The Assumptions of Economic Rationality

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The Rationality Assumption in Neoclassical Economics

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Almost all of the models studied in traditional economics courses begin with an assumption about the "rationality" of the parties involved - rational consumers, rational firms, and so on. When we usually hear the word "rational," we tend to interpret it generally as "makes well-reasoned decisions." In an economic context, however, the term has a quite particular meaning.  At a high level, we can think of rational consumers as maximizing their long-term utility or happiness, and we can think of rational firms as maximizing their long-term profit, but there's a lot more behind the rationality assumption than initially appears.

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Rational Individuals Process All Information Fully, Objectively, and Costlessly

When consumers attempt to maximize their long-term utility, what they are actually trying to do is choose from among the multitude of goods and services available for consumption at each point in time. This is no easy task, since doing so requires collecting, organizing, and storing a huge amount of information about the goods available - more than we as humans likely have ​the capacity for! In addition, rational consumers plan for the long term, which is likely impossible to do perfectly in an economy where new goods and services are entering all the time.

Furthermore, the assumption of rationality requires that consumers can process all of the necessary information in order to maximize utility without cost (monetary or cognitive).

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Rational Individuals Are Not Subject to Framing Manipulations

Since the rationality assumption requires that individuals process information objectively, it implies that individuals are not influenced by the way in information is presented- i.e. the "framing" of the information. Anyone who views "30 percent off" and "pay 70 percent of the original price" as psychologically different, for example, is being affected by the framing of information.

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Rational Individuals Have Well-Behaved Preferences

In addition, the assumption of rationality requires that an individual's preferences obey certain rules of logic. This doesn't mean, however, that we have to agree with an individual's preferences in order for them to be rational!

The first rule of well-behaved preferences is that they are complete - in other words, that when presented with any two goods in the universe of consumption, a rational individual will be able to say which item he or she likes better. This is somewhat difficult when you start to think about how hard to compare goods can be - comparing apples and oranges seems easy once you're asked to determine whether you prefer a kitten or a bicycle!

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Rational Individuals Have Well-Behaved Preferences

The second rule of well-behaved preferences is that they are transitive- i.e. that they satisfy the transitive property in logic. In this context, it means that if a rational individual prefers good A to good B and also prefers good B to good C, then the individual will also prefer good A to good C. In addition, it means that if a rational individual is indifferent between good A and good B and also indifferent between good B and good C, the individual will also be indifferent between good A and good C.

(Graphically, this assumption implies that an individual's preferences can't result in indifference curves that cross one another.)

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Rational Individuals Have Time-Consistent Preferences

In addition, a rational individual has preferences that are what economists call time consistent. While it may be tempting to conclude that time consistent preferences require that an individual chooses the same goods at all points in time, this is not actually the case. (Rational individuals would be pretty boring if it were the case!)  Instead, time consistent preferences require that an individual will find it optimal to follow through on the plans that she made for the future- for example, if a time-consistent individual decides that it is optimal to consume a cheeseburger next Tuesday, that individual will still find that decision to be optimal when next Tuesday rolls around.

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Rational Individuals Use a Long Planning Horizon

As mentioned earlier, rational individuals can generally be thought of as maximizing their long-term utility. In order to do this effectively, it is technically necessary to think of all of the consumption ​that one is going to do in life as one big utility maximization problem. Despite our best efforts to plan for the long term, it is unlikely that anyone actually succeeds in this degree of long-term thinking, especially since, as noted earlier, it's​ all but impossible to predict what future consumption options are going to look like.

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The Relevance of the Rationality Assumption

This discussion might make it seem like the assumption of rationality is far too strong to build useful economic models on, but this isn't necessarily true. Even though the assumption is likely not perfectly descriptive, it still provides a good starting point for understanding where human decision making is trying to get to. In addition, it leads to good general guidance when individuals' deviations from rationality are idiosyncratic and random.

On the other hand, the assumptions of rationality can be very problematic in situations where individuals systematically deviate from the behavior that the assumption would predict. These situations provide ample opportunities for behavioral economists to catalog and analyze the impact of deviations from reality on traditional economic models.