By Larry Marsh, Kansas City Star Midwest Voices columnist

The financial crisis has exposed a deficiency in economic theory.

The underlying cause of the financial crisis was the failure of individuals to exert sufficient mental energy to properly evaluate the risks involved in both the housing and financial derivatives markets. In short, people just didn’t do the math.

In the housing market both borrowers and lenders were unrealistically optimistic and failed to plan for worse-case scenarios.

Likewise, purchasers of financial derivatives failed to determine exactly how much risk these financial products actually contained.

This problem points to a fundamental deficiency in economic theory. Traditional economics assumes that everyone has perfect information and behaves rationally in his or her own self-interest. However, a lot of irrational behavior can be explained by the limitations of the human mind. Our mental energy is limited so we follow the crowd or rules of thumb to avoid thinking too much.

We can’t treat everything as brand new every time we encounter it so we fix expectations. We have expectations about both the physical world around us and about how other people will behave so we can conserve mental energy and not rethink everything all the time. We know that others do this too so we are reluctant to challenge people’s expectations because to do so is to ask them to use more of their limited supply of mental energy.

There is clearly a tradeoff between time and mental energy. Students can work on their homework at a leisurely pace with the television blaring in the background, or buckle down in a quiet room and concentrate on getting the job done more quickly.

Our brain uses about 25 percent of the calories consumed by our body. As we strain our brain to think, we burn up mental energy. Saying “do the math” is easy.
Actually doing the math may not be so easy.

Economists need to realize that not just our time and money are limited. We also have a limited supply of mental energy. Such limits can be important. Are we better off with a president who has lots of mental energy or one who doesn’t think things through carefully? It’s not just being smart but using your smarts that counts.

Economics must now be extended to take into account recent advances in medical science. Using brain scans we are now at last able to measure the amount of mental energy used in performing various tasks in terms of oxygen, electrolytes and calories consumed while looking at a pretty picture, listening to a minute of music or reading a page in a book.

Once economists are able to measure something, they immediately want to create a market to buy and sell it. Lawyers already have a market for reading all that fine print for you. They charge by the hour.

Wouldn’t it be more efficient to just pay for the amount of mental energy they expend instead. Lawyers with lots of mental energy would be able to offer people lots of good deals while those with limited mental energy not so much.

The nice thing about creating a market for mental energy is that some of it could be traded over the Internet. In effect it is already happening with some miscreants paying their fellow students to do their homework for them. It would just be more efficient if we could measure how much it cost in mental energy.

How about your expenditure of mental energy at work? Maybe you should be paid by how much mental energy you expend instead of by the hour. Quick thinkers could handle a whole lot of difficult problems by lunch time and be done for the day, while slow thinkers may need to stay after hours to earn the same.

The average Wall Street banker is paid much more than the typical creative artist. We should compare the mental energy that goes into their work. Does a Wall Street banker’s contribution really justify such a huge pay differential? Are labor markets really efficient or do paychecks just reflect who controls the money?

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Also see:

Google Books changes everything in student teacher education

Spend some of that $650 million for educational video games

H-1B visas, highly skilled immigrants, knowledge economy

Flynn Effect, IQ scores and SAT scores: Are our children smarter than we are?

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