Legal Commentary

How Markets Make Us More Rational

By Ilya Somin

Advocates of ?libertarian paternalism? cite experimental evidence showing that people often make irrational decisions, and argue that we need government regulation to guard against such problems. Economist Richard McKenzie challenges part of this rationale by citing experimental evidence showing that markets actually give people incentives to act more rationally than they would otherwise, thus undercutting claims of irrational behavior based primarily on surveys or experiments that don?t mimic the incentives and other conditions of real-world markets:

People, including economists, are imperfect decision makers because of their mental limitations. But this fact does not mean that markets fail. Indeed, markets do far more than induce improved allocation of resources, given wants and resources. Markets induce market participants to be more rational than they otherwise would be because they must pay a price for being irrational. Thus, markets allow?no, require?economists to assume that people are more rational than they are likely to be found to be in laboratory settings, absent meaningful information and incentives and absent market pressures.

One underappreciated fact about the experimental and survey evidence relied on by advocates of the new paternalism is that it models voter decision-making far more closely than market decisions. Unlike market participants, voters have little or no incentive to either acquire information about the issues they decide, or to analyze the information they do have in an unbiased fashion. The same is true, to a lesser extent, of libertarian paternalist policies established by expert regulators insulated from democratic control (the ?rule of experts? is often proposed as a means by which paternalist regulation can be enacted without being influenced by voter ignorance and irrationality). Such regulators may be more knowledgeable than voters. But unlike consumers, they do not have their own money at stake, and therefore don?t suffer any penalty if they make mistakes, and don?t have much incentive to combat any irrational biases they may have.

By advocating increased government intervention in order to combat irrationality, the paternalists are arguing for a transfer of power to decision-making processes where irrationality is likely to be greater than it is in markets. The proposed cure actually exacerbates the disease.

As with some other aspects of the current debate over paternalism, the relationship between markets and rationality was well-described by F.A. Hayek. In Volume 3 of Law, Legislation, and Liberty, published over 30 years ago, he wrote:

Competition . . . is the method by which we have all been led to acquire much of the knowledge and skills we do possess. This is not understood by those who maintain that the argument for competition rests on the assumption of rational behavior of those who take part in it.... [R]ational behavior is not a premise of economic theory, though it is often presented as such. The basic contention of theory is rather that competition will make it necessary for people to act rationally in order to maintain themselves. It is based not on the assumption that most or all the participants in the market process are rational, but, on the contrary, on the assumption that it will in general be through competition that a few relatively more rational individuals will make it necessary for the rest to emulate them in order to prevail. In a society in which rational behavior confers an advantage on the individual, rational methods will progressively be developed and be spread by imitation. It is no use being more rational than the rest if one is not allowed to derive benefits from being so.

Hayek?s point is particularly relevant to the comparison between voters and regulators on the one hand and market participants on the other. There is little benefit to being a well-informed, rational voter, since the chance of any one such voter affecting electoral outcomes is remote; if a government with better policies does somehow get elected, irrational voters who voted for the other side will benefit just as much as their better-informed compatriots. Voters are therefore almost a paradigmatic example of Hayek?s category of people for whom ?[i]t is no use being more rational than the rest.? Government regulators ? especially those insulated from political pressure ? have some incentive to become well-informed, but very little reason to combat their cognitive biases.

Ultimately, there is little doubt that market participants are sometimes irrational. The problem is that government decision-makers are likely to be more so.

Full post as published by The Volokh Conspiracy on January 06, 2010 (boomark / email).