Rationality and Economics - Lecture 2

Lecture 2 for undergraduate Behavioural Economics and Public Policy is on Rationality.  I am posting brief summaries of some of these lectures on the blog to generate discussion. The main point of this lecture is to give a working definition of what we mean by rationality in Economics. This is a complex construct with many potential meanings across a wide range of literatures. In Economics we generally tend to mean that decision makers are consistent in their behaviour.

The basic microeconomic models of the consumer generally assume rational utility maximising behaviour. In the simplest case of choice under certainty, consumers are assumed to be able to represent all alternatives, rank them consistently and choose the bundle of goods they prefer the most subject to the constraints that they face. Rational consumers allocate their time to work and leisure and the subsequent income to savings and consumption so as to maximise their life-time utility. The implicit or explicit ability to perform the computations necessary to enact optimal behaviour underlie models of choice of consumer goods, labour supply and saving. In conditions of uncertainty, the models so far assume that people are able to represent accurately uncertain outcomes efficiently using available information and to choose consistently between alternatives with uncertain outcomes. If people behave in this fashion and markets are open, then we can view their behaviour as revealing their preferences and we can also predict how they will respond to changes in price and other constraints and the effects of these changes on their welfare. We will revise the basic models in the lecture.

Rabin (2003) gives a thorough but accessible discussion of the main tenets of rational choice in economics and the potential problems with these assumptions. Much of the rest of the course will evaluate the evidence on how people make decisions and how this compares with the basic textbook model. It is worth pointing out at this stage that the rationality assumptions in Economics at first appear ridiculous. We know that people do not perform billions of explicit calculations each time they choose a product. However, it should be kept in mind that most accounts of rationality do not need to assume that they do. Instead, many economists believe that the markets contain sufficient cues to allow people to act rationally even if they cannot perform the computations explicitly or that suboptimal behaviour will simply not survive in a competitive market. I might decide tomorrow to set up a business exporting sand to North Africa but I will quickly find out that this is not a sensible thing to do or else I will just go broke. When we are evaluating the rationality postulates it will be important to push them to their limits. The ultimate test will be whether groups of people systematically act inconsistently in important areas of their life in a persistent fashion. We will go through Rabin's account in the lecture and form an initial impression of the overall argument.

The paper below is an interesting and accessible account of why people's behaviour may not be fully rational in the sense used in the textbook. Beshears et al argue that many choices are characterised by conditions where the chooser does not have much experience, where third-party pressures are operant, where the chooser does not have much scope for trial-and-error and where starting points and consumer inertia dominate active choice. In such conditions, there may be a big gap between what people choose and what they would choose were they making fully informed and deliberative choices. This is an enormous challenge to basic economic theory and also potentially has major policy implications.

Beshears, J. & Choi, J. & Laibson, D., & Madrian, B.(2008). "How are preferences revealed?," Journal of Public Economics, Elsevier, vol. 92(8-9), pages 1787-1794, August.