing to do with the wine in question, or the actual price itself. My choice is thoroughly defined by the price boundaries set by the restaurant owner. And I find myself buying a bottle of wine for $25 that I WOULD NEVER BUY NORMALLY because it costs $6 at the bottle store. But in the restaurant, it seems like a good deal*.
*Or, rather, the least bad of numerous bad deals.

And that irrationality is not just a once-off, it predictably happens every time I buy wine in a restaurant.

Restaurant owners know this.

It’s why you have cheap and expensive dishes and wines on the menu. The ones that the restauranteur want to sell – the ones with the thick profit margins – are always priced to be middle of the range.

And that’s just food!

The same theory can be (and is) applied by estate agents. If they know that you want to buy a two-bedroom place, maybe they’ll show you two apartments (one nice, one less nice) and a relatively cheap house (just to be sure that you’re looking at all the options).

Odds are: you’ll buy the nice apartment.

What To Do About It?

In order to avoid being screwed and/or manipulated by shrewed marketers (and the economists at the Economist), we need to:

Realise that we’re irrational;
Pay attention to those moments when we’re at our most irrational; and
Start questioning the decisions that take place in those moments before we let them be final.

And/or buy wine before you head out. And rent rather than buy.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.