Market Competitiveness and Rationality: A Brain-Focused Perspective

In books and articles, I have laid out problems with behaviorists’ findings.2 I have also developed a new take on neoclassical economics—dubbed “brain-focused economics”—under which I have posited rationality as an endogenous variable, optimized by the brain to achieve the most gains it can from its scarce internal resources. Using neoclassical deductive methods, I can deduce many behaviorists’ decision-making flaws.

Here, I review some basic tenets of brain-focused economics, explaining how my optimal rationality is more rational than perfect rationality and how many behaviorists’ declared “irrationalities” can be construed as rational and welfare enhancing. I then apply brain-focused thinking to a question that would not occur to neoclassicists: How does the intensity of market competitiveness affect people’s brain-based optimum rationality and, thereby, the economic gains from markets? My brief answer is that competitiveness, beyond some level of intensity, can make people more self-serving, rational, calculating, and profit-maximizing than many market participants would prefer—just as it can force producers to accept lower-than-preferred prices.

Essentials of Brain-Focused Economics

Neoclassical economists start their analytics by assuming that resource scarcity is pervasive, and people are the ultimate seat of rational decision-making. The scarcity problem, however, is not taken into consideration within the human brain, given neoclassicists’ perfect-rationality premise, which makes decision refinements costless.

Neoclassicists defer to Milton Friedman’s justifications for “unreal” assumptions: They make thinking about complex human interactions manageable. If unreal assumptions ease the analytics with no loss of predictive power, then why not use them?3 Behaviorists have laid out how people fall short of neoclassicists’ predictions based on perfect rationality: People do not consistently choose welfare-maximizing options. They don’t ignore sunk costs, fail to consider opportunity costs, and succumb to over 200 cognitive biases, including salience and loss-aversion biases, deemed “irrationalities.”

Under brain-focused economics, the seat of rationality and decision-making is shifted to the human brain, the ultimate scarce decision-making resource. It has 86 billion neurons, with trillion of connections, but the demands on those neurons (and needed energy) from its own mental operations, all bodily organs, and massive inflows of sensory information—maybe ten million bits per second when it can handle no more than fifty per second—are enormous.4

The brain must cope with its information overload by not considering much sensory data and then by submitting a minor portion for cognitive processing. Its sensory overload problem is self-evident in how frequently people misplace their keys and forget appointments—and in neoclassicists’ use of simplified models, as well as the many irrationalities behaviorists have identified.

To cope with its scarcity problems, the brain must have evolved some rational capacity to allocate its own resources, including abilities to identify, evaluate, and choose among data inflows to determine courses of action. The brain’s internal allocation decisions must be guided by some general value maximization goal, as neuroscientists have found.5

At the same time, the brain could not have evolved to be perfectly rational. Those protohumans who tried perfect decision-making would likely have starved or been eaten as they wasted neurons and energy refining their decisions. Protohumans’ brains likely devised a capacity to develop imperfect but adjustable decision algorithms for decision categories, for example, catching fly balls in baseball, as well as for the market effects of price changes. Evolution should have provided survival benefits to those protohumans with brains that evolved error-prone algorithms but with a survival- (and welfare-) improving success rate, meaning with the error costs less than the mental costs of weighing decisions separately.

Human brains must also have evolved to judge and adjust their decision algorithms the same way financial managers evaluate and adjust investment portfolios—with an eye toward their portfolios’ relative overall performance. Human brains can be resistant to immediately adjusting their algorithms with decision errors (or irrationalities), given that those algorithms must be tested over a range of decisions within some relevant time period. Rational brains will want to see mounting evidence that the mental costs of adjustments are more than offset by the net benefits of less error-prone algorithms. Faulty algorithms can be retained because the replacement costs exceed the costs of continuing flawed decisions. Hence, many of the behaviorists’ identified “irrationalities” can be construed as promoting the brain’s overall rationality.

Neoclassical economists have largely ignored, understandably, behaviorist Dan Ariely’s insistence that the law of demand be shelved because he has found violations.6 The generality of Ariely’s conclusion is suspect, given his limited research methods, and the law of demand has been supported in a multitude of price-change studies.

