Confusion About Individual Rationality and Market Outcomes

Amongst marketing scholars there is a lot of confusion regarding rationality in markets and plenty of blame to go around for the confusion.

In marketing we have bifurcated into two groups. Psychologically trained scholars often suggest that economically trained scholars all believe in the cult of humans as perfect decision-makers. Psychologically trained scholars should know better — those trained in economics aren’t all complete idiots. (Nearly) all know that human decision making is flawed. Thus Vernon Smith describes the quest to show that decision making is flawed as “cottage industry” engaged in “a search that can only succeed” (Smith, 2003, footnote 8 page 467).

Economically trained scholars are also to blame. They know people aren’t perfect decision-makers but give psychologically trained scholars plenty of reason to doubt this. Economically trained scholars often treat assumptions made because they are useful to their models as laws of nature that cannot be questioned.

The economist Vernon Smith is refreshing as he seeks to justify market rationality as a product of the market not the brilliance of the people within it. The basic idea is that markets can, theoretically, work well from a wisdom of the crowds perspective despite any given decision-maker being a flawed decision maker.

The lesson from Smith isn’t that economic models assuming market efficiency always work despite flawed decision making. The lesson is that the models sometimes can work relatively well. Thus those showing that decision making is flawed are proving things that are widely know but their findings don’t necessarily matter in markets unless the flaws are shown to impact the results of a given model.

To my mind the relevant criticism of economically trained scholars is not that their models can never work. It is that the models often don’t work. Markets don’t magically always compensate for flawed decision making even if sometimes markets can. The big task for business decision making scholars is to find when exactly a given market does work well and when it doesn’t. It is a massive job but much better than psychologically trained scholars showing even more evidence of flawed decision making and economically trained scholars simply yawning.

Read: Vernon Smith, 2003, Constructivist and Ecological Rationality in Economics, The American Economic Review, 93 (3), pages 465-508.