Altman2017 Handbook of Behavioural

HANDBOOK OF BEHAVIOURAL ECONOMICS AND
SMART DECISION-MAKING
Morris Altman - 9781782549574

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Handbook of Behavioural
Economics and Smart
Decision-Making
Rational Decision-Making within the Bounds of Reason
Edited by
Morris Altman
Professor of Behavioural and Institutional Economics and Dean and Head,
Newcastle Business School, University of Newcastle, Australia
Cheltenham, UK • Northampton, MA, USA

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© Morris Altman 2017
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or
transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or
otherwise without the prior permission of the publisher.
Published by
Edward Elgar Publishing Limited
The Lypiatts
15 Lansdown Road
Cheltenham
Glos GL50 2JA
UK
Edward Elgar Publishing, Inc.

William Pratt House
9 Dewey Court
Northampton
Massachusetts 01060
USA
A catalogue record for this book

is available from the British Library
Library of Congress Control Number: 2016957242
This book is available electronically in the

Economics subject collection
DOI 10.4337/9781782549598
ISBN 978 1 78254 957 4 (cased)

ISBN 978 1 78254 959 8 (eBook)
Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

01
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Contents
List of contributors ix
Foreword by Vernon L. Smith xix
Acknowledgements xxi
1 Introduction to smart decision-making 1

Morris Altman
PART I SMART DECISION-MAKERS, DIFFERENT TYPES OF

RATIONALITY AND OUTCOMES
2 Rational inefficiency: smart thinking, bounded rationality and the scientific

basis for economic failure and success 11
Morris Altman
3 Rational mistakes that make us smart 43
Nathan Berg
4 Rational choice as if the choosers were human 68
Peter J. Boettke and Rosolino A. Candela
5 Smart predictions from wrong data: the case of ecological correlations 86
Florian Kutzner and Tobias Vogel
6 Heuristics: fast, frugal, and smart 101
Shabnam Mousavi, Björn Meder, Hansjörg Neth and Reza Kheirandish
7 The beauty of simplicity? (Simple) heuristics and the opportunities yet to be
realized 119
Andreas Ortmann and Leonidas Spiliopoulos
8 Smart persons and human development: the missing ingredient in behavioral
economics 137
John F. Tomer
PART II ASPECTS OF SMART DECISION-MAKING
9 Behavioral strategy at the frontline: insights and inspirations from the US

Marine Corps 157
Mie Augier
10 Feminist economics for smart behavioral economics 173
Siobhan Austen
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vi Handbook of behavioural economics and smart decision-making
11 How regret moves individual and collective choices towards rationality 188
Sacha Bourgeois-Gironde
12 Is it rational to be in love? 205
Paul Frijters and Gigi Foster
13 Behavioral economic anthropology 233
Giuseppe Danese and Luigi Mittone
PART III DEVELOPMENT AND GOVERNANCE
14 Do changes in farmers’ seed traits align with climate change? A case study of
maize in Chiapas, Mexico 251
C. Leigh Anderson, Andrew Cronholm and Pierre Biscaye
15 Rationality, globalization, and X-efficiency among financial institutions 275
Roger Frantz
16 The evolution of governance structures in a polycentric system 290
Edward McPhail and Vlad Tarko
PART IV TAX BEHAVIOUR
17 Taxation and nudging 317

Simon James
18 Income tax compliance 331
Erich Kirchler, Barbara Hartl and Katharina Gangl
PART V SMART MACROECONOMICS AND FINANCE
19 Financial decisions in the household 349

Bernadette Kamleitner, Till Mengay and Erich Kirchler
20 Employing priming to shed light on financial decision-making processes 366
Doron Kliger
21 Experimental asset markets: behavior and bubbles 375
Owen Powell and Natalia Shestakova
22 To consume or to save: are we maximizing or what? 392
Tobias F. Rötheli
PART VI DIMENSIONS OF HEALTH
23 Time orientation effects on health behavior 413

Jannette van Beek, Michel J.J. Handgraaf and Gerrit Antonides
24 Behavioral aspects of obesity 429
Odelia Rosin

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Contents vii
25 Time inconsistent preferences in intertemporal choices for physical activity

and weight loss: evidence from Canadian health surveys 449
Nazmi Sari
26 Suicide among smart people 464
Bijou Yang and David Lester
PART VII SOCIOLOGICAL DIMENSIONS OF SMART DECISION-

MAKING
27 Seeing and knowing others: the impact of social ties on economic

interactions 479
Astrid Hopfensitz
28 Weakness of will and stiffness of will: how far are shirking, slackening,
favoritism, spoiling of children, and pornography from obsessive-
compulsive behavior? 492
Elias L. Khalil
29 The role of identity, personal and social capital in community crime
prevention 515
Ambrose Leung and Brandon Harrison
30 Norms, culture, and cognition 526
Shinji Teraji
PART VIII MORALS AND ETHICS
31 Rational choice in public and private spheres 543

Herbert Gintis
32 Ethics and simple games 557
Mark Pingle
Index 573

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Contributors
Morris Altman is Dean and Head of the Newcastle Business School and is Professor of
Behavioural and Institutional Economics at the University of Newcastle, Australia. He
is also Professor Emeritus at the University of Saskatchewan, Canada. Morris was the
Head of the School of Economics and Finance and Professor at Victoria University of
Wellington, New Zealand. He earned his PhD in economics from McGill University,
Montreal, Canada in 1984. A former visiting scholar at Cambridge (Elected Visiting
Fellow), Canterbury (Erkine Professor), Cornell, Duke, Hebrew, Stirling and Stanford
Universities, he served as Editor of the Journal of Socio-Economics for ten years and is
currently the co-founder and Associate Editor of the Review of Behavioral Economics. He
is also past President of the Society for the Advancement of Behavioral Economics and
of the Association for Social Economics. Morris has published over one hundred refereed
papers and given over 150 international academic presentations on behavioural econom-
ics, x-inefficiency theory, institutional change, economics of cooperatives, economic
history, methodology and empirical macroeconomics and has published eight books
including: Handbook of Contemporary Behavioral Economics, Behavioral Economics
for Dummies, Economic Growth and the High Wage Economy and Real-World Decision
Making: An Encyclopedia of Behavioral Economics. Morris is on the International
Co-operative Alliance (ICA) international committee on research as well as that for the
Asian-Pacific region.
C. Leigh Anderson is the Marc Lindenberg Professor for Humanitarian Action,
International Development and Global Citizenship at the University of Washington’s
Evans School of Public Policy and Governance, USA. Anderson’s research focuses on
how individual and household decision-making is affected by economic and attitudinal
factors including poverty, rural isolation, agricultural livelihoods, and preferences over
risk, time and social standing. Of interest is how policy and programmatic interventions
can be best designed and delivered to improve the lives of the poor and food insecure.
Gerrit Antonides is an Emeritus Professor of Economics of Consumers and Households
at Wageningen University, the Netherlands. He has published in the areas of behavioural
economics, economic psychology and consumer behaviour. He has been an editor of the
Journal of Economic Psychology and has authored and co-authored several textbooks
on consumer behaviour and economic psychology. The behavioural aspects of consumer
decision-making concerning issues of finance, household, environment and health are an
important part of his current research activities.
Mie Augier is Associate Professor at the Naval Postgraduate School, USA. Her scholarly
and academic research interests include strategy, organizations, innovation, interdiscipli-
nary social science, how organizations cultivate innovation capability (including the role
of strategic organizational design), the influence of culture and globalization on strategic
decision-making, and the past and future of management education and business schools.
Her research has been published in more than 50 articles and book chapters in outlets
ix
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x Handbook of behavioural economics and smart decision-making
such as Organization Science, Industrial and Corporate Change, Journal of Management

Inquiry, Management International Review, Organization Studies; Research Policy and
California Management Review, among others. With collaborators she has published on
topics such as the history of business schools (including her 2011 book with James March,
The Roots, Rituals, and Rhetorics of Change, Stanford University Press) and the organiza-
tional mechanisms leading to the rise (and decline) of novelty and innovation in organiza-
tions (‘The flaring of intellectual outliers’, 2015, Organization Science). Active research
interests include: (1) organizational and strategic analysis of the US Marine Corps as an
organization, how they have evolved and organized for innovation, and their strategic
decision-making; (2) the evolution of the teaching of ethics and values within the history
of business schools and management education; and (3) behavioural strategy as a field.
Siobhan Austen is Professor of Economics and Director of Women in Social and
Economic Research (WiSER) at Curtin University Perth, Western Australia. She works
on feminist and institutional economics, with a particular focus on the circumstances and
experiences of women in labour markets.
Nathan Berg is Associate Professor of Economics at University of Otago in Dunedin,
New Zealand. Berg’s work appears in Journal of Economic Behavior and Organization,
Psychological Review, Social Choice and Welfare and Review of Behavioral Economics.
Berg was a Fulbright Scholar in 2003 and Visiting Research Scientist at the Max Planck
Institute-Berlin in the 2000s. His research has been cited in the Financial Times, Business
Week, Canada’s National Post, The Village Voice, The Advocate, Science News, Slate and
the Atlantic Monthly.
Pierre Biscaye is the Research Coordinator for the Evans School Policy Analysis and
Research Group (EPAR) at the University of Washington, USA. He manages and sup-
ports research looking at issues across agricultural development, poverty reduction,
financial inclusion, global health, and development policy. Pierre received a Master of
Public Administration (MPA) from the University of Washington’s Evans School of
Public Policy and Governance. For his capstone, he developed a monitoring and evalu-
ation system and implementation plan for a small non-profit organization supporting
education projects in Sierra Leone.
Peter J. Boettke is a University Professor of Economics and Philosophy at George
Mason University, a BB&T Professor for the Study of Capitalism, and the Director of
the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics
at the Mercatus Center at George Mason University, USA. He is Co-Editor-in-Chief
of The Review of Austrian Economics and President of the Southern Economic
Association.
Sacha Bourgeois-Gironde is Professor of Economics at Université Paris II and research
faculty member of Institut Jean-Nicod at Ecole Normale Supérieure, France. His work
lies at the interface between decision-theory and cognitive sciences. The first aim is to
understand how recent developments in formal decision-theory can supply new testable
psychological insights on our use (or non-use) of probabilities, indeterminacies of our
beliefs and values, and long-term rational purposes in life. The second aim, using interdis-
ciplinary approaches (computer science, neuroscience and experimental psychology), is to

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Contributors xi
probe how bounded cognitive systems can adapt to complex decisional environments and
how the interaction between the two brings about the emergence of particular institutions.
Rosolino A. Candela is a PhD candidate in Economics at George Mason University
and a Graduate Research Fellow in the F.A. Hayek Program for Advanced Study in
Philosophy, Politics, and Economics at the Mercatus Center at George Mason University,
USA. He holds a BA in History from St John’s University and an MA in Economics
and International Political Economy from Fordham University. Previously, he was also a
visiting PhD student in the Department of Political and Social Sciences at the European
University Institute and a Charles G. Koch PhD Fellow at Suffolk University, where he
was also a Koch Summer Fellow at the Beacon Hill Institute.
Andrew Cronholm is an analyst with the King County Office of Performance, Strategy
and Budget in Washington State, USA, where he provides policy, finance, and budget-
ing expertise. Andrew previously held analytical roles supporting the US Environmental
Protection Agency and the City of Seattle’s Department of Transportation. Originally
hailing from Massachusetts, Andrew received a Bachelor of Arts in Political Science
from Drew University and obtained his Master of Public Administration (MPA) and
Certificate in Environmental Management from the University of Washington’s Evans
School of Public Policy and Governance. He currently resides in Seattle, Washington.
Giuseppe Danese is a Fellow at CEGE, the research centre of Católica Porto Business
School in Porto, Portugal. He holds a PhD in Economics from Simon Fraser University.
His research interests are social norms, organizations, property rights, and the psycho-
physiological roots of decision-making.
Gigi Foster is an Associate Professor with the School of Economics at the University
of New South Wales, Australia. She works in many literatures, including education,
social influence, corruption, laboratory experiments and time use. With support from
the Australian Research Council and other bodies, she published a holistic behavioural
economics treatise with Cambridge University Press (An Economic Theory of Greed,
Love, Groups, and Networks, jointly with Paul Frijters) in 2013 and has authored over 25
academic papers published in a range of outlets such as the Journal of Public Economics,
Quantitative Economics, Human Relations and Journal of Economic Psychology.
Roger Frantz is Professor of Economics at San Diego State University, USA and Founding
Editor of the Journal of Behavioral Economics for Policy. He has edited the Handbook
of Behavioral Economics (London: Routledge, 2016). He is Editor of Renaissance in
Behavioral Economics. He is co-editor, with Leslie Marsh, of Minds, Models, and Milieux:
Commemorating the Centennial of the Birth of Herbert Simon and, with Robert Leeson,
of Frederick Hayek and Behavioral Economics. He has also authored Two Minds: Intuition
and Analysis in the History of Economic Thought and X-Efficiency: Theory, Evidence, and
Applications. His work has been published in many journals, including the Journal of
Socio-Economics, Journal of Economic Psychology, American Economic Review, Papers
& Proceedings, Economics and Philosophy, Public Choice, Journal of Post Keynesian
Economics, Journal of Behavioral Economics and the Southern Economic Journal.
Paul Frijters is a Professorial Research Fellow at the Wellbeing Program within the Centre for
Economic Performance at the London School of Economics, United Kingdom and Project

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xii Handbook of behavioural economics and smart decision-making
Director of the LSE’s World Wellbeing Panel. Paul holds a PhD in welfare and well-being in
Russia from the University of Amsterdam and has a wide range of research interests, having
published over 70 papers and books in fields including happiness, labour markets, health
economics, behavioural economics and econometrics. Before joining the LSE, he was the
Research Director of the Rumici Project, an international project into the migration from
the countryside to the cities in China and Indonesia, sponsored by ministries, the World
Bank, the Ford Foundation and many others, tracking 20 000 individuals for many years.
In 2009 Paul was awarded the Economic Society of Australia’s Young Economist Award
(best economist under 40 in Australia). He regularly comments on economic issues in the
national and international media, including the New York Times and the BBC.
Katharina Gangl is Assistant Professor at the University of Göttingen, Germany, as
the Chair of Economic and Social Psychology. She received her Diploma and PhD in
Economic Psychology at the University of Vienna, Austria, and was a visiting scholar at
the Queensland University of Technology, Australia. Her main research areas are ethical
decision-making in organizations and tax behaviour.
Herbert Gintis is External Professor at the Santa Fe Institute, Santa Fe, New Mexico,
USA. His recent books include Game Theory in Action (with Stephen Schechter)
(Princeton University Press 2016), A Cooperative Species (with Samuel Bowles) (Princeton
University Press 2011), The Bounds of Reason (Princeton University Press 2009), Game
Theory Evolving (Princeton University Press 2009), and Moral Sentiments and Material
Interests (MIT Press 2005). His most recent book is Individuality and Entanglement: The
Moral and Material Bases of Social Life (Princeton University 2016). His recent work on
market dynamics includes: ‘The stability of general equilibrium with decentralized prices’
Journal of Mathematical Economics (with Antoine Mandel, 2016); ‘Stochastic stability
in the Scarf economy’, Mathematical Social Sciences (with Antoine Mandel, 2014); and
‘The dynamics of general equilibrium’, Economic Journal (2007). His work on the uni-
fication of the behavioural sciences includes: ‘Zoon politikon: the evolutionary origins
of human political systems’ (with Carel van Schaik and Christopher Boehm), Current
Anthropology (2015); ‘Inclusive fitness and the sociobiology of the genome’, Biology &
Philosophy (2014), ‘Homo socialis: an analytical core for sociological theory’ (with Dirk
Helbing), Review of Behavioral Economics (2015); ‘The biology of cultural evolution’,
Quarterly Review of Biology (2013), and ‘The evolutionary roots of property rights’, in
Kim Sterelny et al. (eds), Cooperation and its Evolution (MIT Press 2013). Professor Gintis
is a top reviewer of scientific books at Amazon.com and was recently cited as a gold star
reviewer for Nature.
Michel J.J. Handgraaf received his PhD in Social Psychology from Leiden University.
Since 2011 he has been an Associate Professor at the Economics of Consumers and
Households Group of Wageningen University, the Netherlands. Most of his research
uses (field) experimental methods and surveys, can be described as ‘behavioural econom-
ics’ and mainly deals with differences between what rational economic theories would
predict and the psychology behind deviations from such predictions. Besides research on
fairness and ethics, Handgraaf’s current research focuses on decisions in the environmen-
tal domain. These decisions typically feature uncertainty, temporal trade-offs and social
trade-offs.

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Contributors xiii
Brandon Harrison obtained a Bachelor of Arts Criminal Justice (Honours) from Mount
Royal University in Calgary, Alberta, Canada. Brandon is currently enrolled in the
Faculty of Law at Thompson Rivers University in Kamloops, British Columbia, Canada.
Brandon is interested in criminal law and energy law.
Barbara Hartl holds a post-doctoral position at the Institute of Organization and Global
Management Education at the Johannes Kepler University, Linz, Austria. Her research
interests include cooperation in social dilemma, sustainable consumption and psychology
of tax behaviour. She follows a multi-method approach, including laboratory experi-
ments, survey studies, interviews and free associations.
Astrid Hopfensitz is currently a Lecturer in Economics at the Toulouse School of
Economics (TSE) in France. Her main research interest concerns the influence of emo-
tions and psychological dimensions on economic decision-making and behaviour. In her
work she employs economic experiments in combination with psychological methods of
measuring emotions and character traits. Since 2012 she has also been affiliated with the
Institute of Advanced Study in Toulouse (IAST).
Simon James is an Associate Professor of Economics, Department of Organisation
Studies, University of Exeter Business School, United Kingdom. He has held visiting
positions at six universities overseas, published many research papers and his 16 books
include a four-volume edited collection of papers Taxation: Critical Perspectives on the
World Economy, 2002, A Dictionary of Taxation, 2nd edition 2012, The Economics of
Taxation: Principles, Policy and Practice (with Christopher Nobes) 16th edition 2016
and, jointly edited with Adrian Sawyer and Tamer Budak, The Complexity of Tax
Simplification: Experiences from around the World, 2016.
Bernadette Kamleitner is Professor of Marketing at WU Vienna University of Economics
and Business, Austria. She is head of the Institute for Marketing and Consumer Research
at WU and President of the Austrian Forum Marketing. Her internationally published
research is positioned at the cross-section of psychology, marketing and economics. Her
particular research interests comprise the psychological underpinnings and consequences
of experiences of ownership and financial decision-making.
Elias L. Khalil is an Associate Professor of Economics at Monash University, Australia.
He received his PhD in Economics from the New School for Social Research in 1990.
His research focus is building a unified theory of human action, a theory that is
based on rationality, virtue and an expanded notion of the self. His papers appeared
in journals such as Economic Inquiry, Behavioral and Brain Sciences, Biology and
Philosophy, Biological Theory, Theory and Decision, Journal of Economic Behavior and
Organization, Cambridge Journal of Economics, Journal of Evolutionary Economics,
International Negotiation, Theoria, Philosophy, Economic Modelling and Economics and
Philosophy.
Reza Kheirandish is Associate Professor of Economics at the College of Business,
Clayton State University, Morrow, Georgia, USA, and is affiliated with the Center for
Adaptive Behavior and Cognition, Max Planck Institute for Human Development, Berlin,
Germany. He received his PhD in economics from Virginia Tech and his BSc degree in
electrical engineering from Sharif University of Technology. Reza has been a (summer)

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xiv Handbook of behavioural economics and smart decision-making
Visiting Researcher at the Max Planck Institute for Human Development in Berlin since
2014. He has served as the Director of the Center for Research in Economic Sustainability
and Trends (CREST) at CSU (2010–15), the Program Co-Chair for the SABE/IAREP
(2013) and the President, Vice-President, Treasurer/Secretary and Program Chair of
SEINFORMS. He is the 2017 Program Chair for the SEDSI and has been a board
member and webmaster of SABE since 2010.
Erich Kirchler is Professor of Economic Psychology at the University of Vienna,
Faculty of Psychology, and Guest Professor at WU Vienna University of Economics
and Business, Austria. He is head of the Department of Applied Psychology: Work,
Education, Economy at the Faculty of Psychology and past President of the International
Association of Applied Psychology (IAAP), Division 9 (Economic Psychology) and the
Austrian Psychological Society. His research is positioned at the cross-section of psychol-
ogy and behavioural economics. His particular research interests comprise financial deci-
sions in the household and psychology of tax behaviour.
Doron Kliger is the Chair of the Economics Department at the University of Haifa, Israel,
specializing in finance and behavioural economics. While in the US, he has been affiliated
with the Wharton School, University of Pennsylvania. Kliger has published in a wide
range of journals in finance, economics, insurance and probability, on topics including
asset pricing, behavioural economics and finance, bond rating, decision-making, indus-
trial organization and insurance pricing. He is a co-author of the book Event Studies for
Financial Research, helping readers to obtain valuable hands-on experience with event
study tools and to gain required technical skills for conducting their own studies.
Florian Kutzner received his doctoral degree in psychology from the University of
Heidelberg. After a research stay at the Warwick Business School he is currently affiliated
with the Department of Cognitive Research in Social Psychology (CRISP) at the University
of Heidelberg, Germany. His research focuses on the descriptive models of decision-making
and learning in the context of social stereotypes and sustainable behaviour.
David Lester has doctoral degrees from Cambridge University, United Kingdom, in
social and political science and Brandeis University, USA, in psychology. He is Emeritus
Professor of Psychology at Stockton University in Galloway, New Jersey, USA. He is a
former President of the International Association for Suicide Prevention. He has pub-
lished extensively on economic issues and suicide, including Suicide and the Economy
(Nova Science, 1997) and ‘Calculating the economic cost of suicide’ (Death Studies, 2007,
31, 351–61).
Ambrose Leung is Associate Professor at the Department of Economics, Justice, and
Policy Studies, Mount Royal University in Calgary, Alberta, Canada. Ambrose received
his PhD in Economics from Carleton University in Ottawa, Ontario, Canada. His main
fields of research include socioeconomics, economics of crime, economic psychology
and economics education. Ambrose has also acted as a consultant for the Department of
Justice Canada.
Edward McPhail is Professor of Economics at Dickinson College in Pennsylvania, USA.
He has published papers in the American Journal of Economics and Sociology, Challenge,
Eastern Economic Journal, European Journal of Political Economy, History of Economics

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Contributors xv
Review, History of Economic Ideas, Historical Journal, Journal of Economic Behavior and
Organization, Review of Political Economy and others.
Björn Meder is a research scientist at the Center for Adaptive Behavior and Cognition
(ABC) at the Max Planck Institute for Human Development in Berlin, Germany. His
research interests include judgement and decision-making, causal inference, information
search and cognitive modelling. Björn holds a PhD in psychology from the University of
Göttingen, Germany.
Till Mengay was Research Assistant at the Institute for Marketing and Consumer
Research, WU Vienna University of Economics and Business, Austria. Currently he
is working at the Federal Ministry of Education, Department for Adult Education,
Austria. His particular research interests are sustainable consumption and sharing
within groups.
Luigi Mittone (PhD, Bristol) is Full Professor of Economics at the University of Trento,
Italy. At the University of Trento he is Director of the Doctoral School in Social Sciences,
Director of the Cognitive and Experimental Economics Laboratory and coordinator of
the International Master in Economics (MEC). He is also coordinator of the research
project in ‘Experimental economics and nudging’ at the Bruno Kessler Research Centre.
He has published extensively on fiscal evasion, consumer behaviour, mental modelling
of uncertain events, intertemporal choices, cooperation, and fiscal system dynamics with
heterogeneous agents.
Shabnam Mousavi’s research revolves around making sense of the ways in which people
make their decisions. She holds a PhD in economics and one in statistics from Virginia
Tech, USA, serves on the Faculty of Business at the Johns Hopkins University, USA, and
is a researcher at the Max Planck Institute for Human Development, Berlin, Germany.
At the moment she is writing her first book, Fast-and-Frugal Decision Making.
Hansjörg Neth is Lecturer in Social Psychology and Decision Sciences at the University
of Konstanz, Germany and an associate member of the Max Planck Institute of Human
Development, Berlin, Germany. His theoretical and experimental research focuses on the
analysis of adaptive behaviour, interactive cognition and ecological rationality, as well
as applied aspects of choice, and heuristic decision-making under uncertainty. He has
served as acting Chair of Cognition, Emotion, and Communication at the University of
Freiburg, taught cognitive and decision sciences at the University of Göttingen, and was
Research Assistant Professor in Cognitive Science at the Rensselaer Polytechnic Institute.
He holds a PhD in psychology from Cardiff University, UK.
Andreas Ortmann is Professor of Experimental and Behavioural Economics in the School
of Economics at the UNSW Australia Business School, Sydney, Australia. He was for-
merly Professor at CERGE-EI, Prague, Czech Republic, and Researcher at the Center for
Adaptive Behavior and Cognition.
Mark Pingle has been a member of the University of Nevada, Reno Department of
Economics, USA, since 1990. He was appointed Conjoint Professor of Economics to
the Department of Economics, University of Newcastle in 2016. He received his PhD
in Economics in 1988 from University of Southern California. Professor Pingle has

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xvi Handbook of behavioural economics and smart decision-making
published in the areas of behavioural economics, experimental economics and macro-

economics. He is Book Editor for the Journal of Behavioral and Experimental Economics,
Associate Editor for the Review of Behavioral Economics and is a past President of the
Society for the Advancement of Behavioral Economics.
Owen Powell is an Assistant Professor in the Department of Economics at the University
of Vienna, Austria. He holds a PhD in economics from the University of Tilburg. His
research interests include experimental finance, growth and growth accounting, and com-
putational economics. His work has been published in the Journal of Econometrics, the
Review of Finance and the Journal of Behavioral and Experimental Finance.
Odelia Rosin is a health economist. She holds a PhD in economics from Bar-Ilan
University, Israel. Her doctoral dissertation dealt with obesity, its behavioral economic
aspects and related public policy. Her research interests are health economics, behav-
ioral economics, nutrition and public health. Odelia is a Lecturer in the College of
Management – Academic Studies (COMAS) in Israel. She also serves as the academic
head of one of COMAS’s campuses.
Tobias F. Rötheli is Professor of Macroeconomics at the Department of Economics of the
University of Erfurt in Germany. He holds a doctorate and a Venia Legendi in Economics
from the University of Bern. His research focuses on behavioural models of expectations.
Much of this work is built on the concept of pattern recognition and combines experi-
mental methods and applied econometrics. A further area of research is the modelling of
boundedly rational agents and their role in financial boom–bust dynamics. Finally, in his-
torical studies Rötheli investigates the coevolution of quantitative methods in academic
economics and in business practice.
Nazmi Sari is Professor in the University of Saskatchewan, Department of Economics,
Canada. In addition to his primary appointment at the university, he is a faculty associate
with the Canadian Center for Health Economics, University of Toronto, and an adjunct
scientist at the Health Quality of Council. His research interests are economics of physical
activity and smoking, quality and efficiency in hospital markets, provider reimbursements
and healthcare financing reforms. He has published articles in health economics, public
health, and health policy journals.
Natalia Shestakova is an Assistant Professor in the Department of Economics at the
University of Vienna, Austria. She holds a PhD in Economics from the Center for
Economic Research and Graduate Education – Economics Institute (CERGE-EI). Her
research interests include behavioural economics, contract theory and experimental
economics.
Leonidas Spiliopoulos received a BA in Economics from Yale University in 1997, an MSc
from the Athens University of Economics and Business in 2003 and a PhD in Economics
from the University of Sydney in 2008. He is currently a Visiting Research Fellow at the
Max Planck Institute for Human Development (Center for Adaptive Rationality), Berlin,
Germany, where he also served as an Alexander von Humboldt Experienced Research
Fellow. He previously held a Vice-Chancellor’s Postdoctoral Research Fellowship at the
University of New South Wales, an Endeavour Cheung Kong Research Fellowship at
the Hong Kong University of Science and Technology, and lectured at the University of

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Contributors xvii
Athens. His work focuses on how economics, game theory, cognitive psychology/neuro-
science and artificial intelligence can inform models of decision-making and learning.
Vlad Tarko is Assistant Professor of Economics at Dickinson College in Pennsylvania,
USA. He is the author of Elinor Ostrom: An Intellectual Biography (Rowman & Littlefield
International, 2017) and co-author with Paul Aligica of Capitalist Alternatives: Models,
Taxonomies, Scenarios (Routledge, 2015). He has published papers in the American
Political Science Review, Academy of Management Papers and Proceedings, Comparative
Economic Studies, Kyklos, Constitutional Political Economy, Review of Austrian Economics
and others.
Shinji Teraji is Professor of Economics, Yamaguchi University, Japan. His research is
mainly concerned with a synthesis of behavioural and institutional economics. He is the
author of Evolving Norms: Cognitive Perspectives in Economics (2016).
John F. Tomer is Emeritus Professor of Economics at Manhattan College, USA. He was
born in 1942 and grew up in New Jersey. He has a PhD in Economics (1973) from Rutgers
University, New Brunswick, New Jersey. He is a founder and past President of the Society
for the Advancement of Behavioral Economics. His research areas are behavioural eco-
nomics and human capital. He has written four books and 50 articles. His recent research
integrates human capital with human development.
Jannette van Beek completed a dissertation on time orientation in relation to both eating
and exercising behaviour. The main aim of this dissertation is to provide insight into the
relationship between time orientation and both eating and exercising behaviour in order
to better understand individuals’ intertemporal decision-making in the health domain and
ultimately stimulate healthy eating and exercising behaviour. Currently, Jannette works
as a Lecturer at both the Economics of Consumers and Households Group and the
Marketing and Consumer Behaviour Group of Wageningen University, the Netherlands.
Tobias Vogel received his doctoral degree in psychology from the University of Heidelberg.
After research stays at the Universities of Louvain-la-Neuve, Belgium, Basel, Switzerland,
and San Diego, USA, he is currently affiliated with the Department of Consumer and
Economic Psychology at the University of Mannheim, Germany. His research focuses
on the psychology of evaluative judgements, with an emphasis on the cognitive processes
underlying attitude acquisition and construction. He is author of the book Attitudes and
Attitude Change (Vogel and Wänke, 2016).
Bijou Yang has BA and MA degrees in economics from the National Taiwan University
and MA and PhD degrees in economics from the University of Pennsylvania. Her dis-
sertation was on econometric forecasting of the world economy, and she worked for
Wharton Econometric Forecasting Associates (WEFA) before returning to academia.
She joined Drexel University, USA, in 1987. Her research has focused on contingent
employment, e-commerce and the behavioural economic approach to suicide and crimi-
nal behaviour. She served as Treasurer of the Society for the Advancement of Behavioral
Economics (SABE) from 1986 to 2010 and as President from 2006 to 2008. She has pub-
lished two books and some 190 scholarly articles and notes. Her research has appeared in
Applied Economics and the Journal of Socio-Economics, most recently ‘Personality traits
and economic activity’ in Applied Economics, 2016, 48, 653–57.

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Foreword
In the study of decision-making by people in the world, the laboratory, in surveys, or in all
of the above, many scholars have derided our decisions as irrational, uninformed, biased
or vulnerable to illusions, if not delusions, that steer us off track. You won’t find that sim-
plistic reduction in this book. You will find plenty of cases of error, sometimes random,
sometimes systematic, and sometimes in the models that are alleged to specify rational
behaviour. You will also find penetrating analyses of institutions and other social systems
that have made us smart, or smart enough to muddle through in an uncertain world.
For me this shift in methodology from the search for anomalies that prove that the
standard model is wrong – a search that was assured of finding what was sought – to
a closer examination of the circumstances that make for success or failure is particu-
larly welcome. Both experimental economics and the anomalies literature grew out of
a welcome new wave of empirical investigation that can only be understood against the
intellectual backdrop of a hundred-odd years of equilibrium theory development. That
development had been jump-started by the marginal utility revolution of the 1870s,
devolving into powerful new theory by the mid-twentieth century. Theoretical insights
into topics ranging from individual decision-making and two-person games to the deter-
minants of prices in markets invited new experimental investigations by psychologists
and economists in the 1950s and 1960s. Both verifying and falsifying evidence surfaced
as part of these investigations. When you are looking to verify the predictions of a theory
and get glaring contrary evidence proving your beliefs are wrong, it changes the way you
think about the phenomenon.
In retrospect, neoclassical economic theory provided insights so powerful and influ-
ential that it displaced rather than supplemented the classical economic perspective.
Under the influence of neoclassical theory, my first supply and demand experiments
were designed to show that complete information – a pillar of theory at the time – was
necessary to observe efficient competitive outcomes. However, the experiments demon-
strated the opposite. We were wrong. Inadvertently, I was rediscovering that process is
what matters. ‘The propensity to truck barter and exchange’ is a process; empower people
with a trading institution, and they will use it to discover rich forms of specialization that
otherwise did not exist.
Neoclassical equilibrium in outcomes displaced rather than supplemented socio-
economic interactive processes of change, prominent in the writings of David Hume and
Adam Smith.
I see this book as a return to that perspective, but driven by new and exciting ways of
modelling and thinking about the great issues that have created the modern world.
Vernon L. Smith, Professor of Economics and Law

George L. Argyros Endowed Chair in Finance and Economics
2002 Nobel Laureate in Economics
Chapman University, USA
xix
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Acknowledgements
This was a huge project and one that breaks from various conventional perspectives on
economic theory and behavioural economics. I must thank Matthew Pitman, our pub-
lishing editor, for supporting this project and for his helpful advice. Of course, it goes
without saying that all contributors devoted so much time and effort towards construct-
ing some enriching and excellent chapters. Thanks for your contributions and support.
The meticulous work from the whole Edward Elgar team was invaluable. I also express
gratitude to life partner and wife, Louise Lamontagne, for her comments and suggestions.
Many thanks as well to our daughter, Hannah Altman, now blossoming into a first-rate
economist and health scientist.
xxi
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To the late Professor Harold (H.R.C.) Wright, brilliant and modest teacher-scholar, my
Master’s and PHD supervisor, teacher, mentor and friend at McGill University.

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1 Introduction to smart decision-making
Morris Altman
This is an original contribution of essays on behavioural economics, which builds upon

the research of Herbert Simon and, more generally, the Carnegie-Mellon school of
behavioural economics. This perspective can be referred to as the bounded rationality
methodological approach to behavioural economics (Altman 1999, 2005, 2015, 2017). In
this perspective, the prior assumption is that decision-makers are relatively rational, intel-
ligent and smart (satisficing, boundedly rational and evolutionarily rational). As one of
the intellectual leaders of the Carnegie-Mellon school, James March (1978, p. 589), stated,
it is of primary importance to determine if we can explain human behaviour in terms of
rationality, broadly defined, even if at first glance such behaviour does not appear rational
and might even appear to be error-prone or ‘biased’. More generally, I refer to this meth-
odological approach as smart decision-making, which encompasses bounded rationality,
procedural rationality, fast and frugal heuristics, the brain as a scarce resource (following
the insights of Friedrich Hayek) and the institutional, sociological and psychological-
neurological determinants of decision-making. This is counter-posed to the world view of
conventional or neoclassical rationality as well as the heuristics and biases perspective on
behavioural economics, pioneered by Kahneman and Tversky (Kahneman 2003, 2011),
that dominates contemporary behavioural economics.
Smart decision-making encompasses intelligent or smart decision-makers or agents,
who develop or adopt decision-making processes and make decisions given their cog-
nitive limitations, the decision-making mechanism of the brain, individuals (or eco-
nomic agents) decision-making capabilities, decision-making experience, environmental
factors, which include institutional and legal parameters, culture and norms, relative
power in the decision-making process and related sociological factors. It is also rec-
ognized that cognitive limitations are affected by technology (computers and calcula-
tors, for example), the capabilities to effectively use new or improved technologies and
the learning processes that affect how the brain is hardwired (neuroplasticity). Smart
decision-makers or agents do the best they can, given the pertinent circumstances that
affect the decision-making process and related outcomes. Herbert Simon refers to the
act of doing the best we can as satisficing behaviour. Satisficing need not result in the
best possible or optimal outcomes for the firm, household, society or individual; but it
can, depending on circumstances.
Deviations from optimality do not imply that decision-makers are not smart and, in
this sense, irrational. Nor does establishing that decision-makers are smart imply that
decision-making outcomes are optimal. Here rationality, broadly defined, relates to the
choices people make and the decision-making processes adopted by individuals given
their various constraints and opportunities as well as their decision-making environment.
Optimality in production and consumption at an individual, firm, household or social
level need not necessarily flow from smart decision-making. Smart decision-making,
however, would often be a necessary but not a sufficient condition for optimality to be
1
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2 Handbook of behavioural economics and smart decision-making
obtained. What these sufficient conditions might be are critically important to research
that stems from the smart agent or smart decision-making perspective.
Inadequate decision-making environments, for example, would preclude smart agents
from achieving optimal results from their own and from society’s perspective (where
externalities exist). For example, you might wish to increase your savings for retirement,
but you invest in high-risk high-return financial paper because of the false or mislead-
ing financial information provided to you, resulting in you losing much of your savings.
Women might want to have one child, but they end up giving birth to four or five, because
they are not empowered to realize their preferences. A firm’s productivity might not
be maximized because decision-makers are maximizing a complex utility function that
includes managerial slack and short-term returns. None of the above is a product of irra-
tionality. They are a product of preferences, decision-making capabilities, experience and
the overarching decision-making environment.
Conventional theory’s point of focus is on very generalized concepts related to how
humans should behave and are expected to behave to generate optimal outcomes. As long
as the analytical prediction is correct, all is well. This is effectively the correlation-based
analysis promoted by Friedman (1953). If you get the prediction correct, you can assume
for reasons of simplicity that humans behave as if they are maximizing profits, minimizing
costs and maximizing utility (which is often assumed to be identical wealth maximization,
controlling for risk). The realism of the simplifying assumptions we make about decision-
makers, the decision-making processes and the decision-making environment are not of
importance from this perspective. We can simply assume that individuals behave as if
they are maximizing profits or utility, as long as the analytical prediction is the correct
prediction. The assumption here is that individuals ideally should behave ‘neoclassically’,
if they are rational, which they are assumed to be. Rationality is defined in terms of neo-
classical rationality. Apart from this, what transpires in the decision-making process is not
of substantive interest. We simply abide methodologically with neoclassical simplifying
assumptions of how individuals behave within the firm and in the household. Moreover, it is
further assumed that the decision-making environment allows for the realization of optimal
outcomes, given neoclassical rationality, for the individual, the household and the firm.
The analytical focus, therefore, is on correlation as opposed to true causation, where
the latter relates to determining what particular behaviours and decision-making envi-
ronments generate particular outcomes. Modelling true causation would address issues
of spurious correlation, omitted variables and the possibility of alternative behaviours,
yielding similar sustainable outcomes. What is key is the determination of what specific
behaviours, decision-making processes and institutional and sociological variables yield
specific outcomes. This deeper modelling agenda is part of the bounded rationality
approach to behavioural economics.
The bounded rationality tradition in behavioural economics plays particular attention
to identifying the actual decision-making process that generates particular outcomes. It
ventures into the black box of the firm, the household and the individual. Only by under-
standing how individuals actually behave, how they make decisions, can we determine
if these decisions are smart and in this broad sense rational. Hence, rationality here is
contextualized. Benchmarks for what is rational are, therefore, not constructed by some
imagined ideal unrelated to the decision-making capabilities and environments of the
individual, household or firm.

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Introduction to smart decision-making 3
For this reason, a core attribute of the approach taken in this book is, following
from Simon, the overall importance of reasonable, reality-based, simplifying modelling
assumptions for robust economic analysis. Related to this is the significance of situating
our definition of rationality and smart decision-making in context. Simon writes (1986,
p. S209):
The judgment that certain behavior is ‘rational’ or ‘reasonable’ can be reached only by viewing
the behavior in the context of a set of premises or ‘givens.’ These givens include the situation in
which the behavior takes place, the goals it is aimed at realizing, and the computational means
available for determining how the goals can be attained. In the course of this conference, many
participants referred to the context of behavior as its ‘frame,’ a label that I will also use from time
to time. Notice that the frame must be comprehensive enough to encompass goals, the definition
of the situation, and computational resources.
The smart agent, smart decision-making approach to decision-making and behavioural

economics not only stands in contrast to what we find in much of conventional econom-
ics, it also stands in contrast, as mentioned above, to a theme running through much of
contemporary behavioural economics where much of the typical individual’s behaviour is
deemed irrational and error-prone. This is the heuristics and biases approach pioneered by
Kahneman and Tversky (Kahneman 2003, 2011). A common thread running through this
approach and conventional economics is adopting neoclassical benchmarks for rationality
and, flowing from this, benchmarks for optimal outcomes in the domain of consumption
and production (although the latter is not a point of focus in the heuristics and biases
approach). In the heuristics and biases approach, as in conventional economics, these
various benchmarks are not empirically derived. Rather, they are taken for granted. As in
the conventional approach, causal analysis is not the point of focus, and it appears that ana-
lytical prediction (correlation analysis) is of greatest significance. However, in the heuristics
and biases approach psychological factors are introduced into the modelling framework to
supplement or replace economic variables. Typically such new variables are said to generate
deviations from neoclassical optimality and, therefore, errors in decision-making. This is
often derived from assumed, but not proven, hardwired biases in the human decision-maker.
However, in terms of the derivation and introduction of psychological variables, these are
often not predicated upon an assessment of how individuals behave within the household
and the firm. Rather, they are generalized descriptors of human behaviour introduced into
the modelling framework to produce improved analytical predictions or predictions that
are as robust as those generated in conventional models, but now contain more realistic
behavioural assumptions. To reiterate, the realism of these new assumptions is typically not
tested against how individuals actually behave in the real world of decision-making.
A point of commonality between the bounded rationality approach, the broader smart
agent approach and the heuristics and biases approach is recognizing that real-world
decision-makers typically do not behave like the individuals in the traditional economic
models. We should note that Gary Becker (1996), for example, makes a similar point
with regard to neoclassical models ignoring sociological variables to their analytical and
scientific peril. He argues that neoclassical predictions are often wrong because they sys-
tematically ignore how social context impacts the decisions of rational agents. Douglass
North (1971) makes a similar point with respect to neoclassical economics systematically
ignoring the importance of institutional variables to decision-making by rational agents.

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Especially with respect to the heuristic and biases approach, a large scholarly industry
has developed documenting the extent to which actual human behaviour deviates from
predicted neoclassical behaviour. More generally, experimental economics, often done in
classroom settings, has documented significant deviations from neoclassical norms. The
fact that individuals tend not to behave neoclassically is no big surprise, even to many
neoclassical economists. The latter simply assume that individuals behave as if they make
decisions and choices based on neoclassical norms, not that they actually behave in this
fantastical manner.
Still this research remains important as it disabuses economists (theoretical and
applied), model users and various types of practitioners, including policy-makers, from
the notion that humans behave neoclassically. The big question is what does this actually
means for analysis and policy? Experiments suggest that, on average, individuals engage
in a wide array of behaviours that are contrary to what conventional economics assumes.
For example:
● Individuals weigh losses more than gains.

● Emotions and intuition drive much of decision-making.
● Individuals are willing to self-sacrifice to punish those who they deem are treating
them unfairly.
● Individuals are willing to punish or hurt those they don’t like.
● Individuals are willing to self-sacrifice for those towards whom they feel sympathy.
● Ethical concerns play a role in economics decision-making.
● Wealth maximization, even when controlled for risk, finds many exceptions.
● Framing affects choices.
● Relative positioning often matters more than absolute levels of income or wealth.
● Sentiment or animal spirits often matter more to decision-making than ‘real’ eco-
nomic variables.
● Individuals often follow the leader when making decisions (herding).
Are these ‘average’ human traits a sign of hardwired cognitive biases, yielding suboptimal
choices, as the heuristics and biases approach intimates? Or, are these characteristics of
smart agents given their capabilities, experience and decision-making environment, even
when some of their decisions are wrong, at least in the first instance (a one-shot game)?
This is where the smart agent or smart decision-making approach and bounded ration-
ality approach part company with the heuristics and biases approach. From the smart
agent approach, deviations from neoclassical norms typically imply that rational decision-
makers do not abide by these norms for good rational reasons that need to be identified
and understood to better engage in robust causal analysis. From the heuristics and biases
approach, deviations from the neoclassical norms imply systemic biases and errors in
decision-making, typically a function of how the brain is hardwired. Humans do not and
typically cannot behave the way they should behave to obtain optimal outcomes. Free will
in decision-making can result in perverse socio-economic outcomes that can sometimes be
corrected by experts nudging individuals to behave in the appropriate fashion as defined
and articulated by the expert (referred to in the literature as the choice architect) (Thaler
and Sunstein 2008).
From the smart decision-making perspective, errors in decision-making can and do

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occur. There can be biases in decision-making, individuals can make decisions that are
not in their own self-interest or they can make decisions in their self-interest but not in
the interest of their group, organization or society, and preferences can be inconsistent
across individuals and within an individual across historical time. All such non-traditional
behaviours can be consistent with the hypothesis that economic agents are smart and,
broadly speaking, rational. Moreover, these smart agents need not generate choices that
are in any sense efficient. This is in stark contrast to the conventional approach wherein
being ‘rational’ implies efficient outcomes. However, rationality need not imply efficiency
or optimality in either consumption or production.
Not conforming to neoclassical behavioural norms need not be symptomatic of irra-
tionality, and free will in choice behaviour in and of itself need not result, therefore, in
perverse socio-economic outcomes. Errors and biases and suboptimal socio-economic
outcomes, for example, can be the product of inadequacies in decision-making capa-
bilities, suboptimal decision-making environments and lack of experience. In this sense
rationality does not mean perfection in actual behaviour or outcomes. Of critical impor-
tance is the determination of the conditions under which decisions and the decision-
making processes can be improved upon; under what circumstances can rational or smart
decision-making result in efficiency or optimality in either consumption or production?
Identifying these circumstances is a critically important research agenda.
Also, non-neoclassical behaviours can generate superior outcomes to those that flow
from traditional neoclassical norms, such as narrowly maximizing behaviour. In other
words, conforming to neoclassical behavioural norms can generate suboptimal outcomes
and might therefore even signal irrationality in behaviour or at least serious biases and
errors in decision-making. Gerd Gigerenzer (2007) and his colleagues have articulated
this perspective in their fast and frugal heuristics narrative. Heuristics (decision-making
short cuts), often considered to be biased and error-prone in the heuristics and biases
narrative, is argued to exemplify superior decision-making processes in the fast and frugal
modelling of decision-making. From this perspective individuals have evolved decision-
making processes that are partially derived from the fact that the brain is a scarce resource,
has a particular processing capability and processes information within a particular
decision-making environment. A prior assumption here is that individuals are broadly
speaking rational. Hence, it is important to investigate whether, and the extent to which,
non-neoclassical behavioural norms (such as fast and frugal heuristics) yield superior
outcomes, and under what circumstances.
At one extreme it could be argued that not only are individuals always rational, but
their decision-making processes and decisions are always optimal as well. This perspec-
tive is derived from Hayek and his notion of ecological rationality (Hayek 1948; Smith
2003; Gigerenzer 2007). But it is critical to determine benchmarks for smart or broadly
rational behaviour and, moreover, contextualized benchmarks for efficiency and optimal-
ity in decision-making outcomes. Smart decision-making is not a necessary and sufficient
condition for efficiency and optimality.
Kahneman (2011) has articulated a categorization of different types of decision-
making, which he refers to as slow and fast thinking. He is basically looking at when par-
ticular thought processes yield better outcomes. Sometimes these might be fast thinking;
very often these would be slow thinking. Some would argue that individuals do not know
which type of thinking best serves their own self-interest and that of their organization

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and, all too often, individuals make the wrong choices as to which thinking decision-
making platform to use. This would be contrary to the fast and frugal approach that
maintains that typically individuals make the right choices with regard to decision-making
platforms. From the smart decision-making perspective, it is a testable hypothesis as to
which thinking platform would be best. This hypothesis needs to be contextualized by the
capabilities and experience of individuals and their decision-making environment. A criti-
cal point here is that the thinking platform the individual should adopt is not determined
a priori by the expert or by theory. It is context dependent.
The smart decision-making approach has differential implications for policy and
approaches for structuring decision-making. The conventional wisdom is, in its extreme,
very ‘hands off’ on policy, both in terms of government and even on suggestions of
what can be done inside the firm and household to improve decision-making processes
and decision-making outcomes. The prior assumption is that ‘free’ markets plus rational
agents would generate optimal results. So, government could intervene to make markets
‘freer’ and perhaps to better secure property rights. If individuals are hardwired to be
error-prone and biased (the heuristics and biases approach) then intervention must be
much more proactive, nudging or more forcefully driving individuals to make what are
deemed optimal or at least better decisions.
With the smart decision-making or smart agent approach, it is assumed, at least as an
analytical starting-point, that individuals are rational. Hence, we need to address issues
of capabilities, decision-making environments, experience and externalities to determine
what is required to facilitate best practice, but also context informed, decision-making
processes. Barring externalities, it becomes critically important to construct decision-
making capabilities and environments to facilitate and nurture informed decisions, based
on the free choice of decision-makers. Therefore, it also becomes important to understand
the circumstances under which individuals lose the capacity (or this capacity is severely
reduced) to make informed choices, such as possibly severe addictions and mental illness,
and perhaps even more importantly the power and even the legal rights to make informed
choices.
These methodological differences between the smart agent–smart decision-making
approach to behavioural economics (related to the concept of bounded rationality), the
heuristics and biases approach to behavioural economics and conventional economics
are illustrated in Figure 1.1. The smart decision-making approach incorporates and is
informed by bounded rationality, process rationality and institutional design. These are
informed by a variety of variables, inclusive of human capital, mental models, preferences,
information, power and learning. Smart decision-making can result in either optimal or
suboptimal outcomes depending on the above economic, sociological and institutional
variables. Both these outcomes can be ‘rational’ from the perspective of the individual,
but they can generate socially inefficient outcomes. We can have what I refer to as rational
inefficiency, but this can be corrected (more often than not) by changing some of the key
variables mentioned above. However, benchmarks for what yields optimal outcomes is
largely unrelated to neoclassical behavioural norms. Rather, it is reality based.
In contrast, the heuristics and biases approach predicts that what is often hardwired
behaviour yields deviations from conventional norms for optimal behaviour, that is, from
neoclassical rationality. The latter is retained as the gold standard for achieving optimal-
ity for the individual, the household, the firm and society. Deviations from the neoclas-

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Suboptimality
Optimality
Persistent errors
Neoclassical rationality
Smart Deviations from
decision-making neoclassical
Conventional methodology
rationality
Process Heuristics and

Bounded Institutional
rationality biases
rationality design
Hardwired
Human Mental
Preferences
capital models
Nudging
Learning Not
Information Power predicted
multi-shot
games Information
Figure 1.1 Decision-making models
sical rationality yield persistent errors in decision-making, hence suboptimal outcomes.

This can be corrected by nudging (which can involve varying degrees of paternalism)
and, sometimes, by correcting for failures in institutional design. The latter includes
improvements to information. Also, the latter as well as institutional design are critically
important to the smart decision-maker approach to behavioural economics. Neoclassical
models predict neoclassical rationality and optimal outcomes. They do not predict per-
sistent deviations from neoclassical rationality which have been well documented in the
literature.
This book covers a wide range of themes from micro to macro, sub-disciplines within
economics, economic psychology, heuristics, fast and slow thinking, experimental eco-
nomics, the capabilities approach, institutional and sociological dimensions, methodol-
ogy, nudging, ethics and morals, and public policy. The book is divided into a number
of parts: ‘Smart decision-makers, different types of rationality and outcomes’; ‘Aspects
of smart decision-making’; ‘Development and governance’; ‘Tax behaviour’; ‘Smart
macroeconomics and finance’; ‘Dimensions of health’; ‘Sociological dimensions of smart
decision-making’; and ‘Morals and ethics’. The authors critically explore the modelling,
methodological and policy implications of a smart decision-making or smart agent
approach to behavioural economics.
This alternative approach to behavioural economics, rooted in the tradition established
through the research of Herbert Simon and his colleagues, holds much promise, incorpo-
rating learning from the bounded rationality approach, the heuristics and biases approach
as well as important insights from other disciplines, such as psychological, institutional
and sociological analyses and neuroscience.

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REFERENCES
Altman, M. (1999), ‘The methodology of economics and the survivor principle revisited and revised: some
welfare and public policy implications of modeling the economic agent’, Review of Social Economics, 57 (4),
427–49.
Altman, M. (2005), ‘Behavioral economics, power, rational inefficiencies, fuzzy sets, and public policy’, Journal
of Economic Issues, 39 (3), 683–706.
Altman, M. (2015), ‘Introduction’, in M. Altman (ed.), Real-World Decision Making: An Encyclopedia of
Behavioral Economics, Santa Barbara, CA: Greenwood, ABC-CLIO.
Altman, M. (2017), ‘A bounded rationality assessment of the new behavioral economics’, in R. Frantz, S.-H.
Chen, K. Dopfer, F. Heukelom and S. Mousavi (eds), Routledge Handbook of Behavioral Economics, New
York: Routledge, pp. 179–94.
Becker, G.S. (1996), Accounting for Tastes, Cambridge, MA: Harvard University Press.
Friedman, M. (1953), ‘The methodology of positive economics’, in M. Friedman (ed.), Essays in Positive
Economics, Chicago, IL: University of Chicago Press, pp. 3–43.
Gigerenzer, G. (2007), Gut Feelings: The Intelligence of the Unconscious, New York: Viking.
Hayek, F.A. (1948), Individualism and the Economic Order, Chicago, IL: University of Chicago Press.
Kahneman, D. (2003), ‘Maps of bounded rationality: psychology for behavioral economics’, American
Economic Review, 93 (5), 1449–75.
Kahneman, D. (2011), Thinking, Fast and Slow, New York: Farrar, Straus and Giroux.
March, J.G. (1978), ‘Bounded rationality, ambiguity, and the engineering of choice’, Bell Journal of Economics,
9 (2), 587–608.
North, D.C. (1971), ‘Institutional change and economic growth’, Journal of Economic History, 31 (1), 118–25.
Simon, H.A. (1986), ‘Rationality in psychology and economics’, Journal of Business, 59 (4), S209–24.
Smith, V.L. (2003), ‘Constructivist and ecological rationality in economics’, American Economic Review, 93 (3),
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Thaler, R.H. and C. Sunstein (2008), Nudge: Improving Decisions about Health, Wealth, and Happiness, New
Haven, CT and London: Yale University Press.

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PART I
SMART DECISION-MAKERS,
DIFFERENT TYPES OF
RATIONALITY AND
OUTCOMES

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M4225-ALTMAN_9781782549574_t.indd 10 03/05/2017 08:20

2 Rational inefficiency: smart thinking, bounded
rationality and the scientific basis for economic
failure and success
Morris Altman
INTRODUCTION
The core argument of this chapter is that individuals (economic agents) can behave
inefficiently in a number of domains, at both the micro or macro (social) level. But this
behaviour can be considered to be rational in the sense that such inefficiency can be a
product of smart or considered choice behaviour. Smart people can be efficient or inef-
ficient. From a smart-rationality assumption, we cannot necessarily derive choices that
will have efficient outcomes. Moreover, what might appear to be irrational and, therefore,
inefficient behaviour from the perspective of conventional economics might very well be,
and often is, rational, smart, intelligent, considered and even purposeful behaviour from
a smart agent perspective.
Rational or, more generally speaking, smart behaviour should also not be confused with
socially rational behaviour. What is rational from the individual’s perspective might very
well be irrational from the social perspective as preferences across individuals and social
groups might, and typically do, differ dramatically. Maximizing the preferences of a chief
executive officer (CEO) need not be consistent with the long-term viability of the firm.
Maximizing the well-being of the male partner in a relationship can be inconsistent with
maximizing the well-being of the female partner. In addition, it is important to differenti-
ate rational individual choice behaviour from behaviour that is error-free or decisions that
are not subject to regret. Making mistakes and regretting these errors in decision-making
can be consistent with rational or smart behaviour. Much depends on the decision-
making capabilities of the individuals and the relevant decision-making environment.
This chapter presents a modelling narrative on rational choice behaviour from a bounded
rationality perspective. This builds on the pioneering work of Herbert Simon (1959, 1978,
1986, 1987) integrating the concepts of bounded and procedural rationality, and overlaps
and is informed by the research and research orientations of Gerd Gigerenzer (2007),
Friedrich Hayek (1944, 1945, 1948), Harvey Leibenstein (1957, 1966, 1979) and Vernon
Smith (2003, 2005), as well as my own research on the subject (Altman 1999, 2005, 2006a,
2010, 2011, 2012, 2015, 2017). It is also informed by the research of Daniel Kahneman
(2003, 2011; Kahneman and Tversky 1979; see also Tversky and Kahneman 1981); the
heuristics and biases perspective. However, the smart decision-making approach gen-
erates results and orientations that contravene the heuristics and biases approach to
decision-making and behavioural economics, which maintains conventional economic
benchmarks for rationality and efficiency.
11
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INTRODUCING RATIONALITY AND RATIONAL

INEFFICIENCY
To proceed in this narrative we have to clarify what is meant by rationality and by effi-
ciency and what benchmarks we have to meet to be deemed rational and efficient. This
remains a gap in the literature critical of conventional economics and, indeed, of the
literature critical of the heuristics and biases approach and of the nudging approach
to behavioural economics. Conventional economics is relatively clear on what is meant
by rationality, what rational behaviours are, and what the expectations are for rational
decision-making and its relationship to choices and outcomes. Conventional economics
not only has reasonably clear benchmarks for rationality (discussed below), it also predicts
rationality in human decision-making and hence in the outcomes emanating from these
decisions. However, we should acknowledge that market failures remain a theoretical pos-
sibility even within the domain of conventional or neoclassical rationality when negative
or positive externalities are present and not internalized by the decision-maker.
Overall, conventional economics hypothesizes that rational inefficiency should not
occur. This is predicated on the assumption that decision-makers are neoclassically
rational (related to conventional economics definitions of rationality, discussed below).
Moreover, given the prior assumption of the neoclassical rationality of decision-makers,
it is assumed or predicted that the choices made by such rational agents will be efficient
(assuming, for simplicity, no externalities exist). Given this overarching assumption of
neoclassical rationality, we can predict that an individual’s choices yield optimal or ‘best’
outcomes given the constraints faced by the individual. By the prior assumption of
rationality and de facto optimality on the part of individual decision-makers, we end up
predicting that outcomes must be efficient and optimal. That which exists is presumed to
be efficient by assumption as opposed to determining the extent of efficiency by empiri-
cal analyses. In this modelling scenario, it becomes possible to presume efficiency and
optimality even when they actually do not exist. This can detract scholars from actively
pursuing an analysis of the actual state of affairs, be it efficient or not, and its specific
determinants. Note that in this approach, rationality is defined such that rational choice
behaviour yields efficient outcomes. A core argument in this chapter is that smart deci-
sion-making is rational, but not necessarily neoclassically so. Rational behaviour can be
inconsistent with ‘neoclassical’ behaviour and need not yield efficient outcomes.
The conventional methodological approach fits nicely with what is referred to as the
Humean fallacy, articulated in the A Treatise of Human Nature (Hume 1738 [2014],
p. 576). Hume raises the problem of individuals deducing from what is, what ought to be
(efficiency) and then attributing particular causes to the assumed efficiency, in this case
a particular type of rationality. Since these deductions are not empirically based, they
represent fallacies according to Hume. In fact, assuming that outcomes are necessarily
efficient when choices are neoclassically rational is merely a testable hypothesis.
This Humean fallacy is rooted in the dominant methodology in economics best articu-
lated by Milton Friedman (1953, pp. 21–3) in his classic work on the praxis of positive
economics. He argues that economically efficient outcomes are invariably the product of
neoclassically rational behaviour. Hence only particular types of choices yield efficient
outcomes. The derivative of this is that we do not have to investigate how actual humans
behave or the process by which choices are made. It is good enough to assume that indi-

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Rational inefficiency 13
viduals behave as if they are neoclassically rational. Why? Because only efficient agents
can survive on the market. If they survive they must be efficient. This efficiency can only
be a product of neoclassically rational behaviour inside the firm. ‘Natural selection’, addi-
tionally, forces neoclassical rationality (in this case, what Friedman refers to as maximi-
zation-of-returns consistent behaviour) to dominate the behaviour of firm members and
more specifically the decision-makers inside the firm. Therefore, the evidence in favour of
rationality, joined with efficiency, is revealed by the survival of existing firms. Moreover,
the persistence and dominance of the maximization-of-returns cum rationality assump-
tion in the literature, both scholarly and popular, aided and abetted by no ‘credible’ alter-
native hypothesis explaining firm survival is, according to Friedman, further evidence of
the scientific validity of the maximization-of-returns assumption.
This type of argument is also developed in Alchian (1950) who argues that market
forces create an environment wherein efficient choices are imposed on decision-makers,
at least those with a preference for surviving on the market. There is no need for individu-
als to attempt to explicitly or carefully maximize profit of utility. Firms that survive are
relatively efficient, because they survive. Hence, the behaviour of firm decision-makers
must be consistent with such outcomes. This line of argument can be situated within the
analytical domain of a Humean fallacy; any behaviour consistent with survival is consid-
ered to be acceptable and appropriate. For Alchian (1950), survival of the firm is evidence
of relative efficiency, but there is no theory of human choice behaviour to benchmark
which type of behaviours can yield, or should yield, relatively efficient outcomes. As with
Friedman, there is little interest in how individuals actually behave. What is of concern is
that any such behaviour yields economically efficient outcomes, at least in the long run.
Alchian argues (1950, p. 213):
Realized positive profits, not maximum profits, are the mark of success and viability. It does not
matter through what process of reasoning or motivation such success was achieved. The fact
of its accomplishment is sufficient. This is the criterion by which the economic system selects
survivors: those who realize positive profits are the survivors; those who suffer losses disappear.
The pertinent requirement – positive profits through relative efficiency – is weaker than ‘maxi-
mized profits,’ with which, unfortunately, it has been confused. Positive profits accrue to those
who are better than their actual competitors, even if the participants are ignorant, intelligent,
skilful, etc.
The conventional world view (and there are variations of this) is that individuals either
behave in a fashion consistent with neoclassical rationality or they behave as if they are
so doing. Ultimately it is expected that the outcomes will be economically efficient or
utility maximizing either because market forces will guarantee this outcome or because
individuals are hardwired to behave in this manner. The latter stronger assumption is
all too often made. Typically, this is done implicitly. The end result is that a dominant
prior assumption in the conventional wisdom is that outcomes will be economically effi-
cient or utility maximizing. Moreover, it is assumed that because individual neoclassical
rationality results in micro-level economic efficiency, this morphs into macro-level or
social economic efficiency. It is then no longer analytically important to determine how
individuals make their choices and which choices are made, or whether or not outcomes
are in some identifiable sense efficient. Even institutional design and policy lose their
importance if neoclassical rationality is predicted to yield economic efficiency in and of

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itself – appropriate institutional design and policy are assumed to evolve naturally in an
accommodating manner.
Mancur Olson elaborates on this point with regards to social or macro-level economic
efficiency derived from assumptions pertaining to micro-level neoclassical rationality and
economic efficiency. Olson (1996, pp. 4–5) writes:
The idea that the economies we observe are socially efficient, at least to an approximation, is
not only espoused by economists who follow their logic as far as it will go, but is also a staple
assumption behind much of the best-known empirical work. In the familiar aggregate produc-
tion function or growth accounting empirical studies, it is assumed that economies are on the
frontiers of their aggregate production functions. . . If the ideas evoked here are largely true, then
the rational parties in the economy and the polity ensure that the economy cannot be that far
from its potential, and the policy advice of economists cannot be especially valuable.
As evidenced above, critical to this neoclassical or conventional rational economic

efficiency perspective is the assumption that the survival of economic entities is proof
of economic efficiency and, correlated to this, economic efficiency is demonstrated by
survival being proof of rationality. This survival principle builds upon the assumption
that only efficient economic entities, which also happen to be rational, can survive in the
market. To the extent that inefficient economic entities can survive in a moment in time
(cross-sectionally) and over time, then survival can no longer serve as proof of efficiency
or neoclassical rationality – critical to the conventional efficiency-rationality narrative.
Survival would imply neither efficiency nor rationality. Moreover, if neoclassical ration-
ality is not necessary to economic efficiency, then economic efficiency is not proof of
economic agents being neoclassically rational.
Another point that is important to note, and which will be elaborated on further below,
is that the rationality–inefficiency–efficiency narrative can be applied to the realm of
consumption or consumer behaviour. Conventional economics assumes that the revealed
preferences of consumers through their choices off and on the market coincide with their
true preferences – their wants and desires. In the realm of consumption this assumption
represents an important aspect of consumption efficiency. Moreover, it is assumed that
the process by which choices are made are consistent with the carefully calculating and
prescient behaviour of consumers assumed in conventional economics. Hence consump-
tion efficiency presumes the identity between revealed preferences and true preferences
and these preferences being actualized within the parameters of neoclassical behavioural
processes.
However, even if we assume neoclassical processes, this is not sufficient to guarantee
that revealed preferences are identical to the true preferences of decision-makers. This
prior assumes that neoclassical processes are indeed the most effective means for achiev-
ing preferred ends. This is typically not the case in the real world of complex, costly and
asymmetric information. The assumption equating revealed and true preferences builds
implicitly upon very strong and unrealistic assumptions about the necessary conditions
required for this equality to hold. Institutional parameters are critical in determining the
extent to which revealed preferences are below optimal preferences. Moreover, unlike the
reference to firm rationality and efficiency, market forces cannot guarantee that indi-
viduals should adhere to neoclassical behavioural decision-making protocols. There is
no so-called survival of the fittest in the domain of consumption, even if we accept the

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assumption that competitive forces can drive such neoclassical outcomes in the domain
of production (Altman 2010).
From the perspective of the heuristics and biases approach (Kahneman and Tversky
1979), there would be such suboptimal consumer behaviour, but this would be a product
of the hardwired cognitive limitations of decision-makers, not the ‘inefficiency’ of insti-
tutional parameters, for example. Also, we expect suboptimal behaviour to be the rule,
not the exception. This is most clearly elaborated and expressed in the Nudge approach
to decision-making, which is well articulated in Thaler and Sunstein (2008).
The more Simon-related behavioural economists situate consumer decision-making
(as they do all types of decision-making) in the ‘environmental’ space, broadly speaking,
within which decision-making takes place. Given this space, outcomes are considered to
be optimal even though the realization of such outcomes does not follow neoclassical
decision-making processes. This is now referred to as ecological rationality. Different
decision-making processes (non-neoclassical processes) are expected to generate these
optimal outcomes in the realm of consumption. So, what might appear to be irrational or
error-prone and biased behaviour from the perspective of both the conventional wisdom
and from heuristics and biases approaches could very well be both rational and optimal
given the decision-making environment. This particular approach championed by Gerd
Gigerenzer (2007), referred to as fast and frugal heuristics and ecological rationality, has
roots in the work of Herbert Simon. Still, it remains an empirical question if, when and
where particular heuristics yield optimal outcomes from the perspective of the individual
or society. However, clearly, the benchmarks for what is consumer efficiency and ration-
ality and what are the expected outcomes of the decision-making process are quite dif-
ferent in the conventional wisdom compared to what would be the case from the various
perspectives in behavioural economics.
Also, of significance to the smart agent approach to decision-making is an understand-
ing of how sociological variables impact on choice behaviour, affecting the constraints and
opportunities that frame the decision-making process and the choices made by economic
agents. What is rational choice behaviour must also be contextualized by sociological vari-
ables such as peers, families, social norms and culture, for example (Becker 1996; Akerlof
and Kranton 2010). Changing the social context of the choice environment impacts on
what choices a smart individual will make.
More generally, the conventional world view as well as most other methodological
perspectives in economics, inclusive of the ‘new’ behavioural economics (heuristics and
biases and related nudging approaches) and heterodox modelling, often also tend to rely,
analytically, on the typical agent, household and firm where these are supposed to be the
equivalent of representative agents. Where it is assumed that all economic agents are neo-
classically rational and economically efficient, it is the typical agent, household and firm
that is assumed to be so. This typical agent more often than not implicitly or explicitly
refers to the average behaviour of economic agents, households and firms. However, the
average cannot represent typical behaviour unless most individual behaviour is identical
to the average. This assumption is unlikely to be true and cannot be assumed to be true
without empirical validation. A critical focus on the typical or average is clearly articulated
by Alchian (1950) – attention is placed on accurately predicting average outcomes and
then imputing economic efficiency from these outcomes.
However, if the objective is to determine the extent of economic efficiency and its

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determinants (very much a function of the choices made by agents given their constraints,
opportunities and capabilities), we have to go beyond the average and analyse the various
empirical slices that comprise the average. There might be slices that comprise the average
or typical that are efficient and others that are not; and there might be different means
by which economic efficiency is achieved, which are smart but not neoclassically rational.
Moreover, within each analytical slice, agents might be facing different opportunities and
constraints and might possess different capabilities. These will affect what we mean by
rational or smart decisions. The latter must be contextualized by the decision-makers’
overarching decision-making environment.
INSTITUTIONS, EFFICIENCY AND RATIONALITY
Institutional frames are vitally important to a discussion of rationality and efficiency at

both the micro and the macro (social) level. Whether or not decision-making is rational,
and the extent to which efficiency is achieved, can only be determined if the decision-
making process and the choices that flow from this process are contextualized by the
institutional environment within which decisions are made. This is typically not done
by conventional economists or even by economists off the mainstream. Not only must
decision-making be institutionally contextualized, the framing must be empirically based.
This entails that the framing must be derived from the actual institutional parameters
within which the decision-making process takes place. We cannot assume that optimal
institutional parameters are in place or will evolve willy-nilly. This is a point addressed
by Simon (1987), articulating the importance of institutional parameters for decision-
making processes and outcomes.
Douglass North, one of the founding ‘fathers’ of what is often referred to as the new
institutional economics, critiques conventional economics for paying no attention to
the role institutions play in affecting choice behaviour and thereby economic outcomes,
especially when decision-making is a dynamic process taking place through historical
time. This is exactly the type of environment within which decision-making is embedded.
Conventional theory is more concerned with stipulating equilibrium conditions given a
particular institutional environment; often conditional upon an assumed institutional
design that yields optimal economic outcomes. North (1994, p. 359) remarks:
Neoclassical theory is simply an inappropriate tool to analyze and prescribe policies that will
induce development. It is concerned with the operation of markets, not with how markets develop.
How can one prescribe policies when one doesn’t understand how economies develop? . . . The
very methods employed by neoclassical economists have dictated the subject matter and militated
against such a development. In the analysis of economic performance through time it contained
two erroneous assumptions: (i) that institutions do not matter and (ii) that time does not matter.
North (1991, p. 97) provides one possible definition of institutions and it would be
this framework that North argues is ignored or assumed to be analytically irrelevant to
cogent economic analysis: ‘Institutions are the humanly devised constraints that struc-
ture political, economic and social interaction. They consist of both informal constraints
(sanctions, taboos, customs, traditions and codes of conduct) and formal rules (constitu-
tions, laws, property rights).’

