Today's 1st Buggy Topic
Rational decision-making --- usually called rational-choice theory in economics and the other social sciences --- is at the heart of free-market theories about major economic agents . . . those spelled out in the title above. It underlies the views of marginalism and opportunity costs in microeconomic theory --- agents consider choosing one option (working longer, spending money on a new car as opposed to repairing the old car, investing in the stock-market or the bond market, or business firms investing in a new risky technology) by calculating the likely benefits of that option compared to the risks and costs of choosing it in dollars spent or foregone. Opportunity costs refer to those foregone options. Thus the trade-off between leisure and working longer entails, if you decide to work voluntarily on the next four Saturdays, spending less time with your family or playing a sport you like or meeting with your friends.
It's on this basis, given good information and making the best use of it, that market economies can move toward optimal efficiency and full employment, through self-adjusting changes in the prices of goods and services and in wages and interest-rates. After reading the rest of these introductory comments, click here for prof bug's lengthy analysis that was left earlier in January 2009 at the Marginal Revolution.
A Newer Bent Still: New Classical Theory and Real Business-Cycle as Its Spin-off
Rational expectations, which lies at the heart of New Classical Theory --- a spin-off of some Nobel-prize winning economists and others of equal caliber starting in the late 1960s --- goes further.
It assumes that economic agents have a full hypothetical knowledge of how a complex economy like the USA's --- including its global links --- works, at any rate as much as economists who seek to model the economy and key policymakers like the Federal Reserve and its targeting of interest rates or the money supply. On these grounds, it follows that except for external shocks --- say, an entirely new technology that renders older technologies obsolete very quickly, or in a sudden new oil-cartel like OPEC raising the price of oil twice in 1973 and 1979 (gasoline in the US five times more expensive as a result), or a war abroad that disrupts imports from abroad or requires massive government spending to fight it as in World War Two --- except for these external shocks, the market economy is always in general equilibrium or will quickly adapt to it. Unless, of course, governments gum up things by excessive regulation, excessive taxation, or excessive deficit spending that cheapens the national currency.
And hence even the business-cycle --- the ups and downs around long-term economic growth trends, the latter set by capital accumulation, the growth in the quantity and quality of the work force, and technological progress --- is something that market economies don't so much cause as have imposed upon them by these external forces. The New Classical theory here that explains recessions and subsequent booms is called Real Business-Cycle theory, with a strong emphasis on the recurring impact of new technological changes. In short, the business cycle's ups and downs are part of what constitutes economic progress. Older, less profitable businesses will be weeded out. Capital and workers will be freed for new, more technologically advanced sectors that incorporate the newer, more promising machines and products. And fairly quickly --- if governments don't seek to control what they can't control: real economic factors that aren't amenable to either monetary fine-tuning or fiscal expansion --- the economy will, on its own, recover long-term trend.
Theoretical Challenges to Rational Decision-Making in the Market Economy: Three Sorts
(i.) The first is now decades old, going back to the creation of a separate macroeconomic theory by John Maynard Keynes. In turn Keynesianism is really a paradigm that guides theoretical work, and there are fairly mainstream versions and more radical ones.
What the more radical ones have in common is the contention that what drives the decisions above all of capitalist savers --- those individuals or financial institutions with large amounts of capital to invest in the bond or stock markets or lend to businesses --- and businesses that have to invest at some point in new machines and plants and R&D, are not driven in either boom times or bust-times by rational calculating decisions at the margins and with proper risks taken into account, but rather by shifting moods in savers' and investors' psychology. Keynes called these "animal spirits." And essentially only effective government macroeconomic policies --- whether monetary or fiscal expansion --- can keep the general economy from falling into a serious shortfall of full employment in major recessions
The more mainstream versions --- now largely called New Keynesianism --- hold onto the original Keynesian insight that there is some built-in massive market-failure that causes market-economies to fall into recessions.
One cause is a rigid price-level of goods and services that business firms won't quickly adjust downward in the face of falling demand, and the underlying reason refers to what Keynes himself glanced at in passing: a contractual economy, in which business-to-business selling of outputs from the seller as inputs to the manufacturer or service-firm are written up and signed legally and can't be quickly changed . . . any more than it's costly and easy to change prices all the time in line with falling demand to end-consumers. This contractual blockage is called "menu costs." A second cause enters here: money wages, for rational reasons, aren't flexible downward, and so in a recession business-firms --- as they find their sales and revenue declining --- can't cut costs by reducing their employees' wages. instead, they prefer to maintain the morale of their senior, better trained employees and lay off their more junior, less experienced ones. (See the illuminating survey of "efficiency wage theory" at wikipedia.)
(ii.) Behavioral economics --- a fairly new discipline in economics, but increasingly important --- eschews rational assumptions about economic behavior and instead analyzes the motives and behavior of specific economic agents of all sorts in concrete situations. This sort of empirical work --- which breaks with the deductive postulates of mainstream economic modeling --- can use observation-techniques or survey data or in-depth interviews . . . as well, please note, the findings of social psychologists who themselves study small-group and individual behavior in laboratory experiments. The work of two social psychologists --- Amos Tversky and Daniel Kahneman, both pioneers in creating prospect-theory (often called framing-theory) --- has been markedly influential in this new discipline. Kahneman, at Princeton, won a Nobel Prize in Economics in 2002 for his innovative work . . . Tversky's equally important collaborative studies with him not awarded because he had died by then. (The wiki article on Kahneman, just linked to, is strongly recommended by prof bug.)
(iii.) Economists with a strong liberal or social-democratic bent have also been wary of rational-assumptions about the behavior of economic agents --- though many have adopted rational-choice approaches in their concrete work: for instance, Paul Krugman who won a Nobel Prize in 2008 for his pathbreaking work on New Trade Theory that incorporates assumptions about oligopolistic markets (as opposed to perfectly competitive markets), the role of governments in trade and multinational investment flows, and geographical influences around the globe.