Irrationality As the Fountainhead of Market Failure

An excerpt from Chapter 4 of Unbeatable

May 27, 2025

Greetings from Doha, Qatar! The next excerpt from Unbeatable awaits.

[from Chapter 4: A World of Irrationality: The Best Case For and Against Government]

What’s the nicest way to say, “You’re wrong”? You could try blaming errors on “lack of information.” Better yet, accuse a villain of deliberately spreading lies. What you definitely don’t want to do is denounce the people in error as “stupid,” “foolish,” or “irrational.” As usual, however, there is a tension between being nice and being correct. Since flawed cognition and flawed information are both potential causes of error, we should be open to the idea that “stupidity,” “folly,” or “irrationality” caused any particular error.

On further reflection, however, we should be more than open to this idea. Why? Because a central feature of proper cognition is weighing the reliability of information! David Berkowitz, the infamous “Son of Sam,” claimed to murder on the orders of his neighbor’s dog. The obvious retort is: “Why would you heed a homicidal dog?!”[i] Similarly, if a stranger on social media insists, “Vaccines don’t work,” incredulity is the rational reaction. If you instead respond with fervent assent, blaming “misinformation” is misleading. “Don’t believe everything you hear” and “Consider the source” are common sense. If you treat Internet randos as authorities, blame yourself. As Homer Simpson once told his wife, “Marge, it takes two to lie. One to lie, and one to listen.”[ii]

Homer’s insight generalizes broadly. On homework problems, yes, unadulterated imperfect information can make mighty markets unravel into nothingnness.[iii] In the real world, however, “imperfect information” problems are usually thinly-veiled irrationality problems. You’re a consumer who can’t independently assess the quality of a product? Don’t despair: In the real world, you can rely on reputation. You’re a producer of a superior but unfamiliar product? Again, don’t despair: In the real world, you can build your reputation with enticing introductory offers and money-back guarantees. A little can-do common sense goes a long way.

Monopoly, too, is less harmful when agents are rational. Textbooks teach us that monopolies set higher prices as consumer demand becomes more inelastic. In the real world, however, “monopoly” is a matter of degree, and demand elasticity heavily depends on consumers’ willingness to shop around. If most consumers robotically pay whatever the market leader asks, they make demand highly inelastic. But shrewd consumers don’t sob, “I’m helpless before this monopoly.” They proactively search for alternatives – and play one off against the other. If you’re not in the habit of asking “Can you do any better on price?” for big-ticket items, try it and see for yourself how much you save. Common sense also tells consumers to be open to so-called “multi-part prices,” where you pay an up-front membership fee to get lower daily prices. A monopoly that faces such savvy consumers raises profits and slashes the deadweight cost of monopoly in one fell swoop.[iv]

Rationality even tempers the harm of externalities. Due to transaction costs, the most creative bargaining cannot solve all externality problems. But creative bargaining can solve plenty of externality problems – and rationality fosters creative bargaining. “The victim of a negative externality should try to ‘bribe’ the perpetrator to harm him less” clashes with knee-jerk notions of fairness. Ronald Coase famously took a whole evening to convert the University of Chicago econ faculty to the Coasean logic of bargaining around externalities.[v] The more people take his famous lesson to heart, the milder the externality problem becomes.