Limits of Rationality: Beware the Paralimbic Cortex

My prior post featured a game theory question from my undergraduate Economics mid-term that illustrated, if nothing else, the practical dangers of applying rational logic to real world economics. While it's fun to ponder the fate of the sheep, who among us would actually take the little lamb's place, shielded only by the recursive logic that promises safety in large even numbers of rational yet ravenous predators? Even setting aside the cerebral limits of feline cognition, we naturally discount the purely logical solution because we intuitively understand the scientific findings that my college roommate has published on the limits of human rationality...

David Laibson is a pioneer and rising star of Behavioral Economics, a new branch of economics that models the reality of non-rational decision-making (I'm guessing he's the only Harvard economics professor to achieve tenure before puberty). Economists initially pooh-poohed Laibson's field (Myron Scholes once told me over a round of golf that behavioral economics is nonsense), but pioneers like Laibson proceeded to produce models that exceeded classical models in their prescriptive power. Laibson now teaches a slew of popular courses on campus including Ec 1030: Psychology and Economics in which, I imagine, he considers in gory detail what really happens to the sheep.

(Our other roommate for all 4 years of college and the first avowed atheist I ever met, Aaron DiAntonio, is also on the Nobel path for his work at Washington University on the biochemistry of fly brains. I was clearly the dunce of the dorm room, tolerated only for my pizza money and general tidiness.)

Laibson's research has focused on inter-temporal choices--that is, decisions we make that affect us later (such as how much to save for retirement). Specifically, studies confirm that many people make short term decisions when offered immediate gratification, and long term decisions when asked to make the same choice well in advance. Consider the following two examples:

1. You are in a shopping mall next to your home and you win a drawing, which pays out either $10o today or $105 tomorrow. Which do you think you would select? Not surprisingly, many people would choose the $100 today (probably because there is something they immediately want to buy). But what if the choice of prizes is $100 credited to your account in 90 days, or $105 credited 91 days from now? Almost everyone (even the people who selected the immediate $100 payoff in the previous situation) figure that they might as well wait the extra day for $5 more. (Of course many will evidently change their minds if given the chance on day 90!)

2. It's time for dessert, and you have just enough room left for the slice of pie presented before you. Of course, sometimes you eat it and sometimes you don't. But if you make the choice well in advance of the meal, you are much more likely to make the longer term choice of declining dessert. We all intuit that it's easier to avoid putting the treat in your shopping cart than it is to avoid the treat at mealtime.

These examples expose the illogic of human decision making. If $100 today is better than $105 tomorrow, than discounting back 90 days ought to yield the same calculus--$100 in 90 days must be better than $105 in 91. And yet it's not. The same goes for eating dessert.

The immediate gratification of food, sex, sleep, entertainment, shopping, comfort and other personal leisures factor stronger in real time decisions than they do in long term planning. That's why we often choose to restrict our own options (buy illiquid investments, buy only healthy food, ask the hotel clerk for two wake-up calls, and avoid old girlfriends)--we don't trust ourselves to make the right decisions. And often when we do trust ourselves, we fail to recognize that we will change our minds when making the same decision in real time. This psychological fact defies the rational assumption in economics that options can only help the optionholder, not hurt. Sometimes, in fact, we act in ways that imply a negative value to our options!

Collaborating with neuroscientists from Princeton, Laibson published fascinating findings last year in Science Magazine. Using functional MRI, they showed that short vs. long term decisions are made using different parts of the brain depending upon the immediacy of the short term benefits (paralimbic cortex for immediate gratification, lateral prefrontal cortex and posterior parietal cortex for delayed gratification). No wonder we can make drastically different decisions around the same set of tradeoffs!

Human intellectual frailty impairs not only classical macroeconomic models, but also our lives. The good news is that, in the absence of immediate gratification, our posterior parietal cortices compel us to overcome irrational impulses. We shop smartly to help our diets; some attend church sermons to curb "sinful" tendencies; as of last week, non-smokers can even take a vaccine to prevent unwanted addictions; and sheep avoid fields populated by large, even numbers of smart but hungry lions.

Finally, this phenomenon explains in part why thoughtful entrepreneurs raise venture capital (Hah! I told you I'd bring this baby home)...

Many entrepreneurs try to control the composition of their boards of directors, but more experienced entrepreneurs tend to share control, inviting the participation of their venture investors and outside directors. Surely, the entrepreneurs reduce their own options in the process, but those options have negative value! They expect good, experienced directors to compel them, once every quarter or so, to stop fighting fires and consider the long term direction of the company. Are we on plan? Why are there variances and what should we do about them? Do external factors (such as competition) warrant a revisit of our plan? Without the deadline of a board meeting, it's easy and natural to let these critical questions slide for too long. Raising venture capital from an investor with a track record of bringing this discipline is tantamount to making the right long term decision before the paralimbic cortex takes over!