A reader directed me to an article in The Atlantic that purported to explain Why Economics Is Dead Wrong About How We Make Choices. Being aware of the anti-market prejudices of so-called journalists I expected the worse: my expectations were not confounded. Derek Thompson, the author of this little masterpiece, tells his readers that “[t]he old economic theory of consumers says that ‘people should relish choice’.” Bulldust. Economics has never said any such thing. The extent to which individuals should or should not “relish choice” is a matter for them to decide. Having displayed his ignorance of classical economic thought he then approvingly quoted Daniel McFadden who states:
Let me try to sum up your paper for readers, because it covers a lot of ground. Classical economists used to posit that, since consumers are rational, we make decisions to maximize our pleasure, end of story.
For fear of sounding repetitive, I never came across a classical economist who made such a claim, though this maximisation concept is standard in neo-classical economics. Nevertheless, economics does not and never has concerned itself with the ‘psychology of choice”, why, for example, a person prefers Bach to Beethoven. Unfortunately, the concept of economic man created an image of creatures whose only concern was the maximisation of wealth, for this I blame John Stuart Mill1. What economics does deal with is purposive action, behaviour intended to achieve an aim, to, as von Mises put it, “remove or at least to alleviate the felt uneasiness”. This is why the Austrian school of economics does not talk in terms of maximisation regarding human action. But if consumers are rational how does one an an impulsive action?
It may happen that an impulse emerges with such vehemence that no disadvantage which its satisfaction may cause appears great enough to prevent the individual from satisfying it. In this case too there is choosing. Man decides in favour of yielding to the desire concerned2
There is nothing new in this sly attack on economics. Drawing on the work of Professor Frank of Cornell University our old friend Ross Gittins wrote on why consumers are frequently irrational, including himself. (Why economists predictably err on the side of human, The Age, January 2003).
Let us start with the fact that it is a fundamental axiom in economics that people are rational. Their actions are purposive, regardless of the nature or morality of that purpose. Even this self-evident truth escapes some people and that is why Ross Gittins felt comfortable in telling his readers that Professor Frank had shown that consumers are frequently irrational in the choices they make.
In an effort to make his point, Gittins gave the example of a radio that sold for $25 dollars in one shop but $20 in another shop several blocks away. Predictably we are told that most people will choose to save the $5 by walking to the other shop. However, when the same situation emerges regarding two televisions priced at $500 and $495 most people will choose to pay the $500. This action, according to Frank, is irrational because consumers are weighing the $5 dollars against the price of the product instead of against the benefit of saving $5. Mr Gittins agrees with Frank, even calling this kind of behaviour crazy though he admits to doing it himself.
This kind of consumer behaviour is neither irrational nor crazy, quite the opposite. Frank and Gittins’ error is to confuse the $5 with the marginal purchase when it is in fact part of it. The money cost to the consumer regarding the two radios in terms of money is not $5 but $25 versus $20. The real cost, however, is what the consumer forgoes in buying one of these radios. That is to say, the alternative goods he would otherwise have bought, what economists call opportunity costs. Therefore, when choosing between the two radios the consumer is really choosing between the values of the goods he must sacrifice to obtain the radio.
If the inconvenience (cost) of travelling to the other shop is less than $5 thus keeping the radio below the $25 price he will buy it. But it must be made clear that the consumer is weighing up the relative values of two possible purchases, not the $5 dollars difference. This explains the apparent paradox of the television set. When dealing with comparatively large purchases of substitute goods where the difference in prices is very small the inconvenience of seeking a slightly cheaper substitute is usually considered not worth the effort.
The consumer has a scale of preferences on which goods are ordinally ranked. At that particular time a TV occupied top ranking and the next ranking is what is sacrificed to buy the TV, perhaps a computer monitor. Now the consumer finds that an identical TV can be had for $5 less if he is prepared to travel a few blocks. Most won’t. Why? Because the real difference between the purchase is, once again, not $5 dollars but the value of the goods that must be sacrificed to buy the TV: In this case, $500 versus $495. In other words, the opportunity cost to this consumer of the $500 TV is still less than opportunity cost of the $495 TV because it includes the cost of travelling to get it. In plain English, the ‘real cost’ of the ‘cheaper’ TV exceeds $500.
Although consumers rarely use percentages to express price differences between similar goods I think it would pay us to do so in this case. The per centage difference for the radios is 25 per cent: for the TVs it is 1 per cent. This not to suggest that every consumer will consider that in this case the 1 per cent is insignificant, only that those who do so are still acting rationally.
To call the forgoing behaviour is “crazy” reveals Gittins a gross misunderstanding of marginalism and the true nature of cost. All that the likes of Frank and Gittins can legitimately claim about these consumers’ behaviour is that their value scales differ from theirs. No more than that. Unfortunately, Ross Gittins’ sloppy economic thinking is to be found in every Australian newspaper.
If one is going to argue that consumers are not rational then this will lead to the conclusion that ‘wise men’ in power will have to make the decisions for them, which is basically what the left believes. Under their guidance goods would be produced to satisfy human needs, as defined by them, and not for profit. No wonder it is no accident that these attacks on economics invariably lead to a demand by leftists for more state control.
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1John Stuart Mill, Essays on Economics and Society, London: Routledge & Kegan Paul, London: Routledge & Kegan Paul, pp. 309-339. Nassau Senior strongly disagreed with Mill in this respect. Despite his devastating critique of Mill’s opinion Senior’s critique faded into obscurity. See Senior’s Four Introductory Lectures on Political Economy, Lecture IV, London: Longman, brown, Green, and Longmans, 1852.
2Ludwig von Mises, Human Action, Henry Regnery Company, Chicago, 1963, p. 17.