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Rationality is a Virtue, Not an Assumption

January 7, 2010

Ilya Somin writes:

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…

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.

One aim of competitive government is to cultivate rationality tout court–that is, for participants in a market for governance.  Markets discipline irrational tendencies; elections do not. Summarizing Paul Romer’s recent talk at the AEA meetings, Tim Kane writes:

When thinking about how to accelerate economic development, the first error people tend to make “Technology cannot change.”  The given tech level of a country is given. The second, and more important, error is that “Rules can change with stroke of a pen.” While there is a growing consensus that rules are the most important factor in permanent changes in a developing country, Romer forces us to accept that rules are very difficult to change.  Nations in particular, even when its leaders recognize the need for rules to change, have difficulty making them happen.

I take the first error as a status quo bias. Of course, it’s easy to see how a market open to innovation rectifies the problem. A list of long dead S&P 500 companies will attest to that. The second error–the stickiness of rules–makes perfect sense because there’s no market to discipline irrational adherence to counterproductive law. Elections,  unfortunately, don’t provide meaningful feedback. So combined and left unchallenged over decades, these biases enshrine the status quo. A true paternalism, one that cultivated virtue in its subjects, would build safeguards against that. The same way we prevent children from voting because we assume they’re too ignorant to know which policies are best.

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