The Myth of Homo Economicus

When I went to school in the Dark Ages, we were taught in Economics that there is such a thing as Homo economicus, a purely rational human who makes all economic decisions based on “What’s in it for me” — sounds a lot like Chicago aldermen, but I digress. In many ways, this short cut made economics much easier.  We didn’t have to worry about things like people’s desire for respect or willingness to impose “fairness” into our negotiations. But it was also a bit like physics, where we were told to ignore the effects of friction in some of our equations – a shortcut than didn’t really help our understanding of the world we live in.

As time moved on, economists and psychologists started to research whether the Homo Economicus was real or a fallacy.  Scholars like Amos Tversky, Daniel Kahneman, Ian Ayres, Dan Ariely and Richard Thaler ran scientific experiments to see if people really did act rationally when it came to economic decisions.  What they all found, in various ways, was that we are not rational at all when it comes to buying, negotiating, selling, responding to advertisements and even going to the movies. In fact, to steal the title from Dan Ariely’s most famous book, we are Predictably Irrational.

I have recently completed reading the book Priceless: The Myth of Fair Value (and How to Take Advantage of It) by William Poundstone. I had read a number of Poundstone’s books before. He wrote books on secrets and puzzlers like How Would You Move Mount Fuji?, but I wasn’t prepared for the level of detail and research that he had completed to write this book.
The book is structured into 53 chapters. Each chapter takes a specific pricing case and talks about the specifics of the deal. There is also a description of a scientific experiment that describes the psychology of the participants. I had read about a lot of the experiments before, but this book allowed you to tie the results of the experiment with the results of a pricing decision in a very real way.

Poundstone opens the book by retelling of the McDonald’s hot coffee lawsuit, where the attorney for the plaintiff in the case employed a simple scheme to raise the amount of the jury award — he simply asked for an astronomical award from the jury.  This raised the anchoring point for the jury so that while they awarded much less than the asked for judgment, they awarded much higher than any rational person would have considered the case to be worth.  Anchoring also works in the grocery aisle.  Not too long ago, the standard size for ice cream was a half-gallon.  Consumers had in their minds what they normally paid for a half-gallon of ice cream.  Manufacturers wanted to raise prices (their costs had increased) but were concerned that if they raised prices, people would notice and either change brands or even more worrisome, consider alternative dessert items.  So, now if you go into the grocery store, most ice cream is sold in 1.5 or 1.75 quart sizes (a reduction of 12-25%), but the pricing is kept in the same familiar range.  The average consumer doesn’t realize that they are getting less for the same price and the market share of ice cream as a portion of the dessert market is safe. Anchoring at its best.

One of the experiments that gets a lot of play in the book is the ultimatum game.  In this game, one person is given $10 and is told that they can give any part of the $10 to another player.  If the other player agrees, then the deal is done.  If the other player does not agree, neither party receives any money.  This simple game uncovers a lot of different outcomes.  Men perform differently from women, Type A’s perform differently from Type B’s, Liberals perform differently from Conservatives, sober people perform differently from those more tipsy.  Is the proposer most rational when he proposes $1 to be given to others while keeping $9 for himself?  Is the receiver rational when rejecting a deal that would make them $1 richer in order to punish the unfairness of the proposer?  The best example in the book of the ultimatum game in real life is the story of Jack Welch’s divorce negotiation.  While we normally think of Neutron Jack as a most savvy businessman, it was fun to read the story how of his former wife turned the tables on him using the precepts of the ultimatum game.

Each of the chapters talks about ways that we as consumers are manipulated to paying more or selling for less than our mythical ancestor Homo Economicus would have been expected to.  This is certainly important to consumers, because a savvy consumer who is aware of the psychological tricks can make smarter purchasing decisions.  As business people, it is helpful to understand how to price your products and services in order to reduce price resistance.

This book was a pretty easy book to get through with enough concrete examples to catch your attention. In the 1-5 star rating category, I would give this book a solid 4 star rating.

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