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CHAPTER 12

HOW GULLIBLE ARE WE?

Information Problems and Their Applications to Schools of Economic Thought

In the United States the burden of proof for a criminal conviction is evidence of guilt “beyond a reasonable doubt.” In death penalty cases, over and above the due process rights to fair and just proceedings, the Supreme Court calls for “super due process,” a painstaking sequence of trials, appeals, and reviews. Even so, the Death Penalty Information Center reports that 119 people have been exonerated from death row since 1973. Death row inmates, such as John Thompson who served eighteen years before an investigator discovered evidence “hidden” by the prosecution, were found to be innocent under the law despite the extraordinary attention that had been paid to factual information at their trials. These mistaken verdicts are information failures of the worst type, and they occur after what are typically protracted, multimillion-dollar explorations into the truth. If society can’t get things right after all that, imagine the errors that might be made with less closely scrutinized information. This chapter discusses barriers to information and rationality and examines the potential for consequent failures in markets and economic models.

Anyone who pays $30,000 a year for college tuition or $50 a month for Internet access demonstrates that information is a cherished commodity that requires time and money to acquire. Often the cost of obtaining all the information desired is prohibitive, and the result is often ill-informed decisions based on incomplete facts. One testament to the degree of misinformation in our economy is the large volume of litigation spurred by alleged information failures. Here are a few examples:

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¹ See http://www.usdoj.gov/civil/cases/tobacco2/.

² See www.jacksonwilson.com/articles/article_mcdonaldsfacts.htm. This case is held up by some as an ex-ample of excessive litigation (see, for example, www.overlawyered.com/2003/12/mcdonalds_coffee_revisited.html). However, the failure to inform patrons regarding the especially high temperature of McDonald’s coffee is seldom disputed.

Uninformed consumers may consume too much of products that have hidden costs, pay more for products than their value, or purchase products that are inferior in price or quality to those available elsewhere. Uninformed sellers face the same problems when purchasing inputs; the possibility of excess costs that result from moral hazard and asymmetric information is discussed in Chapter 11. Incomplete information and irrational behavior also stab at the heart of Homo economicus—the fully informed and rational representative agent whose unfailing utility maximization is used by many economists to model the behavior of us all.

If perfect information and rationality are what spawn efficient decision making, how concerned should people be about errors, bias, and incomplete information as sources of inefficient behavior and inaccurate applications of traditional economic models? This chapter examines chinks in our armor of information and cognitive ability and the implications of those weaknesses for economic theory and practice.

There are differing schools of thought about the significance of information problems and behavioral anomalies. Neoclassical economists, such as Milton Friedman, Arthur Pigou, and Gary Becker, place considerable reliance on rational choice theory, which holds that decision makers are able to compare all their alternatives with full information about the ramifications of their choices. Institutional economists, including Thorstein Veblen, John Commons, John Kenneth Galbraith, and Joseph Stiglitz, stress that decision makers may not behave according to neoclassical theory. They point out that institutions—rules, relationships, organizations, and systems of norms—along with cognitive ability limit our reception and retention of information and our responses to it. Governments, corporations, communities, labor unions, and markets all have rules and norms that can interfere with rational, fully informed decision making.

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Researchers in the field of behavioral economics study the rationality of market participants and find that people often make decisions based on heuristics, or rules of thumb. For instance, many retailers flout the pricing formulas of economic theory and use the keystone pricing method, which means they determine their retail price by simply doubling the wholesale price they paid to their supplier.

As with anything else, it is efficient to continue to seek more information until the marginal cost of doing so equals the marginal benefit. When information comes only at a cost, it may well be rational to act on incomplete information. This does not, however, explain every questionable use of information. In defiance of rationality, individuals are often responsive to the way in which information is framed. A half-full glass is equivalent to a half-empty glass in volume but not in perception. Psychologists Daniel Kahneman and Amos Tversky found that among 4 identical outcomes presented with differing descriptions, respondents overwhelmingly preferred a disease-control program that would save 200 out of 600 people to a program that would allow 400 out of 600 people to die.³

³ “The Framing of Decisions and the Psychology of Choice,” Science (January, 1981), 211, 30.

Dubious about models based on the ever-rational and informed Homo economicus, Nobel laureate Herbert Simon explained that rationality is bounded by limitations in the ability of decision makers to formulate and solve complex problems. In his book Models of My Life (1991), Simon argued that even Albert Einstein could not match the mental gymnastics ascribed to the fictional “economic man.” In further violation of neoclassical theory, some people do pay voluntarily for public goods that could be enjoyed on someone else’s dime. Although it would be rational to free ride on clean air, sermons, and lobbying efforts paid for by others, the Sierra Club has more than 750,000 paying members, most churchgoers give to their parishes, and about 4.3 million National Rifle Association members pay dues to that organization.

