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Rational Irrationality: A Framework for the Neoclassical-Behavioral Debate

Author(s): Bryan Caplan
Source: Eastern Economic Journal, Vol. 26, No. 2 (Spring, 2000), pp. 191-211
Published by: Palgrave Macmillan Journals
Stable URL: http://www.jstor.org/stable/40325987
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RATIONAL IRRATIONALITY:
A FRAMEWORK FOR THE NEOCLASSICAL-
BEHAVIORAL DEBATE
BryanCaplan
GeorgeMason University

INTRODUCTION

Economists havecharacterized beliefsas "rational," ifagentssatisfy Bayesian
probability axioms;or, more if
strongly,they also satisfy the rational expectations
assumption1 [Sheffrin,1996;Wittman, 1995].A diversebodyofexperimental evi-
denceshowsthatindividuals' beliefsdeviatefromthesestandardsofrationality
[Kahneman, Slovic,andTversky, 1982;Camerer, 1995;Rabin,1998].Criticsofthese
findings argue that the anomalies are suspect because financial incentives wereab-
-
sentorinadequate;peoplewouldbe morerational perhapsfullyrational - ifthe
monetary rewardswerelargeenough[Harrison, 1992;1990;1989;Wittman, 1995;
Friedman, 1998;Smith and Walker, 1993]. Defenders ofthe behavioral perspective
replythatanomaliesaregenerally robusttothiscriticism.
Thepurpose ofthecurrent articleis nottoresolvethiscontroversy, buttoprovide
a sharedframework fordebate.I present a modelof"rational irrationality" andshow
thatthemainpositions intheneoclassical-behavioral debateaboutbeliefs arespecial
casesofit.Inthismodel, is a goodlikeanyother,
irrationality andagentsoptimize by
trading Unlessotherwise
wealthforirrationality. stated, is interpreted
"irrationality"
as "deviations from rationalexpectations," ofwhichdeviation from Bayesianaxioms
is a subset.Thecentralassumption of the model of rational irrationalityis thatagents
perceive thepriceofirrationality without bias. On some level,they have rational
expectations abouttheconsequences ofirrationality, eventhough theytypically hold
a positive of
quantity irrationality in their consumption bundle.
Theupshotis thatitis notnecessary tosee theneoclassical andbehavioral ap-
proachesas twoirreconcilable paradigms. Theneoclassical-behavioral disputeover
beliefscaninsteadbe seenas a disagreement within "normal science"aboutparam-
etervalues;evenifresearchers cannotagreeabouttheirconclusions, atleasttheyare
askingthesamequestions. At the same time, the rational irrationality modeldoes
nottautologically definegenuineirrationality away:a keyfalsifiable implication of
themodelis that(compensated) demandforirrationality mustbedecreasing inprice.
Experimental findingsthatirrationality increases as monetary incentives risethus
differ inkindfrom otheranomalies and merit special attention and
[Hogarth Reder,
1987].

Bryan Caplan: DepartmentofEconomics,CenterforStudyofPublicChoice,GeorgeMasonUniver-
Drive,Fairfax,Virginia22030-4444.E-mail:bcaplan@gmu.edu
sity,4400 University

EasternEconomicJournal,Vol. 26, No. 2, Spring2000
191

Sectionsixconcludesthe paper.itis necessary todistinguishpreferences from beliefs[Mont- gomery.Aumann.Ofcourse.is equivocalin at leasttwoways. 1987]. By no means intended to be exhaustive. Attheoutset.1962].. 1994]. then. he wouldchoose to do) in all conceivablesituations.e. 1995]. . Within thesetofpreferences.this section an provides elementary of taxonomy rationality.192 EASTERN ECONOMIC JOURNAL FIGURE 1 A TaxonomyofRationality Thenextsection providesan elementarytaxonomy andirrational- ofrationality ityto clarify thescopeofthecurrent Sectionthreepresents paper'sinvestigations. its function is onlyto delimitthescopeoftherational irrationalitymodel'sapplication. conditions theexpected-utility axiomsofchoiceunderuncertainty . bothmoreandlessdemanding ratio- nalitycriteria canandhavebeenproposed [HarlessandCamerer. thesimplemodelofrationalirrationality.Addingon morerestrictive .furthershrinks thesetof rationalpreferences [Camerer.Sectionfouranalyzesfourspecialkindsof indifference wealth/irrationality curves. onecanthendrawthesub-set of"well-ordered and stable"preferences.Anagent'sbeliefs indi- catewhatprobability hewouldassigntoanyconceivable situation actuallybeingthe case. Figure1 illustrates thiscontrast byshowing preferences and beliefsas two disjointsets. In theinterestsof clarity. 1996. Thisis typically theweakesthurdleforpreferences toqualify as "rational" [Becker. near-behav- near-neoclassical. An agent'spreferences indicate how he wouldbehave what (i."in economic parlance.mostcommonly.Notonly has it beenascribedto bothpreferences andbeliefs.butin eachdomainthereis a spectrum ofrationalitystandards.andbehavioralandtheirimplications debate. fortheneoclassical-behavioral Thefifth sectionshowsthatseveralforms ofwealth-enhancing canalso irrationality beunderstood within therationalirrationality framework.neoclassical. from leasttomostdemanding. A TAXONOMY OF RATIONALITY AND IRRATIONALITY "Rationality. - ioral.

Thesesetnolimitsonagents'priorprobabili- in an ties.it will be argued. agent who is rationalin thisweaksensecouldbe grossly and mistaken systematically aboutwhattheworldis actuallylike.1982.is theunionof(1) non- beliefs.analyzingirrationalbeliefsis .1999a."andusewealthas a synonym can forthelatter. a manageable task.1989.an agentwithrationalexpectations con- . caresabouthis wealth."Rational" is usedinterchangeably with"satisfies therationalexpectations assumption.ortoignore considering theexperimental evidence inother on"irrationality" sensesoftheword. principle. RATIONAL IRRATIONALITY 193 FIGURE 2 Indifference Wealth/Irrationality Curves IRRATIONALITY /" Y* U.Akerlof. wherequitedifferent sensesof"rationality" ap- theleastrestrictive ply.Wealthshouldbeconceived inbroadtermstoincludenotjust consumption value.in andportfolio one fact. Caplan.butalsohumancapital.Rather. pref- erences. Wealthis onthex-axis.Thisis notmeanttosuggestthatthisis theonlyform of"irrationality worth .andtheabsolutevalueofthedeviation from rationalexpectationsis onthey-axis.thecurrent paper focuses on violationsfrom rational becausethisproblem expectations is at onceimportant andtractable. butalsohas a "bliss wealth belief9y*that(holding constant) he wouldmostliketo believe[Akerlof and Dickens. couldjustpartition all argumentsin theutilityfunctioninto"beliefs" and "everythingelse.Typically.health.U- WEALTH Nextconsiderthesetofbeliefs. thatfailtosatisfy therationed expectations assumption.Thesepreferences thenberepresented withindifference spaceas demon- curvesinwealth/irrationality stratedin Figure2. and(2) Bayesianbeliefs Bayesianbeliefs.andsoon. Analyzing be- haviorwithoutwell-ordered preferences butgivenwell-ordered is quitedifficult.2 RATIONAL IRRATIONALITY Supposean agenthas well-defined preferences overbothpersonalwealthand he beliefs.1999b].requiring thatagents notonlysatisfytheBayesianaxiomsbutalsoholdunbiasedpriorprobabilities.Imposing themore rational restrictive expectationsassumption rulesoutsuchcases.leisure. definition requiresonlythatbeliefssatisfy the familiarBayesianprobability axioms. Theremainder ofthispaperdiscussestherationality ofbeliefsalone." The domainof"irrational" theshadedregionin Figure1.

