Esteban.iae-csic.org

Frontier Research in Economics
Instituto de An´alisis Econ ´omico, CSIC ∗I am thankful to Xavier Calsamiglia, Itzahk Gilboa, Clara Ponsat and Debraj Ray for their comments. I retain full responsibility for the opinions expressed here.
This essay deals with trends in economic theory over the past few decades. It isunabashedly subjective and partial. It does not attempt to provide an exhaustivepanoramic view of current research in economics. Rather, I have chosen to focuson some of the recent developments that have tried to relax the highly restric-tive assumptions under which General Equilibrium Theory (GE) had been builtover the second half of the twentieth century. This enrichment in the descrip-tion of the working of individuals, firms, government, and society at large, hasalso had the side effect of significantly increasing the inter-disciplinary natureof current research In economics. We are witnessing a remarkable overlap withpolitical science and sociology, of course, but also with psychology, biology, andneuroscience.
Even with such a severe restriction in scope, I shall have to be more superficialthan I would like to be. Also, my choice has the drawback of leaving completelyuncovered important and dynamic areas of economics such as macroeconomics,finance, trade, and development, to mention a few.
The essay proceeds as follows. In the next section I start by giving a summaryview of the GE model, undoubtedly the core paradigm in economics. Section 3describes the major departures from the standard GE model. Then I move intoa more in depth analysis of the recent contribution of the behavioral approach toindividual decision making. Inspired by the research in psychology and largelybased on controlled experiments, behavioral research tries to carefully documentpatterns of individual behavior that deviate from the choices predicted by theclassical rational behavior model. Section 4 provides a description of all the in-gredients involved in a decision so that we can give a more structured accountof the different results and what are the precise ingredients that are questioned.
Section 5 gives a synthetic account of the main contributions in behavioral eco-nomics. Finally, Section 6 takes stock of the research reported, makes an evalua-tion of the net contribution and derives implications for future research.
2. GENERAL EQUILIBRIUM AND WELFARE ECONOMICS Modern GE theory started in the 1950s. The 1954 paper by the Nobel laure-ates K. Arrow and G. Debreu on the existence of a competitive equilibrium andthe 1959 book by Debreu “Theory of Value” can be taken as the beginning offour decades of an extremely fruitful effort to understand the working of com-petitive markets. The books by Arrow and Hahn (1971) “General CompetitiveAnalysis”, W. Hildenbrand (1974) “Core and Equilibria of a Large Economy”, and A. Mas-Colell (1990) “The Theory of General Economic Equilibrium: A Dif-ferentiable Approach” can be considered the most significant landmarks of thisendeavor.
GE consists of a very complex but schematic model that tries to capture the co-ordinating role played by markets in an otherwise atomistic and individualizedsociety. It provides a rigorous proof of the Smithian claim that the invisible handis sufficient to make mutually compatible the decisions taken by completely un-coordinated individuals and firms.2 In this sense, the elimination of any reasonfor explicit or tacit coordination as well as of individual concern for the oth-ers was crucial to the model. With all participants furthering their own interest(narrowly understood) and limiting their interaction just to supply and demandthrough the markets, the outcome would not turn out to be chaotic but orderlyand efficient [in a sense to be made precise below].
Let us recall some of the assumptions needed to derive this mathematical result.
The participating agents are an arbitrary number of individuals and of firms.
All participants can buy and sell commodities (labor, for instance) through themarkets at the ruling prices. Most important, all participants are assumed tobehave competitively, that is, to take prices as given.3 In addition, individualsown all the shares over the existing firms. The distribution of these shares acrossthe population is arbitrary.
Initially, each individual owns a collection of commodities (which may well beonly labor) and shares. By selling and buying they can obtain a new set of com-modities (for instance, eight hours labor sold and bread and butter purchased).
The amounts traded have to be within each individual’s budget, where the mon-etary value of the budget is determined by the ruling prices. All individualshave preferences over the traded commodities, that is, they can rank any pair ofbundles of commodities in terms of their desirability. Besides being complete,this ordering is assumed to be transitive, reflexive and satisfy a weak convex-ity condition.4 Most important, these preferences depend on own consumptiononly, hence eliminating any form of altruism. Then, individuals are assumed toact rationally. That is, among the trades affordable to them (the value of pur-chases cannot exceed the value of sales) they choose the one they rank highest 2This issue —markets versus socialist planning— became salient in the Cold War political 3This assumption is more plausible when all participants are so small that they cannot influ- ence prices by their action. It is obvious that this is not the case. Governments have had to setup competition agencies more or less effectively trying to guarantee that firms will not colludeto manipulate prices. Workers too are to a large extent unionized in order to keep wages (andworking conditions) up.
4If bundle A is strictly preferred to B, then any convex linear combination λB + (1 − λ)A, (λ > in terms of desirability. Thus, for any given vector of market prices each indi-vidual consumer thus has a well-defined vector of demands and supplies of thetraded commodities.
