Make Money By Assuming the Best (Rationality) but Allowing for the Worst (Irrationality)
Every Tuesday is a Game Theory article at Mind Your Decisions.
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.
6 Responses to “Make Money By Assuming the Best (Rationality) but Allowing for the Worst (Irrationality)”
Used cars are a nice example. I think used cars are a much better deal than new cars, even considering maintenance costs. But people like having a new car, especially rich snobs. My greatest worry is that consumers become more rational, because that would raise the price of used cars and end my deal.
By Anonymous on Feb 19, 2008
Is there a definition in economics for “irrational” behavior? I totally agree that buying marked up chocolates on Feb 14 or paying a premium for the latest fashions seems silly. But I’m not sure I would characterize these choices as irrational – I would guess that most people who buy flowers or chocolates on Valentine’s Day know that the products are marked up, but they also know that they might get rewarded by bringing some home (or avoid getting in serious trouble). Their utility matches the price they are willing to pay. They perhaps could have planned ahead in the case of chocolates, but when they are in the store on Feb 14, that ship has sailed, and their decision to buy is fully informed and based upon the marked up price.
A similar example I have come across recently is the case of an Indian company that is offering a “plane ride to nowhere” on which passengers board an Airbus 300 in Delhi, are waited on by flight attendants, and receive “in-flight” announcements all while sitting on the ground. (http://www.timesonline.co.uk/tol/news/world/asia/article2558290.ece) To me, paying to sit on an airplane and go nowhere would be completely irrational, but to people who may never get to experience the real thing, I can see how it could be worth it. They are getting utility that you are I may not get – just as people who buy chocolates on Valentine’s Day or buy the latest fashions are getting some sort of utility out of it that is causing them to pay the premium.
I’ve always thought of irrationality in an economic sense to be a decision that is made with asymmetrical information where utility is inconsistent. An example of the former would be buying an airline ticket from Orbitz when you could get the exact same ticket from Expedia for $100 less. If you aren’t aware that Expedia is offering a lower price, you might make the decision to buy the ticket from Orbitz, a decision which I think economists would consider “irrational” – under perfect market conditions, economists would predict that Orbitz would sell zero tickets even if its price was even $1 higher. An example of the latter (taken from Berkeley prof Matthew Rabin) would be that many people prefer $10 today over $15 one week from now, but prefer $15 fifty-one weeks from now over $10 fifty weeks from now.
What is the economic definition of irrational? And are there different degrees of irrationality?
By Steph on Feb 19, 2008
I would not call people Irrational per se but as making deliberate sub-optimal choices when given a choice of economic options. Gary Becker at the U.Chicago and the 1992 Nobel Prize winner used preferences as a framework as skewing economic decisions and called it Behavioral Economics for which he was cited in the award. For example, he explained racism as not only morally wrong but why it is suboptimal economically. Expressing an irrational preference in making economic choices is penny foolish and pound foolish. Gary Becker wrote some great columns in Business Week for a long time about this.
To answer’s Steph’s question, economic definition of irrational is your preference to make sub-optimal choices and the degree of irrational behavior is proprtional to the utility you are willing to forgo to make that preference.
By Mahesh on Feb 19, 2008
@Step: You make some great points, and remind me that I am being sloppy with my use of the words rational and irrational. Let me take a step back to be more precise.
–The Formal Definition–
In economics, a rational preference has a specific meaning. There are two requirements:
1. Completeness. For any two options X and Y, you either prefer X to Y, Y to X, or are indifferent.
2. Transitivity: If X is preferred to Y, and Y is preferred to Z, then X must be preferred to Z.
Dealing with preference ordering gets arduous when you have to compare thousands of choices. So economists use “utility functions” as a compact method. This means u(X) > u(Y) only when X is preferred to Y.
A preference can only be represented by a utility function if it is rational.
–What is Irrational?–
Mahesh gives a good definition of irrational. It means that you choose a sub-optimal preference. If you preferred X to Y, but decided to choose Y, then you made an irrational choice.
Or if you preferred X to Y, and Y to Z, but then chose Z over X. This is a topic I discussed in last week’s article of voting.
–To answer Steph’s examples–
Your examples are interesting, and you raise a question of whether the choices are truly irrational. In one sense, no, they are not.
You’re right that people are choosing things that make them happy under full information. They have choice, they are weighing options, and they are making a decision. It’s wrong for me to say it’s irrational just because I would not do those things.
But in another sense, I think the beliefs are irrational. This is because people can be made to have irrational beliefs and then act “optimally.”
When women started smoking in America, they were doing so because celebrities told them it was a liberating experience. It is an example documented in “The Century of the Self.” The narrator explains that it’s completely irrational that smoking would make a woman freer–you become a slave to nicotine and big business. But the image made them feel freer.
And that’s why I call my examples “irrational.” When you look at the payoffs–IF ALL players were rational–then it doesn’t make sense what people are doing.
Valentines day has marked up candy because people buy into the idea. People pay to wait around on an airplane since it sounds fun. Most of us know it’s not really fun.
Somewhere, I would say these strange actions are the result of irrational beliefs. I don’t think people would do these things in the absence of marketing.
–To answer Mahesh–
You caught me–I was using the word irrational lazily. I’ll have to look at those Becker articles; thanks for the pointer.
By Presh Talwalkar on Feb 20, 2008
I think the important part of rationality is the notion that players make decisions according to their preferences. We often casually say that a choice is irrational when we really mean is that the decisions is not in accord with our expectation of the players preferences. Since in the real world it is nearly impossible to know another player’s prefs, a good approximation is to make the assumption of rationality, and let the choices made inform your notion of the player’s utility.
In this way of looking at it, even many clearly insane people are raional; they just have an unexpected preference set.
By Seth on Feb 21, 2008
@Seth: Excellent points. I too made the mistake of imposing preferences on others in determining what is “rational.”
I really like this explanation:
“Since in the real world it is nearly impossible to know another player’s prefs, a good approximation is to make the assumption of rationality, and let the choices made inform your notion of the player’s utility.”
I’m going to use that one in the future
By Presh Talwalkar on Feb 21, 2008