The Naive Illusion of Human Rationality

The Naive Illusion of Human Rationality


by Nicola Gennaioli, Dept. of Finance

People routinely decide how much to save, which stocks to buy, which skills and knowledge to acquire, which politician to vote for, etc. These decisions breathe life into firms, governments and markets, shaping their working in critical ways. But how are individual decisions made?

In traditional economics, decisions are rational: they best promote the decision maker’s self-interest. Rational investors form the best forecasts of the prices of traded assets, and buy those that best match their risk preferences. Rational consumers buy a good, say a sweater, when the best assessment of its qualities (color, materials…) is larger than its combined costs (price, taxes...). In intertemporal choice, it is rational to save or to do physical exercise when the current cost is smaller than the future benefit of earning a higher pension or of being healthier. Rational decisions are of course not perfect because there is much uncertainty about them. But no systematic mistakes are made. People do the best given their limited information.

This idea has deep implications. When decisions are rational, competition works like a miracle. It rewards the best goods or financial assets, driving inferior ones out of the market. It also causes firms to make the best decisions: to produce goods that rational consumers like, to take risks that rational investors are willing to bear. Of course, there are externalities and market failures. But in a rational world these can often be fixed, for instance by taxing undesirable activities. Indeed, rational people will follow tax incentives. Thus, rationality offers an optimistic perspective: public policy can steer markets for the better.

Despite its appeal, much evidence in the last thirty years shows that rationality is a poor description of many decisions. For instance, when choosing investments we are often too optimistic about assets that recently experienced high returns. Rational investors do not make this mistake: they quickly learn that recent history is a poor predictor of future returns. Critically, irrelevant factors appear to influence many other decisions: we overly buy sweaters during unusually cold days, or convertible cars during sunny days, and then regret our choices. Rational people are not swayed by these patently transient conditions.  Interestingly, we also make the opposite error of neglecting some highly relevant factors. For instance, when buying a good we insufficiently consider taxes or fees that are not displayed in the posted price. A rational consumer is attentive to all costs, even the less salient ones. Finally, we all know too well the failings of our own willpower: we would like to save or go to the gym, but unlike a rational agent we are often tempted to procrastinate.

There are two important lessons from this body of work. First, markets are far less benign than we think, in ways that help explain key phenomena. When booms cause many investors to be too optimistic, asset prices are inflated and the system is vulnerable to crashes. The 2000 bubble or the 2007-08 crisis in the US are cases in point. When many purchases are influenced by irrelevant attributes and inattentive to non-salient costs, competition encourages firms to dupe unsuspecting consumers. Strategic discounts to artificially inflated regular prices or hefty fees hidden in fine print are examples of practices that have fallen under the radar screen of consumer protection agencies in many countries.      

Second, when decisions are not rational classical policy levers are often ineffective. Rising taxes to discourage the use of environment unfriendly products will not lower their demand unless the tax increase is so large as to be salient. But then such a large increase may be problematic to implement. Subsidizing gym enrollment to promote health in an aging population will not help: people may well enroll, but still lack the willpower to go to the gym. Rising interest rates during a boom may not discourage excess borrowing by over-optimists; it could counterproductively increase their debt burden. And ultimately, the ability of the electoral process to solve social problems is questioned when voters may fail to pick the best politicians. 

Are things so bleak? Not really. The pitfalls of the rational approach mark the beginning of a new enterprise: developing a better theory of human behavior. Many economists are starting to take psychology seriously, developing theories founded on robust regularities about human perception, memory, emotions, etc. These efforts are beginning to put conceptual order in the long list of anomalous decisions. Applications of these theories are shedding light on important economic problems. Furthermore, more realistic theories of human behavior can offer new, and smarter, policy tools that are based on the subtle psychological cues that anchor our thinking. This research program is still at an early stage, but eventually a new synthesis and a better understanding will emerge. Back to the drawing board: there is an exciting way ahead!

Read more about this topic:
The Influence of Others on University Study Choices
Anger Can Hurt Us and Others
Thinking About It Beats Repeating It
Other Peoples’ Choices Make Organizations Similar
Making Rational Decision Is Good for Performance
How the Axes of Political Belonging Change
Political Corruption Scars Young Voters Forever

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