But the rationalirrationality modeltreatsthemsymmetrically foranalyticalpur- poses. riskingmalpracticesuits. In psychologicalterms. As Nisbettand Rossputit.one shouldnot read too muchpsychological contentintothis choicemodel. proportional to the degreeofbias."Thecostsofwilly-nilly distortionsin percep- tionare simplytoohighto make thema cure-allforthe disappointedor threatened perceiver.thata doctorgenuinelythinksthat95 percentofthe peoplewhotestposi- tivefora diseasehave it.the introspective experienceofthe effect ofincentivescoulddependon the typeofthe bias. is likelyto makea widevarietyoflosingbets.194 EASTERNECONOMICJOURNAL sûmeszeroy.suppressinghis emo- tions. An agentwhoholdssystematically biasedbeliefsthat"justseemobvious"tohimcan be seen in the same light. Agents'wealth/irrationality "budgetlines"therefore normallyhave the familiar negativeslope as seen in Figure 3.3Still. The budgetline'sintersection withthex-axisshows an individual'swealthassuminghe strictly conforms to therationalexpectationsas- sumption.5Mod- elingcognitiveand motivationalbiases symmetrically does notimplythattheyare introspectively equivalent.for example.A hungrypersonmightstate thathe buysfoodnot becausehe "wants"itbutbecausehe "needs"it.For the sake ofconvenience these expectedlosses are drawnas linear. In mostsituationsofpracticalinterest..i.People who overestimate theirown and abilities.1978].misperceptions makeus less able toremedythesituationsthat threatenus or giveus pain than do accurateperceptions"[1980. an agentis assumedtohave somespecificbeliefthat he feelsattractedto. A wealth/irrationalitybudgetline showsthecom- binationsofwealthand irrationality that are feasible.a poorlycalibratedweatherforecaster wouldbe likelyto lose his credibility and his audience[Lichtenstein.For cognitive biases liketheavailabilitybias.Schoenberger.or spendextratimeresearchingthe question. For a motivationalbias like over-confidence.in contrast. As withutilitytheoryin general.indicatesthe .234]. The onlyunusualfeatureoftheseindifference curvesis thattheybend backwardsat theblissbeliefy*. 1980]. and Phillips.1997].Similarly. Fischhoff. 80 mistaking percentprobability forperfectcertainty. thoughthisneednotbe thecase. dissatisfiedcustomers.look at aggregateratherthan anecdotal evidence.ratherthana contrariandesireto be as irrationalas possible.In general.mayreducetheiraverageearnings [Babcockand Loewenstein.e.ask forexpertadvice.Intuitively. accordingly bargain formorethantheycan reasonablyexpectto get.cognitiveand motivational biases are different:themoti- vationaldependon the emotions. Suppose. and Graboys. Earnestlyactingon this biasedperceptionendangersthedoctor'scareerprospects. 1982]. and loss ofprofessional reputation.butthe cognitivedo not [Nisbettand Ross.The budgetline's intersection withthe y-axis.whenin factmerely2 percentdo.systematically biasedbeliefshave a nega- tiveimpacton personalwealth. an agent might describehis responseto incentivesas: tryingto be reasonable.an agentwhois systematically over-confident.A workercouldbalkat thesuggestion thathe "revealshis preference forleisure"whenhe takesa breakaftera doubleshift.or makingan effort to giveopposingargumentsa fairhearing.4thesame agentmightsay thatincentivesmakehim morelikelyto doubthis initialintuition.as in thefamiliarbase rate experiment[Casscells. an agentwhoconsistently respondsopti- mallytothewaytheworldisn'talmostcertainly failstorespondoptimallytotheway theworldis.

butto lay thegroundwork forempiricalcomparison byspelling outtherationalirrationalitymodel'sdetails. irrationality Rationallyirrationalagentschoosetheirutility-maximizingcombinationofwealth andirrationality basedonan unbiased judgment aboutthetradeoffs. RATIONALIRRATIONALITY 195 FIGURE 3 The Wealth/Irrationality BudgetLine IRRATIONALITY /" ' - V WEALTH levelofrationalitynecessarytoactuallydrivean actor'swealthdowntozero.agentshavenopreferencesoverbeliefs.andthe smaller theoptimal purchase becomes ofirrationality as Figure3 shows. and an optimizing agentwouldalwayschoosehisbliss beliefy*.nottheiropinions. curves:"neoclassical" . it is pleasanttobelievethatyourjob is sociallybeneficial.thereare no practicalrepercussions ofdoubtingthetheory ofevolution thatone's or believing nationis the"bestintheworld"[Caplan.Thecrucialassump- tionis thatagentsonsomelevel have rational expectations abouttheslopeoftheir wealth/irrationalitybudgetline."Neoclas- sical"wealth/irrationality cantherefore preferences indif- as vertical be represented ference agentscareonlyabouttheirwealth. butit unclearhowbiased beliefsonthispointwouldbe costlyin termsofmaterialwealth[Klein.Thispolarcaseplausibly arisesundermanycircumstances. Iftheprivate onwealthwerezero. thebudgetline'sintersection withthey-axiscouldbe in- terpreted as thepointbeyond which more extreme wouldbe fatal.The sameappliesto manyreligious and politicalbeliefs:formostpeople.1994]. THE NEOCLASSICAL-BEHAVIORAL CONTINUUM AND ITS PRACTICAL SIGNIFICANCE Curves "Neoclassical"vs.notan endinthemselves. Thehigher the private costof becomes.Beliefs moredesirable area toolforgetting commodities.1999a]. Forexample. irrationality the flatterthe budget linegets.Thisis whatdifferentiates from rationalirrationality the competing hypothesis ofunqualified irrationality.Thepointhereis nottodefine un- qualifiedirrationality away.thewealth/irrationality impactofirrationality budgetlinewouldbevertical.theyperceivetheimpactoftheirirrationality on theirwealthwithout bias. "Behavioral"Indifference In standard neoclassical models.Ifwealth is definedbroadly enough.

Cognitive anomaliesEireusuallyseenas inherently unresponsive to incen- tives.1985. Lichtenstein.Justas thepolar"neoclassical" agentis rational regardless ofhowweaktheincen- tivesare.3].Motivational anomaliestoo.oneshouldbe surprised whenexperi- mentalresultsdo confirm economic theory" [1995. onbehavioral accounts.41-2].Similarly. 1989. however trivial. 1993].1991]. nothowsafetheybelieve their jobis [Akerlof andDickens.1986.Thenaturalwaytodiagram thebehavioral posi- tiononirrationality is withindifference curvesthatarehorizontal at theblissbelief y*.1982].27-30.1992. 1982].Dickens. people have an irreducible propensity to make and clingto systematic errors. "Neoclassical"Indifference Curves "Neoclassical" Z ►Indifference Curve IRRATIONALITY "Behavioral" ^ ~^r Indifference Curve Y* m"Near-Behavioral" ^v^^^ />^ Indifference Curve \ ►"Near-Neoclassical" \^ Indifference Curve WEALTH Theyworry abouttheiractualjobsafety. irrationalityandincentives are essentially unrelated. lackofincen- tivesmerely explainsan increaseinthevarianceofbeliefs. The implication is thattheyhaverational expectationsifirrationalityhasanynegative impact onwealth.SmithandWalker.1998.Wittman forexampleremarks: "Mistakesare quite likelyto occur when no one suffersfrom them (and are especially likelywhenthe researcher is searching forwaysto tricktheunsuspecting subjects). In contrast. and Fischhoff. and Fischhoff.andarewillingto paythepriceforso doing"[1994.[G]iventhe insignificantincentives inexperimental work. Phillips.Withrationalrespondents. . they do not careabout self-image or how certainthey are [Dickens. 1990. itwouldnotaccountfor theoccurrence ofthesystematic mistakes emphasized intheexperimental literature7 [Harrison.Smith..Examining polarcasesof neoclassicalandbehavioral indifferencecurvessuggests thatthiscriticism ofexperi- mentalanomaliesis slightly offthemark.thepolar"behavioral" agentis irrational regardless ofhowstrong thein- centivesareas canbe seenin Figure4.1982].though admittedly payoff-dependent intheory - areoftenseenas payoff-independent in practice[Rabin. 1995. 1990. Wittman.Lichtenstein.wewillchoosethelatter."Between ourrationality andourcognitive pride. Phillips..AsPiattelli-Palmarini putsit.6 Criticsofbehavioral anomaliesoften maintain thatsubjectshaveinsufficient fi- nancialmotivation to makethemthinkrationally[Harrison.196 EASTERN ECONOMIC JOURNAL FIGURE 4 "Behavioral"vs. 1985.

