The case for the market doesn’t require that each of us behave in textbook rational fashion. One of the great benefits of free markets is that they both reduce the frequency of irrational behavior and temper the ill consequences that would otherwise occur when people do – as of course they sometimes do – behave irrationally.
Finding that people sometimes behave irrationally says nothing about the frequency of such behavior. By imposing costs for mistaken behavior on the individuals who behave mistakenly, as well as by rewarding people who behave prudently with personal benefits, markets reduce the frequency of irrational behavior.
If Steve, an adult, makes choices that harm Steve, then Steve has incentives to correct his behavior. At a minimum, no one else has stronger incentives than does Steve to ensure that Steve avoids self-destructive actions. If Steve is shielded from having to suffer the consequences of his choosing unwisely – and if he’s blocked from enjoying the consequences of choosing wisely – then we can be sure that Steve would behave irrationally more frequently than he will when the consequences of his choices fall heavily upon him. Indeed, the fact that we are not hard-wired always to act rationally and prudently strengthens rather than weakens the case for laissez faire capitalism. For that is the system that best motivates individuals to avoid irrational and self-destructive behavior.
Another reason why the findings of behavioral economics do not undercut the case for free markets is summarized by the marketing slogan used in the late 1970s by AT&T: “The System is the Solution.” The case for free markets rests chiefly upon the recognition that the competition and feedback within markets tend to weed out firms and practices that do not satisfy human desires. No one acting within markets needs to aim at generating beneficial system-wide outcomes. Such outcomes emerge spontaneously, as FA Hayek was understandably fond of repeating. They emerge through the feedback-intensive interactions of millions of people, each with his own limited knowledge and personal weaknesses.
The market system fuels and magnifies those practices that people discover through experimentation to be useful and starves and shrinks those practices that people discover to be useless or harmful.
Adam Smith understood that the system is the solution when he wrote that beneficial market outcomes are the result of an “invisible hand.” Another Smith – the economist Vernon Smith, who shared the Nobel Prize with Kahneman – calls the rationality of the market system “ecological rationality,” which he shows is quite real even when many individual actors are less than rational.
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