Rational Choice Theory

Posted by PITHOCRATES - June 10th, 2013

Economics 101

Trying to Predict which Choice People will Choose is Difficult

People.  They’re the worst.  A joke on Seinfeld.  But so true in economics.

People look out for their best interests.  Everything they do that they have power to do they do to improve their station in life.  When they buy gas they choose the station with the lowest price.  When they get a mortgage they go to the lender with the lowest borrowing costs.  When they go shopping they go to the store with the best sales.  Most of the time.

Some nights people may stop at a pizzeria on the way home from work.  Take the food home.  And scarf it down in front of the television.  Sometimes people may go out to dinner at an expensive restaurant.  Enjoying a fine dining experience.  At a fancy restaurant.  Taking their time.  Savoring every course.  A fine wine.  A decadent dessert.  Two very different choices.  Takeout pizza.  And a fine dining experience.  Trying to predict which choice people will choose is difficult.  Especially when the same people may choose one option one night.  Then the other option on another night.

You can’t reduce People’s Decision-Making Process down to a Mathematical Equation

Choice.  What will we choose when given choice?  That is the million dollar question.  For being able to predict how human beings will choose will make the one who can predict choice very wealthy.  Stores would know exactly what to sell.  Investors would always know what stocks to buy.  And television executives would only put television shows on air the people will love.  But stores often have huge sales to unload merchandise that isn’t selling.  Investors lose money in the stock market.  And every fall television executives bring a slew of new shows to air.  Most of which will be off the air by next season.

Yes, people are rational.  And they typically choose to maximize their utility.  That is, getting the most bang for their buck.  But they are human.  They think.  A lot.  And when they consider everything before making a choice they may choose what to others is irrational.  Even if it’s not to them.  That’s the problem with people.  You can’t reduce their decision-making process down to a mathematical equation.  But economists try.  As do politicians.

But their efforts rarely get the people to do what they want.  During a recession they will implement policy to change people’s decision-making process.  They’ll expand the money supply to lower interest rates.  To encourage people to borrow money and buy things.  Like houses.  And cars.  Even if they weren’t even thinking about buying a house or a car.  The hope is that if these people start buying things they weren’t previously going to buy it will generate economic activity.  And pull the country out of recession.

Left to their own Devices the People will make the Best Decisions

But it rarely works.  If it ever works.  A recession is like a cold.  You can take a lot of over-the-counter cold medicine to ease your discomforts.  But you can’t cure it.  You just have to let it run its course.  So it is with a recession.  A recession is a correction.  Prices correct to market values.  And supply corrects to match demand.  Suppliers cut back on production.  And lay people off.  This is the painful part of a recession.  People losing their jobs.  But they have to.  Because there are too many people producing more than others are buying.  But once the recession runs its course the economy can start growing again.  And business will start hiring again.

Trying to prevent this correction with low interest rates will only delay the correction.  Worse, it will encourage people into irrational behavior.  Such as borrowing money to buy a house during a correction.  Getting a mortgage that will soon be worth more than the value of the house.  Once the correction resets housing prices to market values.  While some people make these irrational decisions others make rational decisions.  Refusing to increase production or to hire more people when the government floods the market with cheap money.  Because they know that it will at best delay the correction.  So they won’t act as the government hoped they would.  Leaving the economy in recession.  So it can run its course.  Like the common cold.

Because recessions must run their course the government should not intervene.  They should not try to influence the decision-making process of the people.  For left to their own devices the people will make the best decisions.  Which is why countries with free market economies have healthier economies than countries with managed economies.  And why when the government does not intervene in the economy recessions are shorter and less painful.  Because the correction that must happen happens.  In the shortest time possible.  But when government intervenes we get things like the Great Depression.  And the Great Recession.

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