One of the most familiar justifications for dismissing the conclusions of economic analysis is to accuse us economists of building our analyses on such absurd assumptions that the conclusions then drawn are untrustworthy. Far be it from me to deny that too many economists have been, and continue to be, prone to build their models on – and to lard their analyses with – assumptions that are not only unrealistic but downright misleading. But because no analysis – indeed, no thinking of any sort – is possible without assumptions, the use of assumptions is unavoidable. The challenge is to choose useful assumptions and to employ them wisely.
In my column for the December 2002 Freeman I defended some often-misunderstood assumptions used by economists. My column is below the fold.
I’m proud of the contribution that the best economists have made to our understanding of society and to the preservation of freedom. What would our world be like today if F. A. Hayek, Milton Friedman, Ludwig von Mises, and Adam Smith had not written and lectured as they did?
These four great men, and scores of other economists through the years, have revealed the immense power of private-property markets to create wealth for everyone. They have also revealed government’s inevitable misuse of resources, its stifling of creative energy, and its threat to liberty.
More than any other discipline, economics cogently explains the benefits of freedom and the dangers of government.
And yet the public does not hold economists in especially high regard. In part this fact can be blamed on the many poor economists who make predictions—about such things as the future course of interest rates, stock prices, unemployment rate, and the rate of economic growth—that no one can possibly know to be accurate.
But another, much-less-just reason for economists’ poor reputation is the claim made by those who don’t know economics that economists build their theories on absurd assumptions about human motivation and behavior.
“Well,” says he who wishes to justify greater government control over the economy, “economic theories showing markets working well should not be taken seriously.”
“In particular,” this foe of economics and economic freedom elaborates, “economists assume that people are perfectly rational—that they have perfect knowledge, that they make decisions with unfailing wisdom, and that they care only about their own, narrow material concerns. One look at the world exposes these assumptions to be ridiculous. Therefore, we need not take seriously any analyses or conclusions that economists offer.”
Let’s look at two of the bedrock assumptions that all decent economists use in their work—assumptions that are often singled out for mischaracterization by those who wish to discredit economics. These assumptions are that each of us is rational and that each of us is self-interested.
What do these assumptions mean? Are they so silly that you are justified in ignoring economists? You judge.
People Are Rational
To assume that “people are rational” is to assume nothing more than that human action is characterized by the following three features:
Each of us acts purposefully. To act purposefully is to act with a goal in mind. A goal can be fixed or it can change frequently; it can be noble or depraved, ambitious or modest. Economists say very little about the content of goals. But we do recognize that almost all human action is sensibly reckoned as aiming at the achievement of some goals. Each of us acts to achieve some end.
Each of us learns. Years ago, “Saturday Night Live” did a skit called “The Stupid Family.” It showed the father taking his seat at the breakfast table and being stung by a nail sticking up out of the seat of his chair. Surprised by the nail, he jumped up, screaming “Ouch!”—and then sat right back down on the chair and nail. He repeated this several times.
Likewise, one of the Stupid sons discovered that the milk on his cereal was sour. He spit it out, disgusted by its taste, uttering “Yuck!” He then, repeatedly, took more spoonfuls of cereal from the same bowl with sour milk.
Each of the family members repeated similar feats of stupidity. The audience roared with laughter.
This skit is funny because it shows people doing what real people do not routinely do—namely, not learning. It’s not funny to sit accidentally on a nail once. But it is funny (in a slapstick way) to show a goofus sitting on the same nail repeatedly, immediately forgetting that the nail is on his chair.
In reality, people learn. Each of us makes all manner of mistakes, but we generally learn of these and attempt to correct our expectations and actions accordingly.
Each of us has transitive preferences. “Transitive preferences” is a fancy name for the following fact: If I prefer apples to bananas, and bananas to cantaloupe, then I prefer apples to cantaloupe. (For the mathematically inclined, a transitive preference is expressed this way: If A > B, and if B > C, then A > C.) Preferences can, and do, often change. But at any moment, they are transitive.
It’s difficult to imagine what the world would look like if individual preferences were not transitive. Suppose that I prefer apples to bananas, bananas to cantaloupe, and cantaloupe to apples.
With this preference, I would walk into the supermarket, see a bunch of bananas beside a display of cantaloupe and say, “Oh goody, I like bananas better than cantaloupe; I’ll buy the bananas.” But then my eye would spy a bag of apples. “Wonderful! I prefer apples to bananas. I’ll get the apples instead.” But recalling the cantaloupe, I would then say to myself “Ah ha! I prefer cantaloupe to apples!” I’d put the apples back on the shelf and grab a cantaloupe—only to see the bananas that I prefer to the cantaloupe.
The point is, I’d never make a choice. I’d be wholly indecisive, unable to choose and unable to act.
When economists look at reality, we see the very same people that others see: imperfect human beings with goals that they seek to achieve, however imperfectly. We see human beings who err, but who learn over time. And we see human beings making choices—some wise, some foolish—and the very fact that we see choices being made is proof positive that people have preferences that are transitive.
People Are Self-Interested
The assumption of self-interest means only that each person cares more about himself, his loved ones, and his friends than he cares about strangers. This assumption does not mean that each person is a narrow-minded, money-grubbing miser who cares only for himself and nothing for his family and friends. It doesn’t even mean that people don’t care at all about strangers.
Each of these assumptions about basic human motivations makes enormously good sense. In fact, each assumption might better be called an observation, for each merely reflects what we all understand to be true of reality.
Pay no attention to those who dismiss economics because of the alleged absurdity of the assumptions of rationality and self-interest.