Monday, July 25, 2011

No Philip, There Are Rational Expectations

Philip Pilkington at Naked Capitalism has an article which might as well be titled "Watch Me Confuse Theory with Reality." The complaints are familiar: neoclassical economists assume people are perfectly rational and they have all the needed information to make a decision but its possible to think of times when that's not true so the whole idea is stupid. Advertising is often used as a counterpoint and this article is no more original in that regard. It also has particular problems with rational expectations which predicts that people will try to minimize their error when they are trying to forecast the future.
The fundamental point here is that people – be they consumers or producers, investors or forecasters – often act in an almost wholly irrational manner; one that is quite open to manipulation. And once we allow for this the very premise upon which rational expectations theory rests upon falls to pieces.
I like to keep my blog posts short so let me set aside a few issues: the area of imperfect information is a big field in economics, neoclassical or otherwise; advertising has useful functions such as signalling quality (you spend more on ads to demonstrate you're putting a lot behind a product) and conveying information; and rationality in economics is a very low bar (you do what makes you happiest given your constraints and desires).

More fundamentally, rationality is a general guideline which explains the vast majority of the average person's behavior very well. Precisely because it works so well, we don't notice it because errors are more memorable than successes (and for good reason since making an error suggests we need to re-evaluate how we make a decision in that sphere of our life). For example, today I bought a bagel sandwich for breakfast. I've bought such sandwiches many times in my life and enjoyed them so I rationally believed I would enjoy this one. I was right. I also bought it on a banana nut bagel. I've never had such a bagel before but I like bananas, nuts, and the combination of banana and nut so I believed, again recalling my previous experiences, that I would like this. I was right. I also bought a Diet Coke with my bagel sandwich, a drink I've consumed many, many times before. Again, it was enjoyable. Had I not read Naked Capitalism's article, I never would have given my purchases today a second thought.

Do me a favor and think of all the things you bought today. I'm not just talking about your morning coffee or the toll you might have had to pay to get to work. What about the water that came out of your shower? Electricity? Gas? Trash bags? Internet service? Phone service? Netflix account? (Note some of these things you bought earlier so you could use them later, including today.) Most of these things you don't think about and you probably don't know the price for many of them off the top of your head. You might say this violates rationality and that if people behaved like economists say they do, The Price Is Right would be a very easy game show. You'd be wrong.

We don't know these prices, or think about the purchases, precisely because we are rational. For the vast majority of us, what we are willing to pay (our reservation price) is far greater than what these things cost to purchase (the market price). In other words, there is no question we want to buy them. If there is no benefit to contemplating something but a definite cost (as there is contemplating how happy we are with our phone service or the precise price of water), we don't do it. And that leads us to forget how rational we are.

The advertising argument deserves special mention, since I hear it so often. It is the stock response to the rationality skeptic. Let's consider it carefully. If it were true that people are constantly misled by advertising, if we waste billions each year mindlessly pursuing images of sex and stature, then there would be no product development. Indeed, there would be no products. Everything we buy would be empty boxes with pretty pictures on them. Yes, this is absurd but pointing out the logical extreme highlights just how far away we are from this. Advertising takes up a small portion of a company's budget. Macy's spends 5% of its sales on advertising and that's quite a bit for retail. Wal-Mart spends closer to 0.4% and, of course, Wal-Mart's much larger than Macy's. Packaged goods (whatever that means) can get as high as 10%. Product design and development easily hit the same percent in sales (here's some numbers from Canadian companies) with some sectors such as aerospace and computers reaching well over 15%.

Remember, history's awashed with failed products that had lots of advertising. Several blockbusters and dozens more TV shows utterly fail each year. New Coke also comes to mind. One estimate claims 65% of new products fail (some estimates put it as high as 95% but those tend to come from "how to improve your product" websites so take that with a grain of salt). Yes, many of those products suffered from a lack of advertising but some of them were just bad. Let's not forget Borders recently shut down.

Again, our brain can fool us on such minor issues: we remember the purchases we regret (and by no means does neoclassical econ suggest people make zero mistakes) but there are many, many products we see ads for but don't succumb to. I was in Abercrombie and Finch the other day. Its walls were covered with half naked models. Its aisle filled with attractive salespeople. Its shelved filled with $80 pants. As usual, I bought nothing.