rational markets, irrational actors
TRANSCRIPT
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Rational Markets, Irrational Actors
Neoclassical decision theory has explained various economic phenomena by employing a
psychologically implausible decision theory. How is this possible? Several theorists have
argued that the structure of social and economic institutions pushes real-world agents to
approximate the traditional homo economicus model of rational choice. Some institutions
produce effective economic decisions by limiting choices, a success-through-elimination
model. Yet the mechanism remains obscure. I argue that effective social and economic
institutions produce rational economic behavior when they reduce the cognitive costs
required to make rational decisions by providing agents relevant information. The effects of
even meager information can lead markets converge on economically rational outcomes.
Institutions that effectively reduce cognition costs allow economic actors to coordinate
effectively, which then through imitation and adaptation enables markets to clear as they
would were they populated with rational actors.
This essays proceeds in four parts. In Section I, I review neoclassical decision theory
and psychological challenges to it. In Section II, I discuss some proposed resolutions to the
conflict and criticize them. In Section III, I defend advance a ―costs of cognition‖ approach
and show how it can accommodate the benefits of the models discussed in Section II. In
Section IV, I conclude.
Section I: Neoclassical Decision Theory and Its Critics
(I.i) Most economists employ standard decision theory to produce economic models.i
Standard decision theory is ordinalist, conceiving of rational choice as choice based on
consistent preference orderings. Second, standard decision theory is instrumentalist. It only
specifies the implications of an agent‘s beliefs and preferences. An individual is rational
when his choices are based on an ordinal utility function with weakly ordered preferences,
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which must meet four conditions.ii First, an ordering must be complete. If John has a
complete ordering, he can rank any two preferences vis-à-vis one another; either preference
A > B, B > A or B is indifferent to A. Second, preferences must be asymmetric: if John prefers
A to B, he cannot prefer B to A. The indifference relation is symmetric. If John is indifferent
between A and B, he must be indifferent between B and A. Finally, preferences must be
transitive. If John prefers A to B and B to C, he must prefer A to C.
(I.ii) Economists add conditions to agents with ordinary utility functions to generate the
homo economicus model of economic behavior.iii First, homo economics prefers more to less.
This is a ceteris paribus condition. If John wants a pizza, he prefers more pizza to less all
things equal. Suppose that for $10 John can have two pizzas or one pizza. If he chooses one
pizza we would call him irrational. Even if he does not want to eat the second pizza, he may
be able to find a use for it, perhaps to be eaten later, given to a friend or the homeless, or so
on. One way of putting it formally is to say, following Russell Hardin, that ―the simplest
definition of rationality … is that one should choose more rather than less value.‖iv Second,
homo economicus makes choices at the margin. Thus, if she is consuming units of pizza, she
will prefer the first piece to the second piece, the second to the third, and so on. Economists
call this the law of diminishing marginal utility. The value rational individuals place on
goods diminishes for each additional good acquired. To illustrate, suppose that John is a
farmer and needs grain to meet his ends. He will use his first bag of grain to satisfy his
highest ranked preference, perhaps eating. The second bag will be used to satisfy John‘s
second highest ranked preference, such as sustaining his livestock. From there John meets
further goals, saving grain for future eating, for feeding future livestock and for sale at
market.v John‘s behavior is irrational otherwise; his action would violate his preference
ordering. Homo economicus follows also has downward sloping demand curves. In other
words, when prices rise, demand falls. The law of demand holds due to opportunity costs.
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The cost of satisfying preference A is not satisfying the next ranked preference B; B is the
opportunity cost of A. Homo economicus is also assumed to have wealth-maximization
preferences.vi Some economists however, assume that many agents do not have wealth-
maximizing preferences. Herbert Simon, in his work on bounded rationality, argued that
rational agents often ‗satisfice‘ rather than maximize.vii Satisficing is choosing a solution that
is ‗good enough‘ rather than perfect in order to economize on costs of cognition. Gerald Gaus
notes that ‗it is not always clear whether satisficing is really an alternative to maximizing‘.viii
Sometimes those who maximize do best to satisfice as they will waste time calculating.
Expected utility theory applies the homo economicus model to decision-making
under risk. Expected utility theories combine the utility of an outcome with the outcome‘s
probability, holding that rational individuals will select the greater product of utility and
probability than the lesser.ix All of the choice axioms that apply above apply to standard
expected utility theory.
(I.iii) The homo economicus model has been widely criticized.x Prominent examples come
from cognitive psychologists, such as Daniel Kahneman, Richard Thaler and Amos Tversky.xi
They have documented voluminous cases of poor human decision-making. One well-known
example is the conjunction fallacy. Kahneman and Tversky performed a famous experiment
demonstrating the fallacy by giving subjects the following questionxii:
Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy.
As a student, she was deeply concerned with issues of discrimination and social
justice, and also participated in anti-nuclear demonstrations.
Please rank the following statements by their probability, using 1 for the most
probable and 8 for the least probable.
(a) Linda is a teacher in elementary school.
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(b) Linda works in a bookstore and takes Yoga classes.
(c) Linda is active in the feminist movement.
(d) Linda is a psychiatric social worker.
(e) Linda is a member of the League of Women Voters.
(f) Linda is a bank teller.
(g) Linda is an insurance sales person.
(h) Linda is a bank teller and is active in the feminist movement.
