Rational Action, Uncertainty, and Economics [thesis]

Nicholas Andre Chiumento
Science is more than a body of knowledge. It's a way of thinking, a way of skeptically interrogating the universe with a fine understanding of human fallibility." Economics is a social science, and as such faces a unique set of difficulties that are not prevalent in other 'hard' sciences such as Biology or Physics. There is a tension in economics with respect to theory that often centers on methodology. Ludwig Von Mises described economics as "the science of human action," grappling with the
more » ... ire for universal while contending with experiential bias and innumerable externalities; the ultimate goal being a realization, through logic, of a priori trends and tendencies that we've known all along, but have never been able to explicate (Von Mises, 1960, p. 57). Meanwhile, Milton Friedman asserted that economics must strive to be fundamentally positive and empirical, with the foremost goal being, through the positive methodology, to solidify the predictive aspect of economics, and leave different schools to quarrel on an ideological plane and question the efficacy, not the validity, of the outcome. When Friedman claims that economics strives to 'positive,' he references the aforementioned tension of methodology. In the philosophy of science, there are two general methodologies, which are mainly defined by their different goals. Normative methodology looks to analyze the world as it ought to be, and thus examines ideal conditions in order to provide prescriptions for the real world. An example would the economics of supply and demand, examined on an abstract level. Normative prescriptions would focus on the conditions required for equilibrium, and use those conditions to offer insight into how to improve the efficiency of real world systems. Positive methodology is its opposite, and describes the world as it is. Abstraction is detrimental in positive methodology, generally, because simplification limits the explanatory power of positive analysis. Abstraction is only 'generally' detrimental to positive economics because some abstraction is necessary in order to approximate realistic behavior, and therefore limiting the abstraction required becomes crucial. Mark Blaug, in his book The Methodology of Economics, stresses the importance of the goals of economics, and how changing philosophies on methodology effected the theories that followed; to paraphrase his title, he shows how philosophy has changed "how economists explain." There is a divide between the philosophical underpinnings of economics and economics itself. It is essentially the conflict between the normative assertions of philosophers of social sciences, and philosophers of science in general, and the positive methodology of the economists themselves. In economics, generalization becomes necessary because subjective thought processes are difficult to analyze; however, the objective problems themselves can be identified. These objective problems can be viewed as a crucial motivation for scientific thought and development of theory, i.e. they create the goals that theorizing and modeling strive towards. These motivations, in an economic sense, would serve as constraints of the theory itself; in effect, the logic of the situation, presented by an objective problem, would dictate a certain course of action that is uniquely relevant to certain aspects of that situation. These theories could reasonably be considered valid, i.e. in adherence with a sort of rationality principle, if the situation doesn't change. However, it has begun to change. After World War II, economics began changing the questions it asked, and consequently began to examine new and different areas. Economics has become incredibly influential in new and complex domains, and has begun to assess the affect of institutions and policy changes on agents, and how they behave when faced with change. The major difference between these questions and previous ones is that these questions actively contribute to realworld decisions. The information provided by models is no longer taken as a normative prescription, but is instead treated as a comparative metric of sorts. In these scenarios, the problems that agents face are complex, as are their reactions to changes in these scenarios. However, there still has to be some abstraction necessary, so that the behavior of the agent follows certain guidelines. The behavior of an agent is addressed by assumptions of rationality. A Dictionary of the Social Sciences (1964) defines rationality as behavior "that is appropriate to the achievement of given goals [and] within the limits imposed by given conditions and constraints" (ed. Gould and Kolb, 1964, p. 573). Within economics, the neoclassical school specifies the goals and constraints by three central assumptions, which provide the generally accepted definition of rationality. First, agents have rational preferences between outcomes that are associated with certain values. Second, rational individuals maximize utility and rational firms maximize their profits. Third, the agent acts independently and utilizes complete and perfect information to make a decision. There are multiple areas of interest here. First is the idea of complete and perfect information, two separate aspects of the nature of information. Complete information assumes that the agent has full knowledge of his choice set, his alternatives, his preferences, and all of the relevant information to make a decision. Essentially, the assumption of completeness deals with problems in the quantity of information, so that the agent is not missing any relevant information that would influence his decision. Perfect information assumes that the agent has accurate information about all of his alternatives and the alternatives available to others. Therefore, while complete information deals with quantity, perfect information addresses the quality of information. With this information, the agent will rationally want to maximize his expected utility. Imagine a grocery store, with a rational agent shopping for cereal. He will know his preferences, via his indifference curves, for each cereal, and will have a reserve price that he would be willing to pay for each. By comparing the price of each cereal to his reserve price, the agent can calculate which cereal would give him the optimal expected utility. This is essentially the most units of enjoyment per income consumed. What this establishes is a consistent and reasonable behavior for a rational agent within economic scenarios, which allows for his behavior to be predicted and quantified. By assuming that everyone will behave in a rational manner, many problem scenarios involving hundreds of people can be reduced to one individual who behaves rationally. Therefore, economic activity on a social scale can be reasonably understood through individual preferences and the rational actions based off of those preferences. Moreover, the assumptions that accompany neoclassical rational behavior eliminate constraints that would found within the agent or the agent's perception of the environment. Only the objective characteristics of the problem scenario would be relevant to agent, because he has perfect and complete information about both the environment and his own preferences. Therefore, the rational agent will be able to respond to his objective environment in a consistent and calculable way. These are the basic