The Economics of Rationality

Bill J Gerrard, Bill J Gerrard

• Publisher: Routledge
• Year: 2006
• ISBN:
  9781134915286
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

The concept of rationality is the heart of modern economics. Neo-classical theory seems unable to proceed without assuming a rational agent seeking to find the optimal means to a well defined end. Yet many find this uncritical treatment of rationality problematic. It takes little account of culture history or creativity and consequently many economists find this insistence on rationality of little use when trying to explain a wide range of economic phenomena. Increasingly these include a large number of game theorists and others involved in mainstream theory as well as those typically opposed to neo-classicism.
The Economics of Rationality contains a number of critical perspectives on the treatment of rationality in economics.

1: INTRODUCTION

Bill Gerrard

The notion of the rational agent is the basic building block of modern economics. Economic theorists invariably presuppose that economic behaviour consists of the actions of agents seeking to optimize with respect to some well-defined objective function. Rationality in economics is viewed in instrumentalist terms: the choice of the optimal means to achieve some given ends. Yet, despite its axiomatic status, the conception of rationality in economics is not without criticism. In particular its empirical relevance is seen by many as open to question in all but the very simplest choice situations. This volume is a contribution to the debate on the appropriate conception (or conceptions) of rationality required in economics. The essays represent a number of different perspectives. Many of the authors broadly agree that there is a need to adopt some notion of bounded rationality and to give greater prominence to the effects of uncertainty on decision-making. But this view is by no means universal. The debate continues.

The first essay, by John Hey, attempts to clarify the nature and function of the concept of rationality in economics. Hey defines rational behaviour as people trying to do what they perceive as best for them to do. He considers the different roles that rationality plays in economics. In normative economics rationality is the assumption that agents ought to optimize. As such, rationality is relative to the aspiration of the agent. It requires only that the agent has a well-defined objective function. Different objective functions lead to different rationalities. In positive economics rationality is the maintained hypothesis of consistency, necessary in any predictive science. Rationality provides the structure for meaningful empirical investigation. It cannot be proved or disproved. If any particular form of the maintained hypothesis is discredited by the empirical evidence, an alternative form of rationality must be proposed.

Paul Anand considers the debates on rationality in utility theory in game-theoretic terms. He views these debates as a series of games involving two different language communities. On the one side there is the mathematical language community with its emphasis on precision and tractability. On the other side there is the natural language community with its concern with the vaguer aspects of human behaviour. Anand discusses the reasons for the dominance of the mathematical language utility theory. In particular he focuses on the various immunizing stratagems that have been adopted to protect axiomatic utility theory from apparent anomalous empirical evidence. These immunizing stratagems include reinterpreting the evidence as well as the claim that it is only the degree of rationality of an agent which is testable, not rationality itself.

The next essay, by Geoffrey Hodgson, deals with the two arguments usually employed to justify the orthodox conception of rationality. First, it may be contended that agents do actually have the motivation and abilities to be rational in the global sense of searching out the optimal solution. Alternatively it is argued that there is some form of Darwinian evolutionary dynamic at work ensuring convergence towards optimizing behaviour. Hodgson considers neither of these arguments to be tenable. He is particularly critical of the use of the Darwinian analogy in economics. It may be appropriate in the context of competition between firms but elsewhere its relevance is a matter of some doubt. In what way, for example, would non-rational consumers be eliminated by rational consumers? Also the ability to survive need not imply optimizing behaviour. Hodgson argues for a wider conception of rationality to include habitual and routine behaviour. A viable notion of human action needs to involve a bounded and multilevelled process of monitoring and deliberation with different degrees and levels of consciousness.

