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Friday, June 22, 2012

"Irrationality" in economics

The Question

        Today’s post is a response to a question submitted by Sarah S. via Economystified’s facebook page.

“How do you explain or account for irrationality and/or irrational forces in markets and/or in economics writ large?”

        Goodness, that's a great question.  Its kind of a big one for just a humble blog post.  But I think I can at least us started on answering it...

The rational assumption

        Remember, economics is the study of the allocation of limited resources – things like time, votes, energy, capital, labor…

        To study how humans allocate their resources in any sort of rigorous way, you have to assume that we don’t allocate them willy-nilly, haphazardly, at random.  You have to assume that there’s always some sort of logic or plan.  That people will tally up the cost, estimate the benefits and act accordingly.

        In other words: you have to assume that human beings are always rational.

        Well…are we?

        When it comes to the small stuff, I’d say we’re perfectly rational, pretty much always.  When we feel hungry, we find something to eat, since we know that will satiate us.  When I see a red light, I stop my car for fear of getting into an accident.  We don’t dress ourselves at random, we judge the weather (and the occasion!) and rationally decide what’s best to put on.  In these situations, we size up the costs and benefits, and generally do the right thing.

        But in many cases we come off as extremely irrational!  No nation enjoys being at war, but armed conflicts happen all the time.  There’s no way that your vote will ever influence a national election, but you’ll probably vote in one all the same.

        The way economists have resolved this issue in the past has mostly been to disregard people's motives, and analyze only the methods.  In other words, economists typically don’t care WHY you think that new car is valuable, or feel your old computer is worthless.  They are, however, interested in HOW you go about dumping your laptop and getting new wheels.

        So we can still apply models of rational decision making to situations we may not all agree are rational in the first place.

        We may all feel it’s irrational to go to war.  But if you do go to war, and you have a limited number of soldiers and weapons, you can make very rational choices about how to best allocate them.  It may be completely irrational to think that there’s space beavers beaming messages into your brain, commanding you to gnaw on a chair leg.  But if you were convinced of that, fashioning yourself a tinfoil hat to reflect their transmissions is a completely rational act.  

        I think one of the major reasons economists have stayed away from trying to figure out why we purse what we pursue is that’s a hard thing to measure in a standard, quantitative way.  And if you can’t measure something, you can’t study it in a mathematic, sciencey manner – the manner economists strive to view their fellow man.

        For example, economists make reference to individuals’ “utility functions” constantly.  But they don’t try to measure individual utility in the real world.  That would be like trying to measure in units how happy a person is throughout the day:

“Oh hey Bob, how are ya?” 

“50.2 smileometers on the standard happiness scale.  I was clocking in at 64.3 earlier today, but then I started thinking it might rain.”

        I guess I’m saying that classical economics really doesn't care much about irrationality at all!  Just because I don't share or understand your motives, doesn't mean I can't study your behavior.  Economists don't feel like they need to resolve (or even acknowledge) the issue of "irrational" behavior, and so viola - they can live in a world where everyone is "rational" by defalut.

"Rational irrationality"

        Sometimes humans don’t know the costs, or understand the benefits, but we try our best to guesstimate them all the same.  I wouldn’t say that this necessarily proves we are irrational creatures.  It shows our brains are not the most sophisticated computers in the world, but doesn't prove that they're malfunctioning ones.

        And sometimes we come up with wrong answers, but get to them in a rational way!  We may work with bad information, or attempt to tackle a problem that’s out of our depth, thus leading us to erroneous conclusions.  But that doesn’t make us irrational either. 

        And sometimes actions that appear very irrational are actually super-rational ones in disguise!  We just don't always understand our own rationality!  Here's an example:

Bryan Caplan’s 2007 book, “The Myth of the Rational Voter” starts off making the following argument:
1)      There’s no way that one person’s vote will influence an election.
2)      Every voter knows that.
3)      Therefore its irrational for any individual to choose to vote.

Ok, so far, this is a pretty classic argument in economics.  However, Caplan adds a twist:
4)      Even though voting is irrational, people still do it!  Why?
5)      Voting makes people feel good.  It makes them feel like they matter, like they are important.  It’s a chance to express themselves as an individual, and to reaffirm their membership in a larger group that accepts them.
6)      Therefore, your vote doesn’t influence elections, but it does influence your self-esteem and self-worth in a positive way.  So there is, in fact, some benefit to voting.
7)      Therefore voting can actual be a rational act!! 

        As long as a person does what they do for a reason (some reason, any reason!) whether or not you understand it or agree with it, that person could be viewed as acting rationally!  (Or so Caplan suggests.)

        Caplan calls this kind of behavior "rational irrationality."  Rational irrationality is an act that seems nonsensical from the outside, but has some logical reasoning behind it, once you get down to the nitty-gritty. 

