violations of the rational maximizing assumption

Violations of rational utility-maximization:

Where standard economics breaks down

Assumptions of the Standard Economic Model of Consumer Behavior

1. People have known preferences.

2. People act with full information.

3. People choose rationally so as to maximize utility.

Full Internal Knowledge

Full External Knowledge

Maximizing Choices

It is relatively easy to adjust models for violations of assumption 2

1. People have known preferences.

2. People act with full information.

3. People choose rationally so as to maximize utility.

Full Internal Knowledge

Full External Knowledge

Maximizing Choices

The first two are simple informational deficiencies. Correct information (experimentation, education) cures the deficiency.

Violating rational choice to maximize utility is the problem

1. People have known preferences.

2. People act with full information.

3. People choose rationally so as to maximize utility.

Full Internal Knowledge

Full External Knowledge

Maximizing Choices

There is no easy “cure” when this assumption is wrong. The model just doesn’t work in those cases.

Let’s look at some examples

• We will look at some examples of different people.

• Think about whether or not the person is acting rationally to maximize his or her utility (well-being; happiness; satisfaction).

• I’ll ask your opinion at the end of each.

Example 1

http://www.youtube.com/watch?v=AkvdEoM4Uqs

from 5:05 to end

Rationally maximizing utility?

Do you think the previous person was acting rationally to maximize her utility?a) Yesb) Probablyc) I have no idead) Probably note) Definitely not

Example 2

http://www.youtube.com/watch?v=_7ltjqBn8K4

Rationally maximizing utility?

Do you think the previous person was acting rationally to maximize her utility?a) Yesb) Probablyc) I have no idead) Probably note) Definitely not

Example 3

http://www.youtube.com/watch?v=OswtLmGX9bw

Rationally maximizing utility?

Do you think the previous person was acting rationally to maximize his or her utility?a) Yesb) Probablyc) I have no idead) Probably note) Definitely not

Example 4

First 1:50 of http://www.youtube.com/watch?v=kOPOK24g9Cc

Rationally maximizing utility?

Do you think the previous people were acting rationally to maximize their utility?a) Yesb) Probablyc) I have no idead) Probably note) Definitely not

The impact of these examples

• While these examples may seem extreme, consider the associated societal problems …– Obesity– Addiction– HIV/STDs– Violence

• Do you see how these “exceptions” to the rule are not minor issues?

Beyond opinion: A fundamental conflict

In the previous examples, you may or may not have agreed with the idea the people were behaving rationally so as to maximize their happiness.• Perhaps they simply lacked information?•Perhaps the choice was maximizing for them, even

if it would not be for you?

A fundamental economic law

• If people rationally maximize utility • Then, with full information, more choices are

always better (or at least no worse)– If new options are not better than current options,

I simply won’t choose them

≤

Costly choice removal

Will people willingly paying more money to remove an option?

$1,000 $500

Costly choice removalDo people checking into a drug rehab program know that the drug will not be available?

Costly choice removal

• Do people attending a weight loss camp know that their favorite foods will not be available?

Costly choice removal

Will people fighting alcoholism pay money to take Antabuse (disulfiram), a drug that causes alcohol to be nauseating?

Costly choice removal

Do people ever choose to drive the longer way home in order to avoid being tempted?

Costly choice removal

≤$1,000 $500

Or the person would not make utility maximizing choices in the presence of this option.

Either this choice is not utility maximizing

Costly choice removal contradicts simple rational utility maximization

If I would make rational choices in the presence of the option

Then paying for choice removal is an irrational act

If paying for choice removal is NOT an irrational act

It is because I would NOT make rational choices in the presence of the option

“The false assumption is that people always make choices that are in their best interest. This claim is either tautological, and therefore uninteresting, or testable. We claim that it is testable and false—indeed, obviously false.”

Thaler, R. (U. Chicago), & Sunstein, C. (U. Chicago), 2003, Behavioral economics, public policy, and paternalism: libertarian paternalism. The American Economic Review, 93(2), 175–179.

Homo Economicus v.

Homer Economicus

Conclusion

• Most people understand that we do not always make rational choices that are utility maximizing.

• The widespread presence of costly choice removal is a specific example indicating that people often do not make rational utility-maximizing choices.

Slides by: Russell James III, J.D., Ph.D., CFP®Associate Professor Division of Personal Financial Planning Texas Tech Universityrussell.james@ttu.edu

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The outline for this behavioral economics series is at http://www.slideshare.net/rnja8c/outline-for-behavioral-economics-course-component