, Volume 3, Issue 2-3, pp 217-235

Bounded Rationality of Economic Man: Decision Making under Ecological, Social, and Institutional Constraints

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Abstract

Neoclassical economic theory is implicitly based on the assumption of atomistic individuals living in anonymous societies, unconnected to other individuals by kinship, ethnic, friendship or other social ties. Furthermore, neoclassical economic theory is based on a model of rational, omniscient individuals operating in a zero transaction costs world of perfect markets without institutions. In the last forty years or so, New Institutional Economics (NIE) have criticized Neoclassical economics and have incorporated concepts of bounded rationality, transaction costs, and uncertainty. Neoclassical economic theory has also been challenged by behavioral studies of decision-making showing that cognitive constraints lead to various decisional biases and judgmental errors. However, similar to neoclassical economic theory, behavioral models of risky choice have largely ignored environmental variables such as social structure (group size, group composition, etc.) and institutional infrastructure (the formal and informal ‘rules of the game’). In this paper, we show how social structure and institutions serve as important constraints influencing rational choice in risky situations. Wang’s experimental work shows that a famous ‘cognitive illusion’ called framing effects disappear when kinship relations, the smallness of group size, and group homogeneity are taken into account. These empirical findings are explained in a framework of ‘Bounded Risk Distribution’. Landa’s NIE theory of the ethnically homogeneous Chinese middleman group, based on fielwork, shows that in an environment characterized by contract uncertainty, hence positive transaction costs traders choose their trading partners along kinship and other particularistic basis, a phenomenon not predicted by Neoclassical theory of exchange. Our paper shows that economic and descriptive psychological risky choice theories of decision-making need to take into account the social and institutional environment: the boundly rationality of economic man is influenced by the social contexts in which he makes decisions.

This revised version was published online in August 2006 with corrections to the Cover Date.