Why Economists Fail to Make ‘Rational’ Judgments and Why You Should Too

opportunity-cost

Recently Cameron Murray directed me to an interesting paper entitled Do Economists Recognize an Opportunity Cost When They See One? A Dismal Performance from the Dismal Science. The paper surveyed a whole bunch of professional economists to see if they could answer a basic question on the microeconomic theory of the ‘opportunity cost’.

The results were not so good. They are laid out in the table below — note that there is only one correct answer!

oppcostresults

Most of the profession viewed this as some sort of failure of economic education. So too did Murray on his blog. But I’d like to put forward a different interpretation: what if the entire technical idea of opportunity cost is a load of rubbish?

What do I mean? Well, in order to get where I’m coming from take a look at the question that was asked.

oppcostQQQ

The correct answer is B, by the way. This is because we have to take the subjective value of the Dylan ticket into account, that is $50, and then subtract from it the actual cost of the Dylan ticket, that is $40.

This, as we shall see, is a very particular way of measuring worth. Indeed, it is little more than an accounting trick based on a priori definitions (opportunity cost = potential utility – actual cost) that tells me nothing of substance about the subjective valuation. I can just as easily come up with a new accounting definition; this is entirely arbitrary.

So why do I say that the results prove the theory to be garbage? Well, because each question got somewhere around a 25% response rate. They seem to be, as the paper notes, basically randomly distributed.

And why does this imply that the theory is garbage? Because in microeconomic theory people are supposed to maximise their subjective utility. In order to do so they obviously have to be able to calculate the opportunity cost of forgone purchases. But if economists cannot even do this then why would we expect anyone else to do it?

Let’s go one further. Let’s assume that all of the economists had a vague notion that opportunity cost meant “amount of utility forgone in order to gain another amount of utility”. Then we can also infer that all the economists had different subjective conceptions of how much utility they were forgoing in order to go to the Clapton concert.

This is not actually unreasonable. I can see how people could view this in different ways. I could say, for example, “well the Dylan ticket is worth $50 to me, so I’m giving up $50 worth of utility to go to the Clapton concert”. Indeed, according to the responses this seems to be what most of the economists thought.

Alternatively, I could say to myself, “well, I prefer Clapton to Dylan so I’m not really giving up any utility at all because I don’t care much about counterfactuals or alternative universes”, in which case I would choose answer A. This all depends on how I view placing worth in something which ties back to the idea I put forward earlier that the a priori accounting definition underlying the question is arbitrary.

While only one answer is correct given the definitions laid down in microeconomic theory, this does not mean that any of the choices made by the economists when they placed themselves in the subjective position of the concert goer was incorrect. They simply manifest different manners in which different people order their preferences.

The way that I order my preferences or you order your preferences is not subject to objective judgment. If I choose to view the Dylan ticket as being worth $50 and hence that I am forgoing $50 worth of enjoyment to attend the Clapton concert that is my business, not your’s. (I can even make a pseudo-sophisticated argument based on the fact that I have very limited time and that carrying an extra $40 in cash with me to the Clapton concert does not yield me any utility at all).

This ties back to the tone of the paper. The tone fits into what I have said before about marginalist microeconomics being a manifestation of normative ethics. You can see that the authors of the paper are chastising the economists for not… choosing as economists should choose. This implies that their training should have made them choose in a predetermined manner.

The point is that the idea of opportunity cost is counter-intuitive to how many people (apparently 78% of economists!) actually think when they are weighing up their subjective preferences. This casts serious doubt on whether any theory of behavior based on it is useful for describing the real world. What’s more, trying to subject people to a normative view of how they should view this is an act in moral indoctrination. It has little to do with economics in any sense I understand that word.

About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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46 Responses to Why Economists Fail to Make ‘Rational’ Judgments and Why You Should Too

  1. GermanAngst says:

    I think that’s true for a lot of Behavioral Finance/Economic models. They always assume one rational and correct answer. Everything else that causes a deviation must be irrational. If you introduce emotions or different heuristics into the models, they are therefore always the cause for unreasonable decisions. But neuroscience, sociology, psychology and philosophy all make the case that emotions are in fact necessary for “rational” decisions. It feels like a never ending story: to account for the deviation they endogenize it, so that in the long-run it fits with the already assumed model.

