Humans As Rational Beings

Neoclassical economics is built on very strong assumptions that, over time, have become “established facts.” Most famous among these are that all economic agents (consumers, companies, etc., are fully rational, and that the so-called in- visible hand works to create market efficiency). To rational economists, these assumptions seem so basic, logical, and self-evident that they do not need any empirical scrutiny.

But how rational is human? Only one entity in this entire universe can answer this question with certainty – the One who created all things in this universe.

To Him is due the primal origin of the heavens and the earth; when He decreeth a matter He saith to it: "Be"; and it is. (Aya 117 of Sura Al-Baqara)

Allah (SWT) says in Ayat 19 –21 of Sura Al-Ma’arij

Truly man was created very impatient,

Fretful when evil touches him;

And niggardly when good reaches him

So there are bounds to rationality of human beings. The demands of classically defined rationality, according to Albin, simply go far beyond the capabilities of human actors to deal with the world’s complexities. These are the ‘barriers and bounds to rationality.’

Adam Smith first coined the term “The Invisible Hand” in his important book “The Wealth of Nations.” With this term he was trying to capture the idea that the marketplace would be self-regulating.  The basic principle of the invisible hand is that though we may be unaware of it, an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy. This means that when this invisible hand exists, when we all pursue our own interest, we end up promoting the public good, and often more effectively than if we had actually and directly intended to do so.  This is a beautiful idea, but the question of course is how closely it represents reality.

That’s Harvard economist Greg Mankiw’s advice to students of all ages:

Economists like me often pretend that people are rational. That is, with mathematical precision, people are assumed to do the best they can to achieve their goals.

For many purposes, this approach is useful. But it is only one way to view human behavior. A bit of psychology is a useful antidote to an excess of classical economics. It reveals flaws in human rationality, including your own.

The main stumbling-block with traditional approaches to development, Sendhil Mullainathan said in a talk this year, is “this little three-pound machine that’s behind your eyes and between your ears” — the human brain. “This machine is really strange, and one of the consequences is that people are weird. They do lots of inconsistent things.

In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the Federal Reserve Bank once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.”

Why did Mr. Greenspan, along with the rest of the world’s regulators, fail to foresee that this could happen? We think their mistake was to neglect the role of human nature. To prevent future catastrophes, regulators should focus explicitly on how to provide safeguards against two all-too-human frailties explored by decades of work in behavioral economics: bounded rationality and limited self-control.The standard (non-behavioral) econ­omic model has greatly influenced regulators. In that model, economic agents (econs for short) choose optimally, no matter how hard a problem they face. They play chess as well as they play tic-tac-toe. The problem with this approach is that the world is populated by humans, not econs. Humans are not stupid, but when things get complicated they flounder: they suffer from bounded rationality.