Mankiw’s Principles of Economics Part 3: Rational People Think At The Margin

The introduction to this series is here.
Part 1 is here.
Part 2 is here.

Mankiw’s third principle: Rational People Think At The Margin. His definition is:

Rational people systematically and purposefully do the best they can to achieve their objectives, given the available opportunities.” Principles of Macroeconomics 6th Ed. at 6

He defines marginal change: a small incremental adjustment to a plan of action. He teaches that rational people often compare the results of marginal changes to make decisions. Finally we get to his major premise:

A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost.

The first example is dinner. The choice, Mankiw says, is not between fasting and eating like a pig, but whether to eat another spoonful of mashed potatoes. At exam time, the choice is not blowing them off versus pulling all-nighters, but whether to put in an hour on your notes or goof off for that hour. His next example is seat prices for airplanes. The airline should sell seats at the price above the marginal cost of flying the passenger. Then we get the water/diamonds example. Water is essential for life, but it’s cheap. Diamonds are an extravagance, but they are very expensive.

All of this is in support of a central element of neoliberal and mainstream economics, that economies can be modeled by treating them as made up of rational agents. This idea fits neatly into Mirowski’s commandments of neoliberalism, specifically number 6: Thou Shalt Become The Manager Of Thyself. This means that individuals must learn to act rationally to decide upon a set of investments in themselves and changes in their behavior that will improve your appeal to people with money so they will give you money to work for them.

The food example is straight-forward enough, but how is the choice made? Some people are raised to clean their plates, and they do even if they could have skipped the last few forkfuls. Some people feel differently about meat than about French fries or carrots. Some people are abstemious, and always leave food. Others make the choice at the outset, by serving themselves a fixed amount and then eating all of it. Suppose the person would prefer to eat the last few bites of pork chop and skip dessert? If all these are rational choices for individuals, what possible generalization about eating is there? What, if anything, can this principle predict? How would Mankiw use that idea to model eating dinner?

The study example is fascinating. I remember my college days, and I ‘m sure I didn’t rationally choose whether to goof off with my friends or to study for finals. I chose, but it was random. And how would you calculate the benefit of one hour of study versus one hour of relaxing? Is that a real possibility?

The airline example is obvious to anyone familiar with basic business principles. It certainly isn’t an indication of “rationality” in the sense Mankiw is using the term. It merely requires an understanding of the difference between fixed costs and variable costs.

Then there’s the water/diamonds example. Here’s Mankiw’s explanation, so you won’t think I’m being snarky:

The reason is that a person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.

So water is cheap because people have a lot of it? Of course, there is plenty of water in most parts of the country, in our commonly held lakes, rivers, underground acquifers, and water run-off. As a commonly-owned asset, it’s free, if you could get it. But it has to be cleaned, delivered, and disposed of. That means the real question is why do we have a lot of clean water at the tap and few diamonds? The real reason is that our ancestors decided to make sure we all had clean water to drink, and explicitly chose to keep the “free market” out of it.

There are plenty of diamonds, though they are hard to find and dig up. The diamond business is controlled by a monopoly that artificially restricts the supply. Our ancestors made sure that didn’t happen to water. To see this clearly, think about the price of a bottle of water at the movies. There we have artificial scarcity, produced by the theater’s policy against bringing in snacks. Just ask yourself whether you want to buy your water from a profit-maximizing monopoly, say the Comcast or the DeBeers of water. Maybe you’d like to buy your water from the private company that didn’t have a system in place to detect the foul chemicals in the water supply of Charleston, WV?

So now let’s see how this rationality principle works in practice. Consider retirement savings. What would it mean operationally to say that people act rationally when making decisions about saving and preparing for retirement? What does this principle tell them to do? How should they invest? What should they do to protect themselves against losing big in those investments? What happens if they are hurt and can’t work, or if their spouse gets hurt and they need to quit work to take care of them? How do you calculate the value of a dollar today against the value of that dollar in retirement? For a short lesson in the prevalence of financial literacy, look at this paper, or this site.

Finally, it isn’t just one choice. There is a chain of choices in life, each one eliminates other choices and creates new choices and possibilities, each with its own probability of success. In the retirement example, you might have a 75% chance of correctly guessing at how much to save, a 95% chance of getting an honest financial adviser, a 60% chance that the investments will be very successful, and related chances of less good outcomes. Your chances of getting the best result are about 43%, and that’s before you consider the general state of the economy when you need money, continued good health, unexpected possible current uses for your money, good relations with your partner and your partner’s success in contributing, and all the other variables. That tells you that most people will be somewhat successful, a few will be wildly successful, and a fair number will crash and burn. The reality is that most families have very little success, and are dependent on Social Security and Medicare for a decent retirement. Even people who do reasonably well need those social arrangements to secure a good retirement.

This analysis shows that the margin plays little or no role in the lives of ordinary humans. It’s just a construct used to simplify human life in a way that permits economists to justify their use of calculus.

Here are some possible conclusions:

1. This principle makes sense when considered in the very short run, like the mashed potatoes example. For any longer term, it feels more or less random, mostly because there is no way to determine the probabilitiies. Some people get lucky and win the game of life. Others don’t get lucky. The number of things that seem perfectly rational at a point in time either work, or they don’t, and the results are unpredictable. That accords with my understanding of markets as minute by minute affairs. In the longer run, investment and housing markets are a real threat to the marginal thinking of Mankiw’s rational people.

2. We all want to think we are pursuing their goals systematically and purposefully, Mankiw’s definition of rational people. We want to believe our success is the result of their personal skill, and many people apparently feel justified in looking down on, and even punishing, the losers. I’d say the reality is that it’s better to be lucky than rational.

