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Neither rational nor irrational
Oct. 15th, 2013 07:22 amSay I want to understand human financial behavior. The behavior is actually complex, but if I make the following simplifying assumptions I can at least have a place to start, and can make some calculations, predictions, etc.
(1) In the financial decisions (e.g., job choice, hiring, shopping, selling, investing) all people are trying to maximize their monetary profit or "financial" value and to cut their losses.
(2) Given the available information, people go about this pretty well (e.g., this apple at this store costs $2.00 a pound, the identical apple at that store costs $3.00 a pound, both stores are equally easy to get to and I'm going to both stores anyway for other reasons, so I buy the apple at the first store not the second).
(3) When things don't turn out so well, people modify their understanding of the information and (subject to the caveat in the footnote) they seek new, better information.*
We can say that, given assumption number 1, in doing numbers 2 and 3 people are being rational and that when people don't do 2 and 3 they're being irrational. But this all rests on the simplifying assumption number 1, that in all their financial decisions they're trying to maximize income or financial value etc. But to want to maximize money and financial value in the first place is neither rational nor irrational. And we know, or ought to know, that number 1 in itself is not altogether true, that maximizing profit is not the only motive in play: we posited it as a simplifying assumption so we could get a grip on economic behavior. Motives — such as loss aversion and brand loyalty — that run counter to profit maximizing are no more irrational (or rational) than maximizing profit is, and are no more or less emotional either.**
This is on my mind for two related reasons.
First, a couple of Paul Krugman posts about the parts of macroeconomics that have no "microfoundations" but nonetheless seem to describe macro results better than the alternatives: actually, I'm as ignorant of microeconomics as macro, but I do think that micro has simplifying assumptions that include something like my numbers 1 through 3 above, and that's exactly (or maybe not exactly) why the macro that's micro-based can't explain sticky wages and so on. (I don't pretend to understand the posts to any depth, by the way. But note the word "hyperrational" in the first post and "rational expectations" in the second, which I'm guessing mean that it's taken for granted by some people that assumption number 1 is in itself rational.)
Second, I recently got Daniel Kahneman's highly worthwhile Thinking, Fast And Slow from the library for the second time (I didn't finish it 11 months ago when it first became due), and I think if asked he would, or at least ought to, subscribe to my paragraph above beginning "We can say that..." But actually his language slips a lot, and "rational" and "emotions" sometimes float by in his text without explaining themselves. (I do believe he talks explicitly about at least one of them in the part I haven't read yet; but that doesn't mean he knows what he's doing when the words creep in earlier.)
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( Footnotes )
(1) In the financial decisions (e.g., job choice, hiring, shopping, selling, investing) all people are trying to maximize their monetary profit or "financial" value and to cut their losses.
(2) Given the available information, people go about this pretty well (e.g., this apple at this store costs $2.00 a pound, the identical apple at that store costs $3.00 a pound, both stores are equally easy to get to and I'm going to both stores anyway for other reasons, so I buy the apple at the first store not the second).
(3) When things don't turn out so well, people modify their understanding of the information and (subject to the caveat in the footnote) they seek new, better information.*
We can say that, given assumption number 1, in doing numbers 2 and 3 people are being rational and that when people don't do 2 and 3 they're being irrational. But this all rests on the simplifying assumption number 1, that in all their financial decisions they're trying to maximize income or financial value etc. But to want to maximize money and financial value in the first place is neither rational nor irrational. And we know, or ought to know, that number 1 in itself is not altogether true, that maximizing profit is not the only motive in play: we posited it as a simplifying assumption so we could get a grip on economic behavior. Motives — such as loss aversion and brand loyalty — that run counter to profit maximizing are no more irrational (or rational) than maximizing profit is, and are no more or less emotional either.**
This is on my mind for two related reasons.
First, a couple of Paul Krugman posts about the parts of macroeconomics that have no "microfoundations" but nonetheless seem to describe macro results better than the alternatives: actually, I'm as ignorant of microeconomics as macro, but I do think that micro has simplifying assumptions that include something like my numbers 1 through 3 above, and that's exactly (or maybe not exactly) why the macro that's micro-based can't explain sticky wages and so on. (I don't pretend to understand the posts to any depth, by the way. But note the word "hyperrational" in the first post and "rational expectations" in the second, which I'm guessing mean that it's taken for granted by some people that assumption number 1 is in itself rational.)
Second, I recently got Daniel Kahneman's highly worthwhile Thinking, Fast And Slow from the library for the second time (I didn't finish it 11 months ago when it first became due), and I think if asked he would, or at least ought to, subscribe to my paragraph above beginning "We can say that..." But actually his language slips a lot, and "rational" and "emotions" sometimes float by in his text without explaining themselves. (I do believe he talks explicitly about at least one of them in the part I haven't read yet; but that doesn't mean he knows what he's doing when the words creep in earlier.)
( Footnotes )
