The Problem with Prescriptive "Rationality" in Economics
Behavioral economics is becoming more and more popular. After Daniel Kahneman, who in 2002 received the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for having integrated insights from psychological research into economic science, another representative of this current of thought, Richard Thaler, joined the group of laureates of this prestigious award last year.
But what is the difference between behavioral economics and mainstream economics? After all, economics has been dealing with human behavior since its inception. According to the popular narrative, the basic merit of behavioral economics is to show that people are not fully rational, that the economy is made up of individuals who are weak-willed and susceptible to cognitive biases. Is this interpretation correct?
Rationality of People vs. Model of Rationality
Contrary to the common opinion, behavioral economics does not show that people are irrational. It rather undermines the neoclassical model of human rationality.
Daniel Kahneman was actually aware of this, as he emphasized it several times in Thinking, Fast and Slow that his research did not show the irrationality of human choices, but that the model of homo economicus did not describe true human behavior well. These are two different things: people can behave in a logically inconsistent but reasonable manner. If the people’s actions deviate from the predictions of the theory, it does not necessarily mean that they make “errors” – it may mean that the theory on the basis of which predictions are formulated is incorrect.
Vernon Smith notes that the observed asymmetry of profits and losses (people are loss averse) may not mean irrational behavior, but rather the maximization of the likelihood of bankruptcy being avoided. The observed behavior of individuals would be inconsistent with the profit maximization model, but would fit the survival model.
From an evolutionary point of view, survival is much more important than maximizing profits. In other words, deviations from the standard neoclassical model may be appropriate behaviors from an evolutionary point of view.
Indeed, if people were as irrational as it is often thought, it would be difficult to explain how our species survived. It must be remembered that the actual decision environment is more complicated than the one assumed by the theoreticians. People owe their existence to their ancestors who have developed the ability to adapt to a dynamically changing environment, not to the optimal processing of information about static equilibrium conditions and probability distributions.
It is worth to raise an important point here: is making mistakes when making decisions about abstract choices is really irrational given limited cognitive capacity? Is limiting our mental effort – is there something more valuable to man than his mental resources? – not rational, after all?
From the point of view of the limited “processing capacity” of the mind, committing judgment errors from time to time can be a small price for automating most of the activities we do – especially that, in general, at least in the case of routine situations, it works correctly. As Vernon Smith remarked in his Nobel Prize Lecture, “if it were otherwise, no one could get through the day under the burden of the selfconscious monitoring and planning of every trivial action in detail.”
Individual and Market Rationality
But even if we agree on the irrationality of individuals, does it change anything in economic theory? Contrary to the standard neoclassical model, for markets to function properly people do not have to be rational, omniscient, good or intelligent. After all, the greatest merit of Bernard Mandeville and Scottish philosophers was to show that people do not have to be good, that their behavior would bring good results. As Adam Smith famously says in The Wealth of Nations:
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
And Hayek showed in The Use of Knowledge in Society the great feature of the price mechanism is the economization of knowledge with which it operates, or “how little the individual participants need to know in order to be able to take the right action.” In other words, the perfect information is not a condition of competition – on the contrary, it is on the market that previously unknown information is generated in the competition process. By developing Hayek’s thought, Vernon Smith notes that “markets economize on information, understanding, rationality, numbers of agents, and virtue.”
Indeed, as Armen Alchian has shown in his article “ Uncertainty, Evolution, and Economic Theory,” what really matters for the economy is generating profits, not the individual decision-making processes, motivations or capabilities behind them. Profits are achieved by those who are better than the competition, not the most intelligent, or the most rational individuals. This means that intelligence or individual rationality does not matter, because even in a society of ignoramuses or idiots profits will exist.
The economy will thus achieve the equilibrium anticipated by the standard neoclassical model, even if individuals are not fully rational and do not maximize profits (according to Alchian, in the world with the uncertainty “profit maximization” is a meaningless concept). As in case of the biologist who, thanks to the knowledge about evolution, can predict the impact of environmental changes on organisms, even though they themselves do not know the laws of evolution, the economist is able to describe economic tendencies resulting from the adaptive, imitative trial and error process in the search for positive profits, even if individuals are not rational, i.e. they do not maximize profits.
It is true that the homo economicus model is not realistic. If you treat behavioral economics as a critique of this model, it is the right one. It seems, however, that researchers belonging to this strand of thought have focused too much on finding anomalies relative to the standard neoclassical model, ignoring its predictive achievements. Unfortunately, behavioral economics – especially its popular interpretations – throws the baby out with the bathwater, treating deviations from the model not as evidence of its defect, but as evidence of the irrationality of individuals (which – as Thaler believes – must therefore be nudged in the right direction).
Thus, behavioral economists are not really a real opposition to the homo economicus model. They remain within the framework of constructivist rationality, according to which the rationality of the market is derived entirely from the rationality of individuals. Both neoclassical and behavioral economists believe that markets cannot be rational, unless entities are fully rational in the sense assumed in theoretical models (although Hayek has shown that it is wrong to equate the knowledge needed by the economist to explain the market phenomena with the requirements for knowledge possessed by market participants). Both neoclassical and behavioral economists, therefore, think that the rationality of individuals exhausts the scope of their research; they do not take proper account of social interaction and coordination taking place through the price mechanism.
And the magic of the market is, as Vernon Smith writes, precisely the fact that it aggregates “information far beyond the reach of what each individual knows, and is able to comprehend.” In other words, in addition to individual (constructivist) rationality, there is also market rationality (ecological), which causes that markets lead to equilibrium regardless of the nature of actions (whether they are rational, nonrational or irrational) undertaken by individuals.
Instead of pointing to and complaining about the alleged defects of individuals, economists would probably do better, explaining how “unsophisticated” individuals, which have only crumbs of information and limited intellectual abilities, are nevertheless able to find effective solutions to economic problems and drive the economy towards a socially beneficial results.
Originally published in Polish by Poland's Financial Observer under an "open content" license: