How Markets Can Stimulate Rationality

Ilya Somin at Volokh Conspiracy has some interesting thoughts on whether "libertarian paternalist" arguments based on lab research hold up, and brings in a brilliant Hayek quote on how markets can help make irrational people tend to behave more rationally:

Advocates of "libertarian paternalism" cite experimental evidence showing that people often make irrational decisions, and argue that we need government regulation to guard against such problems….

One underappreciated fact about the experimental and survey evidence relied on by advocates of the new paternalism is that it models voter decision-making far more closely than market decisions. Unlike market participants, voters have little or no incentive to either acquire information about the issues they decide, or to analyze the information they do have in an unbiased fashion. The same is true, to a lesser extent, of libertarian paternalist policies established by expert regulators insulated from democratic control…. Such regulators may be more knowledgeable than voters. But unlike consumers, they do not have their own money at stake, and therefore don't suffer any penalty if they make mistakes, and don't have much incentive to combat any irrational biases they may have. 

By advocating increased government intervention in order to combat irrationality, the paternalists are arguing for a transfer of power to decision-making processes where irrationality is likely to be greater than it is in markets….

….the relationship between markets and rationality was well-described by F.A. Hayek. In Volume 3 of Law, Legislation, and Liberty, published over 30 years ago, he wrote:

Competition . . . is the method by which we have all been led to acquire much of the knowledge and skills we do possess. This is not understood by those who maintain that the argument for competition rests on the assumption of rational behavior of those who take part in it…. [R]ational behavior is not a premise of economic theory, though it is often presented as such. The basic contention of theory is rather that competition will make it necessary for people to act rationally in order to maintain themselves. It is based not on the assumption that most or all the participants in the market process are rational, but, on the contrary, on the assumption that it will in general be through competition that a few relatively more rational individuals will make it necessary for the rest to emulate them in order to prevail. In a society in which rational behavior confers an advantage on the individual, rational methods will progressively be developed and be spread by imitation. It is no use being more rational than the rest if one is not allowed to derive benefits from being so. 

Reason magazine ran a great feature back in our October 2007 issue on the false and biased economic assumptions that voters nonetheless hew to, at little direct personal cost to themselves.