For ordinary undergraduate students with no statistics coursework, 89% ranked (h) as more
likely than (f). But the probability of being an F cannot be lower than the probability of
being an F and an H. The probability of F and H can only be as large as the probability of F
and could be a great deal lower. Thus individuals make poor decisions when conjuncting
identical probabilities and utilities with distinct descriptions. The phenomenon of preference
reversal is similar. When the same decision is presented under different descriptions,
preferences often reverse. In the cognitive psychology literature, these are known as ‗framing
effects‘.xiii Framing effects challenge the homo economicus model because decision theory
requires complete and intransitive preferences; these experiments appear to show otherwise
because they at least seem to show that preferences are often inconsistent. Another
important challenge is based on the status-quo bias, where subjects prefer what they
currently have to clearly superior alternatives.xiv Experiments like these have generated the
‗heuristics and biases‘ tradition in cognitive science. According to this view, humans have
evolved to process information according to crude cognitive heuristics with low cognitive
costs and that produce systematically biased behavior. Despite promoting survival, these
heuristics often get the answer rightxv, despite often erring.xvi
Section II: Attempts at Reconciliation
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(II.i) How might the psychological challenges be reconciled with the homo economicus
model? One common view among economists is that the irrationality of individual actors
doesn‘t matter so long as models have predictive power, a sort of positivist position. This
methodological disposition derives from Milton Friedman‘s early 1953 article ‗The
Methodology of Positive Economics,‘ where Friedman argues that a hypothesis matters ‗if it
abstract the common and crucial elements‘ from a range of phenomena and generate
predictions. Thus ‗a hypothesis must be [emphasis mine] false in its assumptions‘; in fact the
most significant hypotheses will make assumptions that are ―wildly inaccurate descriptive
representations of reality‘.xvii To give an example, Milton Friedman‘s permanent income
hypothesis holds, to oversimplify, that patterns of consumer choices are not fixed by their
current income. Instead, consumers consume according to income expectations over their
lifetime. The theory predicts that short-term changes in income will not significantly affect
consumer behavior and is consistent with the empirical fact that consumption is relatively
smooth over short periods.xviii While other views have superseded the permanent income
hypothesis, it has explanatory power despite the implausible assumption that economic
agents make consumption decisions bearing in mind a coherent and determinate expectation
of their incomes over their lifetimes.xix For Friedman, the psychological implausibility of the
view did not matter.
The positivist strategy is inadequate. Rather than solving the conflict, it tries to
dissolve it. Three replies are in order. First, even if Friedman is right, we might still wonder
how individual psychology and economic reality mesh. Second, we often want science to
illuminate the truth about its subject matter. The permanent income hypothesis is probably
false. But what true theory explains how it fits with data on consumer choices? Third,
philosophers of science and many scientists knew long before Quine made it commonplace
that a vast number of theories are compatible with most data.xx And this is true across the
scientists. Economics deals with more variables than many models in natural sciences;
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accordingly, indeterminacy is worse.xxi One advantage of developing a psychologically
plausible model is limiting the range of theories used to explain empirical phenomena,
increasing the effectiveness of the scientific process.
(II.ii) The conflict between individual irrationality and market efficiency might be resolved
by asserting that psychological evidence demonstrates extensive market failure. Some
behavioral economists and cognitive scientists pursue this line, arguing that economic
evidence for market successes is ambiguous and market efficiency illusory. Behavioral
economists do not believe that markets always fail, but that they appear to work much more
often than close psychological examination of individual economic choices significant
irrationalities.
In Predictably Irrational, Dan Ariely argues that humans are often fooled into
thinking that they make rational decisions when they do not. Ariely asks:
If I asked you for the last two digits of your social security number (mine are 79), then
asked you whether you would pay this number in dollars (for me this would be $79)
for a particular bottle of [wine], would the mere suggestion of that number influence
how much you would be willing to spend online?xxii
The answer is yes, even for a group of MIT MBA students. Humans irrationally anchor
themselves to initially suggested prices and resist moving off of them. Ariely claims that
economists assume that prices are determined by supply and demand, but this depends on
‗the assumption that the two forces are independent and that together they produce the
market price‘.xxiii Ariely, et al.‘s experiments are evidence to the contrary: ‗what consumers
are willing to pay can easily be manipulated‘.xxiv Ariely goes onto suggest that, for instance,
increasing gasoline prices won‘t permanently reduce demand because people will adjust their
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anchors over time; as a result, free market exchanges may not always be mutually beneficial.
Ariely‘s argument is radical. Since we can be mistaken about what brings us utility, why
should economists and policy makers assume that individuals tend to act in their best
interests? While policy makers should ‗take this into account‘, if Ariely is right the case for
the free-market is destroyed. The classic defense of markets is that they utilize the expertise
of individuals concerning their own preferences and local information.xxv If individuals
routinely err when making economic decisions then this classic defense is threatened.
Ariely oddly neglects to mention a fifty-year old field of economics that has already
addressed these questions: experimental economics, a branch of economics that attempts to
verify the details of economic models by running economic experiments with test subjects.
This contrasts with the work of behavioral economists like Ariely, which primarily focus on
individual economic behavior. Smith and his colleagues have conducted hundreds of
experiments that replicate market efficiency. While Smith notes that his experiments do not
always confirm standard expected utility theory, ‗experimental tests of market theories,
which explicitly assume expected utility (or value) maximization, have not falsified many of
these theories‘.xxvi And while many initial tests show marked irrationalities, over time
behavior approximates economic models. Smith has long thought ‗that markets may induce
greater ―rationality‖ in behavior because they force or promote a response to, or discovery of,
opportunity cost conditions, that need not be readily forthcoming when agents merely think
about the choices they make‘.xxvii Framing effects ‗do relatively low level damage to [the
expected utility hypothesis]‘; economic actors can learn to avoid these effects.xxviii Economic
actors become expert statistical reasoners; rather, they learn to avoid options that lead to net
cost. For instance, experimental economists freely admit that individuals exhibit anchoring
effects and that, initially, groups do as well; the question is whether these effects will persist
over time as individuals become more familiar with how to avoid net costs. Experimental
economists would reject Ariely‘s conclusions because his work (i) does not include a choice
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class of objects that are subject to a budget constraint, and (ii) ignores whether in repeat
conditions learned rationality will reduce anchoring effects.
Smith argues that economic experiments show that institutions matter. The formal
and informal rules that govern institutional environments are required to enable economic
learning. On Smith‘s view, economic rationality is an achievement that occurs only under
the right sets of rules.xxix In many cases, market optimization is an unconscious process: Smith
reports that ‗hundreds of double auction experiments … would spotlight the crucial
importance of not ruling out the rationality of unconscious decision in rule-governed repeat
interaction settings‘.xxx Smith also found that market actors often become less rational when
given more information. A bargainer with better information, ‗… knowing that the other
player knew only his own payoff, is more forgiving when his opponent makes large
demands‘. xxxi Surprisingly, ‗[t]his concessionary posture works to the disadvantage of the
completely informed player‘.xxxii Finally, efficiency requires that actors often play dominated
strategies.xxxiii Players should cooperate even when it leads to short-term losses because
cooperation helps form common expectations. Common expectations allow players to
reliably predict what others players will do, and so reduces worries about defection in
economic exchanges. A willingness to sacrifice some benefit for the sake of cooperation helps
to grease the cooperative wheel which in the long-term produces a more efficient
environment. Common knowledge, Smith has found, is not sufficient to produce efficient
outcomes. Common expectations must be established before efficiency can be fully achieved.