Firms purchase through the market commodities and labour supplied by otherfirms and by individual consumers (inputs) to turn them into a set of producedoutputs to be sold in the market. How much output firms can produce froma given vector of inputs is conditioned by the production technology availableto them. The set of feasible combinations of inputs and outputs is assumed tobe convex.5 For every vector of prices, each firm chooses the vector of inputs(purchases) and the vector of feasible outputs (sales) in view to maximize ownprofits.
An equilibrium is a vector of prices such that when all purchases and sales areaggregated for the entire economy, supply is equal to demand in each of themarkets. A good part of the research in GE until the mid nineties was devotedto demonstrate the existence of such an equilibrium vector of prices under theweakest assumptions possible on individual preferences and production tech-nology. Indeed the collection of individual decisions taken by egoistic indi-viduals and firms without any coordination can turn out to be feasible ratherthan generate disorder. Besides proving that the concept of equilibrium is notvacuous —there always exist such equilibrium situations— GE theorists alsoobtained conditions under which this concept was not too lax: equilibria aredeterminate, thus excluding continua of equilibria.
The most remarkable results of GE theory —the “Two Fundamental Theoremsof Welfare Economics”— prove that these market equilibria have interesting ef-ficiency properties. W. Pareto defined a basic efficiency requirement that hasbecome fundamental in economics: a situation is (Pareto) efficient if by reallo-cating commodities in the economy it is not possible to improve the well-beingof someone without harming somebody else. Notice that distributional justiceis completely absent from this notion. An allocation in which one person ownseverything while the rest are starving to death is efficient as long as individualpreferences never reach satiation.
The First Fundamental Theorem establishes that all competitive equilibria arePareto efficient. Therefore, market exchange among self-regarding participantsalso leads to an efficient use of the existing resources. The Second FundamentalTheorem says that every efficient allocation of commodities can be implementedas a competitive equilibrium, with an adequate redistribution of the initial re-sources. It follows that a socialist planned economy cannot do better than com-petitive markets —with an appropriate one-time redistribution of resources.
5If the combinations A and B are feasible, so is λB + (1 − λ)A, 0 ≤ λ ≤ 1.
How much to redistribute and how to do it without distorting the working ofthe markets clearly is a question complementary to GE theory. These kind ofquestions pertain to Welfare Economics. If the government has to choose it has tobe that there are some sort of “social preferences” ranking alternative policiesby the social desirability of their outcomes. As early as 1951, K. Arrow (Nobellaureate, 1972) demonstrated that it was not possible to aggregate individualpreferences into a social preference ranking, if this had to satisfy a set of reason-able properties. Welfare Economics —as well as Public Economics in general—ended up by assuming that somehow social priorities could be encapsulatedinto a social welfare function. The role of the government was then modeled inthe same spirit as individual choice: to maximize social welfare under feasibil-ity constraints. The contributions of P. Diamond and J. Mirrlees (Nobel laureate,1996) in the mid-seventies set the basis of modern public economics by rigor-ously rooting the theory of government intervention on the foundations of GEtheory.
This summary, of course, only records the most essential results of GE theoryand the associated welfare economics.6 At the January 1994 meeting of theEconometric Society one of the most distinguished contributors to the develop-ment of GE theory, Andreu Mas-Colell, gave an invited lecture on “The Futureof General Equilibrium”.7 His presentation transpires the perception that GEtheory had already reached its peak and that the attention of young researchershad already turned towards other issues that had been left aside by GE theory.
We are going to review some of these new lines of research. But, before movingto the marrow of my essay it is imperative to stress one fundamental contribu-tion of GE theory: mathematical rigor. This precisely is Mas-Colell’s (1999) lastline: “I would hope that the role of theorem proving is kept alive, perhaps notas strong as before, we may have overdone it, but with substantial presence” (p214).
3. MAJOR RECENT DEPARTURES FROM THE STANDARD MODEL The extremely stringent assumptions of the GE model were obvious to all theo-rists, but were considered the price to pay to have a clean model of the workingof the markets.
One obvious reservation is that in many markets there aren’t sufficiently manyfirms so as to justify the assumption of competitive behavior. There are situa-tions in which there exists a monoplist, and there are even situations in which 6See Mas-Colell et al (1995) for a state-of-the-art presentation of the General Equilibrium a monopolist is considered to be “natural”, as in the case of the supply of elec-tricity, cable TV, and so forth. A monopolist is not a “price taker”, and it maytake into account that the quantity it decides to produce will affect the price atwhich it is sold. In this case, the market equilibrium will typically not be Paretoefficient. The same result applies if there are several firms in the market, buttheir number is not large enough for each of them to act as if it had no effect onprices. This has given rise to the field of industrial organization mostly developedin the late eighties and nineties.8 A second major departure from the classical GE model has been the study ofthe role of information in the eighties and nineties. In the standard model, allparticipants are assumed to have the same information —which might meanthe relevant probabilities in case of uncertainty. However, it is plain that this isnot always the case. The classical example (Akerlof, Nobel laureate 2001) is themarket for second hand cars: the seller, who has owned the car, has more infor-mation on its quality than does the buyer. In such a situation, one can show thatequilibria are typically not Pareto efficient. Akerlof’s used car example (“themarket for lemons”) is a parable that applies to a multitude of situations inwhich information about trade is not symmetric. Other examples include theinsurance market (where the insured may know more about the risk than theinsurer), employment contracts (where the employed “agent” may know morethan the amploying “principal”), and so on (Akerlof, Mirrlees, Stiglitz, Vickrey,all Nobel laureates).9 Yet another major deviation from the classical model has to do with externalities,namely, situations in which the consumption of one agent might directly affectthe well-being of another. In particular, cases in which there is a public good –a good that can be used by many individuals simultaneously, such as hospitals,transportation, education, defense – fall in this category. Again, it was shownthat competitive markets cannot be relied upon to result in a Pareto efficientallocation in these situations.
