Generally, economists believe that individuals are rational and make choices to maximize utility. How do you reconcile the fact that most people would prefer to own a Ferrari, but actually own a car like a Toyota Matrix? Once you take into account all aspects of this choice (including price) then the Toyota Matrix doesn’t look so bad.
However, an NBER working paper by Beshears Choi, Laibson and Madrian (2008) claims that sometimes, people’s revealed preferences may not coincide with their true preferences:
- Passive choice. If individuals do not actively make a choice, such as would be the case for a default 401(k) enrollment at work, people may not be choosing optimally (at least initially).
- Complexity. It is often difficult for individuals to act rationally in complex situations. For instance, when one is faced with a large number of choices or faced significant uncertainty regarding future prospects, individuals may act suboptimally.
- Limited Personal Experience. “Human learning is often generated by feedback.” Thus, the more experience an individual has, the more rational they will act. You probably get a better deal buying groceries than buying a used car, because you have much more experience with the former.
- Third Party Marketing. “Tom Sawyer tricked his friends into paying him for the privilege of painting his family’s fence. A great deal of real behavior is also influenced by marketing.”
- Intertemporal Choice. How should people discount future utility? The authors claim that “Only discounting due to mortality risk is easily defended philosophically.”
How can we correct for these “incorrect” revealed preferences? Beshears and co-authors give some suggestions:
Structural estimation specifies a positive model with a precise set of economic and psychological motives (perhaps including non-Bayesian thinking and other decision-making errors). This model is then estimated using data, and the resulting positive preferences are mapped into normative preferences using normative axioms.
Active decisions …[require individuals] to explicitly state their preference without beinginfluenced by (or being able to rely on) a default option.
In most stationary economic environments, initial choices are likely to be further from normative optimality than choices made after many periods of experience. One should therefore give more weight to asymptotic choices [preferences revealed after having experience with the choices] when attempting to infer normative preferences.
When homogeneous individuals make noisy, error-prone decisions, their individualdecisions do not reflect normative preferences, but their aggregate behavior can …
Self-reported preferences reveal something about an agent’s goals and values. Normative economics should allow self-reports to have some standing.
- Beshears J, Choi JJ, Laibson D, Madrian BC (2008) “How are preferences revealed” NBER WP #13976.