        The individual exhibiting rational irrationality may not even be aware of their true motivations.  They may convince themselves that what's actually an emotional response is a logical thought.  It may look like their acting irrational, but that's just because were not seeing the rationality beneath.

        So!...classical economics kinda says "Well, who cares if people are irrational?"  And rational irrationality says "Ultimately, "irrational" behavior and thoughts might not even exist!"

        Either way, economics ultimately doesn't really need to address our "irrationality" to function.


        To be fair, I don’t speak for all economists here.  Some would say we're very irrational, some say we're very rational…

        But most would say: it ultimately doesn’t matter!  We can still study how an economy functions without knowing the true motivations of those who inhabit it.  Or more simply - you don’t need to be an automotive engineer to be a good city planner!

Dan Ariely

        Dan Ariely has carved out a niche for himself when it comes to what he calls “irrational behavior.”  In his books, blog, and research, Areily studies situations in which humans try to rationally calculate the costs and benefits of actions, but fail to do so correctly.

        It may be a matter of interpretation, but this doesn’t really sound like "irrationality" to me, per se.  Ariely’s subjects have logic, sense and reason, its just not enough to solve the problems they are facing.  The shortcomings he identifies look more to me like real, sincere attempts to be rational that simply misfire.

        Heck, if we were truly and unequivocally “irrational” in these circumstances all the time, we wouldn’t be able to see our errors even when they are pointed out to us, right?  Areily can explain the mistakes we make in our logic, and advise us as to how to avoid making them next time around – which to me is the very definition of “rationality”!


  1. Thanks for this explanation!

    Now here’s the part where I act kinda like a jerk and split semantic hairs (but not really ‘cause there is a difference). I really did mean “non-rational,” rather than “irrational.” My bad for being careless with my words.
    You’re right; “irrational” does imply craze on par with space beaver mind-control. But “non-rational” (to me, a Not-Economist) simply refers to phenomena like motive, emotion, faith, nature…any force or part of being a human that is not reason, or doesn’t originate in the intellect. I don’t mean “non-rational” as a value judgment, just as a category. So I would argue with Caplan and say that self-esteem and self-worth, while certainly not crazy or “irrational”, do not fall into the category of “rational.” They’re feelings, not intellectual products. But I think you’re totally right in that we humans sure are wont to apply intellect to explain & make the non-rational rational so we can know what the hell is going on. We rationalize the shit out of stuff. Which can be pretty handy for doing things like living, and doing a good job of being alive.

    (sorry for saying swears on your blog)

  2. Sarah is TOTALLY allowed to say swears where she wants.

    Ok, I see what youre saying...I suppose I would just kind of point back to the classical economist argument as to what emotion, faith, etc. (the "nonrationals") means for economics...that being "not much"!

    Why people want what they want isn't so much of interest to economics. Its more the how they go about trying to get it, that more what economists study.

    That being said! Its sometimes impossible to divorce the two. For example, Keynes, when trying to make stock market forecasts often refered to the "animal spirits" that create some of the volatility/variability in markets (similar to what we today usually call 'consumer confidence'). For more:

    Now, animal spirits are not always "nonrational" per se. For example, if people are anticipating a war, the conventional wisdom might all of a sudden be to hoard oil or commodities instead of to sell them, which is a rational thought. There's no war YET, but all the same, very reasonable people are moving to hedge the PERCEIVED risk.

    But often times, animal spirits aren't reasonable at all! The housing bubble, is a great contemporary example. "Why are we investing in mortgage brokerages?" "Cuz we'll make a killing on those investments!" "OH!...wait, how do we KNOW that?" "Well, everyone else is thinking it, and they can't ALL be wrong!" Turns out they could be.

    Extending credit would be another great example of your "nonrational" behaviors. When I want to borrow money, I have to offer to pay interest to give money lenders an incentive to part with their cash. After all, there's no way they know I can ACTUALLY pay them back, and while their money is in my hands, they'll miss many opportunities to spend it themselves.

    The more of a risk I am, and the longer I need the money for, the more interest I'm going to have to offer to pay for anyone to think trusting their money is a good idea. "Trust" is one of your "nonrationals", right?

    Now, we have a GENERAL idea of the dynamic of these sort of things...but we don't know their precise dimensions. If consumer confidence is high, we expect the market to ramp up - but by how much, we don't know. If you have a history of bad credit, expect your interest rates to be high - but how much higher will depend on the lenders discretion.

    The human element, human unpredictability, gives economies their variability. That's something we don't know how to measure and isolate, its just something economists have to accept.

    It would be nice if I had a quantity, in units, of how "confident" the people in my economy are this afternoon, and could tell you that if we could just add 3 more degrees of confidence, the Dow Jones will hop up 10 points. Until that day, economists have to say "confidence is low, we expect a dip in the index" and leave it at that