It so happened that all these deviations from the classical GE model were an-alyzed using game theory. Game theory started out as the analysis of parlorgames in the beginning of the 20th century. In the 1940, O. Morgenstern and J.
von Neumann wrote the first book on the topic, which also suggested that thetheory is the correct way to analyze all social and economic situations. The ap-proach was soon refined by J. Nash, who held that all such situations should 8The books by Tirole (1988) and Vives (2001) give a comprehensive overview of the topic.
9See Stiglitz (2002) panoramic presentation in his Nobel lecture.
be analyzed from the level of the individual decision maker up. Nash sug-gested the notion of “equilibrium”, currently named after him (Nash Equilib-rium), which requires that each decision maker chooses her best course of actiongiven what the others are doing.
Game theory was prefectly suited to deal with non-competitive markets, butonly after the contributions of J. Harsanyi did it become apparent that situationsof asymmetric information were also amenable to game theoretic analysis. Thisalso made game theory the natural method to analyze problems of externalitiesand public goods. Hence game theory became the standard tool of analysis inmicroeconomic theory. Since the mid-70’s, economic theory has become dom-inated by game theory. Over recent decades, game theory has also proven afundamental tool for macroeconomics and even political science. It seemed thatany problem in the social sciences can be thought of as an application of gametheory.10 Current research, however, is grappling with several fundamental problems,which suggest either that not all major problems can be relegated to game the-oretic analysis, or that such analysis might not be complete. One can classifythe different recent departures from the paradigm in three categories: (i) howindividuals and firms decide; (ii) how governments decide; and (iii) how agentsinteract.
Even in such narrow an area of economics there are too many developments topermit a coherent and comprehensive presentation. I shall focus on the frontierresearch in individual rational choice only.11 However, before moving on, I shallgive a sketchy picture of the main lines of progress on group decision and onthe departure from the competitive assumption.
It is plain that government economic policies are not decided on the basis ofmaximizing a social welfare ordering. Rather, in democracies political partiespropose policies and citizens vote over the proposed manifestos. 12 This is theorderly way that modern democracies have designed to resolve the opposinginterests that characterize all societies. Therefore, if we want to understand thepolicies actually enacted we have to explain how political parties choose theirpolitical platforms and how they behave once in office. 13 This approach is what 10Other major contributors to game theory include L. Shapley, J. Aumann, and R. Selten (the latter two are also Nobel Laureates, alongside J. Nash and J. Harsanyi).
11Note that I am skipping the new views on the behavior of firms beyond profit maximization.
As an excuse, let me cite Mas-Colell (1999) who says “I am not sure that (.) we will end upseeing the theory of the firm at the heart of economics.” 12The first classical model of a democracy is due to Downs (1957).
13Roemer (2001) is a rigorous and comprehensive book on political competition.
has become to be known as positive political economy.14 Of course, the literaturehas also explored the known fact that large firms and special interest groups arealso effective in influencing the government in its decisions by lobbying throughvarious channels.15 The political system is itself endogenous and responds to the nature of different,often opposing interests within the society. Acemoglu and Robinson (2006) havestudied the role of social and economic change in forcing the political system tochange. Specifically, they argue that democracies have evolved as a commitmentdevice: tension over the distribution of wealth, and the threat of a revolutionhave historically forced monarchs to share their wealth. However, a promise todo so may not be credible. Democracy, according to this view, involving givingvoting rights to larger fragments of society, allowed commitments to be credibleand thus averted conflicts. But can the social contract always be modified inresponse to social changes? Clearly not. In the second half of the twentiethcentury there have been over 16 million civil deaths in civil wars. This exceedsby a factor of five the number of battle deaths in the same period. The threatof civil wars currently is so endemic that the World Bank considers politicalinstability the most serious impediment for the effectiveness of foreign aid inpromoting growth in developing countries. In economics, Hirshleifer (1991),Grossman (1991) and Skaperdas (1992) have pioneered the study of conflict, butwe are still far from a satisfactory understanding of the causes of civil conflict.16 How economic agents interact is simply not modeled by GE theory. How theproducts produced by firms reach consumers or other firms is left out of themodel.17 This lack of interest in the actual operation of economic transactions ispartly due to the exclusive focus on competitive markets in equilibrium. Indeed,if markets are competitive and in equilibrium there is no point in looking for abetter deal. All the requests get (magically?) satisfied and there is no chance offinding a seller offering a lower price. If, however, there are different prices forthe same commodity or if certain requests (such as an individual’s request to sellher labor) might not get satisfied, it certainly does matter how the transactionsactually operate.
