Economics For Dummies, 3rd Edition
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For simplicity, economists often assume that people are fully informed and totally rational when they make decisions. You may think that gives people way too much credit, but economic models based on those assumptions work surprisingly well much of the time.

However, in the real world, people aren’t always informed about the economic decisions they need to make, and they aren’t always as reasonable as economists assume. Here, you discover some of the limitations of the choice model and explain why they may not matter all that much in the long run.

Understanding uninformed decision-making in the economy

When economists apply the choice model, they assume a situation in which a person knows all the possible options, knows how much utility each will bring, and knows the opportunity costs of each one. But how do you evaluate whether it would be better to sit on top of Mount Everest for five minutes or hang-glide over the Amazon for ten minutes? Because you’ve never done either, you aren’t well-informed about the constraints and costs of the choice and probably don’t even know what the utilities of the two options are.

Politicians touting novel new programs often ask voters to make similarly uninformed choices. They make their proposals sound as good as possible, but in many cases, nobody really knows what they may be getting into.

Things are similarly murky with respect to choices involving luck or uncertainty. People buying lottery tickets in state lotteries have no idea about the eventual possible gain because the size of the prize depends on how many tickets are sold before the drawing is made. The people who choose to play lotteries also tend to have highly exaggerated “guesstimates” about their chances of winning.

Economists account for this reality by assuming that when faced with uninformed decisions, people make their best guesses about not only uncertain outcomes but also about how much they may like or dislike things with which they have no previous experience. Although this may seem like a fudge, because people in the real world are obviously making decisions in such situations (they do, in fact, buy a whole lot of lottery tickets), the people in those situations must be fudging a bit as well.

Whether people make good choices when they are uninformed is hard to say. Obviously, people would prefer to be better informed before choosing. And some people do shy away from less certain options. But overall, the economist’s model of choice behavior seems quite capable of dealing with situations of incomplete information and uncertainty about random outcomes.

Making sense of irrationality and the impact on the economy

Even when people are fully informed about their options, they often make logical errors in evaluating costs and benefits. Following are three of the most common economic errors. Don’t be alarmed if you find that you’ve made these errors yourself: After people have these choice errors explained to them, they typically stop making the errors and start behaving in a manner consistent with rationally weighing marginal benefits against marginal costs.

Sunk costs are sunk!

Economists refer to costs that have already been incurred and which should therefore not affect your current and future decision-making as sunk costs. Rationally speaking, you should consider only the future, potential marginal costs and benefits of your current options.

Suppose you just spent $15 to get into an all-you-can-eat sushi restaurant. How much should you eat? More specifically, when deciding how much to eat, should you care about how much you paid to get into the restaurant? To an economist, the answer to the first question is “Eat exactly the amount of food that makes you most happy.” And the answer to the second question is “How much it cost you to get in doesn’t matter because whether you eat 1 piece of sushi or 80 pieces of sushi; the cost was the same.”

Put differently, because the cost of getting into the restaurant is now in the past, it should be completely unrelated to your current decision of how much to eat. After all, if you were suddenly offered $1,000 to leave the sushi restaurant and eat next door at a competitor’s, would you refuse simply because you felt you had to eat a lot at the sushi restaurant in order to get your money’s worth out of the $15 you spent? Of course not.

Unfortunately, most people tend to let sunk costs affect their decision-making until an economist points out to them that sunk costs are irrelevant — or, as economists never tire of saying, “Sunk costs are sunk!”

Mistaking a big percentage for a big dollar amount

Costs and benefits are absolute, but people make the mistake of thinking of the costs and benefits as percentages or proportions. Instead, you should compare the total costs against the total benefits, because the benefit of, say, driving to the next town to get a discount is the absolute dollar amount you save, not the percentage you save.

Suppose you decide to save 10 percent on a mobile phone by making a one-hour round trip to a store in another town. You plan to buy the phone for only $90 instead of buying it at your local store for $100. Next, ask yourself whether you’d also be willing to drive one hour in order to buy a home theater system for $1,990 in the next town rather than for $2,000 at your local store. You do the math, and because you would save only 0.5 percent, you decide to buy the system for $2,000 at the local store.

You may think you’re being smart, but you’ve just behaved in a colossally inconsistent and irrational way. In the first case, you were willing to drive one hour to save $10. In the second, you were not.

Confusing marginal and average

Suppose your local government has recently built three bridges at a total cost of $30 million. That’s an average cost of $10 million per bridge. A local economist does a study and estimates that the total benefits of the three bridges to the local economy add up to $36 million, or an average of $12 million per bridge.

A politician then starts trying to build a fourth bridge, arguing that because bridges on average cost $10 million but on average bring $12 million in benefits, it would be foolish not to build another bridge. Should you believe him? After all, if each bridge brings society a net gain of $2 million, you would want to keep building bridges forever.

What really matter in this decision are marginal costs and marginal benefits, not average ones. Who cares what costs and benefits all the previous bridges brought with them? You have to compare the costs of that extra, marginal bridge with the benefits of that extra, marginal bridge. If the marginal benefits exceed the marginal costs, you should build the bridge. If the marginal costs exceed the marginal benefits, you should not.

For example, suppose that an independent watchdog group hires an engineer to estimate the cost of building one more bridge and an economist to estimate the benefits of building one more bridge. The engineer finds that because the three shortest river crossings have already been taken by the first three bridges, the fourth bridge will have to be much longer. In fact, the extra length will raise the construction cost to $15 million.

At the same time, the economist does a survey and finds that a fourth bridge isn’t really all that necessary. At best, it will bring with it only $8 million in benefits. Consequently, this fourth bridge shouldn’t be built because its marginal cost of $15 million exceeds its marginal benefit of $8 million. By telling voters only about the average costs and benefits of past bridges, the politician supporting the project is grossly misleading them. So watch out anytime somebody tries to sell you a bridge.

About This Article

This article is from the book:

About the book author:

Sean Flynn, PhD, is an associate professor of economics at Scripps College in Claremont, California. A specialist in behavioral economics, Dr. Flynn has provided economic commentary for numerous news outlets, including NPR, ABC, FOX Business, and Forbes.

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