# Understanding Classical Rationality at a Basic Level

I am a high school student in an intro Microeconomics class (note that we have not covered utility functions) and I'm utterly confused about the classical concept of rationality. I certainly understand that that conception does not accurately describe a good chunk of real-world behavior (hence behavioral economics).

Nevertheless, my concern which I ask about here is more basic: Classical rationality as described in my textbook (Krugman/Wells' Economics) doesn't even seem coherent. It's essentially just defined as "people act to make themselves better off," but then the book (and online sources) go on to conclude that, under this definition, it is irrational to, say, honor sunk costs.

But why need this be so? (again, I'm not even talking about behavioral economics, I'm just trying to understand the justification within the traditional paradigm) After all,suppose person A knows they will derive satisfaction from honoring sunk costs. Then doesn't honoring sunk costs make them better off (it fulfills their desire for happiness), and therefore becomes rational for person A?

I feel like there may be some restrictions to the traditional definition of rationality that my book and teacher have glossed over. Because right now I am utterly at a loss for how my book can draw such specific conclusions about what is rational and irrational when the definition of rational behavior given seems malleable enough to make virtually any action rational for at least some people.

• "People do X because they derive satisfaction from doing so" is a slippery slope. With this type of argument, you can pretty much justify anything and everything. – Herr K. Nov 28 '18 at 0:00
• @HerrK. Precisely my point, and thus my source of confusion. :) – Will Nov 28 '18 at 0:02
• This paper might help at section 2: princeton.edu/~tkelly/papers/… – Samuel Russell Nov 28 '18 at 5:19

(Bottom in bold is a partial TL;DR)

The definition your book gives you only seems incoherent because you take "people act to make themselves better off" (your book's definition) as the same as (or similar enough to) "fulfills their desire for happiness" (your characterization or additional characterization in the question you presented). Let's ignore the whole sunk costs aspect of this question for now, as I think it is a diversion from a deeper misunderstanding with your question.

Imagine if someone burned all their money because they believed doing so would cause it to grow back in the form of plants that sprout lots of 100 dollar bills. They may be acting in a way that makes them "happy" (at least for them), but one would be hard pressed to say they are acting in a way that makes them "better off". You can argue that "making themselves better off" encompasses some sort of foresight to it as well. Once the money burner realizes that there will be no money growing plants coming out of the ground, they will no longer be happy, so they will not have done what is rational even by the definition that you gave. Pursuing what makes you happy or what makes you well off, we would take it to mean to do this across your whole life, not just go off of what you think is right in the moment before thinking things through.

What if this money burner never became unhappy? What if they sat there and waited for money growing plants to sprout until they starved to death, and that they were still relatively happy the whole time? I don't think anyone would intuitively call this rational behavior.

So what confuses me about this question is that you accuse the book of not having a rigorous enough definition to encompass what rationality is; that is, you say sunk costs is a specific example where the book's definition of rationality doesn't fall in line with what we would find to be intuitive, or, fitting with your particular characterization of rationality, to "fulfill their desire for happiness". But your characterization of rationality has its own problems too.

Admittedly, the classical economic definition of rationality is not meant to completely match what laypeople would think of when they think of rationality. It is meant as part of a framework for thinking about economic issues in an organized way, and an introductory textbook is only going to try to give you a broad picture for how to think about the basic concepts, rather than bore you with the fine epistemological details of what it means for a good citizen to be "rational".

But even just using common sense, you can argue that honoring sunk costs is still "irrational".

A sunk cost is a cost that is unrecoverable, or not worth recovering due to opportunity costs. So when choosing to put extra money into a wide variety of other choices you have to pursue, you should not even be thinking about the money you've already put it. That's just logical sense. You might say, what if I put just a little more money into something and then I get a reward from it? Then the cost is not unrecoverable here, but is it worth recovering? For example, what if I was training a worker and they don't seem to be learning. Should I continue putting money into this worker if they might eventually learn? The answer here is that it would depend on the opportunity cost of just finding another worker who maybe will learn faster with less training and money. But people will get hung up on the money that is already put into the existing worker that you've already hired, and that is what characterizes the sunk cost fallacy. It is the failure to adequately consider the opportunity costs of alternative options that contextualizes how economists think about the sunk cost fallacy.

