Class #2 on 1/24/12

Today in class, we learned more about rationality. In class, we learned rationality means:

1. Actors have well-defined preferences and thus have some idea/goal what they want to achieve.
2. Once we have that goal, there is some way we attempt to achieve that goal.

Massive amount of ridicule is given towards the rationality assumption (that we all think rationally). It's important to note that we all don't sit and make lists about what's rational. It is something that is internal.

Keep in mind: It doesn't take a lot of people to be rational to "get the price right."

Here are the notes put together by Professor Rizzo about what today's class was about:

NOTE: This is not my work. Below is the work of Professor Michael Rizzo from the University of Rochester.

Rationality Summary

The rationality assumption is what makes economics economics, apart from the other social sciences. At least so it seems.

However, from the very obvious observation that irrational behavior does occur, and in some settings quite systematically, it has caused some (many) to openly question whether economics has any value at all, or more mildly, if we need to amend our thinking about economic processes.

In other words, if individuals do not always have a goal in mind, if they are not always consistently following a plan to achieve some objective, if they are ignorant, if they are subject to random behavior, if they are prone to static behavior, does that mean that the typical rules and laws and conclusions of economics do not apply?

The point of today’s talk was to answer with an EMPHATIC … NO!

And the reasons for No include all of the following (note that any one of these would be enough to cast doubt on the need for a “revolution” but taken as a whole, they make it wholly ridiculous that these criticisms have any teeth).

1.     Most importantly, in my view, is that the major economic theories and concepts follow from logical chains of reasoning and NOT from the rationality assumption. As Becker explained (and as you will briefly show in a future recitation) even if individuals behaved irrationally, because scarcity forces a restriction of choice sets, we would still see demand curves downward sloping, and we would still see the importance of comparative advantage and the gains from trade.

2.    But suppose you do not like such a proof. How? I don’t know. What we also know is that for economics to work, even if you want to argue that it DOES rely in rationality, we do not need any actor to behave rationally all the time, or more important, we only need a few economic actors to act rationally, to be able to generate the important theorems in economics. The process of arbitrage does not require millions of people, but only a few.

3.    But suppose you don’t like THAT idea either. Well, it turns out that most of our behavior, is, in fact, rational. The fact that these behavioral illustrations are interesting … is … because … they are ANOMALIES.

4.    But suppose you don’t like THAT idea either. And I think this really is the doozy. If you want to argue that irrationality is systemic, and you wish to ignore the proofs which tell us that the laws of economics do not require such an assumption, then what makes you think that actors are limited in their irrationality to only the economic sphere of their lives? When we walk into the voting booth, do we suddenly drop the shackles of irrationality? When we walk into political office, do we suddenly drop the shackles of irrationality? In our love lives? That is pure sophistry. And if you wish to argue that the power of the collective mind overcomes irrationality in these spheres, then we are back to my point in TWO above … that markets have the same collective brain, and in fact it functions much more effectively at “neutralizing” the impacts of irrational people on outcomes.

5.    And suppose you simply dismiss 4 … do you think actors in the political process are uninfluenced by incentives? Do you think, for example, that no corporation stands to gain from paternalistic activity? For example, DuPont chemicals was instrumental in getting marijuana prohibited. But not cigarettes? Why? Well, the hemp plant was a major competitor in the production of materials and fabrics DuPont was in the process of producing at the time of the legislation, but the tobacco plant posed no such problems. I am sure you think this is just one simple, isolated, incident.  And I am 6 feet tall.