2. By deciding that the economy is full of rational people, the door opens to armchair speculation. Hmmm, says Mankiw, if I were faced with a bowl of mashed potatoes, here’s how I’d decide how much to take. I’m rational, so that means everyone would act that way. So, I’ll model mashed potato eating based on purely rational me. In exactly the same way, they figure out how they prepare for retirement, and draw conclusions about the way rational people act and build that into their models. No.

3. I do not think this is the definitive discussion of the role of rationality in human decision making. The entire subject of rational agents has been subjected to criticism on philosophical and practical grounds, and I hope to get to it at some point.

10 replies
  1. Eric Zuesse says:

    I am trying to reach Ed Walker, because a leading publisher is seeking referees and/or endorsers of my book-manuscript which will replace existing microeconomic theory, and all macroeconomic theories that are based upon existing microeconomic theory. (It provides the missing microeconomic foundations for Keynesian macro.) One major economist, and one major investigative journalist on finance, have already endorsed it. I want to recommend to the publisher Ed Walker, but I don’t know his email address. He can reach me at [email protected] and I shall be happy to send him the .pdf of the work, for him to consider either refereeing and/or endorsing the work.

  2. jerryy says:

    One problem you have started to take a good look at in this essay that is (usually) not discussed in context is how an individual may attempt to make rational decisions based upon their perceived self-interest, but these conflict with other ‘guidances’ for lack of a concise term. Yeah, I know, there is always ‘societal interests’, but that is too bland.

  3. Alan says:

    It’s just a construct used to simplify human life in a way that permits economists to justify their use of calculus.

    Yes, they strip out context, culture, and everything that matters in human relationships. No wonder it’s a nonsense science.

    • earlofhuntingdon says:

      Indeed. That’s DeBeers most important job, to keep their products off the market.

      If economic actors are so rational, why are so many billions spent annually on marketing, advertising, company promotional materials, professional apologies (which say so little and promise so much), and so-called “independent” evaluators that provide triple-A ratings?

  4. orionATL says:

    as for diamonds, i use lots of them, thousands, for cutting and sharpening. they are manufactured, not mined, and they are cheaper by far than mined diamonds and do as well or better at the jobs where i need the hardness of diamonds.
    mankiw might have considered “satisficing”:
    developed by herbert simon and others:
    there’s plenty here to skip over while still getting the general idea.

    • orionATL says:

      let’s put microeconomic’s “rational” decision making under the microscope. say a person, a president of the u.s., decides to promote and consumate the invasion of a country that poses no threat to the u.s. we will treat this as a single instance of decision making, like a choice for more helpings of a food.

      in what way is this president’s decision rational (not allowing plays on words) ? in what way does it maximize? whether it maximizes or not, in what way is it a useful to the president? need it be useful also (or solely) to the president’s country?

  5. TarheelDem says:

    The real reason is that our ancestors decided to make sure we all had clean water to drink, and explicitly chose to keep the “free market” out of it.

    The fact that this inclination to treat important resources as infrastructure, even for most of the history so far of capitalism, means that there are some fundamentally different economic principles that the purity of neoliberal thought and prescriptions seeks to destroy. One of the communities I lived in as a kid, which was the first to electrify so smitten of progress were they 100 years ago, would not turn a city water system into a county on and and would not allow annexation by the city (because taxes). It now has a patchwork of private water companies outside the city limits. That system must soon collapse under pricing (like Detroit’s water system) even in water rich South Carolina. Ideology blinded decision-makers and profiteers.

    What I see in Mankiw’s “rational people” is the command to all people to become his “rational people” if they seek any hope of survival. It’s the underlying principle of “every person and entrepreneur regardless of skills” or “every person must sell themelves”. Only the deep-pocketed risk-takers and the prostitutes can survive in that system. That is far from describing what is, the pretense that neoliberal economics uses to defeat alternatives. “That’s not the way the world works.” What Mankiw has created is a class of institutions run by his acolytes (really the acolytes of neoliberal economics) whose mission in life in those institutions is to “make it true”.

    It is false. It is killing people. It is plundering. It’s time it stopped.

    We have been burdened by the Enlightenment with the duty of being “rational”. If we reckon, we pass that test. Under what circumstances does reckoning at the margins make better decisions is a more appropriate thing for theory than to assert that we do (or we should) as an assumption of human life.

    And what is it we are saying we are doing in “reckoning”? (I’m told that’s what folks using reason, rational people, do.) What operations are involved in that? Logic? More than logic? How does that operate as practical reason?

    And when is it that economics got reduced from robbing nature, producing and distributing to mere decision-making? When did politics completely subsume political economy?

  6. Malkovich says:

    Thanks for discussion retirement plans. It’s one of the things that irks me the most. I, as a non-finance person, am expected to understand how to choose investment funds correctly so that in 30 years I can still live comfortable after time inevitably pushes me out of the workforce. The idea that every adult in America needs to self educate themselves in monetary investments is a joke that leads the elderly succeeding or failing often through no fault of their own. We should be guaranteeing that every person can live without worrying about necessities throughout their life.

  7. Synoia says:

    “economies can be modeled by treating them as made up of rational agents”

    Consequently, Fear and greed (both completely rational at all levels) do not control markets, market crashes are predictable, and Chaos theory has no application in human affairs or economics.

    Thank you Mankiw. It’s nice to know this.

    Mr Mankiw, do you have some proof to your thesis, perhaps case studies, or some tests, with documented results, that is: some other small part of the “scientific method” so beloved by rational people, or is your argument dogma, so beloved by what appears to be knee-jerk irrationals.

    Emphasis on the “jerk” part of knee jerk.

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