    • Exactly. That’s why I keep insisting that its a normative or ethical doctrine. The High Priest of utility theory hands down the “correct” answer — which is arbitrary and based on a priori accounting norms (it is ‘baked into’ the structure of the discourse) — and then if you don’t view yourself as acting in line with this “correct” answer then you are “wrong” in some pseudo-objective but entirely arbitrary sense.

      • This is the point that was really driven home for me while reading Keen’s Debunking Economics.

        I’m also simultaneously studying to pass the Micro and Macro CLEP tests and I can’t help but laugh while reading Mankiw’s textbook. It becomes really bizarre to me when he starts discussing how economists are “objective” and that they do not make any ‘normative’ judgments. If I read in a chair I would have fallen outta the thing.

  2. Olle J. says:

    I’m not a trained economist but isn’t the question flawed? I do get the information that I can’t sell the Clapton-ticket but it doesn’t say what the utility of the Clapton concert is to me. The “correct” answer seems to imply that it’s $0, but that’s implicit. I guess I have to add “There’s no preference for or against Eric Clapton” in my list of implicit basic assumptions of neoclassical economics…

  3. Olle J.,
    AFAIK the question is fine. If we believe the strict economic definitions/concepts that are being used, we don’t need to know the utility of the Clapton concert in order to know the utility of the Dylan concert, and hence make the utility forgone vs utility gained comparison.

    Philip,
    This definition is only arbitrary in the sense that the whole conceptual apparatus of utility is arbitrary. One you take the idea of utility seriously, this is a precise result and not open to interpretation.

    Sure, in reality people don’t think as utility theory says. I agree wholeheartedly with that. But if economics is a useful and consistent ‘body of knowledge and concepts’, those at the peak of their profession should at the very least have a consistent understanding of core concepts.

    PS. Murray, not Murphy😉

    • NeilW says:

      “those at the peak of their profession should at the very least have a consistent understanding of core concepts.”

      Do all priests within a Church have the same notion of God and religion?

      After all priests generally have the advantage of having only one ‘instruction book’.

      Expecting people to come to the same conclusion is the same as expecting sodium to behave the same as potassium. And that’s because the mistake in analysis is to assume that sodium and potassium are the *same*, rather than merely *similar*.

    • GermanAngst says:

      It’s the sure-thing principle respectively independence axiom that makes it possible to ignore the clapton utility, right?

    • Cameron,

      Apologies on the name. I changed it. Regarding your first point I was quite clear on that and addressed it when I wrote,

      While only one answer is correct given the definitions laid down in microeconomic theory, this does not mean that any of the choices made by the economists when they placed themselves in the subjective position of the concert goer was incorrect.

      On the second point I also disagree. What if these economists did not specialise in utility theory? Indeed, what if they weren’t even microeconomists? Does a biochemist have to be an expert in analytical chemistry to be a qualified chemist? I would argue not.

      The tone of the paper is smarmy and reminds me of those awful smug micro lecturers who think that they are smarter than everyone else because they have access to some obscure Truth about human nature — one that they will let you access if you engage with their tedious problem sets.

      • “What if these economists did not specialise in utility theory? Indeed, what if they weren’t even microeconomists? Does a biochemist have to be an expert in analytical chemistry to be a qualified chemist? I would argue not.”

        This question is not one of expertise. To make a comparison, the biochemist should be able to identify a cell, or an atom, when given a basic example. This is not an advanced or specialised concept. They may not be able to off-the-cuff answer some advanced specialist question.

        I liken it to engineers have there own personal definitions of force, torque, frequency etc. The concepts are all arbitrary in the grand scheme, but because they all operate with a consistent definition it helps them coordinate to advance understanding.

    • Cameron,

      I’m sorry. I can’t buy into that. What you’re implying is that in order to be a competent mainstream economist — i.e. an economist that can tell the ‘cells’ or ‘atoms’ of their trade — you must fully understand a very technical definition of opportunity cost.

      I just don’t see that as valid. If we accept mainstream economics to be true (and you know this is a pure thought experiment because I loath it) but if you accept it to be true, then there is no reason that those in different spheres need be experts in other spheres. Different levels of aggregation — even in the wasteland that is mainstream economics — call forth different specialisations.