In my own essay I argue for the need to encompass the standard logical theory of rational choice within a more general framework. The logical theory provides theoretical and empirical tractability but its explanatory power is problematic. It can give realistic explanations of behaviour only in very simple choice situations. It can retain explanatory power despite its non-realistic assumptions in more complex situations if there is a strong validation process in the form of learning or competition to ensure convergence to some optimum. The logical theory is of limited use in complex situations with no strong validation process. There is a need, therefore, for a more general theory of economic behaviour. Two specific contributions are discussed as starting points for a more general approach: Simon’s notion of procedural rationality and Keynes’s analysis of the investment decision in which he emphasizes the role of conventional assumptions, confidence and the precautionary motive in behaviour under uncertainty.

The importance of uncertainty emerges also in the essay by Shaun Hargreaves Heap. He attempts to draw parallels between the literature on post-modernism and economics. In both he finds an emphasis on doubt and uncertainty. In post-modernism the denial of objectivist and positivist presuppositions has produced an open-endedness in which the role of human creativity becomes focal. Hargreaves Heap sees the same sort of open-endedness in economics, particularly in the theory of rational expectations, in game theory and in experimental economics. The problem of underdetermination in these areas of economics illustrates the inadequacy of instrumental rationality. Hargreaves Heap argues for a conception of the economic agent as socially located, capable of open-ended and creative actions.

The essay by Ted Winslow provides an account of the changing conceptions of human behaviour to be found in the writings of John Maynard Keynes. The early thought of Keynes resulted in A Treatise on Probability in which Keynes developed a logical theory of probability. Keynes considered probability as the rational degree of belief in a non-conclusive argument given the available evidence. After the Treatise Keynes gave much greater attention to the irrationality of human behaviour, abandoning his belief in the essential rationality of human nature. In his ethical thought Keynes came to argue for the customary morals and conventions as the means by which civilization can protect itself from irrationality. This is in stark contrast to Keynes’s earlier Bloomsbury philosophy which rejected the constraints imposed by customary morals and conventions. Winslow argues that Keynes’s acceptance of the irrationality of human behaviour is also reflected in Keynes’s economics in the analysis in the General Theory of the psychological propensities which underlie consumption, investment and liquidity preference.

David Mayston’s essay is concerned with the rationality of group behaviour, specifically the difficulties of establishing a well-defined objective function for a group. These difficulties are enshrined in Arrow’s impossibility theorem. Mayston shows how the notion of rationality at the group level breaks down once one moves away from a world of single peaked individual preferences over a unidimensional policy variable. The breakdown of rationality at the group level can have serious consequences, including social instability and the threat of dictatorship. Mayston proposes a solution involving the abandonment of Arrow’s requirement of the independence of irrelevant alternatives as well as the use of additional information on individual preferences.

The essay by Graham Loomes considers a specific problem that has arisen in the application of rational choice models in the area of health policy. Practical applications require measurement of the preferences of agents. In the case of health state measures it is found that different methods of valuation lead to systematic and persistent inconsistencies. These disparities also arise if only a single method of valuation is used. Such anomalies raise questions about the validity of the assumption that agents are rational. They undermine the economist’s ability to contribute to policy appraisal. Loomes argues that the disparities in health state measures need not be seen as evidence of irrationality. He shows that they can be explained within the framework of regret theory. However, this is not the complete story, as is shown by the fresh evidence reported in the essay.

The final essay, by Avner Offer, analyses the rationality of the German submarine campaign during the First World War. Offer adopts a framework of bounded rationality and provides a detailed discussion of the arguments within the German Admiralty for the submarine campaign. He shows that the problem lay not in the lack of evidence but in the perceptual framework used. Offer describes the German Admiralty as becoming stuck in a degenerating research programme immunized against counter-evidence. They employed a military rationality which stressed willpower, fighting spirit and acceptance of sacrifice as the means of prevailing in the face of superior material forces. Offer argues that this military rationality is an appropriate response to limited resource endowment but was inappropriate in the context of the submarine campaign. He concludes that economic rationality, an assessment of political and economic costs and benefits, would have been more appropriate in that specific situation, but not universally so as evidenced by American experience in the Vietnam War.

