Behavioral Economics and Rationality

by Mario Rizzo

One of the very good things about the blogosphere is that academics have been uploading their syllabuses for various courses. For the past couple of years, I have been teaching a graduate course taking a detailed and critical look at modern behavioral economics, including its normative and policy aspects.

More and more, I am thinking about this area in terms of the normative vision of the world it presupposes. Most amazingly, behavioral economists tend to accept the normative stance of neoclassical or standard economics (that is, the axioms of rationality). They “simply” do not believe that people behave in accordance with these axioms. Thus they find decisionmaking failure (akin to market failure). All sorts of state interventions may be warranted to correct for the suboptimalities that defective or biased decisions imply.

There are many issues here. (1) What is the status of neoclassical rationality as a normative standard? I think the technical idea of rationality gains acceptance to the extent that it is viewed as the instantiation of a broader rationality — or simply the instantiation of sensible decisionmaking. This is a not very defensible point. (2) Even assuming that is defensible, is “rationality” where economists ought to begin or where perhaps they should end up? Economists such as Philip Wicksteed argued, in effect, that irrationalities were disequilibrium phenomena that would tend to dissappear or be reduced under the pressure of the costs of bearing the consequences of irrationality. (3) Even assuming the empirical stubborness of biases or irrationality, is it possible or feasible to discover what unbiased behavior would be, especially in a world of multiple biases and differential degrees of these biases accross individuals and contexts?

Behavioral economics is one of the many areas of economics that could benefit with a little more fundamental thinking even at the expense of  yet another experiment or psychological study or “innovative” model. Let’s slow down and take a breather.

Here is my syllabus. Behavioral Economics Syllabus 2012

17 thoughts on “Behavioral Economics and Rationality

  1. Mario and others: Here’s an old blog post of mine making a similar point.

    A snippet: “One thing that has always struck me about behavioral economics are the parallels to arguments about market failure (such as externalities). Much of BE shows us that economic agents are not the rational utility-maximizers of standard theory (as does much of psychology of course). But what this result implies for economics and policy depends upon whose hands the results are in.

    One school of thought seems to say “a-ha! Agents don’t act like our ideal models of behavior, therefore agents fail to behave in the way necessary for those models to work.” Thus, in this view, “agent failure” leads to “market failure.” And notice the parallel structure of the two “failures:” in both cases, failure is defined as not matching the idealized, perfect result, either perfect rationality or perfect competition/general equilibrium. The remedy, of course, is some combination of paternalism and intervention to bring the failed agent or market closer to the modeled ideal.”

  2. I think it’s useful to unpack the many components of neoclassical rationality. One component is simply the consistency of means with ends — that is, people make choices that are consistent with their preferences. The normative force of this component of rationality is pretty straightforward. But another component of neoclassical rationality is *internal* consistency of preferences, as embodied in the assumption of transitivity. Yet another component is *comprehensiveness* of preferences, as embodied in the assumption of completeness. The normative force of these assumptions is much less obvious. Historically, it seems they were adopted by economists primarily because they made mathematical models simpler and more tractable.

  3. “Irrationalities” is a misleading term in this context. One aspect of the neoclassical model remains intact: individuals do pursue an end they want, using the best means they can find. This is not irrational behavior but the rational calculation is limited by the individual’s perceptions and information. He or she does the best they can for themselves, subject to partly wrong perceptions of reality. After the event, he or she may see the action as mistaken. Rationality is bounded, but not absent.

  4. Interventions by outside parties to “impose” rationality must still fail, even if the behavior to be corrected is somehow KNOWN to be “irrational,” on these scores:

    1. How is it known what behavior IS rational?
    2. How is it known HOW to induce this rational behavior?
    3. Is the COST of inducing this behavior justified?
    4. Are such induction programs subject to public choice (induction of behavior that is rational/beneficial for the INDUCER, rather than the inducee)?

    Bottom line: don’t go there. Ever. In any way. And don’t let anybody else, either.

  5. Excellent point. I’m reminded of the famous Pepsi vs Coke fMRI experiment. People *really enjoyed* the Coke more, despite the fact that in a blind taste test the Pepsi tasted better. I think it’s perfectly neoclassical to say that utility does not boil down to something as simple as taste buds — that’s why its definition is left ambiguous.

    I think this has very deep implications for social engineering (normative econ). In particular: I might have otherwise thought of marketing (negatively) as “tricking” people into buying a firm’s products, or (positively) as “merely informing the consumer”.

    However the pepsi/coke fMRI opens up a new possibility, that marketing __creates__ utility by, for example, generating an image of an ideal lifestyle that the consumer can become a part of. (Jeep Girl, The Economist magazine, country music,

    Don Draper made a comment to this effect but much deeper in the Mad Men TV series. Essentially saying that consumers have very little interior life of their own and he defines and sculpts a life for them to step into. Dark and it does ring true.

    At the same stroke, perhaps the marketers are creating desires (Saks 5th Ave, Tiffany’s) which are unattainable and cause envy in the middle & lower classes. Then again perhaps the created desires are more-or-less orthogonal. Or, perhaps marketers don’t generate desires or foment lifestyle ideals but rather amplify or reshape what’s already there.

    Anyway, I think you’re right that looking deeper into psychology should make economists question what is in fact normative. For example does an optimum exist for an individual; does better/worse even exist for an individual, and if so in what contexts / over what time frame / over what set of choices.

