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I hear very often from intelligent people that economics cannot be applied to certain problems because people behave irrationally and economic theory is based upon the expectation of a rational behavior. This is an incredibly powerful misconception that keeps persisting over generations and acts as a kind of an excuse for all sorts of attacks against the free market ideas. I'd like to explain why it's false to the core.

The first thing we have to do is look up the definition of irrationality. It's important, because by not using the same language we basically put ourselves in a position from which it is impossible to argue at all. I will address other possible definitions of this word, but for now, let me use this one from Wikipedia:

Irrationality is cognition, thinking, talking or acting without inclusion of rationality. It is more specifically described as an action or opinion given through inadequate use of reason, emotional distress, or cognitive deficiency. The term is used, usually pejoratively, to describe thinking and actions that are, or appear to be, less useful, or more illogical than other more rational alternatives (source: Wikipedia (http://en.wikipedia.org/wiki/Irrationality)).

One thing we can take from this definition is that there is no objective irrationality. Rather it is measured against other actions that may be more or less rational. But how do we tell if one action is more rational than another? Well, the definition mentions reason and logic. That is, if there is a lot less logic in one action than in another, then it might be considered irrational. However, the problem is, people usually confuse logic with judgement. THAT is at the core of this misconception. Let's take an abstract example first.

If a = b, b = c then a = c. That's logic. This cannot be false simply because you or I decide it to be false. Regardless of what I tell other people about this relation, regardless of whether they believe me or not, a will always be equal to c. If I say that a != c, then I'm being illogical objectively. Now let's say I believe x = 1 and y = 2. I now am being logical in believing that x + y = 3. However, if another person believes x = 2 and y = 3 then he would be just as logical in believing that x + y = 5. The logic here is represented by a mathematical operation, whereas the judgement is me believing that x and y have certain values.

Now let's look at a less abstract example. Let's say I believe that knocking on a door exactly three times will prevent bad things from happening (a classic example of OCD). Is there no logic to what I'm doing and am I being irrational? Not at all. My brain does a very dirty trick on me. Some people don't even know it does this trick, because they know nothing about OCD. I know about OCD, yet I still keep knocking three times. Why? Because there's a very specific reason why I do that: my brain thinks it's important and this perception of importance overrides other factors. Now you may think I'm being stupid and my judgement is impaired. But dare you not say there's no logic to my actions.

Another very simple (and related) example would be people who go to church. You may think they are being irrational, yet it's their judgement that is impaired, not logic. The logic is still there. It is perfectly rational to go to church if you believe your sins will be forgiven. It would only be irrational to do this if I didn't believe in god.

Let's take another, more commerce-related example now. Let's say I decided to build a private airport. Building an airport is, by all measures, an expensive enterprise. But hey, I have money and I love aviation. So I'm in. Let's say after a year I realize that I dumped a huge amount of money into it, yet we don't even have half a runway built and nothing's working out. Worse still, I realize that because most airports are government owned, it would be a rather harsh competition against a monopoly. Yet I keep spending money and keep building, even though it's obvious this isn't going to be profitable. I keep doing it because I already dumped large summs of money into this project and because I love aviation. This behavior is known as escalation of commitment (http://en.wikipedia.org/wiki/Escalation_of_commitment). Note, in this description on Wikipedia there are 4 drivers to such behavior: social (peer pressure), psychological (gambling), project (past commitments), structural (cultural and environmental factors). By no means my behavior is irrational; in my particular example at least two of these drivers are present: pshychological (I've already spent so much money!) and project (I love aviation!). Again, my judgement is impaired, but the logic is still there.

An example of irrational human behavior is extremely hard to find in the real world. A contrived example would sound like this: I don't like coffee, I'm not addicted to it, it's not really "cool" to drink coffee and it makes me feel sick - yet I drink it for no reason. That behavior can be called irrational. At least until the logic behind it is discovered. For instance, it may turn out that I simply needed something to get my mouth busy with and there's nothing else around, but coffee. Silly? Yes. Irrational - not at all.

Thus, most people don't act irrationally most of the time. Often we just don't know true reasons behind their behavior. Yet we hear time and again that people are irrational creatures who must be controlled and restrained. This way of thinking sounds more like a failure to try and discover true reasons for human action and inability to see through what appears to be irrationality, but really is just a different set of priorities and judgements.

