Sunday, June 20, 2010

The Problem With Proportions

Much of economic theory depends on the idea that people’s economic behavior is rational. We know no one is purely rational, but economic theories are so much easier to make if we imagine that people make decisions that are roughly in proportion to their understanding of their best interests.

But decisions can hardly be in proportion if people aren’t even aware the proportions of their actions. For example, how well can people really be spending their money if they don’t even know where the money goes?

A BBC News Magazine study that focused on alcoholic beverages asked people to keep diaries of their alcohol consumption for seven days, to see if their actual alcohol consumption was what they thought it was. The result: the majority of participants, 67 percent, drank more than they thought they did. Often, their preliminary estimates were off by a more than a factor of 2.

This study focused on alcohol, but I imagine you could find similar results in many other areas of consumption spending. Some people know what they are spending in a particular area, but others are just guessing. And if you ask people how they spend their time, a matter that has more fundamental importance than money, the estimates they will offer are even farther off.

Here’s the problem: if we are not aware of the proportions that make up our economic lives, not even necessarily within a factor of 2, then what are the chances that we are balancing these proportions correctly, in accordance with our personal priorities? It hardly seems possible that we are. But if we are not, then the majority of economic theories, even the ones that look very precise with mathematical equations and indexes, are no more than mushy approximations.