The Mind of the Market

Imagine you are asked to make the following decision. You must divide $100 between yourself and another individual. But you can decide how to split the money, and the other person can either reject or accept your offer. If she accepts, you get your share and she gets hers. If she rejects, you both get nothing.

When social scientists have run this experiment — called the Ultimatum Game in the jargon of game theory — in US college campuses, proposals beyond a $70-$30 split are generally rejected. Even though they still stand to gain money by accepting even a $99-$1 offer, people seem to want to protect a moral sense of fairness. Researchers call this reciprocal altruism.

So much, it seems, for the idea of rationality. As Michael Shermer argues in his new book, The Mind of the Market, recent research in the subfields of behavioral economics, neuroeconomics and evolutionary economics has raised serious doubts about classical economic thinking. "Traditional economics," Shermer notes, "grounded as it has been in rational choice theory, tells that… people are selfish utility maximizers." But these new fields of research suggest otherwise: human beings make emotional choices, are easily swayed by small amounts of information and tend to rationalize their own prior beliefs.

Imagine you're given $100 and a choice between (A) another $50 and (B) a coin toss in which heads means you get another $100 and tails means you get nothing. Now imagine you're given $200 and a choice between (A) losing $50 and (B) a coin toss in which heads means you lose $100 and tails means you lose nothing. In both cases, the outcomes of A and B are the same from the perspective of maximizing utility. In the first scenario, you get $50 under A and $100 with 50 percent probability (meaning $50) under B. In the second, you lose $50 under A and $100 with 50 percept probability (again, $50) under B. But when you run this experiment with people, most choose A in the first scenario and B in the second. Emotionally, it seems, there is a difference between a sure gain and a sure loss. We are more likely to take a sure gain and more willing to try our luck on losses.

Now imagine you are an expert at the Center for Disease Control and are preparing for an outbreak that is expected to kill 600 people. You have two options: under program A 200 people will be saved, and under program B there is a one-third chance that 600 people will be saved and a two-thirds chance that no one will be saved. In experiments, most people choose program A. But now consider another scenario. Under program A, 400 people will die, while under program B there is a one-third chance that nobody will die and a two-thirds chance that 600 people will die. Even though the net results are the same under both scenarios, subjects in the second scenario overwhelmingly chose program B. That is, how things are phrased — what social scientists call "framing" matters. We prefer to think about the number of people saved rather than the number of people who will die.

What experiments like these tell us is that how we think is not always rational. We are surprisingly risk-averse and our decisions are often clouded by the ways in which our options are presented. We are swayed by what we hear — your estimation of the probability of dying in a plane crash will be much higher if you recently saw news coverage of a plane crash.

For Shermer, that's because these characteristics were useful to us when we evolved them. "What may seem like irrational behavior today," he argues, "may actually have been rational deep in our Paleolithic past. Without an evolutionary perspective, the assumptions of ‘economic man' as selfish, rational, and free make no sense." Thus framing affects us because we evolved to do a better job processing problems involving other people than problems involving symbols. We are risk-averse because, as hunter-gatherers, we survived by hoarding, overvaluing what we have now.

The problem with most of this evolutionary logic is that it verges on functionalism. My nose holds up my glasses; therefore I have a nose in order to hold up my glasses. We would chuckle at such a syllogism, but it's precisely the same logic that allows us to say that we are risk-averse because it helped us hoard back when we were hunter-gatherers. Contrary to popular belief, evolution is not the "survival of the fittest" — in fact, Darwin never used that phrase. Our characteristics are not the ones best suited to our environment, just those that helped us muddle through and survive. Evolution is based on contingencies: random mutations that gave their inheritor a leg up and eventually won out. The traits we inherited from our ancestors were not necessarily those best suited to our survival, just better than the ones that came before.

What's more, Shermer's view of rationality is overly simplistic. The beauty of rational choice — and what most frustrates its critics — is that it says nothing about where our preferences come from or what kinds of things give us pleasure. It simply says that we will maximize the pleasure we get — our utility — which is different from being selfish. If being altruistic makes us feel good about ourselves, then rationality predicts we will be altruistic. If we have an aversion to risk and prefer taking a sure gain over a bet, that's also perfectly rational. Where rationality fails is in explaining how we make decisions. Framing shouldn't matter from the perspective of rationality.

Shermer's book is a readable summary of the advances being made at the disciplinary intersections of psychology, biology, neuroscience and economics. But he is too uncritical in his presentation. More importantly, the lessons he takes from them are strikingly naïve. Since trade was hard-wired in our brains in order to allow us to build social trust, Shermer reasons, international trade should increase trust and promote peace. In fact, most studies of trade negotiations at the WTO show that power matters: wealthy countries generally end up taking the lion's share of the benefits of free trade.

In another feat of reasoning, Shermer suggests that since we take neurological pleasure from giving to others, we should be prodded to donate our money rather than have it "confiscated" by the state and redistributed. Shermer cites a single study that suggests that conservatives donate more money than liberals and concludes that, "governments should give tax breaks to conservatives… in order to reward their prosocial behavior and encourage more giving." Talk about rationalizing prior beliefs.