May 25, 2024; most recent update: November 12, 2024

Table of Contents

1. Redefining "Resource"

2. Essence of Economic Rationality

    a. "Satisfaction" = "Benefit" = "Resource"

    b. The Larger Goal of Economic Rationality

3. Constant Self-Interest is Not an Implication

4. Limiting Factors

    a. Conflicting Goals and Beliefs

    b. Ignorance and Flawed Inferences

    c. Passion

    d. Differences in Circumstance and General Perception

5. Limiting Factors Don't Affect its Fundamental Status

6. Its Truth & Relation to Contrary Truths

    a. Narrowing the Scope of the Principle

    b. Proving Economic Rationality is a Law

    c. How it Can Be a Law Despite Frequent Exceptions

Economics distinguishes resources from goods and services. Resources are the necessary means for goods and services to exist. For example, money, raw material, equipment, and labor are the bare minimum resources for most manufactured goods.

But for this discussion, understanding is made easier if we define "resource" as anything used or that can be used to satisfy our needs and wants, including goods and services. We seek certain resources to fulfill our needs and wants -- we seek food to alleviate our hunger, entertainment to address our boredom, etc -- and, at least to some extent, we each have resources to obtain those other resources. And the amount of resources one truly acquires during a given purchase equals the extent that the purchase can satisfy their needs or wants, whether through consumption or further trade.

Therefore, except for universal requirements, the degree to which something is a resource is not absolute but depends on the person or other economic entity. That, in turn, can depend on how much their trade partners see it as a resource.  The saying "one person's junk is another person's treasure" applies here. 

What a "resource" is in the narrower economic sense is often relative in another way: on our level of focus -- on where something sits in the long chain of means and ends. If the issue is how to achieve law enforcement services, then training, equipment, and wage income are some of the necessary resources. But those services -- and their requirements -- are resources primarily for the further end of public safety; it's not the good/service per se that is sought, but its satisfying the buyer's needs or wants.

Also, in trade the distinction melts too: with resources in the narrower sense and goods/services, either or both can be used in exchange for one or the other.

So, for now, it's useful to simplify with the broader definition above.

The study of economics starts from two axioms. The first is that the world has limited resources. This is the principle of scarcity.

Here, scarce doesn't necessarily mean inadequate or rare, just limited. Still, that's an important difference from unlimited. Some resources might be considered "free" and "unlimited", but nothing truly is. Nature's stars or mountains in the immediate background don't cost any money or material resources for the public to gain pleasure from viewing them. But this does cost people's time, which isn't unlimited. Economists are more interested in "non-free", "limited" resources (goods actually). Ultimately, economists try to understand how individuals, organizations, and societies deal with scarcity in obtaining and distributing goods and services.

While different individuals, organizations, and societies don't necessarily approach the scarcity problem in the same way, there are still some basic truths that help our understanding. One of those is the second axiom of economics: people are fundamentally rational. As it relates to scarcity, this means that people try to satisfy needs and wants at the least cost ("cost" being money, time, other resources, etc). Another side of the principle is that if several options of the same resource have equal costs, people will choose the most satisfying one, all other things equal: each degree of satisfaction is obtained at the least cost, which amounts to the same thing as above. So, in other words, people strive for what has the largest benefit-to-cost ratio among available options, absent any beliefs or goals that conflict with that in a particular case (e.g. loyalty to a certain vendor). That is the principle of economic rationality.

Notice what this entails.

It doesn't guarantee that a financially able person or entity will pay a higher price for a given option if it has a greater value than other options. Even though, say, a bulk option provides a lower price per unit, if the economic player sees no need or desire for those extra units then the option does not provide a higher benefit to cost ratio but the opposite. Therefore it follows that they will stick to a cheaper option despite each unit being more expensive. The same goes for a pricier option that has a much higher quality to cost ratio than the others: if the economic participant's true needs or desires can be met with a cheaper option, then no real benefit is derived from paying more. We can see that the same point applies to other costs as well, not just financial ones.

