Thursday, November 17, 2011

Rational models are NOT more constrained than irrational ones

One more comment on the Raquel Fern├índez conversation at the Straddler that I mentioned in a previous post. I thought she had several good points that she formulated well, but there was one comment that I’ve often seen economists make and that I think is wrong or at least misleading:
There is a beauty to the models in and of themselves. You assume, for example, that people are rational. I don’t think any really good economist thinks that people are perfectly rational, but, on the other hand, if you want to model people as not rational, all of a sudden it’s not clear what choice you should make. There are a million and one ways to be non-rational; there’s only one way to be rational within the confines of a model. Rationality means one thing: you’re maximizing your welfare subject to constraints. Now, if you say people don’t always maximize, and they’re beset by this and that, then all of a sudden you can have a million models. And that’s a little bit unsatisfactory too.
Yes, “there’s only one way to be rational within the confines of a model,” but so what? Within the confines of a specific model of irrationality there would be only one way to be irrational too. And  yes, “there are a million and one ways to be non-rational,” but there’s also a million and one ways to specify a utility function – and this gives us a million and one ways to act that are all rational.
There are actually three points (at least) here:
  1. Strictly speaking, “utility maximization” is empirically empty. We start with a preference relation that summarizes observed choice between pairs of consumption bundles, and which is “rational” in the sense of being complete, reflexive and transitive. We can then represent this with an ordinal utility function constructed to capture the choices described by this preference relation. Any preference relation – that is, any systematic set of choices fulfilling these conditions – can be represented by such a utility function. If you always did what hurt you the most, your choices could still be captured by such a utility function – and saying that you “maximize utility” means nothing more than saying that you “choose the one option within the choice set that would be selected no matter what other alternative in the choice set you set it against in a pairwise choice”. This makes no claims concerning why this option is selected – it may be because it benefits you, is best for the world (but not for you selfishly), is the most brightly colored, was most recently advertised or whatever.
  2. Economists then commonly make the “great leap of welfare economics” by assuming that all choices actually made aim to maximize the welfare of the choosing agent. “Utility” now measures “welfare” in some way.To be “rational” means to be “smart and selfish” – and arguments about whether or not A or B or C “is rational” quickly becomes a tiresome exercise in discussing psychological egoism. “Yes, he gave away his money to the beggar – but this gave him a warm glow which was the most welfare-maximizing item he could purchase for that sum of money”
  3. People are obviously not 100% selfish in terms of money and goods for themselves, so such utility functions need to be defined over non-observable goods as well as observable goods. This means that the “one” model of fully rational choice is actually a million models, due to the many degrees of freedom within the model. You do what maximizes your “utility,” but that can be anything. Take Gary Becker’s work: In his work, your utility function can be defined over “capital stocks” that refer to addictive capital, imagination capital, human capital etc. Looking at the different variants of rational addiction theory that have been developed within Becker’s framework, economists are happy to assume different numbers of such stocks and different cross-derivatives between stocks and other goods. Out, as a result, comes “rational consumption” that is rising, falling, cyclical, chaotic, or involves cold-turkey quitting.
I really don’t understand why (some) economists think “utility maximization” is such a “hard constraint” on theorizing in light of this. If you think it is – let me know one consumption pattern or human behavior that if it were observed repeatedly would be inconsistent with “rationality” or “utility maximization”. If it’s a hard constraint this should be simple – there should be long lists of possible, observable behaviors that could not occur if people were actually rational and maximized utility in some substantive sense and that would not occur if the hypothesis of “rational selfish maximization” was correct.
In actuality, I think you’ll find that there is no behavior weird enough to make rational choice economists doubt there being some rational utility-maximizing explanation out there provided we look long and hard enough. As Stigler and Becker wrote in their De Gustibus Non Est Disputandum article:
On our view, one searches, often long and frustratingly, for the subtle forms that prices and income take in explaining differences among men and periods. […] we are proposing the hypothesis that widespread and/or persistent human behavior can be explained by a generalized calculus of utility-maximizing behavior, without introducing the qualification “tastes remaining the same".
Put differently: If you see human action that doesn't look rational - doubt not! Rationality works in mysterious ways... Believe, think, pray and tinker with your model - and if you are wise enough all will be revealed and the Invisible Hand will publish your paper in a top-ranked journal...