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Behavioral Economics: The More We Learn, The Less We Seem To Know?

-- By MichaelDuignan - 06 Apr 2010

Rationality is v. Rationality does

Neoclassical economics has, over a half century, become a pillar of contemporary legal thought. As a positive system, it provides mathematical precision to legal theory. As a normative system, it shapes vast areas of law dealing with transaction and choice. Some wonder if its legal influence, however, has reached its zenith. As new tools enable researchers to learn more about the human brain and its cognitive limitations, some economists have begun to question certain assumptions about human nature that constitute its core. If a social theory is ultimately valued by the accuracy with which it exposes the impetuses behind human behavior, this essay considers just how these questions might affect the legal principles anchored to the neoclassical model.

Rational Choice Theory and the Law

The debate is loudest at U. of Chicago, with Richard Posner at the helm of the traditional law and economics movement, and Richard Thaler leading a mutiny in the developing field of behavioral economics (“developing,” because, as of yet, the field is without a formal theory). According to Posner, the full range of human psychology can be sufficiently explained within rational choice theory as is. Conversely, Thaler asserts certain peculiarities of human nature, though often predictable, lie outside the scope of the traditional model. Further, the more we learn that human decision-making processes differ from neoclassical presumptions, the less explanatory power of the traditional model retains.

The Hand formula

In the 1947 case of United States v. Carroll Towing Co., J. Learned Hand put forth his eponymous formula for negligence liability. Where the burden of avoiding harm is less than the probability of the harm times the loss associated with the harm (B < P x L), the defendant causing harm acts without requisite care. In that Hand introduced the idea of using a cost-benefit analysis to create a bright line rule of culpability within a tort claim, Carroll Towing represents prescient use of rational choice theory to aid in rendering consistent qualitative judgments in the law. Though the Hand formula was non-binding dicta, it retains analytical significance. It presumes people are capable of making rational decisions before they act.

Fellow Chicagoan Gary S. Becker in his 1976 essay The Economic Approach to Human Behavior said, “[A]ll human behavior can be viewed as involving participants who [1] maximize their utility [2] from a stable set of preferences and [3] accumulate an optimal amount of information and other inputs in a variety of markets.” (p. 14). Though generally accepted, the breadth of this rule has invited challenge ever since.

Reasonable persons, in spite of ourselves

Dan Ariely, author of Predictably Irrational, delightfully exposed the relativity of choice in a social experiment. A group of 100 college students were given an advert from The Economist magazine and asked to select one of three annual subscription options: print-only for $59, online-only for $125, or print-plus-online for $125. A small portion opted for the first, none for the second, and the overwhelming majority for the third, print-plus-online option. Then, Ariely asked another group of students the same question, only this time he removed the second online-only option that no one wanted. When deciding between print-only for $59 and print-plus-online for $125, the majority of students opted for the cheaper package.

The shift in students’ subscription choice undermines Becker’s assumption that people make decisions from “a stable set of preferences.” Ariely demonstrates that people’s preferences are not always fixed and absolute, but can be dynamic and relational to the environment in which choice is permitted to occur. According to Ariely, the way to get people to choose option A over option B is to add option A', a clearly less desirable alternative to option A, thereby increasing option A's relative attractiveness.

You don't have to twist my ARM to get be to buy

Unlike fixed-rate mortgages (FRMs), where monthly payments are constant, adjustable-rate mortgages (ARMs) permit monthly payments to vary based on a predetermined market rate that resets each year. Their meaningful difference comes down to which party bears the interest rate risk over the life of the loan: FRM lenders or ARM borrowers. In exchange, ARM borrowers pay a lower premium than FRM borrowers do.

Rational choice theory would expect utility-maximizing home buyers choosing between an FRM and an ARM to engage in a cost-benefit analysis that takes into account, all else equal: 1) their preference for risk, and 2) the current interest rate spread between FRMs and ARMs. But, under Ariely’s findings, how might the availability of a third mortgage option affect homebuyer preferences?

Hybrid ARMs function like a FRM at the outset of the loan, usually for 3, 5, 7 or 10 years, after which they convert to a traditional ARM, where rates float with the market. Introduced after traditional ARMs and having proven more popular with home buyers, what if the traditional ARM is the option A’ that boosts the relative appeal of the hybrid ARM? In this regard, traditional ARMs, which confer all interest rate risk to the borrower, would make hybrid ARMs, which confer some interest rate risk to the borrower, even more attractive to risk-averse borrowers by virtue of their relative comparison. And, if Ariely’s observation has any value in this unproven hypothetical, more borrowers might choose hybrid ARMs than would be the case if the traditional ARMs were no option at all.

General Implications for the Normative System

The more we as human beings come to understand ourselves and the way we function cognitively, the more we recognize rigid definitions of rationality do not comport with the world as it is. Behavioral economists will keep poking holes in rational choice theory so long as they cannot come up with a formal theory of their own. Neoclassical economists will continue to play Whac-A-Mole with behavioral economists by crafting clever ways to fit their debilitative findings into the confines of rational choice theory as it stands. This competition between the dominant intellectual regime and the experimental uprising will likely continue to frame the debate between libertarian and paternalistic regulatory approaches for some time to come.

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