2: RATIONALITY IS AS RATIONALITY DOES¹

John D.Hey

Some time after I foolishly agreed to give a seminar in the series ‘Deconstructing rationality’, I decided that I ought to discover what I had let myself in for. Accordingly, I trotted along to the library and tried first to find out what the first word in the title meant. I could not find the word in any normal dictionary, and the only volume in the library with the word ‘deconstructing’ in the title was alarmingly called Deconstructing Marxism. I began to panic at this stage. However, things were rather different with the word ‘rationality’. This did appear in various dictionaries and in the titles of numerous volumes in the library. Indeed, there was almost an embarrassment of riches, with several shelves groaning with books devoted to rationality. On closer inspection, unfortunately, they all turned out to be philosophy books, full of words and virtually no maths. I did select a few at random and take them out of the library, but they looked even worse when I got them home. True, there was one by Martin Hollis, The Cunning of Reason, which started off promisingly, but it did not seem to get anywhere, even though it was a refreshing change to read some good English prose.

I decided then that this was all a fiendish put-up job by the seminar organizers to try and get Old Hey educated. But I was damned if I was going to read all those boring words. I’d get my own back by trying to define at least one of the two words in the series title myself. To hell with the other; it probably doesn’t mean anything anyhow.

This got me thinking about a recent article by Amartya Sen on equality that I had read only a few weeks back. Sen spent the first half of the paper asking the question ‘equality of what?’; the second half being devoted to asking the rather more usual question ‘why equality?’. The analogy is not 100 per cent complete, but it stimulates the question in our context: ‘why are we interested in the issue of rationality?’.

I do not want to get bogged down in a fruitless semantic discussion: what is love? What is a banana? What is yellow? (A banana is a banana because we call it that; it’s yellow because we call it that. How do you know what I call a banana is the same thing that you call a banana? How do you know that what looks yellow to you also looks yellow to me? and so on. As if anyone cared.) But I fear that my conclusions, as well as my title, may end up with a rather semantic air. Let us see.

Why then are we, as economists, interested in rationality? In order to begin to formulate an answer to this question, I think we need to distinguish carefully between whether we are doing normative or positive economics. Suppose, to get the ball rolling, that we are interested in the former: we are using economics to tell somebody, or some bodies, how they ought to be behaving. They ought, in common parlance, to behave rationally. But why? And why do we advise them that they ought to behave rationally? Presumably, because it would appear to us that there is some gain for them by doing so: they would be better off in some sense behaving rationally than not behaving rationally. This line of argument immediately gets us into the optimization story beloved of economists. I will return to this shortly.

Now consider the situation of positive economics in which case we are trying to describe (and thence predict) economic behaviour. Why do we worry about rationality here? In my opinion, this is a quite different kettle of fish. What we need rationality for here is to imbue our economic agents (whose behaviour we are trying to describe and predict) with some behavioural consistency. Any predictive theory requires some consistency somewhere, even those theories arising in the natural sciences. How does a scientist ‘know’ that the sun will rise tomorrow? Because it has risen every day in the past and the scientist assumes that this behaviour is consistent. This is, of course, a particularly simple type of consistency, but the same requirement applies in more complicated situations. The economist, when predicting, for example, aggregate savings behaviour, will estimate a relationship using past observations, and use this relationship to predict future observations. So he or she is assuming that the relationship remains constant and that the behaviour on which it was constructed will be consistent in the future with what it was in the past.