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The reason why institutions are of analytical importance, argues North, is because they
affect the incentive environment within which decision are made. For example, relative
prices and relative opportunity costs of various types are conditional upon institutional
parameters. North writes (1991, p. 97):
Institutions and the effectiveness of enforcement (together with the technology employed) deter-
mine the cost of transacting. Effective institutions raise the benefits of cooperative solutions
or the costs of defection, to use game theoretic terms. In transaction cost terms, institutions
reduce transaction and production costs per exchange so that the potential gains from trade
are realizeable [sic]. Both political and economic institutions are essential parts of an effective
institutional matrix.
North continues that optimality in outcomes is not inevitable even if one assumes neo-
classically rational agents. The types of institutions that are constructed, monitored and
enforced determine outcomes. North remarks (1991, p. 110):
When economies do evolve, therefore, nothing about that process assures economic growth.
It has commonly been the case that the incentive structure provided by the basic institutional
framework creates opportunities for the consequent organizations to evolve, but the direction
of their development has not been to promote productivity-raising activities. Rather, private
profitability has been enhanced by creating monopolies, by restricting entry and factor mobility,
and by political organizations that established property rights that redistributed rather than
increased income.
In North’s take on institutional economics, institutional design plays a pre-eminent

role in determining the choices taken by decision-makers. Institutions, therefore, play a
critical role in determining whether the outcomes of these institutionally derived choices
are economically efficient. It is important to reiterate that North’s decision-makers can be
neoclassically rational. However, such rationality need not generate economic efficiency
at a micro level or at a social level, but given the institutional parameters imposed by
a particular institutional design, such rationality would be utility maximizing, at least
broadly speaking, from the perspective of the decision maker. North makes the case for
utility maximizing rational inefficiency, contingent on whether or not institutional design
incentivizes such inefficiency.
Another pre-eminent economist, often associated with the conventional world view,
also makes the case for rational inefficiency, contingent upon institutional design. Mancur
Olson argues that the evidence is overwhelming that there are trillions of dollars lying on
the sidewalk – something that should not occur in a world of rational wealth cum utility
maximizing agents (1996, 19):
The evidence from the national borders that delineate different institutions and economic poli-
cies not only contradicts the view that societies produce as much as their resource endowments
permit, but also directly suggests that a country’s institutions and economic policies are decisive
for its economic performance.
A key point made by Olsen is that even given the assumption of individual-based neo-
classical rationality, societies can be socially inefficient and socially ‘irrational’, and they
are socially irrational because they are socially inefficient. Institutional design determines
the extent to which neoclassically rational agents generate socially inefficient economic

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outcomes. He guestimates that such rationally inefficient outcomes are more the rule than
the exception. Olson writes (1996, p. 23): ‘Some important trends in economic thinking,
useful as they are, should not blind us to a sad and all-too-general reality: as the literature
on collective action demonstrates . . . individual rationality is very far indeed from being
sufficient for social rationality.’
At a very basic level the new institutional economics is incompatible with the core
modelling assumptions of conventional economics. It makes the point that economic
inefficiency can be rational and that economic efficiency requires particular institutional
parameters to be in place. We can have billions, if not trillions, of dollars lying on the
sidewalk even in the long term without rational or smart people picking these up. The
incentive environment need not be appropriate for socially optimal behaviour to take place
among utility maximizing individuals. Private utility maximization, which can take the
form of rent-seeking behaviour, for example, can be consistent with social inefficiency. An
economic agent, a decision-maker, might be maximizing utility, operating along her or
his utility function, while the economy is operating in the interior of the economy’s pro-
duction possibility frontier. Given a person’s utility function and given the institutional
environment, it makes sense for the individual to maximize utility and profits through
redistributing wealth as opposed to wealth creation.
Taking this argument further, derivative of the ‘old’ institutional economics, I argue
that such suboptimal (inefficient) outcomes could easily and predictably take place even
with more appropriate (lower) transaction costs and more secure private property rights
where agents are relatively secure that their legal gains from trade or their assets will not be
arbitrarily confiscated by the state or by private agents. The capabilities of individuals, the
preferences of decision-makers and the power relationship between decision-makers and
potential decision-makers can impact the efficiency of economic outcomes, even given
effective property rights and competitive market structures being in place. For example,
inefficiency producing preferences, which would be a consequence of a preference for
managerial slack (firm inefficiencies) or rent-seeking (social inefficiencies), can dominate
even across different institutional parameters (Altman 2005). This social and power
perspective to institutional economics is also absent not only from the new institutional
economics, but also from the current and various perspective in behavioural economics.
DIFFERENT TYPES OF RATIONALITY
It is important to have an understanding of what conventional economists tend to agree

are the behavioural norms for optimal behaviour; that is, behaviour that yields efficient
economic outcomes. Not everyone would completely agree on what these norms are.
However, there are certain core assumptions that are often made reference to by both
neoclassical and conventional economists, and by behavioural economists. What I outline
below is not a straw ‘man’ that’s easy to attack and shoot down, and there are variations
and modifications to this narrative. However, many would agree that the following is
representative of the assumptions underlying much of conventional economic modelling:
1. Individuals can and do make consistent choices across all possible bundles of goods
and services and through time.

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2. It is assumed that all individuals have a thorough knowledge of all relevant avail-
able options at any given point in time and they all have the means to process and
understand this information in a timely manner – the brain is assumed not to be a
scarce resource and individuals’ computational ability is assumed to be unlimited with
respect to the decision-making process and problem in hand.
3. Individuals can forecast the implications of their decisions through time and hence
calculate, at least in a measurable probabilistic sense, the consequences of their
choices.
4. Individuals are assumed to make choices across alternatives that maximize utility or
well-being, hence choices should not be subject to regret.
5. It is typically assumed either explicitly or implicitly that, controlling for risk, utility
maximization is consistent with wealth or income maximization.
6. It is assumed that individuals are effective and efficient calculating machines, or at
least they behave as if they are, irrespective of age, experience, education or social
context.
7. It is assumed that all individuals independent of context should behave in the same
calculating manner (following conventional behavioural norms) to maximize utility
or efficiency.
Herbert Simon rejects this neoclassical or conventional economics definition of ration-

ality in favour of what he refers to as bounded rationality and, related to this, satisficing.
Simon considers the conventional definition to be completely unrealistic and therefore
useless with respect to constructing models that can speak to causation (as opposed to cor-
relation) and to actual normative requirements to achieve optimal decisions and choices.
Bounded rationality refers to smart or considered choice behaviour in the context of the
choice environment and the decision-making capabilities of the decision maker. Hence,
for Simon there is no unequivocal benchmark for rationality. It is context dependent and
recognizes that decision-making capabilities differ across individuals, firms, households,
ethnicities, cultures, religions, regions and nations. Satisficing is doing the best possible
with what means are realistically available given the reality of bounded rationality. A key
message here is that simply because decision-makers are not behaving neoclassically in
their decision-making processes, this does not imply that they are irrational or inefficient.
Indeed, behaving neoclassically might very well be irrational given the decision-making
environment, yielding suboptimal outcomes (Simon 1978, 1986, 1987).
This point is clearly articulated by James March, a close colleague of Simon. Rationality
cannot be defined and modelled outside the context of the decision-making environment
and the decision-making capabilities of decision makers (March 1978, p. 589):
Engineers of artificial intelligence have modified their perceptions of efficient problem solving
procedures by studying the actual behavior of human problem solvers. Engineers of organiza-
tional decision making have modified their models of rationality on the basis of studies of actual
organizational behavior . . . Modern students of human choice behavior frequently assume, at
least implicitly, that actual human choice behavior in some way or other is likely to make sense.
It can be understood as being the behavior of an intelligent being or group of intelligent beings.
Vernon Smith, a pioneer of experimental economics, makes a related point, basing his
understanding of rational behaviour on what works in effectively generating the preferred

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outcomes of decision-makers. Such non-neoclassical behaviour, which we might refer to

as satisficing, would be the most rational course of action for smart agents and should
form the basis for constructing general norms for best practice behaviour or decision-
making processes. Smith (2005, pp. 149–50; see also Smith 2003) writes:
It is shown that the investor who chooses to maximize expected profit (discounted total with-
drawals) fails in finite time. Moreover, there exist a variety of nonprofit-maximizing behaviors
that have a positive probability of never failing. In fact it is shown that firms that maximize
profits are the least likely to be the market survivors. My point is simple: when experimental
results are contrary to standard concepts of rationality, assume not just that people are irra-
tional, but that you may not have the right model of rational behavior. Listen to what your sub-
jects may be trying to tell you. Think of it this way. If you could choose your ancestors, would
you want them to be survivalists or to be expected wealth maximizers?
We can also refer to Gerd Gigerenzer (2007), who developed the concept of fast and
frugal decision-making. The latter refers to decision-making processes that appear to be
efficient in spite of being inconsistent with neoclassical processes. Fundamentally, the
argument presented here is that decision-making must be contextualized and evaluated
in terms of the decision-making environment and the decision-making capabilities of
the individual (Gigerenzer refers specifically to Simon’s conceptualization of bounded
rationality). Todd and Gigerenzer (2003, pp. 147–8) argue:
‘[B]ounded rationality can be seen as emerging from the joint effect of two interlocking com-
ponents: the internal limitations of the (human) mind, and the structure of the external envi-
ronments in which the mind operates. This fit between the internal cognitive structure and the
external information structure underlies the perspective of bounded rationality as ecological
rationality – making good (enough) decisions by exploiting the structure of the environment . . .
Heuristics that are matched to particular environments allow agents to be ecologically rational,
making adaptive decisions that combine accuracy with speed and frugality. (We call the heuristics
‘fast and frugal’ because they process information in a relatively simple way, and they search for
little information.) The study of ecological rationality thus involves analyzing the structure of
environments, the structure of heuristics, and the match between them.
The foundational behavioural economists, led by Simon, made a point of emphasiz-

ing that they do not dispute that human beings acting in the economic sphere (economic
agents) are rational. They do not dispute this assumption of conventional economics, but
they disagree on how conventional economics defines rationality. On rationality, Simon
writes (1986, p. S210):
I emphasize this point of agreement at the outset-that people have reasons for what they do-
because it appears that economics sometimes feels called on to defend the thesis that human
beings are rational. Psychology has no quarrel at all with this thesis. If there are differences in
viewpoint, they must lie in conceptions of what constitutes rationality, not in the fact of rational-
ity itself. The judgment that certain behavior is ‘rational’ or ‘reasonable’ can be reached only by
viewing the behavior in the context of a set of premises or ‘givens.’ These givens include the situ-
ation in which the behavior takes place, the goals it is aimed at realizing, and the computational
means available for determining how the goals can be attained.
Simon further elaborates on rationality with regard to other social sciences, emphasizing
that the conventional economics definition of rationality is a significant outlier in the
social sciences (Simon 1986, p. S210):

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In its treatment of rationality, neoclassical economics differs from the other social sciences in
three main respects: (a) in its silence about the content of goals and values; (b) in its postulating
global consistency of behavior; and (c) in its postulating ‘one world’ that behavior is objectively
rational in relation to its total environment, including both present and future environment as
the actor moves through time.
In defining rationality relative to decision-making Simon (1986, p. S211) points out that:
The rational person of neoclassical economics always reaches the decision that is objectively, or
substantively, best in terms of the given utility function. The rational person of cognitive psy-
chology goes about making his or her decisions in a way that is procedurally reasonable in the
light of the available knowledge and means of computation.
Simon elaborates on his concept of bounded rationality, making it more specific and
nuanced. This brings him to a discussion of process rationality, which refers to the process
of and the procedures used in arriving at a decision given the decision-making environ-
ment, the capabilities of the decision-maker and the objectives of the decision-maker.
Moreover, process rationality takes into consideration that decision-makers’ understand-
ing of what is best practice or optimal might be misconstrued or flat out wrong, but they
rationally act upon such a misperception. Simon (1986, p. S211) argues that:
if we accept the proposition that knowledge and the computational power of the decision maker
are severely limited, then we must distinguish between the real world and the actor’s perception
of it and reasoning about it . . . we must construct a theory (and test it empirically) of the proc-
esses of decision. Our theory must include not only the reasoning processes but also the processes
that generate the actor’s subjective representation of the decision problem, his or her frame . . .
The rational person of neoclassical economics always reaches the decision that is objectively, or
substantively, best in terms of the given utility function. The rational person of cognitive psy-
chology goes about making his or her decisions in a way that is procedurally reasonable in the
light of the available knowledge and means of computation [it is context dependent].
Bounded rationality, satisficing and process rationality, all fit into a modelling para-
digm that has as its core assumption that decision-makers are fundamentally smart. There
can be exceptions to this rule. However, of critical importance is that we need to begin the
analysis with a premise of smart agents doing the best they can, given their circumstances,
their preferences, their understanding of available choices and their understanding of
the best or optimal means of achieving their objectives. Deviations from neoclassical
behavioural norms should not imply irrationality or inefficiency. More nuanced context-
dependent norms need to be constructed for rational behaviour and what this implies
for economic efficiency. This also implies a better understanding of how social context,
social relationships, social norms and cultural factors, most of which can be reconfigured,
impact on the rational choices that individuals make (Becker 1996; Akerlof and Kranton
2010).
The ‘new’ behavioural economics, emanating from the initial research outcomes and
initiatives of Kahneman and Tversky (1979; Kahneman 2003, 2011; see also Tversky
and Kahneman 1981), sets out to develop theories that are better able to describe human
behaviour, where often such behaviour is related to economic issues. This heuristics and
biases approach rejects the neoclassical prediction that decision-makers will behave in
a manner that will generate predicted ‘optimal’ choices. In this vein, for example, they

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developed prospect theory as an alternative to subjective expected utility theory. Certainly,

Kahneman and Tversky view their scientific project as bearing down on better describ-
ing choice behaviour than conventional economic theory. In the Kahneman and Tversky
approach, such descriptive theories are typically related to the behaviour of the average
individual. The focus on the average has also been a mainstay of conventional economics.
This implicitly assumes that the average is the most appropriate point of reference for
descriptive and analytical purposes.
This ‘new’ behavioural economics also interprets the ‘average’ individual’s deviations
from the conventional economic norms for optimal decision-making to be error-prone
and biased, and typically persistently so. On the one hand, this perspective on behav-
ioural economics maintains and adheres to a fundamental premise of conventional
economics, that there is particular way of behaving in the economic realm resulting
in a particular set of choices and therefore outcomes that are optimal (most, effective,
efficient and unbiased). However, it represents a big break with conventional economics
in that individuals tend not to behave optimally in a large array of choice scenarios. It
is argued that individuals tend to engage in biased and error-prone behaviours; but they
do so because they do not conform to conventional or neoclassical behavioural norms.
Hence, the heuristics and biases approach retains neoclassical normative benchmarks for
efficient and rational behaviour (although little mention is made of the term rational)
(Berg and Gigerenzer 2010; Berg 2014). In the bounded rationality or smart agent
approach to behavioural economics, errors and biases are not hardwired. There are those
individuals with mental disabilities who engage in hardwired-biased behaviour – but
these are clearly the exception to the rule. Overall, there are rational reasons that would
explain most such biased and error-prone behaviour. At least this is the starting point of
the smart agent perspective to economic modelling. What is meant by rational and even
by efficiency (at least in the domain of consumption) would be different from that speci-
fied by conventional wisdom and by the heuristic and biases approach to behavioural
economics (Altman 2017).
Two key points need to be made and developed further. One is that it is important
to specify or to think through (or model) the conditions under which rational decision-
makers generate either persistent local or social inefficiencies. It is important to also
specify the extent to which such rational inefficiencies are a product of preferences of
decision-makers, gaps in their capabilities, and/or biases or problems with institutional
design. This is true for both the production and the household and consumer space.
Modelling the necessary conditions for rational inefficiencies is the mirror image of mod-
elling the necessary conditions for rational efficiencies. The focus of most conventional
and behavioural economists has been on the process of achieving efficiencies often based
on unrealistic assumptions of rationality, often decontextualized from pertinent institu-
tional parameters.
The second key point is the importance of better articulating the benchmarks for
rationality and efficiency. For behavioural economists, following on from the Simon or
bounded rationality perspective, this is a much more nuanced and complex narrative from
what one finds in conventional economics or from the heuristics and biases approach,
which rely largely on conventional benchmarks (Altman 2017).

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PRODUCTION INEFFICIENCY
In production, inefficiency can be defined as not making the best use of resources that
are available for the task at hand. Hence, we would be operating inside the production
possibility frontier. Or, we would be operating along a production isoquant that is further
removed from the origin than it need be. In the latter case we would be using more inputs
than required to generate a given level of output. This is also referred to as x-inefficiency
in production (following the researches of Leibenstein 1966, 1979) as opposed to alloca-
tive inefficiency. The latter is a function of a distortion to relative prices, typically caused
by oligopolistic market structures and presumed government distortions of the price
mechanism. This leads to the misallocation of resources and hence to lower levels of
productivity below that which would be the case when market prices are not distorted.
However, it appears that allocative inefficiency is only of marginal importance as com-
pared to x-inefficiency (Frantz 1997; Leibenstein 1966).
Leibenstein considers x-inefficiency to be a product of irrational behaviour largely
because decision-makers deviate from the norms of rational neoclassical behaviour (see
also Cyert and March 1963). Leibenstein maintains that x-inefficient firms are a product
of decision-makers, such as managers, not maximizing profits or minimizing costs as
they should and would if they behaved in accordance with conventional economic norms.
However, Leibenstein’s definition of rationality, although consistent with the overarching
perspective of the heuristics and biases approach (using neoclassical behavioural bench-
marks), is not at all related to whether decision-makers are making smart decisions given
their constraints and opportunities and their preferences. Rationality is narrowly defined
as it is in the conventional approach and in the heuristics and biases perspective. More
importantly, Leibenstein creates an analytical space for persistent economic inefficiency
by modelling x-inefficiency as a product of the preference function of decision-makers,
where there is a preference for leisure as opposed to maximizing profits and minimizing
costs. Here we have a preference function embodying managerial slack, yielding x-inef-
ficiency in production. Decision-makers are, broadly speaking, maximizing their utility
which, given their preferences, yield x-inefficiency.
An important assumption in the conventional model is that preference functions of
decision-makers are consistent with there being x-efficiency in production – firms using
the fewest inputs possible to produce a given level of output. In reality, preferences of
decision-makers are all too often not consistent with x-efficiency in production. This
conventional benchmark for x-efficiency, minimizing inputs per unit of output, is a rea-
sonable one, unlike the assumption of agents being super-calculators with prescience and
perfect knowledge (in the relevant decision-making domain). I have argued that prefer-
ences inconsistent with x-efficiency (minimizing inputs per unit of output) are consistent
with rational or smart behaviour. Agents can be purposeful, deliberative and even calcu-
lating, whilst still making choices that yield economic inefficiency (Altman 1999, 2005,
2006a, 2015).
Leibenstein introduces the concept of effort discretion into the modelling of economic
agents, something that runs contrary to conventional wisdom’s typical exposé of the
economic agent. Effort should be, at a minimum, constant or even constant at some
maximum according to the conventional wisdom. However, when managers organize the
firm such that effort inputs diminish, then productivity falls and, ceteris paribus, average

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cost increases. The firm is better off if it is x-efficient but, in this case, x-inefficiency in pro-
duction is consistent with the preferences of decision-makers and, hence, with these agents
maximizing their utility. Rational or smart agents attempt to ‘maximize’ their utility even
if this results in suboptimal outcomes for the firm and society at large.
This point can be illustrated in the equation 2.1, representing a simple economy with
labour as the only factor input. Fundamental results do not change as we add other factor
inputs to the production function.
w
Ac 5 (2.1)
a b
Q
L
AC is average cost; w is the wage rate or, more generally, the unit cost of inputs; (Q/L) is
the average product of labour; Q is total output; and L is labour input measured in terms
of hours worked. Reducing productivity by, for example, increasing managerial slack will,
ceteris paribus, increase average cost (AC). Leibenstein assumes that w remains constant
in the face of changes to productivity and average cost.
Another way to visualize this argument is as follows:
De 1 D(Q/L) 1 DAC (2.2)
Going to the basic point, changes in effort input (e) yield changes in labour produc-
tivity (Q/L) which, in turn, yield changes in average costs (AC). In this model, maxi-
mizing effort inputs maximizes average product and, thereby, minimizes average cost.
This would be consistent with x-efficiency in production. Such effort maximization is
possible when the preferences of decision makers are consistent with this particular
objective. I argue that effort maximization is rational or smart only under certain cir-
cumstances. Hence, economic efficiency (maximum x-efficiency), even among rational
agents, should not be assumed as the natural state of things, given that economic inef-
ficiency can be consistent with the preferences of decision-makers. And such prefer-
ences cannot be assumed to be irrational simply because they are not consistent with
effort maximization.
Leibenstein maintains that, given that decision-makers prefer the easy way out (manage-
rial slack), unless product markets are highly competitive, x-inefficiency will persist. Since
most markets are not highly competitive, he argues, x-inefficiency should be expected to
dominate at different rates in different sectors, with a predicted strong positive causal rela-
tionship between more competition and more x-efficiency. However, Leibenstein argues
that the political economy of market economies (which includes lobbying) would preclude
product markets from being competitive enough for economic efficiency to be achieved.
Within the context of imperfect product markets, managerial preferences play a key causal
role in determining the extent of x-inefficiency.
We can take this one step further. Smart agents and their preferences have a critical role
in determining the extent of economic inefficiency because less than maximum levels of
effort need not yield higher average costs, hence potentially threatening such firms’ sur-
vival on the market. The point made in Altman (2005, 2006a, 2010, 2011, 2012, 2015) is
that managerial decisions (the extent of managerial slack, for example) affect the quality

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and quantity of effort inputs among the ‘community’ of economic agents that comprise
the firm as a unit of production. However, changes to effort levels are a costly process,
affecting the levels of compensation to economic agents as well as investments in the
quality of the work environment. Moreover, fixed costs are incurred if the system of
management is transformed to change the level of productivity. This being said, if effort
levels decrease this can be accompanied by lower wages and deteriorating working con-
ditions and we would anticipate higher wages and improvements to working conditions
when effort levels increase. From equation 2.1, we would expect w to be positively related
to changes in productivity (Q/L). We would anticipate cost offset changes in effort levels.
Rational or smart agents, therefore, have significant discretion as to how efficient firms
end up being in long-run equilibrium since even with highly competitive product markets,
inefficient firms can remain competitive and efficient firms need not have a cost advantage
over less efficient firms.
In this scenario, even competitive market forces cannot enforce economic efficiency on
economic agents where this is incompatible with the preferences of the firm’s decision-
makers. Simply introducing more competitive product markets need not generate optimal
economic efficiency. We can end up, as the evidence suggests we do, with firms ranging
from highly inefficient to highly efficient even when the highly efficient outcomes are
feasible and viable given current institutional parameters. We have multiple equilibrium
in outcomes that flow from a multiple equilibrium in preferences (Altman 2016). In
this narrative the preferences of members of the firm, whose preferences dominate the
decision-making process, become of primary importance.
This argument is illustrated in Figure 2.1. In this figure, aLCM represents our cost
curve for the conventional firm if wages increase (effort levels are held constant) and
for the Leibenstein model when effort levels are unrelated to changes in wages. In both
cases the level of x-efficiency is held constant. And, average cost would increase in both
scenarios. For the firm to survive, they would need protection, at a maximum of PLPL*.
Protection and multiple equilibrium P’

P LCM
d Extent of
n
del a PL protection
l mo
e n t iona
onv model BM’ BMT
st: c ity) d c
Average cost
e co enstein variabil
v e r a g
e i b o d u c t (effort
A L e pr
inal Averag
orig
PL* BM
a
Average cost (behavioural model with cost offsets) X-efficiency
Induced
technical
change
0 b g
Wages and different levels of x-efficiency
Figure 2.1 Multiple equilibrium in production

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Leibenstein’s x-inefficient firms can only survive when such firms are protected either
through government policy or through imperfect product markets; but such protection
is often afforded to inefficient firms. Alternatively, x-inefficient firms can survive by
offsetting lower productivity related higher costs, by reducing labour costs. Along aBM,
x-inefficient firms at different levels of x-inefficiency all produce at the same average cost
as the x-efficient firm, given at point b. Cost offsets allow for multiple equilibrium with
respect to x-inefficient and x-efficient firms. Market forces need not eliminate x-inefficient
firms, even in the absence of product market imperfections and government protection,
and even in the long run. The other side of the coin is that higher wages and improved
working conditions need not generate higher average costs if compensated for by higher
effort inputs which, in turn, yield compensating higher levels of labour productivity, here
given by aBM’. In this scenario, higher levels of x-efficiency are consistent with higher
labour costs. Indeed, the latter might be the cause of the former, forcing a reduction in the
level of managerial slack, for example. Such higher labour cost firms can generate further
cost offsets if higher labour costs induce technological change, which is illustrated by a
shift in the average cost curve from aBM to ABMT (Altman 2009).
This modelling narrative is consistent with what is articulated in the traditional pris-
oner dilemma (PD) model wherein particular ‘common knowledge’ assumptions yield
social outcomes that represent a worst case scenario, even given the assumption of
neoclassical rationality. In the realm of production, the worst case social outcome is one
where productivity or output is at some minimum – the PD solution. It occurs when each
participant in the game believes (common knowledge) that the other invests the least
possible amount of time and effort in the process of production; maximizes her or his
gains. This is consistent with narrowly self-interested maximizing behaviour (neoclassi-
cal rationality). In this narrative, we can increase (and maximize) our own individualized
benefits by behaving in very narrowly self-interested fashion, if the other party actually
contributes more than the anticipated minimum to the process of production. This is
the case even though pie size is less than it might be otherwise (x-inefficiency in produc-
tion). On the other hand, if we choose to behave in a manner that increases the size of
the economic pie we risk a reduction in individualized benefits if the other party acts in
a narrowly self-interested fashion.
If the common knowledge is that the other party will act in a narrowly self-interested
fashion, it would be rational to do the same, for only in this way can we minimize any
potential losses to ourselves. Only if we change the common knowledge of the other’s
behaviour will it be rational to behave in a fashion consistent with the common or social
good, increasing the size of the economic pie. With increased pie size, each player of the
economic game could see her or his real income increase – everyone is a potential benefi-
ciary. This would be a cooperative solution to the economic problem, in direct contrast
with the PD solution.
Non-cooperative solutions are possible, as discussed above, when non-cooperative
firms are protected from market forces or when they are able to trade-off low productivity
with low wages and poor working conditions. Both PD and cooperative outcomes are sus-
tainable and rational, given the preferences of decision-makers and the decision-making
environment within which their decisions are made.
It also needs mention that the constraints on decision-making within the firm are set by
members of the firm hierarchy in the traditional investor-owned firm. If joint preferences of

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the firm hierarchy are of the non-cooperative type wherein utility is maximized, the PD solu-
tion is inevitable. If a cooperative solution is what maximizes joint utility, then a cooperative
solution would follow. In cooperative (worker-owned) firms the joint preferences would veer
towards the cooperative solution. Also, power dynamics within the firm can effect which
solution dominates. More bargaining power in the hands of workers can, but does not guar-
antee, a more cooperative solution as members of the firm hierarchy must find the means
to increase productivity to offset the increasing direct costs of production that often follow
when the bargaining power of employees is enhanced. Also, for firms where employees have
a more substantive say on managerial and corporate decisions (a mixed hierarchical model),
a cooperative solution is more likely. The same would be the case if owners and managers
have a joint preference in favour of more cooperative outcomes (Altman 2002).
Further related to the neoclassical assumption of what comprises rational behaviour
within the firm, in behavioural-type models of the firm, simplistic formulations of profit
maximization or cost minimization, especially in their mathematical presentation, tell us
little about what is required for firms to be economically efficient. Being efficient is not
a matter of equating marginal revenue to marginal cost. For example, even within the
framework of a very simple model, assuming that firm decision-makers can actually and
effectively do this calculation in a dynamic fashion, we can equate marginal cost and mar-
ginal revenue without effort being maximized. For any given level of effort input we can
do this calculation. Hence, the firm could be economically inefficient even when marginal
cost equals marginal benefit. The relevant marginal cost and marginal revenue functions
would simply be different from what they would be if effort input was maximized. Also,
in this type of modelling, the decision-makers would be maximizing their utility at differ-
ent levels of effort input.
The utility maximizing level of effort input is given by the preferences of the decision-
makers. Hence, any model that is scientifically robust must incorporate the conditions
under which effort levels inside the firm are higher or lower, since these conditions are
critically important for any determination of why and how rational or smart agents gen-
erate a particular level of effort input and, therefore, a particular level of productivity.
The details of what transpires inside of the ‘black box’ of the firm becomes critically
important because it is in the black box that we can deconstruct the methods adopted by
decision-makers to achieve their chosen ends.
There may also be alternative means to achieve efficiency, all of which might be con-
sistent with the generic and often vacuous normative directive that efficiency is achieved
when economic agents equate or behave as if they equate marginal costs to marginal
benefits. There are those who argue that a heavily monitored and punitive environment
where labour costs are minimized (such as wages and quality of the work environment)
serves to maximize labour productivity. However, there is strong evidence to suggest that
a more collaborative work environment based on teamwork, trust and reciprocity is better
able to achieve economic efficiency. Here there is a more equitable (but not equal) distri-
bution of power and income inside the firm. Both organizational structures and related
processes could be rational from the perspective of the dominant decision makers (and
their preferences), even though neither adheres to the behavioural processes that fit into
the simplistic marginal cost equals marginal benefit narrative of conventional economics
(Altman 2002).
Related to the conventional prediction that rational behaviour should yield economic

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efficiency, there is the commentary of Richard Posner (2009) on the (2007–08) global
economic crisis. Posner was a leading proponent of the efficient market hypothesis and
neoclassical rationality as the best way of modelling the economy and the relationship
between law and the economy. He shifted theoretical ground to overlap with the Simon
or bounded rationality modelling perspective. His perspective also overlaps with the view
that rationality should not be interpreted as neoclassical rationality. Among the critical
points made by Posner is that decision-makers’ rational behaviour in terms of efforts to
maximize income need not take the form of neoclassical processes (they could involve
emotion, intuition and herding). All these rational behaviours, however, can cause long-
run harm to the firm, even while generating significant short- and even long-run benefits
to the individuals engaging in such rational behaviours.
Posner (2009, p. 111) elaborates:
In sum, rational maximization by businessmen and consumers, all pursuing their self-interest
more or less intelligently within a framework of property rights and contract rights, can set the
stage for an economic catastrophe. There is no need to bring cognitive quirks, emotional forces,
or character flaws into the causal analysis. This is important both in simplifying analysis and in
avoiding a search, likely to be futile, for means by which government can alter the mentality or
character of businessmen and consumers.
Posner argues that to prevent an economic meltdown, or at least to reduce the probability
of one, we should not attempt to re-wire decision-makers so that they behave more neo-
classically. Neither should we attempt to re-wire them so that they become less greedy or
less narrowly self-interested – which Posner argues is very difficult to operationalize with
substantive effect on the economy. To prevent or minimize the probability of narrowly
rational income, wealth maximizing or ‘greedy’ individuals (those attempting to maximize
their private income or wealth) causing social harm, which incorporates reducing long-
run firm real income, wealth and/or productivity, governments must change the institu-
tional environment. This goes beyond simplistic references to improvements to property
rights and reducing transaction costs, which is often the focus of the new institutional
economics. Also of importance would be providing decision-makers with improved
information sets, improved information processing and analytical capabilities, and better
understanding of viable organization options (low wage versus high wage, for example),
and internalizing externalities to the firm and individual decision-makers (hence reducing
the probability of moral hazard). Shiller (2008, 2012) argues for the improvements in the
legally enforceable and regulated provision of transparent, accurate and understandable
information to be important to a well functioned and socially efficient market economy.
In summary, rational inefficiency is a very reasonable outcome given the preferences
of dominant decision-makers and the institutional environment within which they are
embedded. By acknowledging the possibility of rational inefficiency and its underlying
determinants, we can suggest means of achieving more efficient outcomes. Moreover, if
we are able to better model the conditions underlying rational inefficiencies, we can better
identify when and where they exist as opposed to assuming ex ante that decision-makers
make choices that yield economically efficient outcomes.
Thus far, I have discussed rationality and efficiency in terms of productive sectors as
opposed to rent-seeking sectors of the economy. However, it is important to note that even
if all agents behave in an economically efficient fashion, this does not preclude this result-

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ing in x-inefficiency in production in the economy as whole. One can have x-efficiency in
sectors of the economy that are of a rent-seeking nature, wherein the firm’s wealth is a
product of transferring resources from one sector to another or from one individual to
another. Here, the non-productive sectors are x-efficient, but the economy as a whole is
operating below its production possibility frontier as a consequence of the efficiency in
the rent seeking sectors. What is important to note also is that criminal behaviour, lob-
bying, corruption and war machines that engage in income transfers to the conquering
population can be run in an economically efficient manner. Institutional parameters
can make such organizational forms more attractive (profitable) to economic agents.
Economic efficiency, even when agents are neoclassically rational at the organizational
level, in no way necessarily translates into social efficiency. At the extreme, we can have
a rent-seeking based society, run by rational agents, that is efficient at the level of the
organization but which is socially inefficient.
Rationality implies neither efficiency nor inefficiency in production. Rationality also
does not imply neoclassical behavioural norms in the realm of production. Smart deci-
sion-makers can deliver firm and socially efficient outcomes in production, contingent
on the preferences of decision-makers, decision-making and organizational capabilities,
and the overall incentive environment; but these conditions all too often do not prevail.
From a smart agent perspective, it is a critically important scientific task to identify those
conditions conducive to economic efficiency at both the firm and social levels. Smart
agents can generate x-efficiency at both the firm and social levels given the appropriate
circumstances.
CONSUMPTION INEFFICIENCIES
Although I have devoted considerable attention to the rationality–efficiency–inefficiency

narrative in the domain of production, contemporary behavioural economics devotes
considerable energies to rationality–efficiency–inefficiency in the realm of consumption-
related behaviour. A fundamental prior in contemporary microeconomic theory is that
the revealed preferences of individuals represent their true and, related to this, utility
maximizing preferences. Moreover it is assumed that these true preferences can be real-
ized through the choices a person makes given her or his income and given relative prices.
I have referred to this as choice x-efficiency (Altman 2010). Conventional economics
assumes that choice x-efficiency is the rule in any given society and at any given point in
historical time.
In brief, true preferences represent those preferences of an individual that are formed
in an environment wherein he or she has access to relatively complete and truthful
information pertaining to pertinent choice decisions, has the capabilities to process and
understand such information, and where this person’s preference formation and choices
are not constrained by coercive circumstances. These assumptions are layered over the
assumption that individuals are rational in their decision-making process. All these
assumptions must hold for choice x-efficiency to prevail. Harsanyi (1982), one of the
pioneers of choice theory, makes similar points with regard to the necessary conditions
for revealed preferences to equal what we might refer to as true preferences (see also,
Altman 2010).

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I have argued that rational or smart choice behaviour requires the prevalence of the
above preference formation and choice environment. However, to be realized, such
rational choice behaviour only requires boundedly rational behaviour as opposed to
the unreasonable and unobtainable prescient and super-calculating behaviour of con-
ventional neoclassical economics. Even smart decision-makers cannot realize choice
x-efficiency unless the appropriate preference formation and choice environment prevails.
Hence, we can end up, under very reasonable circumstances, with rational inefficiencies
(what I refer to as choice x-inefficiencies) in the realm of choice. Even if we can form ‘true’
preferences, rational individuals may not have the power to translate these preferences
into choices or revealed preferences. In this scenario individuals are not free to choose.
For example, a women may want to have one child, but may be forced into having six, or
a parent might want her daughter to learn to read and write but is not empowered to do
so, given social norms and legal parameters.
Building on a bounded rationality platform, we can model conditions wherein
choice x-inefficiencies/x-efficiencies can be obtained. Only under particular institutional/
environmental/social circumstances can choice x-efficiency be realized. Hence we should
be able to identify the circumstances under which choice x-inefficiencies (with smart
decision-makers) exist and how such circumstances need to be changed for revealed pref-
erences to converge to an individual’s true preferences.
It is important to note that true preferences, these utility maximizing preferences, irre-
spective of how ‘rational’ they might be, need not be socially rational. Choices that cause
harm to others can be rational and reveal the true preferences of the individual decision-
maker. This socially suboptimal behaviour represents a form of market failure wherein
externalities are not internalized by the individual decision-maker. Such market failures
are not part of the conventional narrative even when we can legitimately assume that
revealed preferences equal true preferences. This is the case even though the ‘forefathers’
of preference theory recognized this very real possibility (Harsanyi 1982). But market
failure of this type can be easily incorporated into a modelling of preference formation
and choice realization, as articulated above.
In my modelling of choice x-inefficiencies and choice x-efficiencies, as in the con-
ventional wisdom, there is the possibility of revealed preferences being identical to true
preferences; but there is also the possibility that this equality need not hold – there is
an analytical space for rational choice inefficiencies, irrespective of whether or not one
models agency from a neoclassical or boundedly rational perspective. Moreover, there is
a possibility that individuals do not have the capabilities and are not in a decision-making
environment for true preferences to be formed. There is also the possibility of market
failure in the domain of choice. This modelling narrative, therefore, does not accept as a
prior working assumption that choice efficiency at an individual and a social level prevails
everywhere and always. Its existence and prevalence is an empirical question, very much
contingent upon the necessary institutional parameters (inclusive of appropriate power
relationships) and individual decision-making capabilities being in place.
Freedom of choice philosophically underpins the conventional wisdom’s normative
preference for the revealed preference-utility maximizing modelling of decision-making.
The individual’s preferences determine choice that, in turn, allows the individual to
maximize her or his utility. Here freedom of choice is valued as core to the ability of
individuals to ‘maximize’ their utility, their level of well-being. Modelling preference for-

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mation and choice from a critical and bounded rationality perspective does not obviate a
normative focus on the critical importance of individual freedom for utility maximization
(accept when the latter causes harm to others). This overlaps with the critical approach
taken by Sen and Nussbaum (Sen 1985; Nussbaum 2011) on this matter applying their
capabilities analytical framework. Here, too, freedom of choice is critically important.
The problem is that this freedom only exists if the institutional and individual decision-
making capabilities are present. Once these conditions are met then, in this modelling
framework, as in the conventional wisdom, we would predict that individuals’ choices
should be ‘maximizing’ their utility or level of satisfaction. However, in the bounded
rationality-choice x-efficiency approach, public policy would be required to assure
that conditions for choice efficiencies and hence for freedom of choice are met. In the
conventional approach it is typically assumed, ex ante, that such conditions are present
everywhere and always.
This normative approach has been challenged by the stream of behavioural economics
linked with the heuristics and biases analytical framework developed by Kahneman and
Tversky. A key point made here is that individuals are hardwired to be error-prone in
decision-making. The capacity to form and execute our true preferences, therefore, will
not preclude persistent errors and biases in decision-making. If anything, such freedom
(even assuming that there are no choice x-inefficiencies – true preferences can be realized)
can predictably cause more harm than good.
This perspective has been most forcefully and poignantly developed and articulated
by Thaler and Sunstein (2008) in their nudge approach to behavioural economics and
public policy. They argue that there are clear objective benchmarks for what it means for
individuals to be better off or maximizing their utility. These benchmarks appear to be
universal, running across individuals, but it is argued that these universal benchmarks for
utility maximizing, ‘best-practice’ behaviour cannot be realized by the typical individual
exercising free choice. This is in part because individuals are not properly hardwired to
do so – hence the persistent biases in choice behaviour, resulting in individuals’ choices
yielding suboptimal outcomes for the individual decision-maker and society at large. An
important assumption in this modelling is that preferences are the same across individuals
– homogeneous preferences. Hence what is good for all individuals is based upon what
is deemed to be good from the perspective of the expert. Individual preferences do not
inform the content of what is ‘good’. The baseline for what is good is largely based on
‘neoclassical’ benchmarks and a depth of knowledge and emotionless understanding
beyond the limit of typical human decision-makers. However, it is assumed that the expert
has the capabilities, knowledge and understanding to identify what is truly utility or
welfare maximizing and the means to achieve this in a most efficient and effective manner.
Thaler and Sunstein (2008, p. 176) maintain:
We intend ‘better off’ to be measured as objectively as possible, and we clearly do not always
equate revealed preference with welfare. That is, we emphasize the possibility that in some cases
individuals make inferior choices, choices that they would change if they had complete informa-
tion, unlimited cognitive abilities, and no lack of willpower.
Critical to this interpretation of what is good for the individual and what is the baseline
for the good is choice architecture and the choice architect. An important feature of
choice architecture is reconfiguring the choice environment in a manner that induces

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or, in more extreme circumstances, forces the individual to make choices that the expert
deems to be in the individual’s best interest. Note that each individual does not have her
or his own specific choice architecture. The latter is generic, as all individuals are assumed
to be homogeneous in preferences. Actual differences in preferences across individuals
are not recognized here (a type of simplifying assumption). The choice architect is the
expert who designs the choice environment nudging the individual to make choices that
will make her or him better off (higher level of utility, satisfaction or well-being) from the
perspective of the choice architect or expert. This would be the case even if the affected
decision-maker did not believe that her or his nudged choices increases her or his level of
utility or satisfaction – making this person better off. The expert – the choice architect –
knows best.
A fundamental policy implication of the heuristics and biases approach is that people
opposing choice architecture do so because they make the assumption that each individual
knows what is in her or his best interest. This assumption is fundamentally flawed from the
heuristics and biases approach. That is, this approach contests a fundamental world view
of conventional neoclassical economics as well as that of the boundedly rational-smart
decision-maker perspective articulated here. In the conventional perspective revealed
preferences always (or almost always) reveal the true preferences of the individual, which
equates with behaviour that maximizes an individual’s level of utility or satisfaction or
well-being. Smart decision-makers would do what is in their best interest if they have the
capabilities to form and then to realize their true preferences. However, from the heuristics
and biases approach, true preferences are expected to be inconsistent with what is in the
best interest of the decision-maker (Thaler and Sunstein 2009, p. 6):
[A]lmost all people, almost all of the time, make choices that are in their best interest or at the
very least are better than the choices that would be made by someone else. We claim that this
assumption is false. In fact, we do not think that anyone believes this on reflection.
It is important to recognize that the nudging perspective contains many elements, some
of which are paternalist, and others which are consistent with creating the conditions for
the formation and realization of true preferences. However, the focus has been on the
paternalist component, inducing or forcing individuals to make choices consistent with
the expert’s preferences. An important component of the nudging approach is framing
options such that individuals make expert-consistent choices. This could involve forcing
organizations to re-frame options available to consumers so that consumers make expert-
consistent choices.
A fundamental argument put forth by Thaler and Sunstein is that choice options are
always framed and that there is always someone who constructs the frame. Little ana-
lytical attention has been paid to framing because conventional economics assumes that
framing does not affect the choices made by decision-makers. The implicit assumption in
the nudging approach is that different frames contain no new information pertinent to a
particular decision. Hence, individuals are easily manipulated by changing the framing of
a choice option even when the revised frame is not substantively different from the prior
frame. A classic example given is that of the framing of pension options. If the default
option is not to invest in a pension, then most employees will not invest. However, if the
default is to invest, most people will invest. The frame, in this case, is the default option.
Simply changing the frame appears to have a huge impact on whether or not individuals

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invest in a pension. The assumption is that individuals are indifferent in terms of utility
between the two different frames and simply make their choices based on the different
frames while their utility remains constant. However, it is further assumed that one of
the frames yields choices that make the individual and society better off (they are both
individually and socially optimal and welfare improving). Hence the positive view of the
interventionist role of the expert, of the choice architect.
This apparently clear-cut example appears to demonstrate the case for soft and, even,
hard paternalism. However, at a minimum, in a world of complex, asymmetric and even
misleading information, and the limited decision-making capabilities of decision-makers
(partially based on learning deficiencies), defaults can represent signals to decision-mak-
ers as to which choice or choices have the highest probability of making them better off.
When the default is not to invest in pensions (especially in a particular pension plan), this
signals that experts deem this not to be the best idea, and the opposite if the default is to
invest. Hence, the decision-maker is relying on the integrity of those setting the default
to inform the decision-maker on which choice might be the best choice. By changing the
default from non-investing to investing, the ‘expert’ must assure that the investor knows
what he or she is getting into, such as various opportunity costs and risks. Re-framing is
not simply changing the frame from one to another wherein no substantive information
is being changed. Re-framing typically involves making substantive changes to the infor-
mation affording to the decision-maker. This is why it is rational for decision-makers to
change their behaviour when frames are changed. When the default is not investing, the
onus is on the decision-maker to determine what is in her or his best interest, as the expert
is not signalling to invest in this instance. Even here, framing becomes important, but
not in the sense emphasized by the heuristics and biases or nudging perspective (Altman
2011, 2012; Gigerenzer 2007).
How choices are framed is important because frames contain information fundamen-
tal to the determination of choice. Hence, for choices to be ‘optimal’ requires that the
frame provides the individual with truthful, comprehensible and accessible information
so that the individual can make the best possible decision given the choice-set available.
This alternative, smart agent approach to framing focuses on providing decision-makers
with an environment wherein they can better form their preferred choices and exercise
these choices. This approach would not apply to situations when an individual’s optimal
choice causes harm to others. Examples of this would be smoking in public spaces, taking
heroin while pregnant, being abusive to your spouse and children, closing factories and
asset stripping to maximize short-term gain for major shareholders, and cheating and
deceiving customers.
The smart agent approach focuses on improving the preference formation and decision-
making environment, while accounting for and incorporating negative and positive exter-
nalities in this endeavour. Although there is some overlap between this and the nudging
approach, the prior working assumption of the smart agent approach is that individuals’
preferences should, for the most part, be respected and that when choices are suboptimal
even for smart decision-makers, they tend to be so for reasons of institutional design, for
environmental reasons or for reasons of capabilities. Hence the focus is on institutional
design, capabilities development and empowerment of decision-makers. This approach
also pays attention to the enforcement of rules and regulations that can contribute
towards an improved decision-making environment. From this perspective errors in

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decision-making can and are often made. However, this is related to environmental and
capabilities issues as opposed to the hardwiring of the human brain.
The expert plays a role in this analytical construct by contributing to improvements in
the decision-making environment as opposed to determining which decisions individuals
should make. This bounded rationality smart agent approach is libertarian in orientation,
but recognizes the importance of various levels of government and expert intervention to
improve the overall decision-making environment and the decision-making capabilities of
decision-makers as well as developing an incentive environment that accounts for negative
and positive externalities.
Martha Nussbaum, the co-developer, along with Amartya Sen, of the capabilities
approach, makes a similar point. She argues (1999, p. 49): ‘Government is not directed
to push citizens into acting in certain valued ways; instead, it is directed to make sure
that all human beings have the necessary resources and conditions for acting in those
ways. By making opportunities available, government enhances, and does not remove,
choice.’ Related to my narrative on choice x-efficiency and smart decision-making, what
Nussbaum is referring to is the creation of optimal preference formation and decision-
making environments, as opposed to experts determining the choices that people should
make.
MACROECONOMIC CHOICES AND RATIONAL BEHAVIOUR
As with microeconomic behaviour, in the macroeconomic domain, conventional econom-

ics makes the case that decision-makers must be neoclassically rational. The evidence
suggests this is not how individuals behave and this has had some major repercussions
in the construction of macroeconomic theory and for finance theory (Akerlof 2002;
Akerlof and Shiller 2009). However, these reconstructions are rejected outright by those
who remain strict adherents to the conventional assumptions of rationality combined
with assumptions related to flexible factor prices and the capacity of micro decisions
having direct and immediate impact in the macroeconomic domain. The latter ‘school
of thought’, in their pre-Keynesian incarnation, has been dubbed the classical school,
whereas their modern equivalents have been referred to as the new classical school of
macroeconomics.
Many of the underlying revisions to classical macroeconomic theory were made
decades ago by Keynes in his articulation of business cycle theory, more specifically,
his theoretical narrative on the making of deep recessions and the mechanism involved
in the economy transitioning from a deep recession or depression to recovery. Keynes’s
narrative is largely based on the assumption of smart agents making decisions in a world
of complex and asymmetric information with asymmetric power relationships across
decision-makers. Keynes introduces the notion of ‘animal spirits’ as important to the
determination of the timing and depth of recessions and upturns. His narrative suggests
that animal spirits as a determinant of decision-making are rational in the sense that
decision-makers are doing their best, given their decision-making environment. Hence,
Keynes recognizes the importance that non-economic variables can play in determining
economic (macroeconomic) outcomes (Keynes 1936).
In the conventional wisdom, such non-economic variables are assumed away. Keynes

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also recognizes the importance of sticky prices as being a possible and possibly important
determinant of recession/depression, given negative demand shocks. However, the rela-
tive importance of sticky prices in determining economic downturns, especially severe
downturns, is subject to heated debate among those writing in the Keynesian tradition,
but there is no denying the empirical significance of sticky prices.
Most recently Akerlof (2002), in theory, and Bewley (1999), empirically, have made
the case that sticky prices in the face of a negative demand shock are rationally deter-
mined. This is based on what is referred to as efficiency wage theory, first modelled by
Harvey Leibenstein (1957). Smart agents make local (within the firm) utility and profit-
maximizing decisions that have negative macroeconomic consequences, such as persistent
unemployment. Firms do not cut real wages for fear that workers will retaliate by cutting
effort inputs, thereby reducing productivity. Here effort is a variable in the production
function. Employers are also concerned that their best workers will quit, given the oppor-
tunity, for what are perceived to be fairer firms, also damaging firm productivity; but
workers maximize their utility by taking such action, which is common knowledge to
employers. Akerlof considers sticky-price related unemployment to be involuntary. The
employed do not want to lose their jobs or keep others unemployed even though their
locally rational decisions have this effect.
It is important to note that classical economists, old and new, pay no attention to this
efficiency wage modelling of unemployment, but they could interpret such behaviour as
a reflection of labour’s preference for leisure, at least on the margin. There would be the
assumption that in the face of negative aggregate demand shocks, employment would be
restored by cutting real wage below where it was prior to a particular negative demand
shock. The assumption is also made that workers can determine their real wages as
opposed to simply their nominal wages.
In terms of the narrative of this chapter, what is critical for causal analysis and policy is
whether or not decisions-makers are rational, and the implications of this for analysis and
policy. The pre-Keynesian and new classical economics perspectives assume that rational
agents would endeavour to clear all markets (prices are flexible) and behave as if prices
are flexible. Hence, if unemployment exists or if it increases, this is related to the rational
decision to keep real wages too high, for example. Here, unemployment or increases in
unemployment are voluntary. There can no substantive demand-side problem, especially
in the longer run. The assumption here is that increases in the unemployment rate are
a product of changing preferences of workers in favour of more leisure or non-labour
market activities or government interventions that make labour markets less flexible and/
or increase the real wage above what would be generated in a ‘pure’ market economy. The
increased real wage is predicted to increase the rate of unemployment. Such institutional
interventions (such as minimum wages and unions) increase the structural rate of unem-
ployment. Here, too, the demand side is not important.
A popular rendition of this perspective was put forward in Friedman’s classic 1968
article, making a case for supply-side determinants of macro outcomes. He focuses on
what he refers to as the natural rate of unemployment, which is determined by the structure
of real wages. Not much attention is paid to severe negative demand shocks. Ultimately,
if workers wanted more employment they should and would cut their real wages. It is
assumed that this would not have a knock-on effect of reducing aggregate demand and
therefore further increasing the rate of unemployment. Moreover, as unemployment

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increases, even dramatically so, it can be attributed to changing preferences of workers

in favour of more leisure time or changing government policy that permanently
increases real wages to higher levels – facilitating workers’ preferences for more leisure
time.
Notice that among the old and new classical economists, and among many Keynesian
economists, there is a prior assumption that decision-makers are rational, but the under-
standing of rationality differs across schools of thought, with significant implications for
policy. Across the board, Keynesians regard spikes in unemployment yielding substantive
increases in the unemployment rate to be involuntary. These increases in unemployment
would be impossible for the market to deal with quickly and efficiently, that is, in the real
world of complex and asymmetric information, limited foresight, inflexible prices and the
consequential reliance (to a lesser or greater extent) on decision-making heuristics, such as
herding. There is no evidence that markets naturally clear swiftly after a severe demand-
side shock. However, the classical economists assume that this reflects the preferences of
decision-makers (there is very little modelling attention paid to different preferences and
different power relationships across agents). This adds weight to the argument that our
definition of rationality, what it means to be a smart decision-maker, and the realism of
our modelling of the decision-making process, is vitally important for causal analysis and,
in the macro domain, for public policy.
A core Keynesian argument is that increasing demand either through monetary or
fiscal policy will restore the economy to full employment in a relatively quick and effi-
cient manner. Hence, the excessive demand-side related unemployment would be elimi-
nated and the economy restored to the prior and lower natural rate of unemployment.
The higher unemployment rate that is realized during a depression or deep recession is
not the natural rate of unemployment – which is the claim of classical economists, old
and new.
A critical assumption made by Keynesian economists is that for involuntary unemploy-
ment to be eliminated, workers must accept lower real wages, as increasing employment
requires the formerly employed less-productive workers (lower marginal product) to
accept lower real wages. It is assumed here that a downward sloping marginal product
of labour curve, over its relevant portion, characterizes the representative firm, which
is a very big short-run assumption indeed. The decreased real wage must coincide with
adequate increases in aggregate demand. Classical economists argue that accepting lower
real wages would not be the rational response of the typical worker. Hence, increasing
aggregate demand can have no real effect on the economy, measured by increased employ-
ment. However, the side-effect of such activist demand-side policy would be increased
prices or increasing the rate of inflation.
Akerlof has attempted to provide a scientific quasi-rational basis for government policy
to restore employment towards its pre-recession levels (Akerlof 2002). He maintains that
workers in some sense suffer from money illusion (quasi-rationality) and will therefore
not pay attention to reductions in real wages that are a function of low rates of inflation.
Basically, the transaction costs of computing the impact of low rates of inflation on real
wages are not worth the benefits. Hence, increasing aggregate demand to increase employ-
ment should be effective as long as we buy into the realism of this transaction-cost based
money illusion argument.
Decades earlier, Keynes rejected any presumption of money illusion on the part of

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workers, although he accepted the assumption that real wages need to be decreased for
pre-recession or depression rates of unemployed to be restored. Workers would accept
cuts to real wages that were generalized across sectors and occupations, as these would
be seen as fair especially when accompanied by increased employment. This could
be achieved through aggregate demand-side induced inflation. Workers, themselves,
could not orchestrate such a cut in real wages. This would have to be effected through
macroeconomic government policy. There is no money illusion here at all. Moreover,
Keynes theorizes that self-imposed cuts to money wages would simply reduce aggre-
gate demand, further dampening animal spirits and, thereby, further increasing
unemployment.
Keynes (1936, pp. 14–15) argues:
[T]hey [workers] do not resist reductions of real wages, which are associated with increases
in aggregate employment and leave relative money-wages unchanged, unless the reduction
proceeds so far as to threaten a reduction of the real wage below the marginal disutility of the
existing volume of employment. Every trade union will put up some resistance to a cut in money-
wages, however, small. But since no trade union would dream of striking on every occasion of a
rise in the cost of living, they do not raise the obstacle to any increase in aggregate employment
which is attributed to them by the classical school.
Simply because nominal wages are sticky in no way implies that real wages are not flex-
ible enough in a world of rational (smart) agents, for employment to be restored to pre-
recession levels through monetary and fiscal policy. Increased longer-term unemployment
need not be a product of workers suddenly shifting their preferences towards more leisure
but, rather, of misconstrued macro policy that equates sticky nominal prices (especially
wages) with sticky real wages.
On a related note, given the empirics and theory underlying x-efficiency theory, even
if real wages increase as aggregate demand increases, if this is accompanied by com-
pensating increases in labour productivity (a rational response by economic agents),
increasing real wages would not impede the employment of more workers as aggregate
demand increases. In this case, increasing real wages will not affect the economic capac-
ity of the firm to hire more workers on the margin. The marginal product of the labour
curve shifts to the right as real wages increase (Altman 2006b). Here, too, by assum-
ing rational individuals, we cannot logically deduce that increasing unemployment is a
function of workers’ preference for more leisure. Rather, a large reduction of aggregate
demand requires a compensating increase in aggregate demand, given that rational or
smart workers pose no fundamental obstacle to restoring employment to its pre-recession
levels. This x-efficiency perspective strengthens the rational worker approach presented
by Keynes in his narrative on workers accepting generalized fair cuts to real wages, given
the expectation that employment will increase as a consequence.
In this instance, rational inefficiency becomes a product of government not pursuing a
policy that restores aggregate demand, in the face of rational decision-making at the firm
level. The latter is a product of the belief by government decision-makers in the capacity
of markets to self-correct and that the ultimate source of the persistence in the increased
level of unemployment following a severe economic downturn is the unwillingness of
workers to reduce their real wages. This belief in the classical model might be rational
given the information set of decision-makers. However, they yield economic inefficiencies

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at the macroeconomic level, keeping unemployment rates unnecessarily high and output
well below what it might otherwise be.
CONCLUSION
A key argument presented in this chapter is that smart individuals (economic agents) can
make decisions that are economically inefficient in the realm of production and consump-
tion, and at both the micro and macro level. Being smart and being rational, from this
boundedly rational perspective, does preclude outcomes being inefficient and suboptimal.
In the conventional wisdom, rational efficiencies are assumed away at the micro level.
Rational agents behaving in accordance with the dictates of neoclassical theory should
produce results that are both economically efficient in production and utility maximiz-
ing, reflecting the true preferences of decision-makers in the firm and the household in
both the realm of production and consumption. However, if individuals were to deviate
from neoclassical behavioural norms we would expect inefficiencies in both production
and consumption, as they would be behaving irrationally at least from the perspective
of conventional wisdom. However, the more empirically based smart agent approach
redefines rationality more broadly in terms of smart decision-making. This builds upon
the contributions of Simon and the bounded rationality/procedural rationality modelling
platform that he developed. Here, a rational baseline for decision-making is predicated on
the capabilities of the individual and the decision-making environment. This introduces a
different set of norms for what is rational and even for what is efficient.
Moreover, in the narrative presented in this chapter, economic inefficiencies can flow
from rational or smart behaviour in both the realm of production and consumption. Such
inefficiencies can be a function of the preferences of decision-makers and the decision-
making capabilities of smart individuals and their decision-making environment. In fact,
even given optimal decision-making capabilities and optimal decision-making environ-
ments, inefficiencies can arise given the preferences of smart decision-makers. Economic
efficiency cannot be achieved simply by constructing appropriate decision-making capa-
bilities and environments. The latter two serve as the necessary but not sufficient condi-
tions for economic efficiency.
Overall, the different approaches to behavioural economics empirically unmask the
fact that individuals typically do not behave as predicted and as is normatively preferred
by conventional economics. However, the heuristics and biases approach to behavioural
economics, which feeds into and overlaps with the nudging approach, regards such devia-
tions from conventional norms as indicators of suboptimal behaviour, typically hard-
wired into the human brain. From this perspective, modelling choice behaviour requires
investigating and documenting deviations from the conventional norms and determining
means of inducing decision-makers to behave in accordance with these norms for optimal
behaviour to be achieved. Hence, the heuristics and biases approach, although critical of
the conventional assumption that individuals behave ‘rationally’, retain the conventional
economic benchmarks for rationality.
Building upon the evidence, the argument presented in this chapter is that although
smart people do not behave in accordance with conventional economic norms, this should
not imply that such behaviour and the choices flowing from it are irrational, suboptimal or

M4225-ALTMAN_9781782549574_t.indd 38 03/05/2017 08:20

inefficient, given individuals’ capabilities and their decision-making environment. Smart

people make boundedly rational decisions. Benchmarks for what is rational, smart and
intelligent need to be based upon what makes sense given the decision-makers capabilities
and their decision-making environment. There are no specific optimal decision-making
norms that apply across time, space and individuals, although there might be general
behavioural normative rules of thumb.
The approach taken in this chapter, and implicit in Simon’s notion of bounded and
procedural rationality, is that individuals can make mistakes and can even be biased, but
this is not part of the human condition – hardwired in the human brain. Environmental
factors and decision-making capabilities, which can be altered, play a determining role.
We can determine the conditions under which optimal decisions can be achieved by indi-
viduals, households and firms. Herein lies a critical role for societal (from community to
state to international) interventions in economy and society; to facilitate the provision of
improved decision-making environments and capabilities. Also, it is important to correct
for externalities, positive and negative, many of which are related to information imper-
fections and coordination failures as well as preferences that, if realized, cause harm to
others.
Some of the differences and similarities of the different approaches to rationality and
their implications for understanding the source and determinants of the relative inef-
ficiencies in production and consumption are illustrated in Figure 2.2. Conventional
economics presumes that narrowly defined rationality best explains human behaviour,
and yields substantive predictions of production and consumption efficiencies across
time and space. Public policy is of limited importance apart from assuring competitive
markets and secure property rights. The heuristics and biases approach, while retaining
conventional normative benchmarks for optimal behaviour and efficient choice outcomes,
documents the persistent deviations from conventional norms. Hence, we have persistent
inefficiencies (errors and biases in decision-making), typically a function of behaviours
hardwired into the human brain. This yields policy prescriptions designed to nudge
individuals towards what experts (choice architects) deem to be in the best interest of the
decision-maker.
The smart agent approach, building upon the bounded rationality contributions to the
decision-making literature, rejects many of the conventional norms for optimal behav-
iour, while agreeing with the heuristics and biases proponents that humans typically do
not behave in accordance with these norms. However, here rationality is defined relative
to the capabilities of the decision-makers, the decision-making environment, preferences
and power relationships, as well as recognizing differences in these variables across agents
and across time and space.
In this smart agent modelling, rational agents can make errors and be biased in their
decisions, and generate inefficiencies in the domain of production and consumption. But
these suboptimal outcomes can be affected by, for example, changes to individual capa-
bilities and the overall decision-making environment. This underlines the significance of
public policy in facilitating choices that yield more efficient outcomes while increasing the
ability of agents to form and realize their true preferences.