economists withbehavioralpriors(i. Conversely.-asit wouldin an experi- mentwithoutmonetaryincentives.Observeddeviationsfromrationality in beliefsalone.or be- cause irrationality is costly. experimental divergence fromfullrationalisty is oftenlarge.e.See Figure4. The presentpaperdoesnottrytoresolvethebehavioral-neoclassical controversy. criticsofbehavioraleconomicswouldlack an expla- nationofsystematic experimental choiceanomalies.orbecauseirratio- nalityisn'tcostlyenough. thepriorjudgmentthatpeople'swealth/irrationality indifference curvesare vertical) mightinsteadmakethemarginalmovetothe near-neoclassical view as experimental anomaliesmultiply.note thatthefourth boxin Table 1 is empty. Whatthe rationalirrationality modelprovidesis a commonframework fordebate..(See Table 1.e. divergence from income maximization is usuallysmall. There are nottwo irreconcilable approaches. IRRATIONALITY RATIONAL 197 Withinthe rationalirrationality framework.Theycouldin- steadconcedeonlythatindifference curvesare "near-behavioral": theconsumption of irrationality is pricesensitivebutpositiveevenat highprices.thepolar be- havioralpositionis nottheonlyalternative.8 Undermostconditions. near-neoclassical actorsconsumeappreciableamountsofirrationality. The latentdifference revealsitselfonlyas the priceofirrationality nears zero. It is thusimpossibleto simultaneously have rationalbeliefsand divergefromincomemaximization.butcurvingoutwardsaroundy*> 0 as Figure4 shows. whereasperfectly neoclassical actorsare as rationalas ever. actors have "near-neoclassical" indif- ference curves:almostvertical. butat a smallpositiveprice thisdisappears. .how- ever. only neoclassicalpreferences are inconsistent withcostlessirrationality.thenregard- less oftheabsenceofincentives.Economistswithneoclassicalpriors(i.) This is consistentwith bothneoclassicaland near-neoclassical preferences: the agentmightbe rationalbecause he is congenitally rational.Similarly. thereis a straightforward way to reformulate thestandardneoclassicalcritique. but two endpoints on a continuum of possibilities. Adoptingrationalirrationality as a framework can also illuminateHarrison's [1989]claimthatit is more informative to check for deviationsfromrationalityin payoffs ratherthanbeliefs.Supposethatinsteadofperfectly ver- tical wealth/irrationality indifference curves.10 Finally.but due to the flatnessof most payoff functions. thereis evidenceforbehavioralor near-behavioral preferences: theagentmightbe irrationalbecausehe is congenitally irrational.Deviationsfromrationalbeliefsare whatdrag payoffs belowtheirmaximumexpectedvalue.Ifthepolarneoclassicalpositionis empirically untenable.ifan agent deviates from rationalityin both beliefsand payoffs.In thesechoiceenvironments.Ifindifference curveswerereallyvertical.are consistentwitheverything exceptforpolar neoclassicalpreferences.. "near-neoclassical" actorscannotbe distinguished fromneo- classicalactors:Neitheris irrationalifthe priceis non-trivial.Butwith"near-neoclassical" pref- erences.How can thisargumentbe related to the neoclassical-behavioral con- tinuum?Supposethatan agentdeviatesfromrationality in neitherbeliefsnorpay- offs. the main critique ofbehavioral economics is intelligible:people exhibitobvi- ous irrationalbias in theabsenceofmaterialincentives.9Harrisonnotesthatin termsofbothstatisticaland eco- nomicsignificance.thatpeople's wealth/irrationality indifference curves are horizontal) neednotleap totheneoclassi- if cal view some evidence ofprice-sensitive irrationality accumulates.

Beliefs Payoff Yes No Yes near-behavioral.59]..ifrationalexpectations failin experiments without adequateincentives. thelattermayprovoke near-behavioralagentstosetasidetheirbiases[Caplan. purchasing unreliable equipment forthemili- tary). all goods(assets)yieldthesamecharacteristics perdollar(returns).249]. 1989]. behavioral. sometimes themarginal costofirrationality is loweventhough thetotalstakesinvolved arehigh... is consistent with.Aboveall else. then littlecognitionwill be employed. errorsmayhavelargesocialcosts.thengreater cognition willbeinvolved. thusindividuals can choosein anymannerwithout penalty" [1985.. Wittman specifically triestocontrast hypothetical surveys andelections: "When errorsinvolvelittlecost(forexample.In a fullyarbitraged market.BoulierandGoldfarb.1985]."themoreefficient themarket.1999b.198 EASTERN ECONOMIC JOURNAL TABLE 1 Beliefs. neoclassical.and Payoffs Rational Irrationality.Considering theenormous unlikelihood thata votewillchangean electoral outcome. Deviationfromrationality in.. ings ofbiased mistakes matter. 1994].1999a. thelessdiscipline themarketpro- vides. 1998]. 1995]. Thepractical significance ofanydeviation from neoclassical preferencescannot be confined tolab experiments becausethisis onlyoneformoflowstakedecision- making[Kirchgässner and Pommerehne.behavioral near-neoclassical Practical Significance Evenifbehavioral anomaliesdisappearin thefaceoffinancial find- incentives. - behavioral No near- near-neoclassical. surveysabout issueswithexpressive valuemeritsuspicion duetothenegligible private ofbi- cost asedresponses [Brennan andLomasky.1081].Akerlof. Camerer.Contingent valuationsurveys overestimate thewillingness topayfor environmental amenities [Harrison andKriström.In addition. "[T]here areboth low- stakeandhigh-stake economic decisions in life. 1993.as Russell andThalernote.Frey Eichenberger.andall are ofinterest" [1993. one wouldexpectirrationality toplayanimportant roleindemocratic electionsduetothe trivialprivateconsequences ofa vote[Caplan.Moregenerally. itis ratherthesimilarity of surveys and elections that stands out.Considersomeothers:theprivate costofsystematic misestimates ofinflation is smalloversomeranges[Akerlof and Yellen.. When er- rorsinvolvegreatcost(forexample. Wittman's disanalogy conflates private and socialcosts:inan election.answering a surveyquestionincorrectly in a cognitive-psychology experiment)." [1995. Theformer candrawnear-neoclassical agentstodeviatefrom rationalexpectations.eventhough theyrarely . As Smith and Walker observe. 1993]. and 1987.

