Tuesday, September 15, 2009

The 'Homo Economicus' Straw Man

Mainstream economists assume two things. First, we assume that people
always try to get more of what they want for less personal cost.
Second, we assume that a well-functioning market will result in an
ideal, efficient allocation of resources.

The first statement seems self-evident. The second one takes a bit of
work to prove, but it is fairly easy to see that a system that gives
people more choices, in the form of competing offers, will allow them
to improve their condition and find the best deal. Even if they make
mistakes at first, choosing poorly or getting cheated, they will learn
who and what they are dealing with, and find better deals after a
little experimentation. And more importantly, the market system will
allow them to benefit from other people's experience and not just
their own, as inefficient or corrupt traders are driven out of

However, there seems to be a persistent fallacy that economists assume
that all people are hyper-rational. Many non-economists, and even
some of the 'behavioral economists', accuse standard economic theory
of modeling all people as 'Homo Economicus' instead of real people.
They make the claim that 'Homo Economicus' is super-intelligent,
possesses perfect information, and has the willpower to implement any
decision perfectly.

We don't assume any of this, nor are these assumptions necessary for
any theories about efficient markets. The entire point of a market
system with transparent prices is that it aggregates imperfect
individual knowledge and pushes people to make better decisions.
Suppose a nasty frost wipes out a lot of the orange crop. The price
will then go up, and people will cut back. Those who really want
oranges will pay the extra price, while others will eat something
else. There is no need for anyone to make complicated choices or be
super-intelligent. They just have to adjust their behavior in
response to their desires and the market prices. A central planning
system, however, would require someone or something to have perfect
information and make perfect choices, to make sure that the oranges
get to the people who really need them.

Now, it is true that many economists forget that market efficiency
takes time and feedback to achieve. People need to get information
about how their choices affect their lives, and time to try new things
as a result. When making choices with consequences that take a long
time to realize, they will make mistakes. It is also true that
information is expensive. But as a simplified model of reality, the
assumption of rationality works well and allows us to make useful
predictions. When the markets are working right, they end up
producing the result that a hyper-rational person would generate.

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