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People, not a Machine

You have a goal – lose weight, turn your life around, climb Mt Everest – and you want to be sure to stick with it. What’s the best way to get you to make your goal? According to stickK.com a pledge to a charity or a friend if you fail to achieve it is a powerful motivator. That’s what you do at this site and their results are amazing.

The reason? Fear of loss motivates far more than a possibility of gaining.

It’s not exactly rational, but it’s human behavior. Understanding behavior and what drives people to do what they do is called “Behavioral Economics”. It differs from classic economics in that it never presumes people are always rational and always seeking to maximize profit. We have other things that drive us personally and socially – happiness, fear, morality, and shame among them.

And an understanding of behavioral economics is just what’s often missing in business and public policy.

A good quote from Herb Simon.

A good quote from Herb Simon.

There’s nothing new about behavioral economics, but it does tend to go in and out of fashion. Herbert Simon won the Nobel Prize in Economics in 1978 for his view that the rationality of economic decisions was bounded. People act the way they do for a wide variety of reasons, and only some of them are to maximize profits or to make economical choices as consumers.

The public policy implications of this are nearly unlimited. There is no doubt that market forces are powerful when they are built into how the rules of the game are set up, as observed by Armen Alchian of UCLA. As a pioneer of the economics of property he noted that “You tell me the rules and I’ll tell you what to expect.” But he is more famous for noting that “There is no such thing as macro-economics,” which is to say that policy makers at places like the Federal Reserve are just kidding themselves.

It’s best summarized by Paul Krugman in a 2009 op-ed in the New York Times on the crash of the previous year:

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations.

What a "job" used to mean for many.

What a “job” used to mean for many.

Longtime Barataria readers will recognize the sentiments quickly. The roots of business cycles as we know them are related to the amount of time it takes us to forget everything Grandpa was trying to tell us. And that no matter how the extremists might want to tell us, in the end any statement of value at the heart of the economy is based on the values of the people acting in it more than anything.

This is what is limiting in conventional macro-economics. Simply setting rates and expecting everything to go according to Hoyle isn’t the way the game is really played.

There are important implications for business, too. One great example is that employees will always tell you that they prefer cash as a reward for performance over some gift that they might not buy themselves. But studies have shown that the opposite is true – employees keep their eyes on the prize. What has not been tried, at least as far as I know, is a system described above where the prize starts out at, say, $1,000 and a failure to meet important goals reduces it. Would the fear of loss motivate even more if employees already mentally “banked” the cash prize?

"Mind if we watch what you're doing and take notes?"

“Mind if we watch what you’re doing and take notes?”

Behavioral economics also has the advantage that it is rarely theoretical but more often practical and empirical. It starts with the assumption that people are not entirely rational without assuming the limits of their cold, calculating behavior. That can only be found by observation once a system is set up. Even surveys don’t exactly tell the truth, as in the employee motivation example, because people often know that they are supposed to be rational.

That doesn’t mean that they actually do it, of course. Behavioral economics isn’t going to judge anyone for doin’ their thang, either.

In the end, the process of setting interest rates to stimulate growth or motivating employees into diligent focus isn’t actually that different from getting yourself over that mountain. An “economy” isn’t a machine but a collection of individual people all doing whatever it is they want to do for their own particular reasons. What gets you going is what gets the world going, eventually. Behavioral economics is nothing more than the study of how great big systems work as a sum of the people who make them up.

It’s worth understanding a lot better as we move ahead into a new economy which demands new thinking and serious reform in public policy all around.

13 thoughts on “People, not a Machine

    • It is, really, sociology. But very applied and directed. It makes a lot of sense – study what you are interested in and understand it before you decide what it is about or what it does!

  1. I don’t know if this is brilliant or a huge duh. People do things because they want to for whatever reason. I have worked with many businesses and not a one always maximizes profits. Every small business owner does what they think is best to develope customer loyalty. It’s almost always gut feel but it’s way more important than profit to most of them. Calling it rational or not is stupid. They want to have something they can rely on because that’s the most important thing. I feel a lot of economists are passing judgement on people because they aren’t doing what they are “supposed to”.

    • Most things that a brilliant are a huge “duh!”. 🙂
      You are exactly right – cultivating a steady income stream is far more important than maximizing profit for any small business, and that’s far from the only place where traditional economics tends to fail. They can say that this maximizes profit over the long haul, but I doubt it. And yes, it’s entirely by feel because most small businesses are in a “people” biz!

  2. Erik,

    I tend to agree with where you’re going with this piece, but I must admit that when I took my first economics course and in my readings of economists through the years, I was always struck with how much they counted on people behaving rationally, if we could really define what is rational in any given situation.

    I worked in large bureaucracies for 37 years always around the top echelon. What I observed was decision making based more closely to whim, or even animus, than it was to further the goals of the organization. While I would love to say that all of my decisions as a manager were based purely on rationality, I honestly must admit that many times my own feelings got in the way of good management. Since I’m a fairly rational type of person (I hope) I can only extrapolate my experiences, as a model to understand how most organizations operate and my guess is that acting irrationally is pretty much the norm.

    As an example, when you have a past chairman of the Fed, who actually took Ayn Rand seriously, indeed I believe he was an acolyte, could we expect rational monetary policy? My observation of the field of economics, speaking of course as an admitted dilettante, is that for the most part we see people with their vision narrowed by their own personal predilections. In that sense behavioral economics would be a leap forward because it would put human behavior back into the mix. However, reading someone like Thomas Frank discussing Kansas, causes me to wonder if indeed it is ever possible to predict human behavior on a macro level. I still can’t figure out what World War 1 was about. 🙂

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