Rationality is beside the point

Brad DeLong has a post wherein he poses the question

Given that people aren't rational Bayesian expected utility-theory decision makers, what do economists think that they are doing modeling markets as if they are populated by agents who are?

intimating that maybe some ideal modeling scheme exists where you just need to replace the "rational Bayesian" with "behavioral". Along with most economists out there with objections to rational expectations, it seems most econoblog commenters are objecting to the "rational", rather than e.g. me who objects to the "expectations".

DeLong then quotes Andrew Gelman on how nonlinear utility functions used in economics are suspect and how students believe each step of a utility argument, but are "unhappy with the conclusion". The students seem confused by their own reasoning. Noah Smith has a post from earlier this year on other problems with utility functions. Cosma Shalizi sums it up pretty well (emphasis mine):

The foundation on which the neo-classical framework is raised, though, is an idea about rational agents: rationality means maximizing expected utility, where expectations come from maintaining a coherent subjective probability distribution, updated through Bayes's rule; moreover, the utility function is strictly self-regarding. This is a very well-specified idea, readily formalized in clean and elegant mathematics. Moreover, there's pretty much only one way to formalize it, which makes the mathematical modeler's life much easier. All of this appeals to certain temperaments, mine very much included. Alas, experimental psychology, and still more experimental economics, amply demonstrate that empirically it's just wrong.

All true.

Yet markets seem to work.

This is actually pretty remarkable. We're totally irrational potentially hyperbolic discounters subject to framing effects ... yet markets seem to work.

But! This is only pretty remarkable if you see markets as some kind of system that efficiently allocates resources. If we look at my recent post where I attempt a definition of aggregate demand using the information transfer model, then we see the efficient allocation of resources is not the proper frame. A market transfers any information, not necessarily useful, rational or efficient information. Transferring completely crazy information accurately is considered more of a success in this framework than transferring a correct prediction about the future only nine times out ten.

"Gold is going to a million dollars an ounce."

"Inflation will take off at any minute."

The market is "inefficient" when these statements are inaccurately transferred from the aggregate demand to the aggregate supply, not when they are wrong. Of course, for the information to be transferred accurately some element of the aggregate supply has to receive the information accurately. And the world might work in such a way that really crazy information is almost never received accurately -- the person on the other end of a gold transaction really just wants to make a not unreasonable amount of money and thinks gold is going to fall in value [1]. Maybe our normal cognitive biases are transferred accurately, yet markets work [2]. I don't know all the answers. 

I do know that assuming the information is transferred fairly accurately gives you supply and demand diagrams. It also does a good job predicting inflation. So maybe we shouldn't worry too much about rationality or individual utility functions.

At least, if you use the information transfer model.

[1] It is interesting that people who are selling gold seem in advertisements seem to put forward the attitude that one should have when one wants to buy gold ... it's a safe asset, you'll stay rich or become richer if you buy gold; shouldn't these sellers just hold on to their gold? This is the opposite of many other advertisements which usually say something like we have a lot of TVs and we can't possibly watch them all so we implore you to come on down to Crazy Eddie's and take them off our hands.

[2] I'd like to make the distinction between where an unfettered market leads to a Pareto efficient allocation and where an unfettered market leads to some sub-optimal allocation. In both cases, the information transfer may be "efficient" in the sense that the information received is the information transmitted. It may not be socially optimal.