Adam Smith declared that people have an innate “propensity to truck, barter, and exchange.”7 I suggest that propensity evolved partially because specialization and trade enable the brain to limit the range of its decisions and improve their rationally, generating fewer decision errors, an efficiency gain understandably missed by neoclassicists assuming perfect rationality.8

Optimal Rationality

In refining its decisions, the brain should have evolved a proclivity to weigh decision refinements on the margin, or to continue to refine decisions so long as the added benefits of refinements exceed their added costs.

Marginal refinement costs can be expected to rise with added refinements (at least beyond some point) because of familiar neoclassical considerations: First, there can be diminishing returns in shifting neurons into developing refinements. Second, added refinements will draw neurons from progressively more valuable alternative mental and physical operations. In addition, as the brain approaches maximum neuron use, its cognitive efficiency can fade, given increasing electrical and chemical communication problems across tightly-packed neuron networks, experienced as confusion and frustration.

Any marginal cost curve describing rising decision costs will necessarily become vertical at some level of rationality short of perfection, given the impossibility of perfection. Any marginal benefit curve for decision refinements should (beyond some point) be downward sloping, reflecting diminishing marginal benefits and a rational brain’s preference for making refinements in descending order of value.

The resource-constrained brain will settle on that level of rationality where the marginal values are equal, which I dub optimal rationality, falling short of perfect rationality. From my perspective, perfect rationality is necessarily suboptimal (and irrational), resulting in a welfare level less than achievable.

Market Competitiveness and Rationality

Neoclassical economics leaves no room for variations in institutional settings, such as market competitiveness, affecting market participants’ rationality and assessments of competitiveness. Market participants’ rationality is fixed at perfection.

In defending neoclassical methodology, Friedman suggested how competitiveness can affect people’s rationality: People prone to persistent irrational decisions will be pressured to act more rationally, or they will lose market position to more rational competitors: “The process of ‘natural selection’ thus helps to validate the [perfect rationality] hypothesis … [I]t summarizes appropriately the conditions for survival.”9

Friedman never considered how rationality might vary with market competitiveness, but there are reasons to expect a functional tie. Consider decision makers’ rationality under pure monopoly. With prohibitive entry barriers and monopoly rents, monopoly decision makers can relax on the accuracy of their production and pricing decisions, soaking up some of the potential rents (through so-called “agency costs”). In the process, they can reallocate their scarce neuronal resources to resolve, say, personal problems on the job. Investors’ ability to monitor and suppress such agency costs will be thwarted by the absence of comparative firm performances.

If entry barriers are lowered, an otherwise monopoly producer will face added pressures from an expanded market output, a lower product price, and a cut in monopoly rents that might otherwise be siphoned off in relaxed decision-making. Once-protected monopoly producers will be pressed to monitor their employees’ decisions more carefully, and to push for greater profit-maximization. If other competitors studiously consider opportunity costs and engage in marginal thinking, then the former monopoly producer will be pressed to follow suit, upping its rationality. The greater the market competitiveness, the greater the pressure on rational thinking.

Neoclassical economists have long noted how more intense competition can improve welfare from improved efficiency in external (non-brain) resource allocations. They’ve assumed away the brain’s allocation problems. From my perspective, a progressive movement away from a monopoly market toward more intensely competitive markets can result, at least for a time, in the value of the improved external resource reallocation outpacing the net mental costs from people thinking more rationally. But, beyond some point, the added mental costs from the added competitive pressures can exceed the value of the external welfare gains.

Extending market competitiveness to perfect competition is seriously problematic: Producers must then operate on a knife’s edge, always teetering on the brink of being driven from the market with the slightest relaxed, irrational decision. Perfect competitors have no profit cushion to cover agency costs. They must face serious mental stress, having to use their limited mental resources for upgrading (if not perfecting) decisions, pushing their decision precision beyond their individual rational optimums.

Even competitors subject to less perfect market pressures may prefer not to precisely calculate their production levels. However, given their prisoner’s dilemma positions, they are induced to refine their calculations. Competitors may also prefer to charge self-defined “fair” prices and wages or to abate pollutants, but their market position may be too precarious for such (“socially responsible”) giveaways.

Even when competitors have some product pricing power, financial market pressures can force them to charge profit-maximizing prices, for fear that their capital will move elsewhere. Those same pressures can push competitors to test legal and norm boundaries and to go through weak points, meaning that growing competitiveness can, beyond some point, erode faith in the market system and give rise to greater calls for regulations intended to corral market competitiveness from market critics and competitors.

