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Home Publications Blogs Beat the Press If People Act Differently Than Economists Want Them to Act, It Doesn't Mean They Are Irrational

If People Act Differently Than Economists Want Them to Act, It Doesn't Mean They Are Irrational

Thursday, 12 December 2013 08:19

Economists like to think that they get to define the word "rationality." They don't. Economists tend to define a certain type of narrow behavior as "rational," implying that anything else is "irrational."

Binyamin Appelbaum falls into this trap at the end of an interesting piece on Stanley Fisher, when he refers to work by Janet Yellen and others which he says assumes that people are "predictably irrational." Actually much of the behavior assumed in this work is entirely rational, even if it departs from the standard theory that economists would like to apply.

For example, it is not irrational for workers to resist a nominal wage cut from their employers, because this directly implies a reduction in relative wages, even if they would accept a cut in real wages due to inflation. This simply means that workers care about relative wages. Economists have no basis for calling this concern "irrational." Economists are not supposed to be in the business of telling people what they should and should not value. If they care about their relative income, then this is fact that economists must accept, not condemn as irrational.

Much of Yellen's work explores such departure's from narrow rationality as defined by economic theory. However this points to an inadequacy of the definition of economic rationality, not the pervasiveness of irrational behavior.

Comments (13)Add Comment
written by JSeydl, December 12, 2013 7:44
It’s amazing that we are still having these debates. In a world where evidence were acknowledged, the definition of rationality by economists would have expanded to include positional preferences, as the work by Tversky, Kahneman, Robert Frank, and countless others has shown that these are the preferences people actually hold. The problem, I think, is that when this reality is acknowledged, much of what the profession does collapses – e.g., say goodbye to Pareto efficiency when positional concerns are incorporated into the utility function. In this sense, mainstream economics is more of an ideology than a progressive science.
written by JDM, December 12, 2013 7:54
I think it's irrational to think workers are being irrational for being concerned about relative/nominal wages more, or instead of, wages in relation to inflation. They have some control over the nominal wages they receive but little if any control over the rate of inflation. It's rational to concentrate on what you have some control over rather than something you don't.
Rational Micro Doesn't Mean Rational Macro
written by Last Mover, December 12, 2013 8:06
For example, it is not irrational for workers to resist a nominal wage cut from their employers, because this directly implies a reduction in relative wages, even if they would accept a cut in real wages due to inflation.

Excellent point missed by many in their screed against Keynesianism, inflation and sticky prices downwards.

It's like saying if all workers (and potential workers currently unemployed or underemployed) took the same nominal decrease in wages across the board simultaneously (instead of a cut in real wages from inflation) with the expectation of more work available from more output added from more spending, they would "rationally" accept it - in sharp contrast to a cut in real relative pay among different groups of workers which they would reject.

A related application of "rational" is recommended by Paul Krugman for the Fed to be "credibly irresponsible" in the interest of targeting intended inflation and not back off until the target is met. Only then will the "rational" actors believe at the micro level that the Fed means what it says and begin to add the desired spending.

Once again the fallacy of composition rules at the macro level. It's perfectly rational if one person stands up to see the parade better. If everyone stands up, no one sees it better.
I agree, money illusion is not irrational.
written by pete, December 12, 2013 9:13
Could be a rule of thumb a la Herbert Simon and bounded rationality. In the macroeconomic world, it is leads to inefficiencies, since Ackerloff/Yellens general inflation required to drive real wages down is probably not evenly distributed and leads to all sorts of distortions. It is at heart an exploitable behavior, that workers are fooled into working for lower wages. But it does increase output, which is the bottom line in Keynesian models. Clearly, if output increases, and wages are driven down by inflation, then the real returns to capital go up. The unstated goal in this kind of policy. That's why AFLCIO did not embrace Keynes originally, till they were coopted.
written by Jeffrey Stewart, December 12, 2013 9:24
It's irrational to use neoclassical economics and all of its ideological premises to analyze capitalism since the relationship between the latter and neoclassical economic theory is unknown at best and absurd at worst.
What the square root of -1 said to the square root of 2: get rational. Riposte: get real!
written by Squeezed Turnip, December 12, 2013 10:01
As I recall the history (though I am no expert), the term rationality in economics arose in post-WW II era and was mainly being applied to actors in "the market". These "markets" were highly idealized so that theorems could be proved about, say, CAPMs. Which was all fine and dandy, as long as one didn't confuse it with the real world.

