Examining Behavioural Economics: Are People Incapable Of Thinking Rationally?

Anyone who has what might be called an instinct for freedom is likely to baulk at being dictated to by experts. A fundamental liberal principle is that individuals should have the autonomy to make their own decisions about how to run their own lives.

This insight goes back, at least, to the eighteenth century. Immanuel Kant, one of the greatest German philosophers, spelt it out in 1784 in an essay entitled ‘Was ist Aufklärung?’ [What is Enlightenment?]:

Overall the passage sounds strikingly contemporary. In the early twenty-first century, we are plagued with self-proclaimed experts telling us how to do everything from eating healthily to parenting. The main difference with Kant’s day is that we do not have to pay for guidance from above, or at least not directly. We are bombarded with unsolicited advice.

However, there is a key clause in Kant’s comment that is easy to miss. His argument hinges on the assumption that individuals are capable of thinking for themselves. But what if that premise is false? What if ordinary people, those who are not experts, are incapable of thinking rationally?

That is the starting point for the edifice of the burgeoning field of behavioural economics. Many of its proponents, such as Dan Ariely of Duke University, state bluntly that they view humans as irrational. The more sophisticated ones, such as Daniel Kahneman, a Nobel laureate at Princeton, talk more guardedly of “bounded rationality.” Either way, the assumption is that the human thinking process is fundamentally flawed.

One way this argument is sometimes expressed is the claim that humans are more like Homer Simpson than Mr Spock. Most people, in this view, are essentially idiotic and ignorant rather than logical, calculating machines as epitomised by the Star Trek character. (Although fans of the science fiction franchise will know that Spock is actually torn between human emotion and Vulcan reason.)

Whatever metaphor is used, it should be clear that if the claim of irrationality is true, it undermines one of the foundations of mainstream economics.

From a behavioural perspective, it is wrong to view consumers as primarily driven by rational considerations. From this premise, it is a short step to explaining financial crises and economic downturns as essentially bouts of irrationality. The conclusion normally drawn is that experts should play a central role in directing economic activity.

It is important to recognise that such claims should not be rejected simply because they lead to objectionable conclusions. If the assumption of irrationality is true, then, whether we like it or not, it should be accepted. The key question is whether it is indeed correct. There are at least three reasons to question it.

Exaggeration of Reality

First, the claim of irrationality is often based on a caricature of orthodox economics. Even the most ardent mainstream economists do not generally claim that humans always act as perfect robotic calculators. People do not systematically weigh up the costs and benefits of every minute decision they ever make.

In reality, the mainstream claim is that an assumption of a broad rationality should be the starting point for building a model of how the economy works. It does not preclude people from ever feeling emotions, making mistakes, or miscalculating on the spur of the moment. Moreover, outside the economic sphere, say in relation to love or family life, people often make decisions on grounds other than economic rationality.

Assume Nothing

It is also common for behaviouralists to assert irrationality rather than to prove it.

For example, in a BBC Horizon documentary, Daniel Kahneman, the Nobel laureate, gave the working habits of New York taxi drivers as an example of irrational behaviour. His claim was that everyone wants taxis on rainy days, but on sunny days fares are hard to find. So, he argued, taxi drivers should logically spend lots of time driving on rainy days when it is easy to find passengers. The sunny days, when there are fewer passengers around, are the best time for drivers to take time off.

But in reality, many drivers do the opposite. They work long hours on slow, sunny days while knocking off early when it is rainy and busy. Rather than thinking about how best to maximise their income, they simply aim to earn a set amount every day. Once they hit their target, they go home.

Anyone who takes the trouble to talk to taxi drivers or even to think about the question will realise things are not so simple. Some drivers say that, contrary to Kahneman’s claim, there can be fewer people around when it is raining. For example, a potential passenger who is thinking of going out for a meal might decide to eat at home instead if the weather is wet. Other drivers claim that passengers tend to want to go on less lucrative, shorter journeys, rather than long trips, when it is raining.

It is also likely that many drivers have set expenses to pay, whether it is for food or housing, every week. To be sure of meeting their commitments, they may need to drive whatever the weather. On a sunny day they may decide they cannot afford to risk waiting for more lucrative rainy days to come along. The weather itself is uncertain.

In such cases, there is probably no perfect solution which is right in all circumstances. It is likely that the correct answer will vary according to particular local conditions and individual needs.

The key point is that it is wrong to simply assume that taxi drivers who work long hours in sunny weather are behaving irrationally. They may have rational reasons for driving when they do. Indeed they are likely to know a great deal more about how they run their own lives than even the most eminent professor.

It’s Complicated

Finally, the claim that economic downturns can simply be explained as bouts of irrational behaviour is crass. Such arguments tend to be based on simplistic assumptions. Often financial turmoil is treated more or less synonymously with trouble in the real economy when the relationship between the two is complex.

In addition, it is wrong to see economies as mere collections of individual consumers. Modern economies are complex entities with large numbers of producers as well as consumers. Understanding weaknesses on the productive side of the economy involves examining such factors as low levels of business investment and profitability. The difficulties economies face demand careful examination rather than assertions that they are manifestations of market madness.

Indeed it is a rich irony that it is often experts, who in many cases are sympathetic to behavioural economics, who have exacerbated economic problems.

For instance, there is a reasonable case that some central banks contributed to the 2008-09 financial crisis by pursuing an overly loose monetary policy beforehand. Low interest rates contributed to the creation of the financial bubble before the market crash. And this leads to a fundamental issue: those who use behavioural economics often suggest that it implies a greater role for regulators or the state to “nudge” us in the right direction. But are not regulators subject to behavioural biases too? Perhaps, for example, they systematically over-estimate their ability to perfect markets.

Behavioural economics should be seen as part of a broader assault on reason that goes back to, at least, the nineteenth century. It attacks the primary liberal value of individual freedom on the spurious grounds that people are incapable of thinking clearly for themselves. On this basis, it opens the way for both illiberal policy conclusions and flawed economics.

This piece was first published on Foundation for Economic Education and has been republished here with permission.