Economic Rationality
Economics
• Allocation of scarce resources
– “Economics exhibits in purest form the artificial
component in human behavior …”
• Occurs at all levels – individuals, business firms,
markets, and economies
– Outer environment: behavior of other actors
– Inner environment: goals and capabilities for rational,
adaptive behavior
• Illustration of how outer and inner environments
interact
– Substantive rationality – adjustment to outer environment
– Procedural rationality – ability, through knowledge and
computation, to discover adaptive behavior
The Economic Actor
• Textbook economics
– Outer: supply and demand
– Inner: cost curves
• Used
– As description of how
firms behave (positive)
– As advice on how to
maximize profits
• Does not consider
how these values
are estimated
Procedural Rationality
• Many of the values are rough estimates
– How elastic is demand?
• Real life involves many interacting decisions
– Product quality?
– How many products?
– How to market?
• Problem changes from one of choosing the
right course of action to locating a good action
Supporting Economic Decisions
• Operations Research
– Uses linear programming (and similar
techniques) to find optimal solutions to
limited representations of reality
– Optimal solution rarely is optimal but is
often satisfactory
• Artificial Intelligence
– Uses rule-based reasoning (and similar
techniques) to make decisions based on more
aspects of a complex and less well structured
reality
– Solutions are good enough rather than being
optimal in any respect
• Satisficing – finding a solution that is good
enough
Aspirational Levels
• “Because real-world optimization, with or
without computers, is impossible, the real
economic actor is in fact a satisficer”
• Aspirations affect what is satisfactory
– Most people register slightly above/below satisfactory
– Aspirations are based on historical levels
– Aspirations change (up and down) over time
• Many simultaneous aspirations
– Satisficing meets aspirations along all dimensions
Markets and Organizations
• Many mechanisms for coordinating actions
among actors
– Markets
– Central planning
– Bargaining and negotiation
– Hierarchic organizations
– Balloting procedures
• Roughly 80% of human activity in the US
economy takes place within organizations
Markets and Optimality
• Assumptions of market optimization
– Actors have perfect information
– Actors act to maximize utility/profits
• Not realistic
– Markets are populated by satificers
– Information is limited, time is limited, etc.
• “The marvel is not that (the dancing dog)
dances well but that it dances at all”
Order without a Planner
• Complex design is often assumed to be the result of planning
– Example of medieval cities
• Collapse of Eastern Europe Economies
– Cannot function well without smoothly
operating markets
• Poor performance since
– Cannot function well without effective
organizations
• “The most significant fact about this system is the economy of
knowledge with which it operates, or how little the individual
participants need to know in order to be able to take the right
action.” Friederich von Hayak
Uncertainty and Expectations
• Feedforward (prediction) and feedback can help
control for uncertainty
– But actors are not independent
• Actors start trying to outguess one another
– “Economic chicken”, speculation
– Prisoner’s Dilemma – treachery pays
• Unstable solution unless satisficing rather than optimizing
• Classical economics avoided such issues by
focusing on situations where mutual expectations
play no role
Bounded Rationality
• There is a limit to what actors know about the
state of their environment
• Actors have limited time in which to
determine their next action
• Economic actors gradually learn about their
environments to select satisficing, not
optimizing, actions
Business Organization
• Market-organization boundary
– What decisions are made within vs. what is made
outside of the organization
– One view is to consider the transaction costs of using
a market
• Successful organizations structure themselves
– To localize and minimize information demands of
decision makers
– Resulting in specialization of role
– Ensuring no single person or group needs to be an
expert on all aspects
Organizations and Uncertainty
• Each market decision is impacted by the decisions
of others in the market
– Markets result in the type of uncertainty that causes
outguessing and similar behaviors
• Markets absorb uncertainty by removing some
decisions and by causing actors to be more
aligned in their goals
• Organizations also augment human reason by
placing people in cooperative rather than
competitive roles
– (Docile) People can learn from one another
Evolutionary Models
• Local and global optimization
– Hill climbing algorithms
– Choice of metric vs. English measurements
• Each step is better for current situation
– No planning, no feedforward, no design
• Business/economic evolution
– Lamarkian – any new idea can be incorporated as
soon as its success is observed
– No predictable equilibrium but a complex process that
continues indefinitely