What is ‘rationality’?
Rationality, for economists, simply means that when you make a choice, you will choose the thing you like best.¹ This is very different from the way we normally think about rationality. Usually when we talk about rationality we use it to mean sensible, or reasonable. To economists—as long as you’re doing what you want given your situation, you’re acting rationally.
That means that the craziest behavior you can think of could be rational for economists. Burning money is a good example.¹ Surely that should be irrational, right?
Economists aren’t so quick to judge. Maybe somebody hates money. Or loves fire. Or just feels like burning some money. Given any of those interests, burning money might be perfectly rational. (Some economists take this quite seriously; if you want to see 20 pages of math on the rationality of burning money, you’re in luck!)²
Economic rationality accepts that people want what they want, without saying whether those preferences are good or bad. This might make rationally seem like a pretty silly concept. But rationality is a big deal for economists because it lets them assume that people aren’t just crazy, but will act in relatively predictable ways.
They use this assumption to build economic models or theories. One famous theory is the ‘law’ of supply and demand which says that if something costs more, rational people are probably going to want to buy less of it and sell more of it.
Two other important theories based on rationality are rational choice theory and bounded rationality. Rational choice theory thinks of people as not just as narrowly rational, but as economic super-men and women—sometimes called homo economicus. Economists using rational choice theory think about what ‘economic man’ would do and then add up the actions of billions of ‘economic men and women’ to make models, or simplified stories about how the economy works.
Bounded rationality theory sees people as rational, but limited by the amount of information they have and their ability to quickly process that information. Bounded rationality gives us a much more realistic view of how humans actually behave by looking at the ways we don’t (or can’t) act like homo economicus. This make the theory more realistic, but also makes it much harder to make simple economic models about big things in the economy.