An Economic Evolution of Understanding Human Irrationality

Aug 10, 2017 by

by Jake Senior & Enrico Tola

Economic models throughout history have been based on various views of human rationality. Rational behavior can have profound impacts on individuals, economies and the environment. If the system makes the individuals act rationally and only in their self-interest, this can result in ultimately irrational outcomes for the society overall. These negative impacts can affect everything from financial markets and employment to fishery stocks.

The first model, discussed by the lecturer, is market idealism, and started in the late 19th century. This free market approach assumed all consumers act totally rationally comparing their own personal costs and benefits. Prices are determined by the equilibrium of supply and demand for any given resource, assuming perfect substitutability between raw materials, capital and labour. However, this unregulated rationale can lead to uncontrolled economic growth and sudden economic collapse. This ‘Boom-and-Bust’ style of economy occurred in America in 1929, causing a socially irrational state with rising unemployment worldwide.

Economic stability was then implemented by the state to create a more socially rational economic model. This was achieved by monetary and fiscal policy that regulated the levels of investment and expenditure in the economy. Therefore, these government institutions manipulated financial conditions, hence manipulating consumers’ decisions against their previous rationality. Nonetheless, the consumption and trade of natural resources was still unregulated and therefore being exploited. Hence, individuals could still act socially irrationally, causing the destruction of common pool resources.

A strong example of differential irrationality can be derived from fisheries. A fishery is a common pool resource which is non-excludable yet rivalrous. This means that fisher have open-access, however each additional member of the market reduces others’ potential catch. Eventually so many fish are being harvested that the population cannot recover to its natural size and its resilience is broken. Yet, the fisher continue to maximise their catch even if they morally want to protect the stock, because they feel otherwise another fisher would just do it (due to non-excludability). Therefore, individual rationality can cause a stock to become extinct, showing total social irrationality. However, such a conclusion is only partially applicable as in the case of real world examples, societies developed their own rule systems to overcome scarcity, as shown by Elinor Ostrom.

Our current economic model has partially tackled this resource issue through embedding markets. Regulations and taxes are now aimed to manipulate individuals’ rational decisions directly to protect some scarce resources. Therefore, quotas per fisher protect stocks to some extent so as to create an improved socially rational outcome. In this model, social contracts and institutions also play an influential role in individual’s conscious decision making to result in eco-friendly socially rational outcomes (for example choosing to recycle or saving energy). However, there are huge resource scarcities and environmental problems that aren’t being resolved.

Therefore, the next economic model transition must rely on a social movement, inspired by environmental institutions. This will help strengthening consumers conscious decision making to protect endangered species, save finite resources and stop unsustainable practices. This could hopefully shape the next economic system and transition individual rationality from the 19th century individual focus to a new paradigm of common, social, globally rational behaviour.

The blogpost is based on the Lecture by Wolfgang Fellner: Mainstream vs Heterodox Economies