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Adam Smith was one of the first economists to develop the ideas of rational choice theory through his studies of self-interest and the invisible hand theory. The invisible hand theory is first built on the actions of self-interest. The invisible hand theory and later developments in the rational choice theory both refute negative misconceptions that may be associated with self-interest. Instead, these concepts suggest that rational actors acting with their own self-interests in mind can actually create benefits for the economy at large.

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The invisible hand theory is based on self-interest, rationality, and the rational choice theory. The invisible hand theory states that individuals driven by self-interest and rationality will make decisions that lead to positive benefits for the whole economy. Therefore, economists who believe in the invisible hand theory lobby for less government intervention and more free-market exchange opportunities. There are many economists who do not believe in the rational choice theory and are not proponents of the invisible hand theory.

Dissenters have pointed out that individuals do not always make rational utility-maximizing decisions. While rational choice theory is logical and easy to understand, it is often contradicted in the real world.

Joan Robinson, the Rational Rebel

These campaigns led to the semi-shocking and unexpected result of the vote, when the United Kingdom officially decided to leave the European Union. Further, research conducted by Christopher Simms of Dalhousie University in Halifax, Canada, shows that when people are anxious, they fail to make rational decisions. Stressors that produce anxiety have been shown to actually suppress parts of the brain that aid in rational decision making.

Consumption Patterns and Social Change

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Personal Finance. Your Practice. Popular Courses. Login Newsletters. Economics Behavioral Economics. What Is Rational Choice Theory? Key Takeaways Rational choice theory states that individuals rely on rational calculations to make rational choices that result in outcomes aligned with their own best interests. Rational choice theory is often associated with the concepts of rational actors, the rationality assumption, self-interest, and the invisible hand. Many economists believe that the factors associated with rational choice theory are beneficial to the economy as a whole.

From actual human behaviour through to constant innovation, there is much that traditional economic thinking struggles to explain. Neoclassical economic theories describe a world in which rational agents act as optimal decision-makers.

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Guided by possession of a full set of information, self-interested agents maximise utility while firms maximise profits. As a result, the economy is said to behave in a static and linear manner and the system tends towards a state of equilibrium: supply equals demand and an optimal price is set. Macroeconomic patterns are simply the sum of microeconomic properties Blanchard In this model, economies are not necessarily always in equilibrium; exogenous shocks, such as the development of a new technology, can disrupt them.

But these disruptions will be temporary and market mechanisms will work to push the economy back to equilibrium. From a neoclassical perspective, economic development occurs through cyclical patterns of equilibrium, shocks, destabilisation and restabilisation. In each cycle the content of the economy such as the goods and services it offers might change, but its very nature essentially remains the same.

This conventional model can be challenged on four fundamental fronts: the tendency to equilibrium, exogenous shocks, individual rationality and systemic consistency. In the real world, economies are not static and geared towards equilibrium; they are dynamic and in constant flux. This dynamism is endogenous; it originates within the system, not from exogenous shocks. Consumer preferences are not formed by individuals acting solely on their own but are the result of a complex process that includes observing and interacting with other consumers.

Economic agents do not have a fixed set of preferences based on rational assessment; they are subject to whims and to mimicking the behaviour of other agents. As a result, the nature of the economic system transforms over time. In reality, the economy is a complex ecology rather than a complicated machine. It does not respond in predictable ways. It is path-dependent, with each phase building on the previous one. A greater appreciation of this reality has led to the emergence of new schools of thought that are challenging the neoclassical world view and attempting to provide a more realistic understanding of the way economies develop and change.

This term is used to describe any innovative way of thinking about the economy, from those that represent complete breaks from the neoclassical approach to others seeking to undermine only some of its main ideas.

Local Choices: Rationality and the Contextuality of Decision-Making

In this piece, three strands of heterodox economics are discussed in some detail: complexity, evolutionary and behavioural economics. Each offers different insights into economic analysis by seeking a more accurate representation of the economy, and in so doing opens up new possibilities for policymakers. This essay summarises their basic tenets — and discusses what they might mean for public policy. Complexity economics challenges fundamental orthodox assumptions and seeks to move beyond market transactions, static equilibrium analysis and homo economicus the perfectly rational, self interested individuals defined in orthodox economic models.

