Rational Frameworks, Not Rational People

Beware of people selling rationality

A common criticism of economics is that economists assume that people are rational. However, when you interact with people, it is clear that these people (not you, of course) do “irrational” things. Given that premise, what value can economic theory provide if it is built on such a shaky foundation of rationality?

On some level, this is a philosophical issue. What is meant by the term “rational”? To what extent do people behave in accordance with that definition? Furthermore, to what extent do deviations from this definition of rationality matter for behavior and policymaking? If you are expecting a deep philosophical discussion on these issues, I am afraid that you will be disappointed. I do not think these questions matter.

In fact, I reject the premise that economists assume that everyone is rational. To use a saying from the great University Economics textbook by Armen Alchian and William Allen, economists assume rational frameworks, not rational people.

I do not think that anyone is literally a utility-maximizer. I find it hard to believe that anyone has ever walked into their area supermarket, picked up a loaf of bread, and thought, “Yes! Three more units of utility. I’ve just reached my maximum within this budget constraint.” Similarly, I do not know that anyone is consciously and literally comparing the marginal utility per dollar in the choice between two alternatives. Yet, I’m certain that there is a negative relationship between price and quantity demanded, which follows from this utility-maximizing logic. What empirical evidence do I have? Firms have “sales”, in which they offer the same product at a lower price. Why else would you advertise lower prices?

Similarly, I know with certainty that there is not a room at any firm with an economist (or group of economists) sitting around solving profit-maximization problems. Yet, I would confidently predict that the firms that survive are those who only hire a worker or buy a machine if they expect that worker or machine will produce at least as much additional revenue as it costs to hire that worker or buy that machine. Why am I so confident? Because the profit and loss mechanism will determine survival independent of whether the firm sets out to maximize its profit.

The point that I am trying to make is that economic models are not models of human thought processes. Rather, economic theory is rational in the sense that the conclusions of the theory follow logically from its assumptions. The theory makes predictions about the world. The theory is useful if those predictions turn out to be correct and reliable. The theory does not require that the model accurately describes the thought processes of actual people or that people in the real world understand the model. Instead, economic models are frameworks to help economists understand and make sense of observed behavior.

Behavioral economics tells us that we need to dispense with rationality. People have cognitive biases that affect decision-making. Yet, the models used by behavioral economists are rational frameworks in the sense that the conclusions of their models logically follow from their assumptions and provide consistent predictions about human behavior. (Irrational people turn out to behave in predictable ways. Who knew?) Take, for example, hyperbolic discounting. Conventional economic theory suggests that people value the present more than the future and that the value of future rewards declines consistently across time. A common assumption in behavioral economics is what is known as hyperbolic discounting. According to this assumption, the value of something in the very near future declines rapidly relative to its current value. However, the value of a reward declines more slowly over the same duration of time if that duration is more distant in the future. A model with hyperbolic discounting is a rational framework for explaining seemingly irrational behavior. The hyperbolic discounting model provides consistent predictions about how these types of individuals will behave. In fact, this type of model has been used to rationalize (see what I did there?) behaviors like gambling and addiction. It seems that what behavioral economists mean when they say that individuals aren’t rational is that conventional economic theory does not make accurate predictions.

At this point, you might be asking whether I am just playing a rhetorical game. Why does it matter if there is a distinction between rational frameworks and rational people?

This distinction matters because, to quote Lola Lopes, “the idea that people-are-irrational-and-science-has-proved-it is useful propaganda for anyone who has rationality to sell.” Policy interventions can often be justified on the grounds that the social scientist or policymaker “knows better” than the irrational decision-maker. Many behavioral economists argue that we know that people are irrational because conventional economic theory makes bad predictions in certain contexts. Cognitive biases cause people to choose allocations that are worse than those of the conventional model. As a result, we need policies to make people behave like the conventional economic models predict.

Whether such policy interventions are necessary or beneficial depends critically on which rational framework is correct. For example, while hyperbolic discounting can potentially explain the behavior of addicts, Gary Becker and Kevin Murphy also have a model of addiction that can explain key behaviors of addicts with conventional assumptions about discounting. For harmful forms of addiction, consumers generate utility from current consumption of the addictive good, but experience disutility associated with the “consumption stock” of the addictive good. This model generates important predictions about the consumption of addictive goods. One key implication is that the First and Second Laws of Demand hold for addictive goods. In other words, the demand curve for the addictive good is downward-sloping and the long-run demand curve is more elastic than the short-run demand curve. (Indeed, the Council of Economic Advisers recently documented the important role that declining opioid prices played in the opioid crisis.)

Each of these models is a rational framework for understanding addiction. The behavioral model suggests that addiction is a self-control problem. The “rational addiction” model suggests that addicts respond to prices in the same way that consumers respond to the prices of other goods. Getting the policy recommendations correct requires distinguishing between the two models and determining which provides more accurate predictions of behavior. Either way, the policy implications are less about whether the models are accurate representations of thought processes or individuals rationality and more about which rational framework is appropriate for understanding behavior.