2010-10-20

Landsburg the Accidental Austrian?

Steven Landsburg brings us another wonderful article about rationality, utility, and probability. Over the past week or so, he has been discussing the implications on economic rationality embedded in answers to the following questions:
Question 1: Which would you rather have:

A.A million dollars for certain

B.A lottery ticket that gives you an 89% chance to win a million dollars, a 10% chance to win five million dollars, and a 1% chance to win nothing.

Question 2: Which would you rather have:

A.A lottery ticket that gives you an 11% chance at a million dollars (and an 89% chance of nothing)

B.A lottery ticket that gives you a 10% chance at five million dollars (and a 90% chance of nothing)
Statistical and probability concepts imply that a rational person must answer either A to both questions or B to both questions. However, when people consider these questions, they frequently answer A to one question and B to the other.
 
To explain the discrepancy, Landsburg provides the following possibilities, ultimately concluding, "I lean toward number 4":
1. Maybe people don’t take surveys seriously. Actual experiments with real money might give more trustworthy results. Unfortunately, it’s difficult to find funding for experiments that involve disbursing millions of dollars (and it’s not at all clear that you’d get the same responses if you cut all the amounts by a factor of, say, a million).

2. Maybe people have no stable preferences. In Savage’s day, this conclusion would have meant throwing in the intellectual towel. If preferences fluctuate randomly, then it seems there’s no hope of modeling or predicting behavior. Today, the emerging field of behavioral economics (with much input from psychology) holds out hope that preferences might fluctuate systematically in ways that can indeed be modeled. Going down this road means throwing out — or at least reworking — a lot of successful economic theories. Maybe that will eventually prove worthwhile, but it comes at a high cost. It also makes it almost impossible to choose economic policies that will make people happier, since what makes them happy at 2:00 might not be the same thing that makes them happy at 2:30.


3. Maybe people value ignorance. I explained here how this might just barely account for the 1A/2B answers. On the other hand, I also explained how some simple experiments with urns and colored balls might show that the paradox survives even when the prospect of ignorance is removed from the equation.


4. Maybe people sometimes make mistakes — even smart people like Jimmie Savage. This really isn’t so surprising or so troubling. Someone (I forget who) once pointed out that great mathematicians make arithmetic mistakes all the time, but we don’t conclude that something must be wrong with the foundations of arithmetic. If this is all that’s going on, it’s both bad news and good news for economists. It’s bad news because those mistakes are a part of human nature that we’re not good at predicting (though once again the behavioral economists might someday ride to the rescue). But it’s good news because it means that we can make ourselves useful by pointing out some of these mistakes and helping people make better decisions. If you’re sure that 1A will make you happier than 1B, then I’m sure that 2A will make you happier than 2B, and I can explain why.
Note, however, that #2 is completely described by Misesian/Rothbardian subjective utility theory and time-preference. Notice how Landsburg acknowledges that "going down this road means throwing out - or at least reworking - a lot of successful economic theories."

It appears to me that Austrian School theories are starting to squeak their way into the mainstream. People are starting to consider the possibility that Austrian School reasoning is workable, but painful because it involves throwing out a lot of commonly accepted theory.

But isn't that what creative destruction is all about?