These common expectations are formed through repeated cooperation. Thus Smith says,
‗dominated strategies are for playing, not eliminating‘.xxxiv
Ariely‘s experiments no doubt show that individuals can be irrational. And other
behavioral economists have challenged experimental economists‘ account of market learning,
arguing that some irrationality is not reduced through learning.xxxv Some recent work even
purports to show that some irrationality even increases through repetition.xxxvi But it is
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widely established that repetition reduces irrational economic behavior; in many cases
markets can regularly achieve efficient outcomes despite individual irrationality. Market
efficiency is possible if individuals are irrational by themselves, so long as individuals are
rational in groups under the appropriate rules and interact over time.xxxvii
Unlike Ariely, most behavioral economists admit that market repetition sometimes
reduces market irrationalities. Thus widespread market success need not be denied. The
problem with the ‗extensive market failure‘ solution is similar to the problem with
positivism. Instead of struggling to understand an important tension, it simply discounts one
side. The apparent tension between individual irrationalities and widespread market success
cannot be denied; it must be resolved.
(II.iii) Perhaps the most sophisticated attempts to reconcile irrational psychologies with
market rationality lies in the field of alternative expected utility theories. These theories
depart, in one way or another, from the standard assumptions of expected utility theory
outlined in Section I. The theories vary substantially, so I will describe two general
alternative expected utility theories, and show that, while accounting for the psychological
evidence within a decision theoretic framework, they fail to generate a satisfying
reconciliation.
The two types of alternative expected utility theories [henceforth, EUT/AEUT] are
―conventional‖ EUTs and ―nonconventional‖ EUTs.xxxviii Conventional EUTs try to preserve
the expected utility theory generally while relaxing some of its standard assumptions. They
still assume that agents optimize a preference function. Nonconventional EUTs or
‗procedural‘ theory only assume that economic actors use decision heuristics.xxxix One
conventional EUT is weighted expected utility theory, which treats standard EUT as a
specific case of a broader theory.xl Standard EUT holds when all consequences are equally
weighted. Outcomes of actions are ‗weighted‘ when they are given more value in an
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expected utility calculation vis-à-vis other outcomes that exceeds the value warranted by the
product of the utility and probability of the outcome. Advocates of weighted EUT maintain
that divergence from behavior predicted by standard EUTs can be explained by
distinguishing between differently weighted consequences. For instance, in preference
reversal cases sometimes two bets are presented, one with a low probability of a high payout
and the other with a moderate probability or a moderate payout. The expected utility of both
bets is identical, yet betting agents consistently prefer the higher probability outcome.
Weighted expected utility theorists argue that innate decision-making heuristics produce a
tendency to assign more weight to the less risky bet. For instance, if humans use heuristics
that generate framing effects, they may be more likely to weight an outcome more heavily
than under one description than another.
The most prominent nonconventional expected utility theory is prospect theory.xli
Prospect theory argues that normal human decision-makers do not maximize a utility
function and so standard decision theory employs an implausible model of human cognition.
Instead, prospect theorists claim that decision-making under risk has two separate stages, an
‗editing‘ phase and an ‗evaluation‘ phase. In the editing phase, the realized options are
structured and formed to make choice easy. During this cognitive process, heuristics are used
to assign perceived outcomes positive or negative values judged against some baseline.
Common factors are omitted, probabilities of similar outcomes are combined, and dominated
options are removed when detected. However, many mistakes occur. The evaluation phase
contains both a value function and a weighting function, as weighted expected utility theory
suggests. The decision weighting function usually involves assigning what many
psychologists judge as unreasonably high expected costs to low probability events. For our
purposes, take prospect theory as a description of how normal humans make decisions. There
have been some speculations about how to use prospect theory prescriptively.xlii Some
economists have worried about the relevance of the editing phase, so Kahneman and Tversky
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developed cumulative prospect theory, which avoids relying too heavily on the editing
phase.xliii In cumulative prospect theory, only cumulative probabilities are transformed rather
than individual probabilities. Consequently, real agents make choices in accord with the
probability of a class of actions of which the relevant choice is member. Prospect theorists
then argue that the irrationality high weights we assign to low probability events result from
the editing phase. Heuristics are used to edit which events are risky and which are not and
these heuristics, while cognitively cheap and evolutionarily successful, generate irrational
behavior in many cases. Consequently, such heuristic may generate irrational risk-aversion
and make probability assignment overly sensitive to the presentation of scenarios.
Both conventional and nonconventional expected utility theories purport to explain
why markets work in some cases and not others. In some cases, their explanations are
illuminating. Both theories can account for assigning irrational risk-aversion and both can
accommodate framing effects, among others. To this extent, alternative expected utility
theories help to reconcile how markets work with the fact that humans are sometimes
irrational economic actors. In cases where preference reversal, framing, etc. are significant,
markets will not work as well as they could; but in cases where irrationalities do not arise,
markets may be efficient. However, these theories do not directly explain anomaly reduction
through repetition. We saw in II.ii that repetition allows actors to approximate the behavior
that standard expected utility theory prescribes. The feedback from repeated social
interactions helps isolated actors or actors in single-shot bets to act rationally according to
their self-interest.xliv So while alternative expected utility theories may help resolve the
conflict, social interaction, adaptation and common expectations must also play an
explanatory role.
