Why Behavioral Economists Are So Often Mystified

Over the last decade, waves of studies have claimed that individuals aren’t rational — that they often reject options that are in their best interest. That literature is being used to justify government “marketing” efforts to persuade people to accept government “advice” on everything from light bulbs to school lunches to home purchases. Cass Sunstein’s famous “nudge” approach — extolling the moral case for public interest propaganda is indicative of a growing interest in this approach by statists.

Auren Hoffman, a creative West Coast individual, recently wrote this related comment “Differences of Entrepreneurs and Consultants.” He describes a standard “test” similar to those produced by behavioralists.

I toss a coin. Heads you win $10,000. Tails you lose $6,000. Do you play and, if so, why?

To our elite friends, the answer seems simple. The expected payoff is $4,000 and, thus, you should play. People often reject that option, leading the Chattering Class to argue the irrationality of the individual.

But, Auren notes that the entrepreneurial individual will view this question in a larger context:

  • How do I know the coin is fair?  Maybe tails is much more likely to come up.  Can I test the coin by flipping it 500 times to gain more information?
  • How do taxes affect my wins and losses? Can I apply losses only to gambling gains? How are state and city taxes affected?
  • Do I have the cash to pay if I lose and do I get cash if I win? Will I have to show up with the money and, if so, is the transfer secure?  Can I get frequent flyer miles if I pay by credit card?
  • How can I be sure I’ll be paid if I win?  Will the money be held in a third-party escrow account?  How much will that (and other transaction costs) affect the overall economics of this bet?

Real world bets are made in context — there are always questions to be raised before rushing into a transaction. Many policy proposals from behavioral economists ignore that insight — that transactions have transaction costs. This is one reason why those policies are so often foolish.