When it’s sometimes irrational to tell the truth

Centrally planned economies work very badly for two reasons. First, even if you had accurate data on what customers wanted and all the technical relationships between inputs and outputs, you would have a computational problem far beyond any practical solution. Second, and more profoundly, you cannot get accurate data on what people want. One of the most important strengths of a market economy is that people are free (subject to their income constraint) to spend as they wish and so to signal to actual or potential businesses what to produce. Central planners, lacking this data, produce what they think people want or worse, what they think they should want. This leads not only to chronic inefficiency but to tyranny.

Consumer demand information in a market economy is revealed through the price mechanism, reflecting what people actually do. Economists are suspicious of trying to learn what people want from what they say. This is a problem in areas where the market doesn’t work, such as public goods. These are goods or services that are or can be consumed by everyone without diminishing the supply, such as defence. Free market supply of such a good will not work and the state must intervene. So, how much should be spent on this? If you ask people they might well think, the more I say then the higher my taxes will be. So they may understate what they really think should be spent. Although there are elaborately clever ways of solving this in principle, in practice we rely on flawed political mechanisms to sort out such matters.

The problem of eliciting accurate and honest information from people is the problem of incentive compatibility. An incentive compatible mechanism or question is one where the subject has a rational incentive to tell the truth. Some people are honest no matter what, even if it isn’t in their interests but it’s a reasonable assumption that many people, perhaps most, are rational and self-interested enough to consider the consequence of their answers when asked a question such as, for example, how much should be spent on public health?

This is relevant to the field of consumer information. The internet has brought a vast expansion of information for consumers about what other consumers think. I personally find this very helpful. A well known example is the reviews on Amazon. I’ve just bought a new battery for my otherwise brilliant Samsung Galaxy S2 phone, which is prone to losing charge a bit too rapidly. I was going to buy the branded Samsung replacement battery because some reviews of the non-branded batteries recommended that. But a far larger number of reviews panned the Samsung battery and led me to another one that had a large number of very high ratings.

This information is reliable because there is no reason for the reviews to lie (other than company employees fraudulently posing as real consumers, something that has been known to happen, along with authors anonymously trashing their competitors’ books). That’s why the information is so useful and why consumer data is so widely available on e-commerce sites. It improves consumer information and should increase the competitiveness of the market, meaning lower prices and better quality.

But consumer information isn’t always reliable. Consider MBA rankings, which are based in part on the subjective assessment of the students or alumni, who are asked to evaluate the programme choice, faculty and class quality, delivery, alumni and careers services and so on. Many of these things are hard to measure objectively (unlike say the average GMAT score or percentage of female faculty, which are facts, though what they tell you is a different matter). But in this case, the respondents have an interest in the outcome. Anyone who has spent many tens of thousands of pounds or dollars on a course wants it to be highly thought of. The ranking that arises from the MBA student and alumni responses will therefore matter to the people who are filling in the forms. Rationally, they should put the highest possible score in every category. The rational equilibrium is that every MBA would get the maximum score on all of these subjective factors and the ranking would depend entirely on the objective or factual information. Then the newspapers running the rankings would stop asking the subjective questions because there would be no point.

If there were rankings of economics masters degrees, I’m pretty sure that this is what would happen. Economics students are formidably rational and would see quickly through to the logical outcome so the whole process would never even start. But MBAs are mostly not economists. And the evidence is that they are not rational either, at least in terms of my analysis above. The subjective elements of MBA rankings do vary – some students or alumni submit scores below the maximum, even though it means the ranking of the course they have paid for will be lowered as a result.

This is perhaps honest, but it is not rational. The MBA rankings are not, to an economist, incentive compatible and therefore the data are worthless. There are other reasons for not taking the rankings very seriously. There is sample bias and even outright manipulation – not all the students or alumni submit a score and some institutions are known to deliberately discourage lower paid people from taking part, to boost the average salary. If a potential student wants to know the probability of getting a high salary after three years, conditional on their individual skill, effort and experience, the rankings will be a poor guide. Even the GMAT score is, like all standardised test scores, rather noisy, though I’m sure that very high GMAT scores are reasonably highly correlated with intelligence.

An MBA is a consumption good (you enjoy the experience at the time) and an investment good (you hope for a stream of benefits in future). You need very comprehensive data to evaluate the second (long term career information for the majority of the class over many years across many MBA programmes, to allow some statistically confident inference) and the first is entirely subjective. Every year I’ve taught on the Cambridge MBA many, many students have told me that it has been the best year of their life. It’s possible they are just telling me what they think I want to hear (i.e the statement is not incentive compatible) but I don’t think they can all be faking it so convincingly.

Leave a reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.

We are using cookies on our website

Are you happy to accept our analytics cookies, which help us learn about our website visitors and their use of this site? Learn how to disable all cookies.