The Ancient Reason Why Economics Can't Be Rational

Caveman and moneyImagine there's a game where one person is placed in a room and assigned the role of the "sender." A second person in a different room is assigned the role of "receiver."

The sender is given $20, and has to write an offer on a piece of paper as to how that money should be split between the two. If the receiver accepts the offer, each person gets his allotment. If the receiver refuses, neither party gets any money.

If you are the receiver, what's the limit on when you should refuse the offer?

Economists, in an attempt to better understand the forces that govern these types of interactions in real life and real economies (whether it involves a businesswoman in New York or a hunter-gatherer in Australia), have tried to discern a set of rules that can predict our behavior as economic beings.

One of their most popular beliefs is a concept called "rational economics." It asserts that a person will do whatever is in his or her best financial interest 100% of the time.

What happens when you apply the concept to the game above? Rational economics predicts that you should be willing to accept a $19/$1 split!

Think about it: If you're offered a $19/$1 split and you accept, you walk away with an extra $1 in your pocket. If you say no, you walk away with nothing.

But there's a problem with the concept in this scenario and others: People don't always behave rationally.

When $0 Is More Attractive Than $1

In The Upside of Irrationality, Dan Ariely shows that economists simply haven't been able to replicate a situation where receivers are willing to accept a $19/$1 split. More often than not, deals tend to be accepted in the $12/$8 ballpark.

Rational economics, it turns out, doesn't do a very good job of predicting outcomes here.

"There is one interesting exception to this general rule," Ariely notes. "Economists and students taking economics classes are trained to expect people to behave rationally and selfishly. So when they play the game ... they accept the [$1] offer."
That's an important exception to the rule. Economists, surrounded by like-minded individuals, often help form policy that may not translate in the real world.

Fair Is Fair, Not Necessarily Rational

It's not much of a stretch to understand what's going on here. There's no way I'd be willing to deal with a $1 offer. And generally, that's what others think, too.

As humans, we are hardwired for this. A sense of fairness was actually a key to our survival as a species. For the vast majority of our existence, human beings have lived tribally. It's only in the last 10,000 years -- a blink of the eye evolutionarily -- that civilization has become our modus operandi.

The 11 states with the fastest-growing economies
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The Ancient Reason Why Economics Can't Be Rational

GDP growth: 2%
Real 2011 GDP: $305 billion (14th highest)
Population change: 1.29% (5th highest)
Increase in employment: 1.2% (tied-11th highest)

Washington is tied for eighth place with four other states in the competition for fastest-growing state economy. Its durable goods manufacturing industry expanded significantly, contributing nearly half of the state's total GDP growth.

According to the Bureau of Labor Statistics, Washington's manufacturing sector added about 11,000 jobs in 2011. That growth, a 4.3% increase, represents the nation's sixth-largest proportional increase in the manufacturing sector.

According to Washington's State Department of Commerce, its information sector growth came "from household names such as Microsoft, Amazon, and Real Networks, to emerging companies in the transformative areas of cloud computing virtualization and energy efficiency." 

GDP growth: 2%
Real 2011 GDP: $1.735 trillion (the highest)
Population change: 0.95% (11th highest)
Increase in employment: 0.9% (tied-21st lowest)

With a population of 37.7 million, California has one of the largest economies in the world. By itself, it represents 13.2% of U.S. economic production. Due to its enormous size, the state's 2% GDP increase was worth $33 billion -- the second-largest growth in dollar terms in the U.S. after Texas.

California's growth last year can be credited to expansions in its manufacturing, information, and the professional, scientific, and technical service sectors. The state's durable manufacturing sector, which includes the computer and innovation technology-producing Silicon Valley, contributed more than $10 billion of the GDP increase.

GDP growth: 2%
Real 2011 GDP: $201 billion (24th highest)
Population change: 0.15% (22nd lowest)
Increase in employment: 1.0% (tied-21st highest)

Relative to its labor force, Connecticut has the second-largest finance sector, behind national leader Delaware. That sector was the largest factor in the state's economic expansion, contributing 30% to the state's total GDP growth. Banking, financial services, and insurance job openings increased steadily throughout 2011. The professional, scientific, and technical services sectors also grew.

GDP growth: 2%
Real 2011 GDP: $108 billion (17th lowest)
Population change: 1.5% (2nd highest)
Increase in employment: 2.2% (2nd highest)

Utah flourished despite the recession, and continues to now. As was the pattern across the  country, its major contributors to growth were durable goods manufacturing, information, and the professional, scientific, and technical services sectors.

However, several other sectors had strong positive impacts on Utah's economic growth, a fact that speaks to the state having a healthy, well-rounded economy. From 2010 to 2011, the unemployment rate in the state fell from 8% to 6.7%, well below the national averages for both years.

GDP growth: 2.2%
Real 2011 GDP: $349 billion (12th highest)
Population change: 0.49% (20th lowest)
Increase in employment: 0.6% (tied-14th lowest)

Massachusetts' growth rate of 2.2% is actually down from its 2009-2010 growth rate of 4.4%. Still, there were meaningful improvements in several sectors last year, notably professional, scientific, and technical services, which was responsible for almost 27% of GDP growth. Also a major factor, the durable goods manufacturing sector contributed almost 24% of growth.

