I’ve been reading (for work purposes, I hasten to add) a book called Pricing on Purpose, by Ronald Baker. The aim of the book is to convince lawyers and other professionals to charge according to the “subjective theory of value” – in other words, charging according to the value of their work to the client – rather than the traditional “cost-plus” model of hourly billing (which Baker provocatively links to Marxist concepts of the “labour theory of value”).
As such, it’s an intriguing mixture of business manual and Reagan-quoting, pro-capitalist polemic: Atlas Priced. But I’ve found plenty in there of more general interest, in particular the chapter defending the “assumption of rationality” in economics.
This assumption – that people will behave in accordance with their rational economic self-interest – is frequently derided as hopelessly inaccurate. Baker acknowledges this, and lists a number of examples of seemingly irrational human behaviour which would appear to refute the assumption of rationality. These range from our willingness to pay more for products that have been endorsed by a celebrity, to Britain’s willingness to expend huge amounts of money defending the Falkland Islands (“two bald men fighting over a comb”, as Borges put it). Surely it is ludicrous to base our understanding of economics on the assumption that people behave rationally?
The first part of Baker’s defence of the assumption of rationality is that all scientific disciplines make simplifying assumptions that are, in themselves, false, but which are nevertheless useful. But the more interesting defence comes from Steven Landsburg in his book The Armchair Economist, which Baker quotes as follows (on p.44):
To a large extent, the assumption of rationality is nothing more than a commitment to inquire sympathetically into people’s motives. [When we observe what at first appears to be irrational behaviour] we have a choice. Either we can remark – wistfully or cynically, according to our temperament – on the inadequacy of human nature, or we can ask, “How might such behaviour be serving someone’s purpose?”
The first option offers the satisfaction of exempting oneself from the great mass of human folly. The second offers an opportunity to learn something.
This is strongly reminiscent of Luther’s interpretation of the commandment against false witness (the eighth commandment, on the Lutheran numbering) as requiring us to “put the best construction on everything”, assuming the best of our neighbour rather than the worst. As Landsburg continues:
Adopting the rationality assumption means pledging to treat all human behaviour as worthy of respectful consideration. In the process, we discover possibliities and develop insights that would never arise if we allowed ourselves to simply dismiss as “irrational” anything we failed to understand immediately. By disallowing the easy way out, we commit ourselves to careful and creative analysis of why people behave as they do, which is an excellent habit for any social scientist to cultivate.
To give one example cited by Baker, it is often assumed that “.99-pricing” – the practice of pricing goods at £9.99 rather than £10, say – is used by retailers because consumers will feel that £9.99 is significantly cheaper than £10. In other words, retailers are simply exploiting human irrationality.
However, with the assumption of rationality – the willingness to ask, “How might this be serving someone’s purpose?” – another explanation becomes apparent. As Landsburg points out, the practice was introduced when cash registers were invented in the 19th century, because it forces the cashier to ring up the sale in order to give the customer their change. It was thus a cheap (and perfectly rational) way to keep cashiers honest – any gulling of irrational customers was, from the retailer’s point of view, merely a happy by-product.