Are Consumers Rational?

January 6th, 2010

The financial crisis of 2008 had numerous repercussions, many of which are still percussing. Perhaps the most profound was the shaken faith in the efficacy of markets.

This complaint is not new. It origin goes at least as far back as the 19th century. How much of it is true?

What Happened to the Irrational Housing Consumers?

As a preface to the answer, consider this bit of news. Bloomberg Financial News Service reports that home mortgage applications fell during the first week in November to their lowest level in nearly 9 years. Why? Because Congress was considering a bill that would extend a law granting unemployment benefits and tax credits to first-time homebuyers, and in addition make subsidies available to current owners.

Why did Congressional deliberations cause the mortgage market to tank? Anybody who bought their first home before the legislation passed (which it finally did, last week) would miss out on the benefits and tax credit, which only became effective after passage. Consumers wanted to wait until they found out whether the subsidies were available before making the decision to buy.

That seems pretty odd, doesn’t it? For years, consumers in a particular market behave irrationally, finally causing the world to collapse around their ears. Then, all of a sudden, they turn cool, calculating and rational – they pore over the legislative docket, biding their time waiting for Congress to pass a complicated give-away program. What’s up with that?

Answer: They Became Rational

What’s up is exactly what an economist would expect. Every microeconomics textbook states that one of the key determinants of consumer demand for any good or service is consumer expectations about future prices of the good. Another one is taxes and subsidies that affect the good. In this case, benefits and tax credits tied to home purchase reduce the effective price of the home. Since consumers would rather buy a home – or any other good – at a lower price than at a higher price, they waited until the lower price became available.

Rationality in Economics

The economics-textbook models of rational consumer behavior assume that all market participants possess all relevant information about prices, products, preferences and production techniques. In effect, they assume everybody knows everything they need to know to make perfect decisions. (Economists sometimes introduce a condition of “uncertainty,” but this simply assigns know probability values to the uncertain states; it is the perfect-information model, one step removed.)

In reality, nobody has all the information they need. The relevant information is locked up in the minds of millions or billions of people. The only way to make use of it is to allow people to transact freely in markets, making use of their limited stocks of information and transmitting their knowledge to others through their actions. Every market price transmits useful information to buyers and sellers. When government puts its thumb on the scales by interfering with those transactions and prices, it is lousing up the process that makes our decisions more rational.

Reverse Causality

The claim that markets won’t work unless people are rational has it backwards. People become more rational because of market competition. F. A. Hayek, the keenest student of capitalism and markets, put it clearly. “…Rational behavior is not a premise of economic theory…competition will make it necessary for people to act rationally in order to maintain themselves… it is…not rationality which is required to make competition work, but competition…which will produce rational behavior.”

Consumers and producers in the home-mortgage market did not behave irrationally during the period of rising prices. They behaved rationally given the limited information they had at their disposal. Consumers were offered good deals on mortgages. They knew that in times of rapidly-rising prices, leverage and debt can be powerful, successful tools for increasing wealth. What they didn’t know was how soon and how rapidly prices would fall and markets would de-leverage.

They were in good company. Virtually all of the carping critics now condemning markets and accusing consumers of irrationality didn’t know, either. (Does that mean they were irrational, too?) Why was it that so many people were all going wrong at the same time?

Government as Generator of “Irrationality”

They were being nudged in the wrong direction by government. Ordinarily, unqualified buyers who tried to get a mortgage without a downpayment or with insufficient income would be denied or socked with a sky-high interest rate. But policymakers in Congress and elsewhere had decreed that conventional standards of evaluation were unfair and biased; standards should be lowered to enforce fairness. The Federal Reserve that prohibitive interest rates were discriminatory and should be lowered; monetary policy had artificially produced rock-bottom interest rates for practically everybody. Rationality was ruled out of order by government decree.

Big Brother Knows Best

The presumption of consumer irrationality underlies much of what government does. In the U.S., employees are forced to pay F. I. C. A. taxes to fund current payouts to retirees. If used to purchase an annuity from a private insurance company, those tax dollars could fund a retirement far more lucrative than anything Social Security will provide. Yet the presumption is that improvident consumers will waste the money and go hungry if not forced to “contribute” to Social Security.

In other countries, the futility of government-financed social insurance is recognized. Consumers can instead contribute to personal accounts and use the money to fund their own retirement program. Unfortunately, the distrust of consumer choice remains. In Great Britain, Sweden and other European countries, the consumer must use personal- account money to purchase an annuity prior to attaining a specified age. Rationality would decree that some people place a high regard on security and future consumption – they are the legitimate market for annuities. Other people have a high rate of time preference – they value current consumption well above future consumption. These people should not be forced to purchase annuities. Once again, however, rationality takes a back seat to government paternalism.

It is irony of the highest order that some of the loudest complainers about the irrationality of markets are those who also advocate taking decisions out of private hands.

Category: Annuities, Economic Analysis, Economic News, Retirement Planning | Tags: , , , ,

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