New Institutional Economics : Discussing rational choice

While property rights economics and the formal part of contract theory still assume perfect rationality this is not the case with transaction cost economics and the new institutional approach to history of North. Williamson (1975, 4) assumes men to be only boundedly rational, North (1995,18 f.) writes that a theory of institutions has to begin with a "modification of the instrumental rationality assumption", Coase (1984, 231) regards the assumption "that man is a rational utility maximiser" to be both "unnecessary and misleading." Thus, the assumption of perfect rationality is being abandoned by leading neo-institutionalists.

In the past few articles, we have been discussing the building blocks of New Institutional Economics+ (NIE+). We have covered transaction costs, property rights, asymmetric information, public goods and common-pool resources and social capital. In this article, we will discuss how the assumption of rationality in neoclassical economics is at variance with how people behave in the real world. However, not everyone in the NIE school rejects the assumption of rationality. The property rights approach and contract theory retain the assumption of rationality. On the other hand, Williamson and Coase reject the assumption of rationality. While Williamson suggests that individuals are boundedly rational, Coase says that the assumption of rationality is not necessary. North's historical analysis of NIE also rejects the assumption of rationality.

It was, however, psychologists and the behavioural social scientists who proposed and popularised the notion of bounded rationality. Herbert Simon was the earliest social scientist to propose that individuals are boundedly rational and this was taken forward by psychologists such as Daniel Kahneman and Amos Tversky. Kahneman also won the Nobel Prize in Economics in 2010. According to them, the behavioural assumption of bounded rationality, better explains individual behaviour in the real world. This changes many of the implications of the neoclassical model. Let us see how.

Rationality assumption revisited

Recall that the early neoclassical economists such as Jevons took utility to be the same as happiness and assumed that consumers maximise happiness. Contemporary theory bases rational choice on a set of choice axioms that need to be satisfied and typically does not specify where the goal (preferences, desires) comes from.

In contemporary theory, the rationality assumption is rooted in rational choice theory (RCT), which, in turn, is the foundation of neoclassical economics. RCT basically says that individuals are faced with numerous choices when making decisions. The theory assumes that an individual has preferences among the available choices, which the individual ranks in order of his preferences. These preferences are assumed to be complete (the person can always say which of two alternatives they consider preferable or that neither is preferred to the other) and transitive (if option A is preferred over option B and option B is preferred over option C, then A is preferred over C). The rational agent is assumed to take account of available information, probabilities of events, and potential costs and benefits in determining preferences, and to act consistently in choosing the self-determined best choice of action. In simpler terms, this theory dictates that every person, even when carrying out the most mundane of tasks, perform their own personal cost and benefit analysis in order to determine whether the action is worth pursuing for the best possible outcome. And following this, a person will choose the optimum venture in every case. This could culminate in a student deciding on whether to attend a lecture or stay in bed, a shopper deciding to provide their own bag to avoid the five pence charge or even a voter deciding which candidate or party based on who will fulfil their needs the best on issues that have an impact on themselves especially.

Individuals evaluate all the options based on the criteria and rank them in order of their preferences. The option that gives the maximum 'utility' to the individual is the one that is chosen. RCT is therefore an optimisation exercise where all individuals maximise their utility subject to some constraints.

Adam Smith is understood to be the first to propose the RCT when he said that all individuals act in their own self-interest. His invisible hand theory is also based on self-interest, rationality, and the rational choice theory. It states that individuals driven by self-interest and rationality will make decisions that when aggregated will lead to positive benefits for the whole economy. This process is also called methodological individualism. Adam Smith's famous quote from 'An Inquiry into the Wealth of Nations' highlights the self-interest and hence, the rational behaviour of individuals:

"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address

ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages"

The RCT is the cornerstone of the basic microeconomic model of neoclassical theory and rationality is a behavioural assumption that is well known. This assumption began in microeconomics but has also been widely used in other social sciences such as political science and sociology. In economics, the Chicago School is the most ardent follower of the RCT. Milton Friedman, the founder of the Chicago School and the Nobel Prize winner in Economics claimed that the RCT may not describe the choice process but it does a good job of predicting outcomes. Individuals act 'as if' balancing costs against benefits to arrive at action that maximises personal advantage.