Economics doesn't concern itself with people's judgement. It only concerns itself with scarcity. It doesn't matter why people want more bitcoins or why they love drinking beer. Different people may want those things for completely different reasons. The only important thing is that when people want things that are limited, there's a scarcity. You can't beat that.

Your whole theory falls apart thanks to this:

http://4.bp.blogspot.com/_t5r7sFRdmuE/SsAxZjZ79OI/AAAAAAAAJP8/Mf-NlK6c2nY/s400/flash+mob3.jpg

and

http://aeglaeca.org/wp-content/uploads/2012/11/Obama-Wins_oWuTI.jpg

QED

Hmmm.

You say you can't find evidence of irrationality in the real world?  Look around you:

 - 5 months ago, Bitcoin was worth about $10.  It rose to $265.  It fell to $70.  Huge amounts of money were made and lost.

 - Every Saturday here in England, stupid folk line up to be taxed on their stupidity.  Some of them are so happy to pay this tax that they buy little scratch cards for a higher rate tax on stupidity, lets call it a tax on morons.  I'm talking about the lottery - a project where you are more likely to be struck by lightning twice than to win.  Everyone who buys a ticket is irrational.

 - A few years back, the land value of the imperial garden in Tokyo was greater than the land value of all of New York.  Not of Manhattan; not of New York city but the entire Empire State.

I could go on forever with economical irrationality and that's before we look at apolitical irrationality:

 - 10 years ago the US invaded Iraq and the majority of Americans believed it was in retaliation for 9/11.

 - 12 years ago Osama bin Ladin lived in luxury with a $500 million fortune and a harem of nubile Arab girls.  He decided that giving the US a poke on the nose would add to the excitement in his life.

Bloody hell man, I could spend weeks listing irrational behaviours!

No, that's not irrationality. Your examples are examples of impaired judgements. People act completely rational in accordance with their beliefs. I guess I had to make this bold: the problem is, people usually confuse logic with judgement. THAT is at the core of this misconception.

In that case, irrationality is so rare as to be a symptom of mental illness.  But we now need a new word to describe the behaviour that until now we called "irrational."

 :(

I have a problem with your definition of irrationality, because it's very easy to call anyone who disagrees with me an irrational person.

I have a problem with your problem.  Redefining "Irrationality" so that the behaviour we call "Irrationality" is no longer within the definition of "Irrationality" is a pointless exercise.  The underlying behaviour remains a problem and all you have done is ask us to find a new word to describe it.

It is not only rational behavior (whatever that may mean) which underlies a 1st order theory of economics.  We must also assume that each individual has a negligibly small market share (compared to total volumes on the market). 

Consider for example the behavior of a gas.  Sure, a single atom might at any time have very irrational behavior (the word used by physicists is "peculiar").  However the classical, 1st order moment equations can still apply due an important fact:  there are gobs and gobs of atoms, and they are all so damn small their individual motions don't matter at all, only statistical averages matter.


I argue that it is not the inherent irrationality of participants that makes economics hard.  The extremely dynamic scale of the relative size of individuals in affecting markets makes economics a difficult study of non-equilibrium dynamics. 



 

We're not perfect rational efficient machines, and that is what makes us human.

I mean, what would a world of robots look like? Maybe some techno-transhumanists would disagree with me, but I would not want to live in such a world, as I feel something would be missing. Would robots paint pictures or play music?

Now with that said, I also find the irrationality in economics argument silly, because maybe some individual humans may act "irrational" at times, but the point is to identify and predict general tendencies and trends, such as that people will be more likely to buy the same product from the dealer that offers them the best price.

Most of the "Irrationality" that bothers economists is the behaviour of crowds.  Market bubbles for example.

Sure, but this evens out over time. The question is just the time frame. Bitcoin, because unregulated, may move a lot faster than other assets.

Also, what happens during bubbles and bursts? Weak hands -> strong hands. Evolution and all.  :)

No need to be sorry.  Everything evens out over time.  I was in Amsterdam a couple of weeks ago and they have made a full recovery from the Tulip mania.

What have i missed?

Let's hope Supernode mania takes the same road.

Wow - you got it!!!

I worry too much about subtexts :D

The way you present it, there can be no irrationality because there is a reason for everything anyone does. The neurons have a path that they traverse and there is a reason that such a path exists. If you get down to the most microscopic level everything can be explained.

