Rationality of Self and Others in an Economic System

In this paper, I want to disentangle some of the senses in which the hypothesis of rationality is used in economic theory. In particular, I want to stress that rationality is not a property of the individual alone, although it is usually presented that way. Rather, it gathers not only its force but also its very meaning from the social context in which it is embedded. It is most plausible under very ideal conditions. When these conditions cease to hold, the rationality assumptions become strained and possibly even self-contradictory. They certainly imply an ability at information processing and calculation that is far beyond the feasible and that cannot well be justified as the result of learning and adaptation. Let me dismiss a point of view that is perhaps not always articulated but seems implicit in many writings. It seems to be asserted that a theory of the economy must be based on rationality, as a matter of principle. Otherwise, there can be no theory. This position has even been maintained by some who accept that economic behavior is not completely rational. John Stuart Mill (1909, bk. 2, ch. 4) argued that custom, not competition, governs much of the economic world. But he adds that the only possible theory is that Standard economic doctrine makes assumptions of rationality that have very strong implications for the complexity of individuals' decision processes. The most complete assumptions of competitive general equilibrium theory require that all future and contingent prices exist and be known. In fact, of course, not all these markets exist. The incompleteness of markets has several side consequences for rationality. For one thing, each decision maker has to have a model that predicts the future spot prices. This is an informational burden of an entirely different magnitude than simply optimizing at known prices. It involves all the complexity of rational analysis of data and contradicts the much-praised informational economy of the price system. It is also the case that equilibria become much less well defined. Similar problems occur with imperfect competition. * This research was supported by the Office of Naval Research grant ONR-N00014-79-C-0685 at the Center for Research in Organizational Efficiency, Institute for Mathematical Studies in the Social Sciences, Stanford University, Stanford, California.