To quote Milton Friedman from his 'Essays in Positive Economics', published in 1953:

"Consider the problem of predicting the shots made by an expert billiard player. It seems not at all unreasonable that excellent predictions would be yielded by the hypothesis that the billiard player made his shots as if he knew the complicated mathematical formulas that would give the optimum directions of travel, could estimate accurately by eye the angles, etc., describing the location of the balls, could make lightning calculations from the formulas, and could then make the balls travel in the direction indicated by the formulas. Our confidence in this hypothesis is not based on the belief that billiard players, even expert ones, can or do go through the process described; it derives rather from the belief that, unless in some way or other they were capable of reaching essentially the same result, they would not in fact be expert billiard players."

The most prevalent version of rational choice theory is the expected utility theory. The expected utility of an act is a weighted average of the 'utilities' of each of its possible outcomes, where the utility of an outcome measures the extent to which that outcome is preferred, or preferable, to the alternatives. The utility of each outcome is weighted according to the probability that the act will lead to that outcome.

RCT and prospect theory

The RCT has been challenged by the experimental results of behavioural economics. Economists are also learning from other fields, such as psychology and are enriching their theories of choice in order to get a more accurate view of human decision-making. For example, the behavioural economist and experimental psychologist Daniel Kahneman won the Nobel Prize in Economics in 2002 for his work in this field.

However, as mentioned above, it was Herbert Simon, who first suggested that individuals are boundedly rational rather than rational and that they 'satisfice' rather than 'maximise'. Simon was not the from the core neoclassical economics school and more a cognitive psychologist. He got the Nobel Prize in economics in 1978. Simon said that there is a limit to the information that humans can retain and process. They are not supercomputers capable of considering all options, processing them and then ranking them in order of their preferences. Hence, their decisions are based on a limited choice and they are rational given the limited choice and awareness of alternatives. In other words, they are boundedly rational and their objective is satisficing. Hence, the theory of bounded rationality suggests individuals can make decisions based on 'heuristics', which are basically simple efficient rules of thumb. For Simon, satisficing is the heuristic that guides individuals.

Kahneman and Tversky took a different approach from Simon and linked heuristics to cognitive biases. In their paper written in 1974, 'Judgement Under Uncertainty: Heuristics and Biases', they suggested three heuristics that are employed in the judgment under uncertainty: (i) the representative heuristic, which is usually performed when people are asked to judge the probability that an object or event A belongs to a class or process B. (ii) the availability heuristic, which is often employed when people are asked to assess the frequency of a class or the plausibility of a particular development and (iii) the adjustment heuristic, which is usually employed in numerical prediction when a relevant value is available.

Another challenge to the RCT is prospect theory which lays out the phenomenon of loss aversion. The theory was proposed by behavioural economists Kahneman and Tversky. Loss aversion refers to people's preferences to avoid losing compared to gaining the equivalent amount. In their words, "losses loom larger than gains". For example, one would be more unhappy if he loses Rs 1,000 as compared to the happiness one gets by gaining Rs 1,000. This happens because losses cause a greater emotional impact on an individual than does an equivalent amount of gain. Hence if an individual is presented with choices presented in two ways — with both offering the same result — an individual will pick the option offering perceived gains. Extending the logic of loss aversion, prospect theory also shows that a sure gain is favoured over a probabilistic gain and that a probabilistic loss is preferred to a definite loss.

While prospect theory provided an alternative model of human behaviour and this was imported into various disciplines such as economics, law, political science etc. However, prospect theory has its own problems, the main one being framing effects. These effects are basically those that arise because the question is 'framed' in a particular way such that it gives a response that one desires. Prospect theory as originally developed by Kahneman and Tversky explored human decision-making based on choices among a series of financial bets and gambles. It was not originally intended to provide wider generalisation beyond that domain.

Hence, prospect theory fails to provide an adequate theory of framing that explains how and why actors generate, seek, and employ the frames they use. Another criticism in psychology is the way in which prospect theory provided a limited representation of human emotional and affective responses.

Conclusion

In the discussion above, we have looked at the rational choice theory and how it is the cornerstone of the neoclassical model. We looked at the critique of the RCT and the alternative prospect theory, which works on the assumption that individuals are boundedly rational. Finally, we also discussed the problems with prospect theory, chiefly, framing effects. With this article, we conclude the NIE+ series, where we have discussed the building blocks of NIE+, namely transaction costs, property rights, asymmetric information, public goods and common-pool resources and social capital.