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“It is frequently convenient to present such a hypothesis by stating that the phenomena it is
desired to predict behave in the world of observation as if they occurred in a hypothetical
and highly simplified world containing only the forces that the hypothesis asserts to be
important. In general, there is more than one way to formulate such a description — more
than one set of ‘assumptions’ in terms of which the theory can be presented. The choice
among such alternative assumptions is made on the grounds of the resulting economy,
clarity, and precision in presenting the hypothesis; their capacity to bring indirect evidence
to bear on the validity of the hypothesis by suggesting some of its implications that can be
readily checked with observation or by bringing out its connection with other hypotheses
dealing with related phenomena; and similar considerations.”
Simon Says, Bounded Rationality
The polymath Herbert Simon proposed that rationality is bounded.
Because getting information is costly and decision outcomes typically
unknown, instead of maximizing utilities, people only try to “satisfice.”
Satisficing behavior seeks only a minimum, not a
maximum value of a variable; people choose as
well as they think is possible. The behavioral
theory of the firm sees producers treating profits as
constraints, not goals to be maximized. Although
some critical level of profit must be achieved,
thereafter, a firm’s priority turns to its other goals.
“Most producers are employees, not owners of the firms..... Viewed from the vantage point
of classical [economic] theory, they have no reason to maximize the profits of the firms,
except to the extent that they can be controlled by owners.... there is no difference, in this
respect, among profit-making firms, nonprofit, and bureaucratic organizations. All have
exactly the same problem of inducing their employees to work toward the org’l goals. There
is no reason, a priori, why it should be easier (or harder) to produce this motivation in
organizations aimed at maximizing profits than in organizations with different goals. The
conclusion that organization motivated by profits will be more efficient than other
organizations does not follow the organizational economy from neoclassical assumptions. If
it is empirically true, other axioms will have to be introduced to account for it.”
Prospecting for Gains & Losses
Daniel Kahneman & Amos Tversky’s prospect theory posited a gain-loss
cognitive process that guide behaviors under conditions of uncertainty.
Using lottery choices as a paradigm, they divided
behavioral decision making into two phases:
(1) Editing events into a mental model, which
orders alternatives by a simple heuristic, to enable:
(2) Evaluation, which is asymmetric – losses have
bigger impact than gains on choices (risk-aversion)
Prospect theory may offer better explanations than the standard rational choice model of:
• Gambling & betting puzzles – we suffer more from a loss than we enjoy a win
• Endowment effect – over-valuing something once you own it (house, painting)
• Status quo bias – people prefer that things stay relatively unchanged
• Equity premium puzzle – why are stock returns 6% > gov’ment bonds?
• Intertemporal consumption – personal savings are highest in middle-age because
people divide their assets into “mental accounts” with different consumption rates
Unlike additive utility functions of neoclassical economics, prospect theory implies that
personal utilities can derive from social reference groups. Happiness research finds that
subjective measures of well-being remain relatively stable over time, despite large
absolute increases in living standards within a population (Easterlin 1974; Frank 1997).
Uncertainty as a Scope Condition?
Jens Beckert’s (1996) criticized rational choice, not for its unrealistic
informational requirements, but inability to explain how people actually
choose under conditions of uncertainty (no info to assign probabilities).
To lessen hazards, actuaries won’t insure any property for more than it is worth,
or even for its replacement cost, and almost always require a deductible (initial
up-front sum which the insured must pay out of his or her own pocket). They
may also impose other conditions, such as the ownership of fire extinguishers.