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Is Economic Rationality in the Head?

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Many economic theorists hold that social institutions can lead otherwise irrational agents to approximate the predictions of traditional rational choice theory. But there is little consensus on how institutions do so. I defend an economic internalist account of the institution-actor relationship by explaining economic rationality as a feature of individuals whose decision-making is aided by institutional structures. This approach, known as the subjective transaction costs theory, represents apparently irrational behavior as a rational response to high subjective transaction costs of thinking and deciding. The theory has two attractive features. First, it reconciles rational choice theory with the increasing body of evidence cataloguing putative errors in economic decision-making. Second, it vindicates the explanatory power of individual choice against externalist challenges; the subjective transaction costs theory keeps economic rationality in the head.

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  1. For a helpful review of some of the puzzles raised, see Binmore (2007), especially the introduction.

  2. That is, faux-rational decisions, decisions whose cost-benefit analysis excludes subjective transactions costs. I explain the idea of faux-rational choice below.

  3. The embedded-extended mind debate maps onto internalist-externalist interpretations of rational choice theory, as both debates concern whether scientific theories best explain psychological and economic data based on a choice unit that is located entirely within the head or partly outside of it.

  4. This said, decision theory is employed differently by different subfields in economics. For more on the plural understanding of rationality used by economists, see Cowen (2004). Our scope is restricted to those areas of economics that employ the theory in relatively unmodified forms; to the extent a sub-field of economics employs traditional decision theory, to that extent what I say here applies to it.

  5. I draw on the list provided by Gaus (2007, 36–7). But for classic treatments, see Luce and Raiffa (1989), Savage (1972). Indifference is typically symmetric and transitivity can be weakened to quasi-transitivity.

  6. For a clear, concise explanation of expected utility theory, see Resnik (2000, 45–118).

  7. The following list of features of homo economicus is given by ibid., 19–27.

  8. Many anthropologists have argued that in traditional societies, economic decisions are governed by norms of reciprocity. See Polanyi (2001), Sahlins (1972), esp. 1–40. Herbert Simon’s work on bounded rationality maintains that human rationality is subject to certain cognitive limitations. See Simon (1984).

  9. Obviously there are many positivisms. For our purposes, I am simply examining the surprisingly still popular Friedman, Popper-based positivism commonly accepted by economists.

  10. For a summary analysis of Smith’s work and the broader conception of economic rationality he endorses, see Smith (2008). Smith has been the main articulator of the idea of “ecological rationality” that shares much with the STC theory I defend.

  11. These terms derive from Starmer (2000).

  12. One illustration of weighted utility theory can be found in Chew and MacCrimmon (1979).

  13. This distinction is not well-formed. Heuristic use can be represented as optimizing a preference function. The preference function is simply a model for representing choice; utility theory does not require psychological underpinnings. See Gaus (2007, 1–6).

  14. Some claim that Kahneman’s work suggests the more radical thesis that human decision-making cannot be characterized in terms of preference orderings and that such orderings are formed on the fly. But, importantly, Kahneman and his co-authors have not generally taken this more radical step. Instead, they have tried to develop an economic model that understands these phenomena as consistent with certain sorts of orderings, orderings that are often quite stable given persistent heuristics and biases.

  15. Critics of extended mind views follow Rupert in drawing a distinction between institutional causation and institutional constitution. For discussion, see Wilson and Foglia (2011), esp 6.3.

  16. For a brief explanation of transaction costs, see:

  17. One need not be an economic determinist to appreciate this point.

  18. Also see Gode and Sunder (1997).

  19. Their claim resembles Alchian (1950), which sees profits as a constraint rather than an objective. Since only firms that make profits survive in the marketplace, firms may appear to maximize profits when they have other aims, or none at all. I thank Mike Munger for this point.

  20. There is an additional argument for externalism that, given how much institutional factors bear on what agents prefer, we should extend the mind into the environment in order to generate preference stability. But I take it such an argument can only be motivated if we already have an account of what agents want in hand, which would require having already settled the matter of dispute in this paper. I thank an anonymous referee for raising this point.