Also, economic rationality doesn't just pertain to consumers purchasing something, but to all players in the economy. Businesses, and other types of sellers, will take the path of the highest revenue relative to costs -- the Theory of the Firm posits that businesses seek to maximize profit. Laborers will seek the option with the highest wage, unless that option has some other cost (distance from work, fewer employee benefits, negative work environment, etc) large enough to make a lower wage option more attractive. Lenders or renters will try to obtain the largest return or rent relative to cost. Larger loans have a greater risk / potential cost to the lender's total wealth and thus often a higher interest rate (benefit). Larger rented buildings usually cost more to build and/or more for the landlord to maintain, and larger areas of rented land mean the landlord potentially forgoes more by not building on it or otherwise utilizing it. Hence usually there's a higher rent payment than for a smaller building or area of land.

On this last point, why does a lender usually charge a higher interest rate for a riskier borrower? Because the potential cost -- the chance not only that the loan won't be fully paid but that the lender will default earlier -- is greater, thereby demanding a higher return before any default might happen. Yes, there might be other economic motives, but the aim of maintaining at least the same (the highest) benefit-to-cost ratio as with other loans is implicit in such practices; economic rationality is in play.

With economic rationality itself, "satisfaction," "benefit," and "resource" can be thought of synonymously. The expected satisfaction we'll get from a selected alternative is the same as its expected benefits and thus, ultimately, the same as the amount of resources we believe we've acquired. Put another way, our view of the total resources we own -- the worth of our possessions -- is equivalent to how far we think those possessions can go towards satisfying our needs and wants (i.e. how many benefits we believe those possessions have).

The equivalency falls apart when it comes to actual satisfaction received.  The second sandwich eaten can be virtually identical to the first and seem  equal in worth, but yield less satisfaction. However, we have no way of knowing our actual satisfaction beforehand, which is why our choices revolve around expected satisfaction and the equivalency stands.

For all intents and purposes, the benefit-to-cost ratio, satisfaction-to-cost ratio, and resource-to-cost ratio are the same.

The larger goal of economic rationality is to keep the sum of one's limited resources as high as desired or needed.

This doesn't necessarily mean that an individual's or group's economic decisions are always or usually driven primarily by self-interest. It just means that, where there's no conflict of beliefs or goals, scarcity moves a person or group to try to get the best benefit-to-cost option among available choices. Thus even with someone running a non-profit for humanitarian reasons or someone determined to keep their products free or inexpensive for the public, we would expect at least some of their decisions to follow economic rationality. They might, for example, seek the cheapest suppliers in order to stretch their money the furthest and give their organization the best chance of success.

Furthermore, nothing about the principle should be interpreted to mean that it is always realized, intended, or easy to observe among economic players. Certain factors get in the way of its absolute application and clarity. Nevertheless, those do not refute the principle but simply mean that life and knowledge are often complex and imperfect.

These factors are: (1) conflicting goals and beliefs, (2) ignorance and flawed inferences, (3) passion, and (4) differences in circumstance and general perception. Often two or more factors are connected.

The principle of economic rationality is not meant to imply that economic players intentionally follow it in all situations. As mentioned above, a conflicting goal or belief -- such as loyalty to a vendor or that it's wrong to make money on certain holidays or certain days of the week -- can cause a person or organization to make an exception to it. In fact, it's not hard to see that there are many possible circumstances when other interests or beliefs would lead an individual or group to at least temporarily set aside economic rationality. Take, for example, the Theory of the Firm. Again, it asserts that profit maximization is the main goal of all firms. But this does not further imply that the human business owner pursues profit at the expense of everything else in their life. If the owner is the sole employee, they might set shorter business hours even though they could profit more with longer hours, in order to balance business with other interests in life. However, when business doesn't conflict with the owner's other interests that are of equal or greater value, we would expect the owner to usually make decisions aimed at maximizing profit, according to a charitable interpretation of the postulate. After all, that's what the business is there for.