14See Persson and Tabellini (2000) for a very influential book in this area.
15See Grossman and Helpman (2001)16See Esteban and Ray (1999) for a general model of conflict. Fearon (1996), Powell (1999) and Ray (2008b) have developed arguments to explain why society may fail in agreeing on a newsocial contract that Pareto dominates the costly outcome of civil conflict.
17As a consequence, the GE model is unable to analyze how the economy can reach the precise vector of prices that will clear all the markets.
Most of the research on the actual working of economic interactions has beeninvestigated by development economics. The most superficial observation of un-derdeveloped countries makes it plain that their economies cannot be conceivedas a set of competitive markets in equilibrium. We owe to this branch of the lit-erature most of the insights on the role of specific institutions, networks andsocial rules in channeling economic interactions.18 At a more formal level, theexistence of network connections and their impact on economic interactions hascaught the attention of economic theorists. The essence of the model bears sim-ilarities with the local interaction models in physics with a crucial twist: thenodes are optimizing individuals or firms that can create or sever ties.19 Thisapproach has given new insights in different areas of economics such as educa-tion20 and labor market.21 Many of the new directions of research in economics are driven by the needto relate theory to facts more strongly. This is especially true of modern “be-havioral economics”, as some colleagues term it. Since observed individualbehavior is often at odds with the decisions that derive from the standard ra-tional choice assumptions, economists have turned their attention towards thepatterns of behavior that psychologists have been identifying by means of con-trolled laboratory experiments. The pioneering work of psychologists Kahne-man (Nobel laureate in Economics, 2002) and Tversky22 has recently had a pro-found influence in economics. In addition to opening the minds of economiststo the findings in psychology, it has also triggered a remarkable boom in exper-iments on individual and group behavior. C. Camerer, E. Fehr, D. Laibson, andM. Rabin, to mention a few, are among the economists that have worked moreintensively in this field.23 To proceed in an orderly fashion, I find it useful to separate the essential ingre-dients of the individual decision problem.
18Ray (1998) is the basic advanced textbook in development economics. See also, Ray (2008a) for an overview of the recent developments in this area.
19See Jackson (2008b) for an survey of recent contributions and the books by Goyal (2007) and Jackson (2008a) for an extensive presentation.
20See Benabou (1993, 1996).
21See the survey by Calvo-Armengol and Yoannides (2008).
22Tversky died in 1996. See the essay of Laibson and Zeckhauser (1998) on Tversky’s 23Camerer and Rabin invited lectures at the Ninth World Congress of the Econometric Society provide an overall view of the potentials of marrying psychology and economics [see also thediscussion by Ariel Rubinstein]. They are all published in Blundell et al (2006).
The first ingredient is an informational input. Individuals observe some infor-mation about the state of world. In standard consumer theory this informationrefers to prices and incomes and, in an uncertainty environment, to the probabil-ity of each of the possible realizations of the states of the world. This informationtypically constrains the set of actions available to each individual.
The second ingredient is the computation of the consequences (deterministic orprobabilistic) that derive from each possible action. For instance, we take theaction of working for eight hours and purchase meat and fish. Or, we can giveup on consumption by ten euros and spend them in buying lottery tickets withgiven probabilities on a set of prizes.
The third ingredient is individual preferences. These preferences are assumed togenerate a ranking over all possible consequences (independently of the actionstaken as such) accordingly with their desirability, as explained before. When theconsequences are probabilistic, individuals rank actions by their expected util-ity, that is, the weighted average of the utility of the various realizations, usingprobabilities as weights. The standard model assumes that these preferences areegotistic, independent of what the others obtain.
The last ingredient is rational choice. By this we mean that each individual isable to solve the constrained maximization problem consisting of identifyingthe action in the feasible set that has the most desirable consequence.
Experimental work on individual behavior consists of confronting a set of in-dividuals with a situation (as controlled as possible) in which classical decisiontheory has an unequivocal prediction so that the researcher can contrast actualwith predicted individual choices. There is a rich variety of such experimentsexploring different types of violations of the predictions of the standard model.24 For instance, a repeatedly studied experiment consists of subjecting a sample ofindividuals to the ultimatum game. Individuals are randomly matched in pairsand one is assigned the role of proposer and the other that of the receiver. Theproposer announces a division of a given amount of money among the two play-ers. Then the receiver either accepts —and the money is divided accordinglywith the proposed allocation— or refuses —and both players receive zero. Ifplayers care about their own material interest only, the second player shouldaccept any strictly positive amount of money. Knowing this, a selfish proposershould give an arbitrarily small amount to the receiver and cash the rest. As itturns out, in all specifications of this experiment there is a substantial propor-tion of proposers that propose divisions that are quite close to the egalitarian 24See della Vigna (2008) for a comprehensive survey of the different types of experiments.
one and of receivers that are ready to give up even a non-negligible positiveprize in order to “punish” unfair proposals.
The previous experiment is but one example of the plethora of patterns of choicethat are currently being tested by behavioral economists. Some of these exper-iments challenge certain specific ingredient of our previous description of thedecision process. But some are less targeted and try to identify violations of thepredictions of standard rational choice theory.