Again straying from the expectations of Homo economicus, decision makers sometimes make biased choices among competing options. Status quo bias induces people to stick with what they’ve got despite equally attractive alternatives. The authors of Smart Choices (2002), John Hammond, Ralph Keeney, and Howard Raiffa, describe a natural experiment in which the state governments of New Jersey and Pennsylvania both adopted 2 options for automobile insurance. Under plan A, insurance premiums were lower but drivers had a limited right to litigate after an accident. Under plan B, the premiums were higher but litigation options were broader. In New Jersey drivers received plan A unless they specified otherwise; Pennsylvania drivers were assigned to plan B unless they opted for plan A. The result was that the majority of drivers in each state stuck with the status quo, meaning the plan they were given in the first place.

Neoclassical theories of consumer choice rely on assumptions that the amount an individual would be willing to pay for a good and the amount he or she would accept to give up an identical good are the same. However, researchers have found endowment effects, meaning that people place a higher value on what they have than on what they don’t have. In a famous example, Daniel Kahneman, Jack Knetsch, and Richard Thaler found that, after randomly selecting half the students in a class to receive coffee mugs, students without mugs were willing to pay less than half as much to buy one as the people with a mug had to be paid to give one up.⁴ In auctions of seats in overcrowded classrooms, students with seats typically demand more to give them up than those without seats are willing to pay for them.⁵

⁴ “Experimental Tests of the Endowment Effect and the Coase Theorem,” Journal of Political Economy, (December, 1990), 98, 1325–1348.

⁵ An anonymous reviewer of early drafts of this book described this phenomenon.

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It would also be rational for everyone to ignore sunk costs—costs that have already been incurred and cannot be recovered. No matter how much money one has sunk into a project, the project should be abandoned if the future benefits do not exceed the future (or recoverable) costs. For example, the makers of the ill-fated movie Waterworld would likely have lost less money if they had dropped the project when costs ran hopelessly out of control, but having spent tens of millions already, they felt (irrationally) compelled to complete the film at a reported cost of more than $200 million; at the time (1995), it was the most expensive movie ever made. As another example, Air France and British Airways were slow to discontinue their supersonic Concorde passenger jet service despite losses, ostensibly because they had already spent so much money to get the program off the ground. All these examples demonstrate that even when good information is available, people may not use it wisely.

The information superhighway isn’t always super when it comes to accuracy. As one example, the Flat Earth Society asserts that the earth is flat; that all places named Springfield are linked in hyperspace to a single, real Springfield; that gravity is a lie; and that Idaho, North Dakota, and Australia do not exist.⁶ Other Web sites suggest that North Dakota and more than one Springfield may exist after all, so there may be some stretching of the truth on-line.

⁶ See www.flat-earth.org.

Consumers look to newspapers and news organizations for credible information, but even the New York Times and USA Today have admitted that certain reporters have faked news stories. Al Franken’s book Lies and the Lying Liars Who Tell Them: A Fair and Balanced Look at the Right (2004) sparked a lawsuit from Fox News. Did Fox sue because of the many allegations of lies told by their broadcasters? No, they merely objected to Franken’s use of the words fair and balanced, which Fox had been using as its slogan. And in 2005, four employees of CBS News were fired or resigned after an independent panel concluded that a 60 Minutes Wednesday story criticizing President George Bush’s service in the National Guard was based on evidence that might have been forged. Fears that the news media distort the truth have given rise to dozens of watchdog organizations and Web sites, including the conservative www.ChronWatch.com and the liberal www.MediaMatters.com. If what the watchdogs say is to be believed, the media will not save us from our information problems.

The information received about market goods and services can be similarly misleading. Advertisers are under the close legal scrutiny of the FTC, the Food and Drug Administration (FDA), and the Federal Communications Commission (FCC). The FTC regulates national advertising, with the goal of protecting both consumers and competitors from deceptive or unfair ads. One function of the FDA is to regulate food and drug labels to “ensure that they are truthful and that they provide usable information that helps consumers make healthy, safe decisions when using the product.”⁷ This includes setting strict legal definitions for terms such as fresh, light, low fat, and reduced calories. The FCC shares control with the FTC for broadcast advertising and has the authority to grant and revoke broadcast licenses for television, radio, cable, and satellite communications.

⁷ See www.fda.gov.

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With these and other agencies in place to interpret and enforce truth-in-advertising laws, do consumers in fact get the truth? Perhaps not. The FTC finds hundreds of misinformation cases worth investigating each year, and the agency does not pursue such subjective claims as “We have the best product in the world.” This type of embellishment is called puffing. It might also be called another dead end in the search for credible information.

