Critique of Rational Choice Theory

The end of World War Two led to the extensive use of rational choice theory in economics. As defined by Scott (2000, 1), rational choice theory (RCT) is “the idea that all action is fundamentally ‘rational’ in character and that people calculate the likely costs and benefits of any action before deciding what to do.” Scott (2000, 2) went on to explain that “…it [rational choice] denies the existence of any kinds of action other than purely rational and calculative.” All models are based on the utility machine (Homo Economicus), whose only concern is to maximize his welfare and minimize his costs. Moreover, RCT models, which are designed to explain economic phenomena, apply the assumption of perfect information. The idea of perfect information allows all individuals in the model to be fully informed about all prices and output in the economy. However, by analyzing the real world, we will notice the unrealistic assumptions used in the study of economics. In this paper, RCT will be critiqued on three fronts: individuals do not possess anything close to perfect information, decisions are not solely based on utility maximization, and by employing homo economicus in the models we are purging the study of the real man in the economy.­­ We must explain the lack of realism that exists in economics today, otherwise we will constantly make mistakes in predicting the outcomes of certain economic phenomena. I do understand that neoclassical economics must be credited with improving our understanding in economics, but I also would like to provide a critique towards this school of thought. I have provided many critiques in the past and many may find it unsettling for someone to be far too so disapproving. However, to help illustrate my argument, I will employ Abraham Lincoln’s brilliant quote, “He has a right to criticize, who has a heart to help”.

RCT and Utility Maximization

In RCT models, we assume that the real man is removed and “…in its place homo economicus, the cyborg-like optimizer, is substituted” (Boettke, Coyne & Leeson, 2003). The ‘cyborg-like optimizer’ will always pursue the utility maximizing choice. The general equilibrium framework is the one of the heralded theories in economics. According to Boettke, Coyne & Leeson (2000, 5), the general equilibrium framework revolves around the “Walrasian auctioneer”; this fictional individual tries to optimize productivity (utility for a business) by being the price taker in a competitive model. However, there are many instances where we do not try to always maximize productivity or even utility for that matter.

Morality and tradition play a massive role in decision making and they do not involve utility maximization. Clark & Dwight (2011, 2) analyzed duty-based morality “behaving the right way out of a sense of duty”. The authors outlined two characteristics of duty-based morality which is are magnanimous morality and mundane morality. According to Clark & Dwight (2001, 3) “magnanimous morality can best be defined in terms of helping others in ways that satisfy three characteristics—helping intentionally, doing so at a personal sacrifice, and providing the help to identifiable beneficiaries.” On the other hand, as stated by Clark & Dwight (2001, 6), “mundane morality can be described broadly as obeying the generally accepted rules or norms of conduct such as telling the truth, honoring your promises and contractual obligations, respecting the property rights of others, and refraining from intentionally harming others.”  One of the main differences is that magnanimous morality requires ‘pure’ intentions, which are not driven by the hunger of profits. RCT does not necessitate actions based on morality and would allow individuals to make decisions purely on what maximizes utility.

Ever since the financial crisis, we have seen a growing number of people advocating for magnanimous morality. A plethora of examples exist, such as people urging President Obama to attack Wall Street morals (Dwyer, 2012) and the rise of the Occupy Wall Street Movement. Clearly, many actions are based on morality which is completely ignored in RCT modeling, but it is an important factor that motivates people’s tastes and decisions. Undeniably, many of our decisions concerning our goals are often made using morality as a starting point. Much of our life and decision making revolves around the coordination of mundane and magnanimous morality. Unfortunately, it becomes an uphill task to introduce morality into a model.

RCT and Perfect Information

Perfect information is an assumption that is heavily used in RCT modeling in order to avoid making the model “too complex” (Boettke, Coyne & Leeson 2003, 6). However, modeling under assumptions that do not characterize the real world will prove to be an ineffective tool for predictive purposes. It is universally understood that humans do not have anything close to perfect information, yet the assumption is used in perfect competition, among other models. When perfect competition models are used as comparisons to real world problems, then incorrect assertions may be made. This was pointed out by Pascal Salin (1996, 34), when perfect competition models were being compared to real life cartels. The perfect competition models were used to explain that cartels were restricting production and attaining more profits than those of a perfect competition model. We cannot compare the fictional world of perfect information with an imperfect world that does not possess many of the assumptions that RCT models fervently use.

Individuals in the real world are ignorant. It is an element that cannot be properly fitted or measured in any RCT model. To prove that ignorance exists we must note how entrepreneurs become surprised when they have made a mistake. Israel Kirzner (1997, 62) stated that “…sheer ignorance differs from imperfect information in that the discovery which reduces sheer ignorance is necessarily accompanied by the element of surprise—one had not hitherto realized one’s ignorance.”

It is ignorance of some which allows other entrepreneurs to take advantage of the mistakes and attain more market share. This realistic analysis of ignorance and surprise are better suited to understand the economy. An example of the existence of ignorance and surprise is the financial crisis. Many people, including economists, did not predict that the financial crisis would create a situation analogous to the Great Depression of the 1930s. Sadly, our modeling does not make use of the faults of entrepreneurs, stock markets and individuals in general. By utilizing ignorance and surprise of entrepreneurial discovery we can make good qualitative analysis on how the economy actually works.

Another point that ties with perfect information is that decisions are to be made efficiently, or in other words costs and time taken are minimized. However, efficient decisions based on the assumption of perfect information would create an economy free from sluggishness. If there was efficient decision making, then people could utilize information faster and adjust themselves to take advantage of certain events. However, I have yet to see a sustained recovery from the financial crisis. R. Skidelsky (2009, 44) shares these views when he commented, “It was to be expected that, holding the theories they do, the New Classical economists have been embarrassed to admit the crisis. If markets were efficient they cannot fail.” The use of perfect information is a farce considering the global economy malaise that still exists.

