Studies in behavioural finance often highlight the ‘irrationality’ of an economic agent in making decisions. This may just boil down to the definition we use for rationality, which may not necessarily in itself be rationally justified.
We can start by looking at other uses of the word ‘rational’ in the philosophy of science. The Scottish empiricist David Hume  asked “What reason do we have for thinking that the future will resemble the past?” There is no contradiction in supposing that the future could be totally unlike the past. It is possible that the world could change radically at any point, rendering previous experience useless. This is known as the problem of induction; we have no rational basis or reason to expect the past to resemble the future. A famous example attributed to Bertrand Russell is that of a turkey, which is fed every day at 9am for 364 days of the year; the next day the turkey walks out assuming a bowl of food will be waiting and instead the farmer wrings its neck and cooks it for Christmas dinner. There have been a number of attempts to tackle the problem of induction. Karl Popper claimed to solve the problem of induction using the principle of falsification, which can be summarised with a quote attributed to Einstein, “No amount of experimentation can ever prove me right; a single experiment can prove me wrong.” This sentiment is strongly highlighted by the example of Newton’s laws; the most tested and confirmed laws in the history of mankind yet they were proven to be ‘incorrect’ in certain situations and were eventually displaced by Einstein’s theory of relativity.
The definition of rationality in this context relates to deductive reasoning, where if the premisses of an argument are true, then the conclusion is guaranteed to be true – how can inductive references be rational when the conclusions are not guaranteed by the premisses? Normal usage of the word rational is not strictly limited to deductive reasoning; people would class it as one species of rational argument. At the same time nearly everybody applies the term rational to other types of reasoning and in particular to inductive reasoning. If two people designed a bridge, one of whom had already successfully built ten previous bridges out of steel, the other wants to build his bridge from butter, which would people rather walk on? There is no logically guarantee that the steel bridge will not collapse and equally there is no logical guarantee that the bridge made from butter will collapse. Most people would, by definition, say the builder making his bridge from steel is rational because he has designed his bridge using tried and tested techniques derived inductively. This is the ‘paradigm case argument’; what more is needed to show that inductive reasoning is rational than everyone agreeing that it is rational.
Another analogy used to defend the rationality of inductive reasoning is put forward by Peter Strawson. If someone is concerned whether a particular action is legal they can consult the law books; but what if they were to ask if the law itself was legal. The law is a standard against which the legality of other things is judged, and it makes little sense to enquire whether the standard itself is legal. Strawson argues that the same applies to induction. Induction is one of the standards we use to decide whether claims about the world are justified; so it makes little sense to ask whether induction itself is rationally justified.
The logical positivists acknowledged the problem of induction but they took a pragmatic approach and did not see this as a problem in practice – “if an observation to which a given proposition is relevant conforms to our expectations, the truth of that proposition is confirmed. One cannot say that a proposition has been proved absolutely valid, because it is still possible that a future observation will discredit it”. In response to Popper’s solution by falsification Ayer states “If a proposition is consequence of an unfavourable observation, one cannot say that it has been invalidated absolutely. For it is still possible that future observations will lead us to reinstate it”. Ayer rephrases the definition of rationality in relation to induction –”There is no absolute standard of rationality, just as there is no method of constructing hypotheses which is guaranteed to be reliable. We trust the methods of contemporary science because they have been successful in practice. If in the future we were to adopt different methods, then beliefs which are now rational might become irrational from the standpoint of these new methods. But the fact that this is possible has no bearing on the fact that these beliefs are rational now”.
The classical definition of ‘rationality’ of economic man, homo econimicus – In economics, sociology, and political science, a decision or situation is often called rational if it is in some sense optimal, and individuals or organizations are often called rational if they tend to act somehow optimally in pursuit of their goals. Thus one speaks, for example, of a rational allocation of resources, or of a rational corporate strategy. In this concept of “rationality”, the individual’s goals or motives are taken for granted and not made subject to criticism, ethical or otherwise. Thus rationality simply refers to the success of goal attainment, whatever those goals may be.
There is extensive literature in behavioral finance relating to economic irrationality and cognitive biases – the assertion of irrationality is typically framed within the narrow definition of homo econimicus. A classic example of conventional irrationality is found with the Ultimatum Game – an experimental economics game in which two players interact to decide how to divide a sum of money that is given to them. The first player proposes how to divide the sum between themselves, and the second player can either accept or reject this proposal. If the second player rejects, neither player receives anything. If the second player accepts, the money is split according to the proposal. In principle if an unfair proposal (e.g. 95% for me 5% for you) was made by the first player it is strictly speaking still rational for the second player to accept the offer. In practice this rarely happens and the second player will reject the offer as unfair. However if player two left the experiment and told his friends about the decision they would accept that he had done the ‘right thing’. Within the context of a paradigm case argument the majority consensus of the decision defines it as a rational act.
The definition if rationality, as related to deductive reasoning, omits other valid modes of inference. It is equally the case that the narrow definition of rational economic man excludes other valid decision making protocols – we live deep in societal structure where notions of reciprocity are strongly embedded. We use decision making heuristics that serve us well in the complexity of real life; we do not jettison these in the artificial abstraction of a one shot economic game designed to flag contrived irrationality. If everyone agrees that I’m acting rationally then how can the economists say I’m not?