Behavioral Economics, Ep. 3: Why Do We Make Poor Decisions?

Release Date
August 19, 2016

Topic

Basic Economics Economics
Description

Why do we make bad choices?
Making rational choices is expensive. It takes time and energy to collect the information necessary for rational thought, and it takes mental effort to apply rational thinking to the information we gather. For that reason, we occasionally use a different type of decision making all together. Professor Antony Davies of Duquesne University and Erika Davies of George Mason University explain. Learn more at hayekandchill.com/economics

Behavioral Economics (playlist): Heuristics, cognitive biases, public choice– oh my! Watch the entire series to learn more about behavioral economics at http://hayekandchill.com/economics/
Economics Made Easy (playlist): Want to learn more about how the economy works? Check out our playlist for videos on immigration, the minimum wage, and much more! 
Predictably Irrational (book): From drinking coffee to losing weight, from buying a car to choosing a romantic partner, we consistently overpay, underestimate, and procrastinate. Yet these misguided behaviors are neither random nor senseless. They’re systematic and predictable—making us predictably irrational.  

>> Making rational choices is expensive. It takes time and energy to collect the information necessary for rational thought, and it takes mental effort to apply rational thinking to the information we gather. To defray these costs, humans rely on mental shortcuts to make decisions. We call these heuristics. For example, we might choose options that our friends choose, choose the same thing we’ve chosen in the past, or choose the first time we encounter.
 
Employing heuristics doesn’t require the time, energy or mental effort that rational thought requires, but the probability of making a bad choice is higher when employing heuristics.
>> Compared to rational thought, heuristics present a tradeoff. They are easier to employ, but more likely to yield poor choices. And it turns out that humans tend to employ heuristics, well, rationally.
 
We’re more likely to employ heuristics rather than rational thought when the effort we save from employing them outweighs the cost of making a poor decision.
>> In practice, we usually employ a combination of heuristics and rational thought. For unimportant decisions, like choosing a disposable pen, we rely more heavily on heuristics.
 
We just pick the one that attracts our attention first or the one we recognize from past use. For more important decisions such as buying a house, we rely more heavily on rational thought.
>> But occasionally, humans rely too heavily on heuristics when we should be relying more on rational thought.
 
When this happens, we say that the humans have succumbed to cognitive biases. Cognitive biases are errors in decision making caused by an inappropriate reliance on heuristics.
>> In 2002, a teenager committed suicide by flying a private plane into a building in Florida. An investigation revealed that the teenager was taking a prescription drug for severe acne.
 
Further investigations revealed other instances throughout the country in which teenagers who were on the same drug also committed suicide. In response to this news, many people wanted to ban the drug. This is an example of a heuristic at work. Instead of collecting more information, people chose to call for a ban, based on the first information they encountered.
 
But the choice to band a prescription drug has grave implications. And when a choice involves grave implications, over reliance on heuristics can lead to cognitive bias.
>> The cognitive bias in this case was that people’s emotional reactions prevented them from asking an important question. How many teenagers taking the medication did not commit suicide?
 
Subsequent research showed that teenagers who look the prescription drug were not at greater risk of suicide. In fact, it appeared more likely that the cause of the suicides was despair over severe acne rather than the drug used to treat the acne. Yet because of a public outcry driven by a cognitive bias, we came dangerously close to banning this drug.
 
>> When used inappropriately, heuristics result in cognitive biases that lead us to make poor decisions. The decisions are poor not because the humans are irrational, but because we’ve misapplied a tool that evolved to help us make complex choices. Because poor choices have consequences, we have incentive to learn from our mistakes.
 
Where the consequences of making a mistake are great, and they fall on those making the mistakes, they learn faster. Where the consequences are less, or when they fall on others, the actors learn more slowly. This process of making choices and enduring the consequences encourages us to make better choices and provides the dynamic force that is the engine of this wonderous enterprise we call, the economy.