Somehow, this article is one of the most read on this site. I feel somewhat guilty for not updating this earlier. When I first wrote this, I just obtained my bachelor's degree in Econ, and admittedly, the way I thought about economics back then was not very rigorous and might have left this article with a lot more room to improve. So, this update simply introduces a more refined definition, and hopefully, will leave fewer readers confused. Thanks for visiting and reading what I have to share here.
Before we proceed any further, rationality must first be clearly defined for us to be on the same page. Rationality, in a nutshell, is all about sensible and justifiable decisions based on a set of principles. But, let me define rationality in a more rigorous manner. A rational individual is an individual who, given information and knowledge available and accessible to her (including but not limited to information about the alternative choices and their respective outcomes as well as information about uncertainty/risk), makes the best possible decision in a sense that her action that follows and conforms to the decision will give her either the optimal payoff for certain or the highest expected value of payoff when confronting uncertainty. This is a common definition used in economics.
Then, we have behavioural economics that attempts to revise the mainstream assumptions of what is and is not rational due to the observed deviation from the definition in real life. Regardless, it should be no surprise that it still works most of the time. For example, given two options, A leads to a $20 payoff and B leads to a $30 payoff, a rational individual will choose B. If there is a new option superior to all the previous two, say C that results in a $40 payoff, she will opt for C. If all options are available and affordable to her, no matter the order or how the options are presented, she will consistently pick C out of all the three options. If new choices are introduced into the mix, then as long as the resulting payoffs of those choices are less than $40, C remains her pick.
Of course, rationality is quite subjective, and a person's rationality is usually bound by the extent of his/her intellect and the information available. That is to say, Tom might view his decision to start a business as rational, but to a financial guru, that might be an irrational decision considering the fact that 90% of the businesses fail during the first year and that Tom's current job already earns him over $100k a year. Back to our previous example, there can be cases in which the person is not aware/informed about option C at all. The person might be doing her best to maximize her well-being, but given that information about C is not conveyed to her, C is not a part of her set of available choices. As a result, she might just pick B, and from her perspective, this is the most rational decision. Though from the viewpoint of an observer possessing better information, he knows she can do better and her selection is not optimal.
To reiterate, individual rationality is basically a sensible decision/judgement/behaviour/action for an individual following the principle we put forth earlier. Collective irrationality is just the reverse at a larger social scale - i.e., a collectively unsound or unreasonable decision/judgement/behaviour/action of a group. So what I am trying to achieve here is to explain to you how individual rationality can lead to collective irrationality. In other words, concurrent individually rational decisions or actions by the majority can be irrational and lead to adverse results at the macro level.
If you and all your friends suddenly decide to drive to school at the same time, to each of you, it is a good decision. It will be safer, faster, and probably, you have a higher chance to get yourself a girlfriend than those who ride bike (like me). However, the problem is that this decision has led to traffic congestion at the school entrance (and probably within the whole city), not to mention the trouble in finding a parking spot in your school's small parking lot with the capacity of 10 cars. So it will probably cause lots of inconvenience for you, but the negative consequences of this collective decision will also spread to your friends, teachers, especially the principal (just as you planned, perhaps).
Likewise, what happened in the medieval warfare, some scenarios might be no different. Soldiers' morale weakened, and they deserted their base. Of course, when a soldier decided to run for his life, the others might find it irrational to stay any longer risking their life in the process. In the end, they followed each other's "rational" decision, and ultimately, the war was lost even if there was this high possibility that they could have won had they hold on to their base, defending it while waiting for reinforcement. And who knows if they could even escape death? If the enemy pursued them, with scattered force like that, their chance of survival would be much lower. This is really what we call a "worse comes to worst" scenario.
A more relevant example to what happened recently is food price inflation in Cambodia before and after the national election. Since everyone felt insecure due to the political turmoil, people started stocking up their food supply, buying every single piece of meat and preserved food they can find on the shelves. The result? Food price spiked. We all made a rational decision by securing food supply for the need of ourselves and our own family, but at the same time, as the fear pervaded the nation, the aggregate demand for food rose high. Supply was not able to catch up and therefore food price soared. So, in actuality, we were in fact exacerbating the situation, creating more fear of instability, increasing the food price, making it more scarce, and killing ourselves and everyone else (especially, the poor who is most vulnerable to the increase in food price). This is what is known as a "Self-fulfilling Prophecy". Fearing that something bad would happen lead to collective actions that cause the event itself to materialize. Collective irrationality in this case is suicidal.
Why should we care?
Because rationality, just as mentioned in my first article, is one of the core assumption of economics. Of course, people don't always make rational decision, but highly educated people mostly do as education tends to turn people into rational beings who rely more on thought and reason to reach certain decisions. Since those people are the ones whose decisions incur the most impact on the economy, collective irrationality induced by individual rationality can be disastrous. Another point to take note of is that it does not take the whole country to participate to arrive at the collectively induced adverse outcome. There always exists a threshold that only requires a certain proportion of the population to behave in a certain way for the mentioned outcome to be realized.
(One of) The moral of the story is that there has to be someone who can oversee the whole process, someone who recognizes the defect and makes rules and regulations to control and intervene with any form of rationality deemed harmful for the whole society/economy. This is why we have the government, and this is why free market can lead to market failure as it allows free movement with little or no restriction. Government intervention to establish a solid economic foundation is thus necessary.
All that being said, I am not promoting authoritarian government because it would be the collapse of the modern society's foundation itself. The main point of the story I would like to convey to you is that in this world of ours, the ideal free market does not (has never and will never) and should not exist for the reason engraved in the title of this article. In fact, we do not have anything on the extreme (or anything pure for that matter), but only things in moderation, a mixture of at least two elements or more. Any form of collective decision making should be considered with caution and democratic rights should never be the sole argument for it. When contemplating political, social and economic issues, one must always be humble and accept the reality that there is no such thing as a straightforward and simple A-causes-B relationship. On the frontier of economics, for instance, the subject about "how much of the free market should be allowed" still remains controversial among scholars and policy makers. This can cause you to wonder. What take them so long? Decades of research and yet without decisive conclusion. Remember, these are profound thinkers who dedicated years to finding scientific justification to argue for their cases. The reason is because many questions we are trying to answer now are parts of normative economics that usually depends heavily on personal philosophy and the angle from which one views the issue. Moreover, since it is impossible to have a perfect counterfactual (i.e., to experience alternative states of the world), not to mention the challenge in gathering appropriate data and building an unbiased engine/model to squeeze useful information out of it, it is to be expected that we see many clashes within the research community.
Regardless, too much is never good. That is the golden rule. Moderation is almost always better. Collective irrationality discussed in this article is just a part of the problem, one of the many matters to be considered in making decision in the face of uncertainty and lack of proper research results. Note that rational behaviors such as the pursuit of self-interest (the core feature of capitalism) should not be considered as evil. But, the lack of understanding of its nature and the ignorance of its harmful effect in the absence of regulation though are what we all should be wary of. That is why it is necessary that we properly understand its inherent characteristics, so we can make a better decision for our long-term well-being.
This is an important topic connecting to free market, market failure and policy making, about which I will write later. Enjoy learning.