Economic orthodoxy assumes that human beings are rational on average. Models fail to account for basic human psychology, such as rational regret. Another staple of human existence is path-dependence, which is best illustrated in an example:
Consider two scenarios:
- You could make $500 every week for five weeks
- You could make $1250 every week for 4 weeks and lose $2500 the last week
In both scenarios, you end up making $2500; economic theory should consider both outcomes to have equal happiness (or utility).
But each scenario took wildly different paths to reach the same outcome. In the first example, you make $500 like clockwork; your wealth keeps increasing monotonically with each step. In the second, you experience a significant loss of your profit (50%) in the final week. Even though both paths end at $2500, the different way the paths evolved over time is going to impact your decision making process in subsequent weeks.
In the first path, you have made decisions that resulted in a steady-flow of income. Your confidence increased with each week that your decisions have been correct. The world has confirmed your correctness by paying you consistently. You need not alter your path and you feel that this trend is likely to continue into the future. You are probably considering increasing risk.
In the second path, you have suffered a severe setback in your last week. You are not sure if it was your decisions that led to the loss, or just a bad toss of the dice. You are uncertain and fearful that another big loss will occur in the future. You question your ability to make money and are unlikely to increase risk going forward.
Humans prize low volatility; we like being certain of the outcome so we can sleep better at night. Moreover, most human endeavor involves a time lag between decision and outcome. This allows us to sample how the quality of our decisions as time evolves. Humans are constantly updating their own internal probabilities based on the stream of information we receive from our perception of reality. We attempt to filter the trend from the noise.
We are constantly making decisions and evaluating outcomes. Economics focuses on terminal outcomes, ignoring the passage of time in between. Humans evaluate their decisions from the moment they make them until the outcome is known. This evaluation loop profoundly impacts how we perceive ourselves and influences subsequent decision making in ways that are not fully understood.