By: Alex Kanode and Kevin D. Gomez
“He’s been complaining about not having any money and then he goes and buys a brand new Nissan truck,” my friend asks. “He’s acting irrationally!”
The economist responds, “Well, his stated preferences are obviously different from his revealed preferences. His budget constraint must be higher than we think! He’s definitely acting rationally.”
All of the thoughts, choices, and actions we take are limited or constrained by some factor. An obvious one is we all have limited knowledge. Even if we think we know how to drive a car perfectly, we have very limited knowledge about what to expect on the road. Even when we turn on our cars in the morning, we’re just hoping the car turns on, but we never know with 100 percent certainty that it will turn on.
In addition to our limited knowledge, a slew of other pressures–social, financial, mental, physical, etc–guide our decisions. Think of a pinball machine with the bumpers representing our constraints.
Those constraints are best displayed when we actually make the decision or take the action. For example, I can say “I won’t get angry when someone cuts me off in traffic.” But, the only way to find out if that is the truth is by seeing whether or not I get angry when someone actually cuts me off. In economics, we call this stated and revealed preferences. In economics, we can analyze people’s preferences by looking at their purchasing behavior. When a person chooses to buy a Nissan over a Ford, the person has just revealed their preference for Nissan.
On revealed preferences…
Revealed preference theory was pioneered by Paul Samuelson as a way to measure people’s utility. Though it might be kind of helpful in some instances, in reality, it’s still nonsense. We have no idea what their constraints are, so who knows if this person actually prefers Nissan or if they were simply forced by some unknowable pressure to buy the Nissan.
Back to the scene. Obviously, he revealed that he wanted a truck and that his budget constraint isn’t as low or strong enough to keep him from buying it. Therefore, he probably either has or thinks he has some extra cash, an extended credit limit, or some other way of being able to afford the truck. If he didn’t, he wouldn’t have bought the truck.
When people hear the word rational they usually throw their own subjective values on it. “Oh, they didn’t act the way I would have acted so they must be irrational”.
So what does rational mean, if it can’t be used to call your neighbor’s actions dumb or crazy? Using it as a definition is meaningless because the definition covers everything. Instead, it’s used more like a reminder to economists. When we say “This person is behaving rationally” we mean “This person is acting this way for a reason we can’t see yet, we need to look a little closer to find out what drives them.”
So what could you find out about your neighbor once you start digging a little deeper? Maybe you find out that your friend who had trouble with money found work in a service job where he needs to seem put together so people trust him. Buying a nice looking truck helps him earn more money in the long run. Gotta spend money to make money, right?
People make seemingly weird decisions for a reason…and that reason is rational.