12 Whattherational framework irrationality highlightsis thatsuchfindings arenot onemoreanomalyamongmany.1993. but a to challenge rationality on the deepestlevel."11 [1987.Friedman beginsbyexperi- mentally the demonstrating paradox'sstrength: subjectsswitch about 30 percentof thetime. Therefore.1987].theprivatecostoferrorsis effectively zero [Brennan and Lomasky. onecouldsaythatindividuals simply perceivethewrong wealth/irrationalitybudget constraint. RATIONAL IRRATIONALITY 199 will in laboratorysurveys. 1995]. gets to thewrong place faster.1990]findsthatthemarginal incentives in manywell-known experiments havebeena fewpenniesorless.Thisis noteworthy be- causeseveralextantsourcesreport findingsalongtheselines[Einhorn andHogarth.But the privateincentivestructureofsurveysand elec- tionsis identical:in bothcases. butitcannotbereconciled witha specialclassofanomalies (income effectsaside).ifincentivesarehighbutcogni- one tionisfaulty.96] .Einhorn andHogarth rationalizetheseresultsas follows:"Per- formance. however.even if behavioralanomaliesare onlyslightlysensitiveto material incentives.Thereare also self-selection to consider:ifsomepeopleare closerto thebehavioralpolethan effects others. Similarly.and Thaleracknowledges thatthesefindings havenotbeenreplicated "atverylargestakes" [1987. As such.theydeservemorescrutiny: Harrison[1992. Thismakesthelong-runsupply ofrationalitymoreelasticthan evidencefromexperiments withrandomlyselected subjectsmightlead one to expect[Camerer.thenpeopleunwillingto abandontheirbiases evenat highpricesmayswitch to activitieswheretheirbiases makeless difference. calibrate ofirrationality theelasticity toincentives withrespect undervariouscondi- tions. ifincentivesize canbe thought ofas analogoustothespeedwithwhichonetravelsin a givendirec- tion. 1987.Near-behavioralagentswillmake a wide of range systematic mistakes.Thus. Can therational irrationality modelbe rejected?Therationalirrationality modelis consistent witha muchbroaderrangeofobservations thanstandardneo- classicalmodels.Thefirstis totestwhether (andwhen)rationalirrationalitycanbe re- jectedin favorofa modelofunqualified The secondis to empirically irrationality.63] More straightforwardly. but iftheyencounterthesame situationrepeatedlythe of price irrationality may at last inducethem to correct theirerrors.eventhough 100 theywouldswitch percent givenunbiased probabilityesti- . One recentand noteworthy studythatshedslighton thisquestionis Daniel Friedman's [1998]studyofMonty Hall's3-doorsparadox.38-41]. dependsonbothcognition and motivation. it makesa practicaldifference.Camerer.Butitrulesoutthepossibility thatstronger incentives forrationalityactuallymakesubjects lessrational.cognition determines thedirection. EmpiricalImplementation Howexactly wouldempirical workers Twoapproaches usethisanalysis? suggest themselves.Rationalirrationalityleavesopenthepossibility thatbiasesfailtode- forrationality creaseas incentives intensify.

then. A secondwayforempirical research- erstousetherationalirrationalityframeworkis tocalibrate theelasticity ofirratio- nalitywithrespect toincentives. irrationality is still vitalto know"how much. thecoefficients on Intenseand Switchbonus indicatethatat least after fiveturns.a dummyvariableequal to 1 ifa subjecthad "intense"incen- tives.50/turn.He thenestimateslinearprobability modelswith"switch"(=1 ifthe subject switched. In effect.Friedman'sfind- ings are not anomalous. The positivecontinuouseffect ofincentivesovertakesthe negativediscreteeffect by turnsix.944]. SinceFriedman'sdiscrete and continuousmeasuresofincentiveshave different signs.and teststhesensitivity ofthebasic resultsto modifications ofthe experiment.As Friedmanexplains.in an alternativeexperimentaldesign. 1994]?15 Calibratingtheelasticityofirrationality. whichincreasesthe ex ante marginalcostofbiased estimation five-fold. subjectsmightplayforan hour. even he though presentsstrongevidencethatconsiderable irrationality exists.Its discreteeffect is to reducethe"switch"percentageby9 percentage- points.Wouldhigherstakes stillhave a temporarily perverse effect?Or as incentivesrosewouldplayersbe increasingly inclinedto skiplunchand searchout a correctexplanation[Freyand Eichenberger. under whatconditions?"Re- .a declinesignificant at the 5 percentlevel. 0 otherwise)as thedependentvariable.14 Friedmanreportsthatin a multipleregression.the significantly negativeIntensecoefficient shouldbe thoughtofas measuringa residualimpact"[ibid.1998..sinceit wouldimplythat con- of sumption irrationality riseswhen the of price irrationality increases.For example. One potentially important caveatforempiricalresearcherstotakeintoaccountis theshort-run versusthelong-runelasticityofrationality.from$. One variantis to movefromregularto "intense"incentives.his resultspredictthatat firstsubjectsbecomeless rationalwhenthe stakes increase.13 Friedmanuses twodifferent variablesto cap- turetheimpact:Intense. Divergencebetweenthe short-and long-runelasticityofrationalitywouldpre- sumablybe farmorepronouncedifsubjectshad additionaltimeduringwhichto ac- cess a libraryor the internet.The rationalirrationality modelmovesthe analyticalspotlight fromthe"anomaly"in theusual sense oftheterm(violationoffullrationality) tothe anomalousresponseofrationalityto strongermaterialincentives.940] However. [Friedman. thecoefficient on Intenseis actu- allynegative.strictlyspeaking. then.Now supposein- steadthatFriedmanhad foundthatthecoefficients onbothIntenseand Switchbonus werenegative."SinceSwitchbonusalreadycapturesthemostrelevantpositive aspectofintenseincentives.intenseincentivesyieldbetterperformance than regularincentives.receivean hourbreakof"freetime.10/turn to$. thecoefficient on thecontinuousmeasureSwitchbonus is positiveand significant.cumulative for earnings notswitching).200 EASTERNECONOMICJOURNAL mates. Fromthe standpointofthe rationalirrationality model."thenreturnto playforone additionalhour. a continuous variableequal to(cumulative earningsforswitch- ing .This woulddefinitely countas empiricalevidenceagainstthe unlim- ited applicabilityofthe rationalirrationality model. In combination.the short-run responseofrationality to incentivesin the 3- doorsgamemaybe negativeeventhoughthelong-runresponseis positive. Assuming thatirrationality declinesas thepriceof it rises.and Switchbonus.