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Smart agents Heuristics and Neoclassical
biases rationality
M4225-ALTMAN_9781782549574_t.indd 40
Assumed
Deviations from Neoclassical behavioural
Bounded and procedural neoclassical
neoclassical norms benchmarks
rationality behaviour
Capabilities Production and

Fast and frugal heuristics decision-making environment Hardwired errors and
consumption
biases
40
efficiencies
Policy
Extent of production and Capabilities and environmental
consumption inefficiencies based benchmarks Policy Libertarian:
▪ Minimize government
▪ Nudging and Less libertarian:
reframing ▪ More competitive
Policy ▪ Hard and soft markets
paternalism ▪ Development and
▪ Improve capabilities and decision-making
environments protection of property
▪ Improve markets and property rights rights
▪ Internalize externalities ▪ Internalize externalities

Figure 2.2 Rationality and inefficiency
03/05/2017 08:20
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3 Rational mistakes that make us smart
Nathan Berg
[E]very intelligent system makes good errors; otherwise it would not be intelligent. The reason
is that the outside world is uncertain, and the system has to make intelligent inferences based on
assumed ecological structures. Going beyond the information given by making inferences will
produce systematic errors. Not making these errors would destroy intelligence. (Gerd Gigerenzer
2005, p. 199)
I describe theoretical and empirical examples of errors – both in games against nature and
in strategic settings – that confer individual-level and, in some cases, Pareto-improving
benefits to an entire economy or social system. My goal is to demonstrate the wide range
of mechanisms by which we individually and collectively benefit from behaviors that
many behavioral economists have been too quick to label as mistakes, simply because
those behaviors do not conform to the orthodox rational-choice standard of rationality
based on internal logical consistency. I want to invite you to reconsider the interpretations
that can and should be attached to behavioral patterns that are commonly described by
many behavioral economists as decision-making errors.
I argue that mistakes are vital for strengthening and maintaining valuable relationships
and enabling perceptual, inferential, social and financial success. Making mistakes ex
ante, that is, as part of our planned behavior, is an expected and regular characteristic of
smart behavior. Smart people must (that is, descriptively, as a logical consequence of the
requirements of success) and should (that is, prescriptively) make mistakes.
How could success require mistakes? Are such notions of ‘mistakes’ merely a semantic
parlor trick that disappears once proper definitions of success are introduced? Does the
claim that smart people must make mistakes sound like a bad joke? In fact, the mistake
of telling a ‘bad joke’ (that is, an ill-chosen attempt at humor that unintendedly winds up
annoying or offending someone you care about and want to feel good) illustrates the point
precisely that smart people must err (cf., the examples and arguments in Gigerenzer 2005).
BAD JOKE
Consider what happens if I tell my girlfriend a story that I heard from an entertaining
and rough-talking (read ‘severely politically incorrect’) friend of mine. It turns out that
my girlfriend does not like the joke and finds it deeply offensive. Normally, she would
update her beliefs about any person (for example, me) heard to have spoken those specific
words aloud.
My girlfriend might, in fact, be interpreted here as a Bayesian updater whose subjec-
tive belief that I am a high-quality, worthy person (after conditioning on the historical
sequence of speech acts by me that she has observed). Normally, her conditional assess-
ment of my value would decline sharply, conditional on my telling of the bad joke. The
joke was so bad that, conditional on observing me tell it, her updating function abruptly
43
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downgrades the level of subjective esteem associated with the speaker (given the finite
number of virtuous acts that were previously observed in our shared history).
I am assuming that she also uses a threshold condition to accept men worthy of dating
(that is, satisficing on mate choice while updating beliefs according to Bayes’ law). Her
updated level of esteem for me, conditional on the bad joke, now falls strictly below her
minimum threshold required for mate acceptance. She would normally reject me out of
hand as a partner based on her usual belief-updating system. The bad joke I told would
therefore normally exclude me from her consideration set and lead to a breakup of the
relationship already in progress. What should I expect comes next?
Instead of breaking up, she decides to forgive me. She says, ‘I didn’t like the words I
heard you say, but I forgive you. Please don’t say it again.’
Just like that, something outside the normative performance metrics introduced in the
model so far newly enters the analysis. Like bones that heal stronger than in their previ-
ously unbroken state or an immune system that heals stronger, apparently relationships,
too, can grow deeper, richer, more valuable and stronger – in love, business, science, and
friendships of many kinds – thanks to the event of a mistake followed by forgiveness (or
other means of relationship repair). I consider several modeling strategies with the goal
of representing the mechanism of relationships whose depth or robustness benefits from
mistakes and shared adversity in their shared history.
Among my reasons for raising this example are the subtleties it raises regarding the
methodological conventions of constrained optimization and game-theoretic reasoning
that behavioral economists typically use as the benchmark of perfect rationality in rela-
tion to which deviations are thought to measure irrationality, a-rationality, or various
normative gradations of irrationalities (Berg 2003, 2014a; Berg and Gigerenzer 2006,
2010). Next I will present contrasting representations of this interaction corresponding
to different views of other players’ action sets, whether those action sets include the pos-
sibility of intentionally versus randomly bad jokes (as a result of ‘nature’s move’); and
whether the continuation value of the relationship itself is included explicitly, possibly
strengthened as a result of withstanding a threatening event and then recovering thanks
to forgiveness and repair.
SMALL WORLD WITH NO INTENTIONAL TELLING OF

BAD JOKES AND NO INDIVIDUAL CONTROL OVER
PROBABILITY, P
Figure 3.1 shows a simple, small world with no possibility of intentionally telling a bad
joke. Bad jokes are modeled in Figure 3.1 as a random event detached from any other vari-
able under the joke teller’s control such as effort. Note, too, that there is no explicit model
of risk preferences, cautionary motives, pro-social affections or anti-social motives such
as spite. The only decision variable that the joke teller, referred to throughout as Agent 1,
has to make in Figure 3.1 is whether to tell a joke or not.
The second player whose payoffs are represented in Figure 3.1 is Agent 2, the receiver
of Agent 1’s joke (for example, my girlfriend in the discussion above). Without loss of
generality, both players’ payoffs are normalized to zero at the left-most no-joke node,
so that the payoffs associated with the other two terminal nodes, corresponding to bad-

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Rational mistakes that make us smart 45
1
Joke
No joke
Nature
Prob (bad joke) = p Prob (good joke) = 1 – p
(0, 0) (b1, b2) (g1, g2)
Figure 3.1 Small-world event tree with no possibility of intentionally telling a bad or
offensive joke, with bad jokes occurring as an act of nature with probability p,
0<p<1
and good-joke outcomes, respectively, represent changes in payoffs relative to the (0, 0)
no-joke outcome.
I assume that both players prefer the good-joke outcome, which implies that b1 < g1 and
b2 < g2. Note that if b1 > 0, then there is no downside risk in telling the bad joke (relative
to telling no joke) because the joke teller’s bad-joke payoff is strictly greater than zero. To
make the risk of landing on the bad-joke outcome interesting, the bad-joke payoffs should
generally be interpreted as negative numbers.
The probability that nature draws a bad-joke outcome once Agent 1 has decided to tell
a joke is p, 0 < p < 1. I further assume that the joke teller, Agent 1, is an expected payoff
maximizer, so that his decision to tell a joke is, ex ante, rationalized by the following
(obvious) condition describing precisely when Agent 1’s expected payoff from joke telling
is positive, 0 < pb1 + (1 − p)g1, or, equivalently:
p < g1 / (g1 − b1) (3.1)

(condition rationalizing telling a joke in Figure 3.1).
The above condition for rationalizing the telling of the joke requires that the marginal
gain of the good-joke outcome (g1) relative to the no-joke outcome (as a fraction of
g1 − b1, which measures the marginal gain of a good-joke outcome relative to a bad-joke
outcome) is greater than the probability of failure (p). Notice that this condition becomes
non-binding if the ratio on the right-hand-side is strictly greater than 1, which occurs
whenever b1 > 0.
Assuming from now on that b1 < 0 and b2 < 0, should we then agree with conventional
wisdom in behavioral economics that the bad-joke outcome is always best avoided if pos-
sible? In Figure 3.1, there is nothing in either player’s choice set that enables him or her to
control the probability of the bad-joke outcome. However, if there were, would rationality
then trivially require (that is, by definition) that agents avoid making the mistake of telling
a bad joke? The next model gives Agent 1 clairvoyance to focus on the question of whether
he would ever rationally choose a bad joke he has perfect control to avoid.

M4225-ALTMAN_9781782549574_t.indd 45 03/05/2017 08:20

AGENT 1 HAS CLAIRVOYANCE AND THEREFORE PERFECT

ABILITY TO AVOID TELLING THE BAD JOKE
In Figure 3.2, Agent 1 is clairvoyant. An equivalent assumption is that nature moves first
and in a manner that is visible to both players, which determines the quality of the joke
before Agent 1 decides whether to tell it. Therefore, Agent 1 knows in advance if the joke
will land in Agent 2’s ears as a bad or good joke.
An own-payoff-maximizing Agent 1 will never choose to tell a bad joke in the model
depicted in Figure 3.2. If a bad joke occurs, then, because the joke teller is clairvoyant,
Agent 2 knows that Agent 1 actually intended harm or offence. The bad-joke outcome
in Figure 3.2 can never be accidental. Therefore, the possibility of spite or malevolence is
now an unavoidable consideration for Agent 2 upon observing the bad joke. The unnatu-
ral abstraction of the payoffs from the context of the agents’ relationship shows up starkly
and reflects a razor-edge view of what can be rational in Figures 3.1 and 3.2. The missing
context of relationship remains in the next representation, which returns to the setup in
Figure 3.1 but endows Agent 1 (in Figure 3.3) with the capacity to choose cautionary
effort x in a way that reduces the bad-joke probability p(x).
Nature
1 1
No No
Joke Joke
joke joke
(0, 0) (b1, b2) (0, 0) (g1, g2)
Figure 3.2 Nature moves first (deciding whether Agent 1’s joke will turn out to be good
or bad) or, equivalently, Agent 1 is clairvoyant
1 x1
Joke x2 Agent 1 chooses bad-joke-
No joke avoidance effort x
xi
xn Nature
Prob (bad joke) = p(x) Prob (good joke) = 1 – p(x)
(0, 0) (b1, b2) (g1, g2)
Figure 3.3 Joke teller chooses a continuously-valued cautionary effort variable, x P [0,
∞), such that the bad-joke probability is p(x) 5 e–ax

M4225-ALTMAN_9781782549574_t.indd 46 03/05/2017 08:20

JOKE TELLER CHOOSES CAUTIONARY EFFORT X SUCH

THAT BAD-JOKE PROBABILITY P(X) IS DECREASING IN X
Figure 3.3 is an extension of Figure 3.1 (returning from now on to the original assump-
tion of no clairvoyance) in which the joke teller is endowed with a continuously-valued
cautionary effort variable, x P [0, ∞), that effectively reduces the probability of a bad joke.
Therefore, p(x) is assumed to be a decreasing function of x. For simplicity, the specific
functional form p(x) 5 e-ax is introduced as a specific case drawn from the more general
family of decreasing (that is, controllable) bad-joke risk functions.
Assuming that the unit cost of cautionary effort is measured by parameter k, then
Agent 1’s expected payoff objective (conditional on telling a joke) can be written as
follows:
p(x) 5 p(x)b1 + (1 − p(x))g1 − kx, (3.2)
which Agent 1 seeks to maximize by choosing x such that telling a joke is better than
no joke (that is, p > 0) and that p(x) 5 e-ax. The constrained maximization problem just
described has a global maximum at x* 5 [ln(a) + ln(g1 − b1) − ln(k)]/a (in the dense subset
of the parameter space of b1, g1 and k satisfying the conditions that x* > 0 and p(x*) > 0).
In the models of Figure 3.1 and Figure 3.3, we have not considered Agent 1’s reasoning
about Agent 2’s conditions for continuing the relationship or any inferences she makes
about Agent 1’s intentionality. The interactions so far represented are one-offs unless the
payoff parameters are interpreted as depending on both agents’ valuations of continuing
the relationship in future rounds of interaction. Before proceeding fully toward the funda-
mental issue of modeling the intentionality of the joke teller, I now model Agent 2’s deci-
sion to either break off the relationship (that is, not continue) versus continue. Introducing
Agent 2’s continuation decision turns out to be enough to generate the possibility of the
relationship increasing in value following forgiveness in the bad-joke outcome.
AGENT 2 CHOOSES ‘NO’ OR ‘YES’ TO CONTINUING THE

RELATIONSHIP
Figure 3.4 shows an extension of the basic model in Figure 3.1 (without a cautionary
effort choice x that influences bad-joke probability p), which now includes the possibility
of forgiveness and relationship repair in addition to the possibility that Agent 2 chooses
to end the relationship by choosing ‘no’. New notation introduced in Figure 3.4 includes
each agent’s valuation of the relationship itself, ex payoffs from the joke-telling interac-
tion. The agents’ continuation values whenever Agent 2 chooses ‘yes’ to continue are
denoted r1 and r2, respectively.
Down the event branch in which a bad-joke outcome occurs and Agent 2 decides ‘yes’
to continue nevertheless, then both agents’ valuations of their relationship increase to R1
and R2, respectively. In keeping with the previous three figures where payoffs represent
changes relative to the no-joke state, the continuation value of the relationship does not
show up in this representation along the continuation path but instead as a lost continu-
ation value whenever Agent 2 chooses ‘no’.

M4225-ALTMAN_9781782549574_t.indd 47 03/05/2017 08:20

Value to R1 > r1 and R2 > r2, respectively
No joke Joke
Nature
2
2 2
No Yes No Yes No Yes
(–r1, –r2) (0, 0) (b1 – r1, b2 – r2) (b1 + R1 – r1, b2 + R2 – r2) (g1 – r1, g2 – r2) (g1, g2)
Figure 3.4 Same as Figure 3.1, but Agent 2 now chooses whether to continue the
relationship (‘no’ not continue or ‘yes’ continue), depending on whether her
relationship valuation r2 remains positive, with forgiveness of bad jokes having
the effect of increasing both agents’ relationship
The loss of the relationship value shows up at nodes where Agent 2 chooses not to con-
tinue. At the left-most node, for example, the payoffs are now written as (−r1, −r2) if Agent
2 chooses to not continue and (0, 0) if Agent 2 chooses to continue following the no-joke
outcome. If, for whatever reason, Agent 2 perceives negative continuation value, then it
is rational for her to discontinue because discarding the negative value achieves a positive
payoff relative to continuation (r2 < 0 implies −r2 > 0).
At the two nodes following the good-joke branch, the relationship value is assumed not
to change and therefore does not show up in the payoffs (g1, g2) but is instead deducted
from the payoffs as the lost value of continuing the relationship in the payoffs (g1 − r1,
g2 − r2). Presumably, Agent 2 never has any reason to rationally choose ‘no’ following a
good-joke outcome so long as r2 > 0.
The real innovation and main point of focus in the analysis of payoffs in Figure 3.4 are
those that follow the bad-joke outcome and Agent 2’s decision ‘yes’ continuing with the
relationship nevertheless. In this case, in addition to the bad-joke payoffs (b1, b2), each
agent sees something new about their respective assessments of the value of continuing
the relationship. The changes in their relationship values, R1 − r1 and R2 − r2, respectively,
are added to the bad-joke payoffs. Note here there is a distinct new possibility that the
agents who are most well-off are those who endured the bad joke and recovered from it –
or have simply chosen to continue the relationship, thereby revealing to each other greater
continuation values than would otherwise have been observable to either player without
the failure or mistake. The performance advantage referred to here as ‘most well-off’ could
be interpreted as individuals who enjoy the strongest, most durable relationships founded
on joint awareness that they are mutually valuable to each other – enough so to with-
stand a large range of negative-payoff events and nevertheless retain positive relationship
value. The ideas here draw on the pioneering work by Rapoport and Chammah (1965),
Rapoport (1984) and Axelrod (1984).

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Result 1 In the interaction represented in Figure 3.4, if Ri − ri > bi − gi, then Agent 1
is better off after a bad joke is mistakenly told and Agent 2 chooses ‘yes’ to continue the
relationship than Agent 1 would have been without Agent 1 having made the mistake.
It follows from Result 1 that, if the inequality holds for both agents, then the mistake
causes a Pareto improvement (that is, mistakes can unambiguously increase the size of
the economic pie by revealing otherwise latent information about the strength of social
ties). The possibility that mistakes can strengthen social ties through such a transforma-
tively positive (that is, relationship-strengthening) act of forgiveness modeled along the
bad-joke-‘yes’ path in Figure 3.4 brings with it profound implications. Note, too, that
instead of forgiveness, the transformative event that occurs can be interpreted as informa-
tion revelation – that the mistake simply reveals otherwise latent (that is, unobservable)
information about others’ subjective valuations of their relationships with us. From
this observation, a large set of new mechanisms that map mistakes into aggregate-value
expanding outcomes emerges.
For example, if I fail to deliver on a contractual commitment to a key business partner
in a repeated interaction, and that partner expresses understanding and agrees to continue
even though I see that my mistake imposed large costs on the partner, then I may be willing
to take joint risks with that partner that I would not have otherwise. The reason for the
shift in willingness to undertake value-generating risk may be that the process of dealing
with my past failure and the hardships it caused both of us transformed the relationship
or focused our attention on jointly observing the value of our collaboration. Or it could
have simply revealed otherwise unobservable information about my partner’s willingness
to endure joint losses and remain committed to continuing together, which, in turn, trig-
gers my own willingness to take on new projects where our joint actions expose each other
to new risks.
I want to make the case that the interaction in Figure 3.4 and its scope for generating
welfare-enhancing mistakes can be rather broadly interpreted. Telling a bad joke; failing
to deliver on a contractual obligation; or being very late in delivering a promised book
chapter to an editor whom I respect greatly, whose friendship is dear to me and whose
book project I feel great passion for – these examples are illustrative of smart people’s
rational mistakes. I discuss additional examples below. Before considering more examples,
I want to begin addressing the as yet unexamined question of intentionality and why the
mechanism of welfare-enhancing mistakes generally breaks down if this mechanism is
deliberately exploited.
MODEL IN WHICH AGENT 1 CAN CHOOSE TO

DELIBERATELY TELL A BAD JOKE
If a prototypical Agent 1 looks at the payoffs in Figure 3.4 and perceives that the highest
possible outcome is indeed the path along which a bad joke occurs and Agent 2 forgives,
then could Agent 1 rationally pursue this outcome as his goal? Certainly if Agent 2
knew that Agent 1 were hurting her intentionally in order to coax her into forgiving and
revealing her high latent value for continuing with him, then she would likely modify her
assessed continuation value of the relationship downward. If Agent 1 is not sociopathic,

M4225-ALTMAN_9781782549574_t.indd 49 03/05/2017 08:20

then he likely experiences some guilt (denoted g > 0, representing Agent 1’s psychic cost
of deliberately telling the bad joke or otherwise intentionally hurting Agent 2).
To represent intentionality, I introduce the notation w P{B, G} to code Agent 1’s inten-
tion to tell a bad or good joke. Figure 3.5 depicts, by now, the rather elaborate joke-telling
interaction featuring two distinct bad-joke branches which correspond to intentional
versus accidental bad jokes. The dotted oval represents Agent 2’s uncertainty: when she
observes the bad-joke outcome, she does not know whether Agent 1’s intention was to tell
a bad one or not – intentionally offending and hurting her, or, alternatively, intending to
tell a good joke that led accidentally to causing offense or hurt. Because Agent 2’s valu-
ations of continuing the relationship now depend on, and vary with, intentionality type
w (through the functions r(w) and R(w)) while holding constant the bad-joke outcome,
the model therefore becomes non-consequentialist. That is, agents’ subjective rankings
depend not only on the final outcome but also on the process that led to that outcome.
Figure 3.5 expresses payoffs corresponding to each of the two bad-joke outcomes that
differ only in Agent 1’s intention w. But Agent 2 is not clairvoyant and does not know
Agent 1’s intention (or intentionality type w) with perfect certainty. In the second dotted
oval below the main payoff nodes, Figure 3.5 also provides Agent 2’s expected payoffs (in
her state of uncertainty about w), which depend on Agent 2’s probabilistic belief b that
Agent 1 is a bad-intention type. The function R(w) represents Agent 2’s assessment of the
value of continuing the relationship with Agent 1 following a bad-joke outcome as a func-
tion of Agent 1’s type. The function r(w) represents Agent 2’s assessment of the value of
continuing the relationship with Agent 1 along any other discontinuation or continuation
path that does not involve the bad-joke outcome and forgiveness. Note that when Agent
1 is a bad-intention type, both continuation values are assumed to take on very negative
and nearly equal payoff values: R(B) 5 r(B) << 0 and R(B) − r(B) 5 0 whereas R(G) >
r(G) > 0 and R(G) − r(G) > 0 (when Agent 1 is a good-intention type).
In Agent 2’s state of uncertainty about Agent 1’s type, w, and having observed the
bad-joke outcome, we can compute the difference between Agent 2’s expected payoff
from choosing ‘yes’ (to continue) minus her expected payoff from choosing ‘no’ (to not
continue), which I denote Dyes−no|bad-joke:
Dyes−no|bad-joke 5 (1 − b)R(G) + br(B). (3.3)
Agent 2 (assumed to be an expected payoff maximizer with belief b that measures her
subjective probability that 1’s type is bad) chooses to continue if, and only if, Dyes−no|bad-joke
≥ 0 (assuming continuation whenever ‘no’ and ‘yes’ have equal expected payoffs) and dis-
continue otherwise. That is, Agent 2’s continuation decision in the face of being exposed
to the bad joke and uncertainty about Agent 1’s intentionality type turns on the upwardly
revised relationship value and Agent 1’s intentionality type being good, R(G), weighted
by 2’s belief that 1 is in fact a good type − and then comparing this positive expected
continuation value to the negative expected value if 1 were a bad type, r(B), weighted by
2’s belief that 1 is in fact a bad type.
Under what circumstances will 1 deliberately cause 2 harm under the expectation that 2
will forgive and continue, thereby yielding a greater player-1 payoff than by trying to tell a
good joke: b1 + R1 − r1 − g > p(b1 + R1 − r1) + (1 − p)g1? Recall that 1 effectively chooses
his intentionality type w. Figure 3.5 assumes that, if Agent 1 chooses w 5 B, then the

M4225-ALTMAN_9781782549574_t.indd 50 03/05/2017 08:20

1
Intend to tell good joke
No joke
( = G)
Intend to tell
Nature
M4225-ALTMAN_9781782549574_t.indd 51
bad joke Prob (bad joke) = p Prob (good joke) = 1 – p
2 2 2 2
No Yes No Yes No Yes No Yes
(–r1, –r2) (0, 0) (b1 – r1 – γ, b2 – r(B)) (b1 + R1 – r1 – γ, b2) (b1 – r1, b2 – r(G)) (b1 + R1 – r1, b2 + R(G) – r(G)) (g1 – r1, g2 – r(G)) (g1, g2)
51
Agent 2’s expected payoffs after observing a bad
joke but facing uncertainty about Agent 1’s
intentionality type with belief Prob( = B) =
No Yes
b2 – r(B) – (1 – )r(G) b2 + (1 – )(R(G) – r(G))
Figure 3.5 Agent 1 can deliberately tell a bad joke

03/05/2017 08:20
joke will turn out bad with probability 1. If 1 chooses w 5 G, however, then we are back
in the non-degenerate probabilistic world where p measures the probability of the bad-
joke outcome. A further condition is required if 1 is to believe that 2 will indeed choose
to continue. That is, 1 must believe that Dyes−no|bad-joke ≥ 0. The issue arises as to whether
intentions are ever conclusively observable. The model here reflects an attempt to model
real-world scenarios where distinct sets of intentions are in fact observable. If an agent
deliberately misrepresents his or her intentions in a repeated interaction setting, then the
modeling exercise here rests on the assumption that such misrepresentation is eventually
discoverable (for example, my partner overhearing me tell my friend that I deliberately
told a bad joke or showed up late to test the extent of her forgiveness).
Agent 2’s preferences are non-consequentialist, a fact made explicit through the
dependence of the functions R(w) and r(w) on w. Agent 2’s view of her own payoffs is not
invariant with respect to w holding the bad-joke outcome fixed. Agent 1’s intention – to
deliberately tell the bad joke (w 5 B) or to at least try to tell a good joke (w 5 G) – matters
quite explicitly to Agent 2.
The next section applies a slightly different interpretation to the payoff schemes in the
figures above to illustrate the general nature of the phenomenon described above in the
figures and Result 1, namely, that individually and collectively welfare-improving mistakes
are commonplace and broadly distributed throughout the decision environments people
face. The integrity of the mistakes, as distinguished in Figure 3.5, matters. There are
honest mistakes and fraudulent or deliberate mistakes. Smart agents should, in general,
be adept at detecting fraudulent mistakes, although doing so is not necessarily easy in
practice. The broader issue is that errors can be welfare improving when they elicit new
information or provide opportunities for others to reveal more about the objectives they
are pursuing.
YOU’RE LATE!
One way I can learn how much you value my work, or my contribution to a joint venture,
or our relationship, is by observing your willingness to forgive. I sometimes show up late
(or as it turns out, deliver work or other outputs much later than originally promised,
thereby testing the patience – completely unintentionally – of dear colleagues, people
about whom I care deeply and hold in truly great esteem, for example, by delivering late a
chapter for an edited volume on Rational Decision-Making within the Bounds of Reason).
In response to my lateness, some colleagues may classify me as unreliable and choose not
to engage with me on future projects; others may classify me as (once again) unreliable but
nevertheless choose to continue engaging with me, effectively revealing that they forgive
me for being late, or that they value my contributions highly enough to offset the sub-
stantial costs I unintentionally imposed on them with my lateness, regardless of whether
forgiveness is formally expressed. In game-theoretic terms, the act of my colleague effec-
tively forgiving my lateness sends an important signal about their implicit valuation of
engaging with me relative to the respective costs that my lateness imposed on them (again,
completely unintentionally on my part).
Why do I emphasize my a priori intention to not be late followed by ex post lateness
(that is, unintended lateness)? Consider re-labeling ‘bad joke’ outcomes in Figures 3.1–3.5

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with ‘late’. The interactions represented in Figures 3.4 and 3.5, for example, can then be
reinterpreted as: as long as I am not late, then my payoffs and those of my colleagues cor-
respond to good-joke payoffs, (g1, g2), which represents the normal state of affairs based
on the productivity of our relationship with no change in trust, no disappointments and
no forgiveness. However, as soon as I violate my colleague’s expectation, the colleague’s
decision about continuing can then be interpreted as a signal of forgiveness (or otherwise
revealing additional mutual value in continuing). Then something new happens.
There is an objective loss to both players: bi < gi for i 5 1, 2. My colleague bears the
cost of my lateness equal to g2 − b2. I pay a cost g1 − b1 based on embarrassment, loss
of reputation for punctuality, and perhaps stress over future opportunities now at risk.
However, our aggregate payoffs are now mutually recognized as being greater – for both
of us – if we continue, thanks to the synergistic interaction of both individuals (assuming
the condition in Result 1 holds).
Acknowledging that these costs of lateness can be, and often are, substantial, what then
justifies Result 1 and its possibility of greater payoffs – for both of us – corresponding to
the action profile of (late, forgive) with associated payoffs of (b1 + R1 − r1, b2 + R2(G) −
r2(G)) > (g1, g2)?
The answer must be the existence of an offsetting or compensating deepening of the
value of our working relationship, where a signal has now been transmitted showing the
intention to collaborate cooperatively into the future within a larger-than-expected space
of perturbations in the form of missed expectations of various kinds. Another possibility
is more direct: the incremental increase in well-being that follows from an expression of
(relatively) unconditional acceptance.
What have I learned by being seriously late and then receiving implicit forgiveness? I
may have learned that my colleague enjoys interacting with me or benefits to a sufficient
degree that he or she is willing to incur higher costs than I had perhaps previously real-
ized to keep the working relationship alive. Given the benefit discovered by lateness and
subsequent forgiveness, might I then pursue intentional lateness as a mechanism to force
colleagues to reveal signals about their willingness to forgive transgressions and maintain
working relationships? No. None of this works if lateness (or the bad joke, or any other
setback, mistake, disappointment or missed expectation) is intentional.
Suppose I am considering a sequence of lateness decisions, coded as binary for sim-
plicity, with a new person in my life with whom a potentially valuable relationship might
unfold. I would like to know how this other person regards me or, more crassly, assesses
the potential value of our relationship. In other words, I have positive willingness to pay
for a costly-to-fake signal of affection, esteem or some form of perceived value from
continued engagement. The other person would also like such a signal from me. Could I
test the other person by deliberately being late, or deliberately telling an offensive joke, for
example, to get a live observation of the other person’s willingness to forgive?
Intentional mistakes are no longer mistakes, however, and this strategy is unlikely to
work. Problems include the high risk of being discovered and my guilt or embarrass-
ment (g), not to mention the new risk of being discovered, the possibility of an extremely
negative payoff that the other person would perceive if I were outed as a perpetrator of
intentional lateness, deliberately offensive joke telling or some equivalently dis-pleasurable
breach of the other person’s expectations. In case of rare sociopath types who apparently
feel no remorse (that is, g 5 0), the model should be interpreted as representing a world

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where others engaged in repeated interaction should eventually be able to see the socio-
path’s intention to deceive, leading non-sociopaths to break off the relationship and look
for a normal human being with whom to continue interacting.
GAMES AGAINST (OR IN ACCORDANCE, COOPERATION,

HARMONY WITH) NATURE
Gigerenzer (2005) discusses physicist Feynman’s arguments in favor of violating invari-

ance with respect to logically equivalent re-descriptions of the same problem. Feynman
sought out scientifically useful framing effects by which different intuitions about the laws
governing a set of variables became more readily apparent using different frames or logi-
cally equivalent re-descriptions. He wrote that these logically equivalent re-descriptions
are valuable because ‘psychologically they are different’ (quoted in Gigerenzer 2005,
p. 207). In contrast, behavioral economists largely adopt the opposite normative view:
that framing effects and other patterns of making different inferences or taking different
actions in response to logically identical re-descriptions of the ‘same’ decision problem
constitute evidence of irrationality.
Gigerenzer argues that the mind’s perceptual system similarly makes smart bets; the
intelligence of those bets depends necessarily on making mistakes. For example, in making
three-dimensional inferences based on two-dimensional visual input, the mind bets that
there is only one source of light that is located above, implying that objects with dark
shading below are likely to be ‘sticking out’ toward the observer. From this, Gigerenzer
observes that the perceptual system correctly assumes that the world (that is, its three-
dimensional structure) is fundamentally uncertain (that is, we face the challenge of
missing information about three-dimensional structure in our environments) and there-
fore use associational rules to make reasonable guesses. If instead the mind proceeded as
an agnostic Bayesian and waited for irrefutable evidence before logically deducing the
correct three-dimensional structure, it would be paralyzed. Similarly, if it had access to
a veridical copy of all information required to produce an objectively accurate model of
all relevant detail in its environment, the mind and its perceptual system would be over-
whelmed. The functionality of the simple bivariate-association rule, ‘objects with dark
shading below are sticking out toward me’, depends on its partiality and imperfection
with respect to veridical descriptive accuracy. A hypothetically perfect (that is, veridically
accurate) perceptual mechanism would still be too little, leaving perceptual holes when
facing new or unknown environments (that is, situations where a quick action based on
a snap perceptual bet is required without inputting the vast amount of information that
a perfect perceptual mechanism would require). This perfectly veridical perceptual repre-
sentation of the world would also be overwhelmingly too much, presenting the mind with
paralysingly large volumes of spatial information. There are different representations of
the truth with varying degrees of detail. Representations with more information, even
when the additional information is perfectly valid, may induce strictly inferior judgments
and decisions compared to less complete representations which enable minds to make
quicker and more accurate inferences.
The same goes for memory. Is more better? Not necessarily (for example, Schooler
and Hertwig 2005, show that forgetting is beneficial in inference tasks). Gigerenzer

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(2005) discusses individuals with unusually large recall memory that suffer, as a result of
their special pneumonic endowment, with acute inability on tasks requiring abstraction.
Perhaps having more recall memory means less practice at efficiently coding the gist of
what is taking place, abstracting and forming equivalence classes in memory.
Are larger consideration sets better than smaller ones? Among the successful entrepre-
neurs from whom data were collected in Berg (2014b), very small consideration sets with
only three potential locations for a high-stakes investment decision were the rule rather
than the exception. Larger consideration sets were associated with below-average invest-
ment performance. Less (that is, consideration of fewer feasible choices) was more (that
is, greater than expected financial return).
When choosing where to stand to catch a ball, three observations about how profes-
sional baseball players do it are worth noting in that they deviate from how robots would
be programmed to do it using a veridical causal model based on initial velocity, wind
speed, rotation and so on. Many researchers believe that veridical causal models stand
unquestioningly as the gold standard for rational choice. In that view, deviations from
how an idealized robot would do it are automatically labeled as mistakes. This view forces
the interpretation that the deviations of professional baseball players – who are the best
in the world at what they do – are prima facie evidence of irrationality rather than intel-
ligence and high functionality.
If the mind were essentially solving the physics problem of where to stand to catch
the ball based on initial velocity, wind speed and rotation, then players who can reliably
catch the ball in this way should be able to point to and predict the landing point without
actually running to catch the ball. They cannot (see references in Gigerenzer 2005, and
Berg and Gigerenzer 2010 on as-if behavioral economics). If players’ minds were evolved
to approximate the veridical causal mechanism, then they should also run straight to the
ball’s landing spot and do so as fast as they can to leave time for last-minute adjustments.
Instead, they use a gaze heuristic that requires no causally relevant information at all
and no precisely optimal angle (but, rather, allows for a large and forgiving range of angles
that function just fine) at which to fix their gaze. The gaze heuristic is a process model:
fix the angle of one’s gaze to the ball, start running and maintain the angle. It requires no
causally relevant information. And it works.
BIAS–VARIANCE TRADE-OFF
The bias–variance trade-off well known in statistics, machine learning and, more recently,
psychology, implies that deliberate bias is, in general, a requirement of virtually any well-
performing statistical procedure that fits unknown parameters on a training set and then
measures performance in generalization tasks requiring out-of-sample prediction. This
trade-off forces the conclusion that insisting on zero bias will lead inexorably to maximal
variance which, in any application with a single, finite dataset, violates most notions of
‘well performing’.

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LEXICOGRAPHIC ORDER OF ASYMPTOTIC CONSISTENCY

OVER VARIANCE REDUCTION IN ECONOMETRICS
Classical econometrics is still taught in many if not most economics PhD programs as
if there is a unanimous tacit agreement that the normative criteria of an estimator being
unbiased or consistent (asymptotically converging to the correct value with probability
1) is infinitely more important than variance (not to mention performance in out-of-
sample prediction). Orthodox econometric pedagogy advances a lexicographic order
over biasedness and variance, ranking any estimation technique that is biased (or incon-
sistent) as strictly inferior, no matter what compensating characteristics (for example,
speed, accuracy, low information requirements, lower variance, and so on) it may offer.
Therefore, orthodox economic methodology applies lexicographic preferences over
the methodological variables that economists choose when doing their work, while, in
contrast, assuming that the consumers and firms in their models (with utility and profit
functions satisfying the usual smoothness conditions) are never lexicographic in the way
they reason about high-stakes decisions they face.
This odd juxtaposition of methodological norms seems worth noting. Conditional
mean functions are specified as flexible but always compensatory functions of the vector
of conditioning variables. Utility functions are used that assume preferences cannot be
lexicographic. In contrast, in econometrics, economists work under the assumption that
lexicographic preferences over the characteristics of estimators are reasonable (that is,
unbiasedness and consistency trump any comparisons of variance).
MORE INFORMATION NOT NECESSARILY BETTER EVEN IN

GAMES AGAINST NATURE
How much information should we pay attention to? When is it rational to ignore relevant
information even when facing no cognitive constraints or costs of conditioning informa-
tion? Berg and Hoffrage (2008) provide a formal definition of an economic or psychologi-
cal environment and the matching concept of ecological rationality. They demonstrate
that there are dense sets of environments in which, because payoffs and probabilities
cancel out under the expected payoff operation, a non-redundant predictor or decision
cue X that is veridically correlated with future payoffs may nevertheless drop out of
optimal action rules, giving rise to the phenomenon of rational ignoring environments.
Berg et al. (forthcoming) present data collected from economists that measure both
individual-level belief consistency with respect to Bayes’ rule and belief accuracy with
respect to published point estimates for disease frequencies in the medical literature.
Which economists had the most objectively accurate beliefs about prostate cancer risks?
It was not the economists whose conditional beliefs were perfectly Bayesian. Formal
analysis of the analytic measures of belief consistency and belief accuracy, as well as the
empirical data, show that performing well by one of these two distinct criteria does not
imply good performance on the other. In many settings the multiple normative criteria
that are observable in choice data may be negatively correlated. Perfect time consistency
may arise mostly as a result of consistently impatient behavior (so that time consistency
and the present value of lifetime wealth or laboratory earnings are negatively correlated).

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Perfect conformity with the Savage Axioms may arise primarily as the result of consist-
ently risk-averse choices with far-below average mean earnings. Perfect conformity with
transitivity may result primarily as a very clear orientation toward leisure over money,
implying that transitive types are, on average, less wealthy, less entrepreneurial and lower
earning in laboratory experiments.
When might the ‘mistake’ of failing to maximize expected utility and satisficing instead
lead to social welfare improvements? Berg and Gigerenzer (2007) demonstrate just such
an environment. Their model provides a thought experiment about a benevolent social
planner who wants to achieve the greatest possible individual and aggregate payoffs for
all stakeholders in her society. Now suppose she were able to choose whether the agents
were expected utility maximizers or satisficers. Would the benevolent social planner
follow behavioral economists’ preference for constrained optimization and advocate that
individual members of society strive to be expected utility maximizers as opposed to sat-
isficers? Berg and Gigerenzer (2007) show that the society of satisficers is unambiguously
better off according to the same social welfare function. The satisficers achieve higher
social welfare and require far less paternalistic intervention when compared from the
vantage point of a Benthamite social-welfare metric.
STRATEGIC GAMES AGAINST SELF-INTERESTED

COMPETITORS
Mistakes can make an agent’s behavior less predictable and therefore thwart exploitative
attacks. Like Columbo’s feigned ineptitude and lack of cleverness, agents that adopt
decision styles that allow for and plan on committing errors can induce their adversaries
into less cautious play, less aggressive best-response functions and greater revelation of
information. To clarify: the errors considered in this chapter so far have nothing to do
with strategically portraying anyone as stupid. However, it is worth including feigned irra-
tionality in this list of examples that illustrate the breadth of mechanisms through which
mistakes confer genuine value added. If others are convinced that I am stupid, then I may
have more freedom to discover information or trade in markets without others strategiz-
ing against me. Inflated or wrong beliefs can make me a stronger negotiating partner.
Mistakes lead to discoveries when the environment (for example, the reward- or payoff-
generating process) is changing (Bookstaber and Langsam 1985).
MARKETS AND SOCIAL SYSTEMS THAT BENEFIT FROM

LOGICAL INCONSISTENCY AND OTHER ALLEGED ERRORS
At the species level, suboptimal individual decisions may be rewarded by what is effec-
tively a species-level portfolio diversification effect. There are some individuals failing to
maximize in today’s environment, which may seem like a suboptimal waste. In the event
that the payoff environment is buffeted by shocks so that previously optimal behaviors
can no longer survive, however, then the currently suboptimal individuals may come into
their own.
Suppose the energy yield from grazing on the north side of the lake is 80 but only 20 on

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the south side. What is individually rational is, of course, to graze at the north side. At the
group level, however, when attacks, pests or poisons can appear on one side or the other,
it is adaptive for some individuals to graze on the low-energy-yielding south side. This
individual-level mistake averts group-wide cataclysm had all individuals chosen north and
an unexpected attack takes place on the north.
Market liquidity itself depends on noise or liquidity traders. Behavioral, belief and pref-
erence heterogeneity are primary reasons underlying why trade (that is, exchange itself)
creates economic value. Berg and Lien’s (2005) model of Pareto-improving overconfidence
in the precision of information possessed by insiders (in beliefs among the uninformed)
shows that overconfidence in experts, while sometimes damaging, can generate surprising
liquidity benefits in financial markets. These positive externalities in the form of lowered
transactions costs more than offset the individual costs of having wrong beliefs. The
model features informed experts and uninformed non-experts who may be overconfident
in experts’ expertise (that is, the precision of experts’ information about future payoffs).
If these agents’ (otherwise typical) payoff functions were alternatively interpreted as rep-
resenting evolutionary fitness functions, then a striking conclusion emerges: there is no
sense in which rational expectations (that is, objectively accurate subjective probabilistic
beliefs) are adaptive; overconfident belief profiles support equilibria that Pareto dominate
the rational expectations equilibrium.
Sampling to learn about a changing environment is another benefit of making mis-
takes. That may explain why experimental subjects who switch their responses (perhaps
randomly) to the very same decision tasks at different experimental sessions have been
observed to earn more, on average, than do consistently impatient and consistently risk-
averse individuals. The consistent types’ behavior passes the rationality test according
to the norm of internal logical consistency, which is the sole claimant to rationality in
rational choice orthodoxy. These consistent individuals earn significantly less, however
(Berg et al. 2010b).
Such contrasts, once again, highlight the multiple normative standards that economists
employ, whether tacitly or explicitly (Berg, 2014), in characterizing the rationality of
observed choice data. Randomization may confer other surprising benefits. For example,
in social systems that offer opportunities for random face-to-face encounters, Berg et al.
(2010a) show that agents who use a simple lexicographic heuristic for judging the accept-
ability of potential neighbors based on face recognition are capable of achieving stable
multi-ethnic neighborhoods and preventing Schelling-type location-choice dynamics that
tend toward absolute segregation.
In public goods games, behavioral economists alternate in their interpretation of what
constitutes mistaken behavior. Usually, failing to free ride, as required by the Nash-
equilibrium strategy (under the assumption that all players maximize standard rational
choice own-payoff objective functions), is cast as an alleged mistake and serves as one of
the main outcome variables that behavioral economists focus on. Kameda et al (2011)
report evidence of strikingly intelligent behavior in the nonlinear public goods games they
study. The ‘error’ in this case would be choosing an action that is different than the actions
that everyone else in one’s group chooses even though all group members face exactly the
same payoff functions and resource endowments. (That is, the game is completely sym-
metric, but Nash equilibrium requires an asymmetric profile of actions that theorists view
as being very difficult to achieve). The equilibrium in the symmetric public goods games

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they study requires asymmetric action profiles. Therefore, some means of coordinating
or deciding which group member will volunteer to be the sole contributor and agree to be
free-ridden upon is required. Rather than widespread pathology, their data reveal a wide
range of individual and group intelligence.
Regulation to prevent overuse of a commons is another longstanding question in public
economics. The less-is-more principle underlying individual intelligence in Gigerenzer’s
heuristics reappears, once again, as relevant to regulatory policy across multiple settings.
For example, Berg and Kim (2015) show that permissive regulation that places fewer
restrictions on the use of a commons (for example, road transportation networks, fisher-
ies, or bandwidth for stock-price quotation networks that are exploited by high-frequency
trading algorithms) can, counterintuitively, be more effective at mitigating overuse than
stricter restrictions would have been, given imperfect enforcement of the regulation.
A similar surprise regarding what looks mistaken through one lens of benefit–cost
calculus becoming rational when viewed from another such lens shows up in models of
social dynamics that include positive payoffs for coordinating with like types (as well
as potentially negative externalities possibly resulting from extreme racial and religious
segregation). The Kahneman-inspired normative position of much of behavioral eco-
nomics condemning human judgment and decision making as generally pathological
can be turned on its head once again: rather than widespread pathology as the default
normative assessment of behavior that deviates from simple rational choice models and
their assumed consistency criteria, there is as yet much intelligence that can be observed
in apparently mistaken behavior. Take, for example, the money sacrificed on religious
products for which there is an intrinsically equal-value substitute available at substantially
lower price. Such behavior can, even without intrinsic benefit, provide socially valuable
signaling and coordination functions (for example, Berg and Kim 2014, show that paying
a higher premium for Islamic banking services can provide a signaling service that makes
it worth paying for among highly pious types).
SINGULAR VERSUS PLURAL NORMS USED IN DEFINING

RATIONALITY?
It sounds paradoxical and unbelievable to many behavioral economists, which makes it

worthwhile to reiterate: rational choice orthodoxy underlies much of behavioral econom-
ics, and the two share a methodological commitment to there being a single normative
standard of rationality that does not depend on context or domain but instead is decided
based solely on internal logical consistency (Berg 2003, 2014a; Berg and Gigerenzer
2010). The Kahneman-inspired biases literatures within behavioral economics and the
field of judgment and decision making typically focus on deviations from some standard
of logical consistency. Behavioral economists working in this vein are generally interested
in the observational phenomenon of deviations from such a standard of internal logical
consistency.
Rather than question whether this normative standard used to define bias and devia-
tions, the normative validity of the rational choice benchmark remains largely unques-
tioned among both what appears to be most behavioral economists and proponents of
the rational choice orthodoxy. Their shared singular normative standard defines the

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deviations that comprise the main outcome variables of interest to many behavioral
economists. Such standards of rationality based solely on logical consistency include:
logical invariance as the rationality standard against which framing effects become
interestingly pathological; transitivity as the core component of the rational preference
standard against which studies of intransitive and incomplete preference gain traction;
Bayes’ rule in papers about non-Bayesian beliefs; the logic of set theory in investigations
of the conjunction fallacy; and, even, Nash equilibrium as a benchmark of rationality in
hundreds of studies by behavioral economists that report non-Nash play frequencies as
the main dependent variable without ever comparing dollar payoffs (or comparisons by
other normative metrics) among Nash versus non-Nash subsamples.
In this chapter, I am considering the rationality of mistakes and errors of the kinds
described above. To do so automatically implies that a newly pluralistic set of norma-
tive concepts are required. Ecological rationality is explicitly pluralistic by requiring
good-enough (that is, satisficing levels) of match between a decision procedure and the
environment in which it is used. This standard asks that, in a well-specified set of task
environments, the decision procedure performs to a functional and pragmatic standard
such that, despite and sometimes thanks to making mistakes, the procedure is readily seen
as sensible, purposeful and, yes, rational!
In the ecological rationality framework, a particular decision procedure or heuristic is,
in itself, neither rational nor irrational. Unlike the rational choice and behavioral econom-
ics standard in which a single pair of intransitive choices or violation of logical invari-
ance earns the universal assessment of irrationality, a choice procedure in the ecological
rationality framework has performance characteristics that are alternatively rational and
irrational depending on the external environment in which it is considered.
It is only once the decision procedure is embedded in a particular environment that
Herb Simon’s two blades of the ecological rationality scissors (decision procedure and
external environment that jointly determine reasonable performance metrics for defin-
ing what is good enough to achieve success) can do their work at identifying boundaries
that circumscribe the set of task environments in which a particular decision procedure
achieves ecological rationality. It appears that any normative framework integrating the
possibility of beneficial mistakes, as categorized above, necessarily implies that pluralistic
normative metrics and the adaptive toolkit approach to defining what rationality means
are in play.
WHICH ORGAN IN THE HUMAN BODY IS BEST?
Does it make any sense to ask which organ in the human body is the best or most valu-
able? Using the massively interdependent body as an analogy, the behavioral phenomena
of interest to social scientists will generally require multiple normative metrics akin to
separately measuring and considering kidney function, liver function, cholesterol, trig-
lycerides, blood glucose levels, and so on. Would it make sense to integrate all known
organ-specific performance metrics or results from standard blood panels into a single,
scalar-valued assessment, perhaps using a label such as generalized aggregate physiologi-
cal (GAP) score? We would be hard pressed to think of any application where such aggre-
gated summaries that compress the body’s multiple interdependent systems into a single

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scalar-valued metric would be more informative or pragmatically useful than the disag-
gregated components considered as a fundamentally multivariate normative outcome.
By analogy, when we ask the normative question using experimental choice data or
theoretical models whether an observed set of behavioral patterns could be rationalized
as if it were maximizing some scalar-valued objective function with newly exotic prefer-
ence parameters to more flexibly mop up variation in the data, we are most likely asking
a similarly wrong question. The standard analysis of a scalar-valued normative metric
asks us to rely on the optimal choice function (that is, the program that maps exogenous
parameters into an endogenous inference or action maximizing the narrowly defined
objective). This method leads to the erection of a dug-in methodological phalanx that
severely limits behavioral economics to persisting in egregious repetition of what statisti-
cian John Tukey called a type-III error: providing the right answer to the wrong question.
In a massively interactive and interdependent biological or social system, the right way
to behave depends on context. Rationality norms must be pluralistic and thoughtfully
well-matched to a specific (that is, explicitly delimited) class of decision problems where a
particular (that is, explicitly defined, possibly multivariate) standard of rationality makes
sense (cf. Simon’s, 1976, notion of procedural rationality).
IS ECONOMICS THE ONLY DISCIPLINE WITH A

COMMITMENT TO MONO-METHODOLOGICAL
SINGULARISM?
Yes.
INFLUENCE BY AND PARALLELS WITH THE

AXIOMATIZATION PROGRAM IN MATHEMATICS?
The axiomatization program in economics was in part inspired by the axiomatization

program of mathematicians such as David Hilbert, Whitehead and Russell, and the
Bourbaki group, which overlaps with the consistency school of normative bounded
rationality (Berg 2014b). This axiomatization program profoundly influences (that is,
restricts) economists’ normative analysis (that is, the normative questions that can be
asked) in subtle ways that go mostly unnoticed in methodological treatises on the real-
world applicability of behavioral economics and bounded rationality. Economic studies
of bounded rationality would benefit by noticing the waning trajectory of this axioma-
tization program in mathematics and, like many in mathematics have, choose instead to
pursue applied problems and the informal mathematics described in Backhouse (1998).
I define the axiomatization program in economics as the body of economic theory
that seeks a short list of axioms (perhaps minimal in some sense) that exhaustively char-
acterizes the rationality of: preference orderings; sets of observed choices or demanded
bundles (the extensive literature on revealed preference typically associated with Paul
Samuelson); or orderings on choice sets. This axiomatization program can be narrowed
further to investigations that pursue the question of postulating maximally general
axioms (that is, the weakest possible) that can ‘rationalize’ observed choice behaviour. The

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methodological priority of (topological) generality that characterized much of Hilbert’s

program peaked in the latter half of the twentieth century. Since then, the dominance of
the axiomatic program in mathematics has waned, whereas its methodological force in
economics appears to have remained relatively undiminished.
The history of the axiomatization program in economics reflects numerous borrowings
and inspirations from mathematicians: David Hilbert, Bertrand Russell and the Bourbaki
group all sought to rid mathematics of the possibility of inconsistencies. Bertrand’s
paradox provides a primary motivation for early twentieth-century mathematicians’
program of eliminating inconsistency. That well-known paradox posits a collection of
all sets that do not belong to themselves. The contradiction turns on ambiguity in the
definition of the aforementioned ‘collection’ enjoying the status of set. By restricting the
definition of a set to exclude some otherwise well-defined collections of mathematical
objects, Frege, Whitehead and Bertrand, and Fraenkel introduced a new formalism into
mathematics to resolve such paradoxes, most often beginning with axiomatization.
There are even earlier links in the works of mathematicians such as Georg Cantor in
the late 1800s (and axiomatization programs in set theory which followed) to the later
axiomatization program in economics, based on the goal of providing a minimal list
of conditions to ‘rationalize’ choice data. The ‘characterization’ of rationality and the
‘rationalization’ strand of the axiomatization program in economics can be thought of
as beginning with a set of axioms and a universe of observable patterns of behavior and
then projecting the graph that characterizes all allowable patterns of behavior that satisfy
the axioms, which is a strict subset of the larger universe of possible patterns of behavior.
This can be backward engineered as follows: Given the observed set of choices or behavior
patterns, what axioms must this set of choice data satisfy in order to (1) recover a prefer-
ence ordering that could have generated the choice data, and (2) assuming a preference
ordering exists for ranking vector-valued bundles or payoff distributions in the case of
risky choice, what axioms must the data satisfy for the rankings of multidimensional
objects to be representable as scalar-valued utility or value scores?
Note that this rationalization subset of the axiomatization program in economics
contains, for example, Tversky and Kahneman’s (1992) loss-averse cumulative prospect
theory, specifically, versions of it that attempted to rationalize the choice data generated
in Allais’ paradox (which are interpreted as anomalous with respect to expected utility
theory). Rationalizing anomalous choice data is described by Gerd Gigerenzer, Werner
Güth and Reinhardt Selten as a repair program. The goal is to take choice data (from
binary choices over pairs of risky gambles in the case of prospect theory as a resolution
to Allais’ Paradox) that cannot be represented with an expected utility function, and then
show that those data could have been generated by prospect theory, for some unspecified
but theoretically possible parameters that determine the shape of the value-function and
the nonlinear function mapping objective probabilities into decision weights. Note that
this rationalization project, or repair program, bears some similarity to the fallacy of
ranking regression models according to their R-squared. Finding a list of axioms that
‘can explain’ choice data is analogous to a regression model with more right-hand-side
variables fitting a dataset better. As econometric textbooks correctly caution, a model that
fits the data better may not necessarily make more accurate out-of-sample predictions.
Fit can always be made to reach 100 percent if enough free parameters are added to the
model specification, one for each observation in the fitting or training sample. Arguments

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in favor of prospect theory that use different parameterizations to fit each new sample, for
example, do not typically discipline that model to the risks of out-of-sample prediction.
Instead, they use the flexibility of the additional parameters in prospect theory (compared
with standard expected-utility theory) to increase ‘fit’ in a manner entirely analogous
to increasing R-squared by trivially increasing the number of free parameters used in a
regression model.
Cantor proved – more than century ago – that if a binary relation is linearly ordered,
then it is also embeddable as an isomorphism in the real numbers. Technically, this is
almost identical to the intellectual work of writing down axioms (that is, restrictions on
the preference ordering) that guarantee representability with utility, expected utility or
prospect-theory value-function scores.
Ragnar Frisch is credited as the first economist to define preferences as binary relations.
Contemporary graduate textbooks use very different notation (deleting Frisch’s more
broad-ranging ‘choice field’ formulation, which distinguishes commodity space from
what Frisch referred to as the decision maker’s problem space). Frisch played a leading
role in the founding of the Econometric Society and the journal Econometrica, advocating
formalism and math modeling as a primary source of ‘rigor’ needed to put economics on
a ‘scientific’ footing (Bjerkholt and Dupont 2010). Despite his view that mathematizing
economics was needed to displace the ‘verbal’ approaches of institutionalists, his sophis-
ticated appreciation of the fact that the decisions modeled as constrained utility maximi-
zation (exhaustively searching through a feasible set in commodity space) are embedded
in a larger problem space that includes problems perhaps not best handled by the tech-
niques of constrained optimization is striking. This notion of a larger ‘problem space’
foreshadows the notion of ‘environment’ used by writers such as Gigerenzer and Vernon
Smith in advocating ecological rationality. Frisch’s concept of constrained maximization
in commodity space as only one decision domain embedded in a larger problem space
notably does not appear in most contemporary PhD textbooks, which instead emphasize
the flexibility and universality of preference maximization devoid of context specificity.
As is well known to economic methodologists and historians, early representation
theorems in utility theory sought to address debates in economics between those who
interpreted utility as a potentially measurable psychological metric of hedonic satisfac-
tion and those influenced by logical positivism wanting to remove psychological notions
(Bruni and Sugden 2007). Early representation theorems establishing utility as a purely
ordinal concept devoid of cardinal meaning led to representation theorems in expected
utility theory, axiomatizations of Bayesian updating as rational belief functions, and,
more recently, weaker axiomatizations that can account for (as bounded rational) some
well-known anomalies with respect to rational choice theory. It is this last subliterature of
economists writing on rationality axioms in behavioral economics and making reference
to Herbert Simon’s phrase ‘bounded rationality’ that is relevant to this chapter’s focus on
bounded rationality and smart people’s rational mistakes.
It is instructive to recall that the central motivation of Hilbert and Whitehead and
Russell’s (1927 [2009]) axiomatization program was to formalize mathematics and phi-
losophy with the explicit goal of eliminating inconsistency. Hilbert and Russell undertook
this program and advocated that others join them to rid mathematics – and science – of
the possibility of generating inconsistent statements, whether those statements be abstract
or detailed descriptions of the world.

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While Hilbert’s move toward formalism profoundly influenced mathematics (and at

the same time attracted well-established critics), it eventually waned as new subfields in
mathematics applying methods outside the Hilbert program grew up and gained accept-
ance as making substantial contributions to mathematics. Applied problem solving,
combinatorics, category theory and subfields of mathematics overlapping with computer
science achieved influence and prominence, while other theorists working in the construc-
tivist and intuitionist traditions similarly produced new knowledge that followed distinct
methodological priorities.
The methodological influence of formalism and the axiomatization program in eco-
nomics followed an arguably equal if not more profound influence in economics (see
Backhouse 1998, regarding formalism in economics versus informal mathematics). One
minor parallel between the trajectories of formalism in mathematics and economics was
the desire to shed old interpretations (for example, the interpretation of points, lines and
planes in geometry and the psychological or hedonistic interpretation of utility in nine-
teenth-century economics in favor of utility as a purely ordinal device). Another specula-
tive parallel that can be seen in the restrictions that choice axioms placed on what had
been a previously more libertarian view of consumer sovereignty is to see them echoing
the restrictions that Frege, Whitehead and Russell, Fraenkel and Hilbert applied to the
definition of a set (in order to avoid paradoxes such as Russell’s).
Beyond these similarities, however, the differences in the historical trajectories of axi-
omatization programs in mathematics and that of economics are many. Formalism in
economics (until very recently) did not have a long struggle with concepts such as the defi-
nition of a set as its core methodological problem, syntactical formalism, the incomplete-
ness theorems of Gödel, and many others. The mathematical issues in the development
of economists’ formalism were, by and large, far simpler mathematically, and focused on
applying topological formalisms already established in mathematics to preferences and
representations of preferences. In the axiomatization program in economics, the role of
interpretation and motivation of axioms were the primary objects of notable theoretical
economists’ writing. Critiques and crises over the roles of an axiomatization program
(and the ‘interpretation-free’ view of mathematics as a content-free set of primitives and
a formulaic set of statements based on definitions of operations juxtaposed or concate-
nated to generate all permutations allowed by the axioms) did not surface or echo in
economics, at least in obvious ways.
These differences, however, serve to cast into sharp relief the one overriding similarity
between the axiomatization programs of math and economics: internal logical consist-
ency as the pre-eminent normative value.
BEHAVIORAL ECONOMICS IS NORMAL SCIENCE

PORTENDING NO PARADIGM SHIFT IN NORMATIVE
ANALYSIS
Some argue that behavioral economics should be interpreted as a paradigm shift or oth-
erwise momentous contestation in reaction to the axiomatization program in economics.
Behavioral economists’ work could, if such an interpretation were granted, be seen as
echoing earlier methodological shifts in mathematics following the rise and decline of

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the Bourbaki group’s influence in mathematics in the twentieth century. I argue against
this methodological view of behavioral economics as a paradigm shift and instead dem-
onstrate that its overriding normative value remains firmly rooted in the axiomatization
program’s normative view, namely, that the central concern is, and should be, internal
logical consistency. See Berg (2014a) or Berg and Gigerenzer (2010) for further detail
distinguishing different camps within behavioral economics, and Berg (2003) on Thaler’s
and Kahneman’s changing positions regarding the normative implications of implicit and
explicit methodological challenges that behavioral economics put to orthodox rational
choice models.
Those who see behavioral economics and modelers of bounded rationality acting as an
ensemble to ‘expand’ or ‘loosen’ the methodological strictures of rational choice theory
miss a crucial difference in the normative views of the consistency and ecological rational-
ity schools as I have defined them in earlier work (Berg 2014a). Behavioral economists in
the consistency school propose radically narrow normative definitions of rationality and
use the label ‘bounded rationality’ (in a manner that would seem to contradict Herbert
Simon’s normative view). The result is to harden the methodological commitment to
internal consistency as the sole criterion that economists are expected to use in charac-
terizing what it means to make rational decisions – and in prescriptive policy proposals
that paternalistically intervene, aiming to induce people’s private actions to more closely
conform to axiomatic models of rationality.
Backhouse (1998) reminds us that axiomatization, mathematicization and formaliza-
tion are distinct. Gigerenzer and Selten’s (2001) ecological rationality program provides a
clear example of normative decision analysis that draws on quantitative data to produce
theories that can be expressed in the language of mathematics, yet have nothing to do with
axiomatization. Backhouse notices (as many other writers on mathematics and philoso-
phy, and the history of mathematics have) that mathematics itself can be either formal or
informal. In the development of proofs of Euler’s theorem, for example, which relates the
numbers of vertices, faces and edges of a polyhedron, Backhouse (1998, p. 1848) describes
different authors’ proofs as somewhere ‘between formalism and irrationalism. . ..There is
more to mathematics than driving the properties of formal systems’.
The implication would seem to be that applied economics, welfare economics and pre-
scriptive policy analysis cannot be entirely about deductive logic (Berg 2007). Indeed, the
proper role of deductive logic led to animated and productive debates about mathemati-
cal methodology and philosophy regarding the Hilbert program among constructivists,
intuitionists (including Hilbert’s students Brouwer and Weyl), subsequent work in proof
theory, category theory and those inspired by Turing on computability.
Given these prolific bodies of work by mathematicians that raised questions about
consistency as the core methodological concern in mathematics, it would seem wrong for
economists to draw the lesson from mathematics – in the name of ‘providing rigor’ or
‘putting economics on a more scientific basis’ – to insist on applying consistency alone as
the ultimate methodological value.
What are we to make of the long tradition among neoclassical economists – and now
behavioral economists – who seem to follow Hilbert’s singular normative premise in
pursuit of logical consistency? I think we can note the positions of economists like Debreu
and Binmore as playing a role similar to Hilbert’s role in mathematics. Their staunch
position in favor of consistency as a singular methodological and normative-prescriptive

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value is simply one among multiple, competing normative claims within economics.
Heterogeneity of methodological priorities is a positive symptom of productive scientific
investigation. In light of the productivity generated by those who raised questions and
took positions against Hilbert’s consistency program in mathematics, however, econo-
mists might also notice that competing normative claims are likely to play a similarly
productive role in economics. Such methodological debate is no small side issue but rather
a substantial object of core investigation in normative economics.
CONCLUDING REMARKS
Casual empiricism and the theoretical economics, biological sciences and biostatistics
literatures provide a rich collection of source material from which one finds a broad
range of mechanisms by which smart people make rational mistakes. Also, economies
that generate value added and nurture richly multidimensional measures of well-being
generate numerous opportunities by which aggregate performance is enhanced thanks to
systematic deviations from standard rationality criteria based solely on internal logical
consistency. I have provided examples that hopefully give a sense of the technical, substan-
tive and historical range of context-specific mechanisms in which alternative normative
criteria that allow for welfare-enhancing deviations from logically consistent axiomatic
rationality can be given even-minded consideration. May further study of this important
phenomenon bloom forth and melt away the methodological strictures unnecessarily
limiting behavioral economists’ evaluations of rationality.
REFERENCES
Axelrod, R. (1984), The Evolution of Cooperation, New York: Basic Books.

