as Richard Murphy claims (Murphy 2011: 45).6 How different this is from state socialism in which the closer a country gets to the ideal of central planning, the worse the outcomes become (and how ironic that those who criticise the free market for its imperfect competition propose government monopoly as the solution).
To take an example from Econ 101, a model which assumes that lower prices will lead to more sales is useful, not because the outcome invariably follows the intervention, but because it will tend to do so, has been shown to do so and there are common sense reasons why it should do so. Similarly, a model which assumes that people make rational, self-interested decisions is useful, not because people invariably do so, but because most people try to do so, and frequently succeed in doing so, most of the time. Rational man, or homo economicus, ‘is not only a simplification of man, as all models will be, but he is also a caricature for he epitomises to an extreme degree the essential characteristics of economic behaviour’ (Morgan 1996: 20). So long as the caricature represents a fundamental truth about how people tend to behave, the model is useful.
6 Economists ‘assume that every business sells every product it makes at what is called the marginal cost of production. That means all they want back for the product they sell is the precise cost they incur for making the precise item they have sold. So if they sold you, for example, an MP3 download then they not only should but must, if this model of utopia described by neoliberal economists is to work, charge you just exactly what it cost them to make the MP3 download they sold to you. I kid you not: the whole edifice of neoliberal economics and the mantra so often repeated that business is more efficient than government is based on this type of logic.’ (Murphy 2011: 44–45).
Rational choice and behavioural economics
A fair degree of rationality can be expected from human beings. As P. J. O’Rourke says, it would be most peculiar if we consistently acted irrationally: ‘Imagine a world where we went about our daily activities deliberately intending not to profit by them – eating pebbles, wooing the furniture, getting into our car for the sole purpose of driving into a tree’ (O’Rourke 2007: 50–51). Predictions based on logical utility maximisation can be tested empirically. Suzanne Moore may be right when she says that economics is not science, but it is a social science. It studies human activity, and therefore can never predict behaviour with the precision with which we associate the natural sciences. Nevertheless, we can observe behaviour and make reasonable predictions about what most people would do in routine situations based on their rational self-interest.
In mainstream economics, rationality ‘simply means that people behave in ways consistent with their preferences’ (Parkin et al. 2013). Behaving rationally means ‘choosing the best means to the chooser’s ends’ (Posner 1998). The task of economists would be so much easier if the world was populated with clear-headed, far-sighted, logical utility maximisers. Alas, it is not and few, if any, mainstream economists endorse a dogmatic version of rational choice theory in which people are assumed to be cold, calculating machines. Far from having a simplistic view of humanity, economists have relentlessly challenged and undermined the notion of ‘rational man’ for decades (Simon 1955; Sen 1977). Such concepts as ‘bounded rationality’, ‘rational ignorance’ and ‘rational irrationality’ have emerged from within the profession, with economists such as Richard Thaler, Vernon Smith, Ariel Rubinstein, Cass Sunstein, Ronald Coase and Bryan Caplan being among the contributors, assisted by a few psychologists, notably Daniel Kahneman and Dan Ariely. The whole field of behavioural economics has been testing the limits of rational behaviour for years while producing best-selling books and Nobel laureates. This is not some obscure sect challenging the conventional wisdom of rational man.
Behavioural economists have shown that many decisions are swayed by unconscious and irrational biases which result in people falling short of their goal of maximising their utility. Moreover, they have shown that – for some people, at least – these biases are systematic and predictable. We are, they say, predictably irrational (Ariely 2009). We are prone to irrational biases such as the gambler’s fallacy7 and the lightning-never-strikes-twice fallacy. We suffer from loss aversion8 and are susceptible to the madness of crowds. We allow ourselves to be influenced by others, especially when they tell us what we want to hear (confirmation bias). We are liable to expect current trends to continue and to forget previous losses (the new paradigm fallacy). We tend to put an exaggerated value on the present compared with the future (hyperbolic discounting) and even those of us who reject superstition are liable to chase financial losses, or be caught up in market bubbles, or act impulsively due to anger, love or pity. It can be argued that much ‘irrational’ behaviour is actually due to a lack of information rather than a deficit of logic – people tend to over-estimate the odds of being murdered or dying in a plane crash, for example (Posner 1998: 1573) – but there are enough examples of self-defeating irrationality to make us doubt rational choice theory in its most rigid form.
These are all interesting and potentially useful observations, but mainstream economists have never claimed that people are infallible. Supporters of rational choice theory, such as Gary Becker and Richard Posner, do not believe that models which assume a large degree of rationality are threatened by insights from behavioural economics, many of which have been incorporated into their work (Herfeld 2012). ‘The rational-choice economist asks what “rational man” would do in a given situation,’ writes Posner, ‘and usually the answer is pretty clear and it can be confirmed. Sometimes it is not confirmed – and so we have behavioural economics’ (Posner 1998: 1559). In the absence of a more compelling theory, they say, a model which assumes that people try to choose the best means to achieve their ends has greater predictive and explanatory power than any other – it is good enough to be useful. But they also note that economists ‘long ago abandoned the model of hyperrational, emotionless, unsocial, supremely egoistic, nonstrategic man (or woman)’ (ibid.: 1552). Like his close relative, the selfish capitalist, rational man is made of straw.
7 The belief that the outcome of a random event, such as a coin toss, is affected by previous outcomes of the same event.
8 Preferring to avoid a loss rather than make a gain.
Have we found angels to govern us?
Debating mankind’s quotient of rationality may seem like an arcane academic exercise, but there is a practical issue at stake. For free-market economists, the question is not whether people are perfectly informed, impeccably rational individuals – obviously they are not – but whether they are better placed to make informed and rational decisions for themselves than politicians and bureaucrats are on their behalf. Criticism of the rational man hypothesis often leads to the conclusion that the government should intervene more strongly when rationality runs dry and information is imperfect. Ha-Joon Chang, for example, jumps seamlessly from straw man to statism in 23 Things They Don’t Tell You About Capitalism, asking ‘how can we accept economic theories that work only because they assume that people are fully rational? The upshot is that we are simply not smart enough to leave the market alone’ (Chang 2010: 173). By this, he means that ‘we’ (the people) are not smart enough and so ‘we’ (the government) must intervene.
The psychologist and behavioural economist Dan Ariely strikes a similar chord in his book Predictably Irrational. After describing some experiments which show that the price people are prepared to pay for certain goods can be manipulated, Ariely (2009: 48) concludes as follows:
So, where does this leave us? If we can’t rely on the market forces of supply and demand to set optimal market prices, and we can’t count on free-market mechanisms to help us maximise our utility, then we may need to look elsewhere. This is especially the case with society’s essentials, such as health care, medicine, water, electricity, education, and other critical resources. If you accept the premise