(II.iv) Behavioral and experimental economists agree that limiting options is one way to
generate rational behavior.xlv Option restriction is related is called ‗situated‘ or ‗embedded‘
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cognition.xlvi The view, in short, is that human cognition is not merely ‗in the head‘ or
entirely contained within the brain. Instead, cognition arises from the interplay between
brain, body and environment. Philosopher Andy Clark argues that human cognition is
unique not because humans are good individual reasoners but because they possess ‗amazing
capacities to create and maintain a variety of special external structures‘.xlvii He continues:
‗these external structures function so as to complement our individual cognition profiles and
to diffuse human reason across wider and wider social and physical networks whose
collective computations exhibit their own special dynamics and properties‘.xlviii Cognition
extends into the environment, making complex forms of cognition easier. Clark argues that
advanced cognition requires the ability to ‗dissipate‘ some forms of reasoning and thereby
reduce the cognitive demands on our brains. Ultimately what distinguishes us from animals
and robots is our ability to structure our environment to amplify our cognition.
‗Situated‘ cognition and option limitations have analogues in philosophical
interpretations of decision theory. Debra Satz and John Ferejohn defend ‗moderate
externalism‘ about social scientific explanations (including economics).xlix The internalist
holds that social scientific events can only be explained by intentional states interior to the
individual human. Moderate externalism argues that while individual intentional states are
relevant to social scientific explanations, their connection is ‗remote‘. Moderate externalism
‗does not explain behavior in terms of these mental entities; it merely shows that behavior
can be interpreted as consistent with them‘.l It explains social scientific events in terms of the
‗structure in which [individual action] is embedded‘.li The basic unit of analysis for the
moderate externalist is not the individual but a set of individuals and institutional conditions.
The New Institutional Economics shares much with the embedded cognition
paradigm. Neoclassical economics relies on what new institutional economists Arthur
Denzau and Douglass North call ‗substantive rationality‘ or rationality that is contained
entirely ‗in the head‘.lii But Denzau and North argue that economic and political history
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cannot be effectively understood if individuals always act in accord with standard decision
theory. Instead, institutions are required to reduce transactions costs, thereby making market
efficiency possible. Ronald Coase was one of the first economists to focus on the role
transactions costs in economic behavior. Transactions costs are ‗the costs other than the
money price that are incurred in trading goods or services‘.liii Standard neoclassical
economics assumes zero transactions costs, but this assumption is unrealistic; sometimes
transactions costs have substantial impact on market functioning. For instance, Coase saw
that if transactions costs are ignored, firms cannot arise on the free-market. Firms are
centrally directed exchanges—command economics in microcosm. Yet why should centrally
directed exchanges arise in the free market if markets are efficient? Coase‘s answer: to reduce
transactions costs.liv Discovering the information necessary to coordinate exchanges and
produce assurance are costly; firms arise to reduce these costs. However, firm expansion is
limited because the inefficiencies of central direction eventually outweigh the reduction in
transactions costs. Denzau and North apply this Coasean framework to economic history,
arguing that ideologies and cultural institutions arise to reduce transactions costs as well.
Economic and social institutions are also mechanisms that ‗offload‘ cognition onto the
environment, or in their terms, reduce transactions costs.lv
How do these two traditions solve the conflict between psychology and economics?
They argue that individual psychology isn‘t the main explanatory factor for why markets
work. Rather, most market efficiency is caused by the institutional structure in which
economic actors are embedded. Humans create these institutions, to be sure. But once
transactions costs are sufficiently reduced and economic cognition is sufficiently embedded,
choice options are limited. Cognition is easy enough for reliably rational decision-making.
These accounts can explain why markets work in some environments and not others. North
work was influenced by observing how poorly markets performed when implemented in the
Soviet Union. He argues that markets failed there because the Soviet republics lacked the
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cultural and moral institutions required to sufficiently reduce transactions costs. Individuals
could not trust one another and did not know how to run businesses.lvi
North and Clark cite experimental evidence that individual rationality is less central
than is often thought for market efficiency. Their primary evidence comes from economic
experiments where human traders are replaced with ‗zero-intelligence‘ programs. These
programs submit random bids and offers subject only a budget constraint; they engage in no
strategic reasoning whatsoever. Dhananjay K. Gode and Shyam Sunder find that ‗imposing a
budget constraint (i.e., not permitting traders to sell below their costs or buy above their
values) is sufficient to raise the … efficiency of these auctions close to 100 percent‘.lvii They
go on to claim that the efficiency of markets appears to be due to ‗its structure independent
of traders‘ motivation, intelligence, or learning‘.lviii Again, the shape of institutions produces
rational action. Like Satz and Ferejohn, Gode and Sunder explain the rationality of markets
in institutional terms. Like North and Denzau, they find that institutions are required to
make markets work. And like Clark, they argue that rational cognition occurs when
cognition is embedded in the world. Vernon Smith has argued in favor of what he calls the
Hayek Hypothesis, that limited information and reliable trading rules ‗are sufficient to
produce competitive market outcomes at or near 100% efficiency‘.lix But Gode and Sunder go
farther: Economic actors do not need much information or rationality in order to produce
efficient outcomes under the right rules. As they say, ‗Adam Smith‘s invisible hand may be
more powerful than some have thought; it can generate aggregate rationality not only from
individual rationality but also from individual irrationality‘.lx
The embedded cognition/transactions cost approach explains how individuals can be
irrational and ignorant and yet produce efficient outcomes under certain economic
conditions. But it has two drawbacks. First, it implies that individual rationality is largely
causally irrelevant. That said, these experimenters argue that economic rationality is so
embedded in the world and subject to external constraints that the common sense
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conception of individual rationality is threatened. Some will welcome this counterintuitive
consequence, but it has theoretical costs. The causal inefficacy of our rational faculties seems
to undermine our common sense understanding of the world. For instance, we experience
our own rational choices in many economic environments. Some engage in economic
activities such as buying groceries or a house, with a high degree of thought. Surely these
calculations make a substantive causal contribution to our decisions.
The extended cognition model also leaves unclear how economic actors in the lab
improve efficiency in repeat interactions. Experimental economists have shown that
economic actors learn to interact more effectively under the same set of rules. That is to say,
the institutional structure of a market remains the same, but efficiency increases. Zero-
intelligence traders do not update their behaviors which may be crucial for market
efficiency. A better theory explains how irrational humans produce efficient markets and
how they can improve. Clark and North tell stories about how humans alter their institutions
but the stories remain vague; the local-level at work are poorly understood.