  6. Mario, I agree with your observation that behavioral economics accepts the normative stance of standard economics. The normative stance on rationality has led to the market failure literature, welfare economics, and the nirvana approach. The standard economics portrays itself as the science of choice and insists on grounding theory on micro-foundations. No wonder that psychologists have accepted the underlying assumption of economics as given; behavioral economics started out as an immanent criticism of the standard economics. Rationality that started as a description of market tendencies for economists has evolved into a tool of interfering in the market process. Now, behavioral economists turn it into a tool of interfering in the individual behavior. The evolution of the concept of rationality seems to be consistent with Vaihinger’s Law of the transmogrification of ideas.

  7. Dr. Horwitz: I read your Nov ’11 coordination blog post but couldn’t comment there.

    In my opinion, use of terms like ‘perfect’, ‘rational’, ‘ideal’, and ‘market imperfections’ are just as fallacious as ‘market failure’.

    While I’m definitely intrigued by “ecological rationality” and deeper examination of the way institutions, rules, norms, and so on can lead to better welfare… I think that BE should also make us question our concept of welfare itself.

    (I went into a bit of detail in my previous comment and could go more mathematical if anyone’s interested in my opinion.)

    J Bentham himself wrote that he wished he had an “imaginary machine” that would allow him to look inside people’s minds and examine their pleasure/pain experiences. He hypothesised that at some future date, such a device might come into existence (it now has), and that his ideas on utility were a best guess based on introspection — hoping that in the future they could be refined by scientists.

    That said, while neuroeconomics holds a lot of promise it hasn’t delivered too much, yet. However Bentham’s foresight also applies to careful experimentation on decision-theory questions. Again, IMHO we would do well to reconsider the foundations of the utility concept before making normative judgments.

  8. In some examples, behaviours that are departures from rationality as the standard economic model would have it, have been shown to be disavowed when subjects are talked through the decision facing them, given more time, offerd multiple ways of looking at the same decision. So in these cases the philosophical problem identified here arguably goes away, or is at least diminished. We could safely adopt the opinion of the more informed self, rather than the self that has acted on impulse.

  9. I would like to comment on Glen’s comments. The two consistencies, as Glen states, are technically connected. In fact, I am reading something by Hal Varian right now that uses the term “consistency” to mean consistent with utility function (preference) maximization. In turn, however, this requires transitivity of observed choices. The problem is the formalism does not permit you to say one without saying the other.(Lots of math involved.) Thus, our tongues are tied!

    However, we can say acting purposefully or doing the best you can under the circumstances. And then you can say that acting intransitively is sometimes acting rationally, if not maximizing a function. I can produce many examples of this.

  10. Mario, your course looks very interesting.

    You write, “I think the technical idea of rationality gains acceptance to the extent that it is viewed as the instantiation of a broader rationality — or simply the instantiation of sensible decisionmaking.”

    Question for you: what does “sensible decisionmaking” require, or involve, when a person is choosing which of various *ends* to pursue? The neoclassical conception of rationality generally means choosing efficient means to one’s ends, but, like Austrian theory, it has nothing to say (?) about how we should go about choosing our ends. If, by “sensible decisionmaking,” you mean what ordinary people regard as “sensible,” then it’s hard to exclude the rational consideration of one’s ends as well as one’s means.

    “Economists such as Philip Wicksteed argued, in effect, that irrationalities were disequilibrium phenomena that would tend to dissappear or be reduced under the pressure of the costs of bearing the consequences of irrationality.”

    This works if there’s some independent reality that penalizes people who don’t grasp it. E.g., a person who thinks she can hire expert web designers for $10/hour will probably fail if she tries to run a business on the basis of this assumption. But if, in place of an independent reality, the object of judgment is, e.g., what other investors expect the price of a stock will be five years hence, then it’s not clear i) what irrationality means and ii) why, per Wicksteed, irrationality would be eliminated.

    I don’t remember the exact phrase, but as someone once said, “the market can remain irrational longer than you can remain solvent.”

  11. For a while now I’ve been asking people their thoughts on whether taxpayers should be allowed to directly allocate their taxes. The large majority of responses have revealed that people do not understand how the invisible hand works.

    Here’s my blog entry where you can read through a gazillion response snippets…

    If you look over that list you’ll see a lot of radically ignorant people accusing each other of being irrational. You can’t take their individual answers at face value though…you have to add their answers together in order to see the pattern/truth.

    Of course…if any of you truly understood how the invisible hand works then you would have already been advocating that taxpayers should be allowed to directly allocate their taxes. There’s absolutely no economic basis supporting the idea that 538 congresspeople can allocate public funds more efficiently than 150 million taxpayers could.

    The point is…we’re all radically ignorant and irrational to some degree…except for me of course. It seems that I’m the only one that notices that the king is naked.

  12. Greg, that’s an excellent point about the rationality of ends. That was something many people took issue with in economic studies of drug use (it’s irrational to _want_ to use heroin). A game theory professor of mine made a disparaging comment in a similar light about suicide bombers (it’s irrational to _want_ to be a suicide bomber).

    Your quote is due to Keynes.

  13. Xero, let’s move the discussion to your blog since it’s not germane to what Mario said.

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