Inspired by The Price Is Too Damn High, Canadian Edition and Frances' post on behavioural economics.
There is a temptation for non-economists to answer any question that puzzles economists by simply declaring "people are irrational!"
"Why are prices so much higher in Canada?"
"PEOPLE ARE IRRATIONAL!"
"What explains the equity premium puzzle?"
"PEOPLE ARE IRRATIONAL!" etc.
There are two reasons why the rationality assumption is popular in economic modelling:
- It works an awful lot of the time, in that it is a good predictor of human behaviour.
- It provides models which are falsifiable.
I will explain with the use of an example. Suppose consumers are choosing between five options: A, B, C, D, E. Given what we know about consumer preferences, costs, and benefits, we predict that consumers should always choose A. However, it turns out only 80% of the time they are choosing A, and 20% of the time they are choosing B.
If we assume consumers are rational, then there must be some cost to choosing A or some benefit to choosing B that we have not accounted for. We can find candidates for that cost/benefit and test if it makes a difference. If we believe there's a factor X that is a hidden cost to choosing A, we can compare situations where factor X exists and where it doesn't. If our theory is correct, we should expect to see consumers choose A when the factor is not in play, but choose B to a much greater degree when it is in play. This provides the falsifiability we need – we can actually test our theory. We can use a number of methods – we can run laboratory experiments or we can collect data from real-world situations where the cost is both present and not present.
Contrast this with simply saying "people are irrational!". There's no insight, plus there is no falsifiability – it "explains" everything.
If we want to introduce non-rational behaviour, we need to be specific and we need our explanation to be falsifiable. In our A, B, C, D, E example, there could be explanations such as:
- The number of options overwhelm consumers, and causes them to make a mistake.
- One or more of C, D, E is providing some form of framing effect that makes B appear more attractive than it actually is.
If we have a framing effect, replacing one of 'C', 'D' or 'E' with 'F' should reduce the frequency of people choosing 'B'. If this is not occuring, then we can conclude that it is not a framing effect. We could then try removing one of 'C', 'D', or 'E' and see what that does to the frequency of people choosing 'B'. This provides us with the falsifiability we require. We also have discovered not just that people are irrational, but something about the ways people make a decision.
Caveat: I happen to agree with my former Professor Jeff Smith when he states:
Fourth, it irritates me when people equate rational behavior with an assumption of costless information processing. It seems to me that the correct way to proceed is to incorporate a cognitive budget constraint into the optimization problem. It is hardly rational to spend huge amounts of costly cognitive resources to solve some problem when a quick, cheap but slightly wrong heuristic is available Our models should reflect this and, more broadly, we should not treat clearly irrational behavior as the benchmark of rationality. This requires learning a bit of psychology and/or neuroscience in order to get the budget constraint right.
A fair bit of what might be classified as 'irrational' behaviour is simply useful heuristics that occasionally fail. As such, I think the border between rational behaviour and irrational behaviour is very blurry.
When building our models, the distinction between rational and irrational is irrelevant. What matters is that are models are a good predictor of human behaviour and they are falsifiable.
Worthwhile Canadian Initiative 
DavidN: “If economists want to be treated more like scientists then they need to act less like politicians.”
Well put. 🙂
Stephen Gordon: “Physicist: Our knowledge is based on two contradictory theories. Please give us many, many billions of dollars so we can play around.
“Government: Sure! Is many, many billions enough?”
Physicist: Our research spins off technological innovation, from Tang to the Internet. Besides, we help you blow people up.
Gov’t: How much do you want?
“Behavioural Economics and the Rationality Assumption in Economics”
Here is a perfect example of what is wrong.
Titled: “Fed Chief Describes Consumers as Too Bleak”
“Then he said something new: Consumers are depressed beyond reason or expectation.
Oh, sure, there are reasons to be depressed, and the Fed chairman rattled them off: “The persistently high level of unemployment, slow gains in wages for those who remain employed, falling house prices, and debt burdens that remain high.”
However, Mr. Bernanke continued, “Even taking into account the many financial pressures that they face, households seem exceptionally cautious.”
Consumers, in other words, are behaving as if the economy is even worse than it actually is.
Economic models based on historic patterns of unemployment, wages, debt and housing prices suggest that people should be spending more money. Instead, just as corporations are sitting on their money, households are holding back, too.”
Maybe bernanke should get some economic models NOT based on the post WWII period. No wonder he couldn’t see the housing bubble because he sure seems not to understand the word/phrase budget and negative real earnings growth based on budgets and NOT CPI. Is it more like the lower and middle class are starting to make more accurate assumptions about nominal and real wage growth in the future? In other words, if he can’t sucker the lower and middle class (the ones experiencing negative real earnings growth) into debt, then what is his plan B? Nothing?
Title again: “Fed Chief Describes Consumers as Too Bleak”
Is he actually saying I chairman of the fed am right and you consumers are acting irrationally? Start acting rationally (the way I want) and go into debt. Is it really the lower and middle class consumers who are getting more rational, and the chairman of the fed can’t accept that?
Here is a good place for bernanke to start.
The origins of the economic crisis
I believe that what applies to Australia also applies to the USA.
Here is the Nonfarm Business Sector: Labor Share (PRS85006173) from the St. Louis FRED
http://research.stlouisfed.org/fred2/series/PRS85006173
@Chris
I´m sure you can fit hyperbolic discounting into the rationality framework. That is, as I tried to state in the beginning, ALWAYS possible – given that you include more parameters. The simplest way, I guess, would be to simply state that the preferences isn’t stable/stationary with respect to changes in time/base income.
I did not mean that Behavioral economics was any “threat” to a neoclassical economist (but to neoclassical economics, which usually is defined by the assumption of rational actors). All (or at least most) of the skills you learn as a neoclassical economist can/will/should probably be used when you include cognitive problems in the utility/decision function.
So – you can call e.g. hyperbolic discounting “rational”, and incorporate them into “Neoclassical economics” – or – call them “irrational” and use Behavioural economics. Does not matter and does not affect whether the results found by people that call themselves behavioral economists is valuable or testable.
Sure the usual framework might be desirable at times – but when you see e.g. a debate over private health insurance or similar things involving probabilities and long time periods you sometimes just want to cry.
PS: Yes – of course everybody don´t agree that there is hyperbolic discounting. For me, with a rather “free” job, hyperbolic discounting however creates a lot of problems and undesirable outcomes (lets party today and work tomorrow).