The Microeconomic Assumption of Rationality

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The Microeconomic Assumption of Rationality

http://www.nolanchart.com/article3315.html

by Christopher Espinal

Lately, I have been thinking about economics. Please don't believe that I don't have or am not pursuing a woman in my life. It's not my fault that Economics is amazing!

A huge controversy, that I never really paid much attention to, has entered my interest. It is the controversy of human rationality. Are you, your mom, dad, and cousins, and every random person you see in the street rational? Firstly, let's look at the very ideas that make humans rational in other words, what allows us to make optimally rational decisions in our daily lives (if we are in fact rational).

In economics we like to say that humans, if given information, will act on such information rationally. What do we know the most about, or what is the most informational-efficient aspect in our lives? We know the most about ourselves! Humans can talk about anything they want, but they no nothing more than their feelings. In particular, I'm talking about important economic concepts such as tastes and preferences. We know what we are capable of doing best and the very activity that stimulates excitement in us the most! However, we may not know how arrogant we are (like me!).

This matters because of consumer choice theory the very aspect of markets that make markets so damn good. Consumers know their tastes and thus the utility they get out of consuming products. Because they have that information about themselves they can place an accurate self-reflecting price on products given constraints such as budget issues. Overall, humans are rational when they have good information. It turns out that they know themselves and their tastes best, thus they are most rational when evaluating themselves in those particular areas important to economics. People have a real issue with the assumption of rationality in economics because essentially it develops an entire system of thought entailing policies people don't like. In other words, neoclassical economics, or the form of economics that defends markets, utilizes these assumptions, which creates pro-market models and has an effect on public policy. A neoclassical economist would ask the question "Who are we to tell these people what to do when they know themselves best?"

My question is: when do people stop their rational observations and become irrational? When they no longer have good information and they continue to take action, they will no longer act rationally. At least that is what my intuition tells me. Here is a potential answer: what if, as Amos Tversky would say, we use similar information framed differently? According to his legendary research The Framing of Decisions and the Psychology of Choice, we act irrationally when we see the same information in a different twist.

Professor Tversky gave a survey to a large group of surgeons, with this as one of several questions: If a surgical procedure has a 70% success rate, would you recommend this procedure to your patients? A disproportionately high number of respondents said yes. In statistics this group of respondents represented the control group. Check out the experimental group's response in this experiment to this same question framed differently: If a surgical procedure has a 30% failure rate, would you recommend this procedure to your patients? A disproportionately high number of respondents answered no. According to supposedly excellent probability models this was a statistically significant test showing that, yes, people are irrational when confronted with similar information that's framed differently.

Obviously, this work developed a humungous challenge to neoclassical microeconomic theory. Some economists, including Nobel Laureate Joseph Stiglitz, call neoclassical economics a "triumph of ideology over science." But is it really?

There really is no science suggesting that humans are not so rational when it comes to making decisions about their tastes and preferences. I would go as far to say that there is no science suggesting that humans are horribly wrong when it comes to placing a self-reflecting price on some commodity or service. Just how much are people made irrational by this framing of information especially when evaluating their own tastes and preferences? Who knows! I don't believe that Professor Tversky distinguished between whether or not framing of information has a negative impact on the tastes and preferences of individuals.

Interestingly enough, it is right to say that the basics of microeconomic theory the foundation of neoclassical economics - are mostly grounded on philosophy and logic. Economists like to call it normative analysis since we have no detailed psychological research to fully confirm the way the human mind works. No wonder why Stiglitz and others have a problem in accepting neoclassical theory. Despite the Nobel Laureates criticisms, I still think we should follow these models since they are the best models we have.
"Well Chris, tell me how do you know?" someone might ask. The purpose of building models is to develop a system of thought that can predict the future. Microeconomic theory is quite good at predicting practical market situations. We can only expect the number of smokers to go down within a given period of time if the government imposes a tax thus elevating the price. Why? Microeconomic theory shows that people have already valued smoking at some price according to the information they have of themselves. If nothing changes and the number of cigarette users stays the same it's probably because there's a good substitute: black market cigarettes.

We also have to remember that these supply and demand functions change due to constant fluctuations of the impact of their variables. In mathematical terms this is the quantity demand function:

QD = f(tastes = T, interest rate = R, income = I, relative price = RP, quantity of consumers = C).

FYI: this multi-variable function makes mathematics in the field of economics very difficult and hard to accurately define accurate demand functions!

However, there is one debate that I do believe critics of neoclassical theory have won, even though the old-school economists will never admit to it. It's the debate between the effects of advertising on people. John Kenneth Galbraith and Friedrich von Hayek, two very prominent and influential economists, debated whether or not advertising makes people act irrationally to information signaled by companies of their products. Galbraith always thought this to be the case while Hayek believed advertising only signals to consumers a guarantee for quality products. Quite frankly, this isn't the case when I see my friends purchase quality Sean John jeans going for $100 as opposed to quality Old Navy jeans that go for only $40. An obvious framing of information is going on here: people perceive different name brands of similar quality with different functions of utility because their favorite rapper "rocks the better gear."

Or is there a confounding factor that Galbraith never realized? It can still be easily argued that people act perfectly rational when setting prices on goods because they place a price or value on an implicit commodity - culture. There is a price, or the measure of opportunity cost, we must pay to conform to cultural values. Women remake their diets and fitness habits to get as thin and fit as Jessica Alba. The poor inner-city youth trade long run comfort and healthy food for a new pair of sneakers by Jordan. University of Chicago undergrads trade time to hang out with their friends to study and get better grades so that they can keep up with everyone else. All of these examples represent the price we put on cultural acceptance; this isn't something we can accurately quantify but it does exist.

Wait, but it gets more difficult! Did the companies create a culture that consumers adore? In terms of consumption which came first: the company or the consumer? If someone changes their tastes because of a new way to look at some product does that necessarily make them irrational?
As you can see, talking about the rational human is quite difficult but there's still nothing better than what those pro-market neoclassicists have to offer. In other words, the science that Stiglitz speaks of is not necessarily anti-neoclassical wisdom.

All in all I think it is still safe to assume that people act rationally when making choices impacting themselves because they have the most complete information about their own "T" probably the most important variable in QD. As of now, government can only directly and efficiently impact "I" in QD = f(T, R, I, RP, C). Until we understand humans to a greater degree the neoclassical regime holds the torch on this one.
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The Microeconomic Assumption of Rationality

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