Actually, the business-owner example highlights that many "exceptions" to economic rationality aren't exceptions at all -- especially when it comes to so-called "conflicting beliefs" and "conflicting goals." They only appear to be because it's often assumed that the only economic cost is money, since that is by far the most obvious cost in any economic situation. But other resources are also scarce, such as time, etc, not just money. So, it makes sense that economic rationality includes those too, since the chooser is trying to give their economic situation the best benefit-to-cost ratio.

However, other cases -- such as the vendor loyalty example -- really are exceptions, since they involve a lower benefit-to-cost ratio for the chooser. In other words, the higher price tolerated doesn't necessarily give them proportionately more of other resources/benefits if loyalty alone is the reason. If the business owner needs or wants to extend business hours but doesn't in order to meet certain moral obligations, that too would be a real exception. 

Obviously when certain information is unavailable, inadequate, or incorrect, it can lead to choices inconsistent with the best benefit to cost ratio, even when there are no conflicting beliefs or goals. The same can be said for logical errors -- which are sometimes taken as counterevidence of our fundamental rationality. But choices based on these are just mistakes, not refutations of the principle. In those cases, it can be assumed that the intent to realize the ratio -- to achieve what is clearly and intuitively the most rational course economically -- is still present. The main difference is that incorrect information, and any inconsistencies or weaknesses in one's information or logic, aren't always immediately obvious. That is why there can be a divergence in a virtually instinctive goal and attempts to reach it.

Forgotten knowledge would be included here.

The clearest cases of passion conflicting with economic rationality (or any type of rationality) are when an individual or group knows the right course of action but doesn't act on that knowledge due to the influence of desires or emotions separate from it. For example, someone might buy heavily into an expensive stock of a company that has red flags, lured by the exceptional growth the stock has gained so far. The trader has much to gain if their actions are successful but only at too great of a potential cost.

Here, it is that one ignores certain knowledge rather than the situation involved in the previous section, where adequate information is simply unavailable; they have the knowledge -- it hasn't been forgotten and is perhaps being used in other areas of their life -- but it isn't active in the current circumstance. Ignoring new information (i.e. willful ignorance) would also be an instance of passion at odds with reason, but the clearest cases are when the knowledge is present but passion prevents it from rising to the surface.

What is "beneficial" is partly relative and subjective. Certain qualities among some of the options might be, or at least might be perceived as, more/less beneficial or more/less costly to one person than to another. For example, a wealthy but time-starved person might be willing to pay for a high-priced option if it gets the job done quicker, whereas a cash-starved person with more time would likely go for the cheaper, slower option. But the basic principle still stands. Such differences in circumstance or perception can explain why not everyone chooses simply the cheapest option, and why someone's preference may seem to violate economic rationality even though there's no conflicting motive or belief that prevents them from following the principle.

If there are so many possible exceptions, how does the principle fundamentally explain economic behavior? Why isn't it better to say that economic behavior is directed not by one major cause but any of several main ones, depending on the individual case?

First, as already indicated, economic considerations are not the only important considerations in life and thus economic rationality cannot possibly explain all human behavoir. That has implications for some economic transactions.

Second, economically the exceptions mentioned are secondary causes, not primary ones. For example, rationality explains a lot more about economic decision-making than do things like ignorance or passion: we can see rational thinking involved even when ignorance or passion are helping shape the final result.

Finally, the exceptions are in line with our basic notions of metaphysics. A thing's fundamental capacity (its essence) is not necessarily its actual activity (or lack of) at the moment or throughout all of its existence. If it were, then it would be like saying that a television is not a television if it ever fails to give a picture, including when it's off or when the signal has interference. Even if the television is never used, as long as it can do its fundamental activity of presenting a picture and sound, it remains a television in the truest sense. The same points apply to economic players and their fundamental capacity to reason.

Still, it's not enough that a theory explains certain known phenomena adequately and better than other proposed theories. It must also be true.

The principle of economic rationality is usually assumed to be a law. There is  a debate over whether it is a law or something less.

