Lecture VII: Economic Rationality

Introduction to the Economic Concept of Rationality

Review the exchange paradigm

Basic Structure of the Exchange Paradigm

  • Society has n individuals

  • Each individual has an endowment, the origin of which we are not concerned (exogenous)

  • Each individual has a budget constraint, the constraint of which is the value of their endowment

  • Each individual has preferences, expressed by a utility function

  • Each individual behaves rationally, maximizing their utility in the bounds of their budget constraint

  • The individual is in equilibrium when they make exchanges on the market so as to maximize their utility

  • Thee is general equilibrium in the market when every individual is in equilibrium

  • At this point nothing changes anymore

Pareto optimal: you cannot improve anybody else’s position without hurting the other person in the exchange. Even in the context of moral fairness this does not count.

Rationality

  • In the standard definition adopted in economics, being rational means choosing appropriate (the best) action among those that are possible in view of objectives

  • It is an instrumental view rationality: choosing means in view of ends

    • The one below is a specific formulation within the family of rational choice explanations

      • Maximization of a utility function subject to a budget constraint

      • Objects are given we do not discuss preferences

        • (de gustibus not est disputandum) taste is not disputed

Rationality: a normative or positive concept?

  • A positive concept

    • People actually behave rationally (in the way described by economic rationality)

  • A normative concept

    • People ought to behave rationally (in the way described by economic rationality)

  • Different parts of economics use the concept in one or the other way

Five Issues of Rationality

Rationality and Self-Interest

Adam Smith on Human Motivation

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect out dinner, but from their regard to their own interest”

“The chief part of human happiness arises from the consciousness of being beloved”

  • These statements are not in contradiction

  • Individuals have natural inclinations

    • Self interest (different from selfishness): individuals are best positioned to define and pursue their interests

    • But they also have sympathies

  • Individuals do not act in isolation, but within society

    • They follow social norms, are constrained by rules

    • Also recall the “doux commerce“ idea: by interacting with each other through trade, individuals polish their character by taming their worst passions and interest: they thus become more civilized.

Edgeworth’s Definition of Altruism

  • The first economic principle is that every agent is actuated only by self-interest

A way to reconcile the idea that altruism has its place in Economics to understand that the root of altruism can be defined as one of egoism.

Is Rationality Tautological?

Tautological: analytic or logically necessary propositions. a statement that is always true because it covers all possibilities or uses interlocking definitions

Rationality and Consistency

  • According to Sen (1977), one can comply with this definition of rationality and still be a fool in a social or moral sense

  • In fact, the standard definition of economic rationality only requires self-consistency, i.e. that you consistently prefer some outcomes over others (a preference ranking), and act to achieve them

  • In order to make sense of the complexity of preferences that humans seen as a social and moral beings requires, we need a more comprehensive view of rationality

Is one reference ranking sufficient?

  • Sen discusses the idea of “commitment”: the possibility that one chooses an action that leads to lower utility than another, because it relates to some outcome that is seen as important for other reasons

  • Is one preference ranking sufficient to reflect one’s interests, represent one’s welfare, summarize one’s ideas of what should be done, and describe actual choice and behavior

    • This cannot be accommodated under one preference ranking only

    • It requires a ranking of rankings

Is all action about the outcome?

Hirschman (1984): some activities may not be instrumental

  • i.e. they lack any reliability relation between effort and result

  • e.g. activities that concentrate on abstract goals such as beauty or truth

What motivates actors to engage in such activities?

  • Two modes of action

    • Attaining: rewards derive from attaining goals

    • Striving: rewards flow from the very process of engaging in the activity

What about preferences? Can we not discuss them too?

Must we limit ourselves to analyzing how to satisfy given preferences in the optimal way

  • De gustibus non est disputandum (taste cannot be disputed)

  • That is, can economists only discuss that means, but not the ends

Or can we discuss preferences as well?

  • Can you think of situations in which a person should not be allowed to (completely) define their own preferences

What about the preferences of society

  • Do we value low inflation or low unemployment?

  • Do we value efficiency or equity?