Irrational Behavior is Still in a Market

It isn’t often that economists will discuss “irrational” behavior.

I had a few thoughts come to mind.

Economics is not an assumption that all human behavior will be “rational” according to the same paradigm. Econ treats individuals as if they are rational in relation to themselves in relation to their own characteristics and preferences. One set of behavior may appear irrational to an outsider because they do not understand the preference and priority set of the person they are examining. What is called “irrational” by other social scientists (in what they think economists assume, rather than what is actually assumed) as a kind of behavioral inconsistency is often just a failure of observers to understand the utility function.

I would say that is the one great shortcoming of economists in general: the failure to incorporate richer preference sets into the utility function of human behavior and communicate that to other social scientists.

Preferences for others’ happiness can be as “self interested” as preferences for one’s own consumption if serving others’ needs is a high priority and yields personal satisfaction. Does that mean that people are irrationally altruistic? Not at all. It means there is more that needs to be measured.

Often behavioral economics is about taking a lab scenario and showing some exception to the proposed rationality without offering a comprehensive alternative. What is exciting about current developments is that preferences and Supposedly Irrelevant Factors are being incorporated in a more comprehensive way.

But to some, the supposed irrationality of human behavior means that markets do not work on some level. The beef against market mechanisms that often comes from the political left often advocates for State intervention because of this perceived irrationality.

But for every lab scenario that shows an exception to rationality, there is another that confirms that despite such irrationality, (according to Nobel Prize winning work) markets function perfectly well at setting prices, allocating resources, and even punishing those who cause social harm.

The real reason for disliking a market design is that people feel that markets somehow treat individuals unfairly. But markets are not moral creatures. They are like adaptive algorithms. Markets have never promised some sort of Rawlsian outcome that is consistently concerned with the plight of individuals. Markets are about allocating resources for the whole social fabric.

It is then an important consideration for any policy prescription to compare the outcomes of a proposed policy intervention against what an actual market would look like (and no, the US does not have actual markets in many areas of current policy controversy, especially in something like medical care). If a proposed policy does lead to this type of Pareto improvement, wonderful. But more often than not, the whole is harmed in the pursuit of the interests of a rather small group of individuals. Sometimes we decide that is a tradeoff worth making. But when it is not, it becomes the prerogative of individuals to care for the needs of individuals who would be extremely costly to reach on a social level.

So yes, humans may exhibit signs of irrationality (at a superficial level, at the very least). But if we are all a bit irrational, that does not mean that we don’t know how to economically function. Markets still are the baseline test for social construction because they tend to function extremely well–especially considering the alternative.

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