  21. Clark has, however, applied much of his theoretical framework to understanding the successes of neoclassical economic theory despite its putatively implausible conception of decision-making. See Clark (1996).

  22. See Adams and Aizawa (2009) for discussion.

  23. One reason Ross wishes to undermine the use of “metaphysics” of the sort putatively appealed to by the externalist is that he wishes to advance his own account (Ross 2005) of economic rationality where a commonsense agent is understood as a coalition of sub-agents, each of whom tend to follow microeconomic laws. Ross claims that “People are politically complex societies of temporally located selves” (186). The problem with Ross’s view is that it expressly requires dismissing “the explanatory value of supposing that the concept of qualia picks out any theoretical unified class of cognitive objects” (231). Denying the usefulness of the idea of qualia, however, ignores data that we can use to choose between social scientific theories, namely conscious experience. Denying the importance of subjective mental properties in social scientific explanation is deeply implausible, so I set his view aside here.

  24. We could also describe Hausman’s claim as that structural explanations can help explain coupling without postulating a constitution relation.

  25. Suppose that your rate of Wheat Thin consumption is an exogenous variable (you won’t eat them faster if you have more).

  26. I use the term “faux-irrationality” because it seems appropriate to use the term “rational” to apply to an agent’s behavior given her total costs of achieving an outcome, including the costs of figuring out that the outcome is good or best. The problem with much of the cognitive psychology and behavioral economics literature is that they charge individuals with irrationality independently of a crucial set of costs, STCs.

  27. My claim resembles Gigerenzer and Goldstein (1996), though they think classical decision theory is no longer the appropriate normative standard of rationality, as their work shows that more “correct” answers can be achieved with algorithms that depart from traditional models. I am not offering a normative standard, just an explanatory theory.

  28. Gigenrenzer and Brighton (2009) have argued that heuristic use is not justified by approximating more complex, and so more accurate, decision-mechanisms, but rather as attempts to avoid variance errors by relying on bias to make rough and ready calculations that themselves are often more accurate than more complex processes. So it may be mistaken to conceive of the rationality of heuristic use as giving up accuracy in comparison to making complex, explicit calculations. If so, then we can understand heuristic use as a method of becoming more accurate generally, if not more accurate than explicit, complex cognition.

  29. I thank two anonymous referees for raising this objection. One of the referees also raised the concern that the STC view implies that choice in the absence of social institutions will fail to maximize utility, which does not fit well with the view that people are economic agents whether or not they act within social institutions. In response, I would ask what is involved in an agent making choices outside of institutions. The vast majority of human beings are never in this situation. All of their choices will be affected by the social practices and institutional rules that surround them. Even people who live solitary lives have at least been reared within institutional structures whose behaviors can stick with the agent after she becomes isolated. If we imagine humans with solitary childhoods, the objection loses its force since children in those situations have serious cognitive deficits, that is simply never true. All their choice behavior will be affected by the social practices and institutional rules that surround them. Even people who live solitary lives have at least been reared within institutional structures whose behaviors can stick with the agent in isolation. If we are to imagine humans live entirely solitary lives, the concern is remote. Our best evidence of what such an agent would be like (though how it would survive childhood is a total mystery) involves comparison with feral humans or humans who have been deliberately isolated by a captor. But these agents are known to have extreme cognitive deficits.

  30. For an attempt to generate a ratio between these two costs, see Ortmann and Rydval (2004). They authors find around a 2:1 ratio between “capital” and “labor”.

  31. I also believe, but I cannot elaborate here, that STCs can to some extent be measured via exertion of willpower as understood in the growing willpower literature.


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This paper has been long in the making, so I owe many people my thanks, including but not limited to Jerry Gaus, Terry Horgan, Keith Hankins, John Thrasher, Tyler Cowen, Adam Martin, Mike Munger, Alex Von Stein, Don Ross, Mark Alfano, Peter Boettke, Fred D'Agostino, Art Carden, David Schmidtz, Cathleen Johnson, Vernon Smith, Bart Wilson, and several anonymous referees.

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Vallier, K. Is Economic Rationality in the Head?. Minds & Machines 25, 339–360 (2015).

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