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Caplan's Rational Irrationality: Definition & Economics

Instructor: Gaines Arnold
Is all thought rational? This lesson looks at how people make decisions. In this lesson, the theory of rational irrationality is explored and then examples are provided as to economics, politics, personal finance, and religion.

The 2007 Financial Crisis

What caused the mid-2000's financial crisis? Some believe that it was government financial policies that propped up a housing bubble which was destined to collapse. Others contend that it was the result of Wall Street lending institutions that allowed their greed to overcome their sense of reason. Still, other people blamed consumers who purchased properties that were beyond their means. However, the reason may have been a combination of seemingly rational (reasonable) individual actions that added up to an irrational (illogical) whole.

What is Rational Irrationality?

In 2001, economist Bryan Caplan wrote 'The Myth of the Rational Voter' in which he coined the term 'rational irrationality'. Caplan said that 'people tailor their degree of rationality at the costs of error.' What this means is that when there is a low threshold of personal cost in making a certain decision, people will forego inquiry and allow themselves to make an irrational choice. One might say that firms making individual irrational choices in 2007 came at a high cost, but in this case, financial institutions were making what seemed like the rational choice due to lack of information.

Banking institutions saw what was happening and instead of relying on the global information that the economy could absorb a small correction (which ended up being about a trillion dollars), they relied on what other institutions were doing because they did not know what the final size of the correction would be. Obviously, competing financial firms do not share information to any great extent, so when one financial house began to hoard money and divest their subprime mortgages, others followed suit.

The collapse began with this rational (because the institutions did not want to be blindsided by a collapse) irrationality (rationality became irrationality when people realized that the initial hoarding and divestment was an overreaction) and snowballed into an even bigger mess. First, lenders stopped issuing credit in order to protect their capital, and then institutions (banks included) sold assets which, in turn, caused depression in the stock market (due to the sell-off of stock and bond assets).

How the Concept Figures in Real Situations

The financial example is just one of the many ways this concept works itself into people's lives. In his book, Caplan argued that voting is not a rational exercise. Others have applied the concept to everything from religion to how people purchase products. Following are some examples of rational irrationality.

Personal Economics

People buy products they don't need all the time. Sometimes it can be an up-late complex in which an individual purchases items from an infomercial, other times it is buying two 128 ounce jars of mayonnaise at a box store because it's cheaper that way. Although these purchases can be rationalized (saving money is rational), in practice they are irrational.

Politics

Politics may be the best example of rational irrationality because the average voter has the impression that their individual vote doesn't matter. Thus, people vote based on party, a single issue, or how they have been swayed by the verbiage of one candidate or another.

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