Wednesday 1 October 2014

Are Humans Rational?

Economics is a fascinating subject to learn from; it deals with an endless range of topics, from the markets and businesses of the world we live in to poverty and social welfare, from how best Nike could produce shoes to how you are affected by your government's policy. This is really just the tip of the iceberg, but for everything that happens in the world it could be argued that there is an economic explanation behind it. No, really- economics can explain things ranging from health phenomenons like obesity (largely due to the flooding of cheap fast food onto the streets), to why BMWs are often so good (apologies for the shameless self promotion). Just read the brilliantly accessible Freakonomics books and you'll get the idea- economics is everywhere.

However it's important to remember that many of the conclusions economics produces is reliant on us, as humans acting rationally- that is, simply put, in a way where we evaluate the pros and cons of a decision we are faced with, and take the decision should we see the pros outweigh the cons. 

Economics relies often on this notion of rationality with its modelling- a basic example is how economics predicts we as consumers may react to a sale. Take a very basic economic model, one that concludes that consumers are more likely to buy a box of Quality Street chocolates from Tesco, if the same box in every other supermarket is more expensive. This is a perfectly rational decision to make- why would you pay more for the chocolate and buy it from Sainsbury's when you can get the same one from Tesco? This economic model relies upon the axiom that all human actors in an economy are rational- they will always choose the option that benefits them most. 

But questions recently have been raised over this reliance on belief in rationality in economic modelling; the major argument against this is simply that not all humans act rationally. This argument may seem a bit strange in essence but there are two levels to this that we must consider first:

1) We may not act rationally with regards to the economic modelling we are subject to 
Taking the example of the Quality Streets in the supermarkets, the rational choice according to the economic modellers will be that people will take the cheapest option (Tesco); but almost certainly people will fall outside of this category. People almost definitely will buy Quality Streets from Asda even if they have knowledge that the chocolates are cheaper in Tesco, and this is likely to be not due to their lack of judgement but a whole host of potential factors- convenience, for example. 
Even if Quality Streets in Tesco are cheaper than Asda, if I live next door to an Asda and the Tesco is a 10 minute drive away, the overall rational decision would be to walk to Asda (and save fuel money), yet people who behave rationally and take such actions, in the economic model will not be considered so, giving potentially inaccurate impressions of factors such as price that are being tested.
Or, I may have a lack of information- buying the chocolates from Morrison's, ignorant of the cheaper prices in Tesco is still a rational decision as I am still taking the best decision as far as I know.
So factors other than price play important roles in our decision making- the use of rationality as a leveller does little to emphasise a certain factor in economic modelling.

2) What is rational? 
There's arguably no single measure of rationality- what I mean in saying this is that there is a concept of individual rationality but there can be further complications to this- such as being part of a larger group. Let's look at an example: say you need to buy your Quality Streets but this time it's on behalf of your boss, who will use company finances to pay you back for your purchase. The money-saving side of you tells you to go to Tesco, but your laziness tells you to go to the Waitrose nearby, where the Quality Streets are more expensive. Some people would go to Waitrose, (it's not their money after all), acting for their own rationale of convenience, whereas others would find it rational to go to Tesco and save money. In both cases, the person will be acting rationally- but both of them will have separate reasons and thus their rationales are different!

3) Humans are often irrational.
A failure of the claim to total human rationality is that, simply put, humans are often irrational. Our judgements are often clouded by emotion- to our benefit and detriment. A real life example of this could be behind one of the main causes of the recent economic crisis- as the bubble of borrowing grew larger and thrived, bankers got caught in the wave of optimism, willingly giving loans to people who in reality had a low chance of being able to return the money (though there is a conflicting reasoning for their actions). Emotion inevitably plays a large role in a lot of our decisions; think of every time you hear someone 'going with their gut', or 'taking a punt'-  these are examples of relatively irrational decision-making.
IBM's Watson supercomputer: an example of the pure, cold
rationality that no human can possess? 
Interestingly, this is often seen as an advantage that computers and technology as a whole has over humans; for example, this rationality and lack of emotion in judgement has been highlighted as a positive of IBM's Watson supercomputer, especially regarding its ability to perform medical diagnosis.

Of course there is another side to the argument- a common economist's response to these claims of human irrationality is that, when we observe a large group or population as a whole, these individual irrationalities are likely to balance each other out, as people may take different decisions irrationally. Perhaps a better way to put the assumption would be to phrase it as assuming humans are rational actors as a population, as a whole, rather than as individuals.

This is certainly a fair point, however doubt remains over smaller groups of people, where an individual's irrationality will hold more weight.

So, can economics afford to rely on this assumption that humans are rational? And in any case, is there anything that can replace it as a leveller of the population in economic modelling?

Lone Editor

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