Thursday, April 23, 2009

Adam Smith is Not Guilty of One-Dimensional Rationality

David Wolfe's Ageless Marketing HERE:

The End of a Myth: The Rational Man Theory of Markplace Behavior'

‘This experiment and many more are discussed in Ariely’s provocative new book, Predictably Irrational: The Hidden Forces that Shape Our Decisions. I enthusiastically recommend Ariely’s book to anyone involved in product pricing in any category. You will likely come away from this read with a better handle on how to price products.

Classical economics has rested on a premise that Ariely shatters to smithereens. For well over two hundred years economists have based their thinking on the premise that marketplace trends are determined by the rational behavior of people acting in their own interests. This in fact is the keystone of Adam Smith’s book The Wealth of Nations, the Old Testament of capitalism.

Ariely is not the first to challenge the rational man premise of classical economics. A whole new subfield called behavioral economics has taken root because some brave-minded stalwarts in the dismal science decided the emperor was stark naked. The notion that marketplace trends reflect the outcome of human reasoning in an objectively fathomable world is every bit as illusory as the appearance that the earth is more or less flat.

The cat is out of the bad, so to speak. I would expect to start seeing more accurate economic projections in the future now that such prominent economists as those who wrote the books I’ve cited in this post have revealed just how naked the rational man theory is.

David Wolfe bases his article on, ‘Economist’ Dan Ariely’s book, discussed on Lost Legacy earlier this week. Yet Adam Smith’s book, The Wealth of Nations, does not base its ‘thinking on the premise that marketplace trends are determined by the rational behaviour of people acting in their own interests’, where the implication is that all consumers share the same self-interests and to the same degree.

If Dan Ariely has read Wealth Of Nations, Books I and II he would know of the 60 plus incidents in these two books which deal with markets where the self-interests of individuals have negative consequences for others (externalities) and there is no common self-interest that is necessarily shared by all those in the market. People do not buy merely on price (that is a construct of the mathematics of the late 19th century Marshallian demand curve and is an axion of modern neo-classical, not classical, economics).

Even in the simple purchase of examples in Wealth Of Nations introduces a movement of prices: ‘A publick mourning raises the price of black cloth’ (WN I.vii.19: 76-77).

Some people try to buy despite the rise in price; they are in mourning; others do not buy at all – they may be in mourning, they may not be.

Some, but not all, people pay higher prices for a new commodity because they want to be ‘fashionable’, to ‘attract attention’, to ‘cut a figure at a ball’, and any of a dozen other ‘rational’ (to them) reasons. In Book IV of Wealth Of Nations there is a discussion in Chapter ii of the role of the 'delusion' of the 'beauty' or 'fitness' of a contrivance being more persuasive than its utility for soem people - Smith gives it a central role in the motivation of entrepreneurs and consumers.

There is no common rationality. Smith discusses this and more in Moral Sentiments (1759).

Homo economicus was invented as a concept in the late 19th century, not by Adam Smith (he died in 1790). It fits a certain kind of mathematics – the kind that needs to be determinate.

Its sponsors have to find a common explanation, even if their explanation is partial. When used to predict the future, for which large fees are paid (despite the lousy track record), it is at its most vulnerable to ‘events, dear boy, events’.

Behaviourists and psychologists are aware of the variability of human motivation and behaviour. All we have to do now is convince more economists, which, ironically in view of the partial knowledge of Dan Ariely about Adam Smith, means encouraging more of them to read both Moral Sentiments and Wealth Of Nations.

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