The Origin of Wealth, Eric D Beinhocker, 2006, p116-119

“Imagine you walk into your grocery store and see some tomatoes…

You have well-defined preferences for tomatoes compared with everything else you could possibly buy in the world, including bread, milk, and a vacation in Spain. Furthermore, you have well-defined preferences for everything you could possibly buy at any point in the future, and since the future is uncertain, you have assigned probabilities to those potential purchases. For example, I believe that there is a 23 percent chance that in two years, the shelf in my kitchen will come loose and I will need to pay $1.20 to buy some bolts to fix it. The discounted present value of that $1.20 is about $1.00, multiplied by a 23 percent probability, equals an expected value of twenty-three cents for possible future repairs, which I must trade off with my potential purchase of tomatoes today, along with all of my other potential purchases in my life- time. In the Traditional Economics model, all these well-defined preferences are also ordered very logically. So if I prefer tomatoes to carrots, and prefer carrots to green beans, I will always take the tomatoes over the green beans. Likewise, if I prefer tomatoes to carrots, I won’t suddenly go for the carrots simply because I saw some green beans.

Traditional Economics also assumes that you know exactly what your budget is for spending on tomatoes. To calculate this budget, you must have fully formed expectations of your future earnings over your entire lifetime and have optimized your current budget on the basis of that knowledge. In other words, you might hold back on those tomatoes because you know that the money spent on them could be better spent in your retirement. Of course, this assumes that your future earnings will be invested in a perfectly hedged portfolio of financial assets and that you take into account actuarial calculations on the probability that you will live until retirement at age sixty-five, as well as your expectations of future interest rates, inflation, and the yen-to- dollar exchange rate. While standing there, staring at those nice, red tomatoes, you then feed all this information into your mind and perform a cunning and incredibly complex optimization calculation that trades off all these factors, and you come up with the perfectly optimal answer—to buy or not to buy! This Spocklike method is known as the perfect-rationality model, one of the bedrock assumptions of Traditional Economics.

In contrast, at the core of the emerging Complexity Economics view of behavior lies another method known as inductive rationality, and it goes like this: “Hmmm… tomatoes. They look nice and fresh. I kinda feel like salad tonight. Price looks okay.” And into the shopping basket they go…

… the perfect rationality assumptions were challenged and criticized right from their introduction, but economists continued to use the assumptions anyway because perfect rationality enabled the models to be mathematical and no one had a better alternative.

The rise of behavioral economics has left the field in a strange state of cognitive dissonance: many economists admit the validity of criticisms against perfect rationality, but they plug away using the Traditional assumptions because they lack an alternative that they can use in a formally stated model.”