To be a law, it must be true for all economic players whenever two or more options exist for the same needs or desires. But as already mentioned, this can't be taken in a broad, sweeping sense, otherwise it would fail to account for many legitimate exceptions. However, that doesn't mean that it doesn't exist latently in those cases. It's still possible that it's a constant but needs other conditions out of the way to be realized: maybe it's still a law, in a narrower context.

But even when we restrict its application, there's a major problem. In both economics and other related fields, evidence exists that economic decisions often violate economic rationality. So, if it really is a constant, how do those things happen so frequentlyl? It begins to look like economic rationality is only conditionally, and not inherently, true in economic decision-making. We don't expect things that are fundamentally true to usually or even often have exceptions to them. For instance, if someone acts "out of character," it is considered a rare exception to their behavior. But if they continue to genuinely act that way, even if not usually, at some point we will likely see that behavior as part of their character: either we didn't know their true character before or they've acquired a vice, virtue, or other habit. 

Therefore observation doesn't give us any reason to believe that economic rationality is a law.

But observation isn't our only path. So, rather than take a third-person, observer's view, look within and honestly ask whether economic rationality resonates. Would it matter to you if, after a purchase, you saw that you could have bought the same expensive item for half the price? If you later saw a friend or family member attempting to make the same purchase, would you want to tell them they could buy the item cheaper?

Why does economic rationality resonate and why do we naturally assume that it resonates with others too? It springs from at least two basic facts that don't seem refutable and are virtually automatic beliefs: the world has limited resources and more resources are usually better than less.

These things are so obviously true, it's no wonder that economic rationality is often taken for granted. But if pressed, they're not hard to support. It's immediately evident that the world and things in it are finite -- therefore its resources are limited. As for "more resources are usually better than less," it's intuitively obvious that each need or want requires some amount of resources to be fulfilled and that the amount is more likely achieved (less likely missed) with more resources rather than fewer. And because the world's and our own resources are limited, we don't usually have so much of a particular resource that it strains or exceeds the time, space, or other resources we have to manage it.

However, why is the first premise even necessary? Knowing that "more resources are usually better than less" would seem sufficient for us to seek our needs and wants at the least cost. But more is usually better than less only because of limited resources. If individually we had unlimited resources, there would be no need to preserve the resources we have since there would always be enough. So, there would be no concern over the cost of anything. It would be completely arbitrary if we ever sought the least costly route or even a less costly route.

Of course, there are other related premises that we assume -- survival is good, happiness is good, etc -- but the two mentioned are the key ones.

Because these two premises are such primitive, basic facts, they present themselves in every economic situation and are always obvious to every economic player, even if not consciously. Thus economic rationality can be considered a law from two different angles: its premises as universal, objective facts in all economic circumstances, and itself as a universal psychological fact for all economic participants.

Therefore, even in cases of conflicting interests and beliefs, such as when a higher price is paid out of loyalty to a vendor, we can assume that economic rationality is still a motivator underneath and that the buyer would prefer that the vendor decrease their price and hope the price isn't raised. 

There are better arguments for showing it's a law, but the simple ones given seem adequate.

Nothing about the economic rationality being a law contradicts the evidence that economic decisions often violate it. Economic rationality is naturally the course economic players want to take because it and its premises are immediately obvious. But not all economic facts are so obvious and thus not everyone can see the right path in every economic situation. Just because you instinctively understand and aim for economic rationality doesn't mean you know how to run a large business effectively or are a competent investor. So, it is possible for someone to maintain both that economic rationality is a universal, underlying principle in economic behavior and that economic irrationality can be common in more complex economic situations. In those situations, the knowledge required is greater, more specific, and less clear due to increased complexity. Such knowledge is not applicable to everyone (or anyone) in all cases.

Therefore, when passion causes economic irrationality, it is specific knowledge that is clouded, not the always-present basic knowledge mentioned.

In a nutshell, economic rationality and economic irrationality can exist simultaneously in the same person: the first as a desire, and the second in their actions.