Let us go through some relevant complexities that standard rational choice the-ory assumes away at each of the ingredients of a decision. Some have beenstudied by behavioral economics, but many are still to be carefully explored. Asit will become clear, my position is somewhat ambivalent. On the one hand, Ithink that economics has to enrich its basic model of rational choice. But, on theother hand, I am quite skeptical —if not critical— with many of the claims of be-havioral economics. In this respect I feel more in line with the critical positionsof Gul and Pesendorfer (2008) and Rubinstein (2006).
The first ingredient of choice is the processing of information. There are manychannels through which the acquisition of information may affect decisions. Inthe first place, individuals categorize information. This has been an object ofstudy by social psychologists for the past five decades, but only recently haveeconomists started paying attention to it. It is immediate that such a processcan bias our decisions. Fryer and Jackson (2008) study how efficient process-ing of information leads to a coarser categorization of the types of experiencesthat are less frequently observed, lumping them together. As a result, decisionmakers make less accurate predictions when confronted with such objects andthis can result in discrimination. Secondly, individuals have to have an idea ofwhich information is relevant to the decision at hand and which is not. In orderwords, they need to entertain a “model” linking the possible actions to their con-sequences, as we shall soon discuss. However, there is psychological evidencethat individuals tend to censor evidence that refutes they view of the world.
Moreover, Benabou and Tirole (2006) argue that this censoring mechanism mayserve a function by supporting a belief that the degree of social mobility is higherthan it actually is, and thereby inducing individuals to make a higher effort thanrational choice would warrant. Such unrealistic beliefs are especially necessaryin countries with a limited social net, such as the US. Finally, the rational choiceassumption that individuals will use information to perform Bayesian updat-ings of the relevant probabilities may be unwarranted. As argued by Gilboa etal. (2007) there are instances in which individuals cannot have prior beliefs thatare represented by probabilities to start with because rational, justified, beliefsfail to pin down a numerical probability.
The second ingredient consists of mapping actions into consequences, eitherdeterministically or probabilistically. This step presumes that in view of the ev-idence individuals can identify a model that fits the data and that this model isunique. It is plain that this is generally not the case. More formally, Aragones etal (2005) show that given a knowledge base, finding a small set of variables thatobtain a certain value of R2 is computationally hard, in the sense that this term isused in computer science. Because of this fact, rhetorical statements contribut-ing no new evidence can induce a change of behavior, as they may make oneaware of certain relationships among known variables, which are obvious post-hoc, but have not been concieved of before. Multiple theories and as many deci-sions are compatible with a given stock of evidence. Picketty (1995) developeda model in which the belief in a particular theory induces decisions that gener-ate evidence confirming this theory. Different individuals can sustain differenttheories and parents have an incentive to transmit their own theory to their chil-dren. Finally, another way of making decisions in the absence of a determinateinterpretation of evidence is via social imitation. Banerjee (1992) developed amodel of herding in which individuals make inferences from the observation ofthe behavior of others regarding the information they might have had and thisleads them to act in a similar fashion.25 An alternative line is the effect of so-cial identity in behavior. Akerlof and Kranton (2000) were the first to call theattention of economists to the role of individual identification with categories orprototypes. I think that this is an important line of research, unfortunately stillquite unexplored.26 The third ingredient is individual preferences. This possibly is the front whereclassical economic theory is more restrictive and unrealistic. In the first place,it assumes that preferences are defined over own consumption only. This ex-cludes altruistic motivations of which we have ample evidence. There is a vastliterature on altruism, especially reciprocity based. Rabin (1993), Levine (1998),Fehr and Schmidt (1999), Bolton and Ockenfels (2000), and Falk and Fischbacher(2006) have focused on the interaction between pairs of players where eachplayer attempts to infer the motive of its partner and then modifies its socialpreferences accordingly, giving greater weight to partners who are believed tobe benevolent and less weight to those who are selfish or malevolent. Addition-ally, individuals may value actions per se, independently of the valuation of theirconsequences. This refers to the self (self-esteem/pride) and to the others (eth-ical judgments). See Lindbeck et al. (2006) for an economic analysis in which 25See the recent overview on herding by Rook (2006).
26Esteban and Ray (1994) launched the idea that social conflict is driven by the sense of iden- tity with one’s own group, combined with the complementary sense of alienation with respect tothe others. However, they just axiomatize an index of polarization rather than go into developinga model of identity formation.
parents seek to instill work norms in their children which are sustained by guiltand Tabellini (2007) for the adoption and transmission of values of generalizedmorality.27 Finally, individuals seem to face changes in their preferences boththrough time28 and through restrictions in their choice set.29 The fourth ingredient is decision making proper. That is the process of com-bining all the information available and turning it into the choice of a particu-lar action. The assumption of rationality means that individuals are supposedto choose the action they value highest within the actions available to them.
Therefore, one can say that individuals do not behave rationally only when theanalyst can offer an alternative action different from the chosen one and that theindividual accepts as preferable.