butthe long-runelasticityis quitehigh. Butthereare three notableexceptions tothisprinciple. and re- ducesthenumberofturnsrequiredfor90 percentrationality bya factorof4. In fact. The rationalirrationalityframework onlydemandsthatevi- denceofanomaliesbe accompaniedby additionalworkon theirincentive-elasticity underdifferent conditions. Overall. is notits specificconclusions.Yet 10 turns out. In each of thesecases.6.Friedmaninfersthatwith intenseincentives. AND SOCIAL PRESSURE A simpleintuition liesbehindthenegative slopeofthewealth/irrationality bud- getline:ifpeoplerespond optimallyto theway the world is not.1998.onecan roughlycalculatetheelasticityofirrationality in differ- entconditions.themorewealthan agentforgoes ifherefuses to deludehimself.In otherwords. searchingfordeviationsfromfullratio- nality remains useful. Withnon- intenseincentives.Friedman's resultsalso implythat after10turns.then except by pure chancetheyfailto respondoptimally to thewaytheworldis.Thefirstcase is belief-dependent performance.then.940] I calculatethatwithstandard incentives.Thesteepertheline.magnifying theincentives fivetimesincreasesthepercentage ofrationalresponses byonly14 percent. Asbefore.theswitchrategivenintenseand non-intense incentiveswillbe 25 and 22 percentrespectively. (irrationality Togetmoreofone. the Notethat positively-sloped budget linereaches a tangency only at some point moreirrational thany*.5. muchlikeonemight toleratemorepollution inordertoproduceadditional steel.the third. butitcouldeasily be non-linear. and a bad inexcessofy*).though.16 Followingthe same procedure[Friedman. RATIONAL IRRATIONALITY 201 turningtoFriedman. MORAL CONSTRAINTS. the second. "self-serving bias" to circumvent fixedmoralconstraints.Evenifa person likesbeingrational (y*=0).after57 turnsofplay. As in Figure3. Withintherationalirrationality framework. Focus- ing on the moreimmediate effectof incentives. In effect.Friedman'sresultssuggestthatthe short-run elasticityofirratio- nality withrespect to incentivesis fairlylow.theymustenduremoreoftheother.increasingincentivesbya factorof5 increasesthe percentageofrationalresponsesby a factorof2.placingirrationality withina consistenttheoretical framework wouldtendtodefusepurelymethodological objectionsagainstanomalous experimental findings. The impliedelasticitystillhas the"right"sign. . INCENTIVES FOR IRRATIONALITY: POSITIVE ILLUSIONS. wherean agent'sbeliefsare actuallyan argument in his production function.thecorresponding rateafter57 turnswouldbe only35 percent. wealth/irrationality thebudget lineis drawnas a straightlineforillustrativepurposes. agents facea trade-off between a good(wealth).subjectswouldreachthe same level ofrationalityonlyafteran estimated257 turns. Extrapolatingfromthe probitversionofhis results. subjectswouldbe rational90 percentofthetimeafter57 turns.agentsactually face an upward-sloping budgetlineshownin Figure5.thepositive slope ofthebudgetlineprovides an incentiveforsystematicbiasinequilibrium. socialpressure to deviatefrom rationality. the The reasonfordiscussing study.butrather to illustratehowthe rationalirrationality modelmightredirectempiricalresearch.

and Moral Constraints Performance. effective Taylorinterestingly notesthat"Placeboeffects are so powerful thatno newtreat- mentordrugcanbe approved forgeneraluse in thepracticeofmedicine unlessits effectivenesshasbeenevaluatedagainstthatofa placebo"[1989.ratherthanover-optimistic. 1995. andeventsbelievedtobe uncontrollable are normally morestressful thanequallyunpleasant controllableones. whereindividuals' healthreally improves becausetheyfalsely believetheyarereceiving medicaltreatment. Withtheirmoodlesspositive. Thecloseryourindifferencecurvesaretotheneoclassicalextreme. the moreinclined youare tomanipulate yourviewstoyourmaterialadvantage. Thereis alsoevidence thatthe"illusionofcontrol"is onnetwealth-enhancing.theirviewsmaybebiased.Taylor.Similarly. y/ I orMoral Pressure. rationalize to avoidbinding moralconstraints.17 Stressimpairsperformance.202 EASTERN ECONOMIC JOURNAL FIGURE 5 Social Pressure. AsTaylorexplains: .and changetheiropinionsas social fashionschange.More neoclassical agentsreadily"psyche themselvesout"to enhancetheirperformance.Psychological studieshavealsofound thatfrequently individualswithrealistic.incontrast.Thedelusions pole. theyare often objectively less successfulas a result[Camerer. ofthoseclosertothebehavioral are stable.probabilityassessments are morelikelytobe depressed. Belief-Dependent mRATTONALTIY j^ BudgetLineCreated / byBelief-Dependent /7 Social Performace.Butthereare manynon-medical examples too.1989]. S Constraints Y* - WEALTH theresponsiveness variesalongtheneoclassical-behavioral ofbeliefsto incentives continuum.Theclearestexampleis theplaceboeffect. a studentwho believesheis likelytodowellona testfeelscalmandconfident. Belief-Dependent Performance Supposethatsomeofan agent'sbeliefs arearguments inthatagent'sproduction function.buttheyarenotconveniently relatively interpret- ingrealitytoenhancetheirprospects.118].Theproduction functionof a personwiththe"illusionofcontrol" aboutan unpleasanteventis therefore less impaired bystressthantheproduction functionofsomeone immune totheillusion. andinconsequence probably actuallydoesbetter.

[1989.Perhaps thisevenexplainswhyoverconfidence. with.evena painfulorupsettingevent. praise.1995. and Phillips.a nucleusoftruebelieverswho supportsomeirrationalview(thatis.theyreact morenegatively. Waldman. theillusionofcontrol.butthescopeforwealth-enhancing expandsin multi-player irrationality games. Whatis remarkableis thatusingsocialpressure.A personwith rationalexpectations about the controllabilityofstressfuleventscan rationallyexpecta higherlevel of stressand a lowerlevelofwealththana personsubjecttotheillusionofcontrol. Klein. Supposepeopleare morelikelyto hire. 64-68. A personwithrationalexpectations about theprobability ofsuccesscan rationallyexpecttobe less successfuland thereforeless wealthy than the systematically overconfident.thegreaterthe impactofirrationalbeliefsonperformance. 1994.A testsubjectmayhave no strongfeelingsabouttherelative lengthoftwosticks.giving rise to anotherinstance ofthe upward-sloping wealth/irrationality budgetline.leading to an increase in adrenalinsecretion. Taylor. Social Pressure Belief-dependent performance can mattereven fora solitarygame againstna- ture.Psycho- logicaldistressis greaterwhena stressfuleventcannotbe controlled.is perceivedtobe underpersonalcontrol.so it may be to attendproperly difficult to whattheyneed to do.1982. RATIONAL IRRATIONALITY 203 Whenan event.Their physi- ological systemsresponddramatically. shun. The flattertheslopeofthepriceline.and persecutethosewho disagreewiththem[Kuran.and more to likely boycott.Whenpeople experienceuncon- trollablestressfulevents.1996. Langer.evenagentswithno intrinsictasteforirrationality (y*=0)on thesetopicswill decidetobe irrationalin equilibrium.y*=0)mayneverthe- less opttobe irrational.theflatter or the slopeoftheline [Freyand Eichenberger.18The moreintensethe socialpressure(positive negative).at least oversomerangeas in Figure5. The powerofpositivethinkingaside.denounce.befriend. theeventdoesnotproduceas muchstressas one perceivedto be uncontrollable.Facing social pressure to share in popularillusions. with.Whensurrounded byconfederates whoall claimthattheshorter . whichinturnhas accompanying sideeffectssuch as the poundingofthe heart. but otherhumansoftendo. People who are understressthat theycannotcontrolalso perform morepoorlyon othertasks.and sweatiness.agentswithany ofthese formsof belief-dependent performance actuallyfacean upward-sloping budgetline.and some otherbiases predominate empirically[Lichtenstein.1989]: If over-ratingyourpros- pectsactuallyimprovesyourprospects. and givepoliticalpowerto those who share theirbeliefs. Concentration is limited. irrationality [Cosmidesand Tooby.Becker.1974]. natureprovidesno incentiveto be irrational.1982. 1994]. evolutionary forcestend to weed out tastes not forrationality.75-6] In termsofthe rationalirrationality model.As a result. Fischhoff. less rationalitycouldeasilymakeyoumore wealthy.y*>0)can generatepositively-sloped bud- get lines foreveryone.In thisenvironment.nervousness. 1989].people withno intrinsicinclinationtowardsirrationality (thatis.

