The Rational Man Is a Fable
It is a useful narrative device in economic theory but not a faithful representation of real human behavior.
This post digs a bit deeper into the NOT so faithful representation of man within economic theory—which also underpins most of mainstream finance. It continues the path of exploration started in the earlier post titled Homo NOT so Economicus. That first post covers what I would describe as the most common way of critiquing the assumption of the rational man and its foundations in economics. But in line with the ideals of Deeponomics, we need a more nuanced view—and a deeper take.
Let us start at the core of it.
A rational decision-maker has a set of ordered preferences, meaning that when he faces a problem, he asks himself:
What alternatives do I have?
What would the consequences of those alternatives be in relation to my preferences?
He then chooses the alternative that leads to the best consequence, based on those preferences. So far, so good.
In essence, we have a decision-maker who encounters a problem to which he must respond. This decision-maker has to choose only one of the available options presented to him.
And now we need to mention some of the restrictions within this model of man. Even though economists understand that the following factors likely influence which alternative is chosen, within this logic frame—if you will—these so-called non-essential variables are not allowed to affect the decision. This includes things like whether there is a default option, how the alternatives are described, or the order in which they are presented.
The rational man is also considered to be independent, meaning his choices are not influenced by others.
All of these factors are actually very interesting when we look at how decisions are made in real-life settings, or in experiments. And there is a large body of research exploring this—whether in behavioral economics, behavioral finance, or psychology in general. But that is a topic for another day.
The economist want to understand the link between the situation the rational man faces and the decision that rational man ultimately makes. The input and the output.
The rational man will choose the alternative that maximizes the objective function. And by objective function, an economist means the mathematical expression used to model what the decision-maker is trying to maximize. Hence, the objective function encodes the decision-maker’s preferences. So, the objective function represents the preferences of the decision-maker.
It could simply be that you value an orange three times more than an apple. So if you were presented with a choice of one orange or two apples, you would choose the orange, because its value outweighs the apples. But if you were offered four apples, now the apples win. This could be presented as the simple mathematical objective function shown below:
U(x, y) = 1 ⋅ x + 3 ⋅ y
x = number of apples; y = number of oranges
And the utility value of an apple is 1, and of an orange is 3.
However, it does not impose a limitation on the reasonableness of preferences. Let us say that valuing oranges three times more than apples is unreasonable. But economists do not make that judgment. Therefore, the decision-maker’s preferences can be in direct conflict with what common sense might define as the decision-maker’s interest—which could be choosing the option that gives you the most fruit.
Another better example, or at least an example, is the following:
A manager invests in a project that minimizes profits. At first glance, this looks irrational. But if this negative-profit project delivers on a different measure—say it increases the manager's social standing within his peer group, or within a group he would like to gain admiration from or access to—then it is rational.
Okay, but here is the twist: the economist only cares that the preferences are consistent, so that they can model or describe the decision-maker’s behavior as if they are maximizing utility based on those ranked preferences. They do not care about the inner workings of the person, nor whether the model reflects the true motivations of the individual.
Here is an example to drive the point home:
If we observe a person who always chooses the drink that contains alcohol—and continues to do so throughout the evening, late into the night, and even the following day—an economist will model this behavior as if the person is maximizing a utility function through alcohol consumption.
And when economists apply their models to policy questions—questions that require a criterion for individual welfare—they will often equate the person's level of happiness with the preferences that explain this behavior. In this example, it would mean: more alcohol, more happiness.
But here’s the issue: this person is clearly maximizing alcohol intake, but that almost certainly does not promote their happiness. This could be someone who is consistently working toward the wrong goal. Maybe even toward self-destruction, or at the very least, toward becoming less happy.
So we end up with a strange and unsettling conclusion:
A person is seen as rational, even though the more he follows his preferences, the less happy he becomes. Or put even more strangely: the more happiness he gets, the less happy he becomes.
And yet—within the economic model—this is still considered rational.
So yes, there are many examples—and many more to be found—of where, when, and how the model of the rational economic man fails to capture the real actions of us humans. Because it is a model. And models are usually simplistic and unrealistic. The rational man, or homo economicus, is simply the main character in the stories told by economic theory.
This character is used to structure formal models of decision-making, in the imaginary world of economic theory.
These models—or fables, or tales, or stories, or whatever you want to call them—are not good at prediction and often have limited real-world applicability. They do not have to be used as tools for forecasting, but rather as ways to think about logic and structure in human behavior. To clarify thoughts, not to be viewed as scientific truths. Simply as a method for exploring concepts—not for dictating them.
References
Rubinstein, A., 2012. Economic Fables. Cambridge: Open Book Publishers.