Economic Rationality

[Cross-posted at the Foldvarium]

The concept of rational action is a frontier of economic theory. The new field of behavioral economics combines economics and psychology to analyze actions that seem to be irrational. For example, people value health and long life, yet they smoke and eat unhealthy food. A related field, behavioral finance, examines psychological and emotional traits that prevent people from making wise investments. Perverse psychological biases include anchoring to past prices and facts, the bias of weighing recent events too highly relative to the more distant past, being overly confident in one’s abilities, and following the herd to a cliff.

Neoclassical economics often assumes that people are purely self-interested and always seek financial gain, and that therefore altruism is irrational, whereas as Adam Smith and Henry George wrote, human beings have two motivations: self interest and sympathy for others. Since people get satisfaction from serving others, it is incorrect to label altruism or actions based on subjective views of justice as “irrational.”

The Austrian school of economic thought has a different perspective on rationality. The Austrian economist Ludwig von Mises envisioned human action as inherently rational. A person has unlimited desires and scarce resources. Human beings economize, seeking maximum benefits for a given cost, or minimizing costs for a given benefit. At any moment in time, a person ranks his goals, ranging from most to least important. He chooses the resources to achieve the most important goal at some moment, then the second most, and so on, until his gains from trade have become exhausted. This is the inherent rationality of human action.

The process of satisfying one’s ends involves exchange, trades with others as well as trade-offs among one’s own resources. For example, if you goal is to eat delicious food, you trade the money you value less highly for food you value more highly. Economizing man seeks to maximize the utility, i.e. the importance and satisfaction gained, from one’s resources.

Note that economic rationality involves means rather than ends or goals. If a person chooses to drink so much vodka that he gets drunk and then gets sick, there was a reason for doing so, and at that time, he believed that this would maximize his utility. Utility theory does not pass judgment on people’s goals. Utility theory analyzes the means to an end, whatever that end may be.

The man who gets drunk may later regret his action, but rationality has to be based on human action at the moment it occurs. At that moment, his knowledge, emotions, and desires lead him to make a particular choice. At a later moment, he may have different knowledge, emotions, and desires – too bad, because we can’t go back in time. The action was utility maximizing at that time, even if it turns out to be bad in the future.

Rationality in economics is different from rationality in psychology. A psychologist may judge getting drunk as an irrational desire, but an Austrian-school economist recognizes that values are purely subjective, and he takes any particular desire as just data, and economic rationality does not apply to data.

Economic rationality has three criteria:

  1. A rational person has a sound functioning mind. He generally observes and understands reality. We all have incomplete knowledge, and many people hold false beliefs, and rational people may have differing interpretations of observations. But people substantially out of touch with reality, such as due to drugs or dementia, are beyond the domain of economic analysis.
  2. Rational people economize. Economic theory is based on maximizing benefits and minimizing costs. Economics does not claim that all people necessarily economize, but if they do not do so, they are not rational, and we send them to the Department of Psychology to analyze, since economic theory can only analyze rational action.
  3. The preferences of rational persons are consistent. For example, if one prefers an apple to a banana, and a banana to a cantaloupe slice, consistent preference implies that one prefer an apple to a cantaloupe slice. If not, then that person is irrational, and economists send him to abnormal psychology for analysis, since economic theory does not apply to inconsistent preferences.

Given that meaning of economic rationality, what about the perverse psychological biases? Overconfidence is consistent with rationality, since the person is not directly observing what is not there, but interpreting and misjudging his ability as more potent that it turns out to be. A rational person may believe that a black cat brings bad luck, without any evidence, but the rational person does not see himself surrounded by black cats which don’t exist. We call religious belief a “faith” because it is not based on verified evidence, but religious people are nevertheless rational. Merely believing in what is not observed does not imply irrationality.

Behavioral economists sometimes use the term “quasi-rationality” for action that is objectively sub-optimal, but to an economizing man, the future is always uncertain, knowledge is always incomplete, and beliefs cannot all be based on personal evidence, so action is quasi-rational only with hindsight, and not at the moment of choice.

Likewise, with recency bias and anchoring, people weigh some facts and events too much, but again, this is a matter of interpretation rather than direct observation. Suppose somebody buys a financial asset for $50 and the price later falls to $40, and he does not want to sell, because he does not want to experience a loss. In fact, he has already lost $10 per share, and the optimal financial decision has to ignore what he paid, and focus only on expected future risks and yields, but the person anchored to a past price is also weighing in the emotional trauma of acknowledging a loss, so he is still rationally maximizing utility even when keeping a share of stock that is going ever lower.

Likewise the smoker is rational in, at the moment of choice, choosing the immediate pleasure (or avoiding the pain of withdrawing from smoking), over the long-run desire for good health. There are tradeoffs between short-term pleasure and long-term goals, and choosing the short-term pleasure is not irrational, because one’s subjective value at that time is for the pleasure.

Economic psychology has also analyzed the mental process of choice, concluding that much of what we think of as reasoned choice is really induced by subconscious feelings. Much of what we do is based on habit. But even with complete determinism, it is still the case that, at every moment in time, a person thinks and feels that he is weighing costs and benefits to optimize utility, and that state of mind constitutes free will and rational action.

Therefore the claim of behavioral economics and behavioral finance that people do not act rationally is based on a psychological rather than economic meaning of rationality. So long as people can generally observe and believe reality, and they economize to achieve ends, and their preferences are consistent, they are rational, even if they do what they later realize was foolish.

We can well call destructive government policy irrational, but that is a different meaning of rationality than what applies to a choice made by an individual person. The paradox of humanity is that our actions are based on reason, and that human action is rational, yet collectively human beings engage in war, environmental destruction, and economic waste that is inconsistent with the desire of most to live peaceful, prosperous, happy lives.

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