      Opportunity cost is not equivalent to atoms in that you don’t need to know it in detail to build a New Keynesian model (again, nonsense, but I’m playing Devil’s Advocate here). My overarching point is that there are FAR stronger criticisms. And that is what I’m trying to put forward above. Otherwise its just ego and bickering.

      • Larry Motuz says:

        Being ‘willing to pay’ and having the ‘ability to pay’ are different in practice. Micro-economics tends to assume that the ‘consumer’ in question is both ‘willing to pay’ and has the ‘ability to pay’ {i.e., an income endowment such that willing to pay or budget for the alternative in monetary units). Where the ability to pay is lacking, I’d argue that there is no ‘opportunity cost’ :: zero :: but a ‘pure’ gain equivalent in money value to $40. That’s because being able to afford :: the endowment :: cannot be assumed to be true of everyone all of the time.

        This doesn’t mean that I disagree, given the assumptions about consumer behavior. Where I disagree lies in the assumption that everyone has the ability to be such a consumer not matter whether they’d be willing to pay $50. if they could.

  4. Nick Edmonds says:

    I have no problem with the idea that people generally do not act as if they were using an opportunity cost measure. But the concept itself is still useful.

    Forget utility. Say the cash return from strategy D (seeing Dylan) is $50. Which strategy should you follow if the cash return from strategy C (seeing Clapton) is $20? What if it’s $5? What’s the break-even? It’s when the cash return is equal to the opportunity cost.

    People often make mistakes because they confuse accounting cost with opportunity cost. That’s why it’s a useful concept.

    • I don’t see it, Nick. There is no “correct” way to make the decision. People can choose to view the trade-off in any way they want. Insisting that there is a more “objective” way of choosing is an act of moral violence.

      • Nick Edmonds says:

        Phil,

        That may be true if you are talking about utility – a vague and problematic concept. But my point was that opportunity cost doesn’t have to have anything to do utility – it applies also to valuing choices expressed purely in $ terms. So the objective test is how do you make the most $.

        So let’s say you derive no utility from attending either Clapton or Dylan, but you get paid for attending. if you get paid $50 for attending Dylan, what is the minimum you need to be paid to attend Clapton to make it profitable to go to Clapton?

      • First of all, Nick, your first sentence reads “That may be true if you are talking about utility – a vague and problematic concept.”. This indicates that you are going to discuss this without referring to utility. You then bring in utility in your 2nd paragraph. You really can’t get away from this. It is key to the whole concept.

        Secondly, your example is not the one I dealt with in the piece. The one in the piece assumes that I order my preferences in the way that the theory assumes that I order my preferences and then implies that this is the correct way of ordering my preferences. It’s a big tautology.

      • Nick Edmonds says:

        OK. Fair point. That reference to utility in the 2nd paragraph was a bit misleading. But you can ignore it. If we are talking about profitability purely as $ in hand, which is what I meant, then it doesn’t matter what you believe about utility.

        I know I’m not necessarily commenting on your example, but I’m not trying to say that opportunity cost is useful in every case. I’m just saying that the concept is an extremely useful one – certainly in a commercial environment. I have had to go through extraordinarily convoluted explanations in the past to demonstrate to people why a particular course of action makes sense, when those that understand opportunity cost (which apparently is a minority of professional economists) get it very quickly.

      • Nick, I fully agree that used in a very general case the idea of opportunity cost is a good one. I use it often to mean something like “an opportunity lost if we take a given action”. That is a very general meaning and I think that it is good and I like it. It is when it is used in the above supposedly precise sense that it is rubbish and moral propaganda. In fact, the more I think about it the more I sympathise with the economists who got it wrong. They probably held the concept in the same very general sense that I do (and, I think, you do).

  5. philippe101 says:

    Philip,

    off topic,

    In his blog posts, Thomas Palley keeps saying that marginal productivity theory is nonsense, without explaining why. I want to ask him for an explanation, or links to relevant texts, but I can’t leave comments at his site for some reason. You have to log in and even though I have a wordpress account, his site won’t let me log in. Are you able to log in to his site? Also, do you know why “marginal productivity theory is nonsense”?