(Perhaps the real market does tend to converge to a CAPM type world even in the absence of strict rationality, but as a fixed point in the evolution of the system it doesn't have a strong attraction. Moreover, the big external shocks (bad weather and seasons) make such a fixity an impossibility).

The problem is then people such as the empiricist Fama (who has been at UChicago since his graduate school days and thus lives in the freshwater bubble) ended up believing that their data showed the real markets as efficient as the models (Fischer Black disagreed). According to that type of logic, it must be that workers are imposing a "regulatory distortion" on the labor market, if there's downward friction on wages. Hence the war on unions. Those pesky workers just refuse to fit into those durn models. But so do the traders and everybody else. It's sad that he got the Nobel, since it will just encourage crank-in-training John Cochrane and his ilk to believe they have been vindicated, even though they have been spectacularly wrong for almost entirely the past 5 years.
What a maroon?
written by Squeezed Turnip, December 12, 2013 10:15
Ok, pete, where in here do you see declining real wages? Where did you get your false information from? You seem to nice to have made up such lies yourself. But, you really are a rube sometimes.
oops, here's a more current graph :P
written by Squeezed Turnip, December 12, 2013 10:21
This is real disposable personal income per capita. Due to wage distribution skewness, this is not the entire picture, but a lot of people are still better off than they were as time goes on. The poor not so much, probably. Anybody else have time to post a graph for that stratum? I'm interested.
false info squeezer? I was agreeing with Dean and Yellen and Krugman and so forth.....
written by pete, December 12, 2013 10:34
I know this hurts when everything is fleshed out. Macro economics and macro policy are about output. Sticky wages, as Dean asserts, are a problem which can be overcome by driving real wages down with inflation. The issue wasn't is that possible, the issue was is that due to irrationality. I agree that sticky wages are not necessarily irrational, just an exploitable querk.
I don't think your graphs are relevant to the issue...
written by pete, December 12, 2013 11:26
Your graphs do show a spectacular rise in real wages up to the great depression. And a rise in incomes which probably would fit the entire world. So I guess I miss the point. Are you saying that the real growth since 1960 is due to inflation so it should be embraced? 50 years of growth with relatively low inflation over most of this period especially recently. The 70s were an abhoration, and that was an accomodation of a supply shock, not an attempt to correct a demand defficiency. Did you mean what a macaroon in stead of a maroon?
Wage deflation
written by jonny bakho, December 12, 2013 11:26
Wages and prices might deflate. But nominal amounts of outstanding debt do not deflate. Debt service payments don't deflate or go negative. Deflation/inflation are only rates. Salaries and home loans are nominal. If wages are cut below the ability to make a house payment, all the deflation in the world is not going to help and may make things worse if house price deflates to an underwater value.
nyt: Keynes justifies monetary stimulus, but demand/fiscal stimulus verboten
written by jaaaaayceeeee, December 12, 2013 3:42

Applebaum is perfectly happy to say Keynes justifies monetary stimulus to help economies recover from recession, leading to his meditations for investor interested in monetary stimulus.

What fascinates me is that Keynesian fiscal policy to stimulate an economy with depressed demand, however, is completely verboten. Even though Ben Bernanke has been telling Congress that their refusal to enact fiscal policy has been holding back recovery and keeping unemployment too high. In almost every speech since 2010.

If Applebaum or nyt meditated upon whether Stanley Fisher or Janet Yellin will have more success than Ben Bernanke, getting the news out about how Congress has prevented economic recovery, it would be more useful to the public interest.
I agree to a point
written by Lord, December 12, 2013 8:30
but when framing can change the choice but not the outcome, a chance gain vs a certain gain and a chance loss, one could call that a preference for a frame over a result. I am not sure what we should call that.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.