Preferences are Strange

November 21st, 2015

There’s a lot of confusion about preferences and why we care about them. Here are five important reminders when thinking about preferences:

 

You can’t measure actual preferences

There’s no direct measure for preferences, so we have to use a variety of methods to elicit preferences.  Perhaps the strongest way to elicit preferences is to ask people to make choices between alternatives. We can also ask people to reveal their willingness to pay (WTP) using an incentive-aligned technique like the Becker–DeGroot–Marschak method. Or, we can ask people to tell us how much they like an option. These are all proxies for the real, underlying preferences that people have but can’t expose directly. Importantly, different methods of measuring preferences should not yield different preferences.

 

Preferences can't be correct or incorrect

Normative prescriptions for preferences don’t exist.  Each of us will have different preference functions in a given context; we can’t deem a preference correct or incorrect.  

 

There are multiple ways to determine if preferences are good

Ultimately, we care about consistent preferences because we believe that good choices maximize expected utility. A rational decision maker will attempt to pick the best option. If people routinely make choices that don’t maximize utility, then they’re making suboptimal choices. The consistency between what you expect to maximize utility and what actually maximizes utility is one measure to determine good preferences.

 

Making good choices is hard

It’s quite difficult to maximize utility. For example, you can’t really ask someone “is eating that banana the best thing you could be doing with your time and money?” What would they say?  Most people don’t think about opportunity costs in an explicit manner; notable exceptions are low income individuals and lawyers (e.g., “This party is costing me $3,000!”). In addition, a lot of noise can get in the way of making good decisions. When we’re rushed or distracted, it’s no surprise we make suboptimal choices.

 

Even though we make lots of mistakes, only some are interesting

Modern behavioral economics has adopted a view of bounded rationality, which holds that we can’t globally optimize our choices to maximize utility. Instead, we’re bounded by the limits to our cognition and the decision environment, like time pressures. With this view, the interesting mistakes are the ones that are systematic (i.e., mistakes that cut across choices, contexts, and preferences).  When we look at these systematic mistakes, we uncover the heuristics (shortcuts) that lead to biases in choice. The attempt to explain these patterns constitutes the foundation of behavioral economics.