Over the past forty years or so, behavioral economics has exercised enormous influence among economists and policy makers. One of its founding scholars, the late Daniel Kahneman, won the Nobel Prize in economics in 2002. Another of its contributors, Richard Thaler, was awarded this prize in 2017, while another of its champions, Cass Sunstein, served as head of the White House Office of Information and Regulatory Affairs (OIRA) in the Obama administration.

Behavioral economists have documented in human beings several behavioral quirks that allegedly undermine much of the legitimacy of neoclassical and Austrian economics. Because economists who work in these traditions (which is most of them) assume that individuals are rational – and because the quirks that behavioral economists document are seemingly irrational – the findings and implications of neoclassical and Austrian are said by behavioral economists to be suspect.

An example of a behavioral quirk is the endowment effect. A fully rational person who is unwilling to pay $1,000 for a particular vase would, if he already owned this vase, be willing to sell it for $1,000. After all, the vase either is or isn’t worth $1,000 to him. But behavioral economists routinely find that individuals who are unwilling to pay certain prices to acquire particular things are, if they already own those things, nevertheless unwilling to sell them at those same prices.

Merely being “endowed” with ownership of something seems to make that thing worth more to its owner. Behavioral economists assume that there is no rational reason why mere ownership of something should make that something more valuable to its owner than it would be if the person did not yet own it. These economists therefore conclude that the endowment effect is evidence of human irrationality. (Whether or not the endowment effect really is evidence of irrationality can be questioned. But for purposes of this essay I take it, and other findings of behavioral economics, at face value.)

There’s no disputing that each person sometimes behaves in ways that conflict with, rather than promote, his or her own well-being. Many of us succumb to the temptation to eat that piece of cheesecake even though we know as we’re eating it that we’ll later regret the decision. (“A moment on the lips; a lifetime on the hips.”) Many of us also know that we should save that $2,500 for our retirement rather than spend it on a new sofa, but we spend it on the sofa anyway.

It’s tempting to join most behavioral economists and conclude, based on their findings, that laissez faire is a lousy policy. Given humans’ cognitive and psychological weaknesses, how can we trust markets regulated only by the basic laws of property, contract, and tort – that is, markets not regulated in detail by officials whose jobs are to ensure that markets function properly – to generate outcomes that serve the general interest?

Asked differently, doesn’t human weakness and irrationality make the invisible hand of Adam Smith at least somewhat palsied if not completely lame? And, if so, doesn’t a palsied hand need some conscious guidance from caring attendants?

No.

The case for the market doesn’t require that each of us behave in textbook rational fashion. One of the great benefits of free markets is that they both reduce the frequency of irrational behavior and temper the ill consequences that would otherwise occur when people do – as of course they sometimes do – behave irrationally.

Finding that people sometimes behave irrationally says nothing about the frequency of such behavior. By imposing costs for mistaken behavior on the individuals who behave mistakenly, as well as by rewarding people who behave prudently with personal benefits, markets reduce the frequency of irrational behavior.

If Steve, an adult, makes choices that harm Steve, then Steve has incentives to correct his behavior. At a minimum, no one else has stronger incentives than does Steve to ensure that Steve avoids self-destructive actions. If Steve is shielded from having to suffer the consequences of his choosing unwisely – and if he’s blocked from enjoying the consequences of choosing wisely – then we can be sure that Steve would behave irrationally more frequently than he will when the consequences of his choices fall heavily upon him. Indeed, the fact that we are not hard-wired always to act rationally and prudently strengthens rather than weakens the case for laissez faire capitalism. For that is the system that best motivates individuals to avoid irrational and self-destructive behavior.

Another reason why the findings of behavioral economics do not undercut the case for free markets is summarized by the marketing slogan used in the late 1970s by AT&T: “The System is the Solution.” The case for free markets rests chiefly upon the recognition that the competition and feedback within markets tend to weed out firms and practices that do not satisfy human desires. No one acting within markets needs to aim at generating beneficial system-wide outcomes. Such outcomes emerge spontaneously, as FA Hayek was understandably fond of repeating. They emerge through the feedback-intensive interactions of millions of people, each with his own limited knowledge and personal weaknesses.

The market system fuels and magnifies those practices that people discover through experimentation to be useful and starves and shrinks those practices that people discover to be useless or harmful.

Adam Smith understood that the system is the solution when he wrote that beneficial market outcomes are the result of an “invisible hand.” Another Smith – the economist Vernon Smith, who shared the Nobel Prize with Kahneman – calls the rationality of the market system “ecological rationality,” which he shows is quite real even when many individual actors are less than rational.

A nice description of the importance of the market system appeared a while back in an article by Washington Post columnist Sebastian Mallaby. He agreed with behavioral economists that individual investors are frequently irrational – that they “overreact to new information, extrapolate trends too far into the future and value a gain of, say, $100 less than they fear a loss of the same amount.” Surely such irrational behavior undermines the efficiency of markets.

Not so, observed Mallaby:

By turning these insights into trading strategies, hedge funds sold irrationally expensive assets and bought irrationally cheap ones, moving prices closer to fundamental value. In their ceaseless search for profits, hedge funds have sought out inefficiencies on the financial frontier. After Hurricane Katrina, some traditional insurers recoiled from covering offshore structures, a classic example of overreaction to a bad event. Hedge funds hired academic climatologists, crunched the numbers and made a tidy profit by underwriting storm risk.

In other words, individuals’ own irrationalities provide incentives for savvy entrepreneurs to devise ways of profiting by correcting the ill consequences of these irrationalities. The result is the “ecological rationality” identified and celebrated by Vernon Smith – namely, the rationality of the market system.

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Obviously, there is much more to be said about behavioral economics. For an excellent assessment of it I recommend the 2020 book by Mario Rizzo and Glen Whitman, Escaping Paternalism: Rationality, Behavioral Economics, and Public Policy.