This would counter the Jurassic Park explaination of Chaos Theory where the guy takes a drop of water and drips it onto the girl's hand stating that the path the water takes cannot be predicted becauase Chaos Theory dictates that in complex systems, the outcome will be different every time. But by your definition, knowledge of every particle, every skin cell, the size of the water droplet, the slightest shift in air particles during the drop means that there is a rational explaination for the water going one way or another.

While this is true, most people look at things from a more broad level and not at a microscopic level.

In theory, if you knew the exact position and velocity and direction of every micro-particle in the universe you would be able to predict everything that would ever occur from there on out. But that would take a lot of ASICs to do the calculations.

https://en.wikipedia.org/wiki/Uncertainty_principle

This post is very misguided and misinformed by the original poster.
Irrational behavior obviously exists, and if those decisions are economical, well you get irrational economics.
Welcome to the world of Behavioral Economics, a whole interdisciplinary field dedicated to the research of irrational economic decisions.

The very definition of classical economics is that all decisions are rational. This is more a dogma than a law.
The main argument is that all markets act efficiently as an aggregate, individuals doing dumb stuff doesn't affect to the market as a whole. But that is further from the truth, the market failed several times in history, and had enough bubbles to call them rational at all.

Uncertainty at the quantum level is just because there is not enough knowledge yet to explain everything. Not that I am saying there will eventually be that knowledge, but there is likely an explanation behind it beyond our current understanding.

Just like how the rain gods produced rain. It was uncertain exactly which ritual most pleased them.

Actually, this is nothing like that.  It's not instantly intuitive, most pop physics explanations are so bad they're misleading, and trying to understand the underlying math doesn't seem like too much fun (just looked at the wikip page).  Even Schrodinger's Cat, something that's meant to be easy to grasp, is misunderstood & misrepresented by many *writers*.  But it's fun, the only short hint i can give is "if after you get it, it seems 'blah,' the explanation is wrong, or you didn't get it."  Something like that. 

And it's physically impossible to collect all that data.

It's not quite clear yet if this is true or not.
http://en.wikipedia.org/wiki/Hidden_variable_theory#Recent_developments (http://en.wikipedia.org/wiki/Hidden_variable_theory#Recent_developments)

very interesting thread, thanks.

I agree with this quote
Economics has too many variables rationality is more less an average
Patterns can be seen but are not exclusive
Human action is not robotic hence markets are volatile and requires the evaluation of human nature to determine rationality

I am still impressed that people jump from human behavior, a domain that belongs to psychology and economics, to fields that are way way way off tangent such as quantum physics.
Look, quantum physics has a freaking loooooooooong way to even be compatible with general relativity, and we are talking about an endless debate within one single discipline: physics.

From there to extrapolate all the way to psychology, lets say that it is quite a stretch of relativistic scales.
Please lets stay within the relevant field of study please.
The relevant one is neither psychology nor economics, but multidisciplinary field that is a combination of both: behavioral economics.
That's where the irrational economics are specifically studied. If you guys are interested find about Dan Ariely.

Here is a clip in Ted Talks that might interest you guys: http://www.ted.com/talks/dan_ariely_asks_are_we_in_control_of_our_own_decisions.html (http://www.ted.com/talks/dan_ariely_asks_are_we_in_control_of_our_own_decisions.html)

And one more thing, I would appreciate if you guys stop using the word "theory" so lightly.
If you are thinking "what if", that is imagining/conjecturing, not theorizing.
If you are thinking "I think that..." that is just giving an opinion, not theorizing.
If you are thinking "I think that..." AND have a way to test it out, then you have an hypothesis. Still not a theory.

The truth is, in your normal common life, you will never be making theories.
Most of the times if you think "In theory" you are most of the cases extrapolating or conjecturing from common sense or common knowledge.
Please don't do that.

Theories in science are the closest things to truths.
Saying "Theory" in science it is the same equivalent as saying rigorous Scientific Knowledge that has been tested and retested to be robust enough to be considered confirmed (as long as every new experimentation is in line with the predictions of the theory, not only keeps it alive but strengthens it).

Anyways, sorry for this, but I just had to say it.
It is my pet peeve to see people using the word theory so freely.

True story.