Is Everything We Know About (Behavioral) Economics Wrong?

A recent article in Bloomberg describes how mathematical models behind modern economic theory (and, by extension behavioral economics) are being disputed and contested by a new perspective. Specifically, it highlights the publication of a December 2019 article in Nature Physics, by Physicist Ole Peters, describing "The Ergodicity Problem in Economics." That article presented an alternative point of view, suggesting that our seemingly 'irrational' decisions may be more accurate than previously thought by current economic and behavioral economic theory. As a result, Peters' assertions have also sparked a year-long debate among economists, behavioral scientists, and others over the accuracy of essential theories of economic decision-making.

As this debate goes on, both consumers and practitioners are left with a few important questions: What specifically is ergodicity? How does it actually apply to the everyday decision-making of individuals? Does it really revolutionize (or even negate) everything we currently know about economics and behavioral economics? Let's take each of these questions in turn...

What Is Ergodicity?

As Peters explains at the start of the article, "we will call an observable ergodic if its time average equals its expectation value." Breaking this idea down more simply, we are essentially comparing decision-making here from two perspectives—making the same decision over a period of time (time average) versus making multiple decisions at the same point in time (expectation value). The observable process is ergodic if the average of doing them over time and the average of doing them all at once are the same.

When evaluating 'rational' decision-making, however, economic theory tends to focus only on the expectation value perspective (also known as Expected Utility). Unfortunately, as Peters notes, many of the types of decisions evaluated by economics are not ergodic. So, looking at things from one point of view only may lead to incomplete conclusions. Specifically, what may seem like a good bet on average for a group of people may be a disaster for a particular individual over time. Therefore, what is determined to be 'irrational' from a traditional economic perspective, may instead be a completely rational choice for an individual who is considering what is best for their own self-interest over time.

To illustrate this idea further, Peters offers the example of a simple gamble, "toss a coin, and for heads you win 50% of your current wealth, for tails you lose 40%." Viewed only from the traditional economic perspective (of expected utility), taking the gamble seems like a good idea. Specifically, from that perspective, if we were to bet $100, we would expect to win $5 back on average (0.5 x $50 + 0.5 x -$40 = $5). Nevertheless, as behavioral and data scientist Jason Collins explains in his blog post on the topic, this gamble may not be such a good deal from the individual perspective, especially over time. As Collins explains:

" One way to think about what is happening is to consider the four possible outcomes over the first two periods [of the gamble]. The first person gets two heads. They finish with $225. The second and third person get a heads and a tails (in different orders), and finish with $90. The fourth person [gets two tails and] ends up with $36. The average across the four is $110.25, reflecting the compound 5% growth. That’s our positive picture. But three of the four lost money."

In short, even though it looks like the group 'wins' from the expected utility point of view, most of the individuals end up losing from the time average view. Put simply, although a group of people may end up ahead 'on average' with this gamble, you personally are more likely to be a loser at any point. Given that, it might be the rational choice to avoid the bet. In fact, refusing the bet is often what people actually do. Thus, the 'ergodicity problem' emerges. When these two perspectives do not match up—and economic decision-making focuses on the general group outcome of expected utility only—the rational behavior of individuals to maximize their personal outcomes over time appears 'irrational' instead.

Why Should Ergodicity Matter to You?

The most important take-home message here is that the perspective used to evaluate a decision can have a big impact on the final choice. This is true, whether you are an individual consumer deciding on a purchase, or a professional working to persuade a group. Even large theoretical areas can be influenced by adopting a specific frame of reference, drawing conclusions that may overlook other points of view. Given that, if you want to make better choices, then work to evaluate things from multiple points of view. If you want to change the choices of others, however, make sure to influence their frame of reference instead.

Beyond that, Peters' viewpoint also supports an assertion of behavioral economics that is important to keep in mind—we all think differently when we are making risky and uncertain choices (which are often outside the scope of traditional economic models). Put simply, the economic perspective of expected utility works best when individuals are fully informed and outcomes are certain, allowing them to see the 'big picture' view. When information is scarce, however, they maximize their own outcomes over time instead, by adopting other perspectives (called Heuristics) and doing the best they can within the uncertain and risky situation. Given that, when making your own decisions, it is helpful to be mindful of how deeply and thoroughly you are thinking about the information and risks at hand. When choosing whether to persuade or educate others to influence them, it is useful to consider how uncertainty and risk are impacting their thinking processes as well.

Behavioral Economics Essential Reads

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Putting those two points together, we see the psychological reason behind the 'ergodicity problem' in both theory and practice. People tend to adopt a specific perspective (heuristic), given the information and situation at hand—and then simply stick with it, rather than cross-checking it with other perspectives. This leads to a status-quo bias and the tendency for people to be persuaded more by information that is consistent with their previous commitments, often downplaying or excluding the rest. As a result, in our professional and private lives, we routinely find ourselves at odds with others who cannot see the value of our perspective—and we cannot see the benefit of their viewpoint in return either. Thus, we tend to argue, rather than seeing where and how each perspective might be most useful, as well as where they might ultimately agree.

Are Economics and Behavioral Economics Wrong?

Given the above, debating whether a single perspective is entirely right or wrong may not be the best approach...even here. Instead, it may be more constructive to ask where and how each viewpoint is most useful. For example, Peters' analysis makes some strong points that traditional economic models may fall short under conditions of uncertainty and risk—points previously noted by behavioral economists too. Nevertheless, outside of those conditions, the theories and models of economics are still valuable tools for understanding decision-making as well. So, Peters' (2019) work certainly adds to and supplements economic and behavioral economic models (especially by expanding the notion of what we consider 'rational' decision-making), but it does not invalidate or nullify those other perspectives.

Beyond that, exactly where and how the work of Peters fits into economics and behavioral economics is a matter for future research. On one hand, early research results note that the time average perspective suggested by Peters may account for some decision-making phenomenon more fully than aspects of traditional economic and behavioral economic models (Meder, et al., 2019). On the other hand, the time average perspective does not appear to cover other essential aspects of economic theory (see Kim, 2019). Overall then, while Peters' assertions do not abolish the traditional perspectives of economics and behavioral economics, his assertions can add a more understanding, compassionate, and positive viewpoint to those traditional perspectives. Ultimately, he asserts, in mathematical form, something we all know in our hearts. Humans are not 'irrational' creatures. Rather, we are simply striving to do the best we can, with whatever limited perspectives we have in the moment—and just need more education, information, and support to make better decisions over time.

© 2020 by Jeremy S. Nicholson, M.A., M.S.W., Ph.D. All rights reserved.