The joint consideration of the available information, the link between actionsand consequences and the valuation of these consequences involves consider-able reasoning and the reasoning capacity depends on education, training andpast experience. It follows that we can conclude that individuals behave non-rationally only if they insist on their choices after being shown by the analystthat better choices existed for them. We shall come back to this notion of ratio-nality based on Gilboa and Schmeidler (2001).30 In the case of certainty, rationalchoice amounts to solving a maximization problem under feasibility constraints.
However, already in the 1950s Simon (Nobel laureate, 1978) argued that indi-vidual rationality was “bounded” in the sense that human computing capacityis limited. But this line of enquiry has not had much following. Notice that“bounded rationality” does not imply non-rationality in the sense above.
The reasoning required for a decision in the case of uncertainty is much morecomplex as it calls for the additional consideration of the probability of the oc-currence of every consequence possible. Classical rational decision theory as-sumes that individuals value each action by the weighted sum of the valuation 27For the particular case of norms pertaining to work, seminal contributions by Moffit (1983) and Besley and Coate (1992) consider the case in which there is stigma associated with livingon welfare. Lindbeck et al (1999) have extended this analysis to include voting over welfarebenefits. Cervellati et al (2008) let moral judgments on effort determine self-esteem and esteemfor the others.
28The psychological cost of a given time postponement of a prize is higher if this happens immediately than if it does later in the future. Laibson (1997) has termed these time preferencesas displaying “hyperbolic discounting”.
29Here is a prototypical example: I definitely prefer not to smoke. I also would like to have lunch with a friend who happens to be a smoker. I may commit not to smoke by not havinglunch with my friend. I know that if I have lunch with her I may give in to the temptation ofsmoking. This idea has been thoroughly explored by Gul and Pesendorfer (2001).
30See a more detailed analysis in Gilboa et al (2008) of the consequences, using the relevant probabilities as weights.31 Experimentalevidence seems to confirm regular violations of some of the axioms —the so-called Allais and Ellsberg paradoxes. In order to reconcile theory and behavior,Kahneman and Tversky (1979) proposed prospect theory for modeling decisionunder risk. Based on behavior —and not on axioms— they claim that probabil-ities do not enter linearly in the valuation of an action but through a weighingfunction that exaggerates low probabilities and moderates large probabilities.
Also the valuation of each consequence is measured as a deviation from a refer-ence outcome.32 Notice that this approach continues to assume that there existwell defined probabilities for each of the possible consequences of an action. Yet,this is rarely the case. Gilboa and Schmeidler (2001) postulate that decisions arebased on the results observed in previous cases that are considered “similar” tothe current problem. From a set of axioms they derive that the value of an actionis the sum of the utility levels that resulted from using this action in past cases,each weighted by their similarity to the current problem.
As far as rational choice is concerned, we can conclude that, while there is lit-tle controversy on rational decision making in certainty, the case of uncertaintyis still unsettled. Summing up, we have seen that actual behavior appears todisplay deviations in each of the ingredients of a decision problem. There cer-tainly is room for enriching our modeling of how information is acquired andprocessed, of how individuals link consequences to actions or even what arethe different dimensions that agents value (in addition to the material trade-able commodities). However, none of these changes appears to have much todo with the basic notion of making of an optimal decision under certain con-straints.
In the next section we shall discuss what can we learn from the findings of be-havioral economics and the extent to which they challenge the assumption ofrational individual decision making.
Where does the exploration of the links between psychology and economicslead to? The vast and solid empirical evidence that there is a number of psycho-logical factors that matter when individuals make decisions has been seen by 31Properly speaking the assumption is that individual choices respect the axioms proposed by von Neumann and Morgenstern (1944), which imply that the valuation of an action is itsexpected utility 32The case of Ellsberg paradox is examined in Fox, C. R. and A. Tversky (1995).
some behavioral economists as a challenge to the core paradigm of economicson rational choice.33 I shall argue that it is unclear how can experimental evidence be extrapolatedoutside the laboratory —what can we learn from it?— and that the enrichmentof the behavioral description of decision makers is likely to have more influenceon models of applied economics than on the paradigm and core assumption thatindividuals act rationally (and essentially) in self-interest.
6.1. What can we learn from experimental evidence? In the first place, we ob-
tain a controlled confirmation that individuals behave differently from what
prescribes classical economic theory. Indeed, individuals care for things other
than their own material consumption, such as the actions they may take per se,
moral judgements of the self and of others, etc. Decision makers also do not
perfectly process information and often violate some axioms of rational behav-
ior. However, it is not always obvious how such evidence should be interpreted
and, even if it were unequivocal, whether the violations found in experiments
should form part of the standard modeling of individual behavior.
In a sense, the experiment by Kahneman and Tversky (1984) showing that fram-ing does have an effect on individual behavior makes one skeptical about whatwe can learn from experiments. First, there is a suspicion that the observed be-havior has been induced by the particular way the choice problem had beenpresented to the participants.34 Should we then conclude that people generallyviolate the most basic assumptions of the theory, or should our conclusion bethat sometimes, given certain very clever formulations, people may act in highlyirrational ways? Implicit in the work of experimental behavioral economists is the belief thatthere is a natural pattern of behavior that was not properly captured by classicaldecision theory and that can be identified by means of critical experiments.