    • I would imagine because (a) Palley thinks that people don’t act in line with marginalist theory, (b) distribution is mainly based on relative bargaining power and (c) the results of the Cambridge Capital Controversies. Why don’t you email him?

      http://www.thomaspalley.com/?page_id=13

      • philippe101 says:

        Thanks.

        Do you know of any papers specifically about the marginal productivity theory of distribution, and why it’s flawed/wrong/nonsense?

      • Jeez Philippe… you’re talking about the Capital Controversies! I don’t even know where to start with that. I put some links out in this post. If you want a technical overview then Harcourt’s book. But please read my post on it. It might save you an awful lot of wasted energy.

        Also, my recent post on the general differences between the two approaches to income distribution is quite instructive in many regards… (I like to think!).

        You want my personal advice? Read up on this in depth for a week and then bin it. It’s not that relevant and the main proponents of the critique found far more salient criticisms after.

  6. ivansml says:

    Opportunity cost is simply a pedagogical device for teaching students that one should always consider costs and benefits relative to other alternatives, not in isolation. I don’t think that’s controversial – is there any school of thought denying it?

    There’s also a paper [1] arguing that the original question is ambiguous and other answers can be correct, depending on precise definition of the opportunity cost (but all definitions would lead to same decision, so that’s not a problem).

    [1] https://docs.google.com/document/d/1Nu0S7Q00TKqb3WuabCeP7WQKgkMhtIIZEelfR7fjq_Q/edit?hl=en_US&pli=1

    • Not really. If you want students to consider costs and benefits… tell them to consider the costs and consider the benefits. How they do this is really none of your business. It is when you tell them how to consider the costs and the benefits according to some arbitrary formula that you are engaged in a sort of moral propaganda.

      • ivansml says:

        So telling students that they should choose alternative for which (benefit – cost) is greatest is moral propaganda? Interesting.

      • Yes. You’re telling them how, in this example, they should value the lost Dylan concert in line with some crude and wholly arbitrary formula.

      • ivansml says:

        No, I’m telling students that they should go see Clapton IF their willingness to pay for Clapton is higher than 10$; otherwise, they should go see Dylan. What they will actually choose depends on their preferences. Opportunity cost is NOT a measure of value – it’s just a tool to compare different alternatives!

      • I don’t think you’re following the argument. In the example I laid out the preferences were clearly stated. The concert-goer preferred Clapton to Dylan. So, I couldn’t possibly be making the argument that marginalists are telling people what to prefer. (And did you honestly think that I believed this… come on!).

        What I am saying is that you are giving them the framework through which they are supposed to retrospectively value the concert they didn’t attend. What I call framework you call tool.

        Now, here’s what I’m saying very clearly: the tool itself is arbitrary and in giving it a veneer of objectivity you are engaged in moral propaganda.

      • ivansml says:

        And I don’t think you understand what opportunity cost is. First of all, OC can be defined regardless of actual preferences and choice (in the example, authors state that Dylan is “next-best” alternative, but that’s unnecessary, and needlessly confusing). OC of choice X is the highest net benefit from all choices other than X. Once we allow for expressing costs and benefits in monetary terms (which may be questionable, but you haven’t argued so), opportunity cost is merely one particular accounting measure, nothing more, and definitely not any expression of “retrospective value”. It’s arbitrary to the same extent that, for example, definition of company net worth is arbitrary.

      • Now you’re starting to get it. Yes, it is arbitrary in the same way that company net worth is arbitrary. I.e. it is, as I keep saying, an arbitrary accounting identity. Here’s the difference:

        When I define company net worth I am engaged in accounting.

        When I tell students to view their preferences through a predetermined framework I am doing moral philosophy (or propaganda as I like to say, because it’s moral philosophy that pretends not to be moral philosophy).

      • ivansml says:

        “When I tell students to view their preferences through a predetermined framework I am doing moral philosophy”

        That’s what you say. It’s also silly. By the same logic then, teaching students how to calculate net worth is also moral philosophy – net worth and other accounting definitions are a framework that organizes facts in purpose of profit and financial value maximization, so all accounting is in fact propaganda channeling Friedmanite view of firm’s objective.

