Irrationality and How to Avoid It

In the field of behavioral economics, conversations often revolve around ideas of rationality versus irrationality. This blog post will explore what irrationality is in economic terms, and how to avoid it as much as possible.  

While the word may conjure up associations with senseless, unintelligent acts, this is not what behavioral economists are referring to when they speak of irrationality. Irrationality is rather systematic and predictable, and practiced by everyone including experts in their field. Traditional economic theory states that we act to maximize utility; when we act irrationally, we are simply acting in ways that do not maximize our utility, whether due to rushed cognitive shortcuts, psychological tricks we play on ourselves, or a host of other means by which we fail to act in our own self-interest. Below I will outline some of the most common shortcomings in rationality, and how we can actively avoid them.

The Power of Free:

“Free” has a surprisingly strong effect on people, so much so that it can lead to us making poor decisions. Amazon offering free shipping on many items with a $25 minimum leads to a significant increase in sales for them. We know this in part because when 20 cent shipping for Amazon in France negated the free benefit, overall sales declined. In another example, people may wait in line for 30 minutes for a free ice cream event, when they would never waste 30 minutes of their time standing in a line in exchange for the $5 that the ice cream was worth to them. We should be cognizant of how often we buy things we don’t actually want just to achieve a free bonus.

Sunk Costs & Opportunity Costs:

Understanding and living by these economic principles can have a powerful impact on how we spend our time. A sunk cost is a cost that has already been paid and cannot be changed. Opportunity cost refers to the potential benefit of the next best alternative that one misses out on by making their decision. A good example of both of these principles at play is when one purchases advance tickets to an event. If someone arrives at an overcrowded and unenjoyable event, they are likely to stay anyway. Due to faults in our logic, our natural inclination is often to continue doing something we paid for, even though the ticket price was a non-recoverable sunk cost, and we’d be having more enjoyment elsewhere. It is particularly important to consider opportunity costs when we are making a difficult decision. When deciding between two very similar alternatives, we have to consider the loss that comes from not making any decision. Is the benefit from carefully choosing the slightly superior option worth the time spent with neither option, and the energy that went into that decision? 

 Acting as If We Own:

Various mental tricks make us act as though we own items before we really do. When we believe that we own something, we’re inclined to value it higher than it may really be worth to us. One clear example would be bidding on an item on eBay. We can feel like we owned the item simply because we had the highest bid for a time. Because of this, the value of the item is inflated, and we are more likely to get caught up in a bidding war and ultimately pay more than we would have if there had been a fixed price on the item. Free trials or renting both can increase the sense of ownership and attachment we have for the item and thus has the same risky effect.