Backhouse, R.E. (1998), ‘If mathematics is informal, then perhaps we should accept that economics must be
informal too’, Economic Journal, 108 (451), 1848–58.
Berg, N. (2003), ‘Normative behavioral economics’, Journal of Socio-Economics, 32 (4), 411–27.
Berg, N. (2007), ‘Behavioural economics, business decision making and applied policy analysis’, Global Business
and Economics Review, 9 (2–3), 123–5.
Berg, N. (2014a), ‘The consistency and ecological rationality schools of normative economics: singular versus
plural metrics for assessing bounded rationality’, Journal of Economic Methodology, 21 (4), 375–95.
Berg, N. (2014b), ‘Success from satisficing and imitation: entrepreneurs’ location choice and implications of
heuristics for local economic development’, Journal of Business Research, 67 (8), 1700–1709.
Berg, N. and G. Gigerenzer (2006), ‘Peacemaking among inconsistent rationalities?’, in C. Engel and L. Daston
(eds), Is There Value in Inconsistency?, Baden-Baden: Nomos, pp. 421–33.
Berg, N. and G. Gigerenzer (2007), ‘Psychology implies paternalism? Bounded rationality may reduce the
rationale to regulate risk-taking’, Social Choice and Welfare, 28 (2), 337–59.
Berg, N. and U. Hoffrage (2008), ‘Rational ignoring with unbounded cognitive capacity’, Journal of Economic
Psychology, 29 (6), 792–809.
Berg, N. and J.Y. Kim (2014), ‘Prohibition of riba and gharar: a signaling and screening explanation?’, Journal
of Economic Behavior and Organization, 103 (July), 146–59.
Berg, N. and J.Y. Kim (2015), ‘Quantity restrictions with imperfect enforcement in an over-used commons:
permissive regulation to reduce over-use?’, Journal of Institutional and Theoretical Economics, 171 (2),
308–29.
Berg, N. and D. Lien (2005), ‘Does society benefit from investor overconfidence in the ability of financial market
experts?’, Journal of Economic Behavior and Organization, 58 (1), 95–116.

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Berg, N., G. Biele and G. Gigerenzer (forthcoming), ‘Consistent Bayesians are no more accurate than non-
Bayesians: economists surveyed about PSA’, Review of Behavioral Economics (ROBE).
Berg, N., C. Eckel and C. Johnson (2010), ‘Inconsistency pays? Time-inconsistent subjects and EU violators
earn more’, working paper, University of Texas-Dallas, Dallas, TX.
Berg, N., U. Hoffrage and K. Abramczuk (2010a), ‘Fast acceptance by common experience: FACE-recognition
in Schelling’s model of neighborhood segregation’, Judgment and Decision Making, 5 (5), 391–410.
Bjerkholt, O. and A. Dupont (2010), ‘Ragnar Frisch’s conception of econometrics’, History of Political
Economy, 42 (1), 21–73.
Bookstaber, R. and J. Langsam (1985), ‘On the optimality of coarse behavior rules’, Journal of Theoretical
Biology, 116 (2), 161–93.
Bruni, L. and R. Sugden (2007), ‘The road not taken: how psychology was removed from economics, and how
it might be brought back’, Economic Journal, 117 (516), 146–73.
Gigerenzer, G. (2005), ‘I think therefore I err’, Social Research, 72 (1), 195–218.
Gigerenzer, G. and R. Selten (2001), Bounded Rationality: The Adaptive Toolbox, Cambridge, MA: MIT Press.
Kameda, T., T. Tsukasaki, R. Hastie and N. Berg (2011), ‘Democracy under uncertainty: the wisdom of crowds
and the free-rider problem in group decision making’, Psychological Review, 118 (1), 76–96.
Rapoport, A. (1984), ‘Game theory without rationality’, Behavioral and Brain Sciences, 7 (1), 114–15.
Rapoport, A. and A.M. Chammah (1965), Prisoner’s Dilemma, Ann Arbor, MI: University of Michigan Press.
Schooler, L.J. and R. Hertwig (2005), ‘How forgetting aids heuristic inference’, Psychological Review, 112 (3),
610–28.
Simon, H.A. (1976), ‘From substantive to procedural rationality’, in S.J. Latsis (ed.), Method and Appraisal in
Economics, Cambridge: Cambridge University Press, pp. 129–48.
Tversky, A. and D. Kahneman (1992), ‘Advances in prospect theory: cumulative representation of uncertainty’,
Journal of Risk and Uncertainty, 5 (4), 297–323.
Whitehead, A.N. and B. Russell (1927), Principia Mathematica, 3 vols, Cambridge: Cambridge University Press;
2nd edn, 1925 (vol. 1), 1927 (vols 2, 3), vols 1, 2 and 3 originally published in 1910, 1912 and 1913; 1st edn
reprinted 2009 by Merchant Books, USA.

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4 Rational choice as if the choosers were human
Peter J. Boettke and Rosolino A. Candela
1 INTRODUCTION
In a recent paper entitled ‘Principles of (behavioral) economics’, economists David

Laibson and John List claim that ‘behavioral economics is a series of amendments to,
not a rejection of, traditional economics’ (2015, p. 385), which studies ‘how people try to
pick the best feasible option, including the cases in which people, despite their best efforts,
make mistakes’ (2015, p. 389, original emphasis). For a classroom of undergraduates they
would summarize the principles of (behavioral) economics in this way:
If you want to boil behavioral economics down for a classroom summary you might say that
most people are located somewhere between Mr. Spock and Mr. Simpson (aka Homer). Like
Mr. Spock, Mr. Simpson is also an optimizer – he tries to choose the best feasible option. He’s
just not good at it. We need to study and model all optimizers: the good, the bad, and those in
between. (Laibson and List 2015, p. 389)
Oddly enough, these statements made by Laibson and List about human decision-making
parallel strongly with the following statement made by Ludwig von Mises, one of the
strongest proponents of rationality in the history of economic thought:
It is a fact that human reason is not infallible and that man very often errs in selecting and apply-
ing the means. An action unsuited to the end sought falls short of expectation. It is contrary
to purpose, but it is rational, i.e., the outcome of a reasonable – although faulty – deliberation
and an attempt – although an ineffectual attempt – to attain a definite goal. The doctors who a
hundred years ago employed certain methods for the treatment of cancer which our contempo-
rary doctors reject were – from the point of view of present-day pathology – badly instructed
and therefore inefficient. But they did not act irrationally; they did their best. (Mises 1949 [2007],
p. 44)
From the quotes stated above, both Laibson and List and Mises seem to be depicting
rational choosers as if they were human. However, if traditional economics does indeed
need to be amended by behavioral economics, as Laibson and List argue, then the ques-
tion is what notion of man has occupied ‘traditional’ economics? Implicitly, it would seem
that the notion of man they have in mind for traditional economic analysis is none other
than Homo economicus.
The concept of economic man, or Homo economicus, has been under assault through-
out much of the history of the discipline. It has often been a criticism intimately tied to an
effort to discount the lessons that can be learned from economics for the practical under-
standing of public policy. Since economics as a discipline stresses scarcity and thus choice
within constraints, the debate often turns on how competent people are in making choices,
and how binding those constraints are. In an idealized world, the argument goes, individu-
als are fully informed and perfectly rational in making their decisions, and the constraints
68
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Rational choice as if the choosers were human 69
they face are hard and unyielding. Thus, correct decisions will not just ‘tend’ to be made,
but will inevitably be made. Since this applies equally to all in the economy, the equilib-
rium that results will exhibit exchange efficiency, production efficiency, and product-mix
efficiency. In short, all the gains from trade will be exhausted, all the gains from techno-
logical improvement will be incorporated into production, and the array of products that
buyers are willing to pay for would be available on the market. Perfectly rational actors
interacting freely in a frictionless environment produce an efficient outcome.
With that narrative in the background, then consider the argumentative strategy of
those who wanted to critique the free market system – they can go after the notion of the
rational actor, they can go after the frictionless environment, and they can challenge the
ethical status of the efficiency standard. Throughout the history of the discipline, all three
intellectual strategies have been pursued. The easiest target has been the bogeyman of
Homo economicus. Economic man is a bogeyman in two ways – the claim that the concept
implies that economic ends, or monetary motives, enter the decision calculus, and that
the model implies that the decision makers are imbued with omniscience with respect to
all the relevant factors to the decision. ‘The hedonistic conception of man’, Veblen wrote,
‘is that of a lightning calculator of pleasures and pain, who oscillates like a homogenous
globule of desire of happiness under the impulse of stimuli that shift him about the area,
but leave him intact’ (1898, p. 389). Or consider how Keynes in his rhetorical brilliance
was able to link both perfect rationality and perfect markets together and dismiss both
claims in ‘The end of laissez faire.’ As he put it:
Let us clear from the ground the metaphysical or general principles upon which, from time to
time, laissez-faire has been founded. . ..The world is not so governed from above that private and
social interests always coincide. It is not so managed here below that in practice they coincide. It
is not a correct deduction from the principles of economics that enlightened self-interest always
operates in the public interest. Nor is it true that self-interest generally is enlightened; more often
individuals acting separately to promote their own ends are too ignorant or too weak to attain
even these. (Keynes 1926 [1978], pp. 277–8, original emphases)
Human actors to Keynes are not rational as the ‘model’ presumes, and the market system
does not function as smoothly as the ‘model’ suggests assuring that private and public
interests align. The choice Keynes provides is binary – either perfect actors and perfect
markets, and thus laissez-faire, or imperfect actors and imperfect markets, and thus activ-
ist government policy as a corrective. There simply is no way in his intellectual schematic
that imperfect actors operating in an imperfect world could be stumbling upon coping
mechanisms for the complex reality in which they find themselves, enabling them to realize
the productive gains from specialization and peaceful cooperation without the activist
hand of enlightened government. Keynes brilliantly identified the ‘dark forces of time
and ignorance’ (1936 [1964], p. 155) in The General Theory, but in his depiction human
actors are unable to navigate in that world.
The debates over individual rationality and system-level efficiency have proceeded
along these lines ever since. By modelling the actor as a close-ended decision maker and
the economy as exhibiting a single exit, our result is the deterministic model of rational
‘choice’ depicted in a standard economics textbook, in which the human actor is devoid of
any cognitive ability. If we introduce some form of imperfection, either with the actor (say,
informational asymmetries) or in the market structure (say, monopolistic competition),

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then the welfare conclusions derived from the determinant solution shifts. The govern-
ment as a corrective either at the actor level to provide the requisite information, or at
the structural level to provide the requisite regulatory measures, seems to follow naturally
from the model. However, the strict binary intellectual choice that a Veblen or Keynes
imposed on the economic conversation need not be followed. This is true for the contem-
porary discussion of behavioral economics, renewed calls for paternalism, and the entire
practice of nudges.
In this chapter, we contribute to the theme of this book by evaluating how rational
human choosers are in fact ‘smart’ in the decision-making process once we have taken into
account the particular institutional context within which they are evaluating the costs and
benefits of their choices. As Morris Altman states, ‘conventional economics assumes that
people’s choices are made in a vacuum’ (2012, p. 4), which is not only institutional, but
also historical and cultural in nature as well. What we hope to demonstrate is that there
has been from Adam Smith to Vernon Smith a tradition of economic scholarship that is
grounded in the decision calculus of individuals, but requires neither the heroic assump-
tions of omniscience, nor that the individuals are interacting with others in frictionless
environments. Instead, they see man as pursuing their varied purposes and caught, as
they often are, between alluring hopes and haunting fears, and interacting in institutional
environments that are constituted by vaguely and imperfectly understood rules that are
often poorly enforced and path-dependent on the imprint of culture and history. Yet the
filtering mechanisms of this institutional environment are guided to act in ways that coor-
dinate their activities with those of others to realize the mutual gains from social coopera-
tion. It is precisely because these scholars emphasize the open-endedness of choice that
they can identify the role that even imperfect institutions play in coordinating economic
affairs through time.
Section 2 provides a survey of economic thinkers who rejected the caricature of Homo
economicus that critics claimed was in fact held by classical and neoclassical economists,
but who nevertheless defend the rational choice perspective in the social sciences, and
economics in particular. These will include figures such as Frank Knight, Ludwig von
Mises, F.A. Hayek, James Buchanan, Douglass North, Vernon Smith and Elinor Ostrom.
Section 3 focuses on how Hayek, Buchanan and Ostrom develop the argument to move
to the rules level of analysis in human decision making and human interaction. Section 4
discusses the concept of path dependency and imperfect institutions as developed by
North and Ostrom. Section 5 concludes.
2 METHODOLOGICAL INDIVIDUALISTS WHO REJECT

HOMO ECONOMICUS BUT EMBRACE RATIONAL CHOICE
In his Epistemological Problems of Economics, Ludwig von Mises (1933 [1960]), writing
before the rise of the Keynesian revolution in macroeconomics and the growing emphasis
on mathematical formalism and equilibrium analysis in microeconomics, claimed that
there had been a consolidation of certain core propositions from different strands of eco-
nomic thought that had emerged from the Marginal Revolution of 1871. These develop-
ments in neoclassical economics, according to Coase (1992, p. 713), were rooted in filling
‘the gaps in Adam Smith’s system, to correct his errors, and to make his analysis vastly

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more exact’. Choice within constraints had been a staple of economic analysis since at
least the eighteenth century, but the Marginal Revolution led to a deeper understanding
of the subjective nature of utility, the unit of analysis being the individual, and the choice
calculation on the margin of decision. With the intellectual revolution in value theory, any
Ricardian notion that long run costs of production determined value and price was to be
jettisoned, and fallible yet competent human decision makers became the focal point of
economic analysis. As Mises argued:
Within modern subjectivist economics it has become customary to distinguish several schools.
We usually speak of the Austrian and the Anglo-American Schools and the School of Lausanne
. . . these three schools of thought differ only in their mode of expressing the same fundamental
idea and that they are divided more by their terminology and by peculiarities of presentation
than by the substance of their teachings. . .Today we have only one theory for the solution of
the problems of catallactics, even if it makes use of several forms of expression and appears in
different guises. (1933 [1960], pp. 214–15)
The ‘one theory’ for the analysis of catallactics that Mises had emphasized constituted a
set of positive propositions that led to the further development of ‘mainline’ economics
(see Boettke 2012). These propositions, which were held in common by economists from
classical political economists such as Adam Smith to modern experimental economists
such as Vernon Smith, explained the emergence of social order based on invisible hand
theorizing that reconciled a broad notion of self-interest (that is, purposive action) with
the public interest via institutional analysis. Figure 4.1 illustrates this point. Rational
individuals, though imperfect in their cognitive capabilities, yet guided by the institutional
prerequisites of private property, money prices, and profit/loss, will nonetheless coordi-
nate their subjective plans through the unintended design of the invisible hand, yielding
a social order.
These mainline economists did not explain social order or disorder by collapsing self-
interest on to the public interest or by assuming the super-human cognitive capabilities,
or lack thereof, upon individuals. However, in textbook presentations of mid-twentieth
century microeconomics (and unfortunately true till this day) the argument is that social
order results if, and only if, actors are fully informed and perfectly rational, and the
market structure is perfectly competitive. Otherwise, decision making and system-wide
efficiency will be lacking, and in need of correction.1 These two views of what has become
‘mainstream’ economics are illustrated in Figure 4.2. Rather than utilizing a behaviorally
contingent explanation, their analysis was based on an institutionally contingent process
Self-interest Institutional filter Invisible hand Social order (i.e. public interest)
Figure 4.1 Sequence of causation in mainline economics
Perfectly rational self-interest Perfect market structure Social order
Irrational self-interest Imperfect market structure Social disorder
Figure 4.2 Sequence of causation in mainstream economics

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of reconciliation via exchange between fallible but capable individuals within a context of
private property, freedom of contract, and the rule of law.
All the developments that we are talking about are, as we quoted Coase above as saying,
seen as filling in the gaps of Adam Smith’s scientific system. However, as the mainstream
of economics deviated significantly from the mainline of economics as developed by
the classical political economists and early neoclassical economists, acts of scientific
entrepreneurship were initiated to try to place the individual once again at the center of
economic analysis, and to resurrect institutional analysis as critical in explaining observed
patterns of social order (disorder). It is in these acts of scientific entrepreneurship that
we see ‘schools of thought’ playing out their function – in our narrative this includes the
‘Austrian school’, the ‘property rights school’, the ‘public choice school’, and the ‘new
institutional school’ of contemporary economic thought.
For Mises and the Austrians of the 1930s, the major opponents of this mainline
notion of economic theorizing were perceived ‘not as being the followers of Walras or of
Marshall, but as being the historical and institutionalist writers’ (Kirzner 1988, p. 9) who
had criticized mainline reasoning by presuming that catallactics was behaviorally depend-
ent on a notion of Homo economicus. For example, Institutionalist economist Thorstein
Veblen criticized neoclassical economists for basing economic theory upon ‘a faulty
conception of human nature’, which he rejected as a ‘hedonistic’ conception of man as a
lightning calculator of pleasure and pains, namely because ‘under hedonism the economic
interest is not conceived in terms of action’ (1898, p. 394). Remarking on such renditions
made by Institutionalists and Historicists during the Methodenstreit, Mises asserted that:
It was a fundamental mistake of the Historical School . . . in Germany and of Institutionalism

in America to interpret economics as the characterization of the behavior of an ideal type, the
Homo oeconomicus . . . Such a being does not have and never did have a counterpart in reality; it
is a phantom of a spurious armchair philosophy. No man is exclusively motivated by the desire to
become as rich as possible; many are not at all influenced by this lean craving. It is vain to refer to
such an illusory homunculus in dealing with life and history. Even if this really were the meaning
of classical economics, the Homo oeconomicus would certainly not be an ideal type. The ideal
type is not an embodiment of one side or aspect of man’s various aims and desires. It is always
the representation of complex phenomena of reality, either men, of institutions, or of ideologies.
The classical economists sought to explain the formation of prices. They were fully aware of the
fact that prices are not a product of the activities of a special group of people, but the result of
an interplay of all members of the market society. (Mises 1949 [2007], p. 62, original emphasis)
Just like the classical economists, neoclassical economists of the twentieth century also
were preoccupied with explaining the formation of prices, but they were also increasingly
occupied with conceptualizing price determination along Walrasian and Marshallian
lines, both of which take cost curves to be objective and therefore measurable. It is from
this backdrop that a debate emerged over the use of marginal analysis, in which the criti-
cisms of institutionalist economists against the principles of neoclassical economics would
resurface. As Robert Prasch has argued, ‘this episode, now remembered as the “Marginal
Cost Controversy”, presents us with something of an American Methodenstreit’ (2007,
p. 815).
During the 1940s, economist Richard Lester challenged the empirical reality of eco-
nomic actors engaging in marginal decision making. According to Lester, survey data of
labor markets demonstrated that actors had no clue about weighing marginal benefits and

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marginal costs. For Lester, like the Institutionalists, economic generalizations could be
inferred without theory from generalizations that could be verified empirically. Moreover,
when ‘analytical concepts, including the competitiveness of the market, the nature of
economic rationality, or the structure of a firm’s costs, are assumed or asserted without
reference to widely understood and accepted facts, then that theory lacked genuinely sci-
entific foundation’ (Prasch 2007, p. 814).
Although Lester was rejecting marginalist principles, the premise of Lester’s argument
rested implicitly on the notion that cost curves were objective in the sense that they were
measurable by an outside observer. In this respect, Austrian economist Fritz Machlup
responded that cost curves were subjective, and therefore his conclusions were invalid.
Machlup’s position is consistent with that of Hayek’s presentation in ‘Economics and
knowledge’ (1937), where the marginal conditions are not assumptions going into an
analysis, but by-products that emerge out of decision making, ‘discovered anew’ within
the process of market competition itself. Too often Machlup’s contribution is captured
under the heading of ‘as if’ modeling. While Machlup often used the instrumentalist lan-
guage of his day to try to communicate his point, a careful reader will note that he always
makes subtle shifts in language, which was understood by those at the time as qualifiers,
but which have failed to travel through time with him. Such a classic case is his shift in the
debate over verification in economic science where he switches the claim about ‘predict-
ability’ to one focused on ‘intelligibility’ (Machlup 1955; see also Boettke 2015; Zanotti
and Cachanosky 2015). A similar subtle switch occurs when Machlup in the science wars
argues that economics is as scientific as the natural sciences are, but it is just that in the
sciences of man ‘matter can talk’, changing the epistemological problems that must be
confronted in the practicing of the science.
A comprehensive review of the marginal cost controversy is beyond the scope of this
chapter (see also Lavoie 1990). What is important for our analysis of rational choice, in
which economic actors are fallible, but capable, human beings and neither mechanistic
automatons nor hopelessly disoriented actors, is that many textbook presentations of the
Lester–Machlup debate present Machlup as the winner, but present his argument in the
‘as if’ tradition of thinking championed by Milton Friedman (1953). Individuals act ‘as if’
they balance marginal benefits and costs even if they do not explicitly do so in their own
minds. However, this misses the point in the sense that the debate has been understood in
terms of behavioral assumptions of whether or not individuals are profit maximizing or
not. What was lost in the exchange was an analysis of the institutional conditions within
which individuals are enabled to or inhibited from pursuing maximum profits, not only
pecuniary but also non-pecuniary. The marginal conditions have little or nothing to do
with how individuals actually make decisions. Rather, the marginal conditions emerge as
a by-product of the market process within an institutional context of private property,
prices, and profit/loss accounting.
We do not have direct access to motivations of individuals. What we can study is the
systemic effect of different institutional arrangements on the incentives that actors face.
However, we cannot detail what motivates individuals. As the renowned Chicago econo-
mist Frank Knight has argued:
We really know very little about human motives, and still oversimplify them disastrously in
nearly all discussion . . . The larger problem is to arrange things so that people will find their

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lives interesting and will grow into such personalities that they can respect themselves, admire
others and enjoy their society, appreciate thought and beauty, and in general look upon creation
and call it good. (1919, p. 806)
Among those institutional arrangements, Knight not only emphasized the formal con-
straints such as private property, freedom of contract, and the rule of law, but also under-
stood that such formal institutions are dependent on informal norms that are conducive to
self-interest ‘rightly understood’ as the harmony or dovetailing of individual ends among
members of society:
From the falsity of the atomistic-individualistic view of human nature and human desires it is an
easy inference that any mechanical theory of social organization is subject to narrow limitations.
The most potent agency of social control, even today, in spite of all the obstacles thrown in its
way by an antiquated and wooden system of association, is the moral control of the individual’s
sense of decency and the pressure of the opinions of his fellows. (Knight 1920 [2011], p. 87)
Moreover, market interactions are not defined solely by monetary exchanges, but also
encompass and depend upon a realm of voluntary, non-monetary associations, which
Coase recognized are prohibitively costly to effect through monetary exchange because
of the costs of defining separate contracts (Coase 1937). Because of these transactions
costs, not only firms but also other institutions such as marriage and families emerge to
avoid the costliness of pricing non-monetary attributes, such as love amongst marriage
partners and parental devotion towards children:
The great advantage of the market is that it is able to use the strength of self-interest to offset
the weakness and partiality of benevolence, so that those who are unknown, unattractive, or
unimportant, will have their wants served. But this should not lead us to ignore the part which
benevolence and moral sentiments do play in making possible a market system. Consider, for
example, the care and training of the young, largely carried out within the family and sustained
by parental devotion. If love were absent and the task of training the young was therefore placed
on other institutions, run presumably by people following their own self-interest, it seems likely
that this task, on which the successful working of human societies depends, would be worse
performed. (Coase 1976, p. 544)
Returning to Veblen’s critique of neoclassical economics, rational choice does not

depend on ‘mechanical’ or ‘hedonistic’ responses to objective cost and profit functions.
To counter Veblen, economics is in fact an evolutionary science, but one that is firmly
grounded in an open-ended notion of rational choice that embraces both discovery under
uncertainty. Alluding to the marginal cost controversy described above, Armen Alchian
states the following in his classic article ‘Uncertainty, evolution, and economic theory’:
While it is true that the economist can define a profit maximization behavior by assuming spe-
cific cost and revenue conditions, is there any assurance that the conditions and conclusions so
derivable are not too perfect and absolute? If profit maximization (certainty) is not ascertainable,
the confidence about the predicted effects of changes, e.g., higher taxes or minimum wages, will
be dependent upon how close the formerly existing arrangement was to the formerly ‘optimal’
(certainty) situation. What really counts is the various actions actually tried, for it is from these
that ‘success’ is selected, not from some set of perfect actions. The economist may be pushing
his luck too far in arguing that actions in response to changes in environment and changes in
satisfaction with the existing state of affairs will converge as a result of adaptation or adop-

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tion toward the optimum action that should have been selected, if foresight had been perfect.
(Alchian 1950, p. 220)
What Alchian is arguing is that neither the behavioral assumption of profit maximiza-
tion nor perfect foresight is necessarily required ex ante for human rationality. What is
sufficient is awareness of the institutional conditions within which human rationality
manifests itself ex post:
Even if each and every individual acted in a haphazard and nonmotivated manner, it is possible
that the variety of actions would be so great that the resulting collective set would contain actions
that are best, in the sense of perfect foresight . . . The essential point is that individual motivation
and foresight, while sufficient, are not necessary. Of course, it is not argued here that therefore it
is absent. All that is needed by economists is their own awareness of the survival conditions and
criteria of the economic system and a group of participants who submit various combinations
and organizations for the system’s selection and adoption. (Alchian 1950, pp. 215–17)
Regardless of the behavioral assumptions, given the ubiquitous presence of scarcity,

rational human action (that is, the continuous application of discovered means to indi-
vidual aims) will generate the contextual knowledge, manifested through the price system,
for the pursuit of maximum profits given the particular institutional context (Boettke and
Candela 2015). The science of economics analyzes how fallible, but capable individuals
do their best under particular institutional constraints. The art of economics, however, is
uncovering those institutional constraints for understanding how in each particular case
individuals attempt to do their best:
Even if environmental conditions cannot be forecast, the economist can compare for given alter-
native potential situations the types of behavior that would have higher probability of viability
or adoption. If explanation of past results rather than prediction is the task, the economist can
diagnose the particular attributes which were critical in facilitating survival, even though indi-
vidual participants were not aware of them. (Alchian 1950, p. 216)
The outside observer of human behavior who assesses some particular action as
‘irrational’ makes his or her evaluation based on either a value judgment of the ends
pursued or narrowly defining the actor’s utility function to fit a close-ended model of
choice. Criticisms of Homo economicus have been based both on the former, namely, by
challenging efficiency as an ethical benchmark, as well as the latter by subjecting the
model to narrowly defined monetary motives. As Elinor Ostrom states, this ‘thin model
of rationality needs to be viewed . . . as the limiting case of bounded or incomplete
rationality’ (1998, p. 9), that emerges only after all the gains from trade and specializa-
tion have been exhausted. However, ‘as we move away from these conditions we must
explore not only the immediate consequences in terms of choices but particularly the
kinds of institutions that will evolve in such contexts to structure human interaction’
(North 1993, p. 161).
Rational action understood among mainline economists refers to the discovery of
the means applied towards the fulfillment of a particular end; it does not necessarily
depend on all our preferences and means being given or specified in one’s utility function.
‘Consistent with all models of rational choice is a general theory of human behavior that
views all humans as complex, fallible learners who seek to do as well as they can given the

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constraints that they face and who are able to learn heuristics, norms, rules, and how to
craft rules to improve achieved outcomes’ (Ostrom 1998, p. 9). It encompasses learning
from our errors through time, without which institutions would not matter (North 1994).
Thus, the innumerable manifestations of rationality depend on the institutional context
within which learning through time takes place. Therefore, as Vernon Smith explains,
what seems to be ‘irrational’ to the outside observer of human behavior is no more than
a misunderstanding of the institutional context:
Thus, if people in certain contexts make choices that contradict our formal theory of rationality,
rather than conclude that they are irrational, some ask why, reexamine maintained hypotheses
including all aspects of the experiments – procedures, payoffs, context, instructions, etc. – and
inquire as to what new concepts and experimental designs can help us to better understand the
behavior. (Smith 2003, p. 471)
Moreover, institutional analysis does not imply that rules will always be perfectly specified
or that individuals respond passively to the institutional reward structure. Rather, because
of the cost of defining all of the possible actions that may be prohibited or sanctioned
by the institutional framework, entrepreneurial discovery by individuals will generate
endogenous institutional solutions to problems that are institutional in nature, resulting
in gradual changes to the institutional framework. In the next section, we elaborate on
the insights of Hayek, Buchanan and Ostrom in shifting to the rule level of analysis in
analyzing human decision making and human interaction.
3 DEVELOPMENT OF THESE INSIGHTS TO THE RULE LEVEL

OF ANALYSIS
We have previously argued that exposition of economic phenomena in terms of com-

petitive equilibrium as a description of reality rather than using equilibrium analysis as
a heuristic tool had rendered institutional analysis of little concern to economists. By
extending the pure logic of rational choice to closed-form solutions, real-world markets
act ‘as if’ they were in competitive equilibrium, not only purging the analysis of institu-
tional derivations of the logic of choice, but also resulting in economic analysis becom-
ing increasingly reliant on behavioral assumptions characterized as Homo economicus,
around which advocates and critics of the market order would base their arguments.2 By
collapsing the gap between economic models and economic reality, the behavioral inten-
tions of economic actors correspond one-to-one with the outcomes ‘predicted’ within the
model (Boettke and Candela 2014).
What Buchanan, Hayek, and Ostrom acknowledged was that a richer notion of eco-
nomic theory included institutional analysis and that incorporating institutional analysis
enabled economic analysis to explain a broader notion of rational choice as if choosers
were human. Moreover, what distinguished them from earlier classical as well as neoclas-
sical economists was their application of rational choice to the rule level of analysis as
well. Unlike the behavioral and physical laws of nature, which they took as given, what
they explicitly drew attention to was that ‘rules are interesting variables precisely because
they are potentially subject to change. That rules can be changed by humans is one of
their key characteristics’ (Ostrom 1986, p. 5).

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Hayek as early as 1937 in ‘Economics and knowledge’ recognized that rational choice
analysis, or what he referred to as the pure logic of choice, was a necessary, though not
a sufficient, condition for equilibrium analysis. What was sufficient for the derivation of
equilibrating tendencies within the market order, however, was a shift to the rule level of
analysis, or comparative institutional analysis.
Fundamentally, the importance of rules to Hayek was to provide a framework of pre-
dictable guidelines within which individuals could adapt to unforeseen circumstances. As
he states:
We can produce the conditions for the formation of an order in society, but we cannot arrange
the manner in which its elements will order themselves under appropriate conditions. In this
sense the task of the lawgiver is not to set up a particular order but merely to create conditions
in which an orderly arrangement can establish and ever renew itself. As in nature, to induce the
establishment of such an order does not require that we be able to predict the behavior of the
individual atom – that will depend on the unknown particular circumstances in which it finds
itself. All that is required is a limited regularity in its behavior; and the purpose of the human
laws we enforce is to secure such limited regularity as will make the formation of an order pos-
sible. (Hayek 1960, p. 161)
Ostrom also acknowledged that rules ‘are the result of implicit or explicit efforts by a
set of individuals to achieve order and predictability within defined situations’ (1986,
p. 5). More so than Buchanan and Ostrom, Hayek emphasized that rules emerged from a
spontaneous order based on human action, though not of human design. However, like
Buchanan and Ostrom, he also acknowledged that rules that have evolved spontaneously
can also be improved upon by marginal deliberative choices on the level of rules to facili-
tate different patterns of interactions within those rules:
At the moment our concern must be to make clear that while the rules on which spontaneous
order rests may also be of spontaneous origin, this need not always be the case. Although
undoubtedly an order originally formed itself spontaneously because the individuals followed
rules which had not been deliberately made but had arisen spontaneously, people gradually
learned to improve those rules; and it is at least conceivable that the formation of a spontaneous
order relies entirely on rules that were deliberately made. (Hayek 1973, p. 45)
The rule level of analysis requires neither that rational agents are homogenous in their
objectives, nor does it imply that they share only pecuniary aims, such as that attributed
to Homo economicus. As Buchanan states:
The central rationality precept states only that the individual choose more rather than less of
goods, and less rather than more of bads. There is no requirement that rationality dictates choice
in accordance with the individual’s economic interest, as this might be measured by some outside
observer of behavior. The individualistic postulate allows the interests or preferences of indi-
viduals to differ, one from another. And the rationality postulate does not restrict these interests
beyond the classificatory step noted. Homo economicus, the individual who populates the models
of empirical economics may, but need not, describe the individual whose choice calculus is ana-
lyzed in constitutional political economy. (Buchanan 1990, pp. 14–15)
Buchanan argued that economists could analyze the derivation of that framework sepa-
rately through the tools of rational choice political philosophy, namely, social contract
theory, but differently from Hayek and Ostrom, argued that institutions were provided

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exogenously in the first place. Ostrom, building more from Hayek in this regard, saw the
framework itself as an endogenous set of rules that emerge from the bottom up, through
the individual and group striving to minimize conflicts and realize gains from coopera-
tion. It is the notion of ‘constitutional craftsmanship’ that is foundational to the work of
Ostrom that provides the conciliatory link between the dual spontaneous order analysis
argued for here and the restriction of spontaneous order analysis to the market process,
argued notably by Buchanan.
Yet the common thread uniting their shift to the rule level of analysis was that the
ability for individuals to coordinate their actions fell within a paradigm of exchange
behavior to achieve a more preferred arrangement of rules in order to facilitate outcomes
conducive to cooperation through a division of labor. What they did not share was a
vision of political economy through an ‘allocation paradigm’ (Buchanan 1964), in which
rational choosers were purged of any human deliberation as well as confined to perfectly
defined constraints not subject to change and improvements by human rational choosers
themselves.
4 THE INSTITUTIONAL IMPRINT, RATIONAL CHOICE, AND

PATH DEPENDENCY
The fundamental task that has plagued economists since Adam Smith, both mainline
and mainstream, has been to inquire into the nature and causes of the wealth of nations.
Particularly since the collapse of communist regimes in Central and Eastern Europe after
1989, this inquiry has been increasingly marked by a dovetailing of the mainline and
mainstream through its emphasis on comparative institutional analysis and institutional
path dependency in understanding the lag in economic development not only among
countries emerging from communism, but also in Asia, Africa, and Latin America.
The plain fact is that the ultimate source of poor economic performance in third-world coun-
tries is the polity that specifies and enforces the economic rules of the game. As yet the study of
third-world polities is as underdeveloped as their polities themselves. But one thing is for sure:
not much progress is going to be made in modeling such polities without taking into account the
limits of rational choice and the importance of ideologies. (North 1993, pp. 160–61)
The point that Douglass North makes in this quote is that not only do the formal rules
of the game matter for the economic performance of a country, but also that informal
constraints provide path dependency in cultural attitudes towards trade and exchange.
As North argues, ‘once a development path is set on a particular course, the network
externalities, the learning process of organizations, and the historically derived subjective
modeling of the issues reinforce the course’ (North 1990, p. 99).
In this respect, neoclassical economics could not underpin the reform of centrally
planned economies for two particular reasons. First, the theoretical model of perfect
competition operates as a behavioral filter of the limiting conditions that apply to indi-
viduals after all the gains from trade and specialization have been exploited. It illustrates
an idealized world in which individuals are fully informed and perfectly rational in making
their decisions, and that the constraints they face, such as prices and income, are taken as
given. However, lacking any institutional filter of the structure of incentives that gener-

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ates tendencies towards such limiting conditions, deviations from this behavioral model
can only lead the economist to conclude that individuals are behaving ‘irrationally’ and
that the economy is prone to ‘market failure,’ characterized by the prevalence of asym-
metric information, externalities, and monopoly power. As Ronald Coase argued, ‘These
ex-communist countries are advised to move to a market economy, and their leaders wish
to do so, but without the appropriate institutions no market economy of any significance
is possible. If we knew more about our own economy, we would be in a better position to
advise them’ (1992, p. 714).
Secondly, as Coase alluded to above, without understanding the ‘tacit presuppositions’
(Buchanan 1997) that are embodied in the underlying norms, customs, and behavioral
attitudes of individuals that reinforce the prevailing institutions of society, it would be
unclear whether the institutional designs of economic reformers would have the intended
effect on the economic performance of a country. James Buchanan clearly makes this
point:
In Western regimes, markets work tolerably well, within the political-legal framework of widely
dispersed property rights, when the workings of ordinary politics do not interfere excessively.
They do so because they have evolved through a long history which has been interpreted and
understood by experts in such fashion as to reinforce the behavioural attitudes necessary to
make such institutions function. In failed socialist regimes, markets have neither the history
nor the interpretation-understanding that informs behavioural attitudes. It seems naïve in the
extreme to assume that the market order is ‘natural’ to the extent that it can emerge full blown
without history, without institutional construction and, most importantly, without understand-
ing. (1997, p. 106)
It is not just that institutions matter, but history and ideas matter for understanding
the feasible institutional opportunity set within which the economist is able to propose
reforms. Furthermore, Buchanan makes a distinction between an ‘exchange culture’ and
a ‘command culture’ to distinguish the underlying behavioral attitudes in Western and
post-socialist economies, respectively. To understand this point, Buchanan is neither
denying that individuals are choosing rationally, nor is relying on any notion of Homo
economicus. Rather, it is the underlying informal norms prevalent throughout members
of society that motivate the degree of toleration and acknowledgement of the mutually
beneficial nature of trade under anonymity, which fundamentally extends the limit of
the market, and widens the scope for rational self-interest to encompass activity beyond
the behavioral confines of Homo economicus. In Western countries, Buchanan argues the
following:
The attitude of reciprocity in the market relationships remains relatively pervasive in Western
economies, even in those settings where, in a behavioural sense, there remains little or no rational
foundations for such attitude. The salesclerk in the Sheraton Hotel in Houston, Texas, offers
me a postcard as if she, personally, has an interest in my purchase, even when both of us know
that her wage or position depends only in some extremely remote sense on her behaviour in our
exchange relationship. The exchange relationship tends to foster the attitude of reciprocity, even
in as if settings, and behavior reflecting such an attitude tends in itself to promote a mutuality
of expectations that becomes reinforcing. (1997, p. 97, original emphases)
In those countries that have failed to emerge successfully, in terms of economic growth,
from the failures of socialism, the underlying informal norms of society are conducive to

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a command culture, one that ‘describes an idealization of collective reality, as this reality
is interpreted by those who experience it’. It reinforces the idea that the ‘exertion of effort
creates no claim to share in product. Effort is directed toward common purposes, and
linkage between effort and reward becomes the source of envy rather than emulation’
(Buchanan 1997, p. 101, original emphasis). From this cultural context, it would there-
fore seem rational for individuals to regard the market order with suspicion, especially
when viewed in the zero-sum terms of a command culture. Extending Buchanan’s point,
Pejovich elaborates:
In many parts of the region, gains from trade are seen as a redistribution of income rather than
as rewards to innovators for creating new wealth. State authorities are more likely to impose
price controls on producers and/or merchants who earn large profits than to seek ways to create
incentives for others to emulate such individuals in competitive markets. The cultural heritage
in [Central and Eastern Europe] supports an activist state. Historical development and national-
ism are major reasons for cultural differences within the region . . . By feeding on the conviction
that the community’s common good transcends the private ends of its members, nationalism
in many [Central and Eastern European] countries has reinforced the culture of collectivism.
(2003, p. 351)
Although our discussion thus far has emphasized a comparative institutional analysis
between Western economies and the economies of Central and Eastern Europe, our
observations have broader implications for income differences across time as well.
Not only do the formal institutions matter for economic growth, but, perhaps more
importantly, the fact that customary practice dictates the legitimacy of formal institutions
is because informal rules ‘are not a policy variable’ (Pejovich 2003, p. 348) and, therefore,
formal institutions must be crafted to be congruent, or ‘stick’ to the underlying informal
rules of society. Although economic reformers may succeed in designing institutions that
exhibit ‘institutional stickiness’ (Boettke et al. 2008) to informal institutions, this is by no
means sufficient for generating economic growth:
There is no guarantee that beliefs and institutions that evolve through time will produce eco-
nomic growth . . . In fact, most societies throughout history got ‘stuck’ in an institutional matrix
that did not evolve into the impersonal exchange essential to capturing the productivity gains
that came from the specialization and the division of labor that have produced the Wealth of
Nations. (North 1994, pp. 363–4)
With respect to the logic of rational choice, societies that exhibit path dependency towards
economic stagnation does not imply irrationality on the part of economic actors within
that society. Rationality must be understood as entirely subjective and forward looking;
an individual’s perception of costs and benefits are shaped by the institutional payoffs:
In every system of exchange, economic actors have an incentive to invest their time, resources,
and energy in knowledge and skills that will improve their material status. But in some primitive
institutional settings, the kind of knowledge and skills that will pay off will not result in institu-
tional evolution towards more productive economies. (North 1991, p. 102)
As North elaborates on how institutional path dependence can be self-sustaining:
In the case of economic growth, an adaptively efficient path . . . allows for a maximum of choices
under uncertainty, for the pursuit of various trial methods of undertaking activities, and for an

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efficient feedback mechanism to identify choices that are relatively inefficient and to eliminate
them . . . But so, too, can unproductive paths persist. The increasing returns characteristic of
an initial set of institutions that provide disincentives to productive activity will create organiza-
tions and interest groups with a stake in the existing constraints. They will shape the polity in
their interests. Such institutions provide incentives that may encourage military domination of
the polity and economy, religious fanaticism, or plain, simple redistributive organizations, but
they provide few rewards from increases in the stock and dissemination of economically useful
knowledge. The subjective mental constructs of the participants will evolve an ideology that
not only rationalizes the society’s structure but accounts for its poor performance. As a result
the economy will evolve policies that reinforce the existing incentives and organizations. (North
1990, p. 99)
However, the observation that certain societies are locked into an institutional path
unconducive to economic growth does not necessarily imply that intervention from
reformers external to the particular institutional context will resolve the situation, namely,
by establishing private property rights or transplanting other formal institutions that
evolved within the historical context of Western economic development. As Ostrom has
argued:
When analysts perceive the human beings they model as being trapped inside perverse situ-
ations, they then assume that other human beings external to those involved – scholars and
public officials – are able to analyze the situation, ascertain why counterproductive outcomes
are reached, and posit what changes in the rules-in-use will enable participants to improve out-
comes. Then, external officials are expected to impose an optimal set of rules on those individuals
involved. It is assumed that the momentum for change must come from outside the situation
rather than from the self-reflection and creativity of those within a situation to restructure their
own patterns of interaction. (2010, p. 648)
Ostrom recognized that when the definition and enforcement of property rights are
devised from the bottom up rather than from the top down, individuals will have a greater
incentive to conserve on resources used in the process than when that process is imposed
exogenously, not only because they exhibit greater residual claimancy over their actions,
but also because they are able to utilize their contextual knowledge not often available to
external reformers. The ability of individuals to craft rules that are effective within their
own communities hinges upon the mutually agreed-upon rules of governance that then
establish reliable expectations among the community. Elinor Ostrom emphasized the
legitimacy of rules as essential to minimizing the enforcement and monitoring costs of
rules (1990, p. 205). If rules are developed internally, by actors with local legitimacy and
knowledge of the community’s history, then monitoring can be a ‘natural by-product’
of the system of rules (Ostrom 1990, p. 96). In addition, because of the path-dependent
nature of bottom-up institutional solutions, formal enforcement of rules cannot run con-
trary to how individuals perceive and understand them:
Without individuals viewing rules as appropriate mechanisms to enhance reciprocal relation-

ships, no police force and court system on earth can monitor and enforce all the needed rules on
its own. Nor would most of us want to live in a society in which police were really the thin blue
line enforcing all rules. (Ostrom 1998, p. 16)
A summary of the core argument of this section can be restated as follows (Boettke 2001,
pp. 251–9):

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1. People respond rationally to incentives as they perceive them.

2. Incentives and therefore economic performance are a function of the rules of the
game, both formal and informal.
3. Rules are only rules if customary practice dictates.
5 CONCLUSION
In this chapter, we have argued that the caricature of economic man as Homo economicus
has been an invalid and unwarranted characterization of the individual in their interac-
tions with other individuals within the market order. From Adam Smith to Vernon Smith
there has been a common thread that has united economic thought on man’s epistemic
and behavioral capacity, one that rests on institutional analysis and the emergence of
customs, norms, and monetary prices to guide social interaction towards social order.
Hayek best summarizes this common lineage in mainline economic thought:
Perhaps the best illustration of the current misperceptions of the individualism of Adam Smith
and his group is the common belief that they had invented the bogey of ‘economic man’ and
that their conclusions are vitiated by their assumption of a strictly rational behavior or gener-
ally by a false rationalistic psychology. They were, of course, very far from assuming anything
of the kind. It would be nearer to the truth to say that in their view man was by nature lazy and
indolent, improvident and wasteful, and that it was only by the force of circumstances that he
could be made to behave economically or carefully to adjust his means to his ends . . . The main
point about which there can be little doubt is that Smith’s chief concern was not so much with
what man might occasionally achieve when he was at his best but that he should have as little
opportunity as possible to do harm when he was at his worst. It would be scarcely too much to
claim that the main merit of the individualism which he and his contemporaries advocated is that
it is a system under which bad men can do least harm. It is a social system which does not depend
for its functioning on our finding good men for running it, or on all men becoming better than
they now are, but which makes use of men in all their given variety and complexity, sometimes
good and sometimes bad, sometimes intelligent and more often stupid. (1948, pp. 11–12)
The excessive preoccupation with the behavioral characteristics of man in economic

analysis from the late nineteenth century to the mid-twentieth century resulted not only
from misunderstandings about the role of theory and history (Mises 1957) in economic
analysis, but also from depicting economic phenomena in terms of competitive equilib-
rium. Because facts are theory laden, the purpose of economy theory is to engage in his-
torical explanation of facts. To argue that man is rational – that is, that he or she evaluates
the marginal costs and benefits of undertaking an activity towards the fulfillment of a
particular goal – does grant that individual infallibility or omniscience. This is the realm of
price theory, consistent with the understanding of mainline economists discussed in this
chapter. Rather, such decision making and the manifestations of rationality must be evalu-
ated within its particular institutional context. This is the realm of history. The modern
analytical narrative approach employed by Bates et al. (1998) embodies this distinction
between theory and history that Mises specified:
The process of deciding the appropriate individuals, their preferences, and the structure of the
environment – that is, the right game to use – is an inductive process much like that used in
modern comparative politics, by historical institutionalists, and by historians. Once that induc-

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tion is complete, we can use the deductive methods to study behavior within the context of the
game. (Bates et al. 2000, p. 697).
However, when economic theory becomes dependent on behavioral assumptions, not

only does this tend to crowd out institutional analysis, collapsing human intentions on to
outcomes, but it also leads to misleading characterizations of human ‘irrationality’ when
historical events, such as the Great Depression or more recently the Great Recession, are
not ‘predicted’ by theory or do not correspond to some particular efficiency benchmark.
As a result, arguments about the success of comparative economic systems, even those
in defense of the market order, will hinge upon the behavioral capabilities of man. The
predictive power of mainstream theorizing in macroeconomics, both Keynesian as well as
new classical, no less depend on whether individuals are hopelessly irrational or perfectly
rational, respectively.
With the resulting disconnect of theory from history, new emphasis was drawn to the
rule level of analysis, which had not only been emphasized by Adam Smith and Frank
Knight, but was reincarnated as new insights manifesting themselves as the public choice
of James Buchanan, new institutional economics of Armen Alchian, Ronald Coase and
Elinor Ostrom, the market process of modern Austrian economics developed by Mises
and Hayek, the experimental economics of Vernon Smith, and the new economic history
of Douglass North. Each of these scholars, while rejecting the notion of Homo economi-
cus, did not throw rational choice by the wayside either. Instead, their contributions to
economics were built upon ‘Adam Smith’s view of man’ as ‘he actually is – dominated, it
is true, by self-love but not without some concern for others, able to reason but not neces-
sarily in such a way as to reach the right conclusion, seeing the outcomes of his actions
but through a veil of self-delusion’ (Coase 1976, pp. 545–6). While we do not deny that
‘Adam Smith frequently wrote about the psychology of decision-making’ (Laibson and
List 2015, p. 385), accepting this view of man, who is a fallible but capable individual,
will draw the economist’s attention, whether mainline or mainstream, behavioral or tra-
ditional, to the realization that man’s capacity to foster social order and capture the gains
from exchange and innovation depends not on his reason or lack of reason per se, but on
rules that are discovered and crafted to marshal individual reasoning dispersed among
individuals throughout society.
NOTES
1. Economist Mark Thoma, in a 2015 article, goes so far as to say ‘I believe in markets as much as anyone.
But for markets to work well the conditions for perfect competition must be approximated’. The notion
that markets only ‘work’ after all the gains from trade and exchange of goods and services (including
information) have been exploited (that is, perfect competition) is a description of the end result of market
competition, not an analysis of the economic forces at work. Moreover, this characterization of the market
‘working well’ not only commits the nirvana fallacy (see Demsetz 1969) of comparing imperfect markets
to a perfectly efficient benchmark, but more importantly, it also lacks comparative institutional analysis of
market forces under different conditions.
2. During the socialist calculation debate between the 1920s and 1940s, market socialists, arguing against
Mises’s claim that rational calculation was impossible under socialism, utilized neoclassical equilibrium
analysis to establish the invalidity of Mises’s claim. Mises’s as well as Hayek’s fundamental argument during
the debate held that, absent the institutional prerequisites of private property, central planners would be
precluded from the prices and contextual knowledge required to engage in economic calculation. However,

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presuming the conditions of equilibrium and that perfect knowledge was available to central planners,
market socialist Oskar Lange argued that central planners would be able to calculate the opportunity
costs of resources, just as the market supposedly does, through a trial and error process. Surprisingly,
Frank Knight and Joseph Schumpeter, both market-oriented economists of a Marshallian and Walrasian
stripe, respectively, also agreed with Lange’s analytical assessment. Knight’s argument was that there was
no economic problem of socialism because economic science is limited to applying marginalist principles
to economic decision-making in circumstances of perfect knowledge and perfect competition (see Boettke
and Vaughn 2002, p. 159). Schumpeter’s argument was that, assuming the conditions of general competitive
equilibrium, the valuation of the factors of production can be logically imputed ‘ipso facto’ directly from
the valuation of consumers’ goods (see Hayek 1945, pp. 529–30).
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5 Smart predictions from wrong data: the case
of ecological correlations*
Florian Kutzner and Tobias Vogel
INTRODUCTION
With the economic crisis that hit the European continent in 2007, many were interested
in the consequences for those affected, from economic hardship, to emotional well-being
to family planning. Take the relationship between the severity of the crisis and family
planning as an illustration. Across 28 European countries, it was found that an increase in
unemployment rates from 2007 to 2011 correlated with a decrease in birth rates (Goldstein
et al., 2013). To illustrate, we plotted changes in unemployment rates against the respec-
tive changes in birth rates (see Figure 5.1). The correlation of –.34 indicates that those
countries with larger increases in unemployment rates are marked by larger decreases in
birth rates. It seems there exists ‘a strong relationship between economic conditions and
fertility’ (Goldstein et al. 2013, p. 85) and that ‘the extent of joblessness . . . does in fact
have an effect on birth rates’ (BBC 2013). Can we conclude, however, that people who
lost their job delayed having children? In this chapter we show that people respond ‘Yes’
to this question, that this answer can be wrong at times, and yet this response can still be
smart or rational on average.
The conclusion that the correlation between changes in unemployment and birth rates
across countries also holds for individual people, that those becoming unemployed are
0.20
0.10
Change in birth rate
0.00
–0.10
–0.20
–0.30
–5% 0% 5% 10% 15%
Change in unemployment rate
Note: Dashed line 5 regression line.
Source: Data from Eurostat.
Figure 5.1 Changes in unemployment rates (2011 minus 2007) in 28 European countries
plotted against respective changes in birth rates
86
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Smart predictions from wrong data 87
more likely to delay having children, can be severely wrong. Yet, when considering real-life
constraints on decision making, being ignorant about different levels of data aggregation
offers a smart strategy. In many cases, using aggregated data is the only option owing to a
lack of more appropriate data or a lack of resources for appropriate analyses. Also, even
though some conclusions will be wrong, an illustrative demonstration lends credence to
the fact that correlations across countries (or other ecologies) have some predictive value
for correlations across individuals.
ECOLOGICAL CORRELATIONS AND AGGREGATION BIAS
The term ‘ecological’ in ecological correlations is applicable to any grouping of observa-

tions. Talking about people, it is easy to conceive ecologies as macro variables such as
geographical entities. Yet, many other ecological groupings of variables are almost equally
plausible and prominent, including social characteristics such as income or age groups.
An ecological correlation results when a correlation between two variables is computed
using the variables’ mean values for different ecologies. In Figure 5.1 the ecologies are
countries that are assigned mean values for two variables: change in unemployment rates
and change in birth rates. Across 28 of these ecologies a correlation is computed. That is,
statistically the correlation is based on 28 observations. At the same time, thousands of
individuals are behind the mean values, each of which has either become unemployed or
not, and has become a parent or not. This individual information, however, is lost when
aggregated into a country index.
Which inferences about individuals are still valid given such aggregated data has puzzled
statisticians, epidemiologists and sociologists for decades (Hannan 1971; Hammond 1973;
King 2013). With aggregation comes greater reliability for estimating mean values. Asking
30 individuals about their change in employment status will be a less reliable estimate of
the mean tendency than asking 1000 individuals. At the same time, correlations between
these mean values across a handful of ecologies do not become more reliable. Even more
dramatic than losing the reliability benefit, the size and even sign of correlations can differ
from before to after aggregation. This sets the stage for ‘aggregation biases’ or ‘ecological
fallacies’ (Hammond 1973).
An early demonstration of diverging correlations given individual and aggregated data
can be found in Robinson’s work (1950). Across nine US districts Robinson showed that
the correlation between the averages of African-Americans and illiterates living in these
districts was about r ≈ .95. The districts with higher rates of African-Americans had
almost certainly higher illiteracy rates. At the same time, using individual data showed
that the likelihood of being illiterate was barely higher for African-Americans than for
non-African-Americans, only resulting in a correlation of r ≈ 0.2. An analogous diver-
gence can be found with the effect of the economic crisis on birth rates. An analysis based
on the changes in job and parental status of individual people, across a comparable time
span and set of countries, reveals that becoming unemployed does not, on average, affect
becoming a parent (Schmitt 2012).
There are several reasons for a possible divergence (Hannan 1971; Hammond 1973).
Perhaps the most obvious is the presence of an unobserved third variable that influ-
ences both measured variables. For example, allocation of people to districts might be

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driven in part by socio-economic status. If status is correlated with ethnicity as well as

with literacy, the percentage of African-Americans and the percentage of illiterates are
likely to be correlated across districts. Within every district and in the whole population
African-Americans can be as likely to be literate as their counterparts. In a similar vein,
a third-variable – yet, with a different function – could explain the unemployment–birth
rate correlation. If the economic downturn does increase subjective uncertainty, then
everybody, not just those losing their jobs might delay having children. Yet, while many
variables might cause a divergence between aggregated or ecological and individual-level
correlations, it will be hard to know for a given question whether any of these are at work,
especially for the incidental user of aggregated data.
In the next sections of this chapter we elaborate on the use of ecological correlations
from a descriptive and a normative perspective. We first report evidence to demonstrate
that lay people are insensitive as to whether correlations are based on aggregated or
individual-level data. Then, we will illustrate that such ecological inferences are potentially
smart, and though error-prone, provide a good guess about individual-level correlations.
THE USE OF ECOLOGICAL CORRELATIONS IN LAY PEOPLE
The technical term ecological correlations might obscure how prevalent they are as part
of everyday life, especially in the media. The BBC coverage of the change in birth rates is
but one example. Another widely covered article (Preis et al. 2012) found that the coun-
trywide tendencies to Google for dates in the future, as compared to dates in the past, are
positively related to a country’s gross domestic product (GDP). Conclusions such as ‘a
focus on the future supports economic success’ (Preis et al., 2012, p. 2) were readily recited
in the media (Wall Street Journal 2012; Guardian, 2013). But, again, what do readers
conclude from such coverage?
Ecological Inferences when Individual-level Data are Unavailable
Before reviewing a host of pertinent laboratory research, let us present a brief and
straightforward survey of what incidental consumers of the BBC news coverage conclude
from the birth rate article. Shortly after the article appeared under the headline ‘Europe
birth rates “have fallen” since economic crisis’, we had UK citizens (N 5 159) recruited
online read either the headline or the entire article. The article included a figure similar
to the one presented in Figure 5.1. Subsequently, participants were asked to answer the
following question: ‘Who is more likely to delay having children?’ Respondents had three
options: ‘The employed’, ‘The unemployed’ or ‘Don’t know’.
A majority of readers of the headline (see the white bars in Figure 5.2) concluded that
the unemployed would be more likely to delay having children. Only a few concluded
that this was true for the employed or that they did not know. After only reading the
headline, though, this pattern might results from a shared stereotype of what influences
family planning. More interestingly, for those participants who were confronted with the
whole article, including the ecological correlation, this trend intensified, c2 (2) 5 8.25, p 5
.016. That is, even though the correlation presented was not based on individuals, it made
readers more certain that their conclusions about the correlation between employment

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‘Who is more likely to delay having children?’

100%
BBC article
80%
BBC headline
60%
40%
20%
0%
Unemployed Employed Don't know
Note: BBC headline 5 participants just receiving a headline stating ‘Europe birth rates “have fallen” since
economic crisis’.
Figure 5.2 Responses to being confronted with an ecological correlation across countries
(BBC article) between the change in unemployment rate and the change in
birth rate
and parental status for individuals were correct. Of course, the conclusion is intuitively
plausible and the argument well presented. Thus, the more general question is whether
people draw similar conclusions in more controlled settings or when incentivized to be
accurate.
More systematic evidence for the use of ecological correlations by lay people stems
from a series of controlled laboratory experiments. In one experiment (Vogel et al. 2013),
we presented participants with information about a fictitious city. The graphical display
drew on online newspaper formats. Participants saw a schematic map of the city, which
was separated into nine districts. For each of the districts, there was information about
the percentages of citizens belonging to an ethnic majority or an ethnic minority group,
as well as about the percentage of people satisfied (versus dissatisfied) with their lives.
As our critical manipulation, we varied the ecological correlation across districts. For
half of the participants, the percentage of satisfied people increased with the number of
majority members across districts. For the other half of participants, the percentage of
satisfied citizens decreased with an increase of majority members. Asked about individual
citizens, participants in the latter group judged majority members as less satisfied with
their lives than minority members. This finding reversed for participants in the former
group, who had been exposed to a positive ecological correlation between majority group
and life satisfaction. A second experiment, using an interactive map corroborated this
notion. The interactive format required participants to request the relevant information
by clicking on the respective areas. Only participants who were motivated to compare
different areas with regard to the relevant information learned the ecological correlation
and transferred it to the individual judgments. Hence, using ecological correlations do not
seem to reflect cognitive laziness. Instead, using ecological correlations requires attention
to statistical regularities, which are taken to represent individuals as well.

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The media often provides us with aggregate rather than individualized data. As is
evident from the experiments reported above, consumers of such content readily use the
provided ecological correlations to predict individual behavior or attributes. Yet, what
happens when individual-level correlations are available?
Ecological Inferences in Spite of Individual-level Zero Correlations
We might conjecture that the use of ecological correlations as a proxy for individual data is
a necessary evil owing to missing individual data. Indeed, in the case of missing informa-
tion, lay people as well as scientists use the ecological correlation as a best guess. However,
would we expect lay people to continue relying on ecological correlations in the presence
of individual data? This is what a plethora of experimental learning studies suggests (for
a review, see Fiedler et al. 2009).
In one of the first studies to test the use of ecological correlations, Fiedler and Freytag
(2004) presented participants with information about psychiatric patients. Participants
learned about each patient’s test score on two personality tests, called type X and type
Y. Across individuals, high scores in one test implied neither an increased or a decreased
chance of a high score on the other test. In technical terms, the correlation between the
test scores across individuals was zero.
Yet, there was also an ecological correlation. Patients were additionally classified as
belonging to one of two groups or ecologies: those for which previous psychotherapy had
been successful and those for whom it had been unsuccessful. Among the successfully
treated patients, high levels of both personality traits were three times as frequent as for
patients with unsuccessful prior treatment. This created a perfect ecological correlation.
The mean levels of both personality traits varied hand in hand across groups. The critical
finding was that participants expected individuals with a high score on personality trait
X to have a high score on trait Y. Thus, even with individual-level data easily accessible, a
zero correlation is ignored and substituted with a positive ecological correlation.
Ecological Inferences in Spite of Conflicting Individual-level Correlations
Thus far, we have considered evidence for ecological correlations being used to infer cor-
relations across individuals. We have implied that this correlation is the same within the
different ecologies. For example, there was a zero individual-level correlation between the
personality traits within both groups, for patients with successful and for patients with
unsuccessful prior therapy. Yet, this might not always be the case.
Another related yet different type of ecological inference fallacy has been demonstrated
when the individual-level correlation for an entire population is different from the indi-
vidual-level correlations within ecologies of this population. This constellation, in which
different or even reverse individual-level correlations exist within ecologies, is known as
Simpson’s paradox (Simpson 1951). Studies typically found that participants act as if they
do not take the ecological variable into account reproducing the overall correlation across
the entire population (for example, Schaller 1994).
This neglect of an ecological variable seems at odds with claiming there is a strong
influence of ecological correlations. Intriguingly, evidence that has been used to support
the idea that the ecological variable is neglected in a Simpson’s paradox can equally well

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be reconciled with the more recent idea that ecological correlations, not overall individual-
level correlations, are used.
Meiser and Hewstone (2004) provided evidence that favors this ecological correlation
explanation. In a setup typical for a Simpson’s paradox, their participants were presented
with a series of positive and negative behavioral descriptions involving members of two
groups, A and B, distributed over two towns, X and Y. While the individual-level correla-
tion was positive across all individuals, say, being from group A was predictive of behaving
positively, it was negative within both towns. Such a setup, however, implies that in one
town group A members and in the other group B members form the majority. At the same
time, one town is characterized by many and the other by few positive behaviors. Thus, in
creating the Simpson’s paradox, an ecological correlation results between being a member
of group A and positive behavior. This is because the average ‘group-A-ness’ for a town
is perfectly predictive of the average positivity.
When asked to make predictions about individuals belonging to either of the groups
and residing in either of the towns, participants predicted group A members to be more
likely to behave in a positive way, contrary to the correlation actually observed within the
towns, but in line with both the ecological correlation and the individual-level correlation
neglecting the town variable. Thus, either participants neglected the ecological town vari-
able and made judgments based on an individual-level correlation or they relied on the
ecological correlation. Speaking in favor of the ecological correlation explanation, it was
particularly those participants who had accurately learned the ecological correlation, that
is, which town was characterized by a majority of group A members and a prevalence of
positive behaviors, who exhibited this tendency.
Thus, the failure to ‘solve’ the rather complex Simpson’s paradox might not reflect an
attempt to simplify the task by neglecting a confounding ecological variable. It might
instead reflect a genuine attempt to use the ecological correlation as a smart and parsi-
monious proxy for individual-level correlations.
Ecological Inferences in Spite of Monetary Rewards
Converging evidence for the use of ecological correlations stems from even simpler operant
conditioning experiments where accurate responses were rewarded with money (Kutzner
et al. 2008). In these experiments, only one ‘ecology’ with two variables was encountered.
Participants were repeatedly asked to predict whether a ‘left’ or a ‘right’ response was the
correct reaction after one of two signals, a high- and a low-pitch sound. The sounds were
not predictive of which was the correct reaction, that is, on the individual trial level there
was a zero correlation between sound and correct reaction. At the same time, the whole
setting or ecology that participants encountered was special. One of the sounds, say the
high-pitch sound, preceded responses clearly more frequently than the low-pitch sound
and, irrespective of the sound presented, one of the responses, say ‘left’, was rewarded
clearly more frequently than the other. This strangely ‘skewed’ ecology contrasts with an
‘ignorant prior’ ecology where signals and correct reactions can be expected to be evenly
distributed. As compared to this ignorant prior ecology, there is again a perfect ecological
correlation. Knowing the mean value of the high-pitch sound in one ecology is perfectly
predictive of mean value of ‘left’ being the correct response.
The choice pattern in this operant conditioning scenario is in line with the use of an

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ecological correlation (see Fiedler et al. 2013 for a discussion of ecological inferences in
single ecologies). Even though choices tended towards the more frequently rewarded
option, this trend was less pronounced for the less frequently presented sound, signifi-
cantly reducing participants’ payoff (Kutzner et al. 2008). Many more experiments testify
to the use of ecological correlations that did not use monetary incentives but social incen-
tives, calling on participants to form accurate and non-discriminatory impressions about
others (McGarty et al. 1993; Eder et al. 2011; Kutzner et al. 2011).
Ecological Inferences in Both Directions
Given the robustness of inferences from ecological to individual correlations, the question
is whether people are actually insensitive to the level of data aggregation or whether they
are simply not able to assess individual-level correlations. In the end, ecological correla-
tions require assessing less information saving time and processing costs.
To answer this question we conducted two experiments (Vogel et al. 2014). We provided
participants with information about the level of product demand in two supermarkets.
Different ecologies were created in terms of eight different product segments (for example,
cheese, fruit). A first study replicated evidence for the use of an ecological correlation.
Participants acted as if high demand for a specific product in one supermarket was
predictive of high demand for that product in the other supermarket. Yet, demand on
product level was not predictive. Across the product categories, however, high average
category demand in one supermarket predicted high average category demand in the
other supermarket. In the second study, the reverse was true. Here, demand across product
categories did not correlate between supermarkets but demand for individual products
did.1 In that case, participants correctly identified the individual product-wise correla-
tions. Additionally, participants also acted as if there was a correlation across ecologies,
predicting higher average demand for product categories that had been highly demanded
in the other supermarket. These experiments suggest that people substitute ecological cor-
relations for individual-level ones just as readily as they substitute individual-level correla-
tions for ecological ones, committing the so-called atomistic fallacy (Diez-Roux 1998). In
that participants correctly identify existing individual-level correlations but readily and,
in this case, incorrectly generalize them to a higher level of data aggregation, the results
demonstrate a genuine insensitivity to the level of data aggregation.
In sum, examining results across a variety of paradigms, inferences about correlations
have revealed that people are insensitive as to whether aggregated or individual-level
data provides the input to their judgments. Further studies have extended this evidence
to content domains including scholastic achievement (Fiedler et al. 2007) and political
attitudes (Vogel et al. 2013). Together, these studies demonstrate the robustness of the
use of ecological correlations as a proxy for individual-level correlations by lay people. It
appears that whenever there is an ecological variable (for example, countries) allowing for
the grouping of individual observations, lay people will consider the ecological correlation
to learn about the individual-level relationship.