The "amoral"budgetline showsthatcombinations theagentcan financially afford. How can agentsmake moralconstraintsless binding?Rabin [1995] focuseson beliefmanipulationthroughselectiveacquisitionofinformation.themoreintenselyan individualcares about a moralgoal.Rabin explainsthat. butbiased informa- tionprocessingcan in principlebe just as effective.if agents choosetheir normativeas well as positivebeliefs.But iftheyinsteadface moralconstraints." Moralpreferences are in theutilityfunction.Moral constraints. Ifpeoplehave moralpreferences.and irrationality consequently "tricklesdown"fromactiviststo the generalpublic. is thatan agentavoidsalcoholbecause ofa perceivedexternalmoralconstraintthat forbidsor discouragesits consumption.thetangencyshowsthemost-preferred bundle.Suppose. The knowledgeassumptionis critical:The morethe agentun- derestimates itsalcoholcontent. he has to choosewithinthe"moral"budgetset insteadofthe "amoral"budgetset.however.leav- ing the agent on a lower indifferencecurve.milk and whiskey.shrinkone'spermissiblebudgetset.Assumingtheagentrealizesthetruealco- hol contentofwhiskey.makingthemsubjectively worseoff.1999."Forgivenbeliefs." butmatterschange"whenpeoplecan manipulatetheirbe- liefs"[1995.however. For example.andthehigher his utility.these associatesin turn pressureothers. Babcockand Loewenstein. thiswouldbe modeledbyshifting theagent'sindifference curve.Unlikethe internalizedmoralpreference.the"moralbudgetline"disappears. Moral Constraintsand Self-Serving Bias Rabin[1995]distinguishes between"moralpreferences" and "moralconstraints. Ifavoidingalcoholwerean internalizedmoralpreference.thereisn'ta bigbehavioraldistinction betweenthese twomodelsofmorality.test subjectsfrequentlysay.4]. theless themoralconstraintmatters. mistakenpositivebeliefscan expandtheirbudgetset and make themsubjectively betteroff.1995]. butpositivebeliefsare not. sucha moralconstraint wouldshifttheeffectivebudgetlinein alongthex-axis.1997]."Ifbeliefsaboutmoralconstraints get in thewayofself-interest.On a granderscale. on the otherhand.and perhaps convincethem- - selves thattheyagreewiththepopularposition.theimpactofmoralconstraintsdisappearsen- tirely.The contrarypossibility.thatpeople'snormativebeliefsare fixed. they couldjust abandon theirbeliefsin therelevant bind- ing moralconstraints.204 EASTERNECONOMICJOURNAL stickis longer. mistakenbeliefsmisdirecttheirsin- cereefforts to do good.Thenan agentwhomaximizesutilitysubjectto personal moralconstraints mightbe betteroffwithunreasonablepositivebeliefs.whereastheyobeymoralconstraints becausetheyfeeltheymust. Peoplepursuemoralgoals because theywantto. Facingwhat .shownin Figure6.and theyselecta pointon a higherindiffer- encecurvetangenttothe"amoralbudgetline. the morehe wants at a givenprice.suppose an agentchoosesbetweentwo consumptivegoods. The "truebelievers" putpressureon theirclose associatesto sharetheirbeliefs.a smallclique ofcommitted Communists orbelieversinthecastesystemmaymakedissentso costly thattheirdoctrinewinswidespreadacceptance[Kuran.or"self-serv- ing bias"19[Dahl and Ransom. In fact.though.mo- ralityaside.

thepayoff increaseswiththeabsolutedivergence to rationalization betweenyour morally-unconstrained utility-maximizing action and your morally-constrainedutil- ity-maximizing The action.complicated onlyby the factthatperceived moralconstraints shiftthebudget linein. and Fischhoff." NotethatFigures5 and6 illustrate twoquitedifferent tradeoffs. he rationalizes hiswayaroundit.theflatter is thebudgetline'sslope. . withchoiceoverbeliefs In effect.^^^. thereis an additional margin (wealth/irrationality) tooptimize along. Morally Optimum V^^ #^* Unconstrained Optimum "Moral" Budget Line -^^ ^s>^^ < "Amoral" Budget Line WHISKEY appearstobe a binding moralconstraint. Themoreonerousthemoralconstraint is. RATIONALIRRATIONALITY 205 FIGURE 6 MoralConstraints MILK Morally^^^V Constrained^S. The is first to distin- empirically guishbetween beneficial and irrationality low-cost The irrationality. Rabin factors [1995] identifiesas mitigating self-serving bias. thepersoninFigure6 might conveniently underestimate thealcoholcontent ofwhiskey. Theonlythingholding backunlimited rationalization is a distasteforirrationality.Figure6 shows an ordinary tradeoffbetween twogoods. to 1982] illustrate. EmpiricalImplementation Howcouldempirical use thisanalysisofwealth-enhancing researchers irratio- nality?Therearetwodimensionsworth considering. moving the"moral budgetline"closertothe"amoralbudgetline. making a higher level ofwealth feasible." dogmatism. Theindividualwith fixed normative beliefs and flexibledescriptive thusfacesa positively-sloped beliefs wealth/irrationality budget line."cheat- ing"onhismoralbeliefs bymanipulating hisnon-moral beliefs.Forexample. secondis toesti- ofwealth-enhancing matetheincentive-elasticity irrationality.perceived moral constraints relax.suchas "salience "moral injection." and"moral priming" makeequi- libriumbeliefs morerationalbyflattening wealth/irrationality indifferencecurves. Themoreherational- izesthegreater hisutilityfrommaterialgoods. Phillips. itshowsthatas positive beliefs connected tomoralconstraints become more biased. Figure endogenizes budgetlinefor 5 the Figure6. using anoma- overconfidence lies[Lichtenstein. discusses Thissection thedirection work empirical along lines these might take.

