On Rational Economic Behavior
The biggest error holding back many economic thinkers is the idea that rational profit-maximization is the way that people make economic decisions, rather than a way that people make economic decisions. Some people make more of their decisions that way than others.
A full theory of economics requires a good theory of human behavior, at least as far as their production and purchasing decisions are concerned. It’s not much use if you can only talk about how people ought to behave in your idealized thought experiment but can’t describe the actual world. Fortunately, academics have realized this and attempted to fuse economics with psychology, creating the field of behavioral economics. Unfortunately, academic psychology has been pretty much entirely fake for decades, so behavioral economics is mostly nonsense and fraud—garbage in, garbage out. But the general approach is a good one, and yields fruit if done with a better theory of psychology than you’ll get from p-hacked or fabricated Mechanical Turk survey results. Many of the best economists have achieved greatness by applying psychological insights to economic questions, such as Keynes, Weber, Veblen, and Pareto.
Today, the default theory of economic behavior is that people rationally make optimal decisions to (1) maximize their profit and (2) purchase the maximum utility with their funds. Of course this is not actually true. Pretty much everyone will profess to believe that this “homo economicus” model is just a simplifying assumption. And if you actually use it that way and remember the limits to your thought experiment, then it’s useful enough. But in practice, many theorists will pay lip service to the limitations of the rational profit-maximization model of human behavior and then just base their theories on the maximalist version of it anyway.
In reality, it’s not as simple as “people are rational profit-maximizers” or “people are irrational kludges of heuristics and biases”. People are different. Different classes of people tend to use different styles of thought. For economics, the landscape of where and how “homo economicus”-style decisionmaking is present is one of a society’s most important features.
Most people use this thought process little, or not at all. They make decisions mostly based on emotional impulses and/or custom. Much of the customary economic behavior is received wisdom about “responsible behavior” according to rational profit-maximizing logic, so people following “responsible” customary scripts can seem similar if you're not looking closely, since the two often come to similar conclusions except when circumstances are changing and the old scripts stop working. An easier way to tell the difference between economic maximization and adherence to responsible customary scripts is by listening to how someone explains their thought process and justifies their decisions. Many people will in fact do better by following these scripts than by trying to figure out profit-maximizing behavior on their own.1 There are also people who follow rational maximizing logic in one domain but not another, e.g. plenty of people went into business or finance because it pays the best, earn hundreds of thousands of dollars by rationally maximizing their own little corner of the economy, and then back at home they insist on saving eighty cents by consuming inferior toilet paper or whatever. And of course, many people are neither economic maximizers nor responsible script-followers, and will spend 10% of their income on Doordash or 150% of their income on a fancy car.
The class that does largely make decisions based on rational economic maximization is very small. In societies like ours, this minority ends up wielding a tremendous share of economic power. They become vice presidents at big companies, they run small businesses, they found software startups and sell them for two hundred million dollars, occasionally they become the CEO of a megacorporation after the founder dies.2 For major consumption purchases like houses and cars, they produce the books and articles and podcasts that tell everyone else what is “responsible” to spend, and many people (very sensibly) defer to their intellectual authority and take their advice without understanding the reasons. They are not perfectly optimal reasoners, but they do their best, and those who are better at economic maximization tend to outcompete their peers, rise higher, and make more consequential decisions.
So, many parts of the economy come pretty close to following “homo economicus” logic—not as an inevitable truth of human psychology, but as a contingent consequence of this particular class of people being sorted into these roles. Different times and places operate more or less on “homo economicus” logic because this class's position varies. Most famously, when commercial capitalism eclipsed feudalism in the early modern period, this class came to wield a great deal more power over the economy. The burghers of commercial capitalism and the bourgeoisie of industrial capitalism both reorganized their societies according to the logic of economic maximization.
There's another influential minority that also wields disproportionate economic power, and also operates according to reason more than impulse or custom. These people are rationally maximizing political power. They populate government and regulatory bureaucracies, of course, and they also hold many managerial positions in business. They are happy to forgo profits in order to secure position or privileges for themselves, their social class, or their nation—not just instrumentally in pursuit of more profits, but because they fundamentally want certain political results more than they want higher profits. They are capable of rationally pursuing profit, and often do, but they do not attempt to maximize profit, and frequently will deliberately make decisions that reduce profit but achieve political goals. They will provide sinecures for their political clients, class allies, and personal friends. They will direct subsidies to their nation’s unprofitable aerospace company to make sure the infrastructure is available if a war comes. They will pull advertising from a media company, even if that advertising budget helps their bottom line, if the company deviates from the political coalition they support.
When it comes to economic decisions, these four styles of thought—impulse, custom, economic reason, and political reason—are the most important, but they are not exhaustive. For example, in entertainment and music, economic decisions are made mainly by a mix of rational economic maximization, the rational maximization of fame, and the pursuit of artistic greatness. There are many other motives and approaches throughout society, in subordinate roles or in particular social niches.
These divisions are not absolute, and everyone has at least a little bit of all of these styles of thought. No one is completely free, or even mostly free, of the influence of custom or of emotional impulses. In finance, for example, the thrill of gambling and speculation plays some role even among the top practitioners. These impulses can also spur behavior we approve—as Keynes wrote, “If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation.” Even when people are coldly calculating, the line dividing economic reasoning from political reasoning cuts through the heart of every human being.
Caveats aside, though, almost everyone falls primarily into one of these categories. There is one style of thought which they find more natural, which they have trained the most, which they believe is wiser and more fundamental and more moral than the others. The different styles of economic decisionmaking are not randomly distributed, but cluster in certain parts of society due to sorting, training, and experience.
Understanding an individual player’s economic decisions requires understanding what type of reasoning they’re using. Understanding a society’s economic patterns requires understanding which elites hold which economic powers, and how those elites tend to make those decisions.
I can count on my hands the number of times I’ve made a major economic decision by thinking of new ideas for myself with the goal of maximizing my income. I know a lot of people who have literally never done so.
Strictly speaking, most of the people I’m calling “economic maximizers” are more like hill-climbers than maximizers. They can be very good at running big corporations in well-established industries, but not at creating new industries in unexplored areas, even when doing so would be far more profitable. Rather, new industries come from crazy people with idiosyncratic personal or ideological motives, who are adept at economic logic and instrumentally pursue profits to a substantial degree, but are ultimately driven by deeper and stranger priorities—men like Thomas Edison or Steve Jobs or Elon Musk. I doubt if any literal economic maximizers have ever lived. If they did, they must’ve been very strange people.
The greatest economic inflence is not from people who compute all the alternatives but from, well, influencers -- the sort of people who get paid for product endorsements. Often it's celebriies, sports stars, pretty young women, but sometimes influence is less obvious, not from fame but from people who are naturally resistant to being influenced because they pursue their own interests and creations. There's a 1961 Avram Davidson science fiction story, "The Sources of the Nile" about a Madison Avenue guy tracking down the one family who starts all consumer trends, without being aware that they are doing so.
That's very sensible.
What has long puzzled me is that economists talk about rational decision making but assume that everyone comes in with the same point of view. They have the same knowledge, the same skills, the same abilities, the same social status and so on. This is unrealistic on the face of it. It ignores the path dependencies of each economic actor and the resources they can command. You can do physics this way assuming all oxygen atoms are more or less the same, but it doesn't work as well with people.