Is the Rationality Assumption Rational ?

Anyone who has studied economics has always wondered why we need all these assumptions and what purpose would the knowledge serve in the assumption-free real world. Assumptions help to better understand the decisions of individuals, such as in the economic concept of utility. The primary reason that economists make assumptions is to control variables or to exclude variables that don't help determine predictive power. These assumptions help predict the decisions of players in an economy and how different players use scarce resources. So, today we try to understand the importance and the limitations to practical application of knowledge caused by of one of the major assumptions in economics: rationality

Image credits: Shutterstock

Rationality assumption involves two suppositions:

1. Everyone's acts in their own self interest with the goal to make choices that maximize their satisfaction

2. Everyone makes decisions by comparing the marginal benefit and marginal cost of every choice

Most critics argue that such assumptions in any economic model don't hold up in the real world and are unrealistic. They argue that there are a myriad of factors that impact a business or consumer that might make their choices or decisions irrational. Income inequality, Market corrections and bubbles, are all the result of choices made by participants that some economists would argue are irrational. Consumers want to maximize utility based on their needs and wants. Maximizing utility is at the core of rational choice theory, which focuses on how people make rational decisions to achieve their objectives. The theory holds that, given the information they have, people will opt for choices that provide the greatest benefit and minimize any losses. People may act out of love for others, may make decisions without taking into account all the information available, may make decisions harmful to them in the long run, which no "ideal" rational individual from our economics textbooks would have ever taken. Adam Smith, the father of economics, was one of the first economists to work on the rational choice theory. According to his invisible hand theory, “Individuals driven by self-interest and rationality will make decisions that lead to positive benefits for the whole economy. Through the freedom of production, as well as consumption, the best interests of society are fulfilled. The constant interplay of individual pressures on market supply and demand causes the natural movement of prices and the flow of trade.” Rationality assumption helps in explaining individual and collective behaviors and gives meaning to things we observe in the world. It would be very difficult to make sense of economic concepts without this assumption in place as every curve would keep moving around for all individuals and institutions. The rational choice theory gives us a lens to understand why people, groups, and society as a whole make certain choices, based on specific rewards and costs. It also helps explain the seemingly irrational behavior. Because we assume all behavior is rational, any action can be scrutinized for its underlying rational motivations. But the bottom line does remain that individuals do not always make utility-maximizing, rational decisions. Behavioral Economics provides us the stage to explore the economic decision-making processes of individuals and institutions. It explains, from a psychological perspective, why individuals and institutions sometimes make irrational decisions, how and why their behavior does not always follow the predictions made by economic models. In an ideal world people would always make optimal decisions that provide them with the highest utility. Herbert Simon, a Nobel laureate who rejected the assumption of perfect rationality in mainstream economics, proposed the theory of bounded rationality instead. It says that people are not able to always obtain the information they need to make the best possible decision. He argued that knowledge of all alternatives, or all consequences that follow from each alternative, is realistically impossible for most decisions that humans make. However, the rationality assumption is engraved at the core of economics. Many economists are exploring the idea of economic models with irrational individuals and looking at how that changes our idea of economic theory. So, we might actually see a “more rational” economics in the future.

By:-

Astha Mukherjee

(3rd year)

REFERENCES:

• Economists' Assumptions in Their Economic Models. (2022). Retrieved 2 April 2022, from https://www.investopedia.com/ask/answers/032515/why-do-economists-build-assumptions-their-economic-models.asp

• Herbert A. Simon and Bounded Rationality. (2022). Retrieved 6 April 2022, from https://www.investopedia.com/terms/h/herbert-a-simon.asp#:~:text=He%20is%20widely%20associated%20with,and%20social%20ties%20among%20individuals).

• Nobel Prize Lecture: Richard Thaler, The Sveriges Riksbank Prize in Economic Sciences 2017. (2017). [Video]. Retrieved from httej6cygeB2X0 ps://www.youtube.com/watch?v=
  

• Rational Choice Theory. (2022). Retrieved 2 April 2022, from https://www.investopedia.com/terms/r/rational-choice-theory.asp
  

• What Are the Underlying Behavioral Assumptions of Economics?. (2022). Retrieved 2 April 2022, from https://www.thoughtco.com/basic-behavioral-assumptions-of-economics-1147609#:~:text=The%20assumption%20is%20that%20people,do%20this%20exhibit%20rational%20behavior.