Section III: Subjective Costs of Transacting as a Solution
(III.i) In this section, I defend the subjective cost of transacting (SCT) theory.lxi The theory is
not meant primarily as a prescriptive theory or a theory about what humans should do;
rather I advance the SCT theory as an explanation of the compatibility of irrational actors
and rational markets. Subjective costs of transacting are the costs of ‗thinking, calculating,
deciding and acting‘.lxii These costs are subjective because they are cognitive, or internal to an
agent‘s cognitive systems. Further, these are costs that are, to some extent, under the agent‘s
control. That is, they can be paid. To illustrate, imagine that John wants to buy Wheat
Things at the grocery store. When he arrives, he finds two differently sized boxes. The
smaller box is cheaper but contains fewer Wheat Thins. Typically the large box has a lower
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unit price, but today the small box is on sale. John must now calculate the relative unit prices
of the two boxes himself.lxiii For John, division with decimals and multiple digits is a chore.
Even with a mobile phone calculator, John must still slow down and delay moving on to
other tasks. The unit price calculation is a subjective transaction cost. Such costs are (a) and
(b) volitional.
External structure in the economic environment can reduce the subjective costs of
transacting. For instance, common behavioral expectations can be implicitly learned at early
ages. Such expectations may reduce stress when trusting others. If John does not trust that
his box of Wheat Thins does not contain a small piece of metal from a faulty manufacturing
plant, he will have to take the risk of buying the box and checking for himself. If John lives
in a developed country with good institutions, rules like contract laws, regulations and
informal moral norms can effectively eliminate this problem, along with many others. It will
also reduce the costs of decision-making generally. Many economic decisions become
unconscious habit over time, especially when formal and informal rules remain stable. If
humans are rational when subjective transactions costs are low but irrational when they are
high, then rational market behavior should increase within institutions that reduce
transactions costs. Thus, the SCT theory is consistent with the insights of the embedded
cognition/new institutional approach which emphasizes that cognition is eased under good
institutions. For North and Clark, John‘s cognition can be offloaded onto the environment
when he needn‘t calculate the risk that he will find metal in his Wheat Thins or when unit
prices are displayed in the grocery store, even during sales.
Repetition can also reduce subjective transactions costs when rules remain stable.
Learning reduces the subjective transactions costs of acquiring, storing and accessing
information. Human agents learn to make good decisions through repetition, observing
outcome and adjusting behavior accordingly. Consider the insights of experimental
economics: as trials are repeated, individuals approach efficient market outcomes. If
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repetition lowers subjective transactions costs, then it is no surprise that repetition increases
rational market behavior. In fact, Vernon Smith defends the subjective transactions costs
theory to explain how repetition produces market efficiency.lxiv
The SCT approach renders market rationality consistent with the extensive use of
heuristics observed by cognitive psychologists. Explicit and calculative thinking is costly
even with the relevant information collected; gather information is costly as well. In many
cases, it saves cognitive exertion to employ a cognitively cheaper but less reliable decision-
making heuristic. On this view, purported irrationalities documented by behavioral
economists are rational responses to high subjective transaction costs. Heuristic use is a
rational response to expensive cognition. expensive. Some neurological evidence suggest
thats calculation in more explicitly cognitive, less emotional parts of the brain are slower and
more cognitively expensive than other processes.lxv Richard Samuels and Stephen Stich
defend a dual processing theory of reasoning that has gained prominence over the last
decade.lxvi The dual processing theory holds that agents make decisions via two distinct
neurological systems. One system is ‗fast, holistic, automatic, largely unconscious, and
requires relatively little cognitive capacity‘.lxvii But the other system is ‗relatively slow, rule
based, more readily controlled and requires significantly more cognitive capacity‘.lxviii
Psychologists who adhere to this theory argue that the former system is evolutionarily older
than the latter system and that the latter system can be deeply affected by cultural and
institutional factors. Differences in aptitude will affect the degree to which the latter, newer
system functions adequately, while the older system is hard to improve and is equally error-
laden across different agents. Recent work in moral decision-making has built on dual
processing models of decision-making. Joshua Greene has argued that deontological
judgments are associated with the older, more instinctive system while utilitarian judgments
are associated with the latter, more ‗rational‘ system by showing that different parts of the
brain simultaneously react to the same moral problems.lxix In standard moral dilemmas, parts
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of the brain that generate deontological judgments exhibit some of the same putatively
erroneous behavior as those tasks discussed above. Agents may often have a choice as to
which system to rely on. They can can use their ‗fast, holistic, automatic‘ system that
requires ‗little cognitive capacity‘ or spend the resources to employ our ‗relatively slow, rule-
based, more readily controlled‘ system of reasoning. When the information required to make
an explicit calculation is costly to collect or the required calculation is cognitively expensive,
it is rational to select systems of reasoning that are less reliable given the relative costs and
benefits of getting the right answer. The SCT theory does not require that agents always
choose which system to rely on. Most decisions are governed by the faster, less conscious
system. But in economic decisions agents can often choose which system determines action.
Agents can employ their slower, system reasoning to override the outputs of the faster,
system. In many cases, agents cannot prevent the older system from operating, but they can
prevent its outputs from determining action.
In the same way, when a decision is cognitively inexpensive, i.e., when the subjective
transactions costs of calculating are low, rational agents will reduce their heuristic use,
replacing them with more accurate processes. In this way, decision-making can approach
market efficiency by reducing irrationality. As seen above, experimental economists have
recorded this phenomenon. For instance, repetition reduces the endowment effect. Many
experiments that uncover irrationalities rely on probability calculations that require more
difficult reasoning cognition, such as framing effects. Individuals may not realize that they
would do better to calculate rather than let their natural heuristics dictate their decisions.