Maybe all this exposition is not very compelling or tedious to follow. In that case, let's just shoot straight here. What is the rigorous definition of rationality that contextualizes how economists talk about rationality?

From Microeconomic Theory by Mas-Colell, Whinston, and Greene, we have

Definition 1.B.1: The preference relation $$\succeq$$ is rational if it possesses the following two properties:

(i) Completeness: For all $$x, y \in X$$, we have that $$x \succeq y$$ or $$y \succeq x$$ (or both).

(ii) Transitivity: For all $$x, y, z \in X$$, if $$x \succeq y$$ and $$y \succeq z$$, then $$x \succeq z$$.

In laymen's terms, completeness just means you have an opinion on all your options, whether one is better, worse, or indifferent to any other option. Transitivity just means if you like one thing better than a second thing, and the second thing better than a third thing, you have to like your first thing better than the third thing.

Completeness is usually where this definition runs into some raised eyebrows. Very few people will consider every option with every other option. Some people may completely ignore certain options and not think about them. That is something for behavioral economics to look at. But this definition of rationality does not leave room for inadequate consideration of opportunity costs when thinking about sunk costs, which is the main concern when we talk about sunk costs.

If you do get some sort of intrinsic value from "honoring" a sunk cost, some sort of abstract happy feeling or whatever, then it is not necessarily irrational in the economic sense. But most likely if someone goes off of this feeling, maybe they are not considering every option, and that would make it irrational. With my example of the money burner at the beginning, you have to have some sort of realistic expectations of what you can do with your resources, the opportunity cost or pursuing some other course of action, and it has to have some sort of careful thought put into it. You can pursue whatever you like based on if it makes you happy, and you can argue that that is a more compelling version of what rationality is to real people. But economists use the sunk cost fallacy to show that going for what makes us happy in practice (we commit the sunk cost fallacy all the time) is not necessarily what makes you better off.

After all,suppose person A knows they will derive satisfaction from honoring sunk costs. Then doesn't honoring sunk costs make them better off (it fulfills their desire for happiness), and therefore becomes rational for person A?

Utility experienced from honouring sunk costs is treated separately from honouring sunk costs themselves. ( section 2 of http://www.princeton.edu/~tkelly/papers/Sunk%20Costs,%20Rationality,%20and%20Acting%20For%20the%20Sake%20of%20the%20Past.htm )

If I feel good for rescuing my phone from a toilet, or feel bad, that’s separate from the phone being in the toilet.

• Normally one explains a downvote to allow the answer to be improved. – Samuel Russell Nov 28 '18 at 8:10

In microeconomics people are rational if they act to maximize their utility function.

What goes into the utility function? Anything that is relevant when they choose, which is of course up to debate.

Often economists are content to accept a first order approximation of what matters and should therefore be included in the utility function, namely monetary compensation alone.

This might be a reasonable approximation of behavior in certain markets or situation. It is fair to assume that if sunk cost or previous debts are large enough than this would trump most considerations (would you not declare bankruptcy in almost any but the most peculiar circumstances if you owed several million dollars?). It might not be fair if costs themselves are small or there are future reputational costs (you'd probably enjoy more your friendship over 10 dollars).

Hi: I don't know what "honoring sunk costs" means specifically but rationality refers to the idea that people behave in such a way as to maximize their utility function. Since you haven't covered utility functions yet, then my guess is that, in this case, rational just means that people want to maximize their financial well being. So,I think the book is saying that honoring sunk costs is not consistent with that concept of maximizing one's financial well being. Therefore, honoring sunk costs is irrational behavior.