Instead of analyzing the faults of perfect information on a theoretical basis, we can use a real life example. Qatar has been enjoying an infrastructure boom, considering the FIFA? World Cup is to be held there in 2022. But, we have only witnessed the introduction of five or four star hotels in Qatar. Bearing in mind that the World Cup is attended by many individuals who do not acquire as much wealth to stay in a five star resort, it is a wonder that there are not many three star hotels clamoring for a spot in Qatar. This is a good example of how there is no efficient decision making because perfect information does not exist. Companies must not have the resources to move there, or they feel that there is too much risk, or they do not even know of the bountiful rewards of setting up three star hotels in Qatar.

Transaction costs may also play a part as many people are ignorant or not familiar with Qatar’s burgeoning economy. Even with the internet, geography can prove to be a significant transaction cost between economies because starting a business in another country involves a lot of research, time and money. With perfect information, such ignorance and sluggishness would be replaced and we would see many more keen businessmen taking advantage of the lack of three star hotels in Qatar. But, there has been little interest in opening up three star hotels in the gas-rich country. This example explains why perfect information fails as an analysis of real world behavior.

RCT and Study of Real Man

There are aspects of humans that are not taken into consideration by RCT’s narrow definitions. Humans are extremely creative, fallible and prefer to make choices. According to Boettke, Coyne and Leeson (2003, 2),

“Nonetheless, this emphasis on man as the ultimate subject matter of economics was borne out of an appreciation that all economic activity is ultimately the activity of fallible, creative and choosing actors”

This is an important characteristic that should be understood if we wish to understand how humans, businesses, organizations and the economy function.            Since humans are fallible, mistakes in the economy are made. This means that there will be a few creative individuals willing to pounce on such opportunities. This could be done by exploiting the weakness of the businesses at fault. Indeed we have witnessed this in the Android advertisements highlighting the lack of innovation in the Apple iPhone. There have been many complaints regarding the few improvements in the new iPhone, and Android has clearly made the public aware of this. This is how the market works and how the incentive of innovation is available. However, RCT modeling does not take creativity and fallibility into consideration.

Moreover, humans also possess imagination, boldness and must also be alert to notice opportunities. Entrepreneurs all over the world are constantly imagining and trying to find new products and services that will change the way we live. But, they must also have the boldness to pursue such fantasies, otherwise these aspirations will remain just that—dreams. Boettke, Coyne and Leeson (2003, 3) explained “The generator of change is the creative imagination of the entrepreneur, who in his attempt to earn profits and avoid losses, drives the market process.”

But, to recognize the opportunities, the individuals must be alert. “Moreover, the ability to spot changes in information is not limited to a selective group of agents—all agents possess the capacity to do so” (Boettke, Coyne and Leeson 2003, 4). This explains that if no individual were alert to opportunity then we may have not garnered the incredible amount of wealth and amenities.

Also, this helps shed light on how the environment is never static and that the market is a process. Without all these features of humans such as fallibility, creative ability, choice, imagination, boldness and alertness we may not have the driving force of progress as Kirzner (1997, 62) explained, “Entrepreneurial discovery is seen as gradually but systematically pushing back the boundaries of sheer ignorance, in this way increasing mutual awareness among market participants and thus, in turn, driving prices, output and input quantities and qualities, toward the values consistent with equilibrium…” This gives a better picture of the market than the static models we draw in classes on a daily basis.

Understandably, neoclassical economics utilizing RCT modeling have made massive strides in trying to predict how the economy works. Such modeling has fused a great amount of mathematical rigor with economic reasoning, which is an admirable feat. The main use of models is to try and replicate real life in order to make some sort of policy decisions to counteract any problems that will occur. Sadly, this paper showcases where RCT can go wrong and provide faulty analysis to a dynamic world.

RCT modeling involves the use of immense technical ability but it is all to waste since the study of homo economicus is completely out of step with reality. The real man does not have perfect information and seldom does he make calculative rational decisions. From research and analysis, I have noticed that to study economics in the micro-level, we must look at the acting man. How people operate with their features of alertness, creativity, curiosity, boldness, imagination and other elements will determine whether they are successful or not. It is the correct combination of elements which will determine the degree of successfulness of businesses. It is precisely these human features which will make us understand the economy as a process rather than a static equilibrium.

Relevant Material:

Bibliography

Boettke, Peter, Chris Coyne, and Peter Leeson. “Man as Machine: The Plight of 20th Century Economics.” Annals of the Society for the History of Economic Thought 43 June (2003): 1-10. Web. <http://ssrn.com/abstract=881780&gt;.

Clark, J.R., and Dwight Lee. “Markets and Morality.” The Cato Jounral 31.1 (2011): 1-26. Web. 21 June 2012. <http://www.cato.org/pubs/journal/cj31n1/cj31n1-1.pdf&gt;.

Dwyer, Michael. “Liberal activists urge Obama to adopt more combative approach to Wall Street.” The Washington Post 20 June 2003. Web. <http://www.washingtonpost.com/politics/liberal-activists-urge-obama-to-adopt-more-combative-approach-to-wall-street/2012/06/20/gJQAGJgsqV_story.html&gt;.

Kirzner, Israel. “Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach.” Journal of Economic Literature 35.1 Mar. (1997): 60-85. Jstor. Web.

Salin, Pascal. “Cartels as Efficient Production Structures.” The Review of Austrian Economics 9.2 (1996): 29-42. Web. <http://mises.org/journals/rae/pdf/R92_2.pdf&gt;.

Skidelsky, Robert. Keynes: The Return of the Master. 1. London: Penguin Books, 2009. 44. Print.

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