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Rationality in Economics, Constructivist and Ecological Forms by Vernon L. Smith, 2009, 384pp., £19.99 pb, Cambridge: Cambridge University Press, ISBN 978 0 521 13338 8

Reviewer: Seamus Coffey*

Vernon Smith won the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 2002.  The prize is not one of the original Nobel Prizes as conducted by the Nobel Foundation but is offered by the Swedish Central Bank, though it has become closely associated with the original awards. Smith was awarded the prize “for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms".

The book is a hugely expanded version of the lecture which Smith gave when he accepted the award and also includes updated versions of some of his key papers in the area of rationality.  It is not an easy read and the chapters must be consumed slowly.  In fact there are occasions where individual sections must be pondered carefully before progress can be made.  For some this may be a weakness but here it is a strength.  Each chapter provides important insights into human behaviour that do require careful treatment.  There is much to be learned from the book but it does take time.

Traditionally, economics has had a fairly bland definition of rationality.  It is the maximisation of some magnitude, be it utility or profit.  Smith uses the work of fellow Nobel Laureate, Friedrich von Hayek, and considers two forms of rationality, constructivist and ecological. Most economists focus on the constructivist form which is linked to the definition given above.  It is the deliberate use of reason to choose the best course of action from the available set of alternatives.  Ecological rationality is related to emergent order.  Over time practices, norms and institutional rules emerge that allow society to function more effectively. These practices are not the result of deliberate human design but they are rational as the optimal pattern results more often than not.

There has been a huge clamour over the past two decades to find instances of irrational behaviour that runs counter to the typical assumptions which are the basis for most mathematical models in economics.  A cottage industry has emerged of people using experimental and real-world data to disprove the rationality hypothesis.

Vernon Smith was running experiments in economics well before many of the recent advocates of this approach were even born.  Starting in the 1950s he began using classroom experiments to understand the thought processes of individuals in market settings.  Just like those searching now, Smith found examples of behaviour that would be considered irrational if one adopted only the constructivist view of human behaviour. Over his career, however, he has incorporated the work of Hayek and even earlier writers such as Adam Smith and David Hume.  Vernon Smith was not satisfied with merely finding instances of irrationality that made for interesting dinner conversations, He wanted to understand them.  It was this that led him along the road of ecological rationality.

When looked at from a purely individual basis, many of the actions observed in these experiments are indeed irrational.  But people do not make their decisions in isolation, they make them as part of a collective, be it a community, a firm, a religion or a country.  Smith began to explore whether in fact these actions were rational when viewed from the society that had emerged around them.

Foremost amongst these are situations known as Prisoner’s Dilemmas to which Smith devotes considerable attention.  In a situation like this each individual has the incentive to cheat on the other in order to get a higher payoff. The payoff is high if neither cheats and both choose to cooperate with each other and is lowest if both choose to cheat.  The worst individual payoff is to a player who cooperates but has an opponent who cheats against them. Under the constructivist approach the rational decision for both players is to cheat (trying to get the highest payoff or avoid the lowest payoff) but this actually ends up with the worst possible collective outcome. Both players would be better off if they cooperated but the incentives are such that they will always be better off cheating.

Both experimental and real-world data have shown that people are not rational when faced with a prisoner’s dilemma.  Although it varies by setting and the payoffs involved, cooperation rates can range from 40% to 80%.  Constructivist rationality dictates that it should be zero. Of course by cooperating the players have gotten a better payoff than would have resulted if they were rational and cheated.  Smith argues that this is where the ecological approach adds value. His view is that society has an underlying concept of what is “fair” and that this influences individual behaviour.  In all prisoner’s dilemmas a person can make themselves better off by changing their behaviour from cooperating to cheating but there is another motivation that keeps cooperation rates ahead of 50%. In Smith’s hands it is not because people are “stupid” or “irrational”, it is because they are part of a system.  He is never quite able to determine whether people are consciously aware that cooperation allows everyone to capture increased benefits from such actions or whether it is a subconscious order that has emerged.

When writing in 1776 Adam Smith viewed actions of individuals as being based on self- interest when he said “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”. Two hundred years later Vernon Smith has argued that self-interest is also influenced by the outcomes of others.  The outcome could be how they perceive our actions or how they might treat us in the future, and the outcome could also be what they get from exchange and interaction.  Fairness and reciprocity are important drivers of behaviour, not just inward-looking self-interest.

When viewed with the lens provided by Vernon Smith, many seemingly irrational actions do have a rational base. He may have been awarded the Nobel Prize for introducing experiments to the economist’s toolkit but his work has been much deeper than that.  This book is a deep look at human behaviour and interaction. Smith has broadened the narrow concept of rationality, and economics is much richer because of it.