Economic theory bases on a fundamental principle that humans make rational choices.
A rational choice to my understanding, is to make a logical decision that would make you better off than your current situation.
There is a famous game – “Ultimatum Game”, which displays the irrationality of humans. There are many versions but I shall use a simplified example here to let you know the essence of the game:
Imagine you and I are playing the game.
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A banker will pass you $100 and share it with me.
You can offer any amount to me, for example, $1 for me and $99 for yourself.
But I must agree to the arrangement you proposed for both of us to keep the money. If not, none of us gets to keep the money.
The rational choice for me is that I should accept anything you offer, even $0.01, because it is still better than nothing. I would be $0.01 richer. This is the rational choice that economics expect you to take.
But humans are weird. If you offer me $0.01, I think this is unfair, because I know you will take more than me.
To ‘punish’ you, I decided to reject your offer, and both of us gets nothing. This is an irrational choice as both of us did not gain from it. But I am happy.
If you think that the stakes matter, then there are studies that show it does not. Studies by Cameron and Hoffman et al. have found that the higher the stakes are the closer offers approach an even split, even in a 100 USD game played in Indonesia, where average 1995 per-capita income was 670 USD. Rejections are reportedly independent of the stakes at this level, with 30 USD offers being turned down in Indonesia, as in the United States, even though this equates to two week’s wages in Indonesia.
If our economic theory bases on rationality, and it is false, isn’t it a worry that the policies that our economists made, would not yield the effects that are expected to solve our problems?
You can also watched the short video clip of the TV series, “Numb3rs”, which explains the Ultimatum Game: