The Limits of Rational Choice Theory

Behavioral economists assume people operate under bounded rationality, bounded willpower, bounded self-interest, and bounded markets, said Richard Thaler, Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics at the Charles M. Harper Center November 10.

“In particular, the question that behavioral economists address more than traditional economists is, ‘What happens when less than fully rational agents interact in markets with fully rational agents?’” Thaler said during a panel, “Understanding Human Behavior,” at the 2007 Conference on Chicago Economics. Presented by the Becker Center on Chicago Price Theory November 10, the panel included Thaler and Nobel laureate Gary Becker, University Professor of Economics and of Sociology, and moderator Jesse Shapiro, assistant professor of economics.

To answer that question, Thaler said two processes can bring markets to equilibrium. “One is that the markets kind of make the people rational, render them irrelevant, or make them disappear,” Thaler said. “The other is that the markets cater to those irrationalities and you get even more irrationally than you might otherwise. The mortgage crisis of last summer illustrates much of the latter type of behavior.”

Thaler’s research advocates public policy he calls “libertarian paternalism,” he said. “By libertarian, we mean protecting the individual’s right to choose,” Thaler said. “By paternalistic we mean designing policies that are aimed to allow choosers to improve their welfare on their own. We think it’s possible to achieve both goals by applying choice architecture, or the idea that anybody who designs institutional features in which people make decisions must choose something.”

Measuring the utility maximization of individuals in markets and other contexts is subject to the constraints of quantitative production functions, said Becker. Three broad implications are that incentives matter in individuals’ choices, their behavior is “forward looking,” and social environment makes a big difference, he said.

“The market has an enormous impact on what we observe,” he said. “You can’t just have a theory of individual choice and have a good analysis. Everybody knows that, but it’s crucial. Rational choice brought in the concept of equilibrium. The only reason equilibrium makes a great deal of sense is because you have some rational underpinnings of those choices, including corporate choices.”

Another important but often ignored implication is the concept that “it’s rational to not be too rational,” Becker said. “That sounds paradoxical, but it runs pretty close to the optimum,” he said. “Because you’re maximizing, things are pretty flat around the optimum. You can have moderate deviations and still lose very little in the way of utility. What looks like a big deviation may, in fact, be a small deviation.”

For example, children learn to squeeze more from their parent’s altruistic resources, Becker said. “If the parent gives a little more, it doesn’t make that much difference to the parent,” he said. “But it can make a great deal of difference to the child. This is a very general principle. You can be pushed around or kicked around within moderate limits of what’s the true maximum and not fight it very hard, because it’s not going to cost you very much in terms of utility.”

First-year student Kevin Cabral said during the panel he learned that the limits of rational choice can be discussed through the lens of rational choice theory. “That’s one of the themes of this conference - advancing economics without throwing out everything that’s been learned prior,” Cabral said.

“Rational choice says people will always do what is in their self-interest,” he said. “But at the margin, once you have about 95 percent of your self-interest, you might really not care. For example, people tip in restaurants or you have limits on how much money you will ask your parents for.”

- Phil Rockrohr