Neoclassical economics is built on the assumption that the agents in the economy are self-interested and rational. These assumptions are what distinguishes economics from other social science disciplines, such as psychology and sociology; as such, they are simultaneously the source of the power in economic theorizing and the fundamental weakness in the method. The assumption of rationality is what permits economists to use their most powerful theoretical tool: optimization. But, if agents are not rational, what then? My research over the last 15 years has attempted to answer this question.
Of course, critiques of the assumptions of economics are as old as the use of those assumptions. For many economists, Milton Friedman provided the definitive response to such criticism in his famous essay on positive economics.(1) There he argued that theories should not be evaluated on the basis of the validity of their assumptions, but rather on the accuracy of their predictions. An expert billiards player, he noted, may not know the laws of physics, but acts as if he knows such laws. I completely share Friedman's view that theories should be judged on the basis of predictive power; in my research, I have used this criterion to evaluate alternative models. However, as I have tried to show in my series of "Anomalies" articles in the Journal of Economic Perspectives,(2) the theory fails on precisely these grounds. In such circumstances it makes sense to take a careful look at the assumptions. Perhaps most economic agents make decisions the way most of us play pool: badly.
At some level, of course, the rationality assumption has to be wrong. As noted by Herbert Simon, people are only boundedly rational. How does a boundedly rational agent differ from a rational agent? If the differences are random then the rational model still produces unbiased predictions of behavior. However, as the work of Daniel Kahneman and Amos Tversky(3) has shown, actual behavior differs from rational choice in systematic ways. Their research program of discovering the heuristics people use to make judgments, and the biases inherent in those heuristics, provided my motivation in exploring behavioral economics.
If economic agents make judgments and choices that differ systematically from those prescribed by the rational model, then we can improve the models by incorporating these factors into our theories. My first paper in this domain(4) described several ways in which most people fail to act like "Homo Economicus": for example, they fail to ignore sunk costs, they undervalue opportunity costs relative to out-of-pocket costs, and they have trouble exerting self-control. Sometimes, agents know about their own biases. Thus, people who know they have self-control problems will, like Odysseus, tie themselves to the mast to prevent future transgressions. They join Christmas dubs (or used to before credit cards eliminated the need to be liquid at Christmas time), go to fat farms (resorts that, for a high fee, agree to starve their guests), and pay in advance to join a health club, knowing that the sunk cost will help motivate them to go more often.
One objection to models with less than fully rational agents is the claim that in markets, such agents either will be eliminated or rendered irrelevant. Russell and I investigated this claim in a paper(5) that considers a world with two kinds of agents: the fully rational agents that populate standard economic models, and what we call "quasi-rational agents" who make predictable, systematic errors. We then looked for the conditions necessary for such a world to produce the same equilibriums that would obtain if all the agents were fully rational. We find that these conditions rarely are met, even in markets that function very well, such as financial markets. Often, if I insist on choosing a less than optimal choice for me (say a dominated alternative), there will not be any way for you to make money from my mistake, either by exploiting it or by educating me. …