Camerer and Loewenstein (2003) tell us that “behavioral economics increasesthe explanatory power of economics by providing it with more realistic psycho-logical foundations” and that “the conviction that increasing the realism of thepsychological underpinnings of economic analysis will improve economics onits own terms”. Also, Rabin (1998) asserts that “because psychology systemati-cally explores human judgement, behavior, well-being it can teach us important 33Rabin and Thaler (2001) refer to classical expected utility theory as a “dead parrot”, from a 34This and other arguments on the difficulty of extracting conclusions from behavioral exper- iments are carefully examined in Levitt and List (2007).
facts about how humans differ from the way traditionally described by econom-ics.” Therefore, the purpose is to capture the true nature of individual decisionmaking from factual observations in experiments or by other means.35 Can we capture this “nature” of decision-making by experiments? Further, doesthis “nature” exist in a meaningful sense? Leaving apart the reservations on the effective ability to control experiments, itstill remains unclear what is the exact “nature” we are measuring. In order toillustrate my point let me take the most popular experiment that we have de-scribed before: the ultimatum game. The costly refusal of “unfair” proposals isinterpreted as showing that individuals also care about things other than theirpersonal monetary payoff.36 However, it can also be that this costly rejection ofan unfair proposal is an emotional reaction that momentarily obscures what rea-son would have dictated. The extent to which reason overrides emotions variesacross individuals —possibly depending on education and training— and, inany case, only the dictates of reason should be taken to conform to rational be-havior. If we are interested in the choices that a specific group of individualswill make in a given circumstance, it might be critical to know whether theywill react bluntly or they will make cold calculations.37 However, is seems nat-ural that a general theory of individual behavior should abstract from the factthat we may momentarily deviate from rationality.
This raises a fundamental question over to we shall return: whether rationalityis something positive or normative. Should society train citizens to be ratio-nal?38 In fact, we do through the compulsory educational system.
Even for a given degree of sophistication in reasoning specific experiences ortraining can have a profound effect on behavior. The work of Amiel and Cow-ell (1992) trying to empirically identify the notions of equity actually used byindividuals is very pertinent to substantiate the point I am making. Students 35I shall not discuss the current attempts at exploring the link between decision making and brain activity. See Gul and Pesendorfer (2008) for a critical view 36This interpretation is reinforced by the interesting result that when the proposer is replaced by a machine that it is known to select proposals randomly, then the second player accepts unfairproposals much more easily.
37Even if rejection truly were the result of moral disappointment, the experimenter should test whether leaving the decision of rejection for the next day would alter the results.
38“Human beings, Romans argued, consist of two elements: an intelligent, rational spirit, and a physical body. (.) In fully rational people —such as elite Romans, of course— the rationalspirit controlled the physical body. But in lesser human beings —barbarians— body ruled mind.
(.) Where Romans would calculate probabilities, formulate sensible plans and stick to themthrough thick and thin, hapless barbarians were always being blown all over the place by chanceevents.” Heather, P. (2005) The Fall of the Roman Empire, Oxford University Press (p. 69).
were shown a series of two lists of (ten) incomes and should rank them in termsof their relative inequality. The purpose was to test which of the different cri-teria used in economics could find wide acceptance. Among these criteria theytested the principle of progressive transfers popularized by Atkinson (1970). Thisprinciple says that if we transfer one euro from any single person to someonepoorer the resulting distribution is less unequal. The result of relevance here isthat this principle found wide support among economics students —who weredirectly or indirectly familiar with the concept— and quite modest among theother students. Indeed, we can more easily interpret information when we havebeen told how to organize it.
The previous question of whether there is a “nature” of the decision makingthat can be captured by experiments was somewhat rhetoric. The point is thatwith the present state of knowledge it is not possible for the experimentalist tocarry out critical experiments. As discussed in detail by Levitt and List (2007),even the most carefully designed experiment cannot guarantee that all other in-fluences have been effectively controlled for by the analyst. Therefore, whileexperiments have an extremely useful role in highlighting deviations from pre-scribed behavior, they cannot in general unequivocally identify the causes ofsuch deviant behavior. I find it very important that the effort in experimentsbe continued, but I am persuaded that this will be a long term project that willrequire time, effort and patience.
6.2. Behavioralism and rational choice. Behavioralism will have more influ-
ence in models of applied economics than in redefining the core paradigm of
individual rational choice. Let me present two arguments in support of my
point.
My first argument is that there are still too many aspects of behavior of which wehave but a very imperfect understanding. We see that individuals may be moti-vated by altruistic feelings, for instance. However, we are still not able to under-stand the causes of the variation of these feelings across the population. Someresearchers have seen altruism as driven by the search of the benefits of reci-procity. Even this reciprocity can be in material benefits or it can be a reciprocityin attitudes. Other researchers see altruism as deriving from moral convictions.
We also observe that the degree of altruism depends on the proportion of thegroup that behaves altruistically. We have only conjectures as to how all theseaspects interact. So far we don’t know whether moral values, response to ob-served behavior by others, tendency to reciprocate, and the like are exogenousparameters or at least partly result from the variables we are trying to analyze.