$.Thus.Ifhypothesis (1) is correct.1989] can beunclearwhether thosewith "posi- tiveillusions" are(1) betteroffon balancebecausetheyaremuchhappierbutonly slightlylessobjectively successful. The rest of indifference subjects' curves could then bemappedout byvarying/^ andp2.30.00)forthoseremaining.thenraising p2shouldreduceC .doesoverestimating answergeneralinterest one'sabilitytocorrectly questions actually increase the fraction ofcorrect byreducing responses stress? Onewaytogetat thisquestion.Suppose. CONCLUSION Thecentralmessageofthispaperis thattheneoclassical-behavioral debatecan be analyzedas an elasticity "Pure question.20.Forcases wherehypothesis (2) the applies.calibrating theelasticity ofirrationality requires empiricalworkonbothcases.Forexample. anda rewardforsubjectsto accu- ratelyguessthenumber ofquestions oneanswered correctly. afteryMoreover.One could estimate each subject's "blissbelief forC bysettingboth pxandp2equal to0. Forexample. butleaveC if unchanged. Themostunusualfacetofthisproblem is thattheindifference curvesbecome backward-bending *. Designating thenum- berofcorrect answersas C. offbecausetheyaremoreobjectively or(2) better successfulas wellas happier. next task for empirical study is to calibrate the of incentive-elasticity The is irrationality.is to combine standardtestsofgenerati knowledge withtwosortsofincentives: a reward fora subject'stotalnumber ofcorrect responses.50worthof income. Therational modelformally irrationality distinguishes thesetwocases:hypothesis (1) is just thestandardcase shownin Figure3. neoclassical" indif- wealth/irrationality . thisis notnecessarily thewaywealth/irrationality indifference curvesactuallylook. procedureessentially the same as thatin the 3-doorsexperiment: varybothincentives andotherconditions andsee howtheexpected degreeofratio- nality changes.00)foronegroupof andset(pvp2)= ($. forexample. Oneusefultaskforempirical researchers wouldbe to determine whichofthesepossibilitiesis actuallythecase.andtheaveragevaluesofC andC forthe secondgroupwere60 and 65. thatoneadministers a testof100general knowl- edgequestions. Calibratingthe elasticityof irrationality. subjects.indicating agentsaremore that stubbornlycommitted to their wealth-impairing irrationality thantheyaretotheir wealth-enhancingirrationality.hypothesis is then (2) correct.onesuchcompensation formulawouldbe: Payoff pxC- = - p2(C C)2. and rewards/prices pxandp2. raising p2shouldreducebothCandC.Perhapsbeliefsare moremalleable(indifference curvesare steeper)beyondy* than they arebetween 0 and y*. while hypothesis (2) is thespecialcase shownin Figure5.$.onecouldestimatethatsubjectswerewillingto in- creasetheirbiasfrom 5 percent to8 percent inexchange foran extra$1.Somediscussions of wealth-enhancing irrationality[Taylor.thesubject's believednumber ofcorrectanswers C. IftheaveragevaluesofV andC forthefirstgroupwere55 and58. whichtomyknowledge has notbeentried. = onecouldset(pvp2) ($.206 EASTERN ECONOMIC JOURNAL Beneficialirrationalityversuslow-costirrationality. while this show paper'sfigures irrationality as symmetric around^*.

AlexTabarrok. Bradbury.butto simulatepoliticalconditions.Ifnear-neoclassical are preferences widespread.JimSchneider.ask experts.21 NOTES For discussionand usefulsuggestionsI wouldlike to thankDon Boudreaux.it also has two key substantivefindings.you must use privatematerialrewards.privatecostless. theyhave characterized In contrast. RobinHanson. 1.The firstis that experiments whereincreasingincentivesforrationality makespeopleless rationalpose a unique challenge. then behavioral economics providesa distortedpictureofmarketbehavior20.The second sectionofthispaperpresentsa basic taxonomy ofirrationality. Caplan.Higherstakesin a rigidsettinghave beenfoundto makebiases worse[Thaler. The currentpaper focusessolelyon the rationalityofbeliefs. The implicationforexperimentaldesign:to simulate market conditions.Perhaps the long-run ofrationalityis positiveeven ifthe short-run incentive-elasticity responseis nega- tive.J.or evenprivatelybeneficial.Such anomalies merit additional attentionbecause theyare as inconsis- tentwithrationalirrationality as they are with rationality.Bill Dickens.Ed Lopez.1995].seminarparticipantsat GeorgeMason.RonHeiner.two anonymousreferees. Geoffrey Brennan.NickyTynan.Gisèle Silva and Eric Cramptonprovidedexcellentresearchassistance.David Levy. Camerer. 1987]. Daniel Fried- man. TimurKuran. 1999b]. Fab Rojas.RogerCongleton.or experiment? The secondconclusionis thateventhe staunchestcriticsofthe behavioralfind- ingsmustconcedethatmanypeople'spreferences are notneoclassical.such agentscare onlyabout wealth. but ipsofactooffersa compelling accountofmuchnon-market behavior.or.onlyin irrationality thefirstcase are evolutionaryargumentsforperfectly neoclassicalpreferencesat all compelling.Mostnotably. preferences and stable.Both endpointsand all ofthe intermediatecases betweenthemfitcoherently intotherationalirrationalitymodel.Pete Boettke.This seeminglysmallconcessionhas strongimplications. as "rational"iftheyare well-ordered morestrongly.1989."Pure behaviorial"indifference curvesare horizontalat y*. axiomsofchoiceunderuncertainty iftheyalso satisfythe expected-utility [Becker.participantsat the Public ChoiceOutreachseminarand the PublicChoiceSocietymeetings. . But what abouthigherstakes combinedwithsufficient timeto do morere- search. Whilethecentralpurposeofthispaperis simplytoprovidea commonframework fordebate.Moreover.real-worldagentsusuallylack financialincentivesto be rationalin politics[Akerlof.Evolutionary claimsaboutthepossiblescopeofirrationality mustdistinguish betweencases where is privatelycostly.The standarddisclaimerapplies.ToddZywicki. thisframe- workis flexibleenoughto analyzediverseviolationsofrationalexpectations. irrationality is constantand unrelatedto materialincentives. youmustnot. RATIONAL IRRATIONALITY 207 ferencecurvesare vertical.not beliefs.TylerCowen.and membersofmyArmchair Economists'listserv.Games of"manversusnature"wheremoreirrationality has a negativeimpacton private wealthare themostobvious. 1962. 1999a.MitchMitchell.Butit can also be easilyappliedtogamesof"manversus himself(forexamplebelief-dependent performance and fixedmoralconstraints) and "manversussociety"(forexamplesocial pressure)wheremoreirrationality makes youmateriallybetteroff.butonlynear- neoclassical.KennethKoford.C. David Bernstein.Bill Dougan.Dan Klein.

