**UPDATE: 27/April/2020
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.
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Before we proceed any further, rationality must first be clearly defined. Rationality, in a nutshell, is 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 in accordance with the observed deviation from the definition. Regardless, it should be no surprise that it still works on the average. For example, given two options, A 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, C remains her pick. In addition, a rational agent who maximizes utility is not necessarily selfish. Utility encompasses a large array of tangible and intangible objects, not just money as some people have been led to believe. Utility is more about self-interest. Self-interest and selfishness are essentially two different personalities/concepts. Selfishness is about a lack of consideration towards the well-being of the others (making oneself at the centre of everything), whereas self-interest is about making oneself happy/satisfied and some people achieve this goal through altruism. In this sense, the economic utility you often heard of is actually a much broader concept. For example, in the study of life-cycle behavior, for instance, leaving bequest to one’s children increases one’s economic utility. With this broader definition of the end goals that spur human actions, I hope you can see why rationality as an assumption in economics is actually more relevant that you might have thought.
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, while a decision to start a business as rational to some people, to a more financially savvy person, that might be an irrational decision as he is informed about the fact that 90% of the businesses fail during the first year and perhaps also because his 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 the 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. Consequently, 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 manifests itself in a ‘sensible’ individual decision or action following the principle we put forth earlier. Collective irrationality is just the opposite at a larger social scale, and we can loosely define it as a collectively unsound or unreasonable behavior of a group. The purpose of this article is to draw a link between the two concepts, to explain to you how individual rationality can lead to collective irrationality. In other words, we are talking about concurrent individually rational decisions or actions by the majority that are ultimately irrational due to their attendant adverse impacts 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. For those who can afford to do so, It will be safer and faster. However, the problem is that this decision leads 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-capacity parking lot. Individuals fail to internalize social cost/benefit, resulting in what is known as (negative) externalities in economics.
There myriads of examples. Even the medieval warfare had some “collective irrationality” scenarios. For instance, under siege, soldiers’ morale weakens. Some desert their base. When a soldier decide to run for his life, the others might find it irrational to stay any longer risking their life in the process. Eventually, they follow each other’s “rational” decision. As more soldiers give up hope, their strength dwindles, morale plummets, and ultimately, the war is lost, even if there is a high possibility that they can win if they hold on to their base, defending it while waiting for reinforcement.
A more relevant example is the food price inflation in politically unstable nations such as Cambodia before and after their 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. People 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, they 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 is one of the core assumptions of economics. Of course, people don’t always make rational decision in every daily task. How rational a person is might depend on how high the stake is. A decision that will significantly impacts one’s life is probably more likely to induce rationalization. Higher education might also turn people into rational beings who rely more on thought and reason to reach their final decisions. As long as a large proportion of the population engages in rational decisions and actions, we can be sure that economics remains a powerful analytical tool. Its predictions and teachings might not hold true all the time, but we can be condfident that they are on the average. Hence, collective irrationality induced by individual rationality can be disastrous. It does not take the entire population to participate to arrive at the collectively adverse social outcome.
(One of) The moral of the story(ies) is that there has to be someone who can oversee the whole process, someone who recognizes the defect and makes rules and regulations to intervene and help correct the collectively irrational actions 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. The caveat is that the government itself can fail. Furthermore, a failed government project, instead of getting removed, might instead be expanded based on an argument that the failure is caused by insufficient funding instead of bad project per se (driven by institutional interests and the strong incentive of the public institutions to survive and thrive).
All that being said, I want to make it clear that I am not promoting an 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 is that in this world of ours, the ideal free market does not exist for many reasons, one of which is 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 any 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.
Nevertheless, 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 issues to be considered in making decision in the face of uncertainty and the 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.