It is all too easy in the current political climate to disregard conventional economic wisdom as flawed, and seek alternative explanations for why people spurned rationality in favour of ‘excessive’ risk. However, such claims that homo economicus has no place in our calculus (and appealing to ‘animal spirits’ instead) does disservice to economics and the pursuit of truth. Rather, we must pursue proper understanding of human behaviour and what makes us tick.
There is no question that rationality still represents the most appropriate model for human behaviour in general. This is not a naive claim that people always weigh up the costs and benefits of all their actions, discounting for time. Rather, it is the observation that human behaviour typically approximates rationality.
This is because man evolved into a rational creature. Rationality is the ideal mode of behaviour, and any individual that would behave in such a manner is obviously at an advantage in competition for resources. Natural selection made human behaviour closer to the rational over time.
Indeed, most irrational behaviour can be explained by appealing to the circumstances in which mankind developed. Whilst perfect rationality would be wonderful, unfortunately mankind did not evolve in an environment which exhibited a perfect spectrum of possible circumstances. Thus, there were some idiosyncratic characteristics of reality. Since it was never necessary to develop a rational response to changes in these variables, man doesn’t have a rational response in these circumstances.
This might explain why individuals have such trouble making decisions under certain conditions. For example, I recognise that the marginal impact of smoking a single cigarette is minimal, and thus choose in each individual instance to smoke. However, the aggregated effect shortens my life. But it’s very difficult for me to weigh up the long-term health consequences of this decision against the short-term benefits, a common phenomenon.
Apparent myopic behaviour could be the result of the circumstances in which human behaviour developed. In these times, short life-spans would have yielded no cause to devise calculus for trading off short-term benefits against long-term harms. Of course, there’s always the possibility that individuals are making rational decisions when they choose to smoke – without any standards of preference by which to judge, it’s impossible to tell whether they are maximising their utility.
The idea of experimenting to test behavioural economics also seems suspect. Since individuals don’t usually operate within a vaccuum of decision-making, the results might not be as conclusive as many suspect. For example, I might typically not research my choice of beer brand because the benefits would not outweigh the costs of time in investigation.
This might lead to a behaviour of not properly analysing my choice of goods, and rather just making deducations based on what other people around me have experienced and enjoy. This isn’t irrational behaviour. In fact, as a general rule of thumb it might be a neat time-saving trick. However, my eventual choice of a sub-optimal beer doesn’t indicate that I’m ‘irrational’, even if the experiment is undertaken in a laboratory under controlled conditions. Rather, it’s just proof that individuals don’t operate within a vaccuum. They might even find it (rationally) difficult to get out of this mind-set.
The question that we must ask is rather whether difficulty in making decisions, or the fact that decisions aren’t made in isolation, could ever impact sufficiently on the market outcome to undermine our trust. The confluence of factors which unfortunately led to the financial crisis is not evidence that mankind is irrational. Abandoning free market economics out of fear that the anglo-saxon model is flawed, very well might be.
© The Free Marketeer 2009