Rational Pirates and the Behavioural Economics Paradox

Rationality has been the premise of so many economics classes, that for me and the forty other students whom I sit with in class, it has become somewhat of a ‘given’. Nobody has to say that rationality prevails, and yet we know, that every single economic model, right from the simplistic Law of Demand, to the Impossible Trinity is based on rationality. If the decision makers, whose aggregated decisions result in the said economic models were to forsake rationality, the very foundation of economics as we now know it, would collapse upon itself.

It cannot be denied that the economic models seem to be working wonderfully for us. It wouldn’t make sense to question the correctness of research that has been successfully conducted over centuries, or the established fruits that the implementation of these economic policies has borne.

And yet, the marketer inside me cannot accept the assumption of rationality.

Maybe there is something in the very definition of rationality that causes a bother. In economics, we define rationality in terms of benefits – a rational person always makes decisions that are the most beneficial to him. A rational decision is a decision which in effect is optimizing situational returns for the decision maker. Returns are the hallmark of rationality – the very reason behind the way in which the primary inputs such as labour and capital move. But in reality, this return-based definition turns rationality into a something that is much more complex than assumption would allow. There is a famous problem of the five pirates which asserts this complexity beautifully.

Let us say there are five pirates – A, B, C, D and E. These pirates have a bag of gold coins between them, which contains a 100 gold coins. The task before them is to divide the gold coins. The division has to follow certain basic rules mentioned below:

  1. The pirates have an established pecking order. A is the senior-most, B comes next, followed by C and so on.
  2. If anything untoward happens to the senior-most pirate, the next in line resumes the position immediately, and with no difference in power.
  3. Only the senior-most pirate can suggest a division.
  4. If the division suggested by a senior pirate doesn’t achieve majority, then the senior pirate is made to walk the plank (killed, to not use a euphemism), and the next most senior pirate takes up the work of division.
  5. Majority is calculated as follows – For n pirates, majority is the smallest integer function of (n/2). That is, for n = 5, majority is 3, and so on.
  6. It is therefore, in the interest of each pirate to maximize not just his share, but also his lifetime.
  7. It can be assumed that even if only two pirates were left, the senior pirate can be made to walk the plank. Physical strength and sword-fighting skills, are therefore, not a factor.

Given all this information, if you were A, what would be the division you propose? Remember, you are a rational person. And so are the other four (The solution is left to the reader, which if correctly calculated, will result in a VERY surprising answer – A:98, B:0, C:1, D:0, E:1 ; it is also available on Wikipedia)

The solution to this problem (most often wrongly suggested as ‘20 gold coins each’), is what Behavioural Economics implies. The exact solutions to problems of rationality are often very different from the ones which mankind arrives at in the real world. Consider this problem itself to be an example. It’s only the usage of the word ‘rational’ in the statement that dictates an extensive use of logic in arriving at the final answer. The commonly accepted and safe solution, in case of the pirates as well, would have been the most obvious one. 20 gold coins each. Neither would the senior pirate, in fear for his life, try and explore the possibility of a greater number of coins for himself, nor would the juniors see the added benefit or loss in case of a completely equal division. In real life, everyone would except this to be the perfect solution, and the poor pirate A, if he were to introduce the rational solution, would surely lose his life.

We have thus, reached a very subtle crossroads in the subject of Economics. If in situations which display an above average level of complexity, human decisions are not, strictly speaking, rational, then would it make sense to derive complex economic phenomena, such as IS-LM models or the Philips Curve on the basis of an assumption of rationality?

It might be very difficult to digest a large scale departure from generally accepted Macroeconomic phenomena as an outcome of such complex decision making scenarios (which are few and far between), but two things need to be appreciated here. Firstly, complex macroeconomic phenomena after all, are nothing but aggregations of minor decisions made by people. In outlining these, the decisions made by the people are assumed to be rational. But if these minor aggregations are not as assumed, then each misappropriated dollar would change the resultant curve by a fraction (a very small fraction, possibly). With each irrational decision, the net effect on a curve will add up. If the differences are significant individually, they will cause a significant distortion on the curve. This fact, when combined with another thing becomes the very reason behind our crossroads.