GDP growth: 2.3%
Real 2011 GDP: $337 billion (13th highest)
Population change: -0.01% (2nd lowest)
Increase in employment: 1.9% (4th highest)

Michigan added 72,300 jobs in 2011, a 1.9% increase from the previous year. This rate of job growth, one of the healthiest in the country, came primarily from the services and manufacturing sectors, which added more than 30,000 new employees each. This may be due in part to the fact that GM and Chrysler exited Chapter 11 last year

Statewide, unemployment dropped from 12.7%, the second-highest rate in the country, to 10.3%, the seventh-highest. Overall, Michigan's GDP increased by $7.4 billion. Durable goods manufacturing accounted for just over half of this growth.

GDP growth: 2.5%
Real 2011 GDP: $45 billion (7th lowest)
Population change: 1.2% (6th highest)
Increase in employment: 1.1% (tied-15th highest)

The mining industry, which includes  oil, natural gas and mineral extraction, was the leading source of economic growth in Alaska in 2011, generating about $849 million.

The mining and logging industries provide 4.8% of the jobs in Alaska, the second-highest percentage of any state in the country behind Wyoming. Alaska's population increased markedly in 2011,  while unemployment  decreased from 8% in 2010 to 7.6% in 2011.

The harvesting of the state's natural resources returns an annual benefit to every Alaskan: the Permanent Fund Dividend, which gives every resident a portion of the mining proceeds. In 2011, the checks were for $1,174 each.

GDP growth: 3.3%
Real 2011 GDP: $1.150 trillion (2nd highest)
Population change: 1.67% (highest)
Increase in employment: 2.1% (3rd highest)

The GDP of Texas grew by an impressive $36.8 billion, more than the total GDP of five states. Its rapidly growing population helped propel that growth as it surpassed New York to become the second-most populous state.

Its GDP growth can be traced to a number of major industries: Mining contributed about 19%, and manufacturing contributed almost 22%. The unemployment rate fell from 8.2% to 7.9% as the trade, transportation, and utilities companies added 51,100 jobs, and mining companies added 29,800 jobs.

GDP growth: 4.5%
Real 2011 GDP: $56 billion (11th lowest)
Population change: 0.05% (3rd lowest)
Increase in employment: 1.0% (tied-21st highest)

Given that its population increased by less than 1,000 people between 2010 and 2011, West Virginia's 4.5% GDP growth is especially remarkable. The vast majority of this growth -- 86.4%, or more than $2 billion -- was driven by the mining industry. Indeed, mining's boost to West Virginia's economy was the greatest individual contribution to GDP growth of any industry in any state.

The mining and lumber industries provided jobs for 33,600 West Virginians in 2011: 4.5% of all jobs in the state, where the unemployment rate, fell from 8.5% in 2010 to 8.0% in 2011.

GDP growth: 4.7%
Real 2011 GDP: $186 billion (25th highest)
Population change: 0.87% (16th highest)
Increase in employment: 1.0% (tied-21st highest)

Oregon's GDP last year grew nearly three times faster than the U.S. economy overall. The state's durable goods manufacturing industry was the second-fastest growing sector in the nation with a 3.94% growth rate, accounting for almost 20% of Oregon's economic expansion. High tech companies such as Intel, which employs about 16,300 in Portland, dominate the industry.

Some of the growth Oregon is enjoying can be attributed to the reverse offshoring trend: Manufacturing jobs are being brought back to the U.S. as companies respond to product defects, delays, and thefts in their overseas supply chains, as well as other economic factors that make offshoring less cost effective.

GDP growth: 7.6%
Real 2011 GDP: $34 billion (5th lowest)
Population change: 1.38% (3rd highest)
Increase in employment: 4.8% (highest)

From 2010 to 2011, 18,100 net jobs were created in a state with a population just over 680,000. This was three times as many as the 5,600 created over the same period in New Jersey, a state with 8 million residents.

Much of North Dakota's growth has been driven by exploration of the Bakken shale, a geological formation believed to hold billions of barrels worth of recoverable oil. That economic boost echoed in strong job growth in many industries. Jobs in in mining and logging increased by 52.3%, jobs in construction increased 11.1%, and jobs in trade, transport and utilities increased a cumulative 6.5%. All of these were the highest rates of increases in the country.

By Michael B. Sauter and Lisa Nelson, 24/7 Wall St.

One of the tenets of tribal existence is interdependence between the individual and the tribe. Sure, there is a social order, but all experiences are shared. When there's a drought, everyone -- from tribal leader to newborn -- must cut back on food.

It's not that it would be cruel not to feed others in your tribe. It's that it would be suicidal. Everyone relies on everyone else. If we didn't share things equally, we'd never have a tribe around us to help us survive.

This is the framework we are born with, and our brains haven't evolved out of it.

What's Really Governing Our Economies

The problem with rational economics arises when its concept is applied where tribal or simple emotional theories work better.

Robert Shiller, a best-selling author and economist, recently said, "I used to be cowed by the efficient [rational] markets hypothesis, and now I think it's a half-truth ... markets are driven primarily ... by investor sentiment."

In a brilliant New York Times piece, Jonathan Haidt argues that the same tribal and emotional themes explain what happens in the political sphere as well: "Despite what you might have learned in Economics 101, people aren't always selfish .... When people feel that a group they value ... is under attack, they rally to its defense, even at some cost to themselves. We evolved to be tribal, and politics is a competition among coalitions of tribes."

As Ariely, Shiller, and Haidt point out, we aren't automatons -- we're human beings that make decisions based on a wide range of variables. When economists build models for society based on rational economics -- instead of everyday practicalities -- they often end up making predictions wildly off target.

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