But we can still trust our friends, right? I put some stories I heard from my friends to the test. According to the urban-legend-busting Web site www.snopes.com and contrary to common lore:

All these myths persist in the information age, in which mass-communication networks bring news and information rapidly even to remote areas. This is not to say that technology has failed to make market participants better informed. Fishers on the southern coast of India now use cell phones to discover where they can command the highest prices for their lobsters. To improve the fishers’ gains from information, a company called Bharti Tele-Ventures plans to offer them wireless Internet service that will “significantly increase their earnings” by providing real-time catch prices and allow them to book orders from their boats.⁸ Of course, these opportunities for efficiency improvements indicate that the currently available information is incomplete and in violation of neoclassical assumptions.

⁸ See http://meaindia.nic.in/bestoftheweb/2005/02/23bw01.htm.

Our information is imperfect even in those decisions that matter the most. The cost–benefit analysis that in 2003 led to the war in Iraq included the assumption that Saddam Hussein held weapons of mass destruction. However, in 2004, the Deuffler Report indicated that Iraq had unilaterally destroyed its undeclared chemical weapons stockpile in 1991. The investigators found “no credible indications that Baghdad resumed production of chemical munitions” after the Gulf War and no evidence of concerted efforts to restart the nuclear program after 1991.

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Controversial foundations for war are nothing new. Other military offensives initially have been justified as defensive maneuvers. On August 4, 1964, in the Gulf of Tonkin between Vietnam and China, two U.S. warships reported attacks by North Vietnamese torpedo boats. U.S. Secretary of Defense Robert McNamara informed Congress that these and previous attacks were genuine and unprovoked. On August 7, 1964, Congress passed the Gulf of Tonkin Resolution, empowering the president to “take all necessary measures to repel any armed attack against the forces of the United States and to prevent further aggression” and to use armed force to assist allies that had signed the Southeast Asia Collective Defense Treaty of 1954. This resolution was used to justify repeated escalations of U.S. involvement in the Vietnam War under Presidents Johnson and Nixon. However, pilots flying over the area, ship captains, and leaked Pentagon documents suggest that the earlier North Vietnamese attacks had been provoked by covert U.S. assistance to the South Vietnamese and that the August 4 battle had been fabricated.⁹

⁹ See, for example, www.thehistorynet.com/mhq/bltonkin/index.html.

Although World War II may have been touched off in 1937 with battles between Japan and China, alleged deception in 1939 allowed Germany to justify its critical offensive into Poland. On August 31, Hitler’s operatives used murdered German prisoners dressed in Polish uniforms to stage a Polish attack on a German radio station. The next day Hitler declared war on Poland, stating among his reasons this and other alleged Polish attacks. On September 3, Britain and France both declared war on Germany, and World War II had begun in earnest.¹⁰

¹⁰ See www.nationmaster.com/encyclopedia/Attack-on-Sender-Gleiwitz.

Market failure and efficiency loss can result when buyers don’t have full information about available products and prices and when sellers don’t have full information about inputs, manufacturing processes, and buyers. The information that neoclassical theory treats as fully and freely available is often costly, incomplete, and asymmetric. And well informed or not, market participants do not always use the information they have in rational ways. The question is whether problems with information justify an abandonment of neoclassical precepts, some revisions and expansions in rational choice theory, or none of the above. Most contemporary economists stake out middle ground, leaning toward the neoclassical side. Indeed, in the past century, neoclassical theory overcame institutional theory as the predominant school of economic thought.

Despite their flaws, neoclassical models provide useful guidance and predictive power. Experiments find that people—not to mention rats, dolphins, and other decision makers broadly defined—generally respond to incentives in rational ways: They all tend to follow the cheese and sardines. As models predict, competition decreases the prices of goods and services. For example, my research suggests that every additional athletic shoe retailer in a small-to-mid-size town causes the average price of running shoes to decrease by about 5 percent. And decision makers tend to weigh benefits and costs, including opportunity costs, as do teen rock stars and athletes who decide to put off college to pursue their careers.

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“On the other hand” (as economists infamously say), compelling evidence of problems with information and their effects on behavior has led to critical revisions and expansions of accepted economic analysis. Institutional economists point out that lousy information leads to lousy decisions—“garbage in, garbage out”—and that sometimes decisions aren’t very rational even when the incoming information is far from garbage. In the prediction and interpretation of human behavior, it is beneficial to account for possible errors, biases, information failures, and responses to uncertainty. New forays into behavioral economics and the economics of information do just that. We must also acknowledge our low standards for truth and seek improvements in our information whenever the benefits of better knowledge exceed the costs. Ignorance may be bliss, but it doesn’t necessarily lead to the best allocation of resources.