[This is Part 1 of the series ‘NexGen Economics’ (NGE). The series will throw light upon how the future or next generation economics would change the way of doing businesses, managing nations and living lives too. Let us enter and try to decode the future.]

Economic theories have an underlying assumption that all individuals are rational. Rational, if taken literally means normal or logical. That is, people shall behave and make decisions to get the optimum amount of benefit (something which is very obvious because of human nature). For example, we will buy goods when prices are lower or produce goods when we get higher profits. Does that mean economics concentrate on the selfishness of human beings (at least in theories)? And if so, is it true?

Selfish Human
Twentieth-century economists claim that the entire economic system is based on the assumption that the rational economic man (named as Homoeconomicus) maximizes his utility (Utility – The total satisfaction received from consuming a good or service). This assumption is a fundamental premise of economic theories. Rational Choice Theory assumes that an individual always tries to maximize gains and minimize losses in pursuit of self-interest and not in the interest of others. It is interpreted that pursuit of self-interest is the only thing which is rational and anything else is irrational.

Rationality
Rational behaviour does not necessarily always involve monetary or material benefit. Consider a case of an executive who is deciding on whether to continue the job or take an early retirement. It is obviously (monetarily) beneficial for her to stay rather than retire early; however, it will still be considered rational behaviour for her to seek an early retirement if she is happier (or gets more utility from retiring earlier than continue working).

A rational choice of human behaviour does not restrict only to personal gains, but also to the public good; as stated by Adam Smith, the father of economics. He coined a concept of ‘invisible hand’. According to the concept, farmers cultivate crops in order to fulfil their needs and we consume those crops in order to fulfil our energy requirements and the country is served, unintentionally. In the book Wealth of Nations, he wrote – “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

Irrationality
There are two modes of thinking: the intuitive, fast, and impulsive System 1 and the slow, rational, and deliberate System 2, as defined by Nobel Prize winner Daniel Kahneman (2011). Psychologists have proved that most of the human decisions are influenced by the subconscious mind, i.e. System 1 or the “hot state” of mind. It challenges the bases of economic theories which assumes rational (or conscious) mind. Irrationality in human beings is very common. We could see numerous examples around –

1. Stock Market – Daily ups and downs, reactions and speculations can be traced to irrational behaviour (though not all the time). It is a very common mistake; to buy when prices are high and sell when prices are low. It is the fundamental and logical rule to buy at the lows and sell at highs. Stock markets are the soft target of irrational (or herd) behaviour and there is a lot of scope to study from this paradigm.

2. Altruism – Yes, when you give someone without expecting anything in return, you are irrational. It was proved from an experiment where an individual is told to perform a task, which was socially good and noble one (say for example – cleaning roads), without offering any money. The individual completed the task considering it as a noble deed. But when money was involved, the market norms got applied. People started analysing on the basis of whether it was worth their time involved. Also, when individuals felt that the money offered was less than their expectations or standards, they refused to take the task.

However, it could be a rational action too. As written in the book Superfreakonomics, “You give not only because you want to help but because it makes you look good or feel good or feel less bad.”

3. Freebie – Almost everyone falls prey to the freebie. There is an emotional excitement attached to the placards like ‘Free Gift’ or ‘Buy One Get One Free’. It is considered an irrational behaviour since we tend to purchase the item which we do not need. Just for the sake of the free item we get along, we are induced to buy that product, even knowing about its inferior quality or its slow-moving nature.

4. Price Comparison – Similar irrationality is attached to when the price of a product is slightly more than its competitor. We perceive price to be directly proportional to the actual value or the worth. When a product is highly priced, we feel that it is better in terms of quality. Luxury or premium product companies have been able to fill our hearts and empty our pockets on the basis of such irrationality.

Your Rationality ≠ Mine
Gary Becker and Kevin Murphy’s theory of rational addiction states that smokers plan their consumption of cigarettes and they have full knowledge of its effects on their health. Authors argued that they compare future health costs and satisfaction they get today rationally. So, smokers do not become irrational just because it is unhealthy or unethical (for someone).

Meanwhile, an interesting article widened my paradigm of irrational behaviour. In the article ‘Rationalizing the “Irrational”’, author Jason Collins states –

“When we examine objectives from an evolutionary biology perspective, we see that what appears irrational might simply be a misunderstanding on our part of what someone’s objectives are.
Following most evolutionary biologists, we can first ask how a strange behavior might be adaptive before branding it as irrational.”

It suggests that one should not conclude that something is irrational because he/she feels it as irrational. There might be reasons for such behaviour which could be traced back to the evolutionary biology.

Conclusion
The reason behind introducing the ‘rationality’ concept at first was to make you familiar and erudite with the basis of all economic theories. Modern economists are using them to decode the human behaviour, predict further actions and use this as a policy-making tool. Let us see how psychology helps economists in my upcoming article. It would help us understand the next-generation economics in a different angle.

 – Swapnil Karkare