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THE SMART POTENTIAL BEHIND ECOLOGICAL

CORRELATIONS
Given the resilience of the use of ecological correlations or, more generally, the indiffer-
ence between aggregation levels, a pressing question is whether this indifference is poten-
tially smart or, broadly speaking, rational?
Parsimony
Using ecological correlations to infer individual correlations is parsimonious. To make

inferences, only the base rates of variable (how relatively frequently things happen) have to
be assessed. This assessment can be based on experience gathered on different occasions.
It is not necessary to wait for or remember combined observations of, for example, people
becoming unemployed and becoming a parent. Such a complete data matrix, as ideally
assumed in statistics books, is hardly ever available to the lay decision maker in real life.
To illustrate, consider trying to assess which of four dichotomous variables are predic-
tive of happiness. The four zero-order correlations already result in combining, recording,
and remembering 16 types of observations (four for each correlation). Trying to avoid a
Simpson’s paradox, taking into account each of these variables as moderating the others’
influence, creates 24 correlations (96 types of observations) to be handled (four variables
related on each level of the other three variables).
Beyond complexity that might prevent accurate processing, the data might not be avail-
able at the time of judgment. Trying to assess the correlation for a novel variable, say,
engaging in volunteer work, might simply be impossible because the relevant observations
have not (yet) been gathered. However, the base rate of people that volunteer in a given
ecology should be recorded and recalled quite automatically (Hasher and Zacks 1984).
Using these readily available base rates, ecological inferences seem designed to enable
inferences about novel correlations.
In sum, ecological correlations pose relatively low demands on either cognitive
resources or the amount of data that has to be available. Thus using ecological correla-
tions to infer individual correlations satisfies one of the components of being a smart
inference strategy: they are feasible and efficient.
The Validity of Ecological Correlations: The Case of Happiness
Feasibility and efficiency alone, however, do not render an inference strategy smart. Only
if the strategy used has some degree of validity can it be justified. Confounding variables,
as in the case of the Simpson’s paradox, threaten the validity of taking ecological cor-
relations for individual level correlations. Yet, checking for the presence of confounding
variables usually amounts to making sure there is no needle in the haystack.
A pragmatic workaround to the elusive analytical answer to the validity of ecological
correlations in general is to quantify their validity for a specific question. Such an analysis
is presented below. This analysis is but an example of how the validity of ecological cor-
relations can be quantified. It makes no claim to their validity in general. Instead, it could
inspire the classification of questions into those for which ecological inferences are valid
and those for which they are not.

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The strategy put forward to assess the validity of using ecological correlations is simple.
In essence, it compares the correlation of a criterion with a meaningful predictor assessed
across individuals with the same correlation assessed across ecologies. This comparison
is repeated for multiple predictors and multiple ways to form ecologies in the same data.
Ecological correlations are deemed valid to the degree that the comparisons show corre-
spondence between ecological and individual-level correlations in sign and size.
To do so for a given question, we had to select (1) a criterion for which individual-level
data are available, (2) variables used to predict or correlate with this criterion and (3)
ecologies or ecological variables across which ecological correlations are computed. All
of these selections will possibly change the validity of ecological correlations. Therefore,
the resulting selection should be as representative as possible of what lay decision makers
would do to make inferences important to them.
As a criterion we selected happiness. Happiness studies have enjoyed a privileged status
among scientists, resulting in representative large-scale surveys optimal to assess individ-
ual-level correlations.2 Prominent philosophers from Socrates, Meister Eckart (Meister
Eckart and Davies 1995) and Mill (1863) to the Dalai Lama (Dalai Lama and Cutler
1998), but also economists (for example, Anielski 2007), lawyers (Bronsteen et al. 2015)
and psychologists (for example, Maslow 1962; Seligman 2002) have dedicated their work
to the identification of the very predictors of this arguably ultimate goal. Lay people,
pursuing hedonic or utilitarian motives, are also likely to reason about the correlates of
happiness to finally infer what causes it. At the operational level, we used happiness as
represented in the sixth European Social Survey’s (ESS) question C1 ‘Taking all things
together, how happy would you say you are?’ ranging from ‘00 Extremely unhappy’ to ‘10
Extremely happy’.
To select predictors of happiness we relied on variables prominent in the scientific psy-
chological literature. We selected health, social integration, income, religiousness, personal
freedom, educational achievement and gender. Note that some of the documented cor-
relations seem robust and strong, such as those for health and social integration, whereas
others are feebler, such as those with income or gender (for a review, see Diener et al.
1999).
Selecting ecological variables, we tried to reflect social categories that people might
spontaneously think of when thinking about happiness. We included social categories that
are generally considered readily available when thinking about the social world, such as
nationality, gender and age (Gavanski and Hui 1992). We also tried to capture ‘warmth’
and ‘competence’, variables that are usually considered fundamental dimensions in social
perception (Fiske et al. 2002). As proxy for warmth we used what a person’s main occupa-
tion is, including housework, work, being in school or retired. As proxy for competence
we used a person’s income group.
Our selection resulted in eight correlations with happiness, which we calculated five
times, once at the individual level and four times for the four ecological variables. These
ecological correlations include, for example, people thinking about, or being confronted
with, data indicating that middle-aged people are, on average, least free and least happy.
Would it be smart for decision makers to infer that high personal freedom is likely to go
along with high personal happiness?
In Table 5.1 we present the results for one nation, Slovenia. We focus on evidence
within one nation because we assume that people’s information will be biased towards

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Table 5.1 Correlation table for predicting high levels of happiness in Slovenia
Units of observations Individuals Income Nationality Main Age Gender Mean

Predictors (N 5 1257) (N 5 5) (N 5 29) occupation (N 5 5) (N 5 2) validity
(N 5 5)
Good health 0.69 1.00 0.70 0.80 0.93 −1.00
High income 0.56 − 0.34 0.91 0.84 −1.00
Good social integration 0.54 0.98 0.74 0.96 0.97 −1.00
High freedom 0.50 0.80 0.62 −0.24 −0.76 1.00
High edu. achievement 0.25 1.00 −0.05 0.29 0.57 −1.00
High religiousness 0.16 −0.86 −0.19 −0.61 −0.63 1.00
Being female 0.04 −0.97 – 0.08 −0.64 –
Higher age −0.38 −0.98 −0.19 −0.75 – 1.00
Validity for Slovenia

% correct sign 71 63 75 50 25 57
Rank order agreement 0.83 0.83 0.78 0.65 −0.61 0.49
Validity for all 29 countries

% correct sign 75 62 77 56 48 64
Rank order agreement 0.72 0.84 0.71 0.51 0.02 0.56
Note: Ecologies with N 5 5 are based on quintile ranks, except for ‘Main occupation’ which represents the
groups’ paid work, education, housework, unemployed and retired. Rank order agreement 5 correlation with
individual correlation coefficients.
their local social circle (Galesic et al. 2012). We focus on Slovenia because it represents a
modal pattern of results for the validity of ecological correlations among the 29 countries
we analyzed.
As visible in the first column of Table 5.1, results largely replicate research on what
correlates with happiness. Strong individual-level correlations can be found with health,
income and social integration, whereas small correlations result for gender and even a
negative one for age.
These results also provide insights into the validity of ecological correlations. Consider,
first, the ecological correlations with happiness across income ecologies. Even though
treating an income group as ‘ecology’ might sound strange, contrasting rich and poor
people when thinking about happiness might not. For example, we might conclude that
health is lowest for those with little income and highest for those with high income. We
might observe that happiness is also lowest for those with little income and highest for
those with high income. In this case we have an ecological correlation between happiness
and health across income groups.
When computing exactly this ecological correlation for Slovenia, a perfect correlation
of r 5 +1 results across the five income quintiles. As visible in Figure 5.3(a), every move
upward in income goes along with a joint move upward in health and happiness. As com-
pared to the r 5 .69 individual-level correlation between health and happiness (see the first
column in Table 5.1), this ecological correlation is inflated but has the same sign. Yet, we
also found evidence for the ecological and individual-level correlations to also diverge in
sign. As visible in the first column of Table 5.1, being religious is correlated at r 5 +.16

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(a) Health-happiness correlation across income quintiles

8.0 Mid high
Mean happiness (0–10)
High
7.5 Average
7.0
Mid low
Low
6.5
3.4 3.6 3.8 4.0
Mean health (1–5)
(b) Religiousness-happiness correlation across income quintiles

High
Mean happiness (0–10)
8.0 Mid high
7.5 Average
7.0
Mid low
Low
6.5
2.6 2.7 2.8 2.9 3.0
Mean religiousness (1–5)
Source: Data from the sixth ESS survey for Slovenia.
Figure 5.3 (a) Ecological correlation across income groups (quintiles) between health
and happiness; (b) ecological correlation across income groups (quintiles)
between religiousness and happiness
with happiness in Slovenia. When analyzed across income quintiles, a lower mean level
of religiousness almost always goes along with a higher mean level in happiness, r 5 –.86.
Overall, however, five of seven predictors,3 71 percent, correlate in the same direction
with happiness across income groups and across individuals. Additionally, the relative
importance of the different predictors of happiness at the individual level should optimally
also reflect in the ecological correlations. Comparing the ranks of the correlation coef-
ficients in the first and second columns in Table 5.1 seems to support this. If a predictor’s
coefficient has a high rank when computed at the individual level it tends to have a high
rank among the ecological correlations as well. The correlation of correlation coefficients
amounts to r 5 +.83 (see rank order agreement in Table 5.1). Thus, at least across income
groups as ecologies, not only the sign but also the relative importance of the predictors
tends to be preserved when going from individual level to ecological correlations.
Similar levels of validity can be found when considering different ecological variables
such as nationality, main occupation, and age (see third to fifth columns in Table 5.1). The
only exception is gender where the validity in terms of detecting the correct sign or rela-

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tive importance is systematically off. There might be various reasons for this. Foremost,
the difference in happiness between genders is, if present in the population, very small in
the data set. This might render any ecological correlation computed across two gender
categories an unsystematic chance gamble between +1 and –1. More substantially, for
some correlations gender is likely to be a confounding variable. For example, as being
female tends to be related to lower income but females are slightly happier in the data set,
a perfect negative correlation between income and happiness across gender groups mainly
reflects the correlation between income and happiness.
In summary, for our representative case of Slovenia relying on ecological correlations
to infer individual-level correlations has a high degree of validity for inferring which
variables correlate with happiness and in what direction. Inferring the sign allows for 57
percent of correct predictions overall. Rank ordering the size of the correlations amounts
to a validity of r 5 +.49.
To generalize these results to the other countries in the data set, we averaged the valid-
ity indices separately for the five ecological variables across all 29 countries included in
the ESS survey. As visible in the bottom lines of Table 5.1, on average the validities are
even higher, allowing for 64 percent of correct sign inferences and a rank ordering with
a validity of r 5 +.56. Only ecological differences across gender, possibly for the reasons
discussed above, are on average uninformative for individual-level correlations. Further,
for every country there is an overall positive validity in terms of the percentage of correct
sign inferences and the rank ordering. The percentages and rank correlations range from
52 percent in Sweden and .00 in Iceland, to 88 percent and +.91 in the Czech Republic.
Where does this leave us – is the glass half empty or half full? As is obvious from the
imperfect rank correlations, decision makers using ecological correlations will sometimes
mis-estimate the importance of a given predictor, and as evident from the percentage of
sign inferences, ecological correlations also leave space for sign errors. However, in our
data, ecological correlations are well above chance performance when inferring the sign
and relative importance of individual-level correlations. Thus, to infer which variables
correlate and how they correlate with happiness on an individual level, ecological correla-
tions seem to be a valid inference tool overall. Of course, this analysis cannot be more
than exemplifying evidence. Yet, it illustrates the potential validity of ecological infer-
ences for variables meaningful to the passing consumer of information. These arguments
add to the claim, though cautiously, that using ecological correlations represents a smart
strategy. More systematic analyses of the circumstances under which they are smart are
an endeavor for future research.
CONCLUSIONS
This chapter deals with the use of ecological correlations as a proxy for individual-level
correlations as a smart or, broadly speaking, rational inference strategy. In the first part
we demonstrate that people, from passing consumers of newspaper articles to monetarily
incentivized participants in laboratory studies, use correlations that are computed across
ecologies, such as nations, supermarkets or social groups, to infer correlations at the indi-
vidual level. This might be owing to the relative parsimony of ecological correlations in
terms of the processing demands and the demands on the available data. In the second

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part, we show that in the example of inferring what variables correlate with happiness,
using ecological inferences seem to be a valid strategy.
Even though the case of ecological correlations might seem technical at first, our
current social and informational world is ripe with aggregated information inviting their
usage. Many different internet-based services, such as Google and Twitter allow for access
to their aggregated user data. For example, using Google Trends (http://www.google.com/
trends/), everybody can, within minutes, visualize on a map how the propensity to search
for, say, ‘sushi’ differs between regions in the US, and how this compares to the propensity
to search for, say, ‘democrats’. If similar colors are generated on a map, an easily accessible
form of ecological correlation is born. Most government-based statistical services, such
as Eurostat or the European Social Survey, and government agencies now provide similar
access. For example, the London police (http://maps.met.police.uk/) offer results for
recent crime statistics mapped out across different suburbs, ready to be ‘ecologically’ cor-
related with, for example, knowledge about the population composition of these suburbs.
Concluding, using ecological correlations to infer individual-level correlations appears
to be a valid inference strategy in the absence of adequate data or processing abilities. Yet,
it is to some degree error-prone. Whether this probabilistic inference strategy is smart, ulti-
mately depends on the costs, social or material, incurred by inferring wrong correlations.
NOTES
* The research underlying this paper was supported by a grant from the Deutsche Forschungsgemeinschaft
(KU – 3059/2-1).
1. The distribution used in Vogel et al. (2014) is compatible with an ecological variable moderating the correla-
tion between two variables, that is, individual correlations actually differ between ecologies. There are many
examples for this kind of aggregation bias in the economist literature (for example, Jaworski and Kohli 1993;
Grewal et al. 2013). For the sake of simplicity, in this chapter, we only consider divergence between ecological
correlations and individual contingencies pooled across ecologies, but omit discussing heterogeneity regard-
ing within ecology correlations.
2. For the subsequent analyses, we rely on the sixth round of the European Social Survey conducted in 2012
with 54 637 respondents in 29 countries (including Switzerland, Russia and Israel).
3. We removed the correlation of income across income groups from the analysis. Even though possible to
compute, an ecological correlation of average income across income groups seems implausible. Also, result-
ing high correlations seemed to artificially inflate the validity scores. The same was true for age and gender.
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6 Heuristics: fast, frugal, and smart
Shabnam Mousavi, Björn Meder, Hansjörg Neth and
Reza Kheirandish
Recent years have seen important new explorations along the boundaries between economics
and psychology. For the economist, the immediate question about these developments is whether
they include new advances in psychology that can fruitfully be applied to economics. (Simon
1959, p. 253)
INTRODUCTION
Individuals often make smart decisions despite the inherent limitations of cognitive and
material resources. Whereas mainstream economics has focused mainly on the alloca-
tion mechanisms of material resources by cognitively unbounded (fully rational) agents,
behavioral economics aims to include allocation of cognitive resources by using the
insights from the heuristics and biases program in psychology (Kahneman et al. 1982).
In this chapter, we introduce another psychological program with a more optimistic per-
spective inspired by Simon’s view of bounded rationality and developed systematically in
the study of fast-and-frugal heuristics (Gigerenzer et al. 1999).1 We make a distinction
between human decision making in two situations: under uncertainty, in which case we
reason that simple heuristics are successful strategies, and under risk, in which case we
discuss the enhancing role of risk literacy and statistical thinking (for the ways in which
information is processed and knowledge created under risk versus under uncertainty, see
Mousavi and Gigerenzer 2014, Table 1; and for the realms of rationality see Neth and
Gigerenzer 2015, Table 1). Our goal is to make sense of smart and efficient decision-
making processes demonstrated by individuals who use their evolutionary developed and
learned capacities.
Which recent advances in psychology are important to economic theory and behavioral
economics? This chapter has emerged from a series of dialogues between two psycholo-
gists and two economists exchanging views on the study of fast-and-frugal heuristics as it
pertains to the methods of understanding economic behavior and decision making. Our
discussions developed before a backdrop of what we view as the thrust of our fields as
well as their overlaps in relation to formal treatments of human behavior. What econo-
mists now practice and profess as the basis and criterion for rigorous study of economic
behavior traces back to the normative interpretation of subjective utility.2 Psychologists,
by contrast, have often searched for systematic patterns of behavior in laboratory and case
studies, often formulating models without subscribing to or aiming for accordance with
universal maxims of behavior. The heuristics and biases research program (Tversky and
Kahneman 1974) commenced with an inquiry into uncovering general cognitive mecha-
nisms. Mainstream behavioral economics has combined the findings of this psychology
program with the maxims of economics. The resulting body of work has been valuable in
101
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crossing disciplinary boundaries, inspiring scientific inquiry into untapped domains and
generating potential for further discoveries. At the same time, like any other field of study,
behavioral economics has carried baggage from its mother discipline, which generated
byproducts and implications for methods of research. Our assertion is that the study of
the ecological rationality of fast-and-frugal heuristics (Gigerenzer et al. 1999) can provide
important insights and tools for alternative and complementary analyses of behavior.
The framework of fast-and-frugal heuristics can be distinguished from the heuris-
tics and biases approach by the following characteristics and standpoints. In our view,
heuristics are indispensable strategies for successfully dealing with uncertain situations
in the real world. Notably, most real-world situations do not allow identification of all
alternatives, consequences, and probabilities, even subjectively, as required for finding the
optimal solution. Moreover, the best solution from a social perspective does not neces-
sarily accord with rational choice based on self-interest (for example, public goods). For
these reasons, smart decision makers regularly develop and use heuristics, relying on the
wisdom and experience that simple heuristics can outperform supposedly optimizing
strategies in uncertain situations. More often than not, satisficing with respect to a good
enough aspiration level turns out to be both rational and smart for boundedly rational
agents. It is thus not irrational but intelligent to be less than fully rational, in the neoclas-
sical sense, in many decision-making situations.
A two-way influence and exchange between psychology and economics can build upon
shared notions such as ecological rationality of simple heuristic strategies. This is the
core around which we have structured this chapter. We start with juxtaposing economic
and psychological views of ecological rationality (based on interviews with Vernon Smith
and Gerd Gigerenzer, both leading researchers in their respective fields), pointing out
the overlaps between the two views, and then extend questions pertaining to behavioral
economics as a set of suggestions for advancing the dialogue between economics and
psychology. Viewing heuristics as adaptive tools for decision making is discussed next.
Although heuristic strategies can be used both under uncertainty and under risk, the sim-
plicity of heuristics makes them particularly successful under the irreducible uncertainty
of many decision situations. This point is illustrated by connecting the Knightian distinc-
tion between risk and uncertainty to inferential rules, amended by heuristics. The practi-
cal success of simple heuristics is then illustrated in the domains of financial investments
and business decision-making. Next, we consider potential implications of ecological
rationality in two applied scenarios: the current debate on nudging and the use of natural
frequencies in risk communication. We close by providing a brief summary and extending
our collaborative challenge to economists.
WHERE ECONOMIC RATIONALITY MEETS PSYCHOLOGY
In his Nobel Prize lecture, Vernon Smith (2002) focused on two forms of rationality in
economics and their functions with respect to the understanding of human behavior.
The first form is constructivism, which is rooted in Hume’s and British empiricism; here
the study of human behavior starts with observing an outcome and then reconstructing
the steps with which such an outcome can be generated through a deliberate reasoning
process. This reconstruction provides a variety of possibilities and options to choose

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Heuristics: fast, frugal, and smart 103
from, which are not sufficient for the realization of action. For that reason, Smith points
out that ‘constructivism alone leads nowhere; its roots must find ultimate nourishment
outside of [such] reason. Outside means knowledge derived from experience, from social
interactions, and from unconscious sources and processes – the nexus that I have called
ecological rationality’ (Smith 2008, p. 287). Interestingly, this second form of rationality,
the notion of ecological rationality in economics, is shared with the psychological study
of fast-and-frugal heuristic decision-making:
The term ‘ecological rationality’ has been used fittingly by Gigerenzer et al. (1999) for applica-
tion to important discoveries captured in the concept of ‘fast and frugal decision making’ by
individuals: ‘A heuristic is ecologically rational to the degree that it is adapted to the structure of
an environment.’ (p. 13). My application of the term is concerned with adaptations that occur
within institutions, markets, management, social, and other associations governed by informal
or formal rule systems – in fact, any of these terms might be used in place of ‘heuristic’ and this
definition works for me. (Smith 2008, p. xix)
The similarities and some specific connections between the research traditions estab-
lished by Vernon Smith in economics and Gerd Gigerenzer in psychology that evolve
around this shared notion of ecological rationality and lead to a functional view of
heuristics are juxtaposed in Table 6.1 (for a juxtaposition of Smith’s and Kahneman’s
approach to the theory and modeling of human behavior, see Altman 2004). Moreover,
Table 6.1 provides two items under each connected notion. The first item illustrates the
overlap between the two views, and the second outlines research questions that relate the
particular preceding topic to the core of behavioral economics inquiry.
In the study of human action, Smith calls for supplanting the traditional constructivist
framework of rationality with the ecological one. In a similar vein, Gigerenzer calls for
‘a better understanding of human rationality than that relative to content-blind norms’
(2008, p. 19). Constructivist rationality derives normative benchmarks from formal frame-
works such as logics and probability theory, where the situation in which a choice is made
is abstracted from its content. Thus, these norms are blind to the content of the decision-
making situation. Regrettably, ‘these were of little relevance for Homo sapiens, who had
to adapt to a social and physical world, not to systems with artificial syntax, such as the
laws of logic’ (Smith 2008, p. 19). In cognitive science, the study of error has fallen prey
to a major error by maintaining norms of logic and statistics, which despite their coherent
and consistent elegance, and at the price of preserving this elegance, could lack meaning-
ful association to evaluation of human decision-making behavior.3 Pointing out that this
is an unjustified extension from the study of perceptual errors to the cognitive domain,
Mousavi and Gigerenzer (2011; see also Gigerenzer 1991, 1996) argue for adopting and
developing content-sensitive norms for the study of human cognition and behavior. For
example, when the famous Wason selection task (Wason 1966) is given content by assign-
ing two roles of employee and employers to the players who both are tasked with cheating
detection, one group’s correct strategy aligns with the logical truth table associated with
the conditional, but the other does not. Thus, logic appears to capture one part of the
content and miss the other part. In this case, if judgment is evaluated based on logical
truth, one group appears to have wrong judgment, whereas their judgment is completely
correct with respect to the role (content) that they are assigned (Gigerenzer and Hug
1992). Thus, what counts as human rationality depends on the content and domain,

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Table 6.1 Ecological rationality and heuristics à la Smith (economics) and Gigerenzer
(psychology)
Fast-and-frugal heuristics program Constructivist versus ecological rationality in

economics
A heuristic is ecologically rational to the Ecological rationality is concerned with
degree that it is adapted to the structure of adaptations that occur within institutions,
an environment markets, management, and social and other
Humans have to adapt to a social and associations governed by informal or formal rule
physical world, not to systems with artificial systems
syntax, such as logic
Overlap between psychology and economics: same definition of ecological rationality, when
heuristic can be replaced by markets, management, or other rule systems
Research questions for behavioral economics: what is the relationship between rule systems and
heuristics? Do they overlap, or is one nested in the other? What can be learned from establishing
such characterizations?
Unbounded rationality can generate optimal Constructivism or reason provides a variety of
solutions for simple situations, e.g., tic-tac- ideas to try out but often no relevant selection
toe; omniscience and omnipotence can also criteria, whereas ecological process selects the
be used for theoretical examination of human norms and institutions that serve the fitness needs
behavior, but applying them as universal of societies
standard of rationality is a scientific error
Overlap between psychology and economics: Norms produced by unbounded or constructivist
rationality are not useful as selection criteria in complex situations; the ultimate evaluation comes
from the real world, not from theoretical sophistication
Research questions for behavioral economics: In the study of human behavior where does realism
matter, and where does it not? If norms are chosen conditional to the situation, how can we judge
across situations? Can ecological fitness be formalized?
Experimental games are bound to study Observing how people actually behave reveals
social behavior as rule-obeying behavior unanticipated system rules, e.g., hubs emerged
and not as rule-negotiating or rule-changing unexpectedly (like an equilibrium) when airlines
behavior were deregulated
Overlap between psychology and economics: rules are to be discovered as they emerge from social
behavior. Formal models can be used to provide a possible description of what was observed
Research questions for behavioral economics: to what extent can field experiments improve
the relevance of solution concepts used for the study of human behavior and specify their
limitations?
Fast-and-frugal heuristics are strategies Heuristics are a kind of cognitive capacity that we
triggered by environmental situations and can access, although we are not completely aware
enabled by evolved or learned capacities of our access to it
Overlap between psychology and economics: The choice of heuristic strategy is often not fully
deliberate. This does not exclude the possibility of training or altering the trigger conditions
Research questions for behavioral economics: When is a heuristic successful, and when does it fail?
In real-world situations, when is it not rational to be ‘rational’?
Source: Based on interviews in Mousavi and Kheirandish (2014).

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whereas logic is content-free. Extending on this point, Mousavi and Gigerenzer (2011,
p. 102) argue that ‘cognitive scientists studied judgment errors in order to discover rules
that govern our minds, just as visual errors were studied to unravel the laws of perception.
This practice has generated a long list of so-called cognitive biases, with disappointingly
little insight into how the human mind works’. Alongside Smith (2008, p. 31), we find that
‘[t]he failed objective of this constructivist adventure is cause for joy, not despair’.
Behavioral economics is concerned with making sense of human behavior, with the goal
of developing a framework for analyzing decision-making in real-world situations, and
evaluating and predicting human choice and actions therein. Vernon Smith’s following
remark refers to these tasks directly: ‘Whatever it is that people do, it is evident that they
do not think about the problem the way an economist does, nor do they model it that
way’ (Mousavi and Kheirandish 2014, p. 1784). As Gigerenzer elaborates, ‘the question
is not whether it is good or bad to ignore information but what ignoring information
does psychologically . . . “Why a certain strategy?” and “When does it work?” rather than
assuming “It maximizes something,” and that something may be psychological’ (Mousavi
and Kheirandish 2014, p. 1784). This view, which emphasizes the interplay between heu-
ristics and environments, and relies on the notion of ecological rationality to evaluate the
rationality of human behavior, provides an alternative way for understanding our adap-
tive minds where constructivist rationality reaches its limits.
HEURISTICS AS ADAPTIVE TOOLS FOR DECISION MAKING

UNDER UNCERTAINTY
A prevalent view in both psychology and behavioral economics, the heuristics and biases
program (Tversky and Kahneman 1974), presumes that heuristics result from a trade-off
between accuracy and effort and lead to flawed and biased thinking. Typically, the bench-
marks used to corroborate these claims are formal frameworks such as logic, probability
theory, and expected utility theory. These are presumed to provide normatively correct
solutions, and deviations in human decision making constitute errors. We advocate a dif-
ferent view based on formal models of heuristics. Within the framework of fast and frugal
heuristics (Gigerenzer et al. 1999), heuristics are adaptive tools that ignore information
to make fast and frugal decisions that are accurate and robust under conditions of uncer-
tainty (Neth and Gigerenzer 2015).
Heuristics are successful when they exploit an ecologically rational match to the struc-
ture of information in the environment. In the previous section, we discussed the role of
ecological rationality in understanding the success of simple individual and organizational
strategies in the juncture of psychology and economics. Here, we turn our focus to two
central concepts in the theory of decision-making, namely, uncertainty and knowledge.
The path towards making a decision starts with a disequilibrium that triggers a search
for solutions through processing information to create the knowledge we need (Dewey
1938 [1986]). Traditionally, we model this procedure in two forms, deductive and induc-
tive, depending on the structural properties of the situation to be resolved (Goldman
1988). Also, we acknowledge the unknowns of the situation by specifying alternatives,
consequences, and their probabilities, which leads to a characterization of the risk
associated with the problematic situation. The way in which a problematic situation is

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Table 6.2 Decisions under risk versus uncertainty
Nature of Knightian Decision Method Generated

unknown probability process knowledge
Risk A priori (design; Deductive Use probability Deterministic
propensity) theory to model the knowledge
underlying structure; (as in lotteries);
optimization e.g., objective odds
Risk Statistical Inductive Use statistical Stochastic
(frequencies in (statistical inference; knowledge;
the long run) inference) optimization e.g., estimates of
correlations
Uncertainty Estimate; Heuristic Select a heuristic Satisficing solutions
conduct based that is ecologically when optimizing
on opinion; not rational for a task; is not feasible;
fully reasoned exploratory data intuition (as in
analysis entrepreneurship)
Source: Adapted from Mousavi and Gigerenzer (2014) with permission.
characterized, in turn, shapes and limits the type of solution that can be produced because
it dictates the form of knowledge generated from the processing of information. This is
illustrated in Table 6.2, wherein, in addition to deductive and inductive processes, a third
heuristic process is proposed, which involves a less than exhaustive search for or consid-
eration of information and leads to knowledge that is simply good enough for making a
successful decision, but by no means exhausts information or optimizes across conditions.
Note that the idea is not that these decision processes are mutually exclusive categories.
Rather, the current categorization is meant to shed light on the nature of knowledge used
and created in the process of decision making. For resolving disequilibrium, boundedly
rational agents tend to use different types of strategies compared to fully rational agents
(Simon 1955; Selten 1998). They restore the equilibrium by finding satisficing answers
to their problems in situations with irreducible uncertainty, wherein exhaustive search is
often unhelpful or even impossible.
Heuristic decision-making, based on good-enough reasons to act, characterizes the
observed behavior primarily with respect to a functional (rather than mirror image) match
between the mind of the decision maker, the particular strategy employed, and properties
of the task environment. A large number of situations involving unknowns are character-
ized by what we refer to as fundamental uncertainty that cannot be reduced to risk calcu-
lations. This fundamental uncertainty includes what Knight refers to as an ‘estimate’ and
extends to situations where some options, outcomes, or probabilities are fundamentally
unknown (Meder et al. 2013). Heuristics are then to be viewed as less than fully reasoned
strategies to deal with complexities of such uncertain unknowns by not trying to assign a
probability to (including zero for ignoring) every unknown, but just forming an opinion
that allows an action, what Knight calls an estimate:
Suppose we are allowed to look into the urn containing a large number of black and red
balls before making a wager, but are not allowed to count the balls: this would give rise to

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an estimate of probability in the correct sense; it is something very different from either the
mere consciousness or ignorance on which we act if we know only that there are balls of both
colors without any knowledge or opinion as to the numbers or the exact knowledge of real
probability attained by an accurate counting of the balls. In the second place, we must admit
that the actual basis of action in a large proportion of real cases is an estimate. Neither of
these interpretations, however, justifies identifying probability with an estimate. . ..The exact
science of inference has little place in forming the opinions upon which decisions of conduct
are based, and that this is true whether the implicit logic of the case is prediction on the
ground of exhaustive analysis or a probability judgment, a priori or statistical. We act upon
estimates rather than inferences, upon ‘judgment’ or ‘intuition’, not reasoning, for the most
part. (Knight 1921, p. 23)
Note that heuristics can be applied to a variety of situations. For instance, the priority
heuristic (Brandstätter et al. 2006) provides a lexicographic strategy to choose among
lotteries, the classical paradigm for decision-making under risk. The priority heuristic
chooses between lotteries by comparing their probabilities and outcomes (gains or losses)
lexicographically (that is, one at a time) instead of combining probabilities and gains in
a weighted sum. Surprisingly, this simple model logically implies long-lasting anomalies
of human choice behavior, such as the Allais paradox, the fourfold pattern of risk, and
the certainty effect (Katsikopoulos and Gigerenzer 2008). Also, heuristic methods may
be applied to a wide range of other problems, such as catching a ball. One way of solving
the problem would be to compute the trajectory of the ball and move towards the inferred
landing point, but owing to the number of causally relevant variables (for example, veloc-
ity and wind resistance) and the associated uncertainties, this is difficult to impossible.
However, the problem can be tackled by a relatively simple algorithm according to which
the catcher does not compute the landing point, but focuses on the ball and keeps a con-
stant angle of elevation of gaze while running in the direction (McLeod and Dienes 1996).
This example also illustrates the tight connection between heuristics and evolutionary or
learned capacities. Applying the gaze heuristic requires certain capacities (that is, to fixate a
moving object with your eyes, locomotion, and so on) that are necessary for using the strat-
egy, which are far from trivial and cannot be reduced to merely computing the solution.
The simplicity of heuristics is a feature, rather than a flaw. Heuristics are successful
because of their simplicity, which involves a beneficial degree of ignoring information,
not despite it – something that may puzzle many economists, when trying to make sense
of the observed behavior through the lens of constructivist rationality, but is practiced
regularly by laypeople. Whether the benefits of heuristics come at a prohibitive cost is not
a matter of opinion but should be understood as an empirical question. In the following
we turn to the world of business and finance as an example of an uncertain environment
in which the successful use of heuristic strategies accords with the ecological notion of
rationality.
SUCCESSFUL HEURISTICS IN FINANCE AND BUSINESS

DECISION-MAKING
The previous sections have provided theoretical arguments for a shift towards the norm
of ecological rationality and proposed that heuristics are appropriate tools to tackle

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complex problems under conditions of uncertainty. Given that practitioners care more
about measurable results than about abstract beauty or consistency with axioms, it is not
surprising that some of the strongest examples for successful use of heuristics stem from
the world of finance and business decision making.
Any form of resource allocation faces two fundamental problems: (1) how should we
distribute our assets over all available options, and (2) when should we switch from one
option to another? Theoretically, the asset allocation problem is solved by the Nobel
prize-winning mean-variance model of Markowitz (1952), which provides the optimal
investment portfolio by maximizing profit for a given level of risk. By contrast, a domi-
nant strategy employed by many people is a simple 1/N heuristic that allocates resources
equally across all considered assets. When contributing to retirement savings plans, 1/N
has been called ‘naive diversification’ and is believed to incur substantial costs to investors
(Benartzi and Thaler 2001). However, when DeMiguel et al. (2009) compared Markowitz’s
solution and its modern variants with 1/N, the heuristic performed at least as strongly
as the mean-variance model. One reason for the surprising success of the simple 1/N
heuristic lies in the so-called bias-variance dilemma (Geman et al. 1992), pertaining to
minimizing the prediction error. The prediction error has two contributing components:
bias and variance. The error due to bias has been at the center of behavioral economics,
and has led to enlisting several debiasing techniques. The error due to variance, however,
has not been receiving much attention. 1/N exemplifies a simple allocation mechanism,
which is highly biased but has no variance, and overall generates less prediction error
under certain circumstances. 1/N can be viewed as a special case of the Markovitz model,
which implies that the flexibility of the Markowitz model comes at the potential cost of
an increased estimation error (Neth et al. 2014; see Gigerenzer and Brighton 2009, for a
general discussion of heuristics and the bias-variance dilemma). As the benefits of 1/N
have been shown to generalize to investments in international stock markets and different
asset classes (Jacob et al. 2013) it seems smart of Markowitz to have used 1/N himself,
rather than his own method of portfolio optimization (Benartzi and Thaler 2001, p. 80).
The 1/N heuristic is an instance of a more general equality rule (Messick 2008) that is also
applied in parental investments (Hertwig et al. 2002).
Regarding the switching problem (that is, when and how to switch between different
options), biologists and psychologists have examined simple, yet highly effective stopping
rules in animal foraging theory (Green 1984; Stephens and Krebs 1986) and research on
human multitasking behavior (for example, Payne et al. 2007). An applied instance of a
simple and successful temporal threshold rule is the hiatus heuristic (Wübben and von
Wangenheim 2008), which allows directing marketing efforts by abandoning customers
who have not purchased anything for a certain amount of time, say, a number of months.
This period of time that sets the threshold is called the hiatus.
Interestingly, heuristic models combine explanatory parsimony with higher predictive
power for situations of uncertainty.4 This is in direct contrast with the prevalent method
used by mainstream behavioral economics of adding flexible parameters to Bernoulli
utility functions in order to incorporate psychological factors of observed behavior, which
in turn adds to the complexity of the model but often costs predictive power (Berg and
Gigerenzer, 2010).
The abundance and ubiquity of successful heuristics in applied contexts raises the ques-
tion whether existing heuristics can be used to create new or improve existing strategies.

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One aspect of ecological rationality – as a research program – aims at teasing out the ele-
ments of successful strategies to adapt and refine them to novel situations. In addition,
understanding how, when, and why heuristics work well can guide the design of intuitive
decision systems that fit the strategies that people naturally use. For instance, highly trans-
parent and teachable fast-and-frugal trees (Martignon et al. 2003) have been designed
for coronary care unit allocations (Green and Mehr 1997), for diagnosing patients with
clinical depression (Jenny et al. 2013), and for identifying vulnerable banks in financial
regulation (Aikman et al. 2014; Neth et al. 2014). Thus, successful heuristics are not only
discovered, but can also be specifically designed to create efficient and effective tools.
Next, we demonstrate this transformative potential of ecological rationality in the context
of public policy decisions and the communication of medical risks.
APPLIED LESSONS FROM THE STUDY OF ECOLOGICAL

RATIONALITY
In the following, we extend our discussion of ecological rationality to applied issues. First,
we critically evaluate the idea of nudging, a policy-making tool rooted in the behavioral
economics approach. Subsequently, we discuss probabilistic reasoning and risk literacy
as an example of how successful decision engineering can be guided by psychological
research that takes the match between cognitive processes and the information structure
of the environment seriously. This approach is based on the idea of making people risk
literate to help them make better, more informed decisions, rather than merely nudging
them towards an externally specified goal.
The Risk of Using Nudges in an Uncertain World
How to conceptualize human rationality is not only an academic issue, but has strong
implications for policy making and the question of how to help people make better
decisions. A prominent example is the so-called ‘nudge’ approach, which (in the tradi-
tion of the heuristics and biases program) assumes that people frequently make inferior
decisions because their thinking is fundamentally biased and error-prone (Thaler and
Sunstein 2008). The proposed remedy is to structure the choice situation so that people
are more likely to make better decisions, while retaining freedom of choice (Grüne-Yanoff
and Hertwig 2015). Examples include nudging people towards healthier dietary choices
by arranging food items (for example, in a canteen) such that healthier items are more
readily available, or setting default options in retirement saving plans in a way that people
automatically enroll in higher saving contributions, unless they deliberately opt out (for an
alternative approach to public policy that advocates financial literacy, see Altman 2012).
However, what are the implications of nudges in an uncertain world, where it may not
always be clear what it means to make better decisions? Consider nudges in the health
domain. In the past decades, several countries have set up screening programs (for example,
for breast cancer and prostate cancer), with the long-term goal of reducing cancer-related
mortality rates. The idea behind these programs is to detect cancer in early stages, in order
to treat people earlier and more effectively (or at least more cost-efficiently). A key ques-
tion is how to provide information to the target group to increase participation; one way

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of doing so is to resort to the nudge approach. For instance, different nudges have been
used in the Danish breast cancer screening program to increase participation rates (Ploug
et al. 2012; see Gøtzsche and Jørgensen 2013, for a related analysis of the British NHS
breast cancer screening programme). Women in the target group received an invitation to
participate, along with an information leaflet. The default was a pre-booked appointment,
so that women needed to actively opt out. The leaflet also stated that after evaluating the
pros and cons the Danish National Board of Health recommends participating in screen-
ing. These strategies aim at nudging people towards a goal defined by experts and policy
makers, based on the assumption that it is in people’s interest to participate.
It could be argued that people should be nudged to participate in screening – after
all, is it not to their own benefit to participate if such a program can reduce the risk
of dying from cancer (or at least lead to better treatment with less side effects)? What
remains unclear, however, is whether participating in screening always serves people’s
interests, given that there are different benefits and costs associated. In the case of
breast cancer screening, the (currently) available data show that over a period of ten
years, eight out of 2000 women who do not participate in screening die from breast
cancer, compared with seven out of 2000 women who do participate (Gøtzsche and
Jørgensen 2011). At the same time, however, screening entails potential and harms, such
as overtreatment resulting from false positive test results (for example, unnecessary
removal of the breast). Also, the overall mortality rate (that is, total number of women
dying from all causes) does not vary between women participating and not participating
in breast cancer screening (Gøtzsche and Jørgensen 2013). Yet this crucial information
was omitted from the leaflet of the Danish breast-screening program, thereby under-
mining the possibility to make an informed decision based on considering and evaluat-
ing the potential benefits and harms (see Gigerenzer 2014a; Gigerenzer and Edwards
2003; Gigerenzer et al. 2007).
For other screening programs, such as PSA-based screening for prostate cancer, the
current evidence indicates that the potential harms actually outweigh the potential ben-
efits. Consequently, the US Preventive Services Task Force explicitly recommends against
prostate-specific antigen (PSA)-based screening for prostate cancer (Moyer 2012). This
recommendation was issued after a period of uncertainty in which not enough evidence
was available to determine whether PSA-based screening would be beneficial or not.
These examples highlight critical issues in the foundation and application of nudges. An
important precondition for the nudge approach is the possibility to determine – from the
perspective of the choice architect – which decision is in the best interest of the decision
maker. It may be self-evident that an apple is a healthier choice for a snack than a choco-
late bar, but in other domains, such as medical treatments, determining which choice is in
the decision maker’s best interest may be highly uncertain and dependent on individual
preferences. A woman provided with the currently available evidence on breast cancer
screening may decide that the benefits outweigh potential harms and therefore participate.
However, she may also conclude that the potential harms outweigh the potential benefits
and therefore decide that she would be better off by not participating. In each case, the
decision will depend on how she values the associated benefits and costs. This, in turn,
highlights the importance of providing people with the necessary information to make
informed decisions, relative to their goals, values, and individual preferences, and not
merely nudging them towards an externally specified goal. Importantly, not all informa-

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tion is created equal, and identifying or designing transparent and intuitive information
presentation formats is crucial for both psychology and behavioral economics (see below).
In sum, the nudge approach rests on the assumption that there is one right way to make
decisions, which applies to everybody, and that the choice architect knows what is in the
best interest of the decision maker and can therefore enforce it. While this may well be
true in some cases, we advise against an uncritical application of the approach to policy
making. Nudges may be an effective tool in some circumstances, but like any tool (fast-
and-frugal heuristics included), they can cut both ways and need to be handled with care.
In an uncertain and changing world, nudges may lead to adverse outcomes that are not
in the best interest of decision makers.
In our view, rather than precluding the possibility that people can make good decisions,
the goal should be to develop means for communicating the relevant information in a way
that facilitates people’s understanding of it, so that they can make better, more informed
decisions. From the perspective of the nudge program, educating and informing people to
make them risk literate (Gigerenzer et al. 2007; Gigerenzer and Muir Gray 2011) is likely
to be ineffective, because the assumption (rooted in the heuristics and biases program) is
that human thinking and decision making are fundamentally flawed. This view, however,
neglects recent research that demonstrates how people can be helped to make better
inferences (for example, inferring posterior probabilities, such as the probability of
breast cancer given a positive mammogram) by conveying the relevant information in a
transparent and intuitive way, without being patronizing (Gigerenzer and Hoffrage 1995;
Sedlmeier and Gigerenzer 2001; Meder and Gigerenzer 2014). Similar views have been
presented in other domains. In the equilibrium analysis of financial markets, although an
equilibrium state is always Pareto optimal, this optimality does not necessarily coincide
with the best ‘wanted’ outcome for all agents. This is illustrated in phishing equilibria,
where ‘phools,’ who do not act according to what they want or is good for them, are
systematically ‘phished’. Akerlof and Shiller (2015) argue that when information can
be used systematically in forms that would deceive the consumers, the very structure of
free markets provides opportunity for exploitation, a point overlooked by behavioral
economists,
[C]uriously, to the best of our knowledge, they [behavioral economists] have never interpreted
their results in the context of Adam Smith’s fundamental idea regarding the invisible hand . . .
It’s a major reason why just letting people be Free to Choose – which Milton and Rose Friedman,
for example, consider the sine qua non of good public policy – leads to serious economic prob-
lems. (Akerlof and Shiller 2015, p. 6)
As we discuss next, the use of accessible and intuitive representative formats such as
natural frequencies can improve decision making by enhancing their probabilistic reason-
ing abilities.
Moving Beyond Nudges by Making People Risk Literate
Understanding of and reasoning with probabilistic and statistical information is crucial

for making good decisions. For instance, an informed decision on whether to participate
in a screening program requires understanding of the relevant evidence regarding poten-
tial benefits and harms and the implications of medical test results. The nudge approach

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and the heuristics and biases program that provides its conceptual foundation presume
that people lack this capacity. Since humans are assumed to be biased and error-prone
when it comes to probabilistic thinking, the suggested remedy is to nudge people into
making better decisions.
However, is nudging the only way to help people make better decisions? Also, what
does the psychological literature have to say about people’s capacity to reason with
probabilistic and statistical information? In fact, the psychological literature to date has
given very different answers to these questions. In the 1950s and 1960s, researchers began
investigating experimentally whether people’s inferences correspond (approximately) to
probability theory in general, and to Bayes’ rule in particular. For instance, Phillips and
Edwards (1966) used (incentivized) bookbag and poker chip scenarios, in which they pre-
sented subjects with a sequence of draws that came from either a bag with more red than
blue chips or a bag with more blue than red chips. The question of interest was whether
subjects would update their beliefs regarding the bag in accordance with Bayes’ rule, given
the observed data. This and other studies indicated that the human mind is able to deal
with probabilistic inferences, although it was frequently observed that the amount of
belief revision was not as extensive as prescribed by Bayes’ rule (a phenomenon referred
to as conservatism; Edwards 1968). Peterson and Beach (1967) coined the term ‘man as
intuitive statistician,’ mirroring the Enlightenment view that the laws of probability are
also the laws of the mind (Daston 1988).
This view stands in stark contrast to the conclusions drawn from later research in the
heuristics and biases tradition: ‘In making predictions and judgments under uncertainty,
people do not appear to follow the calculus of chance or the statistical theory of predic-
tion’ (Kahneman and Tversky 1973, p. 237). A key empirical finding used to corroborate
this claim was that people often do not seem to appreciate base rate information (prior
probabilities) when making Bayesian inferences. A prominent example is the so-called
‘mammography problem’ (Eddy 1982; Gigerenzer and Hoffrage 1995). Figure 6.1
(left-hand side) gives an example of the task in which the goal is to derive the posterior
probability of a woman having breast cancer given a positive mammogram, based on
information about the base rate (prior probability) of cancer, the probability of obtain-
ing a positive test result for a woman having the disease, and the probability of obtaining
a positive test for women without cancer. The probability tree (Figure 6.1, middle left)
visualizes the given information, which consists of a set of unconditional and conditional
probabilities. The posterior probability can be inferred using Bayes’ rule (Figure 6.1,
bottom left), according to which the probability of cancer given a positive test result is
about 8 percent. Yet many people give much higher estimates in this particular scenario,
which has been interpreted as neglect of the base rate. These and similar findings have led
to the view that people’s probabilistic reasoning is fundamentally flawed (but see Koehler
1996 for a critical review).
More recently, however, psychologists have begun to identify the conditions under
which people are able to make sound probabilistic inferences. This is a case in point for
successfully exploiting the ecological rationality of designed tools. Instead of focusing
on human errors, the focus is shifted to human engineering: What can be done to help
people with probabilistic reasoning? A key insight from this line of research is the power
of presentation formats: The extent to which people are able to make sound probabilistic
inferences crucially depends on the ways in which the relevant information is conveyed.

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Task
The probability of breast cancer is 1 percent for a Ten out of every 1000 women at the age of
woman at the age of 40 who participates in routine 40 who participate in routine screening
screening. If a woman has breast cancer, the have breast cancer. Eight of every 10
probability is 80 percent that she will get a positive women with breast cancer will get a
mammography. If a woman does not have breast positive mammography. Ninety-five out of
cancer, the probability is 9.6 percent that she will also every 990 women without breast cancer
get a positive mammography. A woman in this age will also get a positive mammography.
group had a positive mammography in a routine Here is a new representative sample of
screening. What is the probability that she actually has women at the age of 40 who got a positive
breast cancer? ___ percent mammography in routine screening. How
many of these women do you expect to
actually have breast cancer? ___ out of ___
Representation
Conditional Probability Tree Natural Frequency Tree
1 1000
woman women
Cancer No cancer Cancer No cancer
1% 99% 10 990
80% 20% 9.6% 90.4% 8 2 95 895
Test Test Test Test Test Test Test Test

positive negative positive negative positive negative positive negative
Inference
P(test positive | cancer) × P(cancer) N(test positive cancer)

P(cancer | test positive) = P(cancer | test positive) =
P(test positive) N(test positive)
0.8 × 0.01 8
= ≈ 0.08 = ≈ 0.08
0.08 × 0.01 + 0.096 × 0.99 (8 + 95)
Note: The middle panel shows two types of task representations, a conditional probability tree (left) and a
natural frequency tree (right). The bottom row shows two (mathematically equivalent) ways of deriving the
posterior probability of having cancer given a positive mammogram, P(cancer|test positive), either by using
Bayes’ rule (left) or by deriving it from the natural frequency information.
Source: Task descriptions (top row) are taken from Gigerenzer and Hoffrage (1995).
Figure 6.1 Example of a simple probabilistic reasoning task

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Particular frequency formats, presented verbally or graphically, have been shown to foster
people’s inferences, in the laboratory and outside of it.
Consider the variant of the mammography problem shown in Figure 6.1 (top right),
adapted from Gigerenzer and Hoffrage (1995). Here, instead of using conditional prob-
abilities, information is presented in terms of natural frequencies. The key difference to
conveying information in terms of conditional probabilities is that natural frequencies
preserve base rate information. The natural frequency tree (Figure 6.1, middle right)
illustrates this. This tree represents information as it would result from natural sampling
(Kleiter 1994), providing a joint frequency distribution over the two variables (cancer and
test result) that reflects the base rate of cancer in the sample (as opposed to systematic
sampling, which fixes base rates a priori). Several studies have shown that presenting
information this way strongly improves the accuracy of people’s inferences (for a review,
see Meder and Gigerenzer 2014). One reason is that the provided information makes it
easier to calculate the desired quantity, namely that of 103 women who receive a positive
mammogram (95 + 8), only eight actually have breast cancer (Figure 6.1, bottom right).
This echoes Simon (1978; see also Larkin and Simon 1987), who noted that two repre-
sentations are informationally equivalent if one representation can be translated into the
other without losing information, but that this does not imply that they are computation-
ally equivalent.
Importantly, these findings have guided the development of efficient tools and teaching
methods to help people deal with statistical information. Key examples include the use of
natural frequencies for understanding the implications of diagnostic tests (Hoffrage and
Gigerenzer 1998; Labarge et al. 2003) and forensic evidence (Lindsey et al. 2003), as well
as the use of so-called fact boxes to convey medical information in a concise and easily
understandable format (Schwartz et al. 2009; Gigerenzer 2014b). Research also shows that
training people to use the power of presentation formats is more sustainable than merely
teaching them the application of Bayes’ rule (Sedlmeier and Gigerenzer 2001). Over the
past decade, different ways have been explored for the intuitive and transparent commu-
nication of health information, as well as for the development of graphical presentation
formats that help people make sense of health statistics (for reviews see Akl et al. 2011;
Gigerenzer et al. 2007).
The upshot is that the human mind is not necessarily doomed when it comes to proba-
bilistic thinking. Whereas many researchers endorse the view that people inevitably fall
prey to ‘cognitive illusions’, harnessing the power of presentation formats offers a means
to help people make sound probabilistic inferences. This, in turn, can provide a founda-
tion for helping people make better decisions without nudging them towards an externally
specified goal.
CONCLUSION
A functional match between mind and the task environment leads to successful decision
making. Fast-and-frugal heuristics are ecologically rational when used under conditions
that satisfy such functional matches. Thus, boundedly rational agents make smart deci-
sions by exploiting the ecological rationality of heuristics. Heuristics can capitalize on
learned and evolved capacities, or can be designed to create efficient and effective tools

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for decision making. A heuristic is neither good nor bad per se. Rather, the effectiveness
of a heuristic strategy can only be gauged with respect to the structure of information in
the environment within which it is used. As such, errors can be scrutinized as informative
where they are indicating a mismatch between the environment, strategies, or evolved and
learned capacities. Specifying proper matches and teasing out the mismatches between
heuristics and their task environment constitutes the study of ecological rationality of
heuristics.
Intelligent behavior, when appearing less than neoclassically rational, can be under-
stood by breaking free of the restrictive benchmarks imposed by constructivist rationality.
The answer is to be found in the ecological rationality of intelligent behavior, because in
many real-world situations it is simply not rational to be rational. Through the comple-
mentary frame of ecological rationality, intelligence can be understood to be beyond
the agents’ mind and without requiring complete comprehension of rules. Also, smart
behavior emerges where proper evolved or learned capacities are triggered in reaction to
the structure of the task environment.
This chapter primarily focused on recent theoretical developments regarding the eco-
logical nature of humans’ bounded rationality that ought to be of interest to behavioral
economists. We invite economists and psychologists to join our dialogue and dig into less
explored insights from psychology that promise informing behavioral economics on real-
world, practical, and smart decision making. Beyond encouraging economists to adopt
psychological insights into their models and theories, Simon (1959, p. 253) also challenges
economists to communicate their ideas and findings to psychologists:
the psychologist will also raise the converse question – whether there are developments in
economic theory and observation that have implications for the central core of psychology . . .
Influence will run both ways.
NOTES
1. Fast-and-frugal heuristics are interchangeably used in this text with simple and smart heuristics.
2. Savage (1954) drew significantly on the Theory of Games and Economic Behavior (von Neumann and
Morgenstern 1947) and proposed a normative reading of the subjective expected utility theoretical
framework.
3. McCloskey (1991) spells out the pragmatic significance of this point in ‘Economic science: a search through
the hyperspace of assumptions?’ where she portrays the practice of axiomatic economics as a mathematical
practice faithful to math departments’ ideal of consistency and coherence, but incapable of grasping and
providing solutions to real-world problems.
4. A series of papers (Journal of Business Research, vol. 67, 2014) on the effectiveness of fast-and-frugal
heuristics in business decision-making demonstrate this point.
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7 The beauty of simplicity? (Simple) heuristics
and the opportunities yet to be realized*
Andreas Ortmann and Leonidas Spiliopoulos
INTRODUCTION
In this chapter we focus on the history of fast and frugal heuristics, as sketched out
comprehensively in Gigerenzer et al. (1999) and scores of follow-up books (for example,
Gigerenzer et al. 2011; Todd et al. 2012; Hertwig et al. 2013) and articles. What we
consider must-read papers are listed in the further reading section at the end of the
chapter.
A recurring theme of this edited volume is that individuals can be smart and procedur-
ally rational despite displaying errors in decisions. Such an argument implicitly assumes
that there is an effort–accuracy tradeoff. Consider the feasible set of combinations of
effort and accuracy as being constrained by the decision maker’s cognitive processes and
features of the decision environment – this is the basis of prominent theories of bounded
rationality. In this view, decision errors can be rationalized by arguing that regardless of
which specific combination of effort and accuracy is chosen, as long as it is on the effi-
cient frontier, a choice resulting in said decision error cannot automatically be classified
as irrational per se. Errors are thus uncoupled from the notion of rationality, in contrast
to neoclassical economics where errors are synonymous with irrational behavior.
The notion of fast and frugal heuristics goes a step further than this argument, and its
proponents contend that there exist decision environments – found with sufficiently high
frequency in the real world – which can be exploited by appropriately adapted heuristics
in a way that transcends the effort–accuracy tradeoff. Under such circumstances, norma-
tive models such as expected utility may be dominated by simple heuristics in both the
accuracy and effort dimensions.
We contextualize the emergence of this so-called ‘Ecological-Rationality’ (ER from
here on) program as an explicit counterpoint to the ‘Heuristics-and-Biases’ (HandB
from here on) program initiated by Kahneman and Tversky (for example, Tversky and
Kahneman 1974; Kahneman and Tversky 1979; Kahneman 2003a, 2003b, 2011) that
informed and inspired scores of early behavioral economists. Simple heuristics are here
understood to be fast and frugal rules of thumb because they ignore information that is
available and hence can shorten decision-making time. Also, they ought to reflect cogni-
tive processes (and hence be able to predict) rather than be as-if modelling exercises that
explain ex post.
Our focus seems warranted by the fact that the HandB program has invaded econom-
ics, and other social sciences, to the extent that it is now by many measures thoroughly
mainstream (for example, Camerer et al. 2004, 2011; Heukelom 2015; Thaler 2015). While
in the past few years increasingly critical questions have been asked about the HandB
program (for example, Ortmann 2015a, 2015b and references therein), the predominance
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of it has largely overshadowed the ER program, in our view to the detriment of both
economics and the ER program. It has not helped that those in favor of an ER program
have not done as much out-reach to economics as might have been desirable.
Sketching with a very broad brush, we argue that the HandB program suggested that
various bounds on rationality, and the make-up of human judgment- and decision-
making facilities, induced humans to make rash decisions that produced systematic biases,
or cognitive illusions. Cognitive illusions were rationalized with reference to optical illu-
sions whose reality was well established.
The heuristics that people were said to use, such as representativeness, availability, and
anchoring and adjustment, were motivated by appeal to the principles also underlying
optical illusions. An implicit – and increasingly explicit claim (for example, Thaler 1980,
p. 40) – was that cognitive illusions were as robust as optical illusions (see also Kahneman
2003a, 2003b). Heuristics were considered to be problematic and decision makers as fal-
lible, even gullible, and in dire need of all the help that they could get to improve on their
decision-making skills. As Cochrane (2015) has noted, not inappropriately, this view rep-
resents for the HandB program proponents a considerable moral hazard problem.
It is worth noting that the assessment of people’s performance as being severely wanting
was quite a departure from the prevailing view in the 1950s, 1960s and early 1970s (for
example, Edwards 1956; Peterson and Beach 1967; see also Ortmann 2015a). Even
Tversky and Kahneman (1974), in the article that started it all, did not make the kind of
sweeping claims that were made in the following decades.
Drawing on arguments by Herb Simon (1947, 1955, 1956) and his insight that ration-
ality cannot be defined through cognitive and emotional processes alone, Gigerenzer
and the ABC Research group showed that many of the demonstrations of the HandB
program were highly problematic. The main criticism was directed at the design and
implementation of the experiments used to produce supporting evidence (for example,
prominently Gigerenzer 1991), and that indeed heuristics could have surprising perform-
ance properties, particularly so as environments became more uncertain (Gigerenzer and
Gaissmaier 2011).
We first review in more detail how this battle of programs unfolded, then lay out what
we consider the considerable accomplishments of the ER program and point out some
overlooked connections between the ER program and economics, and finally, enumerate
what we consider to be open questions and challenges.
In the interest of full disclosure, we note that both authors spent time at the Max
Planck Institute for Human Development, which now houses the ABC and ARC groups
(both of which contribute to the ER program; more about this below), Ortmann for
one year each in 1996–97 and 1999–2000 with the ABC group, and Spiliopoulos having
visited the ABC group twice (for a couple of weeks each) and since mid-2014 being
first a Humboldt Experienced Research Fellow with the ARC group and then a senior
researcher.

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The beauty of simplicity? 121
HOW THE BATTLE OF THE HANDB PROGRAM AND ER

PROGRAM UNFOLDED
First, the Heuristics and Biases Program (HandBP)
Calling Richard Cyert, James March, Herbert Simon the ‘old behavioral economists, who
focused on bounded rationality, satisficing, and simulations’ (Sent 2004, p. 740), historian
of economics Esther-Mirjam Sent explained the transition from old to new behavioral
economics (ibid., pp. 742–7), thus: ‘The roots of new behavioral economics may be traced
to the 1970s and the work of especially Amos Tversky and Daniel Kahneman’ (ibid.,
p. 742). She identifies the ‘Behavioral foundations of economic theory’ conference held
at the University of Chicago in October 1985 as a key event. In the preface to their book
that drew on the conference, Hogarth and Reder (1987, p. vii) argued that there was ‘a
growing body of evidence – mainly of an experimental nature – that has documented sys-
tematic departures from the dictates of rational economic behaviour.’ In his review of the
book, Smith (1991, p. 878) dismissed such a claim: ‘(experimental economics) documents
a growing body of evidence that is consistent with the implications of rational models’.
Acknowledging that Simon’s work on bounded rationality had influenced them, too,
Kahneman (2003a, p. 1449) identified three separate lines of research.
The first explored the heuristics that people use and the biases to which they are prone in various
tasks of judgment under uncertainty, including predictions and evaluations of evidence . . . The
second was concerned with prospect theory, a model of choice under risk . . . and with loss aver-
sion in riskless choice . . . The third line of research dealt with framing effects and with their
implications for rational-agent models . . .
and
Our research attempted to obtain a map of bounded rationality, by exploring the systematic
biases that separate the beliefs that people have and the choices they make from the optimal
beliefs and choices assumed in rational-agent models. The rational-agent model was our starting
point and the main source of our null hypotheses, but Tversky and I viewed our research prima-
rily as a contribution to psychology, with a possible contribution to economics as a secondary
benefit. We were drawn into the interdisciplinary conversation by economists who hoped that
psychology could be a useful source of assumptions for economic theorizing, and indirectly
a source of hypotheses for economic research (Richard H. Thaler, 1980). (Kahneman 2003a,
p. 1449)
Kahneman and Tversky’s HandBP was based on the idea that thinking was typically
fast and rarely slow, and very fundamentally about accessibility or intuition. The argu-
ment was that, since our thinking was typically fast, it had to rely on rules of thumb
(heuristics) which led to systematic divergences (biases) from normative behavior as
described by standard economic theories (Tversky and Kahneman 1974; Kahneman and
Tversky 1996; Kahneman 2003a, 2003b). People were increasingly conceptualized as
bumbling fools and this theme was the general drift taken up by those starting the move-
ment that later became behavioral economics. Thaler (1980, p. 40), for example, exclaimed
that ‘Research on judgment and decision making under uncertainty, especially by Daniel
Kahneman and Amos Tversky (1974; Tversky and Kahneman 1979) has shown that . . .

