PEOPLE ARENT ALWAYS RATIONAL 

Economic theory is populated by a particular species of organism, sometimes called Home economicus Members of this species are always rational. A3 firm managers, they maximize profits. As consumers, they maximize utility (or equivalently, pick the point on the highest indifference curve). Given the constraints they face, they rationally high all the costs and benefits and always choose the best possible course of action, Real people, however, are Homo sapiens. Although in many ways they resemble the rational, calculating people assumed in economic theory, they are far more complex. ‘They can be impulsive.

confused, emotional, and shortsighted. These imperfections of human reasoning are the bread and butter of psychologists, but until recently, economists have neglected them Herbert Simon, one of the first social scientists to work at the boundary of economics and psychology suggested that humans should be viewed not as rational maximizers but as satisficers. Rather than always choosing the best course of action, they make decisions that are merely good enough. Similarly, other economists have suggested that humans are only “near rational” or that they exhibit “bounded rationality Studies of human decision making have tried to systematic mistakes that people make. Here are a few of the findings.

People are overconfident. Imagine that you were asked some numerical questions, such as the number of African countries in the United Nations, the height of the tallest mountain in North America, and so on. Instead of be~ asked for a single estimate, however, you were asked to give a 90 percent confidence interval-a range such that you were 90 percent confident the true number falls within it When psychologists run experiments like this, they find that most people give ranges that are too small The true number falls within their intervals far less than 90 percent of the time That is, most people are too sure of their own abilities.

• Peoole give too much weight to a small number of vivid observations. Imagine that you are thinking about buying a car of brand X. To learn about its reliability, you read Consumer Reports, which has surveyed 1,000 owners of car X. Then you run’ into a friend who owns car X, and she tells you that her car is a lemon. How do you treat your friend’s observation? If you think rationally, you will realize that she has only increased your sample size from 1,000 to 1,001, which does not provide much new information. But because your friend’s story is so vivid, you may be tempted to give It more weight in your decision making than you should.

• People are reluctant to change their minds. People tend to interpret evidence to confirm beliefs they already hold. In one study, subjects were asked to read and evaluate a research report on whether capital punishment deters crime. After reading the report, those who initially favored the death penalty said they were surer in their view, and those who initially opposed the death penalty also said they were surer in their view. The two groups interpreted the same evidence in exactly opposite ways.

Think about decisions you have made in your own life. Do you exhibit some of these traits? A hotly debated issue is whether.deviations from rationality are important for understanding economic phenomena. An intriguing example arises in the study of 401(k) plans, the tax-advantaged retirement savings accounts that some firms offer their workers. In some firms, workers can choose to participate in the plan by filling out a simple form. In other firms, workers are automatically enrolled and can opt out of the plan by filling out a simple form. It turns out many more workers participate in the second case than in the first. If workers were perfectly rational maximizers, they would choose the optimal amount of retirement saving regardless of the default offered by their employer. In fact, workers’ behavior appears to exhibit substantial inertia. Understanding their behavior seems easier once we abandon the model of rational man Why, you might ask, is economics built on the rationality assumption when psychology and common sense cast doubt on it? One answer is that the assumption, even if not exactly true, is still a good approximation. For example, when we studied the differences between competitive and monopoly firms the assumption that firms rationally maximize profit yielded many important and valid insights. Recall from Chapter 2 that economic models not meant to replicate reality but are supposed to show the essence of the problem at hand as an aid to understanding Another reason that economists so often assume rationality may be that economists are themselves not rational maximizers. Like most people, they are overconfident, and they are reluctant to change their minds Their choice among alternative theories of human behavior may exhibit excessive inertia. Moreover economists may be content with a theory that is not perfect but is good enough. The model of rational man may be the theory of choice for a satisficing social scientist.

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