In economics, we often assume that people act like what we call a Homo Oeconomicus. That means they are always rational. More specifically, a Homo Oeconomicus always maximizes utility (as a consumer) or profits (as a producer). To do this, they rationally weigh all the costs and benefits and always chose the best possible course of action, given the circumstances and constraints they face.
In reality, however, people don’t always behave like a Homo Oeconomicus. In fact, they hardly ever do. Real people are much more complex than that. Plus, human reasoning faces a number of imperfections. That means, people don’t always consider all relevant factors, because they may be emotional, impulsive or short-sighted. Thus, in the following paragraphs, we will take a closer look at the four most significant imperfections and limits of the concept of Homo Oeconomicus.
1) People Are Overconfident
Imagine you are asked to give an estimate of the number of Ford trucks that are currently licensed in Texas. Pretty tough, right? To make it a bit easier, let’s say you don’t have to provide a single number. Instead, you are asked to give a 90% confidence interval. That is, you have to pick a range so that you are 90% sure the true number will fall within your interval. What would you say?
If you want to be on the safe side, you could simply pick a ridiculously large interval like 1 – 22 million (i.e. the total number of registered vehicles in Texas) or something like that. That way, you can be absolutely sure that the actual number falls within your range. However, experiments show that people often pick intervals that are too small to answer these kinds of questions. As a result, the true number falls within their range far less than 90% of the time. In other words, most people seem to have a tendency to overestimate their own abilities.
2) People Overweigh Vivid Observations
Let’s say you are thinking about buying a new Ford truck. Because you are a rational consumer you inform yourself before you make a decision, so you read exactly 1000 customer reviews online. The majority of them are positive. Additionally, you also talk to a friend who happens to own a Ford truck himself. He tells you that he’s not happy with his truck and advises you to get a different car instead. How would you rate his statement compared to all the other reviews online?
If you were completely rational, this additional review should actually not have a significant impact on your decision whatsoever. After all, it only increased the sample size by 0,1% (from 1000 to 1001). However, you probably value the opinion of your friend more because you are closer to him and his story is more vivid than all the reviews online.
3) People use Rules of Thumb
Let’s say you are still thinking about buying that truck. One of your main concerns is safety. So you do a quick search online for news reports of accidents that involve Ford trucks. To your surprise, you find that Ford trucks are included in far more accidents (according to those reports) than any other type of car. How would you evaluate this information?
Again, if you were completely rational you would quickly notice that you need more context to evaluate this information. For example, it is likely that many of the accidents are caused by human errors that have nothing to do with the vehicle itself (e.g. texting and driving, drunk driving). In addition to that, Ford trucks are among the most popular vehicles in the US. As a result, there’s simply more of them on the road which automatically increases the likelihood of an accident involving a Ford truck. Even though they may be just as secure (or even more secure) than any other car.
Despite all that, these reports will probably leave you with a feeling of insecurity. The reason for this is that people rely on heuristics (i.e. rules of thumb) to make judgments. That is, they judge situations based on individual experiences (anchoring heuristic), the perceived likelihood of something happening (availability heuristic) and the perceived similarity to individual stereotypes that they hold (representativeness heuristic). Now, looking at all these accident reports will affect your perceived likelihood of an accident, because of the excessive media coverage.
4) People are Reluctant to Change their Mind
Finally, imagine you have just bought that new Ford truck we mentioned above. Another friend stops by that day and you tell her about your new purchase. Your friend does not own a car, because she is convinced that Diesel trucks are bad for the environment. Although you are aware of that, you are convinced that in your case the benefits of owning the truck outweigh the potential environmental consequences. To convince you, your friend sends you a scientific report on the effects of road traffic on global warming. The report covers a number of different aspects and lists pros and cons for each topic (as a scientific paper should). Will this report change your mind?
If you were completely rational, you would look at each argument, weigh it against your current knowledge and reconsider your stance. However, you’ll probably look at the paper and conclude that your initial view was the right one. In fact, many experiments have shown that people tend to interpret information differently because they focus on examples that confirm their views.
In a Nutshell
In economics, we often assume that people act like what we call a Homo Oeconomicus. That means they are always rational. In reality, however, human reasoning faces a number of imperfections: (1) People are overconfident, (2) people overweigh small numbers of vivid observations, (3) people use rules of thumbs (i.e. heuristics), and (4) people are reluctant to change their mind.