Rational

What is it economists mean when they say we assume people are rational? Is it that they have complete and perfect information? If so, then any cognitive biases or any errors in judgment can be considered to be irrational. This is illustrated by the old joke about two economists walking down the sidewalk and one sees a $50 bill on the ground. He begins to reach down and pick it up and the other says, don’t waste your effort. If that were really a $50 bill on the ground, it would have been picked up already. This is the strict form of the rational expectations hypothesis. This is the form that Keynesians attacked as their free market straw man during the recent bubble and crash pointing out that if the world was one of REH, then there could be no bubbles. Since there was a bubble the free market does not make function properly.

While perhaps Robert Lucas or Gene Fama support the strict form of REH, I suspect they and most others agree more with the weaker form. If economists accept the weak form of REH, then they say that people do not have perfect and complete information, but will get that information over time. In this case, temporary errors, perhaps such as a bubble, can occur, but these will definitely be temporary. (Fama says bubbles can not develop because when the bubble is occurring no one knows whether it is a bubble or not. So, it is not really a bubble.) In this camp, it is sometimes argued that errors can persist as long as there isn’t a huge profit opportunity to reduce them. For instance, many behavioral economists argue that systematic biases such as Prospect Theory (bad outcomes are disliked more than good outcomes are enjoyed) or Revenge and Reciprocity may determine the equilibrium, or that the economy can reach a stable equilibrium which is second best or inefficient. But this won’t change unless the cost is large enough. Many economists argue that path dependence or network externalities can lead to long term inefficient equilibria. Others point out that the switch from Wordperfect to Word negates such a claim, as does the explanation of VHS over Beta, the existence of the QWERTY keyboard, etc.

The Austrian school is based on praxeology, the study of human action. It does not make assumptions of rationality except to say that individuals are self interested. Humans will act on information they have and information they collect. They are unlikely to have complete information. They have cognitive biases, they are affected by how others view them, they react to the behaviors of others, in short, they are human. The market collects all the information embedded in human action and reflects it in the price. Spontaneous order is the result. Is this second best or first best? This is the wrong question; it makes no sense. The result has to be what individuals perceive to be in their best interest or they wouldn’t behave as they do. Perhaps we could stand above it all and say, oh that is a wrong choice because they didn’t take so and so into account. But this also is wrong – it is the same as saying “I know better what is good for you than you do.” Moreover, the Austrians look on the economy as one of constant motion, not one reaching a static equilibrium. People are always collecting information and responding to stimuli and seeking ways to be more efficient and more profitable.

The reason I bring up this material is that this past week I got into a debate about whether inefficient stable equilibria could exist with a behavioral economist and a Keynesian. The debate went nowhere. It reminded me of Pratt’s frequent posts about civil discourse. It wasn’t. In thinking about the debate, I don’t think we were even talking on the same plane. Their definition of rational was one wherein people can and do make irrational choices all the time. Only those of us who “really know” can say whether their choice is rational or not. It is frustrating because the pseudo intellectual basis of arguments by economists like Paul Krugman and Robert Frank sound reasonable and impressive to numbers of people. Yet, when broken down, their entire argument is “I know better than you do what is good for you.”