Chapter One

Rush-Hour Blues and
Rational Babies

To most people, economics is a dull science full of statistics and jargon, mainly concerned with money and designed to answer a narrow (but important) set of questions. To economists, economics is a powerful tool for understanding why armies run away, voters are ignorant, and divorce rates rise, as well as solving practical problems such as how not to get mugged. Its theme is not money but reason the implications, especially the nonobvious implications, of the fact that humans act rationally. Or to put it more formally:

Econonomics is that way of understanding behavior that starts from
the assumption that individuals have objectives and tend to choose
the correct way to achieve them.

"Economic rationality" summons up an image of a cold-blooded calculator--perhaps Mr. Spock. But economics is not just for Vulcans; the assumption describes our actions, not our thoughts. If you had to understand something intellectually in order to do it, none of us would be able to walk--as became clear when people started trying to program robot walkers. We learn not through logic alone but by a complicated process of feel, feedback, and intuition.

There are lots of ways to behave rationally without reasoning your way to it. Whether or not you have logically deduced that in order to live you must eat, if you don't eat you won't be around long to have your behavior analyzed by economists. So evolution is one source of rational behavior. Trial and error is another. I have never run a map of Santa Clara County through my computer, but I think I know theshortest way home from my office.

For a familiar example of rational behavior without reasoning, consider the situation of an infant--with only one too] available for achieving his objectives. When he is hungry or wet, he makes loud and unpleasant noises--giving any adults in the vicinity an incentive to deal with the problem. I doubt that babies think through the logic of their situation--but they take the action most likely to achieve their ends.

Babies are rational. So are cats. If you insist on reading the newspaper when you should be petting your cat, the cat solves the problem by lying down on the paper. I don't know if that tactic is the product of calculation or trial and error--but it works.

In order to get very far with economics, one must assume not only that people have objectives but that their objectives are reasonably simple. Without that assumption, economics becomes an empty theory; any behavior, however peculiar, can be explained by assuming that the behavior itself was the objective. (Why did I stand on my head on the table while holding a burning $1,000 bill between my toes? I wanted to stand on my head on the table while holding a burning $1,000 bill between my toes.)

Why Economics Might Work

Economics is based on the assumptions that people have reasonably simple objectives and choose the correct means to achieve them. Both assumptions are false--but useful.

Suppose someone is rational only half the time. Since there is generally one right way of doing things and many wrong ways, the rational behavior can be predicted but the irrational cannot. If we assume he is rational, we predict his behavior correctly about half the time--far from perfect, but a lot better than nothing. If I could do that well at the racetrack I would be a very rich man.

One summer, a colleague asked me why I had not bought a parking permit. I replied that not having a convenient place to park made me more likely to ride my bike. He accused me of inconsistency: As a believer in rationality, I should be able to make the correct choice between sloth and exercise without first rigging the game. My response was that rationality is an assumption I make about other people. I know myself well enough to allow for the consequences of my own irrationality. But for the vast mass of my fellow humans, about whom I know very little, rationality is the best predictive assumption available.

One reason to assume rationality is that it predicts behavior better than any alternative assumption. Another is that, when predicting a market or a mob, what matters is not the behavior of a single individual but the summed behavior of many. If irrational behavior is random, its effects may average out.

A third reason is that we are often dealing not with a random set of people but with people selected for the particular role they are playing. If firms picked CEOs at random, Bill Gates would still be a programmer and Microsoft would have done a much worse job than it did of maximizing its profits. But people who do not want to maximize profits or do not know how are unlikely to get the job. If they do get it, perhaps through the accident of inheritance, they are unlikely to keep it. If they do keep it, their companies are likely to go on a downhill slide. So the people who run companies can safely be assumed to know what they are doing--generally and on average. And since businesses that lose money eventually shut down, the assumption of rational profit maximization turns out to be a pretty good way of predicting and explaining the behavior of firms.

A similar argument applies to the stock market. Investors who consistently bet wrong soon have little left to bet with. Investors who consistently bet right have an increasing amount of their own money to risk--and often other people's money as well. So well-informed investors have an influence on the market out of proportion to their numbers.

Some Examples of
Economic Thinking

You are designing a park: a pattern of sidewalks in a sea of grass. One of the objectives of many people is to get where they are going with as little effort as possible--and a straight line is the shortest distance between two points.

Hidden Order. Copyright by David D. Friedman. Reprinted by permission of HarperCollins Publishers, Inc. All rights reserved. Available now wherever books are sold.