However, the SCT is threatened by studies that show statistics courses often do not
reduce probability miscalculations. In some cases, they even seem to increase some biases.lxx
The SCT predicts that knowledge of statistics should reduce subjective transactions costs, and
thereby increase the level of rational decision-making. An experimental economist could
counter that even statistics coursework fails to provide enough reduction in subjective
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transactions costs to engage in explicit calculation accurately; further, calculation may be
regarded as too costly for a psychological experiment, when the outcome is inconsequential
to an individual‘s aims. Some experiments suggest that financial payoffs substantially
improve rational risk-taking, although errors are not eliminated.lxxi Smith and Walker argue
that ‗increased financial rewards [may] shift the central tendency of the data toward the
predictions of rational models … [and] in virtually all cases rewards reduce the variance of
the data around the predicted outcome‘.lxxii Some have argued that the ‗labor cost‘ of
cognition—not the only relevant cognitive cost that matters. Camerer and Hogarth
emphasize the ‗capital‘ aspect, which include cognitive abilities that, while largely invariant
in the short run, can be improved through repetition.lxxiii The SCT theory does not specify
which costs are relevant, only that cognition costs, when reduced, generate rational
behavior.
The SCT theory retains a causal role for individual rationality. Subjective transactions
costs increase the cost of good reasoning; consequently, individuals are less rational when
these costs are high. Thus subjective transactions costs are barriers to the causal efficacy of
rationality; when subjective transactions costs are reduced, individual rationality can more
readily exercise its causal power. The SCT theory suggests that institutions function as
enablers for rationality‘s causal power by reducing subjective transactions costs instead of
displacing rational decision-making or showing that the causal power of reasoning was
illusory. But what about the zero-intelligence traders? One might argue that their success
shows that rationality either lacks causal power or that the results of economic decision-
making are overdetermined by institutions and individual reasoning. The advocate of the
SCT theory could reply that the zero-intelligence traders do so well because the rules of the
economic game in question are clearly defined and all relevant learning has taken place;
accordingly, traders mimic human rational decision-making. The zero-intelligence traders
only show that rational behavior is extremely easy when all the relevant learning has taken
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place and rules are very stable and unambiguous. They do not show that we must adopt the
counterintuitive position that individual rationality lacks causal power; it shows that
individual rationality‘s causal power is consistent with the data.
(III.ii) The SCT theory has advantages over the four previously discussed proposals. First, it
avoids the error of positivism by accounting for psychological errors in reasoning. But it also
avoids claiming that market failure is extensive because agents are sometimes irrational. The
SCT theory accommodates the findings of cognitive psychologists, explaining why agents
rationally rely on prospects and heuristics when they could spend the resources to engage in
more expensive calculations. Further, it fits comfortably with views that rely heavily on the
causal impact of the environment and explains how learning and repetition and learning
reduces subjective transactions costs. The SCT theory does not ascribe most of the effects of
economic decisions to features of the external environment, an advantage it has over more
externalist theories. The SCT theory thereby ratifies the common sense intuition that
rational deliberation has causal efficacy while acknowledging a vital role for the
environment. But the SCT theory has another implication. Note that the SCT theory suggests
that efficient market outcomes can be generated by reducing subjective transactions costs.
Social institutions with stable formal and informal rules enable feedback which promotes
learning. In turn, learning can lead to effective cognition and thus market efficiency. While
these recommendations are abstract, they may be made more concrete through further
scientific inquiry.
(III.iii) The SCT theory has a significant drawback, however. Smith comments that subjective
transactions costs are hard to operationalize within a clear theoretical framework ‗as that
attempted in [expected utility theory] and [weighted expected utility theory], that allow the
latter to be deduced as limiting cases when SCT goes to zero, or when outcome values get
21
large relative to a fixed SCT‘.lxxiv Responding to formalization concerns requires quantifying
subjective transactions costs in the lab and real-world data collection. Yet formalization
proves difficult and so the SCT theory is hard to apply and test. I cannot speculate on
methods of quantification and so must leave it to future work. Nonetheless, the SCT theory
has clear advantages over the four alternatives covered in Section II and thus merits an
attempt to mitigate its deficiencies.
Section IV: Conclusion
This essay began with a simple problem: economists think markets are efficient but their
models assume that humans are rational economic actors, while psychologists think that
humans are not rational economic actors. This apparent tension must be resolved. Four
strategies for resolving the conflict were considered: (a) accepting methodological positivism
in economics, (b) rejecting the effectiveness of markets, (c) building an alternative utility
theory to accommodate the problem, or (d) resorting to an embedded cognition model of
economic behavior. Strategies (a) and (b) were rejected as inadequate and while strategies (c)
and (d) have merits, they needed supplementation. In response, I advanced the subjective
transactions costs (SCT) theory, which embraces and explains the economic and
psychological data, resolves the tension, and integrates the advantages of (c) and (d). The SCT
theory assigns individual rationality a causal role, while explaining the importance of
heuristics and the environment in facilitating rational choice; the theory predicts that
economic actors will behave rationally when the subjective costs of transaction are low. The
SCT theory may be the key to showing how human irrationality can result in efficient
market outcomes.
i This said, decision theory is employed differently by different subfields in economics. For more on the plural
understanding of rationality used by economists, see Tyler Cowen, ―How Do Economists Think About
Rationality?,‖ Satisficing and Maximizing, 213-236. Our scope is restricted to those areas of economics which
22
employ the theory in relatively unmodified forms; to the extent a sub-field of economics employs traditional
decision theory, to that extent it applies to what I say here. ii I draw on the list provided by Gerald Gaus, On Politics, Philosophy and Economics, Wadsworth Publishing,
2007, 36-37. iii The following list of features of homo economicus is given by Gerald Gaus, ibid, 1.3, 19-27. iv Russell Hardin, Indeterminacy and Society, Princeton University Press, 2005, 16. v The grain example is well-known. See Eugen von Bohm-Bawerk, The Positive Theory of Capital, Bk III, Ch.
