However, obviously since humans cannot possibly process all of the available information (some of which is not only unknown, but unknowable), pure rationality is not possible, so as a theoretical foundation rational behaviour is pretty shaky. A recent Joshua Gans post about adult colouring books highlights this. He writes:
We don’t speak of it very often but economists face a fundamental challenge with respect to innovation: if innovation is something no one has anticipated, then the (Savage) axoims [sic] upon which we base our rational choice decision-making cannot apply.
Let me explain. Decision-making is all about actions and their consequences. Leonard Savage created the framework by which economics deals with this by assuming that all agents ‘look before they leap.’ That is, an agent would choose amongst actions available taking into account all possible states of the world and the consequences in each state. This requires agents to have complete knowledge of the state-action space...
And so we arrive at the adult colouring book. In 2015, three of the best selling books of the year were adult colouring books. In Canada it was 5 of the top 10 including the top 2. These sell for around $10.00 and have complex designs that would be challenging for a kid to colour between the lines. They are highly rated and sometimes seen as challenging and sometimes as relaxing.
So, here was a large profit opportunity that sat untapped for a long time (a multi-millions dollar note on the footpath). Colouring books have been around for decades, so the profit opportunity from adult colouring books is unlikely to have suddenly arisen in the last couple of years. So because nobody noticed this opportunity until recently ably demonstrates that people cannot be purely rational.
Which should come as no surprise to us. Herbert Simon introduced us to the concept of bounded rationality in his 1955 article "A behavioural model of rational choice" - the rationality of decision-makers is limited by the information that they have available to them, or that they can obtain at low cost (and note that Friedrich Hayek made a similar point (ungated here) a decade earlier, arguing that people make decisions based on local information). Which suggests that at least some profit opportunities might remain unexploited until some entrepreneur thinks of them, and that economics hasn't totally ignored the obvious.
[HT: Marginal Revolution]