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mental illusions should be considered the rule rather than the exception. Systematic, pre-
dictable differences between normative models of behavior and actual behavior occur . . .’.
Importantly, the cognitive illusions were explicitly constructed (for example, Kahneman
2003a, 2003b) in parallel to optical illusions whose reality and robustness had been rea-
sonably well established. It is striking that the optical-illusion analogy was not taken to
its logical conclusion, namely, that the documented illusions either never occur in the
environment or, in the few instances when they do, they rarely impose any real cost on
the organism. We have argued elsewhere (Spiliopoulos and Ortmann 2014) that specific
diagnostic tasks, that is, specific parameterizations of tasks where competing models
make starkly different predictions, should not be used to infer the rationality of agents.
Rationality can only be assessed on a wide range of parameterizations that must include
those found in the real environment (on this, see Hogarth and Karelaia 2005, 2006, 2007;
Erev et al. 2017).
There were some obvious problems with the HandB approach, and two decades ago
they were the subject of a highly visible dispute between Kahneman and Tversky (1996)
and Gigerenzer (1996) about the reality of cognitive illusions. From the critics’, and the
present authors’, view the HandBP was characterized by a lack of process models (key
concepts such representativeness, anchoring and adjustment, and availability being hardly
more than labels), too much story-telling, un-incentivized scenario studies, polysemy,
often deception, and experimenter demand effects, to name a few. There was, in Nobel
Prize laureate Vernon L. Smith’s sarcastic but brilliant observation, too much fishing
in the tail ends of human behavior (Smith 2003, p. 467, fn. 8). No surprise then that
many anomalies were found that were taken as proof of people’s limited rationality. The
interpretation of that evidence as being indicative of humans’ typically underwhelming
performance has been contested ever since it was proposed, by the ER program and many
others working in the neoclassical tradition (for example, Smith 1991).
Second, the Ecological-Rationality Program (ERP)
The ABC research program (see also Lopes 1992) was constructed in contrast to the
HandBP. Gigerenzer (1991), for example, successfully deconstructed some key findings
of Kahneman and Tversky who eventually found themselves prompted to respond to
Gigerenzer’s critique (Kahneman and Tversky 1996; Gigerenzer 1996). ABC also devel-
oped a fundamentally different view of heuristics and did so by formulating cognitive
process models that could be tested. It is interesting to note that many of the process
models were also based on a frequentist view of the world, with ABC researchers taking
broadly an evolutionary-psychology perspective, which conceptualized humans as intui-
tive statisticians that were almost naturally good at navigating environs that were familiar
to them. It was also demonstrated persuasively that an important moderator of these
findings is the way statistical information is presented (Sedlmeier and Gigerenzer 2001;
see Hertwig and Ortmann 2004 for a summary).
To the extent that the HandBP was gobbled up entirely by the initial waves of behav-
ioral economics/finance, ABC remained an outsider of sorts although its influence has
grown, as recently evidenced by a 20-year celebration that was attended by more than
100 participants. Part of the problem is that ABC rarely engaged with modern econom-
ics and focused its critiques on normative economic models of deductive reasoning. We

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argue below that important work assuming inductive reasoning in economics can serve as
a bridge with the ERP, although important differences remain, and considerable oppor-
tunities have yet to be realized.
THE ACCOMPLISHMENTS OF THE ECOLOGICAL-

RATIONALITY PROGRAM
The ERP is characterized by a heavy reliance on cognitive process models (which require
some serious theorizing), empirical and experimental testing of these models, and an
important methodological innovation: the preferred mode of testing relies on ‘out-of-
sample’ prediction, or ‘cross-validation’ (Gigerenzer and Gaissmaier 2011). That is, per-
formance is not measured by the best fit on an existing dataset but by the performance
of a model on not yet known datasets, also done in Ericson et al. (2015) and Erev et al.
(2017). There is no data-fitting after the fact. Cross-validation addresses the important
bias–variance tradeoff (Gigerenzer and Brighton 2009). Simple models exhibit higher
bias but typically less variance than complex models – it is the relative strength that
determines which type of model outperforms the other in prediction. The key finding is
that heuristics often exhibit little or no bias vis-à-vis more complex models, therefore the
variance effect tends to dominate; we return to this below.
Among ERP’s key successful demonstrations is that, when cross-validation is used, the
performance of simple heuristics such as the recognition heuristic or the ‘take-the-best’
is better than that of complicated, computationally slow and greedy models such as mul-
tiple regression favored by economists (for example, Gigerenzer et al. 1999; Gigerenzer
and Brighton 2009; Todd et al. 2012; Gigerenzer and Gaissmaier 2011). The simple, and
rather intuitive, reason is that multiple regression essentially over-fits, looking backwards,
without taking into account the noisiness that is inherent in datasets. An important impli-
cation is that the widely believed effort–accuracy trade-off (Payne et al. 1993) is often not
something we need to worry about. Those using simple heuristics can have both. Less
can be more.
Much work has been done to understand these remarkable results; what drives the
success of heuristics such as recognition and take-the-best is now much better under-
stood (Baucells et al. 2008; Luan et al. 2011, 2014; Katsikopoulos 2013; Drechsler et
al. 2014). There are three important environmental characteristics that are sufficient,
but not necessarily necessary, that induce these striking results: non-compensatoriness
of cues, dominance, and cumulative dominance.1 If at least one of these three is true, a
lexicographic heuristic exhibits no bias vis-à-vis a linear rule, and is computationally less
demanding. These theoretical results would not be important if these conditions were
not found regularly in real environments. Şimşek (2013), however, found that these condi-
tions are very common in 51 real-world datasets; consequently, a lexicographic heuristic
performed as well as multiple linear regressions in the median dataset for approximately
90 percent of cases. Recent work has analyzed fast-and-frugal trees and successfully con-
nected them to signal-detection theory (Luan et al. 2011, 2014); new heuristics such as
the fluency and priority heuristics have been proposed (Hertwig et al. 2008; Brandstätter
et al. 2006, 2008; Drechsler et al. 2014; but see also Johnson et al. 2008 on the priority
heuristic); and a persuasive rationalization has been provided for the tendency of many

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economists and psychologists to overlook the benefits of simplicity (Brighton and

Gigerenzer 2015).
Another important contribution of the ERP is the distinction between ‘decisions-
from-description’ (DfD) and ‘decisions-from-experience’ (DfE) and the empirical valida-
tion of a robust gap between the two (for example, Barron and Erev 2003; Hertwig and
Erev 2009). It is indeed intuitive that risk maps into, or maybe better invokes, DfD, and
that uncertainty maps into, DfE. Furthermore, these map into Savage’s (1954) distinc-
tion between small (DfD) and large (DfE) world decision making (see Gigerenzer and
Gaissmaier 2011 for a discussion). We also note parenthetically that in strategic environ-
ments DfD and DfE also map into eductive and evolutive (deductive and inductive) game
theory (Binmore 1990; Friedman 1991). Hopefully, researchers both at ABC and ARC
continue recent attempts at theory integration (for example, Schooler and Hertwig 2005,
Luan et al. 2011, 2014) and related attempts to break down disciplinary boundaries (for
example, Hutchinson and Gigerenzer 2005). This was, to some extent, also reflected in
the make-up of the ABC Research Group but perhaps not as much as would have been
desirable ex post in particular regarding the group’s engagement with economists.
An increasing number of economists and researchers from management and organiza-
tion (no wonder here, given where it all started: Simon 1955, 1956) have been attracted
by the ER paradigm. For example, Åstebro and Elhedli (2006) have empirically demon-
strated the usefulness of simple heuristics in forecasting commercial success for early-
stage ventures. Eisenhardt and some of her colleagues (see, for a self-centered primer,
Bingham and Eisenhardt 2014) have argued that successful repeated product innovation
is best implemented through ‘simple rules’, or ‘semi-structures’, which define a path
between too much and too little structure. Maitland and Sammartino (2014) have empiri-
cally demonstrated the use of simple decision rules for location choice by multinational
companies when environments are politically hazardous. Indeed, Artinger et al. (2014)
have provided a useful primer of heuristics as adaptive decision strategies in management
but it seems clear that the use of heuristics in management and organization is under-
studied and remains a fruitful area of research. To see how understudied the topic is
academically, Google strings such as ‘rules of thumbs to determine when projects pay off’
find more than 14 million hits and scores of lists of simple decision rules for everything
from cash flow, real-estate investments, to other financial investments.
While there can be no doubt that progress towards a science of heuristics has been tre-
mendous and that the ABC group’s influence is increasing, there remain important blind
spots though in our view.
THE ERP AND ECONOMICS – A MISSED OPPORTUNITY

(SO FAR)
The incompatibility of the ERP with economics has been emphasized by a number of
ERP researchers. To a large extent, the ERP is positioned as an antithesis both to the
HandBP and the neoclassical-economics program, including behavioral economics, which
some view as a disguised extension of the neoclassical program (Berg and Gigerenzer
2010). We are sympathetic to the claims made, as far as they pertain to the overwhelming
mass of research often dubbed behavioral economics. Exceptions to this exist, this book

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serving as a case in point. For example, we ourselves have argued about the advantages
of process models compared to as-if models (Spiliopoulos and Ortmann 2015). However,
we fear that a purely antagonistic approach of emphasizing the divide has the unfortunate
consequence of deepening the schism rather than fostering an exchange between these
programs. The differences in opinions are well known; here we will attempt to highlight
(perhaps surprising) similarities between these research programs; indeed in some cases
we will find parallel, independent emergence of similar ideas. This suggests that there
is significant scope for future exchange of ideas and productive collaboration between
researchers from the two fields.
Heuristics
Extremely interesting work from economists like Manzini and Mariotti (for example,
2007, 2012a, 2012b, 2014; see also Mandler et al. 2012) seems to have developed in
parallel to the work of the ABC Research Group. Parallel, yet mostly independent,
work can be scientifically counterproductive in the sense that closer collaboration
could have afforded increasing returns to research and the avoidance of duplication
(for example, see Arkes and Ayton 1999 on the Concorde fallacy and related work in
economics on sunk cost effects such as Friedman et al. 2007 and McAffee et al. 2010).
Broadly inspired by the work of Gigerenzer and associates, the well-cited Manzini and
Mariotti (2007) formalizes and axiomatizes a type of sequential eliminative heuristic
demonstrating that boundedly rational choice procedures can be tested with observable
choice (‘revealed preference’) data favored by more traditional economists. The more
recent Manzini and Mariotti (2012a, 2014) builds on this earlier two-stage determin-
istic model of choice by providing models of stochastic choice when consideration
sets are present (that is, agents fail to consider all feasible alternatives), a popular but
typically less formalized approach in management science and marketing science that
is related to random utility models that have been around for decades in economics.
Mandler et al. (2012) provides procedural foundations for utility maximization, with
the checklists in the title of their paper being the equivalent of the – preferably non-
compensatory – cues central to the fast and frugal heuristics extensively analyzed by
the ABC Research Group. The authors show that under specific conditions procedural
utility maximization matches that of substantive utility. In Manzini and Mariotti
(2012b), the authors extend and formalize a choice procedure introduced by Tversky
(1969) that has recently also prominently featured in the work of Luan and colleagues
(Luan et al. 2011, 2014).
How to Choose Heuristics from the Adaptive Toolbox?
Initial criticisms that the ERP had not adequately specified the heuristic selection method
of the adaptive toolbox has prompted work directed at strategic selection. The most
prominent response to this critique was to postulate a reinforcement learning mecha-
nism over heuristics (Rieskamp and Otto 2006) – see also the RELACS model by Erev
and Baron (2005). This is essentially the same solution proposed for strategic decision
making by economists. For example, Aumann (1997, pp. 7–8) writes: ‘Ordinary people
do not behave in a consciously rational way in their day-to-day activities. Rather, they

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evolve “rules of thumb” that work in general, by an evolutionary process . . . or a learning

process with similar properties.’ In the El Farol bar problem (Arthur 1994), agents hold
a heterogeneous set of simple predictive models and learn to use the more effective rules
(given their individual experience) over time; interestingly, such a learning process con-
verges to the Nash equilibrium solution. Empirical work in repeated games by Stahl (1996,
1999, 2000) and Haruvy and Stahl (2012) find evidence that subjects learn to use relatively
simple rules based on their prior performance – they refer to their model as rule-learning.
These are concepts strikingly similar to those proposed by the ERP; however, the ERP
studies were in the domain of individual decision making, whereas the economic studies
are in strategic decision making. Clearly, there is potential here for both disciplines to
interact and advance our knowledge of the strategy selection problem.
What is the Appropriate Performance Metric for Model Comparisons?
The ERP has promoted, rightly in our view, the use of cross-validation to compare the
performance of heuristics to other more complex models, hence shifting the focus from
explanation to prediction. This is a consequence of the effects of the bias–variance
dilemma. More complex models will tend to fit better in-sample than simpler models
(such as heuristics), but may perform worse on out-of-sample predictions. Friedman
(1953) was an early proponent of the notion that theories should be evaluated on the
basis of their predictive power; of course, ERP researchers would take issue with his
contention that the processes (and underlying assumptions) are irrelevant – see, for
example, the billiard player example in Friedman and Savage (1948). Studies pub-
lished in prominent economics journals as far back as Camerer and Ho (1999), and
including more recent work such as Wilcox (2011) and Spiliopoulos (2012, 2013), have
also argued for, and used, cross-validation. See also Erev et al. (2017) and literature
therein.
What is the Appropriate Space for the Calculation of Deviations from Rationality?
A further issue concerns how we measure deviations from rationality, if they exist at all.
The ERP focuses on deviations in the consequence space, that is, comparing the actual
loss in terms of the consequences of a behavior. Consequences can be actual payoffs, if
they are well defined for a problem, or a metric based on the percentage of correct/wrong
responses often used in binary tasks. Using deviations in the consequence space instead
of the choice space is important, as seemingly large differences in choice may not translate
into large deviations in the consequence space, particularly when computational costs
are included. In the early history of Behavioral Economics, deviations from rationality
were typically measured in the choice space, and this still occurs to a considerable extent.
However, experimental economists have taken issue with experiments that have a flat
payoff function around the normative solution, culminating in the payoff-dominance
critique (Harrison 1989) that prompted a large debate in the field (see the comments and
replies to this paper in the American Economic Review, 82 (5) in 1992). While originally
intended as a critique of the design of many experiments in economics, implicit in the
payoff-dominance critique is the notion that non-optimal behavior can only be identified
when it is accompanied by large costs in the consequence space. A large deviation in the

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choice but not consequence space can be thought of as suboptimal behavior with a low
opportunity cost.
The Interaction between Simple Decision Rules and the Environment
The ERP is based on the premise that rationality should be assessed in the context of the
environment, that is, Simon’s ‘scissors’ metaphor. In strategic settings, the definition of
the environment must be extended to include institutions, market characteristics and the
interactions between agents. Perhaps surprisingly, to ERP researchers, an early example
of such interactions was given by Becker (1962) who analyzed a model of markets in
which participants behaved irrationally or randomly. He found that seemingly rational
behavior at the macro level (not only in the consequence space, but also in the choice
space) could arise even from random behavior at the micro level. In this spirit, more recent
developments in economics include the zero-intelligence program initiated by Gode and
Sunder (1993) who examined the effects of the structure of continuous double-auctions
on market outcomes. They found that simple agents, who made random bids with the
only constraint that they do not make offers that would lead to a loss, converged and
achieved near perfect allocative efficiency. The lesson to be learned from this research is
that rationality cannot be ascribed to individual decision makers without explicit consid-
eration of the environment.
Cognitive Bounds and Behavior
The premise that less is more with respect to the amount of information that decision
makers use can be linked to bounds on cognition such as limitations in the amount of
information that can be held in working memory (Cowan 2000) or the long-term memory
retrieval system (Schooler and Anderson 1997). Economists have similarly been con-
cerned with simple strategies that do not use all available historical information, dating
back to the Axelrod (1984) tournament. Tit-for-tat and the win–stay/lose–shift strategies
are examples of relatively simple heuristics that perform well in repeated games and are
robust to the exact composition of types in the population and to noise. Explicit mod-
eling of forgetting has been common in economic studies of learning in repeated games
since Roth and Erev (1995) and Cheung and Friedman (1997). Finite-state automata
are another methodological tool explicitly aimed at examining the effects of limiting
the prior (in a temporal sense) information that a player conditions his/her strategies on
(for example, Rubinstein 1986). Furthermore, it is well known in game theory that more
information does not necessarily lead to better outcomes.
Procedural Modeling
An important characteristic of most ERP studies is the insistence that models should be
procedural (or process based) in contrast to the majority of models in economics that are
as-if models. The advantage of procedural models is that they make more specific predic-
tions (choices and processes) than as-if models and are more falsifiable in the Popperian
sense. For example, see Johnson et al. (2008) who argue that the process data is incompat-
ible with that implied by the priority heuristic; this, of course, would not have been pos-

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sible for an as-if model. It is perhaps here that cognitive psychologists have already exerted
a unidirectional influence on economists. Early work in psychology employing process-
tracing techniques such as Mouselab (Johnson et al. 1989) and eye-tracking have spilled
over to economics; see Crawford (2008) for an excellent overview. Providing process-level
foundations to existing as-if models in economics, and highlighting the value-added of
this, is another way of engaging economists with the ERP. For example, Fischbacher et al.
(2013) modify economic theories of social preferences by imposing a decision tree struc-
ture to the order in which these variables are examined. Similarly, Spiliopoulos (2013)
transforms a process-free model of pattern recognition in games (Spiliopoulos 2012)
into a process-model encompassing both exemplar- and prototype-based categorization
grounded in the ACT-R architecture.
Reasoning by Similarity and Cases
Reasoning by similarity can be a useful tool when confronted with the uncertainty of a
new situation of which an agent has not had experience. Important theoretical contribu-
tions have been made by economists to case-based and analogy-based reasoning; see, for
example, early work by Rubinstein (1988) and Leland (1994) on decision under risk and
the extensive work of Gilboa and Schmeidler (1995, 2001). Other work by economists
exploiting similarity in inductive inference involves the question of how agents play a
new game (that they have not seen before); specifically, how prior experience from other
games may spill over to new (unseen) games on the basis of similarity between games (for
example, Mengel and Sciubba 2014). Also, Spiliopoulos (2013) shows that subjects learn
from the similarity, not between games, but between patterns in the history of play during
a single repeated game.
OPEN QUESTIONS AND CHALLENGES
While the success of the ERP cannot be disputed, there remain many open questions in
need of answers. We enumerate and discuss them next.
First, what is the complete set of heuristics out there? This question may be unanswer-
able for the simple reason that, as illustrated by Ericson et al. (2015), there are probably as
many definitions as there are researchers. Also, researchers very often have vested interests
to differentiate their product (for example, Bingham and Eisenhardt 2014, or the already
mentioned Ericson et al. 2015, who do not reference Gigerenzer et al. 1999). In other
words, there will not be agreement on what is in the adaptive toolbox of heuristics any
time soon. An answer to this question will become even harder as heuristics – which so far
have been studied predominantly in non-strategic decision settings – will be addressed in
strategic decision settings; see Vuori and Vuori (2014) for an excellent primer. An alterna-
tive approach is to first ask what is the set of building blocks that make up heuristics? A
broad, but by no means complete, characterization is that these are comprised of search
rules, stopping rules and decision rules.
Second, how to choose the appropriate tool from that adaptive toolbox remains a
prominent question in search of better answers – see Marewski and Link (2013) for a
review. ERP researchers have made considerable progress on this issue, generating inter-

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esting results about strategy selection (for example, Marewski and Schooler 2011). A
predictable argument has it that strategy selection is the result of evolutionary pressure
or strategy selection using a reinforcement learning mechanism over heuristics (Rieskamp
and Otto 2006). We find that argument only partially persuasive. Our skepticism goes
back to old debates about to what extent people take into account structural changes
in the environment. There is some evidence that people, possibly moderated by market
institutions, have in many circumstances surprisingly rational expectations but, of course,
it is dependent on many things even without market institutions moderating. We do know
that the use of heuristics changes when environmental conditions change (for example,
the work of Hogarth and Karelaia 2005, see also Rieskamp and Otto 2006, Spiliopoulos
et al. 2015, Spiliopoulos and Ortmann 2015) but we are far from understanding the issue
of matching in their totality in a satisfactory manner. Ultimately, the complexity of the
environment will determine the tools in the box.
Third, while it is an interesting question to understand how changing environments can
affect choice of heuristics, to what extent the use of heuristics can shape the environment
is a question that brings about important issues of causality (for example, Hertwig et al.
2002 on parental investment) that strike us as under-researched.
Fourth, ERP researchers have recently argued that the two programs of rationality not
only have very different assessments of human rationality but also have very different
policy implications identified as nudging and boosting (Katsikopoulos 2014; Gruene-
Yanoff and Hertwig 2016). These issues strike us also as under-studied. We are also not
certain that the real issue is that of nudging versus boosting. We do appreciate the fact
that nudging might have some undesirable intertemporal consequences (for example,
Carroll et al. 2009 and the literature that followed it) but submit that boosting is often an
unavailable option. Despite the difficulties, this opens up important avenues for the ERP
to have a significant impact at the policy level.
Fifth, the ERP, it seems fair to say, has not managed to have much practical impact
on management science and organization science. This is surprising given the intellectual
origin of the key parts of the ABC agenda (Simon, anyone?). Despite the fact that many
publications on the theoretical properties of heuristics have made their way into promi-
nent management/organization science journals (for example, Hogarth and Karelaia
2005; Katsikopoulos 2013), we are unaware of any significant impact on this literature
on organizations directly, or applied/empirical work on heuristics in organizations.
This is particularly surprising given that bounded rationality has become an influential
concept in management science and organization science and economics. An exception
is the hiatus heuristic that predicts whether a customer is active or not, that is, will make
future purchases. Wübben and Wangenheim (2013) not only find evidence of its use by
executives, but also show using real-world data that simple heuristics can out-predict more
complex models.
Sixth, as (simple) heuristics are being discovered by management and organization
sciences (for example, Loock and Hinnen 2015), the movement away from non-strategic
decision making (the core of early ER research) to strategic settings brings in new com-
plexities arising from strategic interactions. It is not that ABC has not started to struggle
with these issues but the work in this area seems pedestrian compared with the rather more
sophisticated work on non-strategic decision making. Promising examples include the col-
laboration between economists and psychologists in Fischbacher et al. (2013) mentioned

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earlier, which we hope to see more of in the future. Another example is Stevens et al.
(2011), who examine the effects of forgetting on the emergence of cooperative strategies
in repeated interactions. Further bridging the different concepts of bounded rationality
that psychologists and economists would be a fruitful endeavor. There are important dif-
ferences across disciplines that we cannot fully discuss here – Katsikopoulos (2014) and
Grüne-Yanoff et al. (2014) are excellent primers.
Seventh, the topic of learning has not been broached successfully by the ERP; however,
the potential exists for important work on simple heuristics of learning. A starting point
is Selten’s learning direction theory (LDT), which is ultimately a simple story of ex post
rather than ex ante rationality using minimal information – note again that this is an induc-
tive model of reasoning. For example, LDT requires information only about the direction
that would have led to an improvement in the outcome; reinforcement learning would also
require the magnitude and regret-based learning would require information about coun-
terfactual outcomes. As an aside, we draw the reader’s attention to the edited volume by
Gigerenzer and Selten (2002). An excellent example of work along these lines is Bonawitz
et al. (2014) who show that a simple heuristic (win–stay, lose–sample) can approximate
computationally demanding Bayesian inference in non-strategic settings. Strategic inter-
actions entail additional uncertainty – how often is the assumption of perfect information
fulfilled in the real world? Do we know what the action space is, what the payoffs are, and
the type/motives of our opponent? With so much uncertainty is strategic ignorance or
bounded sophistication necessarily irrational? Ecological-rationality program researchers
should note that economists have not ignored these important questions, such as uncer-
tainty, as the literature is literally full of extensions and concepts specifically addressing
them. On the other hand, ERP researchers can and should critique the characteristics
of the solutions proposed by economists. For example, in many cases the extensions or
refinements to equilibrium solution concepts that deal with these types of uncertainty may
be orders of magnitude more complicated than those under perfect information. Again,
however, we note that these solutions belong to the deductive strand of game theory, not
the inductive strand; the latter should be far more palatable to psychologists.
Eighth, and relatedly, some celebrated heuristics can easily be exploited (for example,
default settings in a situation where the choice architect has vested interests: credit card
companies, and so on). In general, it is necessary to assert to what extent the interests of
the default-setter and the people that default are meant to nudge coincide. It would be a
mistake to assume that it is always the case.
Ninth, Goldberg (2005; see also Goldberg and Podell 1999) have argued that studying
lotteries does not capture decision making in the real world in reasonable ways. The real
issue is what to do with other problems that cannot be represented by lotteries with two
or three outcomes?
Tenth, the fast and frugal heuristics literature, in its insistence on avoiding the calibra-
tion of heuristics to empirical data, has glossed over the issue of behavioral heterogeneity.
CONCLUDING DISCUSSION
We set out to sketch established facts and open questions about simple heuristics, while
also pointing out some areas of similar thinking with the economics discipline that could

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serve as a bridge for future work. As it turns out there is an increasing number of authors
that lay claim to the term ‘simple heuristics’ which seems to originate with Gigerenzer et
al. (1999). While sketching the history and different premises of the two big programs in
the heuristics space, the ‘Heuristics-and-Biases’ program and the ‘Ecological-Rationality’
program, we have focused on the latter and discussed its undoubtable accomplishments
and prospects. Among its considerable accomplishments are the successful demonstra-
tion that, when cross-validation is used, the performance of simple heuristics such as the
recognition heuristic or the ‘take-the-best’ tends to be better than that of complicated,
computationally slow and greedy models such as multiple regression favored by econo-
mists (for example, Gigerenzer et al. 1999, Todd et al. 2012; Brighton and Gigerenzer
2009; Gigerenzer and Gaissmaier 2011). The simple, and rather intuitive, reason is that
multiple regression is prone to over-fitting to the noise in the data-generating process by
only looking backwards. Another important implication is that the widely believed effort-
accuracy trade-off is often not something to worry about. It has also been demonstrated
persuasively that an important moderator of these findings is the way statistical infor-
mation is presented. There remain many open questions and interesting research topics
which we have tried to enumerate.
We have tried hard to draw attention to work in economics that seems closely related to
the ERP and to highlight where common ground exists for the two disciplines to initiate
a dialogue and collaborate despite their differences. The reader will notice that the major-
ity of research that we have cited in economics is firmly grounded in inductive (learning
from experience) rather than deductive models. We believe that much of the criticism
of economics by ERP researchers has been directed at normative solutions involving
deductive reasoning. This, however, is a straw man of sorts, and does not acknowledge
the richness of contemporary economics. We further draw attention to the fact that
many of the studies in economics that we have cited are published in mainstream, highly
ranked journals such as the American Economic Review, Quarterly Journal of Economics,
Econometrica, and Games and Economic Behavior. Therefore, we believe that sufficient
interest exists for work that can be related to the ERP, and for the ERP to make significant
headway into the economics discipline. This attempt will be most successful by connecting
new research to prior work in economics and simultaneously pointing out the similarities
and differences. Economists would also be well advised to seek out common ground with
psychologists beyond the (now) orthodox heuristics-and-biases program.
NOTES
* The authors are grateful for critical and helpful commentary on earlier versions from Morris Altman,
Nathan Berg, Gerd Gigerenzer, Ralph Hertwig, Konstantinos Katsikopoulos, Elizabeth Maitland (whose
suggestion inspired the title of our chapter), and Ben Newell. All errors in judgment and tone are ours.
1. Non-compensatoriness of cues is satisfied if the weight of a higher ranked cue is greater than the sum of
all lower ranked cues. Consequently, lower-ranked cues can be ignored as regardless of the cue values, it is
impossible for them to reverse a decision made using the higher ranked cue. Dominance is satisfied if the
cue values of one object are all greater than those of the other object. Cumulative dominance is satisfied
if the cue values of one object cumulatively dominate those of the other object. Further discussions and
mathematical definitions of these concepts can be found in Şimşek (2013).

M4225-ALTMAN_9781782549574_t.indd 131 03/05/2017 08:20

FURTHER READING
Brandstätter, E., G. Gigerenzer and R. Hertwig (2006), ‘The priority heuristic: making choices without trade-
offs’, Psychological Review, 113 (2), 409–32.
Brighton, H. and G. Gigerenzer (2015), ‘The bias bias’, Journal of Business Research, 68 (8), 1772–84.
Dhami, M.K., R. Hertwig and U. Hoffrage (2004), ‘The role of representative design in an ecological approach
to cognition’, Psychological Bulletin, 130 (6), 959–88.
Gigerenzer, G. and H. Brighton (2009), ‘Homo heuristicus: why biased minds make better inferences’, Topics in
Cognitive Science, 1 (1), 107–43.
Gigerenzer, G. and W. Gaissmaier (2011), ‘Heuristic decision making’, Annual Review of Psychology, 62 (1),
451–82.
Goldberg, E. and K. Podell (1999), ‘Adaptive versus veridical decision making and the frontal lobes’,
Consciousness and Cognition, 8 (3), 364–77.
Goldstein, D.G. and G. Gigerenzer (2011), ‘The beauty of simple models: themes in recognition heuristic
research’, Judgment and Decision Making, 6 (5), 392–95.
Grüne-Yanoff, T. and R. Hertwig (2016), ‘Nudge versus boost: how coherent are policy and theory?’, Minds
and Machines, 26 (1), 149–83.
Grüne-Yanoff, T., C. Marchionni and I. Moscati (2014), ‘Introduction: methodologies of bounded rationality’,
Hertwig, R. and I. Erev (2009), ‘The description-experience gap in risky choice’, Trends in Cognitive Sciences,
13 (12), 517–23.
Hogarth, R.M. and N. Karelaia (2007), ‘Heuristic and linear models of judgment: matching rules and environ-
ments’, Psychological Review, 114 (3), 733–58.
utility theory’, Journal of Risk and Uncertainty, 37 (1), 35–56.
Katsikopoulos, K.V., L.J. Schooler and R. Hertwig (2010), ‘The robust beauty of ordinary information’,
Luan, S., L.J. Schooler and G. Gigerenzer (2014), ‘From perception to preference and on to inference: an
approach–avoidance analysis of thresholds’, Psychological Review, 121 (3), 501–25.
Mandler, M., P. Manzini and M. Mariotti (2012), ‘A million answers to twenty questions: choosing by checklist’,
Journal of Economic Theory, 147 (1), 71–92.
Manzini, P. and M. Mariotti (2014), ‘Stochastic choice and consideration sets’, Econometrica, 82 (3), 1153–76.
Marewski, J.N. and L.J. Schooler (2011), ‘Cognitive niches: an ecological model of strategy selection’,
Pleskac, T.J. and R. Hertwig (2014), ‘Ecologically rational choice and the structure of the environment’, Journal
of Experimental Psychology: General, 143 (5), 2000–2019.
610–28.
Volz, K.G. and G. Gigerenzer (2012), ‘Cognitive processes in decisions under risk are not the same as in decisions
under uncertainty’, Frontiers in Neuroscience, 6 (July), 1–6.
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8 Smart persons and human development:
the missing ingredient in behavioral economics*
John F. Tomer
INTRODUCTION
There’s a growing sense among economists, especially behavioral economists, that the
human actor in economics is not portrayed well by the economic man stereotype nor by
the irrational, error-plagued person who is the stereotype deriving from psychological
economics. The purpose of this chapter is, first, to explain about the inadequacy of these
two stereotypical economic actors and, second, to develop an alternative, a more satisfac-
tory stereotype known as the smart person. In the process, this chapter points the way to
a better behavioral economics, a behavioral economics with smart people, a behavioral
economics that is more realistic and more human. What is missing from the existing
stereotypical actors, but present in the smart person actor, is the human who develops
in stages along a number of developmental pathways over a lifetime. In contrast to the
two existing stereotypes, the smart person’s character and capabilities are neither simply
assumed nor inferred from the outcomes of narrow psychological laboratory experiments.
The smart person’s character and behavior derive in good measure from the research of
a variety of non-economist scientists and careful observers of human behavior. There is
a tremendous need for a behavioral economics with smart persons in which the human
actor, while far from perfect, develops, and all too often fails to develop, character and
capabilities in a realistic way.
The plan of the chapter is as follows. The next section explains what is missing from
mainstream economics and psychological economics. The missing ingredient is the
concept of human development. The third section carefully considers the characteristics
of economic man, the human in mainstream economics. The following section carefully
considers the character and capabilities of the human in psychological economics, par-
ticularly his or her lack of economic rationality. The fifth section develops a conception
of an alternative human economic actor, an actor whose character and capabilities are
much closer to the humans we know. This section explains how a behavioral economics
with smart people has the potential to be a great improvement over the psychological
economics version of behavioral economics with its error-prone stereotype.
THE MISSING INGREDIENT: THE CONCEPT OF HUMAN

DEVELOPMENT
The ingredient missing from economics is the conception of a human being as an

individual who develops in many different ways along a sequence of stages, a matura-
tional path. As wise thinkers through the ages have recognized, humans are capable of
137
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attaining a very high level of development, involving a full flourishing of all their human
capabilities in the broadest and highest sense over their entire life cycle. Clearly, the
high human development (HD) envisioned by these thinkers involves much more than
the acquisition of cognitive capability or workplace skill. High HD certainly involves
social, psychological, emotional, and biological dimensions, among others, but the ideal
or potential HD often fails to occur. Generally, only when the environment is favorable
do humans have a chance of developing a high degree of their potential. Therefore, a
key question is, what has to happen for individuals to develop to, or near to, their full
potential? What kind of environment is necessary for favorable development? Among the
necessary environmental conditions commonly recognized as necessary for reasonably
high HD are a good education and the kind of early life nurturing usually provided by
two loving parents. A supportive community and society are also important. For many,
of course, the environment may not be favorable in some important respects, and as a
consequence individuals may fail to negotiate significant stages of development. Thus,
an individual may get stuck or partially stuck at a certain developmental stage and may
fail to develop further without special developmental interventions. Without such help,
it is likely that the individual will remain stuck at a level of HD that does not allow the
full development of their talents. Conventional economic thinking provides little or no
recognition of how individuals can advance along important developmental pathways
and how they can overcome the types of difficulties that would otherwise prevent or
inhibit their development.
The concept of HD used here draws from a number of different traditions. First, it
incorporates the perspective of developmental scientists whose field of study broadly
encompasses HD in physical or biological, cognitive, and psychosocial domains or
behaviors (see, for example, two HD texts: Kail and Cavanaugh 2007; Papalia et al.
2009). Second, the HD concept is inspired by the humanistic psychological perspective of
Abraham Maslow (1943), notably his hierarchy of needs. Third, it is informed by research
on neurodevelopment (see, for example, Perry 2002), particularly Perry’s work related to
the developmental difficulties occurring in early childhood. Fourth, the HD conception
here has been influenced by Ken Wilber’s (see, for example, Wilbur 2001, pp. 5–16) con-
ception of how humans develop in an unfolding series of stages and levels from lower
order to higher order along many dimensions or lines.
The HD concept used here is related to, but distinctly different from, the HD concept
pioneered by Amartya Sen, Martha Nussbaum and others. The latter concept which has
been much used by international agencies (for example, the World Bank and the United
Nations) concerned with economic development emphasizes a great number and variety
of human functioning and capabilities. The Sen or Nussbaum HD concept is very useful
for thinking about national and world economic development and how its progress can
be measured. A good overview of this concept and its uses can be found in Alkire (2010).
What this concept lacks is a conception of the stages of development in a human’s life
and how human capacities and orientations change in predictable ways and sometimes
fail to change. That is, there is no conception of the multidimensional developmental
process that humans experience and the challenges a human typically encounters along
the developmental pathways.
To better understand the HD concept, it is important to illustrate graphically its main
pathways and the sequence of development along each. For the purposes of this chapter,

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Smart persons and human development 139
Acquiring
overall
life direction,
interests, outlooks,
& motivation
4
Developing
skills & talents:
physical, academic,
arts, technology
3
Learning/appreciating many
types of knowledge and
acquiring academic discipline
2
Learning the basics:

reading, writing, arithmetic
1
Figure 8.1 Educational and cognitive development
HD is represented as a three-sided pyramid. Each side represents a major developmental

pathway. The three developmental pathways are (1) educational and cognitive develop-
ment, (2) psychosocial, biological development, and (3) brain development (or neu-
rodevelopment). In each case, the triangles representing the pathways start from very
fundamental, early development and proceed stepwise to the highest level of develop-
ment. The sequence of steps resembles in some respects Maslow’s (1943) hierarchy of
needs in that, with some exceptions, earlier stages must precede later stages. Also, note
that there is considerable interdependence among the three pathways.
For economists, and presumably many academics, the easiest triangle or pathway to
appreciate is the educational and cognitive development pathway. The side of the pyramid
representing this pathway is shown in Figure 8.1. It starts at the bottom with ‘Learning
the basics: reading, writing, arithmetic’. The second step is ‘Learning/appreciating many
types of knowledge and acquiring academic discipline’. The third step is ‘Developing
skills and talents: physical, academic, arts, technology’. The fourth and final step is
‘Acquiring overall life direction, interests, outlooks, and motivation’.
The second pathway, psychosocial, biological development, is shown as the triangle in
Figure 8.2. It starts with ‘Foundational neurodevelopment’ and proceeds to ‘Early learn-
ing, relating, and doing’ and then to ‘Becoming safe, secure, and satisfying physical needs’.
The fourth step is ‘Finding oneself: competencies, motivations, values, and emotional
intelligence’. The fifth step is ‘Finding oneself: friends, lovers, and loving family relations’.
The sixth and final step is ‘Connecting to one’s highest values, spirituality, creativity, and
aesthetics’.

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Connecting
to one’s highest
values, spirituality,
creativity, aesthetics
6
Finding oneself:
friends, lovers,
5 loving family relations
Finding oneself:
competencies, motivations,
values, emotional intelligence
4
Becoming safe, secure,
and satisfying physical needs
3
Early learning, relating, doing
2
1 Foundational neurodevelopment
Figure 8.2 Psychosocial and biological development
The third pathway, brain development, is shown as the triangle in Figure 8.3. It starts
with ‘Foundational neurodevelopment’ and proceeds to ‘Neurodevelopment associated
with doing, achieving, relating, and learning’. The third step is ‘Overcoming brain devel-
opment deficiencies and problems’. The fourth and final step is ‘Developing creativity and
peak performance brain functioning’.
Figure 8.4 shows how the three triangles described above combine to form the HD
pyramid. No doubt a much more careful and micro elaboration of the pathways by a
developmentally oriented behavioral scientist would include many more steps in each
pathway than the number included here.
The benefit of using the HD pyramid is that it focuses attention on three main ways
that important human capabilities change, have the potential to change, or fail to realize
their change potential. In Wilber’s (2001, pp. 5–6) view, human development involves an
unfolding, emergent process marked by progressive subordination of older, lower-order
behavior and capabilities to new higher-order behavior and capabilities along different
pathways or lines. Using the HD pyramid helps us understand how change along one
pathway may facilitate change along another pathway and how barriers to change in a
pathway may result in lack of desired change along another pathway.
It is important to note that society has a strong effect on an individual’s development.
The society’s ethics, norms, rules, and basic institutions are integrated and have a cohesion
that affects how far individuals develop (Wilber 1996, pp. 138–41). The society’s ‘cultural
center of gravity acts like a magnet on individual development. If you are below the
average level, it tends to pull you up. If you try to go above it, it tends to pull you down’

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Developing creativity and

peak performance
brain functioning
4
Overcoming brain
development
deficiencies, problems
3
Neurodevelopment associated
with doing, achieving
relating, learning
2
Foundational neurodevelopment
1
Figure 8.3 Brain development
Figure 8.3
Figure 8.2
Figure 8.1
Note that the three pathways are interdependent
Figure 8.4 Human development pyramid
(Wilber 1996, p. 139). The society’s developmental magnet helps you reach the expected
level of development, but likely retards your earnest attempts to develop beyond the soci-
etal norm. As a consequence, relatively few people reach the highest developmental stages
but many reach average levels.1

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ECONOMIC MAN: THE HUMAN IN MAINSTREAM

ECONOMICS
Economic man, or Homo economicus, is the well-known human economic actor in

mainstream economics. Because economic man’s behavior reflects the rational choice
theory at the heart of mainstream economics, his or her behavior is machine-like in its
perfect rationality (see Simon 1983, pp. 12–17). Economic man chooses in a narrowly
self-interested way, using perfect logic and a complete knowledge of alternatives, and
thus, selects the alternative that best enables attainment of his or her subjectively defined
ends. If economic man is a consumer, the end is utility; if a producer, the end is profit.
If economic man were human, we could say that he or she possesses infinite, or at least
extremely high, cognitive capacity. In contrast, it seems to be implied that economic
man has no or low non-cognitive capacity, that is, capacity relating to psychological,
emotional, and social functioning. This further implies that economic man has zero
capacity for pure empathetic (or other interest) motivation, the motivation opposite to
self-interest. Economic man is also unreflective in the sense that he or she cannot stop to
consider the appropriateness or rightness of his or her choices.
It is fairly obvious to many, including a number of leading economic thinkers such as
John Stuart Mill (1836), that economics does not consider the whole of man’s nature.
Accordingly, economic man is a one-dimensional being who merely compares alterna-
tive ways to achieve his or her economic ends. The economic man concept continues to
be widely used in economic modeling and analysis despite the fact that there are many
economists who understand (1) that humans do not generally know the consequence of
their actions for their long-term physical and mental health, and (2) that humans cannot
be relied on to make decisions in their strict self and selfish interest.
In their models, economists often use an economic actor who is a representative agent,
a typical decision maker of a certain type. In mainstream economics, such agents are
economic men who perform a particular role; they are, for example, consumers or deci-
sion makers in a firm. These agents presumably have made significant investments in
human capital in order for them to carry out their economic role. Regardless of their
human capital, the agents in these models behave in a perfectly rational manner, albeit in
a particular context.
Economic man’s behavior is in accord with the formal model of rational choice known
as subjective expected utility (SEU) theory in which economic man chooses the alternative
that maximizes his or her expected value of utility. As Herbert Simon (1983, p. 13) points
out, SEU ‘is a beautiful object deserving a prominent place in Plato’s heaven of ideas’.
Unfortunately, according to Simon, the ‘SEU theory has never been applied and can never
be applied . . . in the real world’ (1983, p. 14). This is because ‘human beings have neither
the facts nor the consistent structure of values nor the reasoning power at their disposal
that would be required, even in . . . relatively simple [lab] situations to apply SEU princi-
ples’ (Simon 1983, p. 17). That is, the economic man concept is simplistic and unrealistic.
Consider economic man from a developmental perspective. Economic man is
unchanging; he or she has no history and no future. That is, the qualities possessed by
economic man did not come about through a process of human development, and there
is no prospect of future development that will cause these qualities to change. Economic
man’s character is simply assumed; it is not an object of theoretical or empirical study. If

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economic man’s character (perfect rationality) had come about through a developmental
process, we might say that economic man had reached an egoistic stage of development
in which he or she is aware of having many wants and is perfectly logical and persistent
in the endeavor to satisfy those wants. Such a hypothetical development stage resembles
Wilber’s (2001, p. 9) third stage of human development in which the individual is power-
ful, egocentric, and has a self that is distinct from his or her ‘tribe’. According to Wilber’s
(2001, pp. 9–11) estimates, the great majority of people in the twenty-first century world
develop beyond this egocentric stage during the course of their lives.
PSYCHOLOGICAL ECONOMIC MAN: THE HUMAN IN

PSYCHOLOGICAL ECONOMICS
Psychological economics is the prominent strand of behavioral economics that borrows

from psychology, especially cognitive psychology, in order to achieve a more realistic
understanding of human economic behavior than is possible with mainstream economics.
Psychological economic man is the human in psychological economics (PE). Psychological
economic man’s character, in sharp contrast to economic man, is very much an object of
study, especially empirical study. Psychological economics is oriented to investigating
human cognitive performance in relatively narrow and well-defined situations in order to
isolate humans’ precise decision making and judgment behavior. Psychological econom-
ics researchers have focused to a large extent on exploring the degree to which human
behavior systematically departs from economic rationality, that is, the extent to which
psychological economic man is different from economic man.
Overall, the findings of PE research are that humans are much less rational than main-
stream economics assumes. That is, we humans are systematically and predictably irra-
tional in all phases of our lives; we make many different kinds of errors in a great variety
of particular situations (Ariely 2009, pp. 239–40). These errors derive from, among other
things, the anchoring effect, judgment by representativeness, overconfidence, theory-
induced blindness, loss aversion, salience, use of mental accounts, framing, inconsistent
preferences, defective affective forecasting, difficulties dealing with probabilities and
time, the narrative fallacy, hindsight bias, confirmation bias, overestimating rare events,
status quo bias, planning fallacy, and the availability and affect heuristics (Kahneman
2011). In light of these findings, it is not surprising that the psychological economic man
stereotype is very much one of an irrational and error-prone being. In comparison to
economic man, psychological economic man is decidedly not smart. This characterization
of psychological economic man’s judgment and decision making is more realistic than
that of the economic man stereotype precisely because it is based on a great amount of
research.
An important aspect of PE involves understanding two systems in the mind, system 1
and system 2. System 1, associated with intuition, is the aspect of our mind that ‘oper-
ates automatically and quickly, with little or no effort and no sense of voluntary control’
(Kahneman 2011, p. 20). Many of the predictable human errors which PE focuses on
occur when our minds are in system 1 mode. If, in the face of a difficult question or issue,
no easy system 1 solution comes to mind, that is when we typically switch to system 2.
System 2 refers to effortful mental activities requiring concentration and self-control

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(Kahneman 2011, p. 22). System 2 is slower; it may involve computation, deliberation, and
constructing thoughts in an orderly series of steps.
Psychological economics’ emphasis is less on explaining the reasons why humans
commit cognitive errors and more on accurately characterizing humans’ cognitive
performance. Nevertheless, a number of the leading researchers have offered explana-
tions for humans’ error-proneness. According to Ariely (2009, p. 243), our senses and
brain filter the information that comes to us so that the input to our decision making
is not a fully accurate reflection of the reality of the situations we confront. In other
words, the problem stems from ‘the basic wiring of our brains’ (Ariely 2009, p. 239). In
Kahneman’s (2011, p. 51) view, errors of judgment and decision making often stem from
‘a self-reinforcing pattern of cognitive, emotional, and physical responses that [are] . . .
associatively coherent’ (original emphasis). The errors often arise because our perception
and cognition involve our body, not just our brain.
Psychological economic man can learn and acquire the skill necessary to reduce the
errors that typically occur when humans are operating in system 1 mode. When these
error-causing difficulties are recognized, humans may switch to system 2 mode and may
try harder in order to avoid significant mistakes, especially when the stakes are high
(Kahneman 2011, pp. 25–8). To acquire these error reducing, decision-making skills
‘requires a regular environment, an adequate opportunity to practice, and rapid and
unequivocal feedback’ on decision-making results (Kahneman 2011, p. 416). It should
be noted that this learning does not amount to a move to a higher stage of HD. It is just
psychological economic man’s regular mental mode of operation. It is also important to
note that with respect to decision making and judgment, PE is largely concerned with
humans’ cognitive functioning, not the non-cognitive functioning that would be part of
humans’ move to a higher or lower stage of development.
It is interesting to note that PE researchers, although they do not usually state it explic-
itly in their writings, strongly suggest that the systematic human departures from ration-
ality that they find in their empirical research are ‘hardwired’ in the human brain and/or
body. The term hardwired is understood to mean ‘pertaining to or being an intrinsic and
relatively unmodifiable pattern’ (Etzioni 2014, p. 394). It is possible, though, that these
cognitive errors are merely strong predispositions rather than the determinative attributes
that PE researchers imply.2 If the errors and biases are not hardwired, it may be that these
departures from rationality can be ‘corrected’ (Etzioni 2014, p. 397), possibly by virtue
of education and training, by making a bigger effort, or via other interventions that take
advantage of the human brain’s plasticity.
The upshot of the above comparisons is that psychological economic man is more real-
istic than economic man, less rational than economic man, and is no better than economic
man insofar as neither experiences human developmental stages.
NEEDED: A SMARTER PERSON IN A BETTER ECONOMICS
Essence of the Smart Person
Based on our analysis of the economic man of mainstream economics and the psycho-
logical economic man of psychological economics, there is clearly a need for a better

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economics, a behavioral economics in which the actor is more human and less irrational.
The desired economic actor should behave more realistically than economic man, be less
error-prone than psychological economic man, and be more human in a developmental
sense than either economic man or psychological economic man. Thus, the needed human
actor should not only be a ‘smart person’, a person, who while far from being perfectly
rational, is less fallible than psychological economic man, but should be a person whose
capabilities and character develop in stages over his or her lifetime.
The smart person (SP) is the boundedly rational decision maker whose decision-making
behavior is generally in line with Herbert Simon’s understanding of how humans behave
when making significant decisions. Therefore, in evaluating decision alternatives, SPs will
generally consider a selected set of alternatives, evaluate each alternative sequentially,
and then select the first satisfactory alternative, an alternative meeting the SP’s aspiration
level (Simon 1955, pp. 110–12). This ‘satisficing’ decision-making procedure is boundedly
rational in that it is intendedly rational. However, the SP’s rationality is limited by the
human brain’s cognitive capacity and the complexity of the decision environment. It is
only in the most simple and transparent situations that SPs can be perfectly rational in the
utility maximizing sense (Simon 1959, p. 258). Thus, in the great majority of life decisions,
SPs will be boundedly rational, reasonably competent decision makers.3 It is important to
note that SP’s decision making can still be expected to manifest many of the errors and
biases identified by psychological economics researchers, but these decision-making and
judgment deficiencies will not be the defining characteristics of SPs’ decision making.
With regard to HD, the SP actor is one who has the ability to develop to his or her
potential, progressing along the three developmental pathways mentioned earlier (see
Figures 8.1–8.4) as well as to develop along other unspecified paths, advancing stage by
stage. The SP’s development may, however, fail to occur sometimes because the person’s
developmental environment (parenting, community, society, and so on) has been unfavo-
rable or for other reasons. As a consequence, in the absence of a helpful developmental
intervention (for example, educational or therapeutic), the SP’s development along one
or more pathways may become stuck. Further, owing to the interdependence of the
pathways, progress or lack of progress along one pathway may affect progress or lack of
progress along another pathway.
Important Features of Human Development
To appreciate the human development aspect of the SP, there are some aspects of HD
that need further examination, particularly the non-educational aspects. In this regard, it
is useful to give more attention to the neurodevelopment pathway.
Neurodevelopment success and failure

Bruce Perry’s (see, for example, 2002) work makes clear that we can only develop to our
human potential if our brains develop to their potential. ‘Development [especially the
neurodevelopment part] is a breathtaking orchestration of precision micro-construction
that results in a human being’ (2002, p. 82). Eight key processes are involved in creating
a mature, functional human brain: neurogenesis, differentiation, apoptosis, arborization,
synaptogenesis, synaptic sculpting, and myelination (Perry 2002, pp. 82–5). It is not neces-
sary here to consider each of these processes in detail. Suffice it to say that these processes

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relate to neurons: their birth, movement, specialization, death, formation into dendritic
trees, the formation of connections among neurons (synapses), the structuring of the
synapsis, and the creation of efficient electrochemical functioning in the neural networks.
These neurodevelopment processes occur in response to experience and are most respon-
sive to experience in positive and negative ways during infancy and childhood (Perry
2002, p. 82). All of these processes must go well; otherwise, abnormal neurodevelopment
occurs, causing profound brain dysfunction (Perry 2002, p. 85). ‘In order to develop
properly, each [brain] area requires appropriately timed, patterned, repetitive experience’
(Perry and Szalavitz 2006, p. 248). For optimal neurodevelopment, it is crucially important
that the lower brain systems develop first in a healthy fashion; otherwise, development
of higher, more complex parts of the brain will not be able to occur satisfactorily. Full,
healthy brain development may fail to occur for many reasons, most notably, because of
adverse early childhood experiences that often involve toxic stress or trauma. Owing to
such neurodevelopment deficits, both children and adults can get stuck or partially stuck
at a relatively low stage of brain development with serious consequences for their later
behavior and functioning.4
Other human development failures

In addition to and often coexisting with adverse childhood experiences, three other
important non-educational kinds of situations in which humans fail to develop satisfac-
torily deserve note (Tomer 2014):
1. The molecules of emotion (different types of receptors and ligands in the brain and
body) may fail to flow freely such as when emotions are repressed or denied. As a
consequence, body and brain network pathways get blocked, and people get stuck in
unhealthy patterns of behavior and experience negative emotional states (Pert 1997).
2. People may fail to develop important emotional competencies (for example, inability
to handle one’s distressing emotions) deriving from a lack of coordination between a
person’s thinking brain (neocortex) and their lower brain areas (Goleman 2011).
3. People may fail to develop the personality traits that are needed for their educational
success, labor market success, health, and positive personal outcomes (Almlund et al.
2011).
The Time Pattern of Human Development
There are several noteworthy features of the time pattern of human development.
Non-cognitive versus cognitive development

In early childhood just after birth, a child is not ready to develop cognitively. The devel-
opment that is taking place is non-cognitive development, mainly occurring in the lower
brain areas (Perry 2002, pp. 86–8; Perry and Szalavitz 2006, pp. 247–8). During very early
child development, children are acquiring basic brain organization, a stable emotional
basis, a secure attachment to their primary caregiver(s), and the basis for good social rela-
tionships. Inevitably, as the child grows older and non-cognitive development progresses,
the relative amount of time devoted to non-cognitive development will decline. In other
words, as the child matures and becomes more secure, independent, and confident, the

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child’s need for the nurture and care of a parent will become less and less. Also, as the
child’s higher brain develops, a greater proportion of the child’s development will be
cognitive. More and more of the child’s development will involve learning and acquiring
skills. It is useful to view expenditure of efforts and resources to aid both the non-cognitive
and cognitive development of children as investments in human capital. After all, both
kinds of developmental efforts involve investments of resources that enable humans to
function at a higher level whether at home, in the workplace, in the community, or in
relationships.
Development in transitional periods

It should be noted that in addition to early childhood, there are certain other important
times during an individual’s lifespan when people typically make transitions from one
stage of development to the next. One important example is the transition from middle
childhood to adolescence (see, for example, Papalia et al. 2009, ch. 11). Although some
young people may experience this transition favorably as an important growth opportu-
nity, it is not unusual for others to experience this transition as difficult and stressful. In
many cases, people, often with a great amount of effort and some distress, successfully
make these transitions, moving on to the next stage of their life. However, in other cases,
people may get stuck or partially stuck at their present developmental stage, and as a con-
sequence of this developmental failure, certain later life opportunities may be precluded.
It is useful to think of people who are dealing with transitions as making substantial
investments in non-cognitive human capital, investments that sometimes require profes-
sional help, such as from social workers or psychologists.
ADULT DEVELOPMENTAL STAGES
The developmental stages of children and adolescents have long been recognized,
but adult developmental stages have only gained wide recognition in recent decades.
Levinson’s (1978) study of adult development is arguably the single most important con-
tribution to understanding the progression of adult lives over the years.5 To understand
adult life stages, Levinson studied the life stories of a relatively small number of adults
(40 men in four occupations in his 1978 study).6 His findings led him to conclude that
an adult’s life has a universal pattern, an underlying systematic, non-genetic progression.
According to Levinson (1978), the life course from age 17 to old age consists of a com-
bination of stable periods and transitional periods. During stable periods, a person makes
decisions and commits to building a life structure. During transitional periods, a person
tends to review and evaluate the present structure of his or her life in order to decide what
aspects of their life to keep and what aspects to reject. As Sheehy (2006, p. xvii) explains,
humans have a resemblance to lobsters in that during parts of their lives they develop a
series of hard protective shells, and during other life segments they shed the shell when it
has become too small and confining. Similarly, humans at certain ages tend to find their
life structure (a relatively fixed, stable life agenda) coming undone and deteriorating. This
may evoke a sense of ‘crisis,’ or at least unsettling feelings, that provide them the impetus
and opportunity to change their present life structure in order to incorporate life elements
that were not previously part of their life’s agenda.

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Based on his 1978 research on the pattern of adult development from age 17 to 60,
Levinson has identified a number of developmental periods. First are two eras, early
adulthood and middle adulthood. Early adulthood consists of two transition periods,
early adult transition (age 17 to 22) and the age 30 transition (age 28 to 33), as well as two
stable periods, entering the adult world (age 22 to 28) and settling down (age 33 to 40)
(Levinson 1978, pp. 56–62). Middle adulthood consists of two transition periods, mid-
life transition (age 40 to 45) and the age 50 transition (age 50 to 55), as well as two stable
periods, entering middle adulthood (age 45 to 50) and culmination of middle adulthood
(age 55 to 60). Levinson mentions but did not study late adulthood (roughly 60 to 80)
and late, late adulthood.
During the stable periods, an adult develops a life structure which has important life
components such as occupation, marriage-family, and friends. Adults seeks to create a
structure that is simultaneously ‘viable in society and suitable for the self’ (Levinson 1978,
pp. 53–4). Ideally, persons will decide on and build a life structure that will enable them to
make their greatest contribution to society while enabling them to realize their dreams and
values (Levinson 1978, pp. 51, 53–4, 324, 331). If the developmental tasks do not go well
and a viable, motivating life structure is not created, the individual likely becomes stuck or
partially stuck at an earlier stage of development (Levinson 1978, pp. 321–2). This gener-
ally is associated with decline, loss of vitality, imbalance, and stagnation.
Erik Erikson’s (1982) writings on human development preceded Levinson’s, and they
provide an interesting contrast with those of Levinson. Erikson (1982, pp. 32–3, 56–61,
69, 75) identified eight life (not just adulthood) stages: infancy, early childhood, play age,
school age, adolescence, young adulthood, adulthood, and old age. Each stage is con-
cerned with developing a basic strength and avoiding or fending off a core pathology or
vulnerability. For example, in Erikson’s fourth stage, school age, children are developing
competence and trying to avoid inertia and feelings of inferiority. In his eighth and final
stage (old age), individuals are developing wisdom and integrity and avoiding despair and
disdain. In the seventh stage (adulthood), individuals are developing generativity and care
and avoiding stagnation and rejectivity. As Erikson (1982, p. 59) points out, ‘each [devel-
opmental] step is grounded in all the previous ones’. When any developmental step fails,
the individual may not only realize the vulnerability or weakness associated with that stage
but may regress to an earlier stage (Erikson 1982, p. 67).
According to Levinson’s (1978, pp. 319–20) theory, the sequential developmental
periods do not imply that adult development follows an ascending or hierarchical order.
His view is that ‘the [developmental] tasks of one period are not better or more advanced
than those of another, except in the general sense that each period builds upon the work
of the earlier ones and represents a later phase in the cycle’ (Levinson 1978, p. 320).
Thus, Levinson’s view is that the developmental periods are like seasons in that summer
must follow spring, but that summer is not more developmentally advanced than spring.
Consistent with this, when Levinson (1986, p. 12) refers to adolescence, he uses the term,
adolescing, to mean ‘moving toward adulthood’ and, referring to adulthood, he uses the
term senescing to mean ‘moving toward old age’ and death. In other words, when an
adult grows older and thereby moves into a later developmental period, it does not imply
that the individual’s capabilities have grown. I agree with Levinson to the extent that later
developmental periods might simply allow a person to develop a greater range of abilities
and interests.7 Levinson’s view, however, is contradicted by his findings indicating that

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certain high-level abilities that middle and older aged people were able to develop could
not have been developed unless they had developed certain prerequisite abilities in an
earlier period of adulthood. It seems quite clear to me that adults in later life stages are in
many cases acquiring capabilities that advance them to higher levels of the HD pyramid
than would be possible for individuals in early adulthood. It is certainly true, though, that
some older adults are only broadening their range of abilities and interests, not develop-
ing higher-level capabilities, and still others’ capabilities may unfortunately be declining
as they age. Nevertheless, it is important to note that a significant number of Levinson’s
findings seem to support the view that advancing to a later developmental period makes
possible the development of certain types of higher capabilities. This viewpoint of ascend-
ing capabilities over the life course is more obvious in Erikson’s (for example, 1982) work.
He makes clear that the full development of generativity and care must wait until middle
to late adulthood even though it is based on seeds planted earlier. The full development of
wisdom, integrity, and a number of other virtues must wait until relatively old age despite
their basis in strengths developed earlier.
From the research of Levinson, Sheehy and others, it is clear that adult human devel-
opment is generally not a smooth process; stressful episodes and periodic crises are not
uncommon. To a certain extent, this is inevitable, and adults need to figure out their
developmental paths for themselves. However, as Levinson (1978, pp. 336–40) recognizes,
it might make a lot of sense for society to try to smooth people’s developmental paths and
to help developmentally failing adults.
If a man’s early adulthood is dominated by poverty, recurrent unemployment, and the lack of
a reasonably satisfactory niche in society, his adult development will be undermined. His ener-
gies will [then] go to simple survival rather than the pursuit of a Dream or the creation of a life
structure that has value for himself and others. (Levinson 1978, p. 337)
If it were high on a nation’s priority list, much could be done to help improve adult devel-
opmental experiences especially in workplaces. In this regard, Levinson notes that ‘for
large numbers of men, the conditions of work in early adulthood are oppressive, alien-
ating and inimical to development’ (1978, p. 338). Levinson also notes that much could
be done to provide ‘some degree of emotional support, guidance and sponsorship’ that
would permit better development outcomes in early and middle adulthood. A society that
does more along these lines is making the kind of investments in human capital that are
likely to yield a high payoff for both individuals and society.
SMART PERSONS AND VIRTUE
In addition to the various types of human growth that we customarily think of as ele-
ments of human development, humans may develop virtues. Smart persons can develop
important virtues such as prudence, love of knowledge, courage, firmness, generosity, tem-
perance, and justice. Virtues are acquired capacities or dispositions that enable persons
to contribute in some generic way with a high degree of excellence to activities that are
challenging and important (McCloskey 2006, p. 64; Roberts and Wood 2007, pp. 60–64).
Virtues are not specific, technical skills and do not involve performing specific roles (for
example, managing a business or playing basketball). Virtues are habits of the heart

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(McCloskey 2006, p. 64), and they are deep, enduring, settled character qualities that are
formed by education in the broadest sense (Roberts and Wood 2007, p. 69). Virtues may
be perfections in the sense of perfecting our natural qualities. Or they may be correctives
in the sense of correcting our natural human defects (Roberts and Wood 2007, pp. 68–69).
Virtues generally enable us to achieve excellence in some sphere of activity such as
the interpersonal, the political or civic, the intellectual, or the moral (Roberts and Wood
2007, pp. 60, 215). Virtues may also enable us to achieve the kind of excellence sought in
a certain type of society. The predominant virtues people develop in a socialist or com-
munist society are likely to be quite different from those developed in a capitalist society.
In general, the virtues people develop will depend on political ideologies, religious ideals,
and the prevailing vision of the good society, etc. As Deirdre McCloskey (2006) explains,
capitalist societies, particularly Christian ones, tend to thrive when their citizens mani-
fest the seven ‘bourgeois virtues’ (love, faith, hope, courage, temperance, prudence, and
justice). Prudence is the central ethical virtue of the bourgeoisie. However, settling for
prudence alone, as all too many economists recommend, is a recipe for societal disaster.
A good, stable capitalism can only occur when prudence is conditioned by and integrated
with the other six virtues. In other words, in a healthy capitalistic society, it is important
that prudence, the profane (P) virtue, be sufficiently balanced by the sacred and social (S)
virtues, the other six (see Klamer and Yalcintas 2004; Khachaturyan and Lynne 2010).
Virtues, rather than being a product of activities or institutions in which the intended
goal is to develop certain virtues, are, generally speaking, developed as a by-product of
activities and institutions whose main purpose is something else. For example, in the
home, parents’ values, teaching, and example contribute to their children’s later develop-
ment of virtue. Similarly, school teachers’ values, teaching, and example are an impor-
tant influence on children’s ultimate virtue development. Another important influence
is children’s learning about admirable leaders in political, religious, business, military,
entertainment, and athletic spheres. Young people’s virtue development is also influenced
by their learning about important events in which the actions of persons in the news
have demonstrated out-of-the-ordinary, inspiring qualities. These different experiences
of young people may be instrumental in planting the seeds (values, ideals, and so on) that
only later when opportunities present themselves develop (with much intentional practice)
into full-fledged virtues. Note that with respect to intellectual virtues what is needed
is ‘training that nurtures people in the right intellectual dispositions’ in order that they
develop the ‘habits of mind of the epistemically rational person’ (Roberts and Wood 2007,
p. 22, original emphases). This ‘regulatory’ activity would ‘provide procedural directions
for acquiring knowledge, avoiding error, and conducting oneself rationally’ (Roberts and
Wood 2007, p. 21). Also note that developing human virtues is an activity that is consist-
ent with progressing to the highest level of development along all three developmental
pathways. In other words, developing virtue(s) is consistent with: (1) acquiring overall life
direction (pathway 1), (2) connecting to our highest values (pathway 2), and (3) develop-
ing creativity and peak performance (pathway 3). Moreover, it is consistent with the idea
that virtues represent uncommon, extraordinary development of character (Roberts and
Wood 2007, ch. 3).
No doubt, the person who has developed a high degree of virtue is a wise person whose
thinking and decision making reflect his or her wisdom. This wisdom is not the same
as having a high intelligence quotient (IQ), knowing a lot, or having a good technique.

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Wisdom is ‘the moral quality of knowing how to handle your own limitations,’ notably,
‘the ability to go against our lesser impulses [vanity, laziness, cowardice, and so on] for the
sake of our higher ones’ (Brooks 2014). A wise person with many virtues is a person who
has reached a very high level of HD. Arguably, a behavioral economics for smart people
can help us to appreciate the possibility of a wise human actor, but such a high level of
HD is not a conceptual possibility in mainstream economics or PE.
THE SMART PERSON RECONSIDERED
It is more difficult to specify the qualities and character of the SP than it is for economic
man or even for psychological economic man. This is because the qualities and charac-
ter of the SP are determined by multi-stage developmental processes that do not have
well-defined outcomes, even though much can be confidently said about the develop-
mental processes themselves. For example, we now know a great deal about the process
of neurodevelopment. However, for a specific person, the childhood neurodevelopment
outcome will depend on factors such as the quality of the person’s early childhood envi-
ronment and the person’s genetic endowment. A different set of factors will determine
a person’s developmental progress in later life stages. In general, a person’s development
will be determined by the kinds of life challenges the person encounters and how they
respond to those challenges. Persons who both experience relatively favorable life situa-
tions and who rise to the challenges they face will no doubt develop much farther along
the pathways than those for which this has not been the case. Also, a person’s develop-
ment can go further if he or she has benefited from an intervention (an investment in
intangible human capital) designed to help him or her overcome the difficulties that he
or she has experienced in the transition from one life stage to the next (see Tomer 2008).
In the absence of such an intervention, the person might have become stuck, unable to
move on to the next stage.8
How does SP compare to economic man and psychological economic man from
the standpoint of the stage of HD they resemble? As suggested earlier, economic man
resembles Wilber’s third stage in the development of human consciousness, egocentrism.
What stage do the other two stereotypical men resemble? First, psychological economic
man’s characteristics cannot be said to resemble any of Wilber’s (2001, pp. 5–13) eight
HD stages. This is because psychological economic man does not have a single charac-
teristic way of relating to other humans. Second, SP’s character cannot be definitively
specified, and, accordingly, cannot be said to have a close correspondence to the charac-
teristic behavior associated with any of the particular stages of HD identified by Wilber.
However, it is possible that the character of the SP economic actor could resemble one
of Wilber’s five stages of HD above egocentrism. For example, SP’s character could be
strongly conventional and conformist (level 4) or scientific, materialist, and achievement
oriented (level 5) or any of the other stages up to level 8, integrative (uniting feeling with
knowledge) (Wilber 2001, pp. 9–13). The actual position of a particular SP’s character on
this HD hierarchy will depend on the developmental progress that the SP has made. Since
very few people reach HD levels 7 and 8 and many reach levels 4, 5, and 6, SP’s develop-
ment is likely to be in the latter range. More generally, SP’s character, because it is a devel-
opmental outcome, is determined by the quality and duration of his or her developmental

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experience. In light of the above, perhaps we need to think more about the character of
the people our societies are developing.
THE PROSPECT FOR A BEHAVIORAL ECONOMICS FOR

SMART PEOPLE
The development of a behavioral economics for smart people arguably could end up being
very important. It could represent a significant step forward, not so much because it will
replace earlier economic thought, but because it will strongly suggest both new thinking
about what is possible with respect to developing human capabilities (a broadening of
the human capital concept) and new thinking about the goals and prospects for economic
policy. It could help economists and the public understand how humans, while not having
super rational abilities, do have greater potential than previously understood. An impor-
tant implication deriving from SP behavioral economics is that there is a great deal of
human potential that has heretofore not been realized because of the blinders imposed
on economic decision makers by prevailing economic thought. There is reason to believe
that research in the SP behavioral economics vein will help to remove the blinders and
point toward many of the ways in which individual human potential can be realized, and
thereby, the potential of economies around the world can be realized.
CONCLUSIONS
What economics needs is a behavioral economics with smart people. Unlike the economic
man of mainstream economics and psychological economic man of psychological eco-
nomics, the smart person develops capabilities and character in the course of advancing
from stage to stage along a number of major developmental pathways during his or her
lifetime. Because some persons will experience unfavorable environments without helpful
interventions, they may get stuck and fail to develop very far. On the other hand, other
people will advance to high levels of HD along a number of pathways. While smart people
are far from being perfectly rational, they can improve their capabilities and character,
learning to overcome many of their tendencies to error, thereby becoming competent,
boundedly rational, virtuous, even wise, decision makers who make big and small deci-
sions in their own best interests and in the best interests of their societies. A behavioral
economics with smart people would presumably be a more optimistic economics. This
is because it does not embrace the unrealistic rationality ideal of mainstream economics
nor the entirely predictable irrationality of psychological economics. This is also because
it embodies an understanding of how humans can in important ways improve themselves
and their societies even though they may sometimes fail in the process.
NOTES
* I am indebted to both Leonard Marowitz and Betty Devine who read an early version of the manuscript
and made comments and suggestions that have led to significant improvements.

