Thursday, 22 November 2012

Choice, Preference and the irrational concept of Rationality.

Understanding Ourselves

Everyday in our lives, we have thousands of choices before us. Each day, we subconsciously make quick logical decisions such as whether to eat a banana over an apple, or driving to work or taking the bus, or leaning in for a kiss or just embracing. Even as laymen, we make quick calculations on what we like and what we prefer and decide in a matter of seconds. Economics, surprisingly you will find, focuses on figuring out how this happens. Consumer Behaviour Theory is the incomplete attempt at explaining why we do what we do. Consumers as the name tells, are those economic agents ( not secret agents like Mr. Bond) that have the power to consume. We consume a variety of products that we see in the market. 

In order to understand how we choose, we must first figure out what we like. Economists call this preferences. We must understand what we prefer, and to do so we must make a conclusion about our mindset. Our preferences come from our rationality. Rationality is the basis for all preferences. Hence, it becomes extremely important to try and figure out what exactly is "Rational Thinking". Once we do that we can form a model to explain what is the logic behind choice. And funnily enough, our choices, truth be told, tell us about our rationality. A circular pattern of human reasoning.


There are many views about Rationality, however most of them seem far from reality. Yet, apparantly, economists prefer to use a more simple but less real concept of rationality. This in my opinion, is an area where more research should be done in order to make models more realistic. 

Self Interest Model

1) Self Interest Model of Rationality : The self interest model makes man a very selfish being. It says that man will only look for his benefit in every transaction. While shopping for shoes, he try to get the best shoe for the lowest price. This model says that man wants to get the maximum while losing the minimum. If the cost side is not taken into consideration, man will always prefer more to less. Hence man will prefer more of a comodity to less of the same. 

2) Present Aim Model of Rationality : This model makes man a very spontaneous character. It says that, right at the moment of decision what man wants is what he will choose. If I want to eat a strawberry fruit cake right now, I will choose a strawberry cheese cake over anything else. The flaw here is not hard to see. What about the future? A working man knows he loves to sit on the couch all morning watching cartoons over going to the workplace, but he must realise the trade-off between now and later.

Bounded Rationality

3) Bounded Rationality : This model makes man a slightly confused character. It says that man does not have the perfect knowledge of the market and about the possibility of cheaper/better goods, and hence makes a rational decision based on his current knowledge. Man's understanding is bounded and hence he makes perfect imperfect decisions. He tries to make do with what he knows.

So which model do you think economists use? Bounded Rationality? Well, no! The standard model, uses the Self-Interest model of Rationality. This means to say that more is better. If we are offered more of something, we will always choose it. This might not be true is many cases, and might seem a bit hedonic.

For example, for when we gift our loved ones on christmas or on their birthday, we do not follow this. We in-fact are ready to take a loss in order to see someone else happy. Also, sometimes we are not so greedy as the model says, even if offered we might not take ten mercedes cars, because we simply won't ever require them all. However, for simplicity and a focus, we accept this and proceed.

 Rational Behavior, undergoes 3 steps.

 First, we must chose a model of Rationality, which could be Present Aim or Self-Interest. It could even be a new special model that applies only to certain people like for example, 'Teen-cigarette-10-a-day model', that says that this particular teen follows self-interest model, but must have 10 cigarettes a day as a compulsion. Regardless of these distortions for 'standard models', what is important is to slap the label of some such model onto an individual and say that the individual will remain consistent within the scope of the model. Hence that poor teen cannot deviate from his own model, by having only 9 cigarettes per day.

Second, the individual must figure out what is actually possible for him to obtain. Here the underlying issue is that people cannot buy everything. We all have limited incomes and limited wealth. We are thus constrained by incomes,prices and other factors. Hence in this massive world of choices, most of them are well out of our reach. Some of these constraints may be brought about by age (some of us are too old for certain fun activities at the entertainment park, as for me, I cannot vote!), distance (I want a home in Mars, hardly possible), climate, natural elements, laws of our countries and even time! Usually economists consider only prices and incomes to be real constraints. Luckily, we aren't them.

Third, after deciding what is possible, the individual must decide what is BEST under his Rationality.
Of all the things he purchases, he must measure all items bought to see where is the sweet spot. The balance between what is best and what is possible to buy. Note, the individual may also choose to save a little bit, for the future. This saving also has a certain sweet spot. Save too much and you cannot be happy now, save too little and you cannot be happy later. (Lazy mouse, industrious mouse story anyone?).

In very simple words, we decide how we might BEHAVE (step1), we see what we CAN choose (step2) and finally we choose the BEST of what we can (step3). 

Pi is irrational, he has an imaginary friend.

