The Myth of Perfect Rationality
Mainstream (neo-classical) economics idealizes human beings as perfectly rational actors when it comes to making decisions. This concept, known as rational choice theory, is based on three assumptions:
1. People have complete and consistent preferences (which can be assigned quantitative values called utilities) among a set of decision outcomes
2. People act independently based on full and relevant information
3. People always select the decision option that maximizes their utility.
Rational choice theory is a cornerstone of economics because it makes people’s decisions predictable. Predictability of behavior by individuals and businesses allows economists to derive regularities such as the law of supply and demand in microeconomics. Rational producers choose to make more goods as prices increase, because selling those goods at higher prices increases profits. Similarly, demand from rational buyers for a good decreases as its price increases, because they can afford less of it and other choices for spending become more attractive. Trading occurs at the intersection of the curves representing supply and demand, where both buyers and sellers maximize their respective utilities. However, this logic falls apart if buyers and sellers can’t fully and uniformly specify preferences, only possess partial information about their choices and market, or can’t be relied upon to select the options that maximize their utility.
Critics of rational choice theory (and by extension mainstream economics) attack all three tenets. First, critics charge that preferences are not coherent: people often lack well-formed judgments about all the features of decision outcomes such as properties of product choices (e.g., cost, appearance, reliability, quality, and functionality). Decision-makers also find it difficult to consistently order preferences for different factors relative to one another (i.e., transitivity). Quantifying preferences uniformly can also be problematic, especially for intangible properties such as satisfaction or social values. In fact, the parties involved in a decision might have divergent preferences and calculate utility in ways that are incompatible.
Critics also argue that individuals and businesses rarely have access to complete information about customer preferences, competitors’ capabilities and strategies, decision options, and their consequences. It can be difficult to determine exactly what information is relevant to a decision and what is not. Additionally, business decision-makers generally operate under considerable uncertainty about events and conditions in the future.
Psychologists Amos Tversky and Daniel Kahneman didn’t deny that people make flawed judgments and choices owing to variations or lapses in individual performance caused by distractions, fatigue, and gaps in knowledge or skill. However, they asserted that the primary cause for deviations was more fundamental and systemic—intuitions gone awry. We rely heavily on intuitions to assess and decide how to respond to everyday situations rapidly, given minimal information and effort. Although intuitions work well in most routine settings, they mislead us in more complicated situations, distorting judgments and choices. And because intuitions arise reflexively, often below the level of conscious awareness, they tend to pre-empt more deliberate (and effortful) reasoning.
Tversky and Kahneman identified and experimentally verified numerous biases in our intuitions including representativeness, availability, anchoring and adjustment, and loss aversion: we make judgments based on stereotypes and similarities rather than statistically valid samples; rely on recent or vivid events and memories to make judgments even though they may not be pertinent or as relevant as less easily accessible facts or memories; we fixate on arbitrary numbers such as price or salary and don’t adjust them properly to fit the situation (e.g., counter-offers in negotiations); and we make choices conservatively to avoid losses, but act more aggressively when we focus on potential gains. Tversky and Kahneman argued that these biases are structural or systemic, and sufficiently severe to reject rational choice theory as a workable model for approximating human decision-making. Biases disrupt how we gather, weigh, and interpret situational data, distorting our preferences and judgments about outcomes and utilities that ground our decisions. Cognitive biases dominate current critiques of perfect rationality. Much of the literature on improving decisions recommends psychological “debiasing” techniques to counteract the errors they cause.
Economist Herbert Simon advanced a different objection to rational choice theory with his theory of bounded rationality. Rather than studying intuitions, Simon investigated the cognitive and contextual constraints on our reasoning when we set about making decisions methodically. Simon argued:
"The task of decision involves three steps: (1) the listing of all the alternative strategies; (2) the determination of all the consequences that follow upon each of these strategies; (3) the comparative evaluation of these sets of consequences. The word “all” is used advisedly. It is obviously impossible for the individual to know all of his alternatives or all their consequences, and this impossibility is a very important departure of actual behavior from the model of objective rationality."
In other words, perfect rationality implicitly demands an exhaustive enumeration of decision options and outcomes. However, thanks to constraints on human cognitive capacity, we can envision or design only a partial set of possible responses to most real world decisions. Our imperfect social scientific knowledge about the behavior of individuals and organizations in markets or societies. To add insult to injury, uncertainties about the future, such as contingent events, produce vast numbers of alternative outcomes for any given decision option. Thus, we can only conceive and examine a small subset of the complete range of possible decision options and outcomes. Simon observed:
"For most problems that Man encounters in the real world, no procedure that he can carry out with his information processing equipment will enable him to discover the optimal solution, even when the notion of ‘optimum’ is well defined. There is no logical reason why this need be so: it is simply a rather obvious empirical fact about the world we live in – a fact about the relation between the enormous complexity of that world and the model information-processing capabilities with which Man is endowed."
As finite human beings acting in complex environments, we can only identify a local rather than a global or absolute maximum utility for the set of decision options that we conceive and possible outcomes that we manage to anticipate and assess. Simon called this a satisficing choice—one that is “good enough” given reasonable effort. Thus, Simon’s core objection focuses on the second assumption, that people act independently based on full and relevant information. His objection cuts deeper than the more common criticisms by psychologists and economists reviewed earlier: it holds regardless of how heroically we strive to overcome cognitive biases, formulate coherent preferences, compute accurate utilities, and project for decision options. Taken together, the criticisms of rational choice theory by Simon, Tversky and Kahneman, and others cast significant doubts on its viability. The theory of cognitive biases also catalyzed an alternative behavioral approach to analyzing economic decisions that avoids the myth of perfect rationality.
For More Information
See Eliot Weintraub’s account of neoclassical economics, Michael Lewis’s The Undoing Project or Kahneman’s Thinking Fast and Slow for accounts of cognitive biases, John Manoogian’s Cognitive Codex for a summary graphic of cognitive biases, Richard Thaler’s Misbehaving for a biographical account of behavioral economics, and Herbert Simon’s Sciences of the Artificial for a summary of his theory of bounded rationality and his Nobel Prize lecture for a technical overview of objections to rational choice theory.