premises of neoclassical rational action. Winslow (1993) stresses that the key characteristics of hermeneutic reading are 1) "always remain [ing] open to the possibility that the author's fundamental premises differ from [one's] own," and 2) "also remain [ing] open to the possibility that the author's premises are better than one's own" (Winslow, 1993, p. 91). This appeal is a restructuring of Gadamer's principles of hermeneutic reading, adapted by Winslow. The premises of neoclassical economics can be characterized as rational behavior under conditions of assumed certainty of information. Moreover, it is assumed that in conditions of uncertainty, people essentially behave as though they had certain information, if they are behaving rationally. Therefore, they still judge the perceived characteristics as approximations of the objective characteristics of their environment, and their goals and behavior remain the same. The basic premise of this thesis opposes this. In this thesis, the basic premise is that behavior in uncertainty greatly differs from behavior under certain conditions, and that this difference creates a different qualification of what is 'rational, which is not represented within neoclassical economics. It will be argued that rational agents, when faced with uncertainty in the form of incomplete or imperfect information, adopt different behaviors and strategies to mitigate this uncertainty. Moreover, the strategies for coping with uncertainty depend on the nature of the uncertainty, i.e. whether it affects the quality or quantity of information known by the agent. In order to closely examine behavior under uncertainty, this thesis will first address early economics, specifically Adam Smith, followed by conditions of uncertainty in the quality of information found in the work of John Maynard Keynes, and finally will examine Herbert Simon's bounded rationality and its relationship with uncertainty in the quantity of information. The first chapter, on Adam Smith and his work, is divided into two parts. The first will examine a moral characteristic within Smith's system that has gone largely unheeded, but proves relevant to The Wealth of Nations and the pursuit of selfinterest. This moral characteristic can be generalized as a sense of moral approbation, which could curb the influence of self-interest for it could be interpreted as 'information' about the character of a person, and could contribute or alter what is in one's ultimate 'self-interest.' The second part will look into The Wealth of Nations itself, specifically Smith's observations about behavior under conditions of uncertainty, and will demonstrate that Smith's observations and conclusions on behavior in uncertainty are incongruent with neoclassical theory. The second chapter will focus on John Maynard Keynes, specifically his Treatise on Probability and General Theory of Employment Interest and Money. The first section will define and explain Keynes' notion of rational belief, which finds relevancy and application within the General Theory. The second section will examine Keynes' inducement to invest in his General Theory, and how expectations embody situations of uncertainty in the quality of information. The final section will use Keynes' General Theory in conjunction with his Treatise in order to derive some basic postulates about behavior under uncertainty, specifically with regard to the quality of information. The final chapter will be dedicated to Herbert Simon and his concept of bounded rationality, which examines the cognitive limits of the agent, specifically with respect to computational ability and availability of information, including known preferences. The first section will explain substantive rationality, the type commonly associated with neoclassical economics. The second section will discuss procedural rationality, the basis for Simon's bounded rationality, and how it differs from substantive rationality and proves advantageous in complex problem situations. The final section will cover the empirical application of procedural rationality to complex problem scenarios, and its efficacy in explaining human behavior when faced with uncertainty in the quantity of information. Chapter 1 -Adam Smith "The over-weening conceit which the greater part of men have of their own abilities, is an ancient evil remarked by the philosophers and moralists of all ages. Their absurd presumption in their own fortune, has been less taken notice of. It is, however, if possible, still more universal." -Adam Smith Adam Smith is the father of modern economics and his work The Wealth of Nations provided the first treatment of economics as a system; additionally, his system grounded the analysis of economics for centuries after. His prose often combines normative considerations, qualifications about how an economy ought to be, with empirical and experiential observation, on some occasions to augment his normative argument. However, in other sections these observations provide important caveats to his normative vision. Smith's contribution to rationality is complex, but the most obvious contribution is the emphasis on the self-interest of each individual, and how the pursuit of self-interest is conducive to the aggregate growth of the commonwealth. This is commonly known as the invisible hand. Smith argues that the individual is "led by an invisible hand to promote an end which was in no part his intention" (Smith, Wealth of Nations, pg. 485). This end is ultimately the promotion of "public interest," and "by pursuing his own interest [the individual] frequently promotes that of society more effectually than when he really intends to promote it" (Ibid. p. 484-5). Therefore, when left to pursue his own self-interest, the individual consequently contributes to society; moreover this contribution is largely beneficial. Rational individuals, as an abstraction of human behavior, would pursue the optimal outcome, and when combined with the later marginal revolution, could calculate the maximization of their resources. This maximizing behavior, in Smith's system, would simultaneously be maximizing the individual's contribution to society. However, this is only one facet of Smith's thought on rationality. His training as a moral philosopher, explicit in The Theory of Moral Sentiments, provides an ethical structure that imposes limits to the pursuit of selfinterest. This structure is implicit within The Wealth of Nations. The moral consideration was tossed aside by later economists, but complicates and nuances Smith's ideas on behavior. While Smith does not use explicit economic terminology such as 'rational behavior,' he still hypothesizes on the goals of humanity within certain constraints, and his thought can be placed into economic terms with minimal meaning lost to interpretation. Additionally, within The Wealth of Nations itself, Smith's experiential observations directly contradict what classical 'rational behavior' would predict. Section i will be devoted to The Theory of Moral Sentiments and sympathy, as well as possible implications of that sympathy on rationality, while Section ii will examine experiential contradictions within The Wealth of Nations; contradictions which both are at odds with traditional 'rational behavior' and offer insight into realistic actions that compromise the objective pursuit of self-interest. i. The Theory of Moral Sentiments and Sympathy
doi:10.14418/wes01.1.1022 fatcat:sn5waevxpfhsvn56zrsvboobmm