The Winner’s Curse by Richard Thaler
Maybe my discipline for reading has been waning in recent weeks, because this is the second consecutive book that I’ve been unable to read in its entirety before quitting. The problem with The Winner’s Curse is that it is a highly technical way of saying “duh.” By this I mean that Thaler addresses issues that are only problems for economists that apparently have no experience with actual human beings.
Economists have long assumed that humans are, fundamentally, rational creatures. Even von Mises assumed as such, although it should be noted that his usage of “rational” was tautological, and based solely on economic actor’s behavior (instead of, say, the economic actor’s stated goal) and bound by the limits of human knowledge. Basically, Mises argued that one’s “true” desires were shown by one’s behavior, and that all humans pursued the most efficient course of action to attain the desired ends.
However, mainstream economists generally tend to define “rationality” as one’s tendency to act in one’s best long-term interest. Whether this definition accounts for the constraints of humanity (i.e. imperfect knowledge, the constraint of time, etc.) varies by economist. At any rate, the assumption is that humans have a tendency and desire to act in their long-term best interest, and, furthermore, derive only (or mostly) direct utility from consumption.
These assumptions are wholly fallacious, and contradict observable reality, which creates quite a problem for economists who try to make detailed policy prescriptions, since doing so generally requires the ability to correctly predict micro-level behavior. Obviously, economists have largely been unable to do so, in part because they bought into the myth of the average person, and in part because the average person does not resemble an actual human as much as it resembles a watered-down version of what economists think an ideal human being would look like.
Thus, much of what has been written about theoretical human behavior from an economist’s standpoint has been largely irrelevant and useless to those who live in reality because economists desire a reality that does not exist. One example of this is what’s known as the Ultimatum Game. The game is played by taking two people, giving one of them a sum of money, and telling him to split it however he chooses with the other player. If the other player accepts, they split the money accordingly and go on their merry way. If, however, the other player declines the offer, neither player gets anything and they go on their unmerry way. Theory dictates that the most rational course of action is for Player A to offer Player B one penny and for Player B to accept, with the idea being that one penny is better than nothing.
But when put into practice, as Thaler details quite extensively in his book, the offer is rarely a penny. It is usually substantially more than that (close to 50% in many cases).
It turns out that humans are more complex than economists would lead you to believe. Many humans, it appears, have more than a direct pecuniary interest in monetary offers. This shouldn’t be surprising, since humans are social creatures with a rather common need to show off. Non-economists tend to recognize this, and therefore make a point of making an offer that is not perceived as insulting. If an offer were too low, the recipient would decline it because the recipient would perceive the value of the money to be lower than the value of the social communication that declining the offer would bring (i.e. the recipient would find it more useful to say he’s insulted than to accept the money). This is, without a doubt, an economic judgment. Yet it is one that economists seem incapable of accounting for because it makes no sense to them.
But, without becoming too dryly analytical, humans are not hardwired to think solely in terms of direct utility. Products can serve multiple functions; some direct, some indirect. Polo shirts, for example, have a direct function of keeping one’s upper body shielded from the elements. But certain polo shirts, such as those made by, say, Ralph Lauren, have an indirect function as a status symbol. And there are people in this world, apparently, who find the added, indirect value to be worth the cost. Economists have failed to account for this sort of thinking, and have thus neglected to consider the full range of value that decisions can provide, which is why there is such a divergence between reality and theory when it comes to things like Ultimatum Game.
The rest of the book, or at least the parts I read, seemed to bear this sort of thing out as well. Why is there such a difference between reality and theory in economics? The answer is, for the most part, quite simple: Economic theory doesn’t actually account for the behavior of real people.
Thaler, in making this decidedly simple point, feels compelled to dress it up in fancy mathematics. There is, of course, nothing inherently wrong with doing this, but it does make for a very dry read. Also, it seems to be a very complicated way of stating the obvious.
However, this degree of precision and insight makes the Winner’s Curse a necessary read for any aspiring economist. Economics, as a method of study, is not particularly useful if one neither knows nor corrects for the fundamental mistaken assumptions upon which the intellectual edifice is built. Economics does have plenty to offer, as a method of analysis, but it is only useful if its axioms are realistic. The Winner’s Curse, then, is useful because it questions the basics of theory. Not only that, it provides the answers as well.