Daniel Kahneman has a new book, “Thinking Fast and Slow“, that is prompting a lot of excellent articles about his work. For example, Vanity Fair has a nice article by Michael Lewis. Back when I was an undergraduate, Kahneman and Amos Tversky’s Prospect Theory paper was one of the first academic papers I read that motivated me to become an economist.
The article quotes Kahneman as being astonished to learn early in his career that:
The agent of economic theory is rational, selfish, and his tastes do not change.
I just want to point out that this model of decision-makers in economic models is more innocuous than it seems. It means that when we put a decision-maker in an economic model, we assume that she
- has things that she cares about, and
- will do the best she can to achieve the things she cares about.
This is what we mean by rationality. The great thing about this assumption is that it is completely flexible – it can accommodate any preferences at all.
For example, the decision-maker might care about the wellbeing of her neighbor, and so give up some of her own material wealth to help her neighbor be better off. This is both rational and selfish!
For any decision we observe, some preferences will rationalize it. As economic theorists, the crucial assumption is therefore not rationality, but on what it is that the decision-maker cares about and what constraints there are on her making a good decision.
The great contribution of Kahneman and Tversky was to present evidence on the psychological constraints on our decision-maker’s ability to achieve the things she cares about. Making decisions is hard: even if I know what I want to achieve, “doing the best I can” is subject to how I process the options I have to choose from.
Rationality is not supposed to be a realistic model of the process by which people actually make decisions. Rather it attempts to capture the outcomes of decision-making in a plausible way, so that we can try bit by bit to analyze economic settings without simply saying “people are completely unpredictable, so let’s give up”. Kahneman and Tversky helped to show how to write models of rational choice that better reflect the decisions we observe people make.