Irrational Preferences in Modern Microeconomics

The Relativity of Value

Pretend I just completely wiped your memory of all things groceries, prices, and fruit, could you give me a fair price for a pound of apples? Trick question. You wouldn't be able to. The brain is a marvel- a veritable supercomputer in its own right; however, similar to a computer, our brain relies on petabytes of data to shape our preferences(Harrison et alt, 2023). For example, in my hometown I have the choice of buying apples from ShopRite, Wegmans, or Whole Foods, listed in order from least to most expensive. The price heterogeneity of the stores informs a more balanced valuation for apples compared to an area with one predominant grocery store. If I grew up with only a ShopRite next to me, I would never pay a Whole Foods price for apples.

Another way of thinking about the concept is using statistics as a reference point. The "true value" of items is analogous to the population mean and the sample are the set of different alternative valuations for the same item or valuations for similar items. How we derive economic value for things is inherently relative but also incredibly unintuitive to the point of delusion. Just like mundane statistical experiments, our brain has lackluster study design, untold biases, and disastrous statistical significance(Ariely, 2008). Summarily, all our brains are excellent, efficient supercomputers with a few critical kinks in our circuitry; let's crack open our brain's CPU and look at the logic behind how we derive economic value.

Relative Preferences in Traditional Economics

Neoclassical economics has long used revealed preference models as the basis for consumer behavior; wherein, the relative preferences of consumers are "revealed" by their habits. Hierarchies are set up based on the different levels of relative utility with which we interpolate between preferences, forming a supposedly holistic picture of behavior. In Micro you probably learned about modeling these revealed preferences on indifference curves, graphs that model your utility given certain decisions. Your micro professor probably swore up & down that these curves are wholly generalizable to any economic form due to certain axioms that make human behavior predictable(Samuelsen, 1938). For example, they created axioms to help define human behavior.

Imagine three sets of bundles with different linear combinations of commodities,{A,B,C}, with the following preferences: A ? B, and B ? C. The relationship between bundles A & B is explicitly stated; but on face value we can't logically compare A & C without making some generalizations. The only way to come to the optimal bundle to maximizing utility out of set of all possible combinations is to assume that, B ? A. If we assume that and assume that our hierarchy of preferences never change, the transitive property would imply that A?C. Despite not having any direct point of comparison between A & C, due to the Generalized Axiom of Revealed Preference(GARP), we should be able to understand our relative preferences and form inferences about larger consumer behavior in its totality(Ariely, 2008). Another way of thinking about consumer demand is simply the aggregate of all of these sets of preferences, given meaning by our supposedly air tight axioms of human behavior (Samuelsen, 1938).

A More Realistic Perspective

Newsflash, this is not quite how it pans out in the real world. Let's think about the above ABC's example. To me, it seems as though our so-called axioms are trying to compare apples to oranges by way of peaches. In truth, conventional consumer theory is more well developed than the few snippets I have torn apart today;regardless, In my opinion, they remain an approximation, a poor one, of people's consumption preferences. Humanity is just too irrational to fit predetermined axioms. For instance, some people refuse to pay more than $15 for a monthly haircut and some people pay $40 + tip for a haircut. The economically optimal decision for your preferred price is probably somewhere in the middle between the two extreme choices; however, the interesting part is how I knew to pick those values as bookends(Ariely, 2008).

As a child ,all my haircuts were monthly bowl cuts from Great Clips for $15 +tips due to the aggressive couponing so, for me a reasonable price for a haircut is around $20 including tip, anything more is too expensive for my taste. In contrast, the bourgeois person finds themselves always paying around $40 dollars, having grown up in a relatively more gentrified area, the other person would be comfortable paying up to $20 more per haircut consistently. If it were the case that humans were some sort of rational decision making bot, wouldn't everyone instantly deploy a first order optimization algorithm to ascertain the haircut distribution to maximize their utility? Yeah, not exactly(Ariely, 2008).

Sticky Prices and Anchors

Another form of related thinking insanity humanity employs having extremely stubborn, sticky self concepts. My father has not bought new shoes since 2011. Recently, he went to the store to purchase new shoes and came back empty handed. My dad found the average price of shoes to be too expensive to his taste. His relevant sample estimator for the price of pants was stuck in 2011- even the most reasonably priced shoes seemed overpriced for my father. Just like my dad with the shoes, we develop reference points for which we default to- irrespective of reality. As another example, since my mom drove a Toyota Camry, if I were to buy a family car, I would automatically compare the feeling to my mom's Toyota(Ariely, 2008). Life is perhaps more complicated than shoes and wheels, so perhaps my words come off as a tad flippant but I would just urge you to do some further introspection. Is it really not obvious to you that humanity is a delusion robot rather than a rational one?

The Limitations of Rationality

As I have written about ad nauseam, my thoughts are not new or original. Prospect theory is not new. There are people who have spent their entire adult life proving prospect theory; yet, why has prospect theory gone mainstream? In his book Predictably Irrational, Professor of Behavior Economics at Duke- claims it's because neoclassical theorists do not take the consequences of irrationality seriously. Neoclassical economists can obviously recognize their own inherent proclivity for irrational decision making; yet, they still dogmatically cling to the idea that when it comes to important decisions and when looking at decisions on a greater scale, eventually humanity nets out to a position where they always arrive to an optimizing quantity(Ariely, 2008). The idea of some sort of quasi central limit theorem for rational thought is evidence itself of humanity's propensity fordelusion. Simply put, the pro economic robot camp seems to forget about the coastline paradox.

Human preference, similar to the length of a coast line, scales unevenly based on the granularity of our view(Mandelbrot, 1967). For example, after a nice glass of wine I will get hungry and finish a whole pizza by myself- only starting to feel overfull on the penultimate slice; however, when I am sober, I start feeling diminishing returns after the 2nd slice and I am tapped out by my 4th. It is clear that my change in utility is a result of a shift in my utility curve itself and not a movement along it. So as a proof by counterexample, the assumption that I make rational decisions every time is clearly false. Stepping back from math- intuitively I think that feeling is generally reflected in our surroundings too. I doubt Milton Friedman would be able to explain the existence of meme stocks or the use of 0 DTE options as perfectly rational behavior.

The Future of Irrationality

Despite constantly railing against Neoclassical economics, I get where they were coming from, people tend to think mostly rational in most situations. As a great mind once said: more complicated is definitely not always better(Nagaram, 2024). In this case, I think we're starting to stay a little bit too long in the past. Studying these phenomena was prohibitively harder without modern advances in technology; but, now that we have access to more interesting tools, It's high time we upgrade our thinking. As I have written about previously, I am a proponent of agent based models of behavior that can use dynamical systems theory to give shape to our unpredictability(Poledna et alt, 2023). I envision a reality where we can give a valid form to the dynamism of our thinking.?We are still in the age of electricity, still fiercely clinging to torch light, one inch at a time- I would love to move us out of the dark.