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Rationality on trial in three exhibits


Daniel Tan

By

August 31st, 2014


This month, Daniel Tan attempts to explore the concept of rational decision-making by questioning his own rationality in a recent experience.


Practically every first-year Commerce student is introduced to Microeconomics through the all-important assumption of rational decision-makers: a “rational” person makes a decision by comparing the marginal benefit of an action against the marginal cost it incurs. The economy as visualised in the textbooks is made up of all these rational actors, making decisions entirely in their own self-interest.

In Accounting Reports and Analysis, its incarnation is known as Agency Theory, rather unflatteringly summed up as “we are all self-interested pigs”.

I think few people would disagree that rational choice theory is a useful model   for understanding the economy. But it starts to sound quite hollow when lecturers and textbook start overstating its universality and usefulness. So I introduce my thoughts of rationality over my first semester with a recent experience.

Cost-benefit analysis

Exhibit A: It was after 9pm on a chilly Monday night when I saw a pile of books on the corner of Elizabeth and À’Beckett Streets, surrounded by some very morally confused, half-desperate students. Ten minutes later, we decided that, as most of the books had no names on them, we could each take a couple of books home.

Taking someone’s books did not sit well with my conscience though, and morally-confused me then tried to rationalise my action in terms of thinking at the margin.

Simply put, the marginal benefit is to assume the satisfaction I would get out of each book I took is simply its monetary value. As for marginal cost, considering they are just lying there, there is no marginal cost anyway. Positive marginal benefit outweighs zero marginal cost. And so I take one book.

And another. And another. And another. And another. And another. With zero cost, I should have taken as many books as the others would allow me to. And yet I stopped at six. Why?

Well, it didn’t feel “nice” taking so many, what more when the others only took two each – as greedy as I was, I had no desire to be viewed as such. In fact, I almost felt obliged to “leave some for others”, or at least some in case the owner/s returned. I had been swayed by moral and social considerations; was I still “rational”?

Of course it could be argued that social attitudes inflict costs on socially unacceptable behaviour. But why should that be, when others’ opinions of us does not figure in our simple cost-benefit calculus for making decisions? Rationality fails to explain why five individuals  made a collective decision which  did not depend solely on each person’s marginal costs and benefits, yet nevertheless left everyone more satisfied than if they did. Therein lies one of the assumption’s greatest weaknesses, that it assumes many people each maximising their own satisfaction, will somehow maximise the satisfaction of society as a whole. By the same token, it is unable to account for the motives behind collective actions.

Typical questions also create an illusion that we make decisions based on quantifiable  benefits and costs . In reality this is hardly the case. What is to say that price is a good indicator of my satisfaction? In fact, not once while considering which books to take did I glance at the prices. This question becomes even more pertinent when we start talking about opportunity costs, which are the next best alternative given up when we make a choice. My next example illustrates this.

Opportunity costs

Exhibit B: This Saturday, I decided to attend an event advertised for 12.30 to 4.30 in the afternoon, having weighed that on balance, that was the maximum time I was willing to allocate to something other than catching up on 147 pages of textbook reading. Sounds like a rational decision, except that the event lasted an extra hour and involved far more physical activity than I expected, basically ruining my study plans for the rest of the day. Again, I could have been the only non-rational person, but I know others were in the same position.

This illustrates two points: that firstly, rationality assumes we have perfect knowledge of the benefit and costs of the choices facing us, and that there is a certain hierarchy these choices fall into. Clearly this flies in the face of all the uncertainty we face in daily life. Secondly (at least in tutorial and exam questions), we can put a number on everything and presto! We can compare the payoffs and make a clear decision. So tempting, but the impracticality of it all is hardly worth mentioning, especially when one is comparing such wildly different things as apples and pixie dust.

Sunk costs

One last beef I have is with the idea of sunk costs, that whatever has happened, has happened and is not taken into account in present decisions. This is by far the least practical assumption I have had to bear in Microeconomics, and it is not difficult to see why. Exhibit C: I had a ticket for a public lecture on dark matter. Come that night, I was torn between studying (again) and attending the lecture. If I was “rational”, the fact I went to the trouble of  joining a waiting list just to get it would not have mattered, for that was a sunk cost. Even if I had paid for the ticket, rational choice theory supposes it would have made no difference. But we rarely treat sunk costs so coolly: we usually expect a return from some money or effort we have put in, or we act on a chance we might not get again.  A great example is a ticket to the World Cup finals – it would be a senseless waste of my US$ 440 if I chose not to go, especially as I could not know when Germany would play the finals again.

That, in summary, is my experience of Introductory Microeconomics. On the whole, I am still impressed by how well rationality explains quite a lot. However, I would love less snobbery and more recognition that it is, like all models, a good approximation of economic behaviour at best.

Oh, and a word from Alan Accountant to all the Edwina Economists dissing him in every tutorial question: accounting places a lot of emphasis on representing the underlying economic reality as faithfully as possible. It is high time economics do the same. University economics should not  be straitjacketed in the perfectionism of rational choice theory and its one-model-explains-all, reductionist way of thinking. It’s time for textbooks to get real and describe the economy as it really is, not as certain economists think it should be.

 

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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