The Illusion of Rationality: How Behavioural Biases Affect Economic Decisions and Market Equilibrium

Abstract

The assumption of rational market participants lies at the core of many economic models. However, real-world observations often reveal systematic deviations from this ideal. Economic decisions are frequently shaped by psychological patterns such as loss aversion, anchoring effects, and herd behaviour. These cognitive distortions do not occur randomly, nor do they neutralise each other in the aggregate. Instead, they tend to reinforce one another, leading to structural shifts that question the classical notion of stable market equilibrium. This paper examines how behavioural biases alter the dynamics of market processes and how their cumulative effects influence pricing, coordination, and systemic stability. Drawing on insights from behavioural economics and the epistemological critique of the Austrian School, the study challenges the assumption that markets function as efficient arenas of rational exchange. The research follows a qualitative methodology, combining a conceptual literature analysis with case-based insights from financial markets, particularly during episodes of volatility and crisis. Rather than proposing a new predictive model, the paper suggests a different lens through which to view market phenomena: one that acknowledges perception, expectation, and error as constitutive elements of economic activity. Market behaviour is presented not as the outcome of logical optimisation, but as a reflection of human subjectivity under uncertainty. The study further discusses the implications for economic policy, highlighting the limitations of both laissez-faire ideologies and technocratic intervention. It concludes that robust institutional frameworks are needed to mediate between psychological vulnerability and systemic resilience. The paper calls for a pragmatic approach to market regulation, grounded in a realistic understanding of decision-making processes. In doing so, it reframes the idea of equilibrium from a normative anchor to a contingent outcome shaped by human behaviour, cultural context, and epistemic constraints.