Why Do Rational People Make Irrational Choices?

In the world of markets and money, it is often believed that people behave like calculators: always choosing what benefits them the most. This image of homo economicus (the rational economic agent), has been the backbone of capitalism for many decades. But beneath this lies the irrational, psychological and emotional side of humans.

Traditional economics assumes people will always act in their own best interest. Raise wages, and people will work more. Increase prices, and demand will fall. These are near rules – and they work. Sometimes. But as behavioural economists like Daniel Kahneman (Nobel Prize, 2002) and Richard Thaler (Nobel Prize, 2017) have shown, humans are less like cold machines and more like flawed strategists in a high-stakes game they don’t fully understand.

“We think fast and slow. But markets often expect us to only think fast” – Daniel Kahneman

Consider this: why do consumers keep buying products that they don’t need? (Why did millions hoard toilet paper during COVID?) Why do people vote for policies that end up hurting their wallets? Why do CEOs sometimes take decisions that damage their own companies?

The answer lies in cognitive biases, social norms, loss aversion, and what I call the “mispricing of emotion”.

The beauty of capitalism is its ability to incentivise innovation. But its weakness is the assumption that incentives are always understood, and always rationally acted on.

In reality, consumers will often make poor decisions because of marketing manipulation, limited information (information asymmetry), or just plain exhaustion. Workers don’t always respond to pay increases with greater effort; sometimes, they burn out. Firms don’t always compete efficiently; they collude, they panic, or they follow herd mentalities – shown in during the 2008 financial crisis.

Capitalism assumes that if the rules are set, the player will play optimally. But if the players are running on flawed mental models, the game breaks down.

This is where psychology enters.

The Prisoner’s Dilemma Economy

Game theory offers a fascinating insight. In the classical Prisoner’s Dilemma, two rational individuals end up with a worse outcome because they don’t trust each other. In global markers, we see this all the time – from trade wars to climate inaction.

What makes this even more dangerous is surveillance. If every economic move is being watched – whether that be through algorithms, competitions, or foreign governments – the incentive to act unilaterally decreases. This leads to stalemates, and not innovation. In a world where everyone is waiting for everyone else to move the first chess piece, progress stalls.

We have built a hyper-connected capitalism based on outdated assumptions about individual autonomy. But the 21st -century economy is less about isolated actors, and more about psychological interdependence.

But what if we could simulate rational decisions in a structured, forward-looking way? This is where macroeconomic modelling – specifically the DSGE framework – steps in.

The Importance of The DSGE Framework

Modern macroeconomics has tried to respond to these complexities using Dynamic Stochastic General Equilibrium (DSGE) models. These frameworks simulate how rational agents make decisions over time under uncertainty, integrating micro-level behaviour into a macroeconomic system. DSGE models assume agents form expectations about the future; for example, inflation or interest rates, and optimise accordingly. These models essentially try to simulate hoe people make decisions over time – whether to save, spend, or invest – when facing uncertainty about things like inflation or interest rates.

A simplified macroeconomic loop: how DSGE models rationalise policy and agent behaviour LibertyStreetEconomics

While some argue that DSGE models often rely on too much rationality (ignoring psychological or behavioural quirks), newer generations of these models have become more flexible, allowing for shocks, bounded rationality, and even frictions in labour or credit markets. Economists like Oliver Blanchard and Paul Romer have been vocal in both using and critiquing DSGE models, especially after the 2008 crisis, which exposed their limits in predicting real-world financial collapses.

So, how do we fix this?

First, we must redesign systems with bounded rationality in mind – that is, accepting that people act on limited information, under stress, and often with flawed reasoning. That means:

• Nudging: subtle tweaks (e.g, automatic pension enrolment) can help people be more educated, thus making better choices without removing their freedom.

• Transparency: Markets need clear, honest information – not opaque pricing or manipulative advertising.

• Trust building mechanisms: Whether in climate deals or corporate cooperation, trust must be embedded in institutions – not assumed.

• Educational reform: Economics should be taught with game theory, psychology, and real-world complexity front and centre – not just supply and demand curves.

Capitalism must recognise that the chessboard has changes – and stop pretending we’re still playing checkers.