Ecological Rationality Matters

• John Vandivier

1/26 was my first class with Professor/Dr. Pete Leeson. He seems to be very intelligent and also personable, but by nature of man and blogs I am choosing to write about some things he said with which I disagree rather than all of the things he said with which I strongly agree. The things he said with which I disagree are threefold:

  1. Virtually all pro-rational actor model theorists have supported a tautological concept of ecological rationality. In particular, Chicago School theorists.
  2. The prefix \"ecological\" in Vernon Smith's concept of ecological rationality is an extraneous modifier
  3. Behavioral economics sucks
He also discussed these I think in a different order but it's easier for the argument in this article with the order given above.

Background information before my responses: What do we mean by rationality and irrationality?

Big deal: The definition of rationality and irrationality in economics has varied over time. This is <a href="http://www.jstor.org/stable/1827018?seq=1#page_scan_tab_contents">acknowledged by Becker explicitly.

  1. 3 concepts of rationality: Classical, Neoclassical, and Ecological.
  2. Classical rationality: People act in a way which maximizes their own (actual) well being.
  3. Neoclassical rationality: People, in particular at the market level, tend to act as if they were a homo economicus.
    1. Homo economicus is a superhuman fiction which is able to make mathematically optimal choices in the context of a special competitive market. This animal has perfect information, can consume infinitesimal quantities, and other special features. The competitive environment allows production where marginal costs equals marginal benefit, transaction costs don't exist, and has other special features.
  4. Ecological rationality: People act in a way which maximizes their own (expected, but predictably not actual) well being.
    1. People have certain constraints like limited or asymmetric information, cognitive biases, and so on. These factors may cause perceived costs and benefits to diverge from actual costs and benefits. People maximize against perceived costs and benefits subject to such constraints.
  5. A concept of irrationality for each concept of rationality
  6. Classical irrationality: People don't maximize their own actual well being because they are missing information and have various biases.
  7. Neoclassical irrationality: People aren't like homo economicus in theory, and also in practice you economists keep making wrong predictions. So I don't buy this.
  8. Ecological irrationality: We agree with ecological rationality, but we are going to call it irrationality.
    1. Big overlap with Behavioral Economics. Behavioral Economic Rationalists (Caplan) and Irrationalists (Ariely) pretty much agree that people maximize subject to biased expectations, but some of them call this ecological/constrained rationality while others call it irrationality.
First of all let me grant the obvious point: Austrians are pro-market folks who ascent to a tautological concept of rationality. I disagree that Chicago folks ascent to a tautological concept of rationality. I think Chicago folks agree that most people tend to act rationally most of the time, but they are happy to acknowledge occasional irrationality. The sort of rationality to which they refer now looks basically like ecological rationality, but it looked more like a ridiculous assembly of obviously wrong assumptions prior to the 1960s.

Leeson named dropped Stigler, Becker, and Friedman in particular. <a href="http://www.afterecon.com/economics-and-finance/non-becker-rationality-kahneman-irrationality/">This article I wrote previously details that Becker and Friedman certainly did not support a tautological concept of rationality. Here are some additional points:

  1. Friedman famously incorporated expectations into neoclassical and Chicago theory. Eg the expectations-augmented Phillips Curve. This means that beforehand the theories did not incorporate expectations. Therefore they were not ecological concepts.
    1. Prior to that, irrationalists could argue that a person's expectations were incorrect, leading them to make a choice they thought was optimal but which was in fact not optimal. This was considered a form of irrationality.
  2. Stigler basically founded search theory and a key result was that imperfect information is optimal. This in one sense represents a refinement and evolution of neoclassical rationality into ecological rationality, but another interpretation of the same fact is that previous irrationalist criticisms that neoclassical assumptions are invalid had merit. It also shows a distinction between classical, neoclassical, and ecological forms of rationality.
  3. In his current text on Price Theory, Chapter 1, David Friedman clearly articulates that people are sometimes irrational, where irrationality is defined as \"making a mistake.\" He says, sounding entirely true to his Chicago lineage: \"Economics is based on the assumption that people have reasonably simple objectives and choose the correct means to achieve them. Both halves of the assumption are false; people sometimes have very complicated objectives and they sometimes make mistakes. Why then is the assumption useful?\"
In addition to the Chicago school guys, Caplan is an interesting character. Using a neoclassical price-theoretic model, basically a Chicago-type model, Caplan famously argues for rational irrationality. Clearly, then, he does not support tautological rationality. Indeed, he supports predictable irrationality. Yet he is a proponent of the rational actor approach to economics.

So I think I've pretty well established that not all historical proponents of rational choice theory have supported tautological or ecological rationality. Instead, tautological rationality was a pretty unique Austrian view through most of economic history until the recent advent of ecological rationality as a replacement for classical and neoclassical concepts of rationality.

Given my above discussion I think I have also pointed out the usefulness of the ecological term: It distinguishes a refined kind of expectations-augmented, constrained, behavioral economics-friendly concept of rationality.

I'll now proceed to the third point. I'll argue that not all Behavioral Economics sucks. Instead, the bad part sucks and not the other part.

  1. Good Behavioral Economics
    1. Form a well-evidenced theory of preferences to improve the accuracy and richness of economic theory
    2. Provide data to evidence the ecological nature of rationality and also to evidence various other theories, because sometimes theories are theoretically indeterminate and require data to resolve
    3. Improve value of applied economics by providing data, considerations, and techniques which improve applied estimates and forecasts
  2. Bad Behavioral Economics
    1. Ad hoc research which is not reproducible, generalizable, or useful for application in business or elsewhere
    2. Trying to equivocate cognitive and behavioral features with Keynes' animal spirits in order to resuscitate Neokeynesianism
    3. Trying to call behavioral features irrationality and arguing non-sequitur that if irrationality exists then markets fail therefore we need state intervention