Brian Arthur, Steven Durlauf and David Lane suggest complexity has six defining characteristics. An alternative definition is based on the observed tendency of the economy to produce dynamic outcomes. In other words, complex systems are non-linear, dynamic and involve continuous adaptation to patterns the economic system itself creates. As a result, these systems are, in contrast to the linear systems described by neoclassical economics, unlikely to rest at a given equilibrium point.

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Agents do not just respond to market signals, such as price; they also interact with other agents and this influences their subsequent choices and actions Arthur The system is adaptive because agents learn from experience, and from the experience of others, and so gain knowledge they would otherwise have lacked. If we accept the existence of these complex and overlapping interactions, this requires us to rethink the equilibrium outcomes that are at the centre of neoclassical assumptions. In complexity economics, it is accepted that interactions between different actors at the micro level will lead to particular macroeconomic outcomes.

Micro level interactions mean macro patterns cannot be reduced to individual level behaviour; these patterns can only be seen as a whole Durlauf Thus, economic growth, for example, cannot be reduced to its individual properties or elements; rather it is a result of various interactions at the micro level Metcalfe et al Furthermore, once a macro pattern has been established, there is nonstop adaptation that leads to a generation of new patterns — emergent phenomena — arising from within the system. This process is referred to as endogenous evolution.

In a complex system, these interactions not only influence macro patterns but also create increasingly complex networks.

Economic transactions take place across a range of networks, unlike in traditional models, which assume agents interact only through auctions or oneto-one negotiation Beinhocker If agents have the ability to learn and adapt their behaviour accordingly, and alter their preferences and decision-making in an unpredictable manner, they can no longer be seen as rational entities operating with perfect information.

In this respect, complexity economics has much in common with behavioural economics, while learning and adapting is central to evolutionary economics.

Local Choices: Rationality and the Contextuality of Decision-Making

Evolutionary economics is closely related to complexity economics and, as its name suggests, sees the process of evolution as central to economic developments. Evolution involves endogenous change — a process of selection, adaptation and multiplication Metcalfe et al As a result of experience and adaptation, some economic strategies and decisions work and some fail. Those that succeed are scaled up or multiplied; those that fail are cast aside.

This process of continuous knowledge gathering and adaptation is driven by feedback mechanisms and the interactions between agents and their environment Nelson and Winter Innovation is central to evolutionary economics and is considered a marker of the capitalist economic system Lent and Lockwood Indeed, innovation implies experimentation with new forms of physical technology, social technology and business techniques which — as history tells us — are core drivers of increases in efficiency and productivity, economic growth and the generation of wealth Beinhocker Like complex systems theory, evolutionary economics emphasises the crucial role of history in shaping the future.

Past interactions and decisions have major impacts on the economy — a characteristic known as path dependence — and any initial small changes in an economy can produce drastic downstream effects, partially driven by networks and cross-cutting hierarchical organisation. Economic outcomes are determined not only by current conditions but also by previous decisions and initial conditions Durlauf If adaptation and innovation are central to the evolutionary economics critique of neoclassical economics, then the psychology of human beings is central to that of the behavioural economists.

In short, behavioural science is a combination of psychology and economics that has led to a debunking of the traditional economic assumption of rational, self-interested individuals. This approach explores the limits to human rationality in decision-making. It argues that human agents do not possess the flawless ability to maximise utility or profits by weighing all available alternatives presented to them and that there are flaws and imperfections associated with decision-making Lambert Behavioural economists believe decision-makers exhibit what they call bounded rationality, bounded self-interest and bounded willpower Jolls et al Bounded rationality recognises the limitations agents face when it comes to decision-making.

Despite any prior intentions to be rational, limited information and other constraints prevent agents from making optimal decisions. In addition, agents are not always selfish, or self-interested: their self-interest is usually bounded by a sense of fairness. And bounded willpower acknowledges that agents at times find it difficult to make decisions that will benefit them in the long term. Agents and firms rely on decision-making methods that differ from those described in neoclassical economics.

Heuristics, framing and loss aversion shape their choices Thaler and Sunstein When making decisions, economic agents cut corners. They use rules of thumb heuristics rather than gather all the relevant available information an impossible task anyway ; they reach different conclusions depending on how a problem is framed to them; and they avoid taking decisions that might lead to losses Lambert These behaviours characterise the actions of consumers.

For example in a study commissioned by the Office of Fair Trading in the UK , price framing was found to heavily influence outcomes.