Preference & Indifference

By preference, we imply taste. What are our tastes? What do we like over what ? The first problem that economists encountered was the problem of measure.
 If we say that we prefer A over B, A must have a higher value to us than B. This value in use, in simple terms is utility. The utility we hope to derive in A is more than the utility we hope to derive from B, hence we chose A over B. This utility is more basically, just a scheme of ranking various options. If we rank A over B, we prefer A over B. 
Again, there can be a case where we decide A is equally as good as B. Here, we are indifferent in our choice. We find A indifferent to B. In other terms, the utility of A is equal to the utility of B. 

How do we measure and compare commodities so different as chocolates and shoes?

  •  The Cardinal Idea : This fancy name is simply short for giving a number to satisfaction or utility. For example, a chocolate can give us 10 utils of satisfaction and a pair of shoes can give us 15 utils of satisfaction. Utils, here is the unit of satisfaction. From the example it is easy to see that we will always choose a pair of shoes over a chocolate. However, as you can see, this is a very unrealistic way of comparing two goods. For every person, the utility for chocolates of shoes varies - I might value shoes at 10 utils and chocolates at 20. Hence this model takes us very far from real life, and we do not use it anymore. 

  • The Ordinal Idea : This idea says that utility can only be compared not measured. And from many comparisons, we can form a general idea about all the possibilities. If A is prefered to B and B is prefered to C, then A is prefered to C. By adding D, E, F, G and more, we can construct an entire table of preferences. 

This was how the ordinal idea gave structure to preferences. This is the model that we use to understand consumer behaviour theory. The Cardinal Model is used, in other areas of Economics.


Now that we have defined preference we go on to the part which involves the larger part of economics. Choices are the actual deal, ultimately everything is life happens not by what we think, but by what we do. This is the real stuff, our choices. We choose our governments (in some countries), we choose the type of lifestyles we live, we choose our significant others and so many more. Robert Frost spoke of a very fundamental choice that he made in his poem, 'The Road not Taken', he however was not an economist and hence his poem was not labelled,

'Countless roads/crossroads not taken, taken, thought upon and some maybe chosen again, by countless people'
Too many choices?

Phew. If you ever wondered what Economists really do, now you know. Ultimately every economist, sits with his mates, and thinks about what people might choose or have already chosen. Economics, here reminds us that ultimately it is people who influence everything. The prices, the laws, governments, fluctuations, inflations, recessions, wars, poverty, equity, incentive, etc. There are no aliens dropping from Europa who influence our economy. You may say, what about incomes and prices? Those certain constraints that influenced our decision. But once again, how really are incomes and prices decided? What about natural endowments like minerals, marine resource and population that constrain a country's choices? Well, the answer to that is, no country is 100% efficient and ultimately our fate is sealed by the hard work and
co-operation of our people.

 In short, our choices DO matter.


Imagine, for example you are living in the island of Mordor, where only you and Legolas live. In this world, there is only one item that you intake as food, entertainment, medicine, leisure and everything else. This is called 'Jojoba' (pronounced Hohoba) and you are the buyer and Legolas is the seller. You being European, have 100 Euros with you and each Jojoba costs 20 Euros.

First, we assume that you are following the self-interest standard of rationality. From this we obtain your preference, you prefer having 5 Jojobas over 2 Johobas. The more the better.
Next, we figure out what is feasible. As you can see, you can afford uptill 5 Jojobas. You cannot have 10 or 6 Jojobas. But you can have 4 or 3 of them.
Next, with relevance to your selfish nature, and ignoring the effects of savings, etc; you will realize that you WILL buy 5 Jojobas. You have got the BEST from what you CAN.

This is your Optimal Choice.
This is your Quantity Demanded. (With respect to the price i.e 20 Euro)

  • What happens if Legolas, increases the price to 25 Euro per Jojoba?
  • What happens if Legolas, reduces the price to 10 Euro per Jojoba?

Economists, would redraw that 'feasible set' and then use the preference structure to determine how demand changes. From every way we go, we will hit the Law of Demand. Economists use this approach in 2 Commodity worlds and even in N-Commodity worlds, to reprove the Law of Demand. They also figure our the interesting income effects and substitution effects (missing from above case).

Unlike us, they use complex mathematical models and utility functions to do this. Horrible sounding words like Kuhn-Tucker Conditions and Strictly Quasiconcave over compact and convex domain, are common in studies involving Consumer Behaviour.

However if you ignore the details, and be a little realistic even a child can figure out the inner clockwork design in the choices of people. Simple model building and logical ideas of Rationality, are easy to understand. The whole point of Economics is to simplify and explain beautifully how the world works. For that matter, any science should try to be simple.

Some of the people who write economics, write terrible economics. For example our dear Keynes, who saved a nation and probably the world. His General Theory is probably the single most important book in all of economic history and future. However, NO normal person outside the subject can EVER understand it. Even I can't go beyond 6 pages, without smashing it against the wall and slitting my wrists in agony. This book will go on to be an epic. Billions would have learnt so much, and understood something so fundamental, if only Keynes, would've remembered :-

Economics is for Everyone!