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1. Wilber (2001, pp. 9–13) has estimated the percentages of the population that reach eight major conscious-
ness development levels. He estimates that less than 2 percent of the population reach the highest two levels
of development.
2. The language used by PE researchers further implies that the cognitive errors they identify are universalistic,
applying to all humans, not just particular groups of people (Etzioni 2014, pp. 394–5). There is, however,
some evidence supporting the view that some groups of people do not behave in a predictably irrational
manner.
3. Gerd Gigerenzer has explained in his research how human decision makers with limited computational
ability and knowledge in the face of limited time and resources may make reasonably good decisions using
heuristics, especially when they have had an opportunity for learning how to use them (see, for example,
Gigerenzer and Goldstein 1996).
4. See, for example, the important empirical research of Anda et al (2006) and Felitti et al. (1998).
5. Levinson’s research builds to some degree on the research of Carl Yung and Erik Erikson (Levinson 1978,
pp. 4–5); see, for example, Erikson (1982).
6. See also Levinson’s (1997) research on the adult developmental patterns of women.
7. It should be noted that there are certain types of human capabilities (athletic, mathematic, music, and so
on) for which peak performance typically occurs prior to early middle age. For example, there is evidence
that mathematicians generally make their greatest contributions prior to age 40.
8. Note that any society will have many characteristic developmental patterns, which include the typical devel-
opmental challenges faced and the typical levels of development reached by their citizens. In a particular
society, the term SP presumably would refer to a person whose development outcome is somewhat typical
for the society. Of course, in any society, there is considerable inequality in developmental outcomes. Thus,
it can be useful to distinguish among groups with broadly different levels of development and competence.
Recognizing this inequality may help us think more clearly about the kind of human capital strategy that
would be best to achieve a country’s HD goals as well as its economic inequality goals.
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Anda, R.F., V.J. Felitti, J.D. Bremner, J.D. Walker, C. Whitfield, B.D. Perry et al. (2006), ‘The enduring effects
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Ariely, D. (2009), Predictably Irrational: The Hidden Forces That Shape Our Decisions, revd edn, New York:
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Etzioni, A. (2014), ‘Treating rationality as a continuous variable’, Society, 51 (4), 393–400.
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Khachaturyan, M. and G.D. Lynne (2010), ‘Review of Deirdre N. McCloskey, The Bourgeois Virtues: Ethics
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Levinson, D.J. (1978), The Seasons of a Man’s Life, New York: Ballantine Books.
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McCloskey, D.N. (2006), The Bourgeois Virtues: Ethics for an Age of Commerce, Chicago, IL: University of
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Mill, J.S. (1836), ‘On the definition of political economy, and on the method of investigation proper to it’,
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PART II
ASPECTS OF SMART
DECISION-MAKING

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9 Behavioral strategy at the frontline: insights
and inspirations from the US Marine Corps
Mie Augier
1 INTRODUCTION
This chapter discusses and applies a few little ideas from the literature in behavioral
organizational theory and strategy and discusses some implications for strategic manag-
ers of the behavioral strategy framework.1 In particular, it argues that behavioral strategy
can help shed light on important decision making and organizational behaviors, illumi-
nating but also helping to address key biases; and helping to contribute to the strategic
design of the organizational and psychological architecture of organizations. This may
help managers to understand the influences of key behaviors and improve the strategic
management of them.
The field of behavioral strategy has recently become successful as a scholarly frame-
work (in particular within the strategic management literature); a framework which also
can serve as an important lens to understand and address management issues such as
behavioral biases. Behavioral strategy as an academic field is more recent than its practice,
just as the field of organizations and management existed as practices well before the
scholarly studies of them emerged. Indeed, it has been argued that ‘strategy’ as a practice
is inherently ‘behavioral’ (Levinthal 2011; Fang 2013). In addition, strategy (and strategic
management) is also inherently organizational; the strategic management of business
firms and other organizations is the art and science of creating and sustaining competitive
advantages in a world of competing organizations.
The organizational and behavioral nature of strategy and strategic management
combined make the nature of the manager’s task complex and challenging, dealing with
complex environment, limited rationalities, and uncertainties and ambiguities; but it is
also what makes it possible. There are traits, behaviors, norms, cultures, practices, and
organizational mechanisms that alone and together make it possible to understand empir-
ical behavior in organizations and, therefore, improve the management of them. The field
of behavioral strategy, explicitly emerging within the organizational and behavioral realm,
is therefore a promising field for scholars as well as practitioners; and, as it has evolved, it
has contributed to the explication of several key dynamics of decision making and behav-
iors in organization (around themes such as learning, biases, and the interaction between
individual psychologies and organizational characteristics), central to the domain of the
strategic management of firms (Levinthal 2011; Powell et al. 2011).
Behavioral organization studies and strategy holds valuable lessons for managers on
several fronts. For instance, it views the organization as being shaped by its own history
(as well as the interaction with others), but not entirely so, as there is room for proactively
shaping the strategic environment and one’s performance in it. Behavioral strategy also
provides important tools for implementing behavioral insights in practice (Lovallo and
157
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Sibony 2010). For example, understanding organizational behaviors and decision biases
are central to making strategic decisions in a proactive way and shaping outcomes without
being trapped by biases and earlier decisions (including investment decisions). Also,
(strategic) managers must be able to successfully identify strategic asymmetries in the
competitive environment, and translate those into the building and maintaining of com-
petitive advantages (preferably in a sustainable way). Moreover, managers must be able
to embrace essential and unavoidable uncertainties in the competitive battlefield – while
skillfully adapting their own organizations (with the inertias and competency traps that
entails). Strategic management and leadership of organizations is not easy, but behavioral
organizational strategy as a framework has valuable tools for understanding the strategic
environment, for understanding individual and organizational traps and biases, for under-
standing strategic asymmetries which can be useful in building organizational capabilities
and competitive advantages, and for adapting and implementing the steps as part of the
process of organizational adaptation.
The potential of the newly emerged perspective includes not only developing scholarship
or deriving managerial implications, but also facilitating the interaction and mutual learn-
ing between the scholarship and practice, thus enabling further development of empiri-
cally realistic scholarship as well as real world management strategies. That is, behavioral
ideas are useful not only for our theories about strategy and our management of them;
but also for the further (strategic) development of scholarly concepts and ideas (Simon
1986, 1997). In particular, behavioral strategy can help (re)connect behavioral perspec-
tives to the organizational context, relevant as most decisions take place in organizational
contexts (March and Simon 1958; Simon 1991).
To explicate the importance of behavioral strategy and behavioral ideas in strategy, the
chapter looks at a few behavioral concepts and ideas (organizational identification, the
exploration–exploitation balance and the importance of organizational ambidexterity,
and the nurturing of organizational innovation). Each of these dimensions are central
to organizational performance; yet difficult to manage. By using behavioral ideas about
organizations, decision making, and strategy to understand examples of such behavioral
issues in action, the chapter also uses the perspective as a lens to understand a few aspects
of an organization which is seemingly very successful in recognizing and managing the
behavioral and organizational aspects of strategy in practice.
The rest of this chapter elaborates some of these tools as relevant to understanding the
managerial implications of behavioral strategy (section 2), uses those concepts and tools
to understand the dynamics of a particular organization, the United States Marine Corps
(USMC) (section 3), before discussing insights from the Marine Corps for both manage-
ment and behavioral strategy as a field (section 4). The closing summarizes the chapter
and provides a few suggestions for further research.
Throughout the chapter, behavioral strategy ideas are used to explicate three ideas/
concepts/mechanisms useful for understanding aspects of ‘behavioral strategy in action’
in the Marine Corps, and with important managerial implications (which, in turn, may
also help develop further the field of behavioral strategy).
First, organizational identification and loyalty are powerful altruistic forces which
can help minimize costs as well as key biases in organizations (Simon 1991). How can
organizations encourage and develop organizational identification and loyalty, and how
can strategic managers help shape human motivation in organizations? Using behavioral

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Behavioral strategy at the frontline 159
strategy and examining how Marines cultivate – in part through design of organizational
and psychological architecture of their organizations – a devotion to the organization,
and the importance of this to their ability to adapt, have important implications for how
organizations can cultivate organizational identification and counter interest biases.
The second theme concerns balancing organizational routinization and innovation, and
managing inertias. Important research has led to greater understanding of competency
traps, stability biases, social biases; and the organizational tendency to, in particular as
they grow in age and size, repress variation, creativity and other forces which could lead to
innovation. Behavioral research has also shown that it is essential to try and generate and
manage a balance between the two. Using behavioral ideas, this chapter looks at how the
Marine Corps has tried to pursue both organizational rigidity/stability, and innovative-
ness (through their educational and organizational structures as well as their approach to
leadership). Lessons for management include the importance of intellectual outliers; and
a decentralized leadership and management structure allowing for new ideas to be heard,
regardless of where in the organization it comes from.
The third theme is the pursuit of organizational transformation through a strategy
of evolution with design. Creating even small changes in organizations is very difficult
and initiating organizational transformation even more so, but is also necessary in order
to adapt to the changes in competitor behavior and structure, and other external (and
internal) events. The Marines used behavioral ideas in action to guide their most compre-
hensive transformation in recent (if not all) history, which helped rebuild the organiza-
tion with ambidextrous elements in the design, enabled learning from failures and from
hypothetical futures, and focused on changing how the organization ‘think’, not just what
it could do. Lessons for managers include the importance of understanding the future
competitive environment (for example, minimize competitor neglect and other action-
oriented biases), and to design the organization to embrace competencies and routines
that improve efficiency but also with a key role for experiments and learning.
All three aspects or themes are examples of behavioral organization theory and strategy
‘in action’, and its managerial implications, but can also be useful for the future develop-
ment of the field of behavioral organization theory and strategy itself.
2 BEHAVIORAL STRATEGY, A WHIRLWIND OVERVIEW OF A

FEW KEY IDEAS
‘Behavioral strategy’, although only recently emerging as a distinct perspective within stra-
tegic management, is in many ways embedded in a significant part of the foundation for
organizational decision making and strategic management, as well as understanding (and
improving) management and strategy making in practice. Behavioral ideas about organiza-
tions have been part of the foundation for strategic management theory as it has evolved,
both in diagnosing and framing the field’s central questions and in shaping some of the
main scholarly perspectives such as evolutionary perspectives and (dynamic) capabilities
theory (see, for example, Rumelt et al. 1994; Winter 2000; Augier and Teece, 2007, 2008).
Building on the earlier foundational work in organizational behavior and combining
behavioral perspectives on organizations, research on behavioral and psychological deci-
sion making, behavioral strategy focuses on themes such as learning, attention, satisficing

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and cognition. Recent behavioral strategy work also has called for a ‘new beginning’ to
reconnect with behavioral economics and finance; to explicate the psychological ground-
ing; and to integrate further psychology and strategy (Powell et al. 2011).2 Identified
by merging ‘cognitive and social psychology . . . with strategic management theory and
practice’ and aiming to ‘bring realistic assumptions about human cognition, emotions,
and social behavior to the strategic management of organizations’ (Huy 2012, p. 240),
the ‘new’ behavioral strategy is often largely rooted in individual behavior, but behavioral
strategy as a whole also has significant organizational aspects, including insights into the
development of organizational competency traps which may be beneficial for the organi-
zation in the short run, but inhibit ability to adapt to change in the longer run (March
1991).
Implications for management and real-world strategy include illuminating certain key
biases and bringing to light unconscious processes in organizational decision-making
processes and asking key questions regarding the ongoing strategic processes in organiza-
tions, including if the strategic direction has to change, how to adapt and to what, and
what key trends are important for shaping the strategic context for the firm. Research into
the nature of organizational competency developments and the nature and need for inno-
vation and change (as well as the psychological and organizational barriers to change)
also include work on the mechanisms enabling and discouraging innovation and the pos-
sibilities and barriers to organization’s ability to adapt to disruptive changes (including
technologies) (March 1991; Christensen 1997).
Methodologically, behavioral strategy embraces multiple methods and methodologies
in order to better understand real behavior and decision making in organizations.3 Using
multiple methods, and disciplines, is important since understanding real-world behavior
does not fit one or two lenses very neatly; yet it is also quite difficult for many reasons,
including institutional and intellectual homophily which inhibits variation at the organi-
zational as well as the ideas level. The mechanisms of homophily (operating in organiza-
tions as well as in communities of scholars) includes the inclination of organizations to
recruit and retain people who are similar to each other in beliefs and competencies, as well
as individuals within organizations often seeking to work with those individuals who are
most like themselves. Over time, organizations forming groups of similar individuals are
unlikely to create and encourage new and innovative thinking, so central to the healthy
development of organizations and academic fields in the long run. Behavioral strategy,
by embracing an empirically relevant perspective and using multiple methods, may be less
likely (but not immune) to get stuck in such traps.
Recent contributions relate behavioral strategy to related perspectives from behav-
ioral neuroscience and cognitive neuroscience and reference point theory (Powell et al.
2011). Lovallo and Sibony (2010) emphasize also managerial implications, including
biases which management can understand and discuss using the language of behavioral
strategy. The biases are often manifestations of behavioral and organizational dynamics,
and are shaped by such dynamics often in co-evolutionary and self-reinforcing ways. For
example, ‘stability’ biases and organizational inertias are products of both individual
psychologies and resistance to change (such as loss aversion and biases for status quo), as
well as the way in which organizational routines and competencies develop, often leading
to under-sampling of trying new things, and oversampling of doing more of the same,
although for the organization to survive in the long run, a balance is central (March 1991).

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Another example around human motivation and conflicting interests in organizations

opens the door for issues such as misaligned incentives (people pursuing individual goals
at the expense of the organization’s goals) or misunderstanding (and misperceptions) of
organizational goals (Cyert and March 1963). Understanding and awareness alone does
not eliminate biases, but it is a central first step. For example, ideas from organizational
behavior can help managers understand and design organizations that are more ambidex-
trous and that have mechanisms to cultivate creativity and ‘hot groups’ within organiza-
tions; groups that explore new ideas, despite stability, competency traps, and social biases
for the status quo (March 1991; Leavitt 1995). Moreover, behavioral strategy can offer
insight into the ‘strategic organizational design’ of organizational structures as well as
the psychological and social architecture of the organization to help create a great sense
of organizational identity and loyalty which can help curb issues of misaligned incentives
and possibly help de-bias interest biases (Simon 1991). In both examples, integrating
insights from both the older and more recent work in behavioral strategy into the behav-
ioral and organizational nature of decision making can help us to better understand and
address the biases.
2.1 The Importance of Organizational Identification
Herbert Simon’s contributions to behavioral organization studies and strategy include

providing (with co-authors) many of the concepts which underlie behavioral economics
and strategy (such as bounded rationality and satisficing) (March and Simon 1958). There
is also in his work much untapped potential for strategy theory and management (Simon
1993; Augier and Sarasvarthy 2004). One source of insight and inspiration comes from
his ideas on organizational identification, loyalty, and altruism; all ideas and mechanisms
which counter self-interest seeking behavior and ‘interest biases’.4 A few decades ago,
Simon pointed to the irony that despite the ubiquity of organizations, many of our schol-
arly theories of organizations were based on individual behavior and analysis of markets,
rather than organizations (Simon 1991). He also emphasized the fact that real-world
behavior in organizations often included motivational aspects that many theories could
not explain, yet they were important to organizational dynamics and performance. Also,
as Powell et al. pointed out, in behavioral strategy, ‘the whole question is how particular
forms of behavior arise in and among organizations. If we do not show the mechanism,
we do not explain the phenomenon’ (2011, p. 1375).
A key in Simon’s ideas on identification is that while putting an organization’s goals
ahead of our own may not be beneficial for individual organizational or societal members,
it contributes to the overall adaptive and strategic fitness of the organization: ‘[S]ocial evo-
lution often induces altruistic behavior in individuals that has net advantage for average
fitness in society’ (Simon 1993, p. 160). He also finds that most economic and strategic the-
ories ignore the powerful role that organizational identification can have in shaping both
organizational member’s goals as well as their perceptions and cognition. Thus organiza-
tions with a higher degree of organizational identification and loyalty are more likely to
be able to sustain elements of altruistic behaviors and trust, reducing further costs (for
example, those associated with contracts and monitoring of possible agency problems),
as well as strengthening the organization’s sense of identity and ‘culture’. Organizational
identification can also help improve organizational coordination, as evolved shared goals

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and norms serve as ‘focal points’, reducing the costs of coordination and also making it
more adaptive (Simon 1991). Also, as organizational members develop a greater sense of
loyalty, they become more inclined to identity with the organization’s goals rather than
their own, thus reducing ‘interest biases’.
How can managers cultivate, foster and sustain organizational identification? Most
management literature gives little clues – building explicitly or implicitly on notions of
self-interest seeking individuals (embedded in concepts of ‘opportunism’ or ‘guile’; Dosi
2004; Augier and March 2008). The difficulty of building organizational identification,
given its importance, suggests that studying organizations which have a strong culture of
organizational identification might be useful.
2.2 Nurturing Innovation, Creativity and ‘Hot Groups’ within Organizations to Help
Develop Entrepreneurial and Dynamic Capabilities
Even though many organizations have evolved towards being smaller, flatter, and more
decomposed over the past decades, still many organizations are quite large. Big organi-
zations are great for many things, but they also have some weaknesses, at least from the
point of view of contributing to innovation and innovative capabilities in the long run.
Behavioral strategy is a useful lens for understanding and addressing key challenges of
big organizations, including:
● Stability biases and homophily dynamics. The tendency of organizations towards

institutional and intellectual homophily, and towards reinforcing stability and social
biases, and a tendency towards inertia rather than innovation.
● Inertia and competency traps. One of the most important concepts to capture the
tendency for organizations to get ‘stuck’ doing more of the same is March’s idea of
competency traps, and the need for organizations to balance exploring and exploit-
ing activities (March 1991). March has argued how organizations, in order to be
adaptive, must nurture and cultivate also the generation of new ideas, of creativ-
ity and other sources of innovation. The balancing between stability and change,
exploration and exploitation is one of the most difficult things to do, and organi-
zations such as Kodak are examples of failure to adapt owing to a fundamental
imbalance between exploration and exploitation.
● Organizations as ‘unhealthy’ environments. Hal Leavitt adds a dimension to the
competency trap argument by arguing that big organizations are ‘unhealthy’ envi-
ronments for human beings, in part because their hierarchical structure undermines
intellectual freedom and creativity which can lead to the generation of new ideas
and innovations at the organizational and industry level (Leavitt 2007).
Other reasons for the stifling of entrepreneurial activities include social biases and
norms leading to the elimination of outliers, and discouraging creative and ‘out-of-the-
box’ thinking. Repressing creativity and the generation of new ideas is detrimental not only
to the development of innovations in the longer run (and on the industry level), but also
to the generation of organizational capabilities in the individual firms. Creative thinking
and entrepreneurial behaviors are needed for managers too, and if not encouraged at all
levels of the organization it is less likely that managers will exhibit entrepreneurial qualities.

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Managers must think outside of the box, set new goals, visions, aspirations for the organi-
zation and create new paths forward (Simon 1991). Thus, understanding better how some
organizations cultivate individual outliers as well as hot groups is essential to the man-
agement of organizations (as well as giving inspiration to current managers as to how to
generate such entrepreneurial dynamics within the firm) (Leavitt 2007; Augier et al. 2015).
Carefully understanding the biases and dynamics of one’s organization (as well as
others) can help management counter some of the biases and help determine and set
clear and realistic strategies. The combined insights into behavioral and organizational
aspects of decision making improve management’s ability to learn from and adjust its
organizational and psychological architecture in order to develop robust capabilities for
competing in the long run. The next sections take a look at some of the mechanisms and
concepts of behavioral strategy ‘in action’.
3 COMPETING ON WARRIOR CAPABILITIES: THE ART AND

SCIENCE OF BEHAVIORAL STRATEGY IN THE USMC
One organization with great potential for strategy/management/leadership insights is the

USMC, a well-established organization, older and larger than most (business organiza-
tions at least) – yet it has received surprisingly little attention from strategy, organizations
and management scholars, although it is an organization which can give a lot of insight
and inspiration for practicing managers (as well as possibly for strategic management
scholars), regarding the art and science of strategy. The Marine Corps provides useful
examples of ‘behavioral strategy in action’, having both behavioral ideas about individual
and organizational decision making (such as embracing uncertainty and being highly
adaptive), as well as having mechanisms in place to counter some important biases.5 In
particular, the Marine Corps’ ability to cultivate organizational identification and loyalty,
its ability to maintain innovativeness, ambidexterity, and balancing of exploration and
exploitation (even within a large organizational and seemingly hierarchical structure), and
its adaptiveness through evolution with design might provide useful insights for managers
and management scholars alike.
The Marine Corps has a rich history of competing in several different environments
(including peacetime) since its birth in 1775. The issue of ‘What makes marines a marine’
has been the source of puzzlement for decades, including the strong sense of organiza-
tional identification and unity – despite seemingly strong hierarchy – as manifested, for
instance, in General Gray’s statement, ‘Every Marine is, first and foremost, a rifleman’ –
putting functional specialties and individual interests aside. Indeed, a lesson from Gray is
‘always put your organization and your people ahead of yourself’ (personal conversation
with General A. Gray), an interesting contrast to much of management theory’s emphasis
on self-interest seeking.
There are many components to what makes Marines seemingly more agile and able
to adapt, including: issues of the organizational structure of the organization; how they
cultivate their particular organizational culture; and if and how they attract those with
more broader and curious minds. Here the focus is on only a subset of components that
can help us see the relevance of behavioral strategy – for understanding organizational
dynamics but also for learning from them to better manage our organizations.

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At its most basic level, organizational capabilities include resources (physical, intellec-
tual and intangible), organizational aspects facilitating and shaping motivation, structure
and processes. As all organizational capabilities, the Marine Corps organizational capa-
bilities are more than the sum of its parts; more than the resources, training, and organi-
zational structures, it is the synergy between them that creates uniqueness. Elements of
Marine Corps ‘warrior capabilities’ include the following.
3.1 Cultivating Learned Selflessness, Organizational Identification and Loyalty
Human motives change over time, responding to experience and the surprises of history. (Simon
1993, p. 160)
As mentioned above, behavioral strategy suggests that certain kinds of human motivation,
such as loyalty, can increase organizational identification, which in turn can help mini-
mize interest biases and improve alignment with organizational goals. How organizations
train, mentor and educate people helps provide a better understanding of the organiza-
tion’s goals, values and culture. The Marines have an exceptional sense of organizational
loyalty and dedication to the organization’s goal. Part of that may be explained due to the
purpose and mission of the Marine Corps (as it might attract people dedicated to higher
causes), but there is also an important element of strategic organizational design, includ-
ing design of the psycho-organizational mechanisms to build and cultivate team spirit,
organizational identity and loyalty.
The Marines cultivate and build organizational identification and loyalty that encour-
ages a kind of ‘learned selflessness’ and concern beyond oneself, and an identification
with the organization’s goals, rather than individual goals, thereby contributing to one
of the most powerful altruistic forces in Simon’s discussion (Augier and Guo 2016). The
Marines do that at several (interrelated and overlapping psychological, psycho-cultural,
sociological, physical, intellectual) levels, including:
● Sematic level: entering boot-camp, young Marines are no longer identified by their
individual name but by reference to ‘this recruit’, ‘that recruit’, and so on; so the
loss of ‘self’ relative to the identification with the organization is embedded even in
the language used.
● Symbolic level: a first symbol of losing individual identity and giving up self is
yellow footprints at the entrance to boot-camp, symbolizing a new path for the
young Marines, stepping towards the disappearance of the individual and into a
tradition and culture of selflessness and sense of duty. Stripping away individual
characteristics include also the haircuts; sometimes making the young marines
unrecognizable to themselves (which helps them shed their individualism and build
team and organizational identity).
● At the physical level, Marine boot-camp is well known for its grueling exercises
and tough physical standards. That too helps build team identity. For instance, by
punishing recruits as a group for individual behavior (for example, being slow or
otherwise not living up to the organization’s standards) helps instill the sense that
any organization or team is only as strong as its weakest link (and discourages
agency problem behavior). Several exercises are also designed to only be able to be

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successfully finished as teams. They also are taught to embrace uncertainty and fear,
and to run towards the sound of the gun, not away from it.
● The fact that the Marine Corps builds a new identity instills in the young men an
attitude that being a Marine is not a job; it is a calling. Such values help encourage
an organizational identity and loyalty, and a pursuit of a logic of identity rather
than one of consequences.
Thus the building of team identity, organizational identification and loyalty in the
Marines has several levels and layers; including aspects of ‘strategic organizational
design’ (for example, of exercises) as well as design of the psychological architecture and
mental characteristics of marine training and education. This involves knowledge of what
motivates humans and how to train and change psychology and behavior, as well as how
individuals interact and are shaped by others and by the organizations they are in, in a co-
evolutionary way. The facilitation of organizational identification and loyalty can reduce
possible conflict of interests as well as ambiguities and misperceptions about goals and
interests. It also helps Marines to be highly adaptive on the battlefield.
3.2 Competing on Warrior Capabilities: Designing Ambidextrous Organizations to

Counter Biases and Competency Traps
Marine training also signifies another interesting aspect of the organization; it exempli-
fies behavioral strategy in action and illustrates one way of managing the dynamics of
inertia and innovativeness – not by balancing them (as in ‘either-or’), but by integrating
them (both-and) into the heart of the organization’s capabilities. As the Marine Corps’
training guide states: ‘Training must be challenging. If training is a challenge, it builds
competence and confidence by developing new skills. The pride and satisfaction gained by
meeting training challenges instills loyalty and dedication. It inspires excellence by foster-
ing initiative, enthusiasm, and eagerness to learn’ (USMC 1996, p. 4). It is not that marine
training does not emphasize routines and rigidity; boot-camp is, after all, about the
transmission of basic routines needed for successful military operations; marine training
in history, martial arts, swimming, land combat – and training 37 000 recruits annually –
requires much standardization, routinization and rigidity (Guo and Augier 2015).
However, along with a reputation for rigorous training, the Marine Corps has also
developed an instinct and inclination for innovativeness and a capacity for out-of-the-box
thinking (for instance, the Marines have implemented one of the most visible and effective
energy programs, the Expeditionary Energy Office). How can one organization simulta-
neously pursue rigidity and innovativeness? The routines underlying Marine training are
focused enough to provide direction, yet flexible enough to accommodate the needs to
adapt to changing conditions and commanders at all levels of the organization. Moreover,
Marines are encouraged to think outside the box and ‘think strategically’ at all levels,
despite a seemingly very hierarchical organization. The ability to listen to ideas from all
levels is key to other intellectually innovative organizations in the past (Augier et al. 2015).
The uniqueness of the Marine Corps from an organizational and capabilities perspec-
tive includes not only the important element of identification and altruism mentioned
above, but also the fact that the Marine Corps is, effectively, ambidextrous by nature,
mixing and integrating ‘core competencies’ of other services. While the Army is known for

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and trains for land combat, the Air Force for its flying, and the Navy for sea capabilities,
the Marine Corps has important land as well as sea and air components, so it has a built-in
need for flexible capabilities as well as for a mindset that is both able to learn from the past
(and from other organizations) as well as creating the future (and combining capabilities
and ideas).
The embracing and simultaneous pursuit of exploration and exploitation in the Marine
Corps is made possible in part by the leadership style. Far from being about micro man-
agement, a key to how Marines operate is the shared understanding of the commander’s
intent (again, made possible by organizational loyalty and identification). In particular
when in combat, the ability to adapt and be innovative at the front line comes from the
ability of junior leaders to make in-real-time decisions – based on their understanding of
their leader’s intent.6 The shared understanding of the organization’s goals (minimizing
interest biases through training and the building of loyalty) is also made possible through
organizational communication; not formal communication channels but largely informal
and implicit channels; almost shared mental and cognitive models or frames:
We believe that implicit communication – to communicate through mutual understanding, using

a minimum of key, well-understood phrases or even anticipating each other’s thoughts – is a
faster, more effective way to communicate than through the use of detailed, explicit instructions.
We develop this ability through familiarity and trust, which are based on a shared philosophy
and shared experience. (USMC 1997, p. 72)
3.3 Organizational Transformation is Difficult but Not Impossible
A third lesson from the Marine Corps exemplifying behavioral ideas in action relates
to the difficulties in creating strategic change and transformation in organizations.
Organizational change and transformation is so central to organizational adaptation, yet
also very difficult. Powerful mechanisms of individual and organizational inertia include
stability biases (such as preference for status quo, anchoring and loss and risk aversion);
social norms and biases; and individual and organizational and bureaucratic inertia which
alone and together make organizational change exceptionally difficult.
The Marine Corps has successfully changed and adapted to the changing strategic envi-
ronment over the past centuries. One of the most recent comprehensive transformation
of the Marine Corps into a more adaptive organization was in the late 1980s and 1990s,
led by legendary Marine General Alfred Gray, which manifested behavioral strategy at
organizational design level, living strategy and the strategic management of organiza-
tional change as a process of evolution with design. A core insight is the limited ration-
alities and psychologies (and dynamics of the changing strategic landscape) not only of
the strategic competition (who might opponents be 30–40 years from now?), but also the
limited rationalities and psychologies of our own organizations and people. Gray knew
that in order to really improve the Marine Corps, he had to change ‘how the organiza-
tion thought’. The transformation needed to be intellectual as well as organizational and,
starting with a hard diagnostic look, needed to be about how to think, not what to think.
Gray outlined a framework for ‘war-fighting’, which evolved as a symbol of adaptive
and strategic thinking. A key text which is read by all Marines at all levels, ‘War-fighting’
was first described as a ‘doctrine’ but was much more than that; it is a philosophy and a
strategic way of thinking instilled in all Marines regardless of rank and age, and to be

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applied in peacetime as well as in wartime. In Gray’s words, it is a ‘philosophy for action

that, in war, in crisis and in peace, dictates the Marine Corps approach to duty’ (personal
conversation with General A. Gray). The overall war-fighting framework also became a
foundation and framework for the Marine Corps’ central initiatives, such as maneuver
warfare and decentralized leadership.7 Central ingredients in the philosophy were to be able
to understand competitor weaknesses (a strategic asymmetry) and to use agility, decen-
tralized decision making and speed to their own advantage. In effect, maneuver warfare
emerged almost as a behavioral and evolutionary alternative to previous static approaches.
The broader context for war-fighting and maneuver warfare as paradigms for enabling
strategic change within the Marine Corps had a lot to do with the strategic context in
which the Marine Corps found itself after Vietnam. The concept and philosophy did not
come out suddenly, but resulted from organizational adaptation and careful strategic
organizational design in order for the organization to adapt to the changes in the external
strategic environment. Gray had encountered maneuver warfare earlier (having spent a lot
of his youth overseas and having done a lot of reading). He had read a lot of Clausewitz –
but also developed an affinity for Sun Tzu, studied strategic deception, and was interested
in learning from mistakes made in past conflicts (in particular, Vietnam and Korea). The
end of Vietnam War was a time of crisis for the country but also for the Marine Corps
as an organization. They had lost some of their traditional core competencies and had
big moral problems and knew they needed to upgrade the quality and capability of the
organization, starting with education; broad reading lists also became an integral part of
the Marine Corp’s educational experience, helping young marines to be intellectually agile
as well, and cultivating broad and curious minds and lifelong learning.
Another aspect of the upgrading of Marine Corps capabilities had to do with learning
from experience and from experiments including failures. To buffer innovation within
the organization (and to protect it from mechanisms that would kill it), Gray set up a
maneuver warfare board in the second marine division in order to show the rest of the
organization that using maneuver warfare could be successful and was central for organi-
zational adaptation. At the training level, Gray also set up a combined arms operations
exercise to test ideas. This was a free-play type exercise in order to inspire and facilitate
learning across all levels and to encourage creative thinking and after-action discussions
in environments where subordinates could speak freely and contradict superiors without
fear and commanders could learn to receive criticism.
While the maneuver warfare board as an organizational experiment did not last long,
it illustrates the kind of experimentation with ideas and organizations which behavioral
strategy scholars have argued can lead to improved adaptation (March 1991). It also
illustrates Gray’s profound belief in people and in ideas; when asked about how he
managed to change organizations (despite all the reasons organizations resist changed),
he said ‘It’s easy! Unleash the people with ideas; and protect them from bureaucrats,
admin and paperwork’ (personal conversation with General A. Gray); a refreshing
bottom-up approach to change, very much in keeping with the emphasis from March and
others on the need for nurturing novel and new ideas. In keeping with this, the current
Marine Corps commandant issued a call just last year for more disruptive thinkers in
the organization.

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4 MANAGING ORGANIZATIONS WITH THE TOOLS OF

BEHAVIORAL STRATEGY AND WITH INSPIRATION FROM
BEHAVIORAL STRATEGY IN ACTION
Building on the foundations and concepts of (old and new) behavioral strategy, and using
some insights and inspirations from the USMC, we can find several ideas useful for stra-
tegic managers in organizations today. These include the following.
4.1 Building Organizational Loyalty
Leaders should think more about others than themselves . . . Being in the [organization] is not a
job. We don’t work . . . We serve. (General Alfred Gray, 1991)
Recognizing the importance of mechanisms and behavioral ideas such as organizational

loyalty, identification and altruism, how can managers help encourage and cultivate such
behaviors? While business organizations probably will not develop ‘boot-camps’ for
their people anytime soon, looking further into the psychological mechanisms of how
the Marine Corps builds identification through boot-camps might provide insights that
managers can be inspired to try to cultivate organizational identification.8
4.2 Embracing Uncertainty and the Simultaneous Pursuit of Exploration and

Exploitation Can Help Counter Pressures towards Competency Traps
In the ‘fog of war’ there is chaos, and in that chaos opportunities present themselves. (Gray
1987, p. 18)
Behavioral strategy embraces uncertainty and ambiguity rather than trying to repress it.
The competition organizations face involves uncertainty but if embraced, rather than
assumed away, can also help shape the competition in the future. This involves under-
standing the psychologies of competitors, trying to create and utilize asymmetries in the
competition to create and sustain competitive advantages. At the heart of this is a behav-
ioral conception of decision making with individuals being limited in their rationalities
and computational powers (March and Simon 1958; Cyert and March 1963).9 Thus the
basis of the management of organizations in behavioral strategy is the ambiguity and
uncertainty inherent in all decision making, giving rise to particular behaviors and neces-
sitating the facilitation of shared perceptions and beliefs, starting with the leader’s vision
and an understanding of the nature of the organization and its strategic environment.
Technology has a place in uncertain situations, but not trying to reduce it. Marines use
‘technological advances to facilitate the human interface, not to chase after certainty in
an inherently uncertain environment’, thus living the essential ‘ambiguities of experience’
(Mattis 2006, p. 16).
Another insight from the Marine Corps is its ability to be adaptive in the battlefield
owing to decentralized decision making and, essentially, satisficing (not maximizing) deci-
sions. This is consistent with insights from behavioral decision making and strategy that
have emerged with implications for both individual decision making and organizational
behavior. The insight is that, in addition to perception, the human brain has other modes
of thought – intuition and reasoning – each with its own characteristics. Intuition is

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particularly relevant to on-the-spot decision making in competition where there is no time

for careful analysis of alternative options – much less any attempt to optimize. Instead,
behavioral strategy and the Marines’ approach show that there is an evolutionary and
adaptive value to being able to make on-the-spot ‘good enough’ solutions (Simon 1955).
The research into and the importance of how Marines, chess players, fighter pilots, inten-
sive care medical personnel and others use intuition and knowledge of past experiences
without much analysis also invites further research on behavioral strategy into these proc-
esses and the synergies between the art and the science of strategic management.
4.3 Pursuing Organizational and Strategic Transformation through ‘Evolution with

Design’
One of the paradoxes of organizations is that the more they build capabilities to do
one thing, the less inclined they are to do others. Management scholars have pointed
to the importance of ambidextrous organizations; those that can manage and balance
both exploration and exploitation. Embracing a metaphor of organizational strategic
management as one of evolution with design puts emphasis on the continuing strategic
transformation and renewal of organizational capabilities as well as using and refining
existing ones.
Managers can help create better environments for this through strategic organizational
design of the organizational and psychological architectures to facilitate learning, includ-
ing from failures and counterfactual histories. Also central is an environment where ideas
matter at least as much as rank; new ideas often do not come from the top of the organiza-
tion, and if organizational members do not feel free to discuss them, these ideas will never
reach the top. Google and others are famous for having setups for experimental thinking,
and RAND, many years before, had carefully thought of this as well. It is essential to have
an environment that encourages creative thinking. A former commandant of the Marine
Corps University noted that he wanted a place where ‘freedom of thought was not only
encouraged but rewarded. The idea is that the experimentation should be taken to the
failure point . . . that only by reaching that point would we understand the unknowns’
(personal conversation with General A. Gray).
Finally, at the level of the strategy making and the strategic leadership of such evolu-
tionary and behavioral management processes, an important implication is captured in
Henry Mintzberg’s image of a potter modeling clay into a piece of pottery being a better
metaphor for how organizations actually develop strategies (rather than the planning met-
aphor in which senior decision makers formulate courses of action based on systematic,
rational analysis of oneself and competitors, one organization’s strengths and weaknesses,
and so one) (Mintzberg 1987).
Such lines of thoughts suggest that we can generate implications for the generation of
management strategies, including: learning about (and trying to cultivate) organizational
identification and loyalty (to minimize interest biases; encouraging innovative and out-
of-the-box thinking (countering stability biases and competency traps); and embracing
a vision of strategy as one of evolution with design, with decentralized leadership with
emphasis on shared visions.

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5 CLOSING
The early work by behavioral organization scholars on the limitations of rational decision
making was central to the development of ‘behavioral economics’ and its applications to
investment decisions (and the subfield of behavioral finance); and behavioral organization
theory also was significant as a foundation stone for the very field of strategic manage-
ment as it began to take off in the 1990s. Work in the field of strategic management has
continually built on and integrated these ideas as it has also evolved concepts (such as
core competencies and dynamic capabilities) that are behavioral in origin and with impli-
cations for management, and this has helped the field of behavioral strategy to take off.
Discussing the new developments in the field of behavioral strategy, Powell et al. (2011,
p. 1370) noted that practitioners are skeptical, ‘doubting whether the field can go beyond
cognitive biases to produce useful framework that integrate psychology and strategy
practice’. They then attribute a large part of the problem to ‘inadequate paradigm devel-
opment’ within the behavioral strategy camp itself, partly due to terminological confusion
and not being sufficiently embedded in the existing intellectual and institutional structure
of the larger research community.10 However, such a ‘pre-paradigmatic’ state also offers
opportunities. For example, as fields become more ‘mature’ and professionalized, centrip-
etal forces often lead to an increase of conversations within itself, thus inhibiting interdis-
ciplinary learning. Moreover, it is also interesting to note that other fields and subfields
developed some of their most successful – and empirically relevant and operationalizable
– contributions before they became too self-aware of their development as a ‘field’.
This is not an argument against developing behavioral strategy further; that is key too.
However, doing it in a way that is less concerned about its relative status within the aca-
demic fields, and more concerned about developing behavioral strategy in a ‘behavioral’
(and empirically realistic) way, means that the field is less likely to get too far trapped in the
usual competency traps of specialization, and more likely to be able to retain core behav-
ioral elements, such as using different research methodologies, as well as being able to help
organizational and behavioral strategy remain empirically relevant in Simon’s sense (1997).
Several decades of work in behavioral strategy ideas and perspectives have brought
about important concepts and ideas on several fronts. For example, at the level of the
development of ideas on management, the areas of management, organizations, econom-
ics, leadership and strategy have become enriched with behavioral ideas and concepts
(such as bounded rationality, routines, slack, and learning), helping to motivate new sub-
fields such as evolutionary and capability reasoning, which, in turn, are key inspirations
for the ‘new’ behavioral strategy framework. Such a framework, especially when combin-
ing old and new behavioral ideas, invites research on organizational altruism, innovation,
‘hot groups’, intellectual outliers, and creativity – in addition to already semi-established
sub-fields such as entrepreneurship and learning.
In addition to being a useful lens for developing the field(s) of strategy organiza-
tion, and understanding issues such as biases in organizations, the behavioral strategy
framework is also possibly useful for examining practices not usually well understood
in the strategy literature – including issues of organizational identification and loyalty.
Although many of these go against much of the scholarly work on strategy, they are
important parts of the real-world psychological and social processes in organizations;
and also can deliver important value (contributing to issues such as retention, trust, and

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networks). By explicating such processes in real-world organizations, we may also, in time,

help shape the future development of behavioral strategy as a field.
NOTES
1. The use of the term ‘little ideas’ is inspired by Jim March’s style and approach to research (Augier 2015;
Maslach et al. 2015).
2. We can further argue that since strategy is essentially organizational in nature, it might be relevant to recon-
nect behavioral strategy (again) with organizations (without downplaying the work on individual decision
making), and to try and develop behavioral strategy in a ‘behavioral’ way (Simon 1986).
3. This is an argument in both behavioral strategy and some of its intellectual foundational roots. See, for
example, March (1965), Simon (1954) and Powell et al. (2011).
4. Understanding the mechanisms of organizational identification and how it influences organizational per-
formance and strategy can also help address a call from the ‘new’ behavioral strategy school: ‘Behavioral
strategy has a long way to go in linking individual psychology with organizational strategies. One of the
distinctive features of strategic management is its emphasis on collective behavior, and behavioral strategy
must explain the psychological or social mechanisms by which mental processes affect organizations’
(Powell et al. 2011, p. 1374).
5. Using empirical behavior in organizations as inspiration for understanding certain managerial behaviors
(as well as for theory development) is consistent also with the ‘old’ behavioral organizational perspective
underlying the field of strategic management as the ‘old’ field of behavioral organization studies started
from (1) using different disciplinary perspective and ideas to get insights into real organizations and (2)
using empirical studies of mechanisms in real-world organizations, to inform the further development of
those theories as well as facilitating a better understanding of practice, thus embracing both an inter-dis-
ciplinarity in theories and methodologies as well as two-way street learning between scholars and practice
(Simon 1986).
6. ‘[S]ubordinate commanders must make decisions on their own initiative, based on their understanding of
their senior’s intent, rather than passing information up the chain of command and waiting for the deci-
sion to be passed down. Further, a competent subordinate commander who is at the point of decision will
naturally better appreciate the true situation than the senior commander some distance removed’ (USMC
1997, p. 71). We elaborate on the leadership aspect in Augier and Guo (2016).
7. Inspired by Sun Tzu, and in keeping with the Marines’ embrace of uncertainty, maneuver warfare is about
embracing and even creating ambiguity and uncertainty: ‘Maneuver warfare seeks to shatter the enemy’s
cohesion through rapid, focus and unexpected actions which create a chaotic situation with which the
enemy can not cope’ (USMC 1997, p. 73).
8. This also appeals to a logic of identity rather than a logic of consequences, and doing things not because
of their consequences, but because it is a calling and a duty; a sense of ‘doing what must be done’ (Gray
1991a).
9. This has been at the heart of behavioral ideas since Simon’s landmark articles in the 1950s explicating the
dynamics of the limits to rationality and satisficing. Also embraced by Marines: ‘A military decision is not
merely a mathematical computation. Decision making requires both the situational awareness to recognize
the essence of a given problem and the creative ability to devise a practical solution. These abilities are the
products of experience, education, and intelligence’ (USMC 1997, p. 86).
10. ‘The term “behavioral strategy” is not widely used and means different things to different people.
Behavioral strategy does not have an agreed statement of purpose, conceptual framework, core research
problems, methodological standards, communities of scholarship, or supporting institutions’ (Powell et al.
2011, p. 1370).
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10 Feminist economics for smart behavioral
economics
Siobhan Austen
1 INTRODUCTION
Many of the key themes and concerns of feminist economics were summarized by
Marianne Ferber and Julie Nelson in their introduction to the ten-year retrospective
Feminist Economics Today: Beyond Economic Man. They noted that feminist economics
is distinctive in the serious attention it gives to women, its challenging of the common
confusion of gender and sex, and its challenging of the economics discipline in masculine-
only terms (Ferber and Nelson 2003, pp. 1–2). They highlighted the social construction of
both economic behavior and the contemporary discipline of economics.
Several of the themes and concerns of feminist economics overlap those of smart
behavioral economics. There is, for example, a shared critical perspective on mainstream
economic models and a common concern with the particular issue of preference forma-
tion. In this chapter we elucidate key themes in feminist economics and highlight its
relevance to smart behavioral economics.
The discussion in this chapter is organized through the use of concepts drawn from the
institutional analysis and design (IAD) framework developed by Elinor Ostrom and her
colleagues. Although this framework is most commonly associated with new institutional,
rather than feminist, economics, its concept of situated actors is relevant to one of femi-
nist economics’ central themes: of the gendered nature of economic behavior. The IAD
framework allows us to trace out the various ways that men’s and women’s preferences
are shaped by socially learned expectations associated with being male or female. This is
particularly useful for the analysis of observed sex-based differences in behavior, a field
of research where the interests of many behavioral and feminist economists appear to
intersect.
Several additional aspects of the IAD framework, including the influence of mental
models on individuals’ processing information, can be used to highlight other shared
interests of feminist and smart behavioral economists. This chapter includes a discussion
of how ideas about the structure and influence of mental models are in line with the femi-
nist critique of the methods commonly used in studies of sex-based differences in behav-
ior. In doing so, the chapter highlights a further important theme in feminist economics,
that science is a socially constructed activity, with the social location, status and gender
of scientists and scientific communities all playing a significant role in determining the
methods and practices of science (Barker 1999, p. 325).
As a meta-theoretical framework, the IAD also has the advantage of facilitating com-
parisons of different theories and models. This helps us identify some of the particular
features of feminist and smart behavioral economics in comparison with other theoretical
traditions in economics, including mainstream economics. Toward the end of this chapter
173
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the discussion focuses on the feminist economics’ critique of the separate/soluble dichot-
omy in mainstream economics, whereby individuals in market situations are assumed to
be atomized, self-interested, with exogenously determined preferences, while individuals
in family situations are characterized as connected to each other, altruistic and engaged
in a process of shaping preferences. Feminist economists have identified several problems
associated with this dichotomy, including barriers to the economic analysis of the unique
aspects of women’s lives. Reflecting one of feminist economics’ basic aims, of addressing
the realities of women’s lives and their economic and other contributions (Harding 1999,
p. 131), an alternative concept is thus advanced; that of ‘individuals-in-relation’. The
chapter argues that this concept has the potential to guide future empirical and theoretical
studies of men’s and women’s economic behavior.
Some prominent feminist economists have already identified the strategic potential
to link new institutional economics, which is Ostrom’s field, with feminist theory. Paula
England and Nancy Folbre (2003, p. 62), for example, note the relevance of concepts such
as endogenous tastes and reciprocity, which feature in new institutional (and smart behav-
ioral) analysis, to notions about the gendered nature of economic behavior.
However, many feminist economists contest other core concepts of new institutional
and smart behavioral economics, such as the notion of boundedly rational economic
agents. Julie Nelson (2003a, 2003b), for example, emphasizes the emotional and subjec-
tive aspects of decision-making, albeit the latter is incorporated in behavioral economics.
Acknowledging these tensions, this chapter aims to further explore the potential
connections between feminist, smart behavioral and new institutional economics. The
organization of the chapter reflects these aims. The following section provides a brief
introduction to the IAD framework. This is followed with a summary of the key features
of feminist economics. Section 4 turns to a key research topic where the interests of
feminist and smart behavioral economics appear to intersect, namely, the presence (or
otherwise) of differences in the preferences and behavior of men and women. Section 5
explores the issue of (possible) differences in risk aversion in some detail, while section
6 considers the issue of altruistic preferences. Section 7 brings the discussion to a close
with a summary of the key themes of feminist economics and some recommendations for
smart behavioral economic research.
2 THE INSTITUTIONAL ANALYSIS AND DEVELOPMENT

FRAMEWORK
The IAD framework is closely linked to the life work of Elinor Ostrom, the first (and thus
far the only) woman to be awarded the Nobel Prize in economics. Ostrom described the
IAD as a multi-level taxonomy of the universal components (organized in many layers)
that are relevant to regularized social behavior (including interactions in markets, hierar-
chies and other situations).
The broad features of the IAD framework are summarized in Figure 10.1. Of prime
importance is the idea of an action arena. This is a ‘social space’ within which ‘par-
ticipants with diverse preferences interact, exchange good and services, solve problems,
dominate one another, or fight’ (Ostrom 2005, p. 14). The focus of IAD analysis tends to
be on how the interaction between participants in different action situations is affected by

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Feminist economics for smart behavioral economics 175
Exogenous variables Action arena
Biophysical/
material conditions
Action situations
Interactions
Attributes of Evaluative
community criteria
Participants
Rules
Outcomes
Source: Ostrom (2005, p. 15).
Figure 10.1 A framework for institutional analysis
the characteristics of the situation itself, including the characteristics of the participants
and their positions, preferences, levels of information, approaches to information process-
ing, possible actions and potential payoffs.
As Figure 10.1 indicates, interactions within situations lead to particular outcomes,
which may be desirable or undesirable. The framework incorporates feedback loops to
account for the way in which participants may respond to these outcomes by engaging in
efforts to either change or reinforce the structure of the arena (as indicated by the line at
the bottom of the figure).
An important feature of IAD framework is its emphasis of the context of each action
situation. Each action situation is understood to be ‘located’ within an action arena that
is affected by a range of exogenous variables, including the attributes of the bio-physical
world, the structure of the more general community (including the values generally
accepted and the prevailing gender norms within the community), and the current set of
rules in use, which will reflect the arena’s historical context.
Some aspects of Ostrom’s work address the role of culture in shaping the mental
models used by boundedly rational participants in different action situations. Ostrom
(2005, pp. 106–7) highlights how the cultural environment, including its prevailing gender
norms, shapes participants’ perceptions of what actions are possible, legitimate and
desirable (or preferred), and it coordinates the actions of groups of participants. She also
asserts that, because mental models are affected by culture, they are likely to be transmit-
ted across generations, producing stability in patterns of behavior and outcomes over
time. However, in Ostrom’s analysis, mental models can change/are not constant. Factors
such as vividness and salience can be relevant to the type of model that is adopted and
can be a source of change or difference in participants’ perceptions and actions (Ostrom
2005, p. 108).

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3 FEMINIST ECONOMICS
The IAD can be used to explain key features of feminist economics. Feminist econom-
ics can be distinguished especially from mainstream economics by its concern for the
influence of the contextual environment on the preferences, possible actions, payoffs and
outcomes for men and women in market and family situations. The ‘situated’ nature of
economic behavior is a fundamental concept in feminist economics. Informed by feminist
philosophy of science, feminist economics considers how individuals’ (participants’) eco-
nomic power, obligations, goals, interests and, ultimately, their economic outcomes are
affected by their social roles and relationships, and how these, in turn, are affected by their
ascribed social identities, including their gender, race, sexual orientation, and ethnicity.
As its name suggests, feminist economics pays particular attention to the gendered
nature of the contextual environment, and its implications for men’s and women’s eco-
nomic roles, actions and outcomes. Gender is distinguished from sex, or the biological dif-
ferences between males and females.1 It is understood that societies or communities assign
different roles, norms, and meanings to men and women and their actions. For example, in
most societies individuals are assigned to distinct social roles based on their gender (such
as men to ‘breadwinner’ and women to ‘caregiver’ within the family). Men and women are
also expected to comply with different norms of behavior (for example, men are expected
to be brave, and women modest). Furthermore, psychological traits of masculinity and
femininity are linked to gender norms (for example, women are considered virtuous if
they comply with a norm of modesty but assertiveness can be considered a vice).
Using the language of the IAD, a community’s gender norms affect various elements
of the action arenas within which men and women participate. The norms influence
the ability of men and women to participate in particular situations, the positions that
they can take up within these situations, the range and nature of their possible actions,
their access to information, and, potentially, the way they process this information, their
payoffs from different actions, and, arguably most importantly, the quality of their out-
comes. In turn, the gendered distribution of economic outcomes is likely to be reflected
in patterns of action at various levels of the social hierarchy aimed at either entrenching
existing norms or challenging them.
The way in which these perspectives have influenced the feminist economic analysis of
economic behavior and outcomes can be illustrated with examples relating to the labor
market. Feminist economic analysis of occupational choice have focused on the impact
of social structures and relationships on women and men’s work and career goals (Pujol
1997; Strassman 1997). Studies of the gender pay gap have explored the influence of social
norms associated with providing care on the distribution of unpaid household work and,
subsequently, on the gendered nature and configuration of work (Folbre 1994). Other
studies have examined the failure of apparently gender-neutral market institutions to
adequately value the commodities produced by women (Himmelweit 1995; Ironmonger
1996).
Importantly, feminist economics’ emphasis on the social construction of behavior and
outcomes has also influenced its relationship with the discipline of economics. Feminist
economists have identified the influence of a range of gender norms and cultural biases
on (using the language of the IAD) the action situations associated with the development
and perpetuation of economic theory. These include the tendency for ‘culturally “mascu-

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line” topics, such as men and market behavior, and culturally “masculine” characteristics,
such as autonomy, abstraction, and logic . . . [to] define the field’ (Ferber and Nelson
2003, p. 1). It is important to note that feminist economics challenges these definitions
of economics, and devotes energy to exposing the biases in the discipline, in addition to
focusing on ensuring that the lives and experiences of women feature in economic analy-
sis, and attempting to remedy the common confusion of gender with sex.
4 FEMINIST ECONOMICS AND THE ANALYSIS OF

OBSERVED DIFFERENCES IN THE PREFERENCES AND
BEHAVIOR OF MEN AND WOMEN
As can be anticipated, given the description provided in the previous paragraphs, femi-
nist economics’ analysis of observed differences in preferences and behaviors of men and
women is distinguished by its focus on their social origins. Observed differences in the
preferences and behavior between men and women are, thus, often the starting point of
inquiry (into their origins), rather than the end point of an investigation of (apparent)
differences in the ‘natures’ of men and women.
Feminist economics’ focus on the social origins of observed differences in the prefer-
ences and behavior of men and women reflects an argument that preferences and behavior
are gendered. For example, boys and girls in most communities are socialized into particu-
lar behavioral patterns; trained to different norms of bodily comportment from an early
age. Gender norms in Western societies tend to emphasize physicality, aggression and
indifference for boys and constraint for girls and, as a result, men and women are likely
to find different types of behavior comfortable and achievable with a degree of fluidity.
Performing the gendered actions might feel ‘natural’, be associated with positive ‘payoffs’,
and result in positive ‘outcomes’. On the other hand, performing actions that are typi-
cally assigned to the opposite sex might illicit a sense of novelty, self-consciousness, and
awkwardness (negative payoffs and outcomes that are evaluated as poor). There are also
important feedback effects, with the experience of poor/good performance influencing
the incentive to invest in gendered skills.
Gendered socialization can also cause differences in the way men and women process
information about a similar situation or arena. This is because representational schemes
that are functional for different gender roles can make different kinds of information
salient. For example, in traditional domestic settings, women may notice dirt that men do
not, ‘not because women have a specially sensitive sensory apparatus . . . [but] because
they have a role which designates the females of the household as the ones who have to
clean up’ (Anderson 2009, n.p.).
These processes may also result in cognitive styles that differ between men and women.
For example, the tendency for men to be allocated positions associated with political and
economic power that require detachment and control may encourage a cognitive style that
is abstract, theoretical, disembodied, emotionally detached and analytical. The tendency
for women to be assigned positions associated with the provision of care may encourage
a cognitive style that is concrete, practical, embodied, relational and emotionally engaged.
(England 2003, pp. 36–8).
Patterns of value are also gendered. There is a cultural tendency in most communities

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to link psychological traits considered ‘masculine’ with virtue when demonstrated by

men, and ‘feminine’ traits with virtue when women demonstrate them. This influences
the payoffs from different actions that can be performed by men and women and creates
incentives for individuals to comply with prevailing gender norms. In academic work
situations, for example, the quest for ‘masculine’ prestige may encourage the continued
use of ‘masculine’ methods by men, and a rejection of methods associated with feminin-
ity or female-dominated fields of enquiry. For example, Nelson (1992) notes how the
term ‘hard’ is often metaphorically attached to mathematical and quantitative analysis,
and seen as positive and masculine. In contrast, the term ‘soft’ is attached to qualitative
methods, is used as a pejorative, and is associated with femininity (see also Nelson 1996,
2003c). More generally, the material and other payoffs associated with different jobs or
career paths can vary depending on whether the tasks entailed in the occupational role
align with the individual’s gender. For example, men might perceive costs associated
with their participation in types of work regarded as ‘feminine’, such as childcare; and
women might attach costs to their involvement in types of work regarded as masculine,
such as mining.
The gendered distribution of power between men and women in many action arenas
is an additional important influence on behavior and outcomes. It can cause ‘masculine’
actions to be valorized in particular privileged situations and women’s ability to partici-
pate in these situations to be limited. In academic situations, for example, the historical
dominance of men has resulted in several formal and informal institutions that value (and
thus produce positive payoffs for) ‘masculine’ forms of work and contributions to knowl-
edge. The formal institutions include promotion criteria that emphasize a track record
of journal publications and research grants. Often these criteria can only be satisfied by
academics who are able to commit long working hours and have uninterrupted tenure,
especially in their thirties. Gender differences (and inequity) in outcomes arise if men who
conform to a traditional breadwinner role have some ability to achieve success in these
situations, while other men and the many women who take on direct care roles in their
families find it difficult to achieve positive outcomes.
Finally, commonly held ideas about gender affect our perceptions of others (and their
actions). A number of studies have demonstrated that the gender of a person affects
the costs, benefits and probabilities that others assign to their actions (see, for example,
Kahneman 2003). Barbara Reskin (2003), for example, highlighted how in employment
situations managers might unconsciously attach certain behaviors, such as reliability or
competitiveness, to particular individuals because of their gender. While the managers
might consciously reject discrimination, their tendency to rely on familiar social catego-
ries might still cause them to think and ultimately act in ways that privilege individuals
with a particular gender and disadvantage others. Paula England, Michelle Budig and
Nancy Folbre’s (2002) analysis of the labor market outcomes of care workers has similar
themes, highlighting how women are commonly perceived to be ‘naturally’ able to accom-
plish the work involved in caring for children, and for sick and elderly people. This is
consequential because it tends to result in judgments of care work as something that does
not require skill or effort, contributing to the low-wage outcomes of the many women
engaged in care work (see also Austen and Jefferson 2014).

