We like to believe that we are rational, and what is called as the neoclassical theory of
economics is based on the assumptions, that humans have fixed preferences, and these preferences are transitive. Transitivity means, for example, if you decide about the dessert to complete your dinner in a fine-dining restaurant, if you prefer key lime pie to caramel fudge cheesecake, and these cheesecake to chocolate mousse, than you will prefer this pie to the chocolate mousse, too. So, the choice of a dessert is a rational activity, but in a restricted sense of the world. We would not tell somebody that she is crazy by still choosing chocolate mousse to key lime pie.
Neoclassical economic theories are based on the concept that we are rational in a sense that during decision making we are maximizing our expected gain expressed by the utility function. However, if we want to make a mathematical analysis, say to maximize the utility function for the dessert selection, we should be able to assign numerical values to our desire to consume pie, cheesecake or mousse. The rational choice theory made possible to represent and solve problems of choice in a formal manner, and was the basis of many results in decision theory, game theory, and microeconomics. While probably the even the most dogmatic mainstream economist believed that ”hyperrational” utility maximizing agent is a plausible model for describing human behavior, and the rational choice theory was attacked from different angles, still the new paradigm is being emerged slowly. Herbert Simon, who worked far from the mainstream, somewhat unexpectedly got the Nobel prize in economics in 1978, for introducing and propagating the concept of bounded rationality. A satisfactory, even not optimal solution is good. We have to accept that our ability of making decisions is limited by a number of constraints, such as the complexity of a problem, limits on resources (such as time and money), limited available information, our limited cognitive skills, values, influence by our feelings etc. With the words of the political scientist Bryan D Jones:
“As Herbert Simon . . . notes, homo politicus is not irrational. He seems to behave
purposefully, adopting strategies that are relevant to general goals, given the limits of cognitive capacity and the complexity of the political world. But these facets to try to make it impossible to maximize and often inappropriate maximize. Homo politicus seems to Simon to operate according to the model of bounded rationality, that is, adopting means that are relevant to goals within environmental and cognitive processing limits.”
Cognitive bias makes us ”predictably irrational”, by using with a fashionable expression. (Dan Ariely). It frequently blocks people from making rational decisions, even they try to do their best. But what is rationality behavior? Is it true that we always behave in favor of our narrow economic interest? A counterexample is the Ultimatum Game There are two players, the proposer and the responder, who have to agree on how to split a certain amount of money. The proposer makes an offer. The responder has two possibilities, to accept or reject. If she accepts, the deal has been done, If she rejects neither player gets even a single penny. Rationality would require to accept any positive offer, even the smallest one. In this case, the proposer would obtain the overwhelming majority of the entire sum. Studies with humans across different cultures showed that often the responders reject offers below 30% . Still we may say the expected utility concept
works, but we should take into account the psychological benefit for being able to reject an offer just to penalize the miserly proposer.
Richard Thaler, Amos Tversky and Daniel Kahneman not only revolutionized behavioral
economics, but also wrote best-seller books. The takeaway is that we should understand and accept that we humans are evolutionary wired to make errors in judgment (including ranking) and we need a nudge to make decisions that are in our own best interest. The understanding our own fallibility can help us to bring better decisions. The behavioral economists’ approach enhances the rational choice model.