Rational economics

In a recent article in The Freeman Steven Horwitz writes in a review of Dan Ariely's book Predictably Irrational, that Ariely argues that,

People act “irrationally,” in the sense of not picking the utility-maximizing (that is, money-maximizing) choice, all the time. (Of course this notion of rationality is much more stringent than the Misesian idea of rationality as choosing the appropriate means for a desired end.) But, as his title suggests, the experimental evidence is also clear that these irrationalities are not random, but predictable. Our reasoning processes are subject to a variety of what seem to be built-in biases that lead us to deviate from the rational-actor model. Ariely doesn’t discuss the sources of these biases that much, but other literature on cognition indicates that they may be features of the very structure of our brains that reflect the long evolutionary path that created modern humans.

Lynne Kiesling comments on this by noting,

If you use the “money-maximizing” definition of rationality to evaluate individual choices, many things are going to fail to meet that definition that would still meet the more general conception of rationality as “choosing the appropriate means for a desired end”. Steve attaches that idea to Mises, correctly, but I’d also attach it to Vernon Smith’s ecological rationality (and through him to David Hume and the psychologist Gerd Gigerenzer and his evaluation of “fast and frugal” heuristics), Herb Simon, and Thomas Schelling. Not all desired ends can be captured neatly or observed as being “money-maximizing”, so that narrow definition of rationality is quite restrictive.

and she adds,

Note also the difference in focus between the two concepts. The “money-maximizing” definition of rationality emphasizes outcomes, and outcomes as measured using a particular unit of account. The “choosing the appropriate means for a desired end” definition still poses a desired outcome, but note how the locus of evaluation of the action shifts back from the demonstrated outcome toward the process of choice. It’s a subtle shift; even in the theoretical literature grounded in the “money-maximizing” concept of rationality the point is to evaluate the choices individuals make. But that concept relies more on using the outcome to evaluate the rationality of the choice process ex post, while the “choosing the appropriate means for a desired end” framing of the concept takes a more process-oriented, ex ante evaluation of whether or not the choice process appears to make sense.

Horwitz goes on to say,

What Austrians and their fellow travelers can argue is that it’s not the rationality of market participants that matters, but the institutional context within which they act. In other words, rationality is not a feature of the individual choosers but of the market as a whole. Even if people make “mistakes” by not acting as the strict model would suggest, they will receive feedback from the competitive marketplace that will demonstrate their errors and give them the incentive and knowledge to correct them. Those who can recognize their biases and correct for them will do better than those who can’t, and markets enable us to do that when they are genuinely free and competitive. This is what Nobel laureate Vernon Smith calls “ecological rationality.” Even if individuals are irrational, the system as a whole produces rational outcomes.

The case for markets is not about people making perfectly rational choices. Rather the question is comparative: Under what set of institutions will people learn from and have incentives to correct the mistakes they will inevitably make? The standard is not perfection; it’s learning.

So what's important is not the rationality of what agents do but rather how they learn from mistakes and observed outcomes. The system will result in a rational outcome even if the individuals in it act "irrationally". Note that this places much emphasis on the institutional framework in which decisions take place. Getting the right institutional in place for a given transaction - for example, should it take place in a market or a firm - effects the learning that goes on and the incentives that agents face.

Also this means that agents don't have to be strictly rational in order for us to think that markets are good. If markets help people learn and adjust their behaviour then they are "good".