IV, 151. vi It is not essential that homo economicus be self-interested; she may have altruistic preferences. vii See Herbert Simon, 1959, ―Theories of Decision Making in Economics and Behavioral Science.‖ American Economic Review, 49, 258-283. Some hold that satisficing is rational as an alternative to maximizing not just as
a method of maximizing. See David Schmidtz, Rational Choice and Moral Agency, Princeton University Press, 1996, 31-37. viii Gaus, On Politics, Philosophy and Economics, 26. ix For a clear, concise explanation of expected utility theory, see Michael Resnik, Choices: An Introduction to Decision Theory, University of Minnesota Press, 1987, 45 – 118. x Many anthropologists have argued that in traditional societies, economic decisions are governed by norms of
reciprocity. See Karl Polanyi, 1944, The Great Transformation, Beacon Press, 1991 and Marshall Sahlins, 2004,
Stone Age Economics, Chapter 1, ―The Original Affluent Society,‖ 1-40. Herbert Simon‘s work on bounded
rationality maintains that human rationality is subject to certain cognitive limitations. See Herbert Simon, 1984,
Models of Bounded Rationality, V. I, Economic Analysis and Public Policy, The MIT Press, Cambridge, MA. xi Some classic studies include Amos Tversky and Daniel Kahneman, ―Rational Choice and the Framing of
Decisions,‖ in Hogarth, Robin and Reder, Melvin, eds. Rational Choice: The Contrast Between Economics and Psychology, Chicago: University of Chicago Press, 1987. An original version of the critique appears in
―Judgment under Uncertainty: Heuristics and Biases.‖ Science, September 1974, 185(4157), 1124-31. See also
Richard Thaler, Quasi Rational Economics, New York: Russell Sage Foundation, 1991. xii Kahneman, D. and Tversky, A. 1982, Judgment Under Uncertainty: Heuristics and Biases, New York, NY,
Cambridge University Press, 92. xiii Amos Tversky and Daniel Kahneman, ―Rational Choice and the Framing of Decisions,‖ in Hogarth, Robin
and Reder, Melvin, eds. Rational Choice: The Contrast Between Economics and Psychology, Chicago:
University of Chicago Press, 1987. For the original study of preference reversal, see Maurice, Allais, 1953, ―Le
Comportement de l‘Homme Rationnel devant le Risque: Critique des Postulats et Axiomes de l‘Ecole
Americaine,‖ Econometrica 21, 503-546. xiv See D. Kahneman, J.L. Knetch, and R.H. Thaler, ―The endowment effect, loss aversion, and status quo bias,‖
Journal of Economic Perspectives, 5, 1, 193-206, 1991 for more on the status-quo bias. We will discuss the
endowment effect below. xv Cf. Kahneman, Daniel, and Amos Tversky. "On the Psychology of Prediction." Psychological Review 80
(1973): 237-51. xvi Cf. Bower, B. "Rational Mind Design: Research Into the Ecology of Thought Treads on Contested Terrain."
Science News 150 (1996): 24-25. Also see: Gould, Stephen Jay. Bully for Brontosaurus : Reflections in Natural History. Boston: W. W. Norton & Company, Incorporated, 1992. xvii Milton Friedman, Essays in Positive Economics, Chicago: Chicago University Press, 1953, 3-43, 14-15. xviii For a helpful discussion of the permanent income hypothesis, see:
http://ingrimayne.com/econ/FiscalDead/PermIncome.html. xix A. S. Deaton, ―Life Cycle Models of Consumption: Is the Evidence Consistent with the Theory?‖ In Advances in Econometrics, ed. Amsterdam: North Holland, 1987.
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xx See W.V. Quine, ―On the Reasons for Indeterminacy of Translation,‖ Journal of Philosophy, 67 (6), 178-183. xxi Nobel Laureate economists, F. A. Hayek, discusses his theory of complex phenomena in his Nobel Lecture,
see http://nobelprize.org/nobel_prizes/economics/laureates/1974/hayek-lecture.html. xxii Dan Ariely, Predictably Irrational, HarperCollins, 2008, 26-28. xxiii Ibid, 45. xxiv Ibid. xxv See F.A. Hayek, ―The Use of Knowledge in Society,‖ American Economic Review, XXXV, 4, 519-530. xxvi Vernon Smith, ―Experimental Economics: Reply,‖ 267. xxvii Ibid. xxviii Ibid, 268-269. xxix Vernon Smith, ―Economics in the Laboratory,‖ Journal of Economic Perspectives, 8, 1, Winter 1994, 113-
131, 116. xxx Ibid, 118. xxxi Ibid, 119. This is often called the ―curse of knowledge‖, a term coined in Colin Camerer, George
Loewenstein, and Martin Weber, ―The Curse of Knowledge in Economic Settings: An Experimental Analysis,‖
Journal of Political Economy, October 1989, 97:5, 1232-54. xxxii Ibid. xxxiii A dominated strategy is one that can be systematically beaten by a dominant strategy. See gametheory.net
for further definitions: Shor, Mikhael, "Dominant Strategy," Dictionary of Game Theory Terms, Game
Theory.net, < http://www.gametheory.net/dictionary/DominantStrategy.html> Web accessed: June 15, 2009. xxxiv Smith, ―Economics in the Laboratory,‖ 122. xxxv See George Loewenstein, ―Experimental Economics from the Vantage-Point of Behavioral Economics,‖ The Economic Journal, 109 (February), F25-F34 for criticism. Some irrationalities do not go away after repetition in
social settings or after extensive learning, but irrationalities are often substantially reduced. Other work
suggests that repeated experience significantly reduces the endowment effect, John A. List, ―Does Market
Experience Eliminate Market Anomalies?,‖ The Quarterly Journal of Economics, February 2003, 41-71. xxxvi Cf. Jacinto Braga, Steven J. Humphrey and Chris Starmer, ―Market Experience Eliminates Some anomalies –
And Creates New Ones,‖ CeDex Discussion Paper No. 2006-19, October 2006, forthcoming, European Economic Review. For an opposing view, see Gijs van de Kuilen and Peter P. Wakker, ―Learning in the Allais
Paradox,‖ working paper, August, 2006. xxxvii This point is emphasized in David K. Levine, ―Is Behavioral Economics Doomed? The Ordinary versus the
Extraordinary,‖ Max Weber Lecture, June 8th, 2009. xxxviii These terms derive from Chris Starmer, ―Developments in Non-Expected Utility Theory,‖ Journal of Economic Literature, 38. 332-82. 2000. xxxix 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 Gerald Gaus, Politics, Philosophy and Economics, introduction. xl For generalized expected utility analysis, see Mark Machina, ―‘Expected Utility‘ Analysis Without the
Independence Axiom,‖ Econometrica 50, 277-323. For disappointment Aversion, see G. Loomes and R. Sugden,
―Disappointment and Dynamic Consistency in Choice under Uncertainty,‖ Review of Economic Studies, 53,
271-282, 1986. For rank-dependent EUT, see J. Quiggin, ―A Theory of Anticipated Utility,‖ Journal of Economic Behavior and Organization, 3, 323-343, 1982. For weighted utility theory, see S. H. Chew and K. R.
