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It is important to understand that the term ‘rationality’ is used in many different
senses, depending on the discipline of the user of the term; even within the discipline
of economics there are different meanings. When we refer to people acting rationally
in the everyday sense we usually mean that they are using reason. This kind of action
is often contrasted with people being prompted either by emotional factors or by
unconscious instinct. However, economists have tended to regard this interpretation of
rationality as too broad and imprecise.
Instead, they have started out from a tightly specifi ed means–end framework of
rational decision-making, as a particular interpretation of instrumental rationality. In
that framework, individuals are assumed to entertain preferences over a set of available
courses of action and act such as to realize their most preferred outcome. At the heart
of this model lie several basic assumptions about the nature of these preferences:
Completeness Individuals entertain a preference ordering
across all alternative
courses of action that they face.
Transitivity
Individuals make consistent choices, in the sense that if A is
preferred to B, and B is preferred to C, then a rational individual
will prefer A to C.
These two axioms together ensure that individuals will be able to pick at least one most
preferred course of action out of the various alternatives they face. Both axioms may be
relaxed in certain ways while it will still be possible to meaningfully talk of instrumentally
rational choice. But for the most part, economists have added stronger assumptions in
addition to these rationality axioms, either to simplify technical treatment, or sometimes
just out of tradition. Two important additional assumptions, sometimes referred to as
the ‘economic’ assumptions that are added to the two rationality axioms above, are that
more of an economic good is preferred to less of it (‘monotonicity’), and that averages
are preferred to extremes (‘convexity’).
However, this simple model of economic rationality is only applicable to decisions
under certainty, such that outcomes are unambiguously tied to actions. As soon as one
allows for uncertain outcomes, more complex frameworks of analysis become necessary,
based on mathematical theories of uncertainty such as probability theory. The standard
model for these contexts is usually augmented by the twin assumptions of expected
utility maximization and Bayesian probability estimation. Further assumptions are
necessary to adapt the model to decision-making stretching over a period of time into
the future, notably assumptions regarding time preference and discounting of future
horizons.
But even this framework is not yet suffi ciently general for all decision contexts
studied by economists. Uncertainty may not just be an exogenous factor, in the sense
of being given independently of the decision taken. You may, for example, decide to
act on a weather forecast predicting sunshine with 90% probability by leaving your
umbrella at home. Unless you are subject to superstitious beliefs, you would not accept
that this decision has any effect on whether it will actually rain in the end or not.
Many economic problems are subject to yet a different kind of uncertainty that is
endogenous to the situation studied. This is behavioral uncertainty that arises from the
mutual dependencies involved in the strategic interaction of two or more individuals.
Assume you are walking down a narrow lane and fi nd yourself walking towards another
individual heading in the opposite direction. Whether or not you will brush coats with
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that individual will not just depend on your own actions but also on how the other
side behaves. Economists have used a strong assumption known as the common
knowledge assumption as a further augmentation of the standard model. This is a
stricter assumption, whereby it is not suffi cient for each person or player to be rational,
they must also know that all other players are rational, and that all other players know
that all other players are rational ... ad infi nitum.
Finally, some economists hold the view that the rationality of individual behavior
should be judged not on the level of the individual but on the level of systemic
outcomes. This tends to be the view of Vernon Smith, who has been particularly
concerned with examining the predictions of economic rationality in terms of long-run
market equilibria. Smith does not accept the norms of the standard model in terms of
individual behavior, and believes that individuals can violate these norms and still act
rationally according to his view of rationality. This view equates rationality with the
end results of the decision-making process as far as market effi ciency is concerned. For
Smith, if markets are effi cient, for example, in terms of market clearing, then this is
evidence that individuals are rational.
On the other hand, by other defi nitions of rationality, people may act rationally
and the predictions of the standard model may prove incorrect; this tends to be the
view of Kahneman and Tversky, whose approach will be discussed in detail in Chapter
5. Unlike Smith, Kahneman and Tversky do accept the norms of the standard model
as a benchmark for judging rationality. By these standards they claim that individuals
frequently act irrationally. However, they also argue that the systematic errors and
biases that they fi nd in their empirical studies do not necessarily constitute irrational
behavior. We see here a theme emerging that will run through the other chapters of this
book, by which the standard model of economic rationality, under which a considerable
amount of frequently observable behavior would have to be classed as irrational, gives
way to alternative conceptions of rationality that more properly account for observed
behavior.
At one extreme we have a view, which was perhaps fi rst formulated by Ludwig von
Mises (1949), that any action must by defi nition be rational. This approach essentially
defi nes rationality in terms of revealed preference. If we perform a certain act it must
be because we have a preference for doing so; if we did not have such a preference
then we would not perform the act. Associated with this approach is the view that
‘a pronouncement of irrational choice might seem to imply nothing more than our
ignorance about another’s private hedonic priorities … individual tastes are not a
matter for dispute, nor can they be deemed rational or irrational’ (Berridge, 2001).
The problem with such an approach is that it obscures the important factors involved in
terms of the determination of revealed preference, and therefore, while it is a coherent
view, it is not very useful in terms of aiding analysis and understanding since it remains
consistent at the price of becoming a tautology.
Similar to the above view is the argument that evolution has necessarily produced
organisms that form true beliefs and that reason rationally (Fodor, 1975; Dennett,
1987). However, this view has been much criticized as misunderstanding the role of
natural selection in the evolutionary process. Most evolutionary biologists agree that
natural selection does not guarantee that rational beings will evolve, or even intelligent
beings for that matter.