David R. Henderson  

Predictably Irrational or Predictably Rational?

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This is not to say that people are "perfectly rational." "Perfect rationality" as a statement of human nature, as distinguished from a theoretical device, makes for evolutionary nonsense. Had hominids sought to achieve perfect rationality in their decisions, they would have died out as they spent all of their time refining their cost/benefit calculations: Spending too much time calculating the possibility of outrunning a velociraptor would, no doubt, have had dire results. Perfection in choices is impossible, and uneconomical, just as, in a world of scarcity, developing a perfectly safe automobile is impossible--and uneconomical.

People, including economists, are imperfect decision makers because of their mental limitations. But this fact does not mean that markets fail. Indeed, markets do far more than induce improved allocation of resources, given wants and resources. Markets induce market participants to be more rational than they otherwise would be because they must pay a price for being irrational. Thus, markets allow--no, require--economists to assume that people are more rational than they are likely to be found to be in laboratory settings, absent meaningful information and incentives and absent market pressures.

This is from the featured article for this month on Econlib. In it, Richard McKenzie tells how he tweaks some behavioralists' well-known experiment that they use to show people are predictably irrational. When people have time to talk about the experiment, guess what, they actually learn things.


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COMMENTS (7 to date)
david writes:

We've seen this trick before. Whenever neoclassicists go on the defensive, their claims miraculously evaporate into weaker forms, like the bounded-rationality, costly-information version espoused here (Mr. McKenzie of course quietly omits that he is reproducing the same ideas that the behavioral economics he dismisses proposed as solutions).

Then when your back is turned, those claims immediately transform back into their stronger versions. You can see an attempt at this in the last paragraph quoted above, where "people can learn to avoid irrationalities, if fed the appropriate framing and given elaborate hints and discussion" miraculously becomes "people do avoid irrationalities". The earlier concession that people are not, in fact, physically capable of the computational power and strength of will this requires is suddenly absent.

Arthur_500 writes:

But this fact does not mean that markets fail. Indeed, markets do far more than induce improved allocation of resources, given wants and resources. Markets induce market participants to be more rational than they otherwise would be because they must pay a price for being irrational.

The problem is that markets are somewhat like mobs. They go on a roll and later are embarrassed by the hangover. Markets do not induce participants to be more rational because they need to get on the gravy train before it leaves the station. Once they are on board they find out Casey Jones is at the throttle and this isn't the gravy train they thought it was.
Markets correct but it is too late for most participants to act rationally.

Loof writes:

There’s a critical problem with the theoretical device of “perfect rationality” when the economics profession does not know when—or how I surmise—to turn it off; and, always keeps it on. For sure, it’s a useful device for economists given wants and resources rationalizing goods and services relative to supply and demand. That’s predictably rational. However, when wants become wanton economic theory fails greedily, since voracity isn’t rational at all and is predicably irrational. Same at the other end of the “preference” scale, at the point where wants become needs. There economic theory fails miserably, since people in need get emotional, are predictably irrational, with no rational choice.

Tracy W writes:

I don't think this is a very good article, because I've read a lot by behavioural economists and I've never come across a case of a behavioural economist arguing that people are irrational because they are risk-averse. Behavioural economists tend to use clearer sources of irrationality, such as the Allais paradox.

The framing argument behavoural economists use is different to to what McKenzie describes, their only difference in framing is between framing something aa potential losses or as potential gains.

McKenzie may have a valid point in his argument about learning, but in not addressing behavioural economists' strongest experimental evidence and in subtly misrepresenting the framing problem, he weakens his whole article.

Tracy W writes:

Loof, I don't follow your arguments

For a start you say: However, when wants become wanton economic theory fails greedily, since voracity isn’t rational at all and is predicably irrational.

What does this mean? For a start, did you mean to type "fails greedily"? And if so, how can I tell economic theory that fails greedily from economic theory that just fails? How could anything or anyone "fail greedily"? Can you give me an example of something that failed abstemiously?

Secondly, why isn't voracity rational at all? If you are talking about someone who gives in to their appetite for food that they will eat until their stomach explodes, economic theory is still applicable in this case. Probably not very useful, as most economic theory is about trade-offs and in my hypothetical case the person's utility function is extremely simple and involves no trade-offs. But I don't see how economic theory *fails* here. Where economic theory (or at least economic theory that is built on the assumption of rationality) would fail is if someone was massively hungry for food but attempted to obtain food by irrational means and not out of ignorance. For example, someone who voraciously desired food, was well aware that food could be obtained by fishing, and yet irrationally ignored this information in favour of running up and down the beach screaming in the hope of scaring all living things away. (As a theoretical matter, economists can't mind-read so any economist observing this scene would probably fall back on revealed-preference and say "actually this bloke doesn't want food".)

I really don't understand the point you are trying to make here.

Same at the other end of the “preference” scale, at the point where wants become needs. There economic theory fails miserably, since people in need get emotional, are predictably irrational, with no rational choice.

I don't believe this. For example, once I was windsurfing, got knocked off my windsurfer in a way that knocked all the air out of my lungs, and then when I tried to bob back up to the surface of the air I found myself underneath the sail of the windsurfer, in murky water with about zero visibility. At that point, I consciously and rapidly decided to duck dive to avoid the bar, and then swim a distance underwater to get away from the sail and windsurfer and then resurface to get my oxygen. I then carried out my plan successfully (with part of my brain going "4 minutes to brain damage"). I don't see what was irrational about my actions in that case, surely if they were irrational I would *not* have lived to tell the story.

Indeed, if people were irrational in how they obtain needs like air, food, water, how would humanity have survived long enough to produce economists, or critics of economics?

Richard McKenzie writes:

Whew! A bit of a tempest here, I detect. I wish readers of my commentary would take note of the fact that my points are extracted from a recently released 300-page book titled Predictably Rational? in which I deal with lots of rationality issues in considerable detail. Also, before someone tags me as "defensive" or suggests I am playing to some well-worn "trick," I wish they would read the book. "Defensive"? Sounds like I've had some sort of knee-jerk reaction to behavioral points, which is hardly the case. For what it is worth, I do think behavioralists have presented a challenge to mainstream economists to re-examine how they do what they do. I have taken on the challenge by trying to organize an intellectual history of human motivations in economic theory over the past two hundred years, and more. I put a question mark at the end of the main title for good reason and, I hope, to good effect. And I undertook an open and honest search for defenses for continued use of the rationality premise by economists. I suspect that commentors will be surprised, if they go to the book itself.

David R. Henderson writes:

Thanks, Richard.
David

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