We recently read on the Psy-Fi Blog an interesting academic study about a group of “irrational” participants forming what appears to be a rational market. Specifically, researchers John List and Daniel Millimet studied groups of children at suburban malls which were hosting sports card shows.
One sign of being irrational is when a person does not have what geeky economists call “well-ordered preferences”. Children often lack well-ordered preferences, and it is why we don’t allow them to sign contracts, or vote. It sounds eggheaded, but it is a simple concept to understand. If someone likes A better than B, and they like B more than they like C, then, logically, they should like A more than C. Sometimes it doesn’t work out that way, and people express their preferences something like this:
A > B > C > A
So the researchers bribed kids with juice boxes and bags of chips to participate in the nearby trade show, measuring their ability to form well-ordered preferences as well as their interactions at the show. The money quote from their paper is “Our findings suggest that even in markets populated entirely by irrational actors, several fundamental features of markets, such as price and quantity realizations, meet neoclassical predictions after a few rounds of market experience.”
Anyway, this got us thinking about a dirty little secret we learned back when we were an economics student: a group of irrational people will, by necessity, act as if they are rational. Consider a world where the only foods available are hamburgers and pizza (what else do you really need?). Hamburgers cost $5, a slice of pizza is $2, and we will give each person $100 to spend. The range of possible purchases is represented by the red line on the graph on the left. Our irrational subjects, being irrational and all, spend their money in a completely random way. They could end up at any point along the red line regardless of their personal tastes for hamburgers or pizza. And if you take the average of a group of people behaving similarly, you end up at the midpoint of the red line. On average, the idiots would buy 10 hamburgers and 25 slices of pizza.
Now let’s change the prices a bit and see what happens. We will reduce the price of hamburgers to $4 and increase the price of pizza to $2.50. Economic theory, and even common sense, says that faced with these changes in prices, people will shift their purchases toward more hamburgers and less pizza. However, our group of crazy spenders will just go on buying hamburgers and pizza randomly. Again, they each land at some random point on the red line on the graph on the right and the average mix is the midpoint of the red line. Guess what? As a group, our unthinking random spenders bought more hamburgers and less pizza!
Go ahead and chew on that for a while. We are going to our local pizzeria to take advantage of their “happy hour” special.