It is obvious that without exactly knowing (or hypothesizing) what determineswhat, these behavioral features cannot be incorporated into a general model.
My second argument is that, even if we knew much more about individual be-havior, how many specificities do we want the paradigmatic model to take onboard? When the objective is to predict the demand for a given product (a newcar, for instance) textbook consumer theory is of modest help only. The sales de-partment of large companies know all too well that there are many motivationsother than price to buy a product and that a certain share of the market reacts tothe pride of driving a new car, while another share carefully reads consumer re-ports, and so on. By correctly mimicking the reaction of each type of consumerthey are able to estimate the potential demand with remarkable precision. How-ever, most researchers would consider that this kind of exercise does not belongto economics as a science.
How has economics dealt with features that do not fit with the assumptions ofthe core model? For long, modern economics has identified “anomalies” suchas public goods (the enjoyment of which does not reduce the supply available,such as public tv broadcasting or law-and-order, as in Samuelson, 1954), Giffengoods (whose demand increases with its price, already mentioned by Marshallin 1895), inconsistencies in inter-temporal choices (as analyzed by Strotz, 1956)or the social status effects on consumption (as in Duessenberry, 1953). However,the recording of such anomalies in actual behavior did not erode classical theoryof rational choice. Rather, economics reacted by developing “auxiliary” modelsto examine how each such departure from the classical assumptions could mod-ify the intuition derived from the GE equilibrium model.
Classical decision theory is not meant to be descriptive in the literal sense of theword. The contribution of the GE model has not been to produce theories thatactually predict anything with any precision, but a new way to think about theworld which is truly illuminating. Giving up accuracy for insight is a familiartrade-off in economics, and perhaps the social sciences at large. How far oneshould go in skipping specificities in behavior is debatable. Should research ineconomics proceed as in the aforementioned cases and also develop “auxiliary”models while preserving the essence of the GE model as the core paradigm? Myposition as of today is in the affirmative, at least as long as we cannot neatlyidentify the exogenous determinants of the observed behavioral patterns.39 6.3. How realistic a theory has to be? There is little doubt that, for specific
applications, one would like to have as accurate a theory as possible. However,
for theoretical applications, such as the derivation of the welfare theorems, it is
not obvious that more accurate assumptions result in more accurate, let alone
more useful conclusions. The reason is that theoretical applications use models
39I personally find more embarrassing the assumption of competitive behavior when, for instance, the critical oil market is controlled by the OPEC countries.
that are known to be false as a way to sort out and test arguments. Certainassumptions, which are certainly incorrect when tested in a laboratory, can bemore useful for certain purposes and less for others. There is a danger that anexperimental finding such as framing effect might, when put together with othertheoretical assumptions, lead to a result that is less realistic than the assumptionthat framing does not matter.
Thus, the question we should ask ourselves when we deal with general eco-nomic thought is not whether a particular assumption is accurate. Rather, aspointed out by Milton Friedman (Nobel laureate, 1976) long ago, we shouldask whether it leads to more accurate conclusions, when coupled with other as-sumptions, and, importantly, whether it suggests a reasonable trade-off betweenaccuracy and strength. If we end up rejecting all assumptions, and thereforesaying nothing, the accuracy of our models will be of little consolation.
6.4. Closing comments. Some researchers have been tempted to interpret the
observed deviations in behavior as a challenge to the assumption of rationality.
As we have seen, many deviations in behavior are due either to mistakes in pro-
cessing the information, to framing or to a misunderstanding of the relationship
between actions and consequences, or due to temporary perturbations in pref-
erences or in time discounting (provoked by emotions and the like). As pointed
out by Gilboa and Schmeidler (2001) and Gilboa et al. (2008), all these devia-
tions have the following in common: if exposed to the analysis of her behavior,
the decision maker would wish to change her choices. For instance, she would
want to eliminate identifiable errors in reasoning or blunt reactions. Thus, what
is irrational for a decision maker are those types of behavior that will not be
robust to analysis; they are likely to change when talking to an expert or brain-
storing the decision with other decision makers. It appears more useful to focus
on those deviations from classical theory that pass this test of robustness, that
are “rational” in this sense. Other violations are sometimes thought provoking
and often amusing, but they need not qualify as a basis for responsible economic
analysis.
I wish to conclude this essay with a few words for the immediate future of re-search in behavioral economics. There is nowadays a burst of departures fromthe standard rational choice model, all motivated on the grounds of psychologi-cal evidence. In Rubinstein’s (2008) words, a model “that has at its core fairness,envy, present-bias and the like is by now not only permitted but even preferred”.
All this variety of departures certainly produce intellectual excitement, but italso produce perplexity and a sense of lack of direction. Every newly identifiedpathology is cheerfully welcome. In my view, an effort should be made to in-troduce some order in this chaotic landscape. Research should concentrate on a few types of deviations only. The ones that may be more critical from the per-spective of economics —as Gul and Pensendorfer (2008) recommend. Once theimplications have been well understood we may move to a further enrichmentof our modeling of individual decisions.
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