The Ancient Reason Why Economics Can't Be Rational

Caveman and money
Caveman and money

Imagine 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.

%Gallery-157845%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.