According to various economists, the irrationality in making decisions is not limited to situations of high complexity. As espoused by Dan Ariely in Predictably Irrational, behavioural economics is at play while consumers make the simplest of decisions. He outlined several situations in which the decisions of the people differ from that of a rational thinker’s, not just at an individual level, but also as a mass. Some of the best examples are:

  1. When consumers were given three choices, A, B and B`, where B` was merely a toned down or unviable version of B, consumers chose to go for B, without considering the viability of A. In this offering, the consumers simply stop thinking of A, because their minds are too busy comparing B and B` and declaring B the winner.
  2. Consumers were irrationally positive in going for a deal with a ‘free’ offering, even though on a money per volume basis, the ‘free’ deal was less viable. This is hardly rationality by returns. A 15g bar of chocolate priced at $5 is rationally a much better option than a 10g bar of chocolate priced at $6, along with which, you receive a smaller 5g bar free, but consumers can hardly ever tell the difference.
  3. Consumers tend to identify and stick to ‘anchors’. If someone was told that all products in category A ranged in price from $10 – $20, and a highly inferior product (of actual value less than $5 was presented), consumers failed to evaluate it competitively and priced it in the ‘anchor’ range. Similar evaluations take place in real lives as well. If a consumer is exposed to a category of products through a luxury brand, they tend to associate the category with a higher price range than actual, and may become delighted when a nominally priced product is presented, thus triggering a completely changed buyer behaviour.
  4. A consumer buying a $10 pen is liable to search for another shop which offers the same for $5, but would hardly consider changing to another shop if it offers a $3000 car for $2995. The saving is the same in both cases, yet the scale of the purchase in the second case diminishes the importance of $5 in the consumer’s mind. Not something that rationality would suggest.
  5. Consumers value personal possessions at premium. Personal attachment might force people into selling their own property at a much higher rate than that fixed by the market. Associated strongly with this, is the concept of emotional or abstract value. Why do consumers agree to pay disproportionately high amounts of money for tickets (especially for very important sporting events) purchased in black? It is because the value of a special cricket match in the consumer’s mind might be much, much higher than the purchase price.
  6. Similarly there are two completely different norms by which consumers function – the market norms and social norms. In case of social norms, the rationality of transactions is virtually overturned. In the market, people only lend at interest and pay even for drinking water. At your friend’s place, however, you never lend or borrow at an interest rate, or pay for a meal. The idea is ludicrous. Thus, whenever social norms mix into market transactions (in case of NGOs or MFOs for example), the rationality of decisions is affected.
  7. Very importantly, consumers procrastinate. They may not invest in assets on a timely basis, or save, or not give in to temptation, or follow the exact procedures which a rational consumer might. If all consumers were a 100 percent rational, all early-bird schemes should run more than ninety-five percent of their market potential in the very first day, which hardly ever happens, as evidenced by the stretching out of these schemes over days, or even weeks.

The above situations identify the problems in assuming a rational economic model. While the first three point strongly towards the way in which people are supposed to buy consumer products, point 5 puts several models of fixed asset pricing and purchasing (especially real estate and aftermarket products) under question, and point 7 questions the
very basis on which the LM curve is formulated – the demand for real balances, given a fixed money supply.

The next time, you go to a supermarket, you might try to observe the inherent irrationalities, that you actually operate with, when making purchase decisions. You might realize, that in effect when a smart-phone sales person is telling you how horrible one of the three phones on the table is, he might not just be drawing your attention to the second phone, which is a better deal for him, but making you completely disregard the third phone, which is the worst deal for him.

It is, therefore, not that difficult to understand why for a marketer, the validity of the rational economic model hangs in the balance. While it is often suggested that over large population samples the variations average out to give the same result, nothing can truly be said about Pirate A surviving the ‘rational’ division in any community of pirates, no matter how rational.

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