Irrational economic man

He defeated communism, successfully lobbied for deregulation of the financial markets and was instrumental in the formation of capitalism as we know it. But in the wake of the global financial crisis, writes David Orrell, isn’t it time to abandon the idea of rational economic man?

August 24, 2011

One of the greatest of economic myths is the animal known as rational economic man. This mythological beast is frequently described in introductory economics books, and is defined by certain striking characteristics.

He is highly individualistic – he is never seen in a pack or an unruly mob – and only acts to optimise his own utility. He makes his decisions based on cold rationality, rather than coarse emotion. He knows what he likes, and his preferences never change. He knows everything there is to know about prices, and he is blessed with an Apollon ability to look into the future. He never slips up.

Rational economic man – or Homo economicus, as he is also known – is clearly a fictional creature. You don’t need to be a psychologist to realise that most people don’t behave like that. Memories of last year’s office party should suffice.

Despite such objections, rational economic man has played an enduring and important role in shaping our economic theories. He was introduced by the early neoclassical economists, whose mathematical models needed to make certain simplifying assumptions. In the 1950s, his magical powers – including infinite computational capacity and the ability to look into the future – were called upon in the Cold War to prove that, unlike communist systems, free markets would optimally balance supply and demand.

In the 1960s, he was invoked to lend credibility to the efficient market hypothesis. In the 1970s, he was the star of rational choice theory. Even in the 2000s, he helped to justify models such as those used to value the collateralised debt obligations behind the subprime crisis.

Although only a fictional caricature, he has proved very robust, and has had more influence than most living people. So what exactly is the appeal of this mythological creature? What gives rational economic man such remarkable staying power?

The selfish gene theory
One reason is the simple fact that rational, stable people are easier to model than irrational people. Given a certain situation, and a certain set of preferences, there is only one rational decision, but many irrational ones – in the same way that there are more ways to draw a crooked line than a straight one.

The idea of Homo economicus was also given a significant boost in credibility by zoologist Richard Dawkins in his 1973 book The Selfish Gene. “If you look at the way natural selection works,” he wrote, “it seems to follow that anything that has evolved by natural selection should be selfish.” According to this neo-Darwinist theory, we might think we are complex, multidimensional people, but in fact we are only a vehicle for our rational-minded genes, which are bent on propagation and eventually world domination. The only reason we do things like write plays, or come up with scientific theories, or help other people, is because our genes have decided it is a high-probability way of making it with the opposite sex.

However, this theory ignores the fact that selection acts not just on the level of genes or individuals, but also – as Charles Darwin himself was aware – on groups and social structures. As the Santa Fe economist Samuel Bowles has shown, this type of selection leads to “the proliferation of group-beneficial behaviours” that are “quite costly to the individual altruist.”*

The selfish gene theory also ignores the empirical evidence that demonstrates rather convincingly that, not only can we be altruistic, we can also be just plain flakey. Whichever way you look at the subprime/credit crunch debacle – from the decisions of overly indebted homeowners, to the decisions of firms like Lehman Brothers – rational is not the descriptive term that springs naturally to mind.

In a long series of experiments, starting in the 1970s, psychologists Daniel Kahneman and Amos Tversky showed that people are prone to make all sorts of irrational judgements when it comes to money. For example, we tend to underestimate the possibility of extreme events like crashes, and overestimate our ability to cope with them.

Their work helped create the field of behavioural finance, which has since been supplemented by the work of neuroscientists, who use brain scans to monitor our decision-making processes. But really, when it comes to debunking rational economic man, that’s like using an MRI machine to crack a nut.

Improving abstractions
So is there an alternative to this model of human behaviour? There are three aspects to rational economic man: rationality, access to perfect information, and independence. All of these are desirable in the framework of traditional economics, which relies on simplifying equations. However this is not the case for models used in the life sciences.

In systems biology, for example, agent-based models simulate the many proteins or genes which form complex networks of interactions. One of the key principles of systems biology is that what matters is less individual “selfish genes” than the connections between them.

Similar agent-based models are now being used to simulate the economy. Here the software agents, which represent individual people or firms, make decisions based on a fuzzy set of preferences, influence one another’s behaviour, and only have access to limited information (no magical powers to look into the future or make perfect decisions).

The fact that we are influenced by what happens to other people also highlights the importance of modelling network effects, such as financial contagion, which are not captured by traditional risk models. The group behaviour of investors often seems to resemble, less that of rational economic man, and more herds of thundering wildebeest, as they storm in and out of markets in unison.

Finally, our proclivity for altruism means that utility is less straightforward than optimising consumption. Human wellbeing has more to do with complex social and psychological factors than traditional economic metrics such as GDP.

Just as the selfish gene theory from biology influenced economic thought, so new ideas from other life sciences can lead to new insights about the economy – and perhaps finally end the reign of rational economic man.

*Bowles, S. (2009), Did Warfare Among Ancestral Hunter-Gatherers Affect the Evolution of Human Social Behaviors?, Nature, 456, 326-327.