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1 January 2014 CFA Institute Journal Review

The Irrationality Illusion: A New Paradigm for Economics and Behavioral Economics (Digest Summary)

  1. Louis A. Lemos

The homo communitatis paradigm, an original framework for analyzing economic decisions, is presented. This framework is in the form of principles that articulate factors that affect choice. The authors demonstrate that traditional economic analysis is a special case of homo communitatis analysis in which key variables are absent.

What’s Inside?

The authors’ primary objective is to present an entirely new approach to economics and demonstrate that the appearance of irrationality, as the term is used in traditional economics, is an illusion. The field of behavioral economics is criticized as being an improvised approach of “psychological” factors grafted onto the standard neoclassical economic model to account for some of the model’s failures. The authors advance a new principles-based framework, not to replace the focus of the study of traditional economics (understanding the production and consumption of wealth, goods, and services) but to provide a better set of analytical tools for engaging with it.

How Is This Research Useful to Practitioners?

Practitioners have long recognized that client choices often do not conform to expected utility theory. This anomalous, or nonconforming, behavior is often said to be a demonstration of irrationality because the individual is not making decisions that are in his or her best interest. The authors contend that when viewed properly, such behavior can actually be seen as rational.

The authors point out that it is a fundamental fact in economics that all economic phenomena and data are the outcomes of actions by economic actors. They reason that it logically follows from this observation that the central focus of a comprehensive theory of economics must be the actions of people.

To provide a way to articulate the factors that affect choice, including aspects of individual behavior and the communities to which the actor belongs, the authors develop a framework in the form of seven principles. Using these principles, they show that the anomalies of behavioral economics are not irrational but give the impression of irrationality because of incomplete specification and control of independent variables illuminated in the principles.

The authors believe it would be a significant advance in the economics profession and the finance industry to understand the deficiencies of traditional and behavioral economic analysis—namely, that people are irrational if they do not seek to maximize expected value. Their new approach to analyzing economic decisions recognizes that people act on the truth as they understand it to achieve what they value, which is the core of rationality.

How Did the Authors Conduct This Research?

The framework the authors present (i.e., the homo communitatis paradigm) is in the form of seven principles: (1) “Choice” is choice of behavior; (2) “behavior” means intentional action; (3) human behavior is deliberate action; (4) people act on their reasons; (5) people choose what matters to them; (6) each behavior is an occurrence of engaging in a social practice of a community; and (7) for any individual, a state of affairs may be real, actually possible, or merely possible.

When expanding each principle, the authors’ approach is to clarify each situation by formulating economics as the outcome of behavior with a careful examination of the context of the situation. They demonstrate that such experimental results as loss aversion, framing effects, mental accounting, and judgment biases are not necessarily examples of irrationality and that irrationality is an illusion resulting from incomplete specification and control of the independent variables emphasized in the principles.

The authors discuss the need for future research, including particular models of socioeconomic systems, significantly more powerful and detailed economic simulations, and different experimental design approaches that take into account all the variables involved in human choice.

Abstractor’s Viewpoint

Although it is in its initial stages of development, the new paradigm presented by the authors is a thought-provoking alternative to traditional and behavioral economics for analyzing economic decisions. I would argue that in practice, clients would be better served by advisers not assuming that their clients are irrational if they do not conform to standard economic theories. Instead, advisers should recognize that there is a range of factors that affect economic choices and use the process developed by the authors to better understand their clients’ behavior, which is likely completely rational from their distinct perspectives.

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