What I would appear to be arguing is that rationality used in positive economics is simply the assumption of consistency (or constancy?—we shall see); and we need this in order to use the past to predict the future. In any area of scientific discourse, the scientist must, of necessity, take something as given. It is simply not possible to carry out any kind of empirical test or empirical investigation without so doing. For instance, the physicist carrying out an experiment in the laboratory will control for those factors that he or she thinks are relevant, but will, of necessity, ignore those factors that are considered irrelevant. When asked to justify this procedure there will follow, if the scientist is honest, an embarrassed silence. When carrying out, say, a test of Boyle’s Law will the physicist control for the time of day, or for the race and sex of the laboratory assistants or for the weather on the other side of the globe? Of course not. But how is this justified? How does the physicist know that the sex of the laboratory assistant does not influence the outcome of the laboratory test? How does the physicist know that the colour of the desks in the laboratory does not affect the outcome of the test? The simple and honest answer is that he or she does not know. Possibly, however, the reply might be that on some previous occasion the physicist concerned had carried out a carefully controlled pair of experiments, identical in all respects except that one was carried out by female assistants, the other by male assistants, with no perceptible differences in the results. But note the phrase ‘carefully controlled’—what controls had been enforced in this previous experiment? Had control been exercised over the colour of the desks? Had control been exercised over the race of the assistants?

Clearly there is an infinite regress problem here. However much prior testing has been done, there can be no guarantee that those factors considered irrelevant to a particular problem are actually so. In this sense then, even ‘proper’ science is religion; it is an act of faith that certain things are irrelevant.

We have a similar religious problem in economics. The economist takes certain things as given, but there can be no guarantee that those things are actually given. Some would argue, but I do not want to get involved in this argument here, that one can always decide whether something is not given. But this is slippery ground: how do we know, for example, that an individual’s income is relevant to that individual’s saving decision? Just because we have observed some correlations in the past? But how were we led to estimating those particular correlations? Because our theorizing told us that certain other things, such as the length of hair of the prime minister of Australia, were irrelevant to Joe Soap’s saving decision. But how did we know that?

It is the same point really: the economist takes certain things as given, but there can be no guarantee that those things are actually given. But, like the ‘proper’ scientist, we need to do this in order to carry out any empirical investigation. In particular we take rationality as given. I have almost gone full circle: rationality is simply consistency, when we are doing positive economics.

Rationality is therefore something rather flexible: like the ‘proper’ scientist, we work within some maintained hypothesis (that is, we work with a particular set of givens) while generating testable hypotheses. These we test. The outcome of the test is either acceptance or rejection of the hypothesis (or more realistically partial acceptance or partial rejection of the hypothesis), and if the test suggests to us that there appears to be something badly lacking in our maintained hypothesis, we then grudgingly go back to it and reappraise it.

This has been happening par excellence in my own field—decision-making under uncertainty. Some years ago (despite the mutterings of Maurice Allais in the 1950s) the maintained hypothesis in the field of decision-making under uncertainty was subjective expected utility (SEU) theory. This generated numerous testable hypotheses which people went out and tested. Gradually, sufficient evidence accumulated (after translation in some instances) to convince many that SEU theory was not a particularly good maintained hypothesis for a large portion of human behaviour. This generated a new generation of theories of decision-making under uncertainty: prospect theory, regret theory, disappointment theory, weighted utility theory, implicit utility theory, generalized expected utility theory and so on. On the surface the move from the partially disgraced SEU theory to these theories was intimately tied up with an ongoing debate about rationality. Were the SEU axioms correct as characterizations of rational behaviour? Were other sets of (weaker) axioms more correct?

Yet, on one interpretation, certainly my interpretation as far as positive economics is concerned, this was not a debate about rationality per se but rather a debate about the nature of the maintained hypothesis. Strike out the word ‘rational’ and replace it by ‘consistent’ or ‘reasonable’ or some other name and nothing changes. The debate was simply about the maintained hypothesis.

At this point one might want to bring in some consideration of the role of theory in economics; if one is not careful—or even if one is—the above process of maintained hypothesis/hypothesis formation/hypothesis testing/reformulation of the maintained hypothesis could simply degenerate into empiricism. I say ‘degenerate’ as most economists would defend the use of theory and would argue against ‘pure’ empiricism. But w...