Incentives and Rationality

November 5, 2018 10 Minute Read

By Adam Aurioles, Guest Author

A term I often hear thrown around is rationality, and more specifically the notion of rational decision making by different actors. As I have noted before, I study economics at the University of Chicago and as such we learn quite a bit about this notion of rationality. While I don’t think it fits every situation to sit down and solve a utility maximization problem and set up a model as we might do at UChicago, there is still something to be gleaned from this process.

Rationality is by far the most misunderstood economic term by the general public, for “the assumption that individual behavior is purposive or rational does not imply that a particular individual’s desires are reasonable per se” but rather “rational choice manifests itself through the consumer’s optimal allocation of his scarce resources.” (Dr. Victor Lima, Price Theory) The second misinterpretation comes with much-wasted ink on Homo Economicus. Economists “[Do] not state that individuals actually strive to maximize their utility. We state that individuals act as if they do so.” These critical distinctions set up a framework that better allows us to see what is going on in the world.

To give the definitions some context let’s look at an example, a man having the typical mid-life crisis might buy a Corvette. His financial situation might barely be able to support such a purchase, but in his current state, he is likely valuing a feeling of youth and risk over stability. While it might be easy to see that this is not the most sensible purchase at this juncture in his life, he is still striving to maximize his own utility by maximizing the feeling of youth and freedom.

Let us also look at the opposite end of the transaction, the salesman selling the car to the man going through a mid-life crisis. The salesman acts as a knowledge base for the customer such that the man can make the best decision, i.e. a Chevy Spark likely will not achieve what the man wants in a car so their incentives are aligned. However, the salesman is likely on a commission based pay scheme and so rather than sell him a Camaro SS that begins at $37,000 and achieves the same goal for the man, he will try to upsell him to purchase a Corvette that begins at $55,000. In this way, their incentives are both aligned and misaligned, for the salesman does not want his customer to come back dissatisfied which would likely see him lose time and money in the long run if there is some sort of satisfaction guarantee and he also wants to get as large a commission as possible off the sale.

I hope that this is helpful in analyzing how economists (at least those of certain schools of thought) think about incentives and rationality. This framework does not simply extend to the sale of goods and services. Dr. Kevin Murphy in an article on Dr. Gary Becker describes how this same framework I presented to you (along with a few other key parts) can be used to understand the economics of discrimination, marriage, crime etc. I hope you will give this a read as well and begin to think about how the principles of rationality and incentives affect the way people behave.

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