      • I entirely agree. I’ve written a few things on that. I did a whole post on this here. This was also a point made by EF Schumacher quite consistently. And he knew a little bit about designing accounting systems given that he invented the modern system of clearing houses. Keynes was well aware of this too. Which is why the national accounts by default favour Keynesian interpretations.

        When we put accounting norms in place these shape society and change behaviors. The same is true, for example, when we put capital requirements in place against certain assets. (In fact, I had a 30min conversation about just this point with a very prominent regulator yesterday and this is exactly how he sees his job: the accounting and banking regulations are a means by which to influence behavior).

        I am fine with all this. A functioning society needs institutions. I am not some anarchist. But I draw the line at moral instruction on an individual level. That is not only slightly poisonous but completely backward. Microeconomics is the only discipline in modern universities that does this so forcefully. It has literally replaced religious instruction. But, as the above study shows: its not working; the sheep are straying from the flock. People just aren’t interested in that old time religion any more. Thank God for that!

    • GermanAngst says:

      maybe this example makes sense:
      it might be the right tool for an economist that has the time to think about this stuff, sits in the class room and sees some sense in it. Turn Clapton into Manchester United and Dylan into Liverpool FC to make it more extreme. A Liverpool fan wouldn’t even consider to go to a Manchester game. He is on his way to the stadium with his season ticket and has no opp costs. What makes the economist more rational than the football fan?

      • They’d just make some negative utility BS argument for that. Man U = negative utility etc.

        No, the key problem is that the structure of the whole thing is arbitrary. That is shown quite clearly by the fact that the results of the study are randomly distributed.

      • GermanAngst says:

        Yes it is. Maybe it’s a bad example but I just want to highlight that there are different ways to reason and that the one for the economist is in some way typical for what they are in comparison to the other people. I am thinking about something like Bourdieus habitus theory. Only an economist who studied at an university will think about it in this way and claim that it is an useful tool to compare different alternatives while in a particualr praxis it is not.

      • It’s just arbitrary. I could change the accounting relationship. Formalise it. Call it something different. And teach it in classrooms. The formalisation gives it an air of objectivity. But its not.

  7. GermanAngst says:

    You could do that as long as you are in the position to teach a class. The formalisation and your position make it happen that it gets more objective for the real world. Not for the economic real world but the academic world. Some people could start calling you a crank b/c you are not in line with the rules of the academic world.

  8. Be A Debaser says:

    I love Dylan. But clearly the person posing the question hasn’t seen him live!
    Jesus, you’d have to pay me the $50 to sit through another of his “concerts”.😉

  9. Kris says:

    I think the opportunity cost concept is too simplistic compared to how people actually make decisions. It ought to calculate the net opportunity costs of both potential decisions (EC vs D) under different frameworks and then compare them. So, if the benefit to me of seeing Eric Clapton (EC) is the same as the benefit of seeing Dylan, then the net benefit of seeing EC = +50(EC) – 50(D)+40(saved)=+40. If I see Dylan instead under that condition (that EC=D), then the net benefit = -50(EC)+50(D)-40(cost of D)= -40.

    On the other hand, if EC>D I would always choose EC since I’d save the $40. But if EC<D, it would depend: if EC<10, then I would choose D, but if 10<EC<50, I would choose EC.

    I don't think it makes sense to regard EC as a sunk cost since I've not yet enjoyed the benefit.

    I also think there are limits outside of which this rationale would not work, or at least not continue to work linearly. At some level of cost I'd start to wonder if seeing any concert were wort that much money, or if I ought to set aside that portion of my income for entertainment. One thing economists often do with models is to assume that what is true at one point remains true at all times without regard to other factors' influence in limiting actual potential answers.

  10. allan harris says:

    You say that the opportunity cost and marginal utility theories are “garbage,” but you also say you don’t accept Marx’s (and Adam Smith and Ricardo’s) labor theory of value. Is there any theory of value you do accept?

  11. Who goes to a concert like that alone?

    Only an economist with no friends…

  12. Pingback: Philip Pilkington: Why Economists Fail to Make ‘Rational’ Judgments and Why You Should Too | naked capitalism

  13. The normative value! for god’s sake wont somebody correlate the normative value, it was there a minute ago…

  14. Pingback: Philip Pilkington: Cody Wilson and the Language of Power | naked capitalism

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