genuinestupidity.248] .20. howeverstrongtheexperimental case againstpolarneoclassi- cal preferences." 3. distraction.predictably affect theease ofrecallingexamples.141]. "Incentives do notoperatebymagic:theyworkbyfocusing attention and byprolonging deliberation." plus truncation.These biases are notattributable to motiva- tionaleffects such as wishfulthinking or the distortion ofjudgmentsbypayoffs and penalties. emotionalimbalance. and thus the expectedmarginalcost of biased versus unbiased probabilityestimatesis E(payoff | don'tswitch)=$. and thus E(payoff | switch)-E(payoff|don'tswitch)= $.thatis.40+l/3 X. butbecausehe has an intrinsic tastefortruth.In- deed.1998] For regular incentives.It shouldbe emphasizedthatcognitive scienceconsistsofprobingtheordinary mentalstructures ofthe humanspecies." 10.itcouldn'thavebeencognitive in thefirst place.ifa formofirrationality decreasesas payoffs rise. 4.a correctpickearns $1. 12. emotions. Considerthe specialcase ofbehavioralindifference curveshorizontalat y*=0. Near-neoclassical preferences have no connection toRusselland Thaler'snotionofquasi rationality: "[Dependingon howtheproblemis framed.double-check withan expert. turnto aggregateevidence.freefromsuchspuriouseffects as are due to motivation. It shouldbe notedhoweverthatotherresearchersappearto takeresponsiveness to incentivesas defi- nitional.40) = $. braggadocio.50.E(payoff | don'tswitch)= $(2/3X. Consequently.E(payoff | don't switch) = $.as TverskyandKahnemanexplain. Withregularincentives. E(payoff | switch)=$(2/3x.90].20=$. everywhere butthatpole is consistent withtheevidence.10. theyare morelikelytopreventerrorsthatarisefrominsufficient attentionand effort thanerrorsthatarise frommisperception or faultyintuition" [Tverskyand Kahneman. 5. but afterconsidering threepossibleexplanationshe concludes thateconomists "havenousefulbusinessfussingaroundin an attempttomakesenseofunmotivated behavior"[1992.arisesbecause"peopleassess thefrequency of a class or the probability of an eventby the ease withwhichinstancesor occurrences maybe broughtto mind"[1982. But whycouldn'tincentives promptpeopleto be moreskepticalabouttheirintuitionorperception.whilea wrongpickearns$.1441].or aggressivity" [1994.whilea wrongpickearns -$. We proposecallinganysuchregularyetnonrational behaviorquasi rational"[1985.208 EASTERN ECONOMIC JOURNAL 2. Harrisonis aware ofthisdifficulty. elsewherein thesame volumeHogarthand Reder[1987.10)= $.. | switch)-E(payoff E(payoff | switch) = $.In termsofmyframework.30. [Friedman. a correct pickearns$.10. 13.understand and forecast'theworldverywell. 7. "Truth-loving" indifference curvesare interesting at least fornormative purposes.suchas fa- miliarity and salience.A personwithsuch indifference curveshas rationalexpectations notbecauseit is in his self-interest.$.He therefore staysrationalevenwhenirrationality has a positiveeffect on wealth(see section4).or expendmoreresearchtime? 6.ifonethinksofrationalexpectations as havinga 'correct' understanding ofthe 'mechanisms' thatactuallydetermine outcomesin the real world.lackofinter- est. This paper takes the sensitivity ofcognitivebiases to incentivesas an empiricalquestion.1987."Indeed. . 8.As Piattelli-Palmarini putsit. however.Tverskyand Kahnemanseem to: "Thisarticlehas been concernedwithcognitivebiases thatstemfromthe relianceon judgmentalheuristics.yetstill behave'irrationally/ meaningin a waythatdid notinvolvemaximizing his or herutility.00.Forintenseincentives.withintenseincen- tives.poorpreparation. it can be predicted whethertheagentwillchoosex ory.10+1/3 X. severalofthe severeerrorsofjudgmentreportedearlieroccurreddespitethe factthatthe subjectswereencouragedto be accurateand wererewardedforthe correctanswers"[1982. The availability bias.18]."It is in factimportant to distinguish carefully betweencogni- tiveillusionsand simpleerrorsofjudgmentorblundersdue to inattention.40. timidity.Smithand Walkeralso recognizetheneedto explain"whysubjectdecisions are notjust randomresponsesin the absenceofsalientrewards"[1993. 9.12] applythispoint moregenerally.sincetheycapturetheideals ofscientific and philosophic objectivity.50.and so on. As an anonymous refereeputsit..as for example.thattheirmodelcan explainprice-sensitive systematic errorswhentruncation problems are notan issue.11] eventhoughfactorsotherthanfrequency and probability .3O . It is notclear. I owe thisformulation to an anonymous referee.50. The experimental findings Einhornand Hogarthdiscussedhereconcernutilitytheoryratherthan rationalexpectations.1072].thensome- onecouldhaverationalexpectations ." "expectedpayoff space"insteadofjust "payoffs. 11.00. Theirdecisioncost modelexplainsbiasederrorsas theproductof"boundedrationality. Harrison[1989] actuallyuses slightlydifferent terminology: "messagespace" insteadof"beliefs. Thispointis nearlyidenticaltowhatHarrisoncalls his "payoff dominance" critiqueofexperimental findings.

Andnoteventhatin everycase. J. Boulier. 21.but withouta measureof"truefairness"thereis no way to test forrational expectations in the usual sense. L.wherethe conceptofsystematic bias is moredifficult to apply.oras Russelland Thaler's[1985] findings on consumers'detergent choicessuggest.1995].Iftheansweris no. G.JournalofPoliticalEconomy.Spring1989. In termsofwealth. Rationality inpoliticsis in effecta publicgood.1-15.307-19. and Yellen. . ExplainingBargainingImpasse: The Role ofSelf-Serving Biases.beliefs.116]. The EconomicsofIllusion. self-servingbiases have oftenbeen seen as coa/iter-productive: A personwhooverestimates his productivitywillprobablyearnless. and Goldfarb. IrrationalBehaviorand EconomicTheory. R.Manyformsofself-serving bias have been seen in normative. G.Schoenberger. 16. Babcock.September1985.1995. Caplan. Casscells.UnpublishedManuscript.January 1996. The LogicofCollectiveBelief. B.November1978. and Lomasky.L. Becker. RationalIgnorancevs. GeorgeMasonUni- versity. On the Use and NonuseofSurveysm Economics.1063-91.G.American EconomicReview.981-97. Thisis onlyoneformofself-serving bias discussedin theliterature. 17.which. and Tooby. and Loewenstein.. Interpretation byPhysicians ofClinicalLaboratory Results. 19. Graboys.999-1001.Even in a searchof"switchstay3.109-126.as Akerlof andYellen[1985]show.1- 13. Winter1997. RATIONAL IRRATIONALITY 209 14. JournalofPoliticalEconomy. JournalofEconomicPerspectives. 1-73. RationalIrrationality.AmericanEconomic Review. Akerlof.1993. Akerlof.1-21. A secondpossibleresponseto socialpressureis toengagein "preference i.1-18.in The HandbookofExperimental Economics. Democracy and Decision:ThePure TheoryofElectoralPreference. it consists in treatingchanceeventsas controllable.Economicsand Politics.231]. A TheoryofSocial Interactions.not more. Aumann.GeorgeMason University."thefirstthreehitsexplainthecorrectanswer.June1982.UnpublishedManuscript. . Camerer.holdingconstantthebeliefsoftheotherparty"[1997. because the set ofindependent variablesalso includesa trendvariable.June1974. thenit can be analyzedwitha standardnegatively-sloped budgetline. . Moregenerally. G.pretendto falsification. Kagel and A.thenit shouldbe analyzedwitha positively-sloped budgetline. Switchbonus shouldnotbe interpreted as a simplepracticeeffect. Do Biases in ProbabilityJudgments Matterin Markets?Experimental Evidence.editedby J."one ofthefirsttenhitsoffers a correctexplanation. L. J. subjectsplayedeither12 or 15 turns. . W.as numerousexperiments show. C. The "illusionofcontrolis definedas an expectancy ofa personalsuccessprobability inappropriately higherthantheobjectiveprobability wouldwarrant"[Langer1982. CorrelatedEquilibriumas a ExpressionofBayesianRationality. The EconomicConsequencesofCognitiveDissonance.Ifthe answerto theirquestionis yes fora givenformofself-serving bias.1999]. B. NJ:PrincetonUniversity Press. 15.moreover. 1999b. 1998.as a result.G. 1999a. 18. AreHumansGoodIntuitiveStatisticiansAfterAll?Rethinking SomeCon- clusions from the Literatureon Judgment Under Uncertainty.1995] REFERENCES Akerlof.. and Dickens.e.Self-interest maybe empirically shownto influence perceivedfairness[Dahl and Ransom.Babcockand Loewensteinraise an important caveat whentheyask "whether it benefitsa partyto be less biased..New EnglandJournalofMedicine. Can SmallDeviationsfromRationality Make SignificantDifferencesto Eco- nomicEquilibria?AmericanEconomicReview. ratherthanpositive.February1962. Cam- bridge:CambridgeUniversity Press.Princeton.Econometrica.December1987. 20. Cosmides. Roth. IndividualDecisionMaking.G.JournalofEconomic Methodology. W. Brennan.708-20.R. January 1987. and T.Cognition.A. On a basicAltavistasearchof"3 doorspuzzle. Forthepartoftheexperiment withbothintenseand standardincentives." shareadvantageousviewswithoutactuallyadoptingthem[Kuran.less bias is harmfulgiventhebiases of others .willtendtobe under-supplied evenifit is notentirely absent[Ledyard.

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