Saturday, June 28, 2008

Three degrees of rationality in Economics

I believe that economical decisions can be roughly divided into three levels with rationality decreasing: Outside arbitrage. Big consequences. Small consequences.

1) Outside arbitrage. Where a few rational individuals can make money out of other’s inconsistencies. Example put/call parity in options.Here the market is almost always rational. Because it is enough to have very few rational guys to rationalize it. These rationalizing the market should be have an interest in rationalizing the market. E.g. making money of other's irrationality

2) Big consequences refers to where irrational decisions are going to be exposed no matter how careless people are. Example: The very idea of saving for pension.
While single individuals ignore saving many times, there is public awareness to the need, and society makes an effort to rationalize behavior.Other examples relate to financial decisions that many people know they have to consult about. The big consequences ultimately insert rationality in the system, via various routes.

3) Small things. Here I see no doubt that human nature is quite capricious. There are so many examples about this.

I believe that rejecting an even chance bet of winning 200 and losing 100 is strictly irrational. Many reject such a gamble. But this is a small decision. The direct consequences of this irrationality are not that big to make society aware on them.

I never saw this distinction written, but it looks obvious. Anyone saw these definitions stated somewhere?

PS. Definition of small/big
When I talk about big decisions, I am not talking about the effect of the decision itself. I am sure people make irrational decisions about huge decisions.
My category of “big” talks about mistakes that are repeated many times, and their effect is disastrous. This may lead to correction from various places. Not taxing car entrance to the city centers can be said irrational, and one city at least reacted, while other tried. It can be seen that rationality emerges when the effects are severe enough. Even then rationality does not rule.

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