In a World of Stupid People, Profits Will Still Exist

One might ask, “But how? Aren’t profits the result of shrewd business deals and wise choices by [greedy] CEOs and shareholders?”

“Maybe, but probably not.”

Economics is claimed to be married to the principle that people are “profit-maximizing”. I admit that I am guilty of furthering this notion.

What I mean is that they behave as if they were profit maximizing. I imagine most economists understand this, but when they speak amongst themselves or to non-economists, this tenet of the field gets misconstrued.

Behavioral economics is founded on the idea that people are not profit maximizers. In fact, they make a lot of decisions that would say they are acting “irrationally”. So much so that Dan Ariely, an economist at Duke University, among many others, wrote a book highlighting a bunch of examples and experiments showing how Predictably Irrational we are. He asks questions like, “Why do our headaches persist after taking a one-cent aspirin but disappear when we take a 50-cent aspirin?.” Or, “Why do we go back for second helpings at the unlimited buffet, even when our stomachs are already full?”

Ariely and Co.–all the behavioral economists–correctly point out biases and heuristics that affect how we make decisions. We make all kinds of dumb decisions because of these “biases”. But, are we really acting irrationally?

Well, no.

When was the last time you chose to be irrational in your decision? Never, right? Decisions only seem irrational in hindsight, but never while making the decision. Every decision we make is rational. If not, we wouldn’t do it. Right?

In the act, people are making the best decision under their perceived constraints.

We live in an uncertain world

One of those constraints is uncertainty. Uncertainty is a huge part of our decision making, yet our clean models in economics fail to depict it. At times, economists attempt to add probabilities to the models. But that still misses the mark, by a lot! Most of the decisions we make in the world are shots in the dark and don’t even come close to profit maximizing. What’s more, we have NO IDEA what a profit-maximizing decision would look like. That would require omniscience, all-knowing…God.

So, why are economists married to the profit-maximizing principle? It’s because the evolutionary process that emerges from all these lucky guesses ends up with decisions that look like they had it all figured out–they were profit maximizing. To the world, Jeff Bezos and the other barons of capitalism, look like they knew all the right decisions.

But, they all just took a risk and could have easily fallen flat on their faces. The unlucky lot who end up falling on their faces aren’t seen. They disappear into the environment. They become fossils for us to reminisce upon.  

ob-wk329_hender_g_20130219184529Armen Alchian (from whom I stole the title of this post) pointed all this out in 1950 in a paper titled “Uncertainty, Evolution, and Economic Theory”. If we were all profit maximizers, we wouldn’t need to read Dale Carnegie’s How to Win Friends and Influence People or Donald Trump’s The Art of the Deal. We would simply know how to do things. Instead, we imitate others and pray we made the right call. And, even after all that, we still fail.

The best we can hope for is to not be in the red, or operating at a loss. Alchian calls it positive profits. If we do better than failing, that is as efficient as we can get. Moreover, simply seeing positive profits is a sign that we are acting rationally.

We use our foresight to plan and adjust to our environments and, in turn, the environment also adapts to our decisions. This is what economists mean by the market process. Within this process, this uncertain, changing, crazy process, is where the magic happens. It’s where people innovate and change the economic landscape of the world.

The point is that even stupid people plan for things and adjust their behaviors. Stupid people can also find themselves in the middle of an uncertain opportunity and make the right call. Shoot, I do it all the time and I’m sure you do, too! But, that doesn’t mean we aren’t rational! The presence of ANY profits in a world that is so uncertain is enough to say we are all acting rationally.

2 thoughts on “In a World of Stupid People, Profits Will Still Exist

  1. We have been taught the reason for economics is grounded on the scarcity principle. Which indeed is not the whole truth. The second principle is “people do not always act rationally” and the third is”information is not available to all at the same time”. Indeed one needs scarcity, irrational behavior and uneven information, to generate arbitrage. And it is because all the three meet in the melting pot, that arbitrage reigns. And that – arbitrage – makes the world go round.

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