Make Money By Assuming the Best (Rationality) but Allowing for the Worst (Irrationality)

Some people think game theory is a joke. They say the games are unrealistic and yield poor predictions. I understand the criticism, but I completely disagree with the overall point.

I profit tremendously from game theory. I gain an advantage when game theory works. That’s what I usually write about. Today, I explain why I love it when game theory fails. In fact, I usually profit more when game theory predictions are wrong.

I’m going to look at one reason why game theory is (rightfully) criticized. Then I’ll explain why the criticism is too harsh. There are useful remnants of game theory. I will give three examples when you win because game theory fails.

Some of you will be impatient to read all of that. I’ve thought about it and distilled the point for you. All you really need to do to profit from game theory is understand one sentence:

Don’t confuse theory with practice.

This is not as easy as it sounds. I still find myself making mistakes, but that’s okay because I think I win more than I lose. I’ll get started with some people who seem to miss the point entirely.

A Valid Criticism of Game Theory

Standard game theory assumes players are “rational.” This means players seek to maximize individual payoffs. The assumption has major flaws, but all economists are taught why this assumption is used. I personally think it is a good assumption, and I’ll go into reasons later.

But something goes wrong with academic economists. They spend years studying rational agents, deriving complex mathematical models, and testing these models. I think some people use the assumption so frequently that they forget it’s a constructed rule. These are people who confuse theory and practice.

It is not true that people are rational all of the time. People might not even be rational most of the time. Most economists would not want to admit that because it would seemingly be a harmful admission.

Trying to justify the rationality assumption becomes a tiring task. Economists have come up with some good-sounding answers. I recently came across one from Tim Harford in U.S. News and World Report. Here’s the excerpt:

[Question]: Are we generally rational people? Do we make good decisions?

[Harford]: Yes, and more than people would expect. When you put people in familiar circumstances–their work, doing shopping, their relationships–they make better decisions, often in an unconscious way.

This is interesting. We are rational in “in an unconscious way.” This idea is self-serving, since we like to think we’re smart, and intellectual sounding. It makes us feel better that we’re somehow programmed to do smart things.

But let’s take a step back. What does it mean to be rational in “an unconscious way”? Here’s Harford’s explanation:

It’s like a skilled baseball player catching a ball. The equations you’d have to solve in a logical way (to make that catch) are incredible, but somehow the mind is solving them all the time. The same is true for our economic decisions.

Baseball players are unconsciously solving differential equations? Now that strikes me as odd. I think a better explanation is that players have an innate sense of time and can improve hand-eye coordination. I’ll admit I’m not sure exactly why players are able to catch baseballs, but I’d rather not appeal to a theory about solving differential equations unconsciously.

Something is amiss with this theory.

Don’t confuse theory with practice. I don’t think we should throw out the theory. I think there are useful lessons from it.

I Think Rationality is a Good Assumption

Now don’t get me wrong: I love theory. That’s clear enough from the title of my Tuesday articles. I just think it’s foolish to confuse theory with practice.

When I discussed the principal-agent problem two weeks ago, I explained the model and why it’s important. I gave a concrete example where I think it went into play. And then, all you smart commenters pointed out things I completely missed. I didn’t take into account hidden incentives, other possible strategies, and other hidden games.

The simple theory did not predict well, but that was okay because I did not blindly follow the prediction. I separated the useful lessons from theory and the actual implementation in practice and solved my problem.

I also think there are compelling reasons to assume rational agents in economics.

The first reason is a practical one. What’s the alternative? There really one way to model rationality versus the millions of ways you can model irrationality. If you try to model altruism, for instance, you have to decide how much people care about others–not an easy task.

(New experiments are determining if there are systematic divergences from the rational agent. These could be used to create better theory. Many of these behavioral economics experiments are great, and I’ll discuss some in upcoming articles.)

The second reason for rationality is a philosophical one. Rationality gives a guideline for comparison, a sort of bright line test. For instance, game theory predicts that rational tennis players should mix their serve strategy to keep opponents off guard. This becomes a standard for testing professional tennis players who are good. As it turns out, the best tennis players do appear to follow this strategy. The result is that theory can inform new tennis players how to avoid the mistake of predictability. Theory gives a broader picture than practice.

But let’s not get too excited with theory. Don’t confuse theory with practice.

Thank You Irrational People

There are cases when people are irrational and stupid. We’ve all consciously experienced them. No amount of evidence will ever stop people from acting irrationally. I do stupid things every day, and likely so you do. The rational agent model is great, but even Harford would not go as far as saying we’re calculating machines. His point is that we’re more rational than we think, and he gives many thought-provoking examples (like how divorce is underrated).

Theory is good, but think before you leap into practice. Real life strategies can be larger. Communication can be easier, or harder. And of course, people might not act rationally.

When you stop confusing theory with practice, you can profit in a variety of ways. I’ll give you three examples. These are situations where you are much better off when people around you act irrationally. These games that I call “I’m smart because you are stupid.”

Example 1: Shopping for clothes

It’s fun to get clothes on clearance and for cheap. Stores discount clothes when seasons are changing and they have already made a profit on people keeping up with the trends. If everyone became a smart shopper, stores would stop discounting and I would have to pay more for clothes. It’s exactly because other people are irrational that I get cheap clothes.

But some stores are wary about customers like me. So they are fighting back using game theory. It’s a topic I wrote about before.

Example 2: Special event shopping

Did you spend a ridiculous amount during the holidays? How about that marked up box of specially wrapped Valentines candy?

The truth is that chocolate will taste no better on Valentines Day than any other day of the year. I’m glad you bought those ridiculous chocolates at marked up prices. I am ready to swoop in after the craze and pick up deeply discounted products.

Again, if customers bought on practicality alone, I would be out of luck.

Example 3: Misbehaving students

My friend was a resident assistant during college and he got paid well. He once complained to me that he had to deal with a lot of stupid people. Some people didn’t clean up after themselves, and others were playing music too loud. He told me that if people had some common sense, and were rational, his job would be easier.

I replied that he should give those misbehaving students a gift instead of scolding them! If all he had to do was be in charge of well-behaved students, his job would be easy, it would be desirable, and consequently, it would pay poorly. He should be trained to think, “Thank you irrational people.”

What’s your story?

Let’s take some time to appreciate that practice is different from theory. It’s great that there are irrational people.

How have you benefited from irrational people around you? Family members, coworkers, or people you see in the mall?

Write your story in the comments and I’ll add the best ones to this article.