The Mysterious Methodology of Rational Choice Theory | Christopher Clarke

 

In the last few decades, economists have puzzled over the curious phenomenon of so-called ambiguity-averse preferences. You are indifferent between (A) receiving a cash prize if a coin lands heads, and (B) receiving the prize if a coin lands tails. You are also indifferent between (A*) receiving the prize if the Nikkei stock index goes up and (B*) receiving the prize if it goes down; for you are totally ignorant about the Japanese stock market. But you prefer (A) to (A*), and you prefer (B) to (B*). Thus, intuitively, you prefer gambling on the more familiar toss of a coin than on the less familiar stock market.

 

Now, your indifference between (A) and (B) suggests that you think that the coin landing heads is just as likely as tails; standard rational choice theory says it has probability ½. Similarly, your indifference between (A*) and (B*) suggests that you think that the Nikkei going up is just as likely as its going down; it also has probability ½. So standard rational choice theory says that (A), (B), (A*), and (B*) really amount to the same thing, namely, receiving the cash prize with probability ½. Therefore the standard theory is inconsistent with your preference for (A) over (A*), and (B) over (B*). And to accommodate such ambiguity-averse preferences, many economists have proposed variations to standard rational choice theory. But how are economists to go about modifying the standard theory, the theory of individual decision-making that constitutes a bedrock assumption of most economic models?

 

Introductory courses in economics teach students that there is a sharp distinction between two branches of economics. On the one hand there is ‘positive economics’ whose job is to describe and explain economic phenomena such as prices, unemployment, and consumer demand. On the other hand there is ‘welfare economics’ whose job is to tell national governments how they should intervene in the economy. Students are thus taught to keep the descriptive and the evaluative projects within economics sharply distinct. Given economists' invocation to keep descriptive and evaluative projects distinct, one might expect economists to distinguish two theories of individual decision-making. On the one hand, there might be a theory of what decisions—as a matter of actual fact—individual agent's will make in various contexts. On the other hand, there might be a theory of what decisions an individual has reason to make in these contexts; or of what is required of the agent in order to count as rational.

 

But this expectation will be confounded. For when it comes to rational choice theory, economists tend to mix the descriptive project with the evaluative one. The really curious thing, I find, is that economists conflate the question of whether a new proposal gives an accurate description of actual agents' choices, from whether the proposal delineates the requirements of rationality. In particular, those economists who propose theories that can accommodate ambiguity-averse preferences (for descriptive purposes) think it very important to defend ambiguity-averse preferences as rational. They wouldn't be satisfied to claim that ambiguity-averse preferences are widespread, but irrational. (See the contributions to the 2009 special issue of Economics and Philosophy, for instance.)

 

This practice raises some foundational questions. Does this practice signal a shift in the philosophical assumptions of economists, a jettisoning of the sharp distinction between description and evaluation, between positive and normative economics? Or is something deeper going on in the special case of rational choice theory? Do these economists think there is a deep conceptual tie between theories that describe decision-making and those that evaluate it as rational or irrational?

 

University of Cambridge

Comments

[Will Thomas]

Christopher, thanks for this post. This is a deep question that I've had to deal with in my work on the history of operations research, decision theory, and their relations to economics and other areas. My book on this, Rational Action, will be coming out with the MIT Press this winter.

I think the key in this case is to understand that rational choice theory is a heuristic enterprise. If ambiguity-averse preferences are irrational, then there is nothing more to be said about them: they simply constitute an arbitrary preference between alternatives. However, if the preference is non-arbitrary, then there is a hidden rationale that must be explored using theory.

I've never looked at ambiguity-averse preferences explicitly, but I expect that the preference would be founded on a treatment of uncertainties suspected to exist in the more ambiguous option. We may surmise that the Nikkei stock index is as likely to go up as down as a Bayesian prior, but our lack of knowledge suggests a risk in the assumption. For instance, we might suspect that stock indexes are actually slightly more likely to go up than down on a given day. That treatment of risk constitutes a rational calculation, which can only be assessed by presuming its rationality.

The crucial question in establishing whether a theory of rational choice is positive or normative is to establish how well it captures the (explicit or implicit) rationality of extant decision makers. If it fails to do so, then it is a heuristic attempt to describe that rationality. If it does so and exceeds it, then it is prescriptive. The crucial event in this history is the development of sequential analysis during World War II (see Judy Klein's "Economics for a Client"), where unsuspected, and newly powerful quality control tests were developed by explicitly formulating the decisions made by experienced quality control engineers to truncate a testing sequence.