All competitors can end up in a tragedy of the commons in which they are more calculating, rational, self-serving, and profit-maximizing than they would prefer, as well as with lower-than-preferred market prices and little to no economic profits.

Some (if not many) people can be expected to dislike intensely competitive markets because of excessive mental strain. No entrepreneur in his right (rational) mind would invest, produce, and work in perfectly competitive markets, given the implied mental strains and the competitors’ inability to recover, through above-marginal-cost pricing, their upfront development costs.10

Investors and workers will understandably favor market opportunities in which entry barriers exist or can be developed. Many people obviously choose to work in post offices and not at private delivery companies, at universities and not on Wall Street, and in state bureaucracies and not in real estate firms because of moderated competitive pressures, which translate into lower pay but less work and fewer mental demands, yielding net welfare gains. This suggests that variations in the competitiveness of markets (and non-profits) can be welfare-enhancing because they allow people to sort themselves according to their competitive/mental-stress preferences.

Neoclassical economists have a difficult time understanding the growing hostility toward markets—and capitalism—and the growing affection for market controls (say, tariffs). The brain-focused perspective suggests a market-based explanation, albeit partial, if mental scarcity is acknowledged. People may strive to be rational—and calculating, self-serving, and profit maximizing—but only up to some optimal degree. Competitive pressures can become so intense that many people would prefer constraints on competitiveness, accepting a loss of some income gains to face lower market pressures.

This suggests that people’s growing disaffection with markets can be partially explained by the growth in global-market competitiveness, fueled in part by the downfall of communism in China, beginning in the late 1970s, and in the Soviet Union, beginning in the late 1980s, as I’ve explained elsewhere.

Conclusion

Conventional neoclassical economics has served economists well for more than a century. Many predictions, from the impact of rent controls to monopoly pricing, have been repeatedly validated in empirical tests. However, as behaviorists have shown, neoclassicists’ methodology needs an upgrade, mainly because its founding premise, perfect rationality, leads to an array of decision-making predictions at odds with observations.

I have also shown how rationality can be treated as a variable, subject to change in response to, in this case, market competition. My approach predicts that perfect competition will not, and cannot, exist—first, because no one would invest in the development of a product for such markets and, second, because no one would likely choose to operate under the mental demands of such market conditions. The mental demands of intensely competitive markets help explain the dominance of market structures far less competitive than perfect competition, the (wrongly) supposed epitome of market efficiency.

Finally, my proposed shift in the seat of rationality opens new avenues of scientific inquiries. For example, my shift permits economists to connect findings in neuroscience on, say, drug use, food deprivation, and personal freedoms with changes in people’s rationality and, thereby, competitive market efficiency. In addition, my proposed approach can accommodate explorations into the feedback loops between changes in market efficiency and people’s rationality.

Footnotes

[1] See Thaler, Richard H and Cass R. Sunstein, 2009. Nudge. New York: Penguin Books, p. xiii; and Kahneman, Daniel. 2011. Thinking, Fast and Slow. New York.

[2] See “Predictably Irrational or Predictably Rational?” Library of Economics and Liberty, January 4, 2010; and “Of Diet Cokes and Brain-Focused Economics.” Library of Economics and Liberty, March 5, 2018.

[3] Friedman, Milton, 1953. The Methodology of Positive Economics. Chicago: University of Chicago Press, p. 13.

[4] As reported in 2016. “Human Brain Can Store 4.7 Billion Books,” The Telegraph, January 21. See Nease, Robert, 2016. The Power of Fifty Bits. New York: HarperBusiness.

[5] Glimcher, Paul. W. 2013. Neuroeconomics: Decision Making and the Brain. New York: Academic Press.

[6] Ariely, 2008. Predictably Irrational, pp. 51-53.

[7] Smith, Adam. 1759. The Theory of Moral Sentiments. Indianapolis: Liberty Fund, 1982), bk.2, p. 2, par. 1.

[8] See my 2018 article “Brain-Focused Economics: More Than Just Comparative Advantage,” Regulation, summer.

[9] Friedman, Milton 1966. Essays in Positive Economics. p. 20.

[10] See McKenzie, Richard B. and Dwight R. Lee. 2008. In Defense of Monopoly: How Market Power Fosters Creative Production. Ann Arbor, Mich.: University of Michigan Press, especially chap. 9.