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The rationality assumption is what makes economics economics, apart from the other social sciences. At least so it seems. What is this assumption? It is best thought as this: when we study human action, we assume that individuals have a goal they are trying to achieve, and that they pursue that goal in a consistent matter. This is not exactly very controversial and it boils down to understanding that actors are regularly making (usually implicit) cost-benefit calculations to guide their behavior.

However, from the very obvious observation that irrational behavior does occur, and in some settings quite systematically, it has caused some (many) to openly question whether economics has any value at all, or more mildly, if we need to amend our thinking about economic processes. In other words, if individuals do not always have a goal in mind, if they are not always consistently following a plan to achieve some objective, if they are ignorant, if they are subject to random behavior, if they are prone to static behavior, does that mean that the typical rules and laws and conclusions of economics do not apply?

The answer is an emphatic NO!

And the reasons for No include all of the following (note that any one of these would be enough to cast doubt on the need for a “revolution” in economics but taken as a whole, they make it wholly ridiculous that these criticisms have any teeth). I may expand on each of these in the near future.

  1. Most importantly, in my view, is that the major economic theories and concepts follow from logical chains of reasoning and NOT from the rationality assumption. As Gary Becker explained in a famous 1962 paper even if individuals behaved irrationally (such as by making choices randomly in one extreme or by always choosing what you did in the past in the other extreme), because scarcity forces a restriction of choice sets, we would still see demand curves downward sloping, and we would still see the importance of comparative advantage and the gains from trade.
  2. But suppose you do not like such a proof. What we also know is that for economics to work, even if you want to argue that it DOES rely in rationality, we do not need any actor to behave rationally all the time, or more important, we only need a few economic actors to act rationally, to be able to generate the important theorems in economics. The process of arbitrage does not require millions of people, but only a few, to be rational, and market prices will adjust to capture the rational decisions of the few.
  3. But suppose you don’t like that idea either. Well, it turns out that most of our behavior, is, in fact, rational. The fact that these behavioral illustrations are interesting … is … because … they are anomalies.
  4. But suppose you don’t like that idea either. And I think this really is the doozy. If you want to argue that irrationality is systemic, and you wish to ignore the proofs which tell us that the laws of economics do not require such an assumption, then what makes you think that actors are limited in their irrationality to only the economic sphere of their lives? When we walk into the voting booth, do we suddenly drop the shackles of irrationality? When we walk into political office, do we suddenly drop the shackles of irrationality? In our love lives? That is pure sophistry. And if you wish to argue that the power of the collective mind overcomes irrationality in these spheres, then we are back to my point in two above … that markets have the same collective brain, and in fact it functions much more effectively at “neutralizing” the impacts of irrational people on outcomes.
  5. And suppose you simply dismiss 4 … do you think actors in the political process are uninfluenced by incentives? Do you think, for example, that no corporation stands to gain from paternalistic activity? For example, DuPont chemicals was instrumental in getting marijuana prohibited. But not cigarettes? Why? Well, the hemp plant was a major competitor in the production of materials and fabrics DuPont was in the process of producing at the time of the legislation, but the tobacco plant posed no such problems. I am sure you think this is just one simple, isolated, incident.  And I am 6 feet tall.

6 Responses to “How Fundamental is the Rationality Assumption?”

  1. Nice, and it’s important to stress that “rationality” doesn’t require full rationality, for all people, all the time. Still, I think the “public choice” argument is weaker than libertarians sometimes think. The idea is that people who get fat from eating too much unhealthy food are just weak-willed, but really they would prefer it if someone else would prevent them from making self-destructive choices. So the asymmetric treatment of ordinary people and politicians really is justified. The scientists at the FDA aren’t influenced by momentary pleasures like trans fats that cloud our decisions.

    On the other hand, I think Hayek offers a much more solid response, in his “Individualism: True and False” essay:

    “Another misleading phrase, used to stress an important point, is the famous presumption that each man knows his interests best. In this form the contention is neither plausible nor necessary for the individualist’s conclusions. The true basis of his argument is that nobody can know who knows best and that the only way by which we can find out is through a social process in which everybody is allowed to try and see what he can do.”

    Constructing a “rational” economic order means solving the knowledge problem, which is aided not at all by entrusting the economy to government control.

  2. Harry says:

    Well- said, William and Wintercow.

    I would add that assuming rationality all the time begs the question.

    In Econ 101 one of the first subjects is the notion of perfect competition and pricing, where the perfect price is always below the oligopolistic price. This becomes an invitation for Progressive economists to assume a role in determining a Platonic price, justifying their intervention in everybody’s life.

  3. Harry says:

    There are other fallices there in their assumptions beyond begging the question.

    An interesting exercise would be for your students to find how many fallacies they can find from Sara’s chart. Give them a donut if they can find any in your propositions, or mine, or any of your contributors, not counting Speedmaster or jb, of course.

  4. I think there are a few excellent arguments you did not list. If economists and the theories which they are instructed are meaningless its hard to understand why private companies continue to higher and pay large salaries to economists to do economics.

    I guess Goldman Sachs and Blackstone just don’t know how to make money. They should just hire sociologists.

  5. chuck martel says:

    An individual making a choice believes that he is making the choice rationally but, in fact, he might be wrong. Further events could prove that he was mistaken. Since all the information needed to make a rational decision may not be available to the individual and he may not be able to predict the future, decisions that seem at first rational can turn out to be bad ones.

  6. Harry says:

    As always, Chuck gets it right.

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