MacCrimmon, ―Alpha-Nu Choice Theory: A Generalization of Expected Utility Theory,‖ Working Paper No.
669, University of British Columbia, Faculty of Commerce and Business Administration, 1979. xli See Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk",
Econometrica, XLVII (1979), 263-291.
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xlii Bleichrodt, Han; Pinto, Jose Luis; Wakker, Peter P (2001) ―Making Descriptive Use of Prospect Theory to
Improve the Prescriptive Use of Expected Utility‖, Management Science, 47, 11, 1498-1514. xliii Tversky, Amos; Daniel Kahneman (1992). "Advances in prospect theory: Cumulative representation of
uncertainty," Journal of Risk and Uncertainty 5: 297-323. xliv See ft. 26. Also see Graham Loomes, Chris Starmer and Robert Sugden, ―Do Anomalies Disappear in
Repeated Markets?,‖ The Economic Journal, 113 (March), C153-C166, 2003. xlv See ft. 36. xlvi See Andy Clark, Being There, 1997, Cambridge, MIT Press. xlvii Clark, 179. xlviii Ibid. xlix Debra Satz and John Ferejohn, ―Rational Choice and Social Theory,‖ Journal of Philosophy, 91, 2, 71-87,
1994. l Ibid, 77. li Ibid, 78. lii Arthur T. Denzau and Douglass C. North, ―Shared Mental Models: Ideologies and Institutions,‖ working
paper, 1995. liii For a brief explanation of transactions costs, see: http://www.auburn.edu/~johnspm/gloss/transaction_costs liv The classic article here is Ronald Coase, ―The Nature of the Firm,‖ Economica, New Series, 4, 16, 386-405,
Nov., 1937. lv This view may smack of economic determinism, but one need not be an economic determinist to appreciate
this point. lvi For an elaboration of this story, see Douglass C. North, Understanding the Process of Economic Change, Princeton, Princeton University Press, 2005, Chapter 11, The Rise and Fall of the Soviet Union, 146-170. lvii Dhananjay K. Gode and Shyam Sunder, ―Allocative Efficiency of Markets with Zero-Intelligence Traders:
Market as a Partial Substitute for Individual Rationality,‖ The Journal of Political Economy, 101, 1, 119-137,
1993, 119. Also see Dhananjay Gode and Shyam Sunder, ―What Makes Markets Allocationally Efficient?‖ The Quarterly Journal of Economics, May 1997, 603 – 630. lviii Ibid. lix Smith‘s test is positive. See Vernon Smith, ―Markets as Economizers of Information,‖ Economic Inquiry, Vol.
20, April 1982, 165-179. lx Dhananjay K. Gode and Shyam Sunder, ―Allocative Efficiency of Markets with Zero-Intelligence Traders:
Market as a Partial Substitute for Individual Rationality,‖ The Journal of Political Economy, 101, 1, 119-137,
1993, 119. lxi See Jacob Marschak, ―Economics of Inquiring, Communicating, Deciding,‖ American Economic Review Proceedings, May 1968, 58, 1-18. Also Vernon Smith, ―Microeconomic Systems as an Experimental Science,
―American Economic Review, December 1982, 72, 923-55, esp. 934. lxii Smith, 268. lxiii Suppose that your rate of eating Wheat Thins is an exogenous variable (you won‘t eat them faster if you have
more). lxiv See ft. 63. lxv See Richard Samuels and Stephen Stich, ―Rationality and Psychology‖ in Piers Rawling and Alfred R. Mele
(eds.), The Oxford Handbook of Rationality, Oxford University Press, forthcoming . lxvi See Evans, J. and Over. D., ―Dual Processes in Thinking and Reasoning,‖ forthcoming. Also see Sloman, P.
―The empirical case for two systems of reasoning,‖ Psychological Bulletin, 119, 1 (1996), 3-22. lxvii Samuels and Stich, 24. lxviii Ibid.
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lxix Greene, ―The Secret Joke of Kant‘s Soul,‖ in Moral Psychology, Vol. 3: The Neuroscience of Morality: Emotion, Disease, and Development, Walter Sinnott-Armstrong (ed.), MIT Press (2007). lxx See Kahneman, Daniel, and Amos Tversky (eds.) 2000. Choice, Values, and Frames. Also see Kinga Morsanyi,
Caterina Primi, Francesca Chiesi, Simon Handley, ―The effects and side-effects of statistics education:
Psychology students‘ (mis-)conceptions of probability,‖ Contemporary Educational Psychology, 34, 3, 210-220
(2009). lxxi Smith and Walker, ―Monetary Rewards and Decision Cost in Experimental Economics,‖ Economic Inquiry, 31, 245-261. Although, these effects do not increase monotonically, see Gneezy and Rustichini, ―Pay Enough or
Don‘t Pay at All,‖ Quarterly Journal of Economics, 115, 791-811. lxxii Ibid, 245. lxxiii C. Camerer and R. Hogarth, ―The Effects of Financial Incentives in Experiments: A Review and Capita l-
Labor-Production Framework,‖ Journal of Risk and Uncertainty, 19, 7-42. For an attempt to generate a ratio
between these two costs, see Ondrej Rydval and Andreas Ortmann, ―How Financial Incentives and Cognitive
Abilities Affect Task Performance in Laboratory Settings: An Illustration,‖ Economics Letters, 85, 3, 315-320.
The authors find around a 2:1 ratio between ‗capital‘ and ‗labor‘. lxxiv Smith, 268. See Sydney Siegel, ―Decision Making and Learning Under Varying Conditions of
Reinforcement,‖ Annals of the New York Academy of Science, 1961, 89, 766-83.