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5 FEMINIST ECONOMICS AND STUDIES OF SEX-BASED

DIFFERENCES IN ATTITUDES TO RISK
We can consider now how feminist economists engage with the growing body of literature
on sex-based differences in preferences and behavior. An important part of this literature
deals with differences in the risk aversion of men and women. Much of it has been moti-
vated by concern about evidence of an over-representation of women in relatively low-risk
forms of assets and in particular occupations. This section provides an overview of these
studies before introducing a critical perspective – informed by feminist economics – on
the common conclusion that women are more risk averse than men.
Studies of sex-based differences in risk preference have featured both studies of invest-
ment and insurance decision-making in the presence of risk and lottery or gamble experi-
ments of risk-taking. Studies in the first group have used pension fund data to study the
allocation of assets between investment options associated with different levels of risk.
Studies in the latter group have included gambling experiments with student partici-
pants. They have typically focused on whether (and to what degree) the willingness to
take a gamble or invest in a lottery is affected by the level of risk involved. Reflecting
the acknowledged importance of both risk and loss aversion, many of these experiments
have include scenarios where the possible outcomes are framed in terms of gains, while
others are framed in terms of losses. Understandably, the analysis of sex-based differ-
ences has focused on the magnitude and statistical significance of observed differences
in the choices of male and female participants. Commonly the studies have incorporated
controls for other factors that might be relevant to a person’s risk preference, such as age.
Several contextual environment experiments have involved students participating in
computer-based simulated currency trading and stock market games (where the decision
to enter particular currency markets or purchase particular securities involves risk). Apart
from testing for sex-based differences in risk preference, these studies also examine the
effects of factors such as ambiguity about the game’s outcomes, knowledge of financial
markets, and confidence in financial decision-making. A recent study by Alison Booth,
Lina Cardona-Sosa and Patrick Nolan (2014, p. 128) compared risk preferences exhibited
by participants in mixed versus same-sex groups.
Cathrine Eckel’s and Philip Grossman’s (2008, pp. 6–11) assessment is that neither the
experimental nor the other studies provide conclusive evidence on the nature or extent of
sex-based differences in risk preferences. Apparently this is ‘consistent with results from
psychology, which tend to show differences in risk attitudes across environments for a
given subject’ (Eckel and Grossman 2008, p. 6). Booth et al. (2014) also conclude that
attitudes to risk are influenced heavily by contextual factors. In their study, the female
participants’ willingness to invest varied substantially across the same-sex and mixed
group settings of their experiments.
Despite the mixed evidence from studies of the issue, Eckel and Grossman’s (2008, p. 6)
general summary of the results of the gamble experiments is that they ‘suggest greater
risk aversion by women’. Rachel Croson and Uri Gneezy (2009, p. 448) are more strident,
claiming from their review of the literature on gender differences in preferences that
‘women are indeed more risk averse than men’.
This is the starting point for an important review by prominent feminist economist
Julie Nelson, who challenges the assumptions, methods and conclusions of behavioral

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studies of sex-differences in risk preferences. In her 2012 paper ‘Are women really more
risk-averse than men?’, Nelson reported the findings of a meta-analysis of published arti-
cles on the topic of sex and risk, including the studies canvassed by Croson and Gneezy
(2009), Eckel and Grossman (2008), and Booth et al.’s more recent work. It examined the
available evidence on the quantitative magnitudes of the differences between the average
level of risk aversion observed for men and women, and the extent to which the observed
distribution of risk aversion varies between male and female samples. In doing so, Nelson
attempted to redress the tendency for behavioral studies to rely on measures of statistical
significance in their judgments of the significance of observed differences in the risk aver-
sion of men and women: ‘In the gender-and-risk literature, as in other literatures, however,
judgments of “significant difference” are generally based on statistical significance alone.
Discussions of the absolute size of the difference, much less its possible implications for
society or policy, are rare’ (Nelson, 2012, p. 6).
Nelson’s ‘alternative’ approach to assessing the evidence on gender differences in risk
preference produced some revealing insights. Only 25 percent of the studies that she
reviewed identified a difference favoring lower male risk aversion of more than half a
standard deviation. Only two studies found a difference of more than one standard devia-
tion of difference. Four studies identified differences that are statistically significant in the
direction of greater female risk-taking.
Thus, in Nelson’s assessment, an appropriate summary of the results of studies of sex
differences in risk preference is that they point to ‘a statistically significant difference in
mean risk aversion between men and women, with women on average being more risk
averse’ (Nelson 2012, p. 2). This stands in important contrast to Croson’s and Gneezy’s
(2009, p. 448) claim that ‘women are indeed more risk averse than men’. The latter state-
ment implies that risk preference is a stable characteristic of people defined by their sex,
and that a lower risk preference is universally true for every individual member of the class
‘women’ (as compared with ‘men’). As Nelson notes (2012, p. 3), ‘this exceedingly strong
implication is not likely intended by those who write such statements’, noting that ‘just
one example of a cautious man and a bold woman disproves it’. However, she goes on to
draw our attention to how the more probable meaning of the statement (that women are,
or are disposed to be more risk averse by virtue of being a woman) is also problematic. ‘In
the current example, the statement would imply that greater risk aversion is an essential
characteristic of womanliness – or, by parallel reasoning, that greater risk seeking is an
essential characteristic of manliness’ (Nelson 2012, pp. 3–4).
Reflecting themes in feminist economics introduced earlier, Nelson rejects the notion
that risk aversion is a sex-linked ‘trait’ and, instead, locates the source of observed sex-
based differences in risk preferences in patterns of gendered socialization and power. As
such, observed sex-differences should not be the end-point of inquiries into risk prefer-
ences but, rather, the stimulus for further inquiry into the gendered norms and other
institutions that influence men’s and women’s attitudes to risk. This potentially creates an
important role for future studies of the issue in different cultural contexts.
It is important to note that Nelson’s critique of the gender and risk literature also
relates to another theme of feminist economics that was highlighted in earlier sections
of this chapter, namely, its critical perspective on possible biases within the economics
discipline. Nelson highlights the influence of mental models on the work of researchers;
of how the inferences we derive from empirical data are likely to reflect ‘the structure of

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our inside worlds – that is, of evolved, developmental human cognition’ (Nelson 2012,
p. 5). She notes that the models that we use are significantly influenced by our experiences
of and beliefs about men and women and, thus, perhaps, it is not surprising that many
studies ‘leap’ from evidence of a statistically significant difference in average levels of risk
aversion to conclusions about men’s and women’s natures. That is, researchers are (as are
others) prone to ‘confirmation bias’, whereby we tend to more readily absorb information
that conforms to our pre-existing beliefs, including our beliefs about the ‘nature’ of men
and women. This can be an important (and potentially dangerous) source of distortion in
our work. For example, as Nelson points out, if we report a statistical significance in risk
aversion that is not substantially significant we can reinforce common stereotypes about
men’s and women’s ‘natures’. To the extent that this diverts attention from cultural and
other institutional sources of differences in behavior, it can be an obstacle to the design
of appropriate policy measures aimed at improved gender equity. That is, there is a risk
that research into sex-based differences may contribute to the perpetuation of gender
inequality, rather than help to reduce it.
6 FEMINIST ECONOMICS AND STUDIES OF ALTRUISM
Similar themes are apparent in feminist economic analyses of altruism. A number of

studies of differences in altruism between men and women have been undertaken, moti-
vated by a sense that they could lead to different patterns of charitable giving, bargaining,
and household decision-making. As such, gender differences in altruism are potentially
consequential for outcomes across a number of different market and family situations.
In their 2008 paper ‘Altruism in individual and joint-giving decisions: what’s gender got
to do with it?’, Linda Kamas, Anne Preston and Sandy Baum reviewed the experimental
evidence on sex-based differences in altruism, and contributed the findings of their own
study of the issue. The first part of this section draws heavily on their summary of the
relevant literature. Broader feminist economic perspectives on the topic of altruism are
considered in the latter part of this section. Here the focus of the discussion turns away
from the question of whether women are more or less altruistic than men and toward
the general importance attached to altruistic (and other other-regarding) preferences by
feminist economists.
As Kamas et al. (2008) describe, experimental studies of altruism typically assess
participants’ willingness to sacrifice their own outcomes to improve the well-being of
another either by using a dictator, ultimatum, public good or investment or trust game.
The authors favor a dictator ‘game’, where the dictator decides how to allocate a sum
of money between himself or herself and another player, on the grounds that it has the
greatest ability to separate the effects of altruistic preferences on behavior from the effect
of risk and competition. In their dictator games, the recipient of the money is a charity.
Kamas et al. (2008) report findings from their own experiments that indicate significant
gender differences in altruistic behavior, with women giving significantly more, on average,
than men. Their finding was generally suggestive of a pattern of difference similar to that
observed by James Andreoni and Lise Vesterland (2001, p. 293). However, several studies
included in their review, such as those by Martin Dufwenberg and Astri Muren (2006),
reported higher levels of generosity by men. Kamas et al. (2008, p. 25) conclude that in

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the experimental literature there is no consensus on the substantive significance of gender

differences in altruistic behavior.
The explanation offered for the mixed results on altruistic preferences by Kamas et al.
(2008, p. 25) centers on the differences in the experimental settings of the various studies.
These differences relate to both the type of game used as well as ‘the experimental design
or context . . . the framing of the experiment, the degree of anonymity, the subject popula-
tion, and/or the manner in which the participants are chosen’ (Kamas et al. 2008, p. 25).
Whether men or women are identified as the ‘more generous sex’ apparently varies with
the price of giving, the degree of anonymity, and the possibility of reciprocity (see also
Cox and Deck 2006). Several studies conclude that the gender of the recipient of an altru-
istic act also affects gift-giving. The study conducted by Kamas et al. (2008) found that
gift-giving increased in mixed-sex team situations, and especially when the participants
were able to negotiate a common gift.
Kamas et al. (2008: 44) acknowledge (albeit in a footnote) that they do not provide
an in-depth explanation of the causes of observed sex-based differences in altruism.
However, they do allude to a number of influences stemming from the social environment,
and these are potentially reflective of the processes of gendered socialization that were
noted in earlier sections of this chapter. For example, their explanation for the observa-
tion of higher levels of gift-giving by mixed-sex teams includes a role for social informa-
tion (about the social norm for gift-giving) and social image (a desire to be considered
favorably by others) (Kamas et al. 2008, p. 27). As a reviewer of their paper apparently
observed, it may also be possible that women are socialized to be more giving than men,
and women’s identification as mothers or caregivers may lead to altruistic acts (Kamas et
al. 2008, p. 45). The authors also acknowledge the possibility that as experiments of this
type are conducted beyond the confines of the current set of developed western coun-
tries, the impacts of cultural and sociological forces on gender differences in altruism will
become more apparent.
The interpretation of experimental evidence offered by Kamas et al. contrasts that
provided by Andreoni and Vesterland (2001). The latter appear to succumb to the various
pitfalls involved in assessing sex-based differences in behavior that were noted by Julie
Nelson. They infer from their experimental evidence (of a statistically significant gender
difference in the observed levels of gift giving across 142 students in eight experimental
settings) that ‘when altruism is expensive, women are kinder, but when it is cheap, men are
more altruistic’ (Andreoni and Vesterland 2001, p. 293). The focus of their results is on
the statistical significance of observed differences in means, rather than on the magnitude
of these differences or the distribution of results. This is problematic when the observed
gender gap is relatively small. Generally, the Andreoni and Vesterland study ‘essentializes’
the nature of men and women, reinforces common stereotypes, and fails to acknowledge
the preferences of men and women who do not conform to group averages. It provides
no insights into the possible sources of observed gender differences in altruism, and its
discussion of policy implications is limited to a consideration of the consequences of
gender differences in charitable gift giving and restaurant tipping.
A more important feminist economic discussion of altruism shifts the focus of atten-
tion away from possible sex-based differences and toward the general importance of altru-
istic preferences (for men and women). This discussion forms part of a broader critique
of the theoretical structure of mainstream economics by feminist economics. The critique

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argues against a narrow specification of the sources of individual motivation and argues
instead for specifications that take account of various sources of motivation, including
altruistic preferences, and the social influence on these motives.
The critique of mainstream economic theory, developed by Paula England (see, for
example, England 2003) focuses, first, on its assumption that individuals in market
situations are atomized, self-interested, and have preferences no one can change. This
is contrasted against the assumption that individuals in family situations are connected
to each other, with interdependent preferences and engaged in a process of shaping the
preferences and values of the young. As England explains, while the theory’s analysis of
market situations features a ‘separative’ view of the self that presumes, amongst other
things, that individuals lack sufficient emotional connection to others to feel any empathy
– or to be altruistic, a ‘soluble’ self is assumed in its analysis of family situations, allowing
both empathy and altruism to influence behavior and outcomes.
England (2003, pp. 36–40) highlights the various problems with this theoretical struc-
ture. These include problems caused by incorrectly assuming pure self-interest in market
situations, and by over-emphasizing the extent of empathy and altruism in family situ-
ations. Additional problems arise from the separative or soluble dichotomy and its rela-
tionship to gender dichotomies in western thought. England notes that in simple (sexist)
formulations of western thought, men are seen as naturally separative, autonomous
and individuated, while women are seen as naturally soluble, connected and yielding.
Separation has been valorized in western thought, at least for men, while connectedness
has been devalued. As a consequence, writing in economics and other fields has ‘failed to
recognize that men are not entirely autonomous . . . whilst women’s nurturing work was
taken for granted and excluded from . . . theory’ (England 2003, p. 38, original emphasis).
These observations link to several of the themes of the feminist critique of main-
stream economics noted in earlier sections of this chapter. For example, the valorizing
of separation – and market situations – has contributed to a failure to adequately rec-
ognize the experiences and contributions of women. The gendered nature of the separa-
tive–soluble dichotomy helps to explain common confusion of gender with sex; of the
tendency to identify ‘essential’ differences between men and women.
Feminist economic analysis suggests that it is appropriate to assume that both male
and female participants in market and family situations will have both ‘separative’
and ‘connective’ qualities; and that these qualities will have both positive and negative
aspects. Core concepts, therefore, are of ‘individuals-in-relation’ or ‘relational autonomy’
(England 2003, p. 39).
These concepts have obvious relevance for the feminist economic analysis of altru-
ism (and for the analysis of the related concepts of cooperation and strong reciprocity).
Altruism is potentially relevant to the preferences and behaviors of men and women. It
should be considered as a source of motivation in market and other situations. There is
a need for more theoretical and empirical studies of men’s and women’s altruistic (and
other other-regarding) preferences. We need additional insights to how these preferences
interact with other preferences, including self-regarding preferences; how they are shaped;
and how they are influenced by different aspects of the contextual environment, such as
general levels of altruism in the surrounding community. Taking this approach, studies of
gender difference in altruism would ideally focus on women’s traditional association with
the family sphere; how, therefore, they have been traditionally assumed or expected to be

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altruistic; and the consequences of these assumptions or expectations for their observed
behavior and their economic outcomes.
This approach features in Nancy Folbre’s (1995) analysis of caring labor, a topic that
calls into question the role and impact of altruistic preferences and which also has rel-
evance for a range of important policy issues, including the future quality and cost of
child and elder care, and pay equity.
Folbre highlights that caring relies on a range of motivations, including reciprocity,
altruism and responsibility. She also emphasizes that these motivations are constructed
in a social environment. Folbre recognizes that caring labor is associated with tasks that
women often specialize in, such as mothering. However, she also emphasizes that caring
labor can (and is) undertaken by both men and women, and that it occurs in both family
and market situations.
Folbre is particularly concerned with the interactions between the different sources of
motivation for caring labor. She acknowledges the role of altruism but notes that it inter-
acts with long-run reciprocity and the fulfillment of obligation or responsibility. As such,
she describes carers as being both ‘connected’ (through their altruistic preferences) and
‘separate’ (in their concern for their individual payoffs). In Folbre’s analysis, individuals
may provide care out of a sense of affection or responsibility for others, but their motiva-
tion to care is likely to also be influenced by long-run expectations of reciprocity of either
tangible or emotional services. Care motives are also described as being dependent, in
part at least, on the level of altruism and reciprocity within the surrounding community.
In turn, social norms are ascribed a potential role in helping prevent a coordination (or
caring) failure.
Folbre accounts for gender differences in caring labor in a variety ways. First, social
norms, as well as notions of obligation, are gendered. As such, they result in a different
structure of payoffs for men and women involved in caring and other roles. The historical
context is also important, with women’s traditional roles in caring for others potentially
affecting the nature and extent of their altruistic ‘preferences’ and, thus, their evaluation
of caring and other roles.
The outcomes from caring situations, described by Folbre, are often not positive for
women. Caring labor is typically low paid and aspects of the work – including the respon-
sibility, skill and effort involved are not generally reflected in wage and other outcomes.
Given that at least part of the motivation for caring labor is self-interested, the low wages
place at risk the ongoing supply of care. An appropriate policy response to this dilemma
would be to improve the ‘rate of return’ from caring labor, regulating wage outcomes to
ensure that low wages do not crowd out care motives.
The contrast between Folbre’s analysis of caring labor and that offered by mainstream
economists is stark. The latter tend to rely on the notion of non-pecuniary preferences,
which are typically ‘lumped together’ and modeled as exogenously (and, presumably,
biologically) determined. The independent determination of motivation in these models
results in a prediction that if an individual gains positive utility from caring he or she will
be willing to trade-off lower wages to ‘indulge’ this preference. Wage regulation is rejected
on the assumption of the absence of social or other barriers to mobility. Indeed, in some
analyses, higher wages for carers are viewed as a threat to caring labor – based on a belief
that higher wages would encourage the participation of individuals with less altruistic
preferences (Heyes 2005).

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7 CONCLUSIONS
This chapter has attempted to convey key themes in feminist economics of relevance to
smart behavioral economists. It takes a novel approach to this task by structuring the
discussion using concepts and terms drawn from the institutional analysis and design
framework, developed by Elinor Ostrom. The framework was used to identify the distinc-
tive features of feminist economics, including, perhaps most importantly, the emphasis
it places on understanding the social influences on individual preferences, actions and
outcomes. The ‘situated’ nature of economic behavior is a fundamental concept in
feminist economics. Feminist economics pays particular attention to how individuals’
economic power, obligations, goals, interests and, ultimately, their economic outcomes
are affected by their social roles and relationships, and how these, in turn, are affected by
their ascribed social identities, including their gender. Gender is distinguished from sex,
or an individual’s biological identity of being male or female. It refers to socially learned
expectations and behaviors associated with being male or female.
The chapter has highlighted the various ways in which the concept of a ‘situated actor’
influences feminist economists’ engagement with topics in smart behavioral economics.
It has demonstrated that feminist economists tend to take a cautious approach to the
analysis of observed differences in behavior between men and women. While feminist
economists do not deny that these differences exist, they emphasize the need to explore
their sources in the social environment, and they sound a strong warning about the
dangers of drawing inferences about the essential ‘natures’ of men and women from
these differences.
The concept of a situated actor is also apparent in feminist economists’ perspectives
on the theories and methods used in the analysis of economic behavior. The chapter
highlighted the feminist perspective that academic inquiry itself is a fundamentally social
process. As such, participants in academic work situations are subject to biases that arise
from their own (essentially limited) set of experiences, including their experiences of and
beliefs about men and women. This can be an important source of error in academic work,
potentially contributing to a reinforcement of stereotypes about men and women, rather
than promoting greater gender equity. An important concern of feminist economists is to
minimize these sources of error by training economists and promoting the adoption and
enforcement of methodological principles designed to check the influence of gender bias.
The chapter also emphasized the feminist economics’ critique of the separate–soluble
dichotomy in mainstream economics. The mainstream assumption is that individuals in
market situations are ‘separate’, that is, essentially atomized, self-interested, with prefer-
ences no one can change. In contrast, this theory assumes that individuals in family situ-
ations are ‘soluble’, that is, connected to each other, with interdependent preferences, and
engaged in a process of shaping the preferences and values of the young. The critique
observes that the separate–soluble dichotomy that characterizes mainstream econom-
ics has a strong gender dimension, with market situations commonly associated with
the activities of men, while family situations are commonly linked to the activities of
women. This has various negative impacts, including the tendency for the lives and experi-
ences of many women to be excluded from economic analysis, and the ‘essentializing’ of
men’s and women’s natures (‘men are self-interested and autonomous, while women are
caring and dependent’). The approach has limited the analysis of the range of motivations

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(self-interested and other-regarding) affecting the behaviors of men and women in market
and family situations.
Feminist economics offers an alternative concept to guide future empirical and theoreti-
cal studies of behavior: that of ‘individuals-in-relation’. It conveys that men and women,
in market and non-market situations, are likely to be influenced by self-interested and
other-regarding preferences. The recommendation is for smart behavioral economics
(smart decision-making) to continue to pursue studies of how different sources of moti-
vation interact with each other; how preferences are shaped; and how they are influenced
by different aspects of the contextual environment, such as general levels of altruism
or reciprocity in the surrounding community. Further studies of gender differences in
behavior are needed, but they should focus on how, for example, prevailing gender norms
affect the positions men and women can participate in, the payoffs and value attached
their alternative actions, and, ultimately, their economic outcomes.
NOTE
1. Increasingly, the analysis acknowledges multiple genders. This takes into account individuals whose gender
identity differs from their biological sex.
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11 How regret moves individual and collective
choices towards rationality
Sacha Bourgeois-Gironde
1 IDENTIFYING REGRET
At first sight, regret, which is semantically very ambiguous and confined to psychological
notions such as disappointment, remorse, or even repentance, is not the ‘smartest’ state of
mind we can entertain in the course of our life. It is the feeling that we have been less than
optimal in particular situations or longer stretches of time, where we could have acted on
better lines, and we know it or realize it now, while in the throes of that negative emotion.
It is ironical that the author most associated with a vindication of the virtuous role of
emotions in decision-making in contemporary popular neurobiology, namely, Spinoza
as interpreted by Damasio (Damasio 2004), emphasizes the irrationality of regret:
‘Repentance is not a virtue, that is, it does not arise from reason; instead, he who repents
what he has done is twice wretched, that is, lacking in power’ (Spinoza 1677 [1996], p. 4).
The individual not only has been practically suboptimal but a negative feeling accrues and
prolongs her helplessness. Regret, thus viewed, does not represent the emotional side of
a retrospective and corrective, cognitively driven process. To refute that view and make
apparent how regret can help optimize decision-making processes rather than reinforce
past failures, we need, first, to decompose between backward-looking and forward-
looking aspects of regret and, second, to better understand the articulation between its
emotional and cognitive components. Taken altogether, these distinctions will permit us
to define regret as a biologically anchored learning mechanism liable to direct decisions
along an optimal path. In the absence of this psychological device, which apparently con-
sists of dumbly lamenting over spilled milk, our decisions would really be dumber, as it is
likely that we would not become aware, or at least sensitive, to our past mistakes. As for
the emotional part, we are, by means of emotions such as regret, sensitized to suboptimal-
ity. However, the forward-looking and cognitive component is what makes regret a smart
mechanism, and ourselves smarter by the same token, to the extent that the aversive aspect
of felt pangs of regret drives up regret-avoidance behavior over the repetition of similar
decision situations and, through the conscious anticipation of the emotional impact of
comparatively bad or good consequences of a choice over several available options, it
generalizes to a whole range of repeated or even one-off decisions. This pervasiveness of
regret and its inherent cognitive nature triggered attempts at incorporating it in formal
decision-theoretical frameworks.
Regret, with its conceptual correlate disappointment, is one of the rare emotions
which have been singularly identified and incorporated in formal decision-theory. Elster
(1998) extends a long argument about how economists fail to account for specific emo-
tional mechanisms. Most of the discussion about the relationship between emotions
and rationality has been couched in general terms, falling short of phenomenological
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How regret moves individual and collective choices towards rationality 189
characterization and a specific analysis of emotional mechanisms potentially associated

with behavioral optimization in choice contexts. This amounts to deliberate ignoring
or downplaying of game-theoretical models of guilt or envy and regret-based decision-
theory that were already developed in the 1980s and 1990s. However, this also triggers
attention and effort towards the possibility to more finely integrate the psychological
description of emotional mechanisms – including phenomenological, behavioral and
neurobiological levels – and decision-theoretical normative issues. At the same time, this
reveals the tension between descriptive and normative relative imports in accounting for
human rationality. One obvious way to alleviate this tension is to uncover some normative
aspects of emotions.
What has distinguished regret among other emotions is that it definitely bears a cog-
nitive component. It is an articulate, sensitive state of mind. Regret consists in feeling
negatively the comparison between two states of affairs. This involves a series of sub-
performances, alternatively pointing to cognitive processes and hedonic states and, on the
whole, their integration into a unified affective state. Imagine you have forgone an optimal
option and now find yourself in a position to compare what you have got with what you
could have got; this implies your ability to:
● engage in counterfactual thinking;

● ascribe a value to a present state of affairs and to a counterfactual one; and
● compare actual and counterfactual values.
This becomes even more intricate when we envision anticipated regret. Anticipated
regret is the heuristic we need to incorporate into smart regret-based behavioral
decision-theoretical models, as, on its basis, individuals will tend to avoid negative future
consequences. From a cognitive standpoint, the smartness then required amounts to the
following:
● representation of possible future states of affairs;

● hedonic simulation of the future (also known as mental time travel);
● ascription of value to future alternative states under different courses of actions
taken; and
● comparison of utilities derived from possible alternative states.
The integration of these cognitive sub-processes functionally yields a future utility-

weight in present decisions. Specific cerebral mechanisms underpinning each of these
processes and their functional integration have been described (Gilbert and Wilson 2007;
Boyer 2008; Schacter et al. 2008). It is worth noting from the outset that the way regret
has entered decision-theory in the past three decades, as a rival to a standard model of
expected utility theory, relies on a much more stylized version than that which cognitive
and affective neuroscientists probe into our brains. However, we think there is enough
overlap between the working definitions of regret respectively adopted in psychology and
in economics (especially in experimental decision-theory) to allow a fruitful hybridization
of the approaches and uncover regret as a smart mechanism both from a psychologically
realistic and a formally tenable perspective. The main distinctions to be drawn in both
contexts are in terms of available information, responsibility, and valence (in that order),

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Table 11.1 Varieties of decision-theoretical emotions
+ −
Information Regret Disappointment
Responsibility Regret or remorse Deploring
Valence Rejoicing Regret
rather than in terms of mental abilities to project ourselves into alternatives and experi-
ence feelings about them (Zeelenberg 1999).
Under that most basic view, to experience regret, individual X needs to know that her
action A has led to consequence C and to further know that, had she taken another action,
A’, the consequence would have been C’. Now, the difference, in terms of utility, u(C) –
u(C’), if negative, is what regret amounts to.
If we weaken or modify an element of this sequence, a typology of alternative ‘decision-
theoretical emotions’ derived from this definition of regret is generated (see Table 11.1).
More forms of regret and related emotions can be encompassed if we consider the
timing of the emotions with respect to the unfolding of the action; in particular regret
can be post hoc, ex ante or online (we sometimes regret what we are doing while doing it).
What has interested decision-theorists is the learning process associated with regret which
ensures the transition from post hoc regret to anticipated regret and bias decisions to a
predicted error minimization procedure (also known as minimax-regret). Young (2004)
excellently accounts for this transition from experienced regret to anticipated regret. That
transition goes from a backward-looking emotional state to a cognitive anticipation of
future consequences and is at the core of what makes regret a potential smart mechanism
in decision-making. In a past-payoff decision-model based on the elimination of regret,
a single agent who faces a t-times repeated decision problem will try to eliminate or mini-
mize regret over the period [1 − t]. The agent makes her choice over a set of actions A and
obtains a payoff following each action taken. We do not have to consider the time that
elapses between the action and its feedback, even though of course in a richer regret-based
model this parameter is likely to play a role. The feedback of the action is not in itself the
parameter to elicit regret: it has to be contrasted with the expected outcome or, differently,
with the information about what she could have obtained had she taken another course of
action, say, a. Let us suppose that second comparison is made possible at the end of period
[1 − t]. As of period t, then, the agent’s regret for not having chosen action A is defined
as the difference between two terms: the average payoff she would have obtained had she
chosen a in periods 1 through to t, and the average payoff she actually obtained during
those periods. Young defines an optimal regret-based strategy for this repeated decision
problem: it satisfies a no-regret criterion if it ensures that for any sequence of action
feedbacks, the agent’s regret for each of his actions becomes non-positive as t approaches
infinity, all other things being equal.
Some notable contributions made this stylized typology of regret and related emotions
fit the investigation of underlying neurobiological mechanisms. We discuss them in the
next section. By borrowing experimental paradigms from experimental decision-theory,
neuroscientists indeed uncover specific mechanisms associated with the way repeated
emotions are optimally biased by regret aversion. One of our concerns is to assess to

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what extent these uncovered neurobiological mechanisms correspond to the more styl-
ized notion of regret that has been integrated in some decision-theoretical frameworks in
the view of formalizing how anticipated regret-based learning happens to be an optimal
decisional heuristic.
2 THE NEUROBIOLOGICAL BASIS OF REGRET
Damasio (2008) has largely documented the effect of some bilateral lesion of the ventral
medial prefrontal cortex on regret aversion driven decision-making. He and his colleagues
have studied several cohorts of patients who, post-lesion, display deep difficulties in
planning their life, establishing friendly associations, finding business partners, avoid-
ing financial losses, keeping a stable occupation, refraining from certain impulsions and
profanities. These behavioral patterns are in neat contrast with these subjects’ profiles
before the lesion. However, the lesion has left unscathed the cognitive abilities: normal
intelligence, linguistic understanding, and memory, normal visual, hearing and tactile
acuity (Bechara et al. 2000). What essentially differs before and after the brain accident is
the decision-making process which has become long and intricate, with all sorts of alter-
natives entertained and pondered, leading to choices which are found difficult to make
and most often disadvantageous. When such choices are repeated, no learning apparently
occurs, no lesson of bad past experiences is taken and consistency in suboptimal behavior
is observed. This main difference affecting decision-making has been probed on a specific
task, called the Iowa gambling task (IGT). Behavioral responses on this task were associ-
ated with a measure of variation of the physiological skin conductance response (SCR)
and cardiac pace, considered as the main somatic markers of emotional states.1
In the IGT, participants face four decks of cards from which they can freely pick
cards one after another. They know nothing about the relative value of the decks except
that they are not equivalent. So, they must learn about this difference, which amounts
clearly to a learning task. Unbeknown to them, the game will stop after 100 cards have
been turned up. The decks differ in the variance between gains and long-term profit they
present. Decks C and D present a small spread of value (small gains and small losses) to an
extent that makes them profitable if the participant sticks to them. Decks A and B embed
a few attractive large gains but also large losses such that sticking to them surely makes
the participant lose his or her initial endowment. Control subjects, after having explored
for a short while Decks A and B, turn and keep on playing on Decks C and D. Ventral
medial patients stay on Decks A and B and ask for credit when their endowment happens
to be exhausted in the middle of the game. Besides this behavioral particularity, patients
exhibit a special physiological pattern compared with controls: they fail to exemplify the
somatic markers that induce healthy subjects to avoid negative consequence choices in
favor of optimal decision-making. This neurobiological grounding of corrective anticipa-
tory behavior seems a key element of more explicit and cognitively driven regret-based
learning processes.
Ventral medial patients seem unable to relate together current actions, expectations and
past failures. Only the internal building of this temporal binding between past, present
and future is likely to sustain the process of regret-based learning guiding repeated deci-
sions towards optimal payoffs. They also seem to be unable to evoke emotions and to make

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them efficient mechanisms in action. Indeed, they are not deprived of all emotions and
can abstractly judge that a situation (or an image or a fantasy) with a horrid component
should trigger in them some felt negative emotion, but this emotion does not occur. They
present the converse dissociation that the neuropsychologist Brenda Milner (1962) had
observed with dorsal-lateral and hippocampal patients, who do the right thing but cannot
verbalize it. The generation of this signal and its incorporation into executive function
is an efficient mediation in decision-making. This signal amounts to an internal bias
unconsciously diverting decisions from bad outcomes before it reaches the consciousness
threshold, although this point has been contradicted by several authors (see, in particular,
Persaud et al. 2007). Whether or not this signal is efficient before or after it reaches the
individual’s consciousness, it is instrumental in defining anticipated regret as a mechanism
whose cognitive and behavioral role is not independent of an embodied emotional alert
system.
The underlying cause of the decisional deficiency of ventral-medial patients is there-
fore, according to Damasio, a failed activation of covert emotional signals which are sup-
posed to bias decision in a favorable direction in the long run. Damasio has, through his
implementation of the IGT and the implicit role of SCR, made popular the view that the
conscious explicit knowledge of preferences and choice-criteria is not enough to generate
optimal decision behavior. Decision processes in the brain are distinct from other cogni-
tive abilities governed by frontal lobes (for example, work-memory and responses inhibi-
tion) in the sense that they directly plunge in visceral pre-executive mechanisms associated
with emotional autonomous arousal. More has to be said on how a post hoc experience
of disappointment can change smoothly into an ex ante regret-aversive optimal behav-
ior. We find some possible explanation when considering Damasio’s distinction between
two types of internal signals (Damasio 2008). First, a genuine somatic loop generating
‘primary’ signals is triggered when individuals face choices under uncertainty and ambi-
guity. Second, a para-somatic loop can be activated by a mental representation of somatic
states (consisting in cognitive states in which the subject simulates his being in a primary
emotional state). This loop is selected by choices which, through previous repetitions
of the similar situation, looms as quasi-certain or inevitable consequences. The transi-
tion from one loop to the other is driven by regret learning and, as we see, amounts to
a deep change in the perception of the decision-theoretical context, from uncertainty to
quasi-certainty.
The study of this transition has given rise to several studies of what brain mechanisms
help us adapt to different decisional structures. The fact that the choices are under ambi-
guity, uncertainty or risk is differentially treated by the brain (Hsu et al. 2005); the fact that
we tend to systematically violate decision-theoretical axioms that are supposed to prevail
in these distinct decisional-structures is also a feature that can be explained by the study
of our brain fabric. In that context, regret has been made a paradigmatic case.
For the purpose of studying specifically regret-aversion based decision-making, rather
than conceptually and phenomenologically generic somatic markers, the IGT has been
modified into a regret gambling task and used in several seminal studies (for example,
Camille et al. 2004; Coricelli et al. 2005). In that task participants are invited to choose
between two ‘wheels of fortune’, one on the left, one on the right. They display colored
zones corresponding to possible gains or losses. For instance, in one typical choice, if
subjects choose the gamble on the left, they might win €200 with 20 percent probability

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or lose €50 with 80 percent probability; if they choose the gamble on the right, they might
win or lose €50 with equal probabilities. The regret gambling task differs from the IGT in
that it implements two contextual conditions in terms of feedback provided. Partial feed-
back shows only the outcome of the chosen gamble; to that extent it amounts to IGT and
participants can be disappointed given their expectation that the needle stops on a positive
zone of the wheel. Complete feedback allows for a comparison between the consequence
of participants’ choice and that of the foregone option, eliciting possible regret or relief.
Physiological responses (skin conductance responses), choice behavior and brain activity
are influenced by these different levels of feedback.
Coricelli et al. (2005) have shown that the same brain areas are activated when the
brain faces a certain choice situation, before a decision is made, as when it processed the
outcomes of similar choices over past repetitions. Precisely, the orbital frontal cortex and
the amygdala mediate how past regret history biases subjects towards minimizing regret
across similar choice situations in anticipation of its possible consequences. This result
is consistent with Damasio’s result, according to which ventral medial structures support
the integration between cognitive and emotional components of the entire process of
decision-making. Besides the bottom-up mechanisms that make emotions inflect deci-
sions in an optimal sense, the orbital frontal cortex specifically uses a top-down process in
which cognitive components, such as counterfactual thinking, modulate emotion.
This complex, double-looped, relation between cognition and emotion has been
modeled by evolutionary and behavioral responses. However, such a lesson from neuro-
biology about the adaptive value of regret stresses the tension between the construal of
regret in biology and in decision-theory. We proposed a study of the Allais paradox with
ventral medial lesions to explore this tension.
Allais (1953) showed that people tended to exhibit inconsistent choice patterns when
presented with pairs of options that involved a contrast between quasi-certain and risky
options (see Table 11.2).
The presentation of the Allais paradox in Table 11.2 contrasts a pair of choices among
pairs of lotteries. The individual is first invited to choose between Lottery A and Lottery
B. He is then confronted with a list of probabilities of obtaining certain payoffs, as in
every classical lottery. We can see, for instance, that in Lottery A and Lottery B, he has the
same chance (89 percent) of obtaining €500 000. Likewise when confronted with the other
choice between Lottery C and Lottery D, he has the same 89 percent chance of winning
nothing across the two then concerned lotteries. If the subject rationally applied von
Neumann and Morgenstern’s axiom of independence (von Neumann and Morgenstern
1944) which states that a choice between two options should be independent of what is
Table 11.2 Matrix of the Allais paradox
Lotteries Probability of alternative states of nature S1, S2, S3

S1: 0.01 S2: 0.10 S3: 0.89
Lottery A €500 000 €500 000 €500 000
Lottery B €0 €2 500 000 €500 000
Lottery C €500 000 €500 000 €0
Lottery D €0 €2 500 000 €0

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common (in terms of both payoffs and the probability of their realization, which is clearly
the case for the fourth column of the table when we consider alternatively A and B and
then C and D) between the options, he should realize that the pairs of lotteries A and C
and B and D actually present the same contingencies. This lack of application of such an
independence axiom is what makes the subject reverse his choice, without realizing most
of the time that he does so, across the two pairs of choices.
Most of the time, a same individual will tend to prefer A to B and at the same time,
without realizing any reversal in her preferences, will tend to prefer D to C. In order
to grasp the implicit violation of the independence axiom presented by this preference
reversal, please delete the last column of the table, which presents common consequences
to be bracketed, and now realize how A = C and B = D. Regret theory provides a simple
explanation of Allais’s paradox. A person who has chosen option B has, if state of nature
S1 materializes, strong reasons to regret his or her choice. A subject who has chosen option
D would have much weaker reasons to regret his or her choice in the case of S1. When
regret is taken into consideration, it seems quite reasonable to prefer A to B and D to C.
Several psychological mechanisms have been hypothetically suggested to account for
this type of preference reversal, among which the attractiveness of sure gains and the
anticipation of regret if those sure gains would have been forgone and yet realized. The
bottom line is that an emotional disposition towards possible future outcomes is involved
in the Allais paradox. We tested this hypothesis on a population of patients suffering
from behavioral variant frontotemporal dementia (bvFTD), a clinical population known
to present ventromedial prefrontal cortex dysfunctions and deficits in experiencing emo-
tional deficit in decision-tasks. We contrasted this group to matched controls and patients
with Alzheimer’s disease (AD) who had no ventromedial prefrontal atrophy. Our results
showed a drastic diminution of Allaisian behavior among bvFTD patients by contrast
with controls and AD patients. We concluded that prefrontal regions are crucial in the
production of a behavior that typically stands in contradiction with a basic axiom of
rational decision. By contrast, impaired emotional mechanisms ironically produce hyper-
rational (non-Allaisian) behavior in bvFTD patients (see Bertoux et al. 2013).
Decision-theory aims to provide an axiomatic – and thereby in principle intuitive –
basis upon which we can assess whether actual choices and repeated decision patterns
comply with norms of rationality these axioms are supposed to encapsulate. When these
patterns deviate from what logically follows from axioms, we would be alternatively
tempted to weaken the latter for the sake of psychological realism or discard evidence on
behalf of a principled incommensurability between the descriptive and normative levels.
Regret-based decision-theory is a unique attempt, in the recent history of decision-theory,
to combine these opposed tendencies in a sort of reflexive equilibrium approach that
would jointly increase the intuitiveness of the axiomatic basis and the cognitive adequacy
of the proposed theory.
3 REGRET IN DECISION-THEORY
The Allais paradox gave rise to alternative decision-theoretic accounts. One explanation
for the A-D pattern is that decision-makers anticipate regret if they choose B and find
themselves in the state of nature S1. Note that at this juncture two comparisons with the

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realized outcome are possible which can give rise to two distinct emotions, two forms of
regret if one wishes. Depending on information about counterfactual outcomes or states
of nature, the unfortunate decision-maker can express two forms of regret. Most natu-
rally, he can regret his own choice B, since the state of affairs S1 has been the case and he
won nothing. Had he chosen choice A he would have won a certain €500 000. However,
not regretting his choice B, he could deplore his lack of luck and the fact that neither S2
nor S3 had been the case. To our best knowledge these two possible attitudes and types
of regret when a risky decision has been made have not been studied.
However, if that choice were repeated, it would be contrary to a rational regret-based
decision to avoid B, which presents higher than expected utility, because there would be
no grounded reason to think that the ‘universe’ is fatally stuck to the actualization of S1
(if it were, why would we speak of S2 and S3 in the first place and why would we have
attributed the probability 0.01 to S1?). Per absurdum, we would systematically be deterred
from choosing B, in a repeated sequence of choices, on the basis of anticipated regret if
that individual had either developed extreme pessimism or, which amounts to the same,
developed a distorted view of probabilities. This remark on the contrast of the relevance
of taking into account regret in a single-choice versus repeated-choices situation makes
the picture of how regret should enter into decision-theory more complex than at first
sight. Regret-theory has been formalized to account for comparisons between actual and
counterfactual outcomes within a single state of nature or ‘world’. Regret is relevant in
that single world, as expressed through these introductory terms by Suhonen (2007, p. 11,
emphasis added):
The central idea behind regret theory is that, when making decisions, individuals take into
account not only the consequences they might experience as a result of the action chosen, but
also how each consequence compares with what they would have experienced under the same
state of the world had they chosen differently . . . Then the overall level of satisfaction derived is
a combination of the basic utility of the consequence actually experienced, and some decrement
or increment of utility due to ‘regret’ or ‘rejoicing’.
In standard expected utility theory a prospect is evaluated according to the utility of

each outcome irrespective of what the other possible outcomes can be. This is strictly
forward-looking and consequentialist. As soon as an individual looks to past decisions
to base his present choice on them or, more complexly, anticipate a future backward-
looking state of mind in which he anticipates he will be regretting the present decision
he is liable to make, he immediately ceases to be strictly deciding along consequentialist
guidelines. To incorporate such backward-looking attitudes in decision-making leads us
to adopt a non-standard expected utility theory. For instance, an individual may wish to
avoid uncertainty, or an individual may not be able to evaluate single payoffs per se but
only by comparison with other possible outcomes, his mind being fit to reference points
and relative status rather than to processing absolute values. Under a narrow Savagean
interpretation of the Allais paradox (Savage 1954 [1972], consequences are identified
with monetary payoffs. Under this restriction, expected utility theory is violated by most
individuals (including Savage, according to the legend). Under a broader interpretation
of what consequences are, or, equivalently, of what a decision-process amounts to, such
as that provided by regret-theory, no violation exists. This way out may appear less than
satisfactory, though once we relax axiomatic constraints every type of decisional pattern

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can be interpreted as satisfying some revised state of the axiomatics, emptying the theory
of all normative and descriptive content. As Tversky (1975) underlined, because we wish
to maximize the predictive power of the theory, we are tempted to adopt a restricted
interpretation of utility, such as the identification of outcomes with monetary payoffs. In
this respect, we can consider regret-theory (Bell 1982; Loomes and Sugden 1982, 1987a)
as an optimal trade-off between axiomatic revision and predictive power, a maximally
conservative attempt at deviating from standard expected utility with a view to intuitively
account for robust behavioral data. Loomes and Sugden (1987b) have built a model that
generates testable prediction and compares with alternative theories, standard or not.
Regret-theory consists of the intertwining of two factors in a single utility function that
thereby incorporates two measures of satisfaction: utility of outcomes, as usual, and a
quantitative measure of regret. The mixing of the two – which supposes their commensu-
rability and, therefore, a conceptual assimilation of regret to a negative payoff – yields a
moderately modified concept of utility. In Bell’s terms (1982, p. 963) regret is measured as:
‘the difference in value between the assets actually received and the highest level of assets
produced by other alternatives’. Tracking this difference across choices is what regret
amounts to. This is represented by a two-parameter function u(x, y) where x is the actually
received payoff and y the difference just referred to. x and y cannot jointly increase and by
construction x is maximal when y is null, which means that in this approach, the payoffs
of options to be compared always sum to zero and there is always a dominant choice.
Interestingly, this functional representation, thus interpreted, presents a potential con-
tradiction with another heuristic supposed to make us smart, namely, Simon’s satisficing
principle (Simon 1956, pp. 129, 136). If I reach a level xˉ of payoff above which I do not
experience any utility increase, then y can freely increase, in the sense that I could have
gotten more than xˉ , but without the difference Y − xˉ any longer generating any regret.
The contradiction is swiftly spelled out, at the theoretical level first, if we consider that
the use of a minimax-regret heuristic is compatible with the optimal determination of our
satisficing threshold: given a certain difference between x and y, we can decide not to take
it into account, either because it is too small or because it is too large. In that sense, it is
the individual’s sensitivity to comparisons and regret they elicit that endogenously defines
their satisfaction threshold. We can indeed assume that people are sensitive in a non-linear
way to different payoff intervals between what they get and what they could have got.
If the different is negligibly small or unrealistically too large, I can cease to be sensitive
to the discrepancy between actual and forgone outcome. It is likely that the individual
feels regret when the comparison falls between a certain perceivable and conceivable gap,
beyond which it appears a vain feeling. In that sense minimization of anticipated regret
and satisficing are not incompatible smart decision-making principles. This is consistent
with some recent results about the behaviors of maximizers and satisficers with respect
to their feeling regret about their decisions (Moyano-Diaz et al. 2014). As the authors
of the study point out, a main difficulty in the study of decision-making is precisely the
combination of the two coexisting partially incoherent aspects and dimensions that are
maximization and satisfaction. Regret can be seen as playing a subtle mediational role
between these two dimensions. Regret is more than an emotional reaction against bad
consequences; it is also an internal transformation, as we have seen, of these bad conse-
quences into an anticipatory process. Regret is then inherent to its future avoidance and
is compatible with maximizing utility. As Schwartz et al. (2002) found and is reported by

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Moyano-Diaz and his colleagues, maximizers tend to engage more often than satisficers
in social comparisons and are more affected by them. Regret is for them a driving force
towards optimization. Maximizing is not blind forward-looking or full-fledged conse-
quentialism, then, as past errors and all alternatives are scrutinized. However, this type of
regret-based maximization decision-making style bears a high psychological opportunity
cost and potentially generates a lot of continuing frustration. In contrast, satisficers
proceed more easily and are satisfied with their good enough option. In that sense, satisfic-
ers can be said to minimize the counterproductive use of first-order regret minimization.
We then equate Simon’s satisficing to second-order minimax-regret in what we consider a
fuller account of the psychological cost associated with the presence of bad decisions and
the correlative first-order regret they tend to provoke. We could thus envisage a Simon-
based regret model in which the individual is likely to experience regret when the psycho-
logical cost to do so does not exceed the benefits of correcting his or her present decision
in view of future benefits. Admissible regret is thereby endogenously defined because
future benefits are themselves bound by the individual’s level of satisfaction. When the
latter is attained, there is no more valuable motive to admit regret as a reasonable emotion.
This Simonian perspective on the link between satisfaction and regret suggests a deeper
analysis of how the different ways of incorporating regret into decision-theory also
convey different views of human rationality. In summary, Loomes and Sugden’s way is
still essentially consequentialist, in the sense that regret is both included in a maximization
process and that the functional representation they propose remains fundamentally com-
patible with a forward-looking attitude. Differently, the short analysis we have provided
of the compatibility of satisficing and second-order regret-minimization amounts to a
non-consequentialist view, decision-makers deciding now to ignore certain information
and consequences of their choice beyond a certain threshold; satisfaction, in the Simonian
sense, meaning not only to cease to adopt a utility maximizing attitude but also to cease
to make any counterfactual comparison once a certain level of utility is reached. This
way of blocking potential feelings of regret emphasizes, by contrast, the role of signals
and omens in standard decision-making. We can imagine individuals ready to pay not to
receive information about outcomes of forgone decisions. Karlsson and colleagues (2005),
in an unpublished study, have documented a very similar phenomenon on financial
markets, which they label an ‘ostrich effect’, people deliberately discarding information
about their investments portfolios when markets go down. Regret aversion is seemingly
an ordinary feature of decision-making related to a human propensity to respectively seek
or avoid positive and negative omens and base our decision at this symbolic level rather
than strictly focus on the evaluation of our choices’ consequences.
We have studied regret in connection with the Newcomb problem in that perspective.
This problem tackles deep philosophical issues around the nature of rationality, along the
dividing line we have discussed above: can we rationally take into account information
about our choices that in fact does not change the way consequences will be realized. Is
there a way to vindicate the fact that, in some cases, we are sensitive to consequentially
irrelevant information? This dividing line among decision-theorists – only among those
of a philosophical bent though – has been labelled in terms of a difference between causal
decision-theory (individuals make their choices according to basic stochastic dominance
and independence principles) and evidential decision-theory (individuals may legitimately
be influenced in their decision-making by symbols or information present in the choice

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situation which, in principle, do not affect the consequences) (Joyce 1999). Nozick (1969)
devised that paradox of rationality with the explicit purpose of contrasting consequen-
tialist and symbolic forms of rationality. In this problem, two boxes, one opaque, one
transparent, are presented to a decision-maker along with the following message:
Imagine a being with great predictive powers. You are confronted with two boxes: B1 and B2.
B1 is opaque and B2 is transparent, you can see that it contains €1. B2 contains €1; B1 contains
either €10 or nothing. You may choose B1 alone or B1 and B2 together. If the being predicts that
you choose both boxes, he does not put anything in B1; if he predicts that you choose B1 only,
he puts C10 in B1. 5> What should you choose?
We had hypothesized that if this choice of alternatives, as Nozick thinks, coincides with
different types of rationality, they could also elicit different levels of confidence in our
choices. If I really believe in God, I might be inclined to accept a certain level of non-
consequentialism in my choices. However, disappointment can be greater in that case
than if I had made a purely consequentialist choice (ignoring the omen) followed by a
bad outcome. I therefore considered that regret, when I realized what I could have got had
I made the other choice, is modulated by the type of rationality implied by our choices
(Bourgeois-Gironde 2010).
Let us label individuals one-boxers and two-boxers according to their decisions in the
Newcomb problem (Nozick 1969). Two-boxers go against the prediction. The decision-
criteria they presumably follow have been characterized, as we did, as consequentialist,
but also, in philosophical parlance, as we commented above, as ‘causalist’, by contrast
with ‘evidentialist’. Two-boxers thus apparently exhibit a higher autonomy, that is, a
higher level of decisiveness, in their choices than do one-boxers, although the latter’s faith
in the omniscient predictor can also yield a high level of decisional confidence (think of
Pascal’s wager; Pascal 1897). Integrating the decision-criteria predictions, signs and sym-
bolic value may not be altogether irrational (Nozick 1994). It is pervasive enough, as, for
example, in convincing ourselves of our good health or of the influence of our vote in
national elections by going to vote, by accomplishing acts that amount to generate self-
manipulated positive signals (Quattrone and Tversky 1988).
Shafir and Tversky (1992) ran the first empirical investigation of Newcomb problems.
They submitted to their subjects a Newcomb problem. Their cover story was that ‘a
program developed at MIT was applied during the entire experimental session to analyze
the pattern of your preferences, and predict your choice (one or two boxes) with 85% accu-
racy’ (Shafir and Tversky 1992, p. 461). Although it was obvious that no deus ex machina
intervened at the moment of choice, most experimental subjects opted for the single
opaque box rather than for the dominant two-boxes strategy. It is as if they believed that
by declining to take the money in box B2, they could change the amount of money already
deposited in box B1. Adding on their test, we measured whether regret was different when
negative outcomes are revealed to one-boxers and two-boxers. We observed – by means
of a retrospective measure of satisfaction on a five-point Likert scale – that one-boxers,
when facing negative outcomes, experience a significantly greater amount of regret than
do two-boxers in the same situation. This is due, we speculate, to the lesser decisiveness
or autonomy with which those choices are made, in spite of their greater faithfulness to
the prediction. If a difference emerges between types of decision and amount of regret in
the Newcomb problem, this can be considered as a step toward a better understanding of

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how regret taps into rational antecedents of choices and can be modulated by competing
criteria of rationality.
4 REGRET AS A COORDINATION DEVICE AND A SOCIAL

MECHANISM
Bob wants to go to the opera with Ann tonight. However, in their last discussion, they
split on a doubt about what they would do; Ann definitely seemed to wish to please Bob
and to agree to go to the opera, although she had declared her preference for the boxing
match in another part of town. When they left, Bob said clumsily but audibly that he
would like to please her too. In the confusion they omitted to give each other their mobile
numbers. Now Bob goes to the boxing match, and does not find Ann. In another scenario
he goes to the opera but learns the next day that Ann had opted to go to the boxing match,
having understood that Bob would join her there. One could say that an ex ante post hoc
regret-minimizing based decision would have induced Bob to go to the fight, as he would
have had the moral comfort to have tried to please Ann retrospectively. However, if Ann
follows a similar strategy, they miss each other and fail to go out together to their joint
detriment.
Imagine this situation is repeated every day, with the same level of conversational con-
fusion and omission of electronic devices coordination, by Bob and Ann. It is as if they
both lived in ‘groundhog day’ with the characteristic fact that some external and internal
elements (such as their inability to correct their spontaneous lack of coordination) fatally
befell them. However, they can change their decision every day. There are many ways
for them to get out of their predicament. They still have available external and internal
resorts. They can use a binary coordinative device, like tossing a coin, or look at the sky,
whether it is sunny or overcast, and silently fit their behavior, after a few learning trials, on
this conventional signal. Or they can use regret, which is internal, on the hypothesis that
they tend to feel the same, which was in the premise of the argument. The use of the coin,
or the sky, or a traffic-light for that matter, is a coordinative device that leads to a cor-
related equilibrium (Aumann 1974). A correlated equilibrium arises in a situation where
mis-coordination is likely, owing to several present Nash equilibria leading to suboptimal
effects, and when players resort to a set of received signals or instructions by a neutral
referee. A correlated equilibrium, technically, is a probability distribution over the players’
space of strategies realized by the referee (or by nature) and from which no player has a
unilateral interest to deviate. Hart and Mas-Collel (2000) have shown in what sense regret
is an adaptive heuristic in reaching correlated equilibria.
Basing a decision on the one that simply minimizes our regret, in the ‘battle of the
sexes’ between Bob and Ann described previously, could apparently lead to persistent
mis-coordination. If one pleases the other in the same way, their paths will continue to
diverge, but this could be solved by using the following heuristic: ‘Switch next period to a
different action with a probability that is proportional to the regret for that action, where
regret is defined as the increase in payoff had such a change always been made in the
past.’ (Hart 2005, p. 1405). This works because it dynamically removes the players from
a single-handed strategy (that would consist, for example, of blindly pleasing the other).
Players engage in a learning dynamics that will make sources of regret endogenously

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evolve and, thereby, by individually, but jointly, directing their effort to minimize this
regret, happen to reach a correlated equilibrium in an efficient way. Regret owing to mere
failure of coordination (not simply because of own fault or misplaced benevolence) will
progressively guide the choice of strategies by pondering the probability of which of the
strategies is played. It means that both players end up feeling the same type of regret based
on their suboptimal payoffs, whatever the personal motives that previously led them to
mis-coordinate. Interestingly, jointly minimized regret, although an internal endeavor and
learning mechanism, plays the role of a public coordination device, avoiding any need for
external communication or objective means of coordination, as is required in other ways
of reaching correlated equilibrium.
The use of regret represents a smart heuristic in the sense that it allows players to
eschew the computation of highly complex objects such as repeated games strategies
and beliefs. By means of Hart’s heuristics they can simply trade-off between past payoffs
associated with a given course of action and match past frequency of success with the
probability with which they will stick to this course of action. More precisely, regret is a
‘smart’ heuristic in the sense that it is cognitively parsimonious (to match past payoffs and
future actions probabilities is relatively easy), but also in the sense that it is not dumb or
fully blind either, as it requires a certain level of freedom of choice and self-modulation
of the weight the individual wants to give to this signal. It then requires a certain degree
of rationality. In evolutionary dynamics, by contrast with learning dynamics such as the
use of a matching-regret heuristic, agents do not have to exhibit any level of rationality,
as their phenotype (observable behavior) is deterministically dictated by their genotype
entailing that they have no leeway to modulate their strategies and learning mechanism.
They play relatively fixed actions that aggregate into group behavior. What can be called
rational or irrational in that context is the collective dynamics of the population to the
extent that it leads to optimal steady states. Our next question, then, is to ask to what
extent assessments of collective rationality can be informed by regret-based decisional
patterns at the individual level?
Voting procedures are paramount social mechanisms that display this discrepancy
between individual and collective rationality. It can go both ways. The paradox of voting
is a typical instance of collective rationality (the possibility of an optimal social choice
through aggregation of individual preferences) not being supported by individual ration-
ality (in large groups, it is ‘irrational’, when we think in costs-benefits terms, to pay the
cost of going to the voting booth). Arrow’s impossibility theorem (Arrow 1951 [1963]),
on the other hand, is a deep illustration of how individual rationally structured prefer-
ences (with respect to their transitivity) do not necessarily aggregate into a transitive social
preference.
A solution of the paradox of voting has been proposed by Ferejohn and Fiorina
(1974) in terms of the minimax regret criterion. Voters choose the action that yields a
minimal regret in a worst case scenario. This implies a form of strategic voting which
can seem contradictory with the fact that, if voters are aware that their vote is unlikely
to be pivotal, they could still vote sincerely. The situation is far from being unrealistic.
Also, collective regret is likely to arise in that situation. Regret being elicited by the pos-
sibility of comparing what one has got from what one could have got depends on the
possibility of counterfactual learning at some point of the democratic process. The 2007
elimination of candidate Lionel Jospin in the first round of the 2007 French presidential

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election may have aroused such an emotion among the voters for the minor left candi-
date, Taubira, leading to the far-right candidate Le Pen’s presence in the second round.
The use of alternative voting procedures may not only have led to another result, but
perhaps also to lesser pangs of regret felt by some of Taubira’s supporters (Baujard et
al. 2014). Uninominal majority voting, approval voting, and evaluative voting differ in
three comparable respects: (1) they are more or less expressive, in the sense that voters
can convey more or less fine information about their preference in selecting their options;
(2) it is more or less polarized, in the sense that negative feeling towards a candidate can
be strengthened in evaluative voting if negative grades are allowed; (3) it can be more or
less easily strategized. The parameters inherent to the voting procedure can be associated
with its varying susceptibility to regret. If we have the opportunity to express a fuller and
finer choice without jeopardizing the election of a consensual candidate (which is the case
by use of approval voting in particular), regret, in case of non-success, will presumably
be minimized.
Tideman (1985) extended the minimax regret model of voting by borrowing from
the Sugden and Loomes’ framework we discussed in section 3. He adds the concept of
remorse and elation to the model, which are ‘emotions that arise as a consequence of
being responsible for one’s circumstances by one’s own actions’ (Todeman 1985, p. 103).
The key, there, is this feeling of responsibility which is a constitutive element of regret:
losses and gains are accentuated if we are or feel responsible for the feared result. Guilt
drives regret, even in a context where there is no objective influence of the voter on the
outcome. It disproportionately distorts it and might explain high levels of voter turnout.
Can it be smart in this social and political context?
Emotions are an important element of the political game and influence behavior (indi-
vidual or collective) (Groenendyk 2011). However, what has been less studied is how emo-
tions endogenously depend on certain features of given democratic structures, in terms
of choice procedures, aggregative mechanisms and informational filters and feedbacks.
Understanding how the mechanisms of social choice generate by themselves emotional
states and flux is crucial in view of the democratic regulation of the political game:
democratic leaders do not want their institutions to be undermined by extreme political
affects nourished by their constituencies. Several levels of analysis are relevant for this
still widely open set of issues: (1) mechanisms of choice – essentially how the procedure
used for voting and the aggregative mechanism associated with those rules trigger posi-
tive or negative emotions; (2) information and feedbacks about the political process and
its results (pools and so on), on the basis on which payoffs comparison can be made and
an adaptive regret heuristic launched; and (3) timing of choice – frequency of elections,
possibility of voicing popular opinion in regular moments and channels – determining
fluctuating emotional states in the population of voters.
At a more general level, we could wish for a society that maximizes consensus, by mini-
mizing the distance between the social choice and each individual vote (see Kemeny 1959)
and that also minimizes regret in terms of minimizing individual loss functions. This is
not strictly equivalent, and some dynamic emotional fluctuations in democracy might be
due to the interplay between those two minimization functions. More generally, the issue
is the analysis of how emotional dynamics in democracy might depend on fine structural
choices on aggregative and informational political mechanisms. Again, we point here at a
possible discrepancy between social consensus thus defined and individuals’ psychological

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factors such as regret or satisfaction with respect to the effective social choice. Each indi-
vidual feels more or less satisfied with the current social choice (for example, the result of
the last election). Ignoring, for the sake of a simpler presentation, dynamic effects occur-
ring in the course of office terms, these levels of regret or satisfaction can be envisioned, as
a first approximation, as products of loss functions (minimax regret) for each individuals.
From a computational point of view the aggregation of individual loss functions in the
population and the measure of the distance between each individual preference of that
population and the social choice are not identical.
Incorporating individual levels of regret as a parameter of social satisfaction with
respect to some social choice function is then an attempt at combining collective and indi-
vidual rationality. It also potentially anchors back social choice mechanisms into adaptive
heuristics upon which real individuals tend to make decisions, combining emotional and
cognitive abilities, and fine-tuning our biological and social fabrics.
5 CONCLUSION
Anticipated regret is one of the most efficient heuristics that we can use in order to avoid
suboptimal decision-making. It has been incorporated in decision-theory at an axi-
omatic level, both in individual decision-making and in interactive strategic situations.
Moreover, it has been demonstrated an efficient learning mechanism, leading to optimal
decision-making, and coordinative device in multiple equilibria game-theoretical con-
texts. Regret-theory is nevertheless compatible with bounded rationality paradigms such
as Simon’s satisficing principle; the latter involving a form of second-order modulation
of the amount of regret that an individual can reasonably experience in order to guide
his or her decisions towards a satisfaction threshold. This view seems in agreement with
what recent brain-imaging studies have taught us about the neurobiology of regret. The
emotion of regret lies at the junction of the processing of aversive states and of the cog-
nitive anticipation of future outcomes of the individual’s actions. For this set of reasons,
we consider regret to be one of the best candidates with a view to unifying biological and
decision-theoretical approaches to optimally bounded decision-making.
NOTE
1. Somatic markers such as perspiration, hence skin conductance of body parts such as fingertips, or heart-
beats, pulsations, and so on form a particular class of measurable bodily states that Damasio and Bechara
in a series of influential studies in the 1990s have shown to be correlated with so-called secondary emotions.
The latter are feelings that have been associated, through past repeated experiences, to the learning and
anticipation of future outcomes in certain typical choice situations. When a somatic marker is associated
with a particular negative outcome it functions as an alarm bell and is a reliable signal. It is convenient to
understand anticipated regret in the framework of this ‘somatic marker hypothesis’. Interestingly these pre-
dictive somatic markers can be effective without fully arising to consciousness, making them an automatic
self-corrective mechanism. (For another type of experimental approach on feelings of errors and their
predictive and corrective roles see Gangemi et al. 2015.)

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12 Is it rational to be in love?
Paul Frijters and Gigi Foster
1 INTRODUCTION
Einstein reportedly once remarked that ‘only a life lived for others is a life worthwhile.’
Implicitly, Einstein thus viewed Rational Economic Man, who knows what he wants
and only cares for himself, as not living a worthwhile life. To the degree that living a
worthwhile life is rational, Einstein would have implicitly deemed ‘Rational’ Economic
Man to be, well, not.
The core process we aim to illuminate in this chapter consists of people – even very
smart ones – being programmed, through economic and social means, to exhibit loyalty
to both other people and abstractions. As members of families, nation states, religions,
sports teams, professions, and friendships, most of us will have loyalties outside ourselves,
deriving pleasure from seeing our loved ones thrive, but economists lack a tractable theory
for how such loyalties come about. We therefore also lack an understanding of how groups
employ institutions and strategies to make new generations of individuals adopt those
loyalties that are useful to existing groups, as well as to successful functioning in their
future lives, including as members of groups yet to emerge. In this chapter we try to fill
that void, adding loyalty to the basic economic toolkit.
Our theory of how people change their loyalties includes a large role for the uncon-
scious mind: we will argue that changing loyalties is not a conscious choice. Based on
introspection and simple observation of the human condition, we claim that people
cannot consciously choose to increase their love to any level they want. They may con-
sciously put themselves into circumstances that push them towards falling in love with
something, but they cannot simply decide to love something and make this state of affairs
come about instantaneously. In that sense, being in love is an unconscious process and
thus rational in a limited way, on a par with other bodily processes that are unconsciously
regulated, like maintaining blood sugar or testosterone levels.
We start with a toy model of standard economic rationality wherein individuals never
change their loyalties, which we then stretch and shape, via a series of intermediary
models, into a model of fluid loyalties and rules of thumb as to how those changes come
about. We illustrate how the fluid notion of loyalty throws light on group-mediated phe-
nomena such as education, national symbols, group ideals, and adherence to the ideals of
science. We use a simple public goods game to illustrate how particular loyalties to group
abstractions held by a small minority help to coordinate a whole group of individuals on
the optimal outcome for the group as a whole – a feature that has come in particularly
handy during the course of human development. This then leads to a short discussion of
the institutions via which group power is organized and maintained.
The topics addressed in this chapter are thematically related to existing large economic
literatures on household bargaining, parental investments, and reciprocity. However, as
far as we know, these literatures have never discussed in mathematical terms how loyalties
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arise and change, which is the main focus of our chapter. In that sense, we know of no
prior work that we directly build upon. When we speak of ‘mainstream economics’ as the
counterpoint to our models incorporating loyalty, we have in mind the notion of rational
economic man that is taught to undergraduate students of economics, rather than the
many expansions in various sub-literatures that the few who proceed to higher studies
will encounter. The literatures adjoining this chapter and the content of first-year text-
books that we take as indicative of ‘mainstream economics’ thinking are both discussed
in Frijters and Foster (2013). What this chapter adds to that book is an extended set of
mathematical models that describe how loyalty arises.
We also contemplate here a meta-question: is it advisable to resist changes in loyalties,
seeking to remain immutable and fixed over time, like the rigid figure of mainstream eco-
nomic models? Or is it smarter to be what we call in later sections a Rhytonian rationalist,
whose notion of self changes over time via the ebbing and flowing of his bonds with other
people and entities?
We argue that from the view of the initial self, changing loyalties is like submitting to a
form of premature death: a betrayal of what was originally cared for. From the view of the
rational ever-experiencing self, however, developing loyalties to abstractions and people as
they are encountered is likely to be the more adaptive and happiness-maximizing strategy.
In this sense, we explicitly embrace self-delusion, belief in non-existing entities, and the
jettisoning of loyalty towards prior notions of self as potentially quite ‘rational’ and
evolutionary adaptive choices.
2 THE ARGUMENT FOR LOYALTY
We start with the observation that people are capable of forming lasting bonds both
between themselves and other humans, and between themselves and abstractions that
they conjure in their minds. These bonds are all held in the mind, but have large behav-
ioral implications. The clearest evidence for this claim is pure introspection: is there truly
nothing outside yourself that you care about, and with which you feel yourself to have
long-lasting bonds? Is every favor you bestow on others the result of selfish maximization,
providing no ‘warm glow’ (Andreoni 1990) or other positive internal reward?
We need the concept of loyalty to explain behavior. Without a mental adherence to
gods and spirits, we should not see lucky charms or private prayer, or any other activity
that others cannot see us doing but that involves a time investment towards unseen and
arguably non-existing entities. Additional evidence comes from our emotional responses
to how we think others view us, showing a mental adherence to abstract ideals of behavior
against which we believe we are judged (for example, fairness, chivalry, integrity): loyalty
to these ideals is implicit in self-loathing internal experiences like guilt and shame that in
turn have been known to drive behaviors from listlessness (Hentschel 2007) to self-harm
(Inbar et al. 2013). A great deal of human behavior seen throughout history, from the child
sacrifice of ancient cultures to the Australian Aboriginals’ ritual of pointing the bone, is
extremely difficult to explain without the existence of some unseen link people sense they
have to things outside themselves.
How do these mental bonds arise? How does a person come to start ‘believing’ in
social institutions, such as democracy, human rights, or equal opportunity? How does

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Is it rational to be in love? 207
he develop bonds with gods, or for that matter with other humans? Only once we have a
working model for the development of such bonds will we be able to think in an organized
way about when they arise and what their behavioral implications might be.
Throughout this chapter, we refer to such bonds as ‘love’ or ‘loyalty’. We will offer a
precise mathematical definition in later sections, but intuitively, true loyalty will be defined
as the inclusion of a mental depiction of an outside entity within the mental depiction of
the Self.1 Love will push the one who loves to take actions that support the loved entity,
because the loving individual receives internal rewards (‘utility’) from doing so and pain
from perceiving that his ideal is suffering, just as he would experience pleasure or pain
when other parts of his Self (such as his physical person, or his self-esteem) are stimulated
in positive or negative ways.
3 FROM GREEDY RATIONALITY TO RHYTONIAN

RATIONALITY
In this section, we sequentially work through a series of simple models of the objective
function that individuals are trying to maximize, starting with a standard mainstream eco-
nomic model. Our final model nests a classical vision of rational individuals who are loyal
only to a limited notion of Self, but also accommodates rational individuals who have
fluid loyalties to a much broader notion of Self. To experience the difficulty of deciding
which among the alternative personas these models accommodate is the most ‘rational’,
a reader might approach them from the point of view of a concerned grandparent: which
persona would you wish your own grandchild to have?
3.1 Greedy Rationality
To set the scene, suppose there are N entities. At least some subset of N must be thought
of as actual individuals throughout all of our models, although later the set N will also
include entities that do not exist. We focus on human decision maker i, a member of set
N, where i will throughout the exposition denote the experiencing individual (that is, ‘the
entity known as i that experiences utility’). Final consumption in period t of individual i
is denoted by the vector of consumption goods Xit.
Apart from consuming goods, individuals also have a resource that we call ‘power’,
which can be intuitively understood as the ability to influence the environment, most
notably other individuals. Power is intimately tied to the social environment. The power of
individual i is denoted by sit and can be at least partly expressed as a function of the ele-
ments of Xit, as when some amount of power derives from the purchasing power denoted
by a weighted average of consumption goods. However, power is not fully reducible to
a function of consumption, as it can also come from an individual’s physical strength
and other socially recognized promises and rights – elements that do not have a straight-
forward relation to traded consumption goods. The Xit vector can also include sit as an
element, to accommodate the possibility that power may provide direct utility.
We think of consumption goods – that is, Xit excluding the sit element, for all i and t – as
transferable among entities, with the pre-transfer allocation (called the ‘endowment’ or
‘production’) of a good x to entity i in time t denoted by | xit. By design, if an entity is a

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member of the subset of imagined but not real entities, its actual endowments of both
consumption goods and power are zero. Each transfer of good x from i to j, which is part
of a ‘trade’ as traditionally understood if j directly reciprocates, is denoted Txjit. Each use
of the power of an individual i towards an entity j is denoted Tsjit.
Transfers of goods can encompass trades between people, but also may include offer-
ings to gods or ideals that do not exist but still appear in the set N of perceived market
players. While we initially think of the transferable goods in this model as physical goods
and readily observable services, we later allow for the possibility that some consumable
goods do not exist at all: they can include imagined goods like salvation in the afterlife, the
triumph of science over ignorance, and other such higher-order imaginary things that rely
on the abstractive capacities of the real traders to be sustained as goods with consumption
value. Individuals’ goods-transfer and power-application decisions at time t are based on
expectations of the elements of Xi at time t and in future periods. This formulation allows
for the possibility that people make investments (transfers) in order to have a higher Xi
now or in the future that never in actuality materializes.
The simplest form of ‘greedy rationality’ is then associated with an individual i who at
time 0 (= today) makes choices based on his attempted maximization of
EUi 5 E c a e2rtUit d 5 E c a e2rt (uc (Xit)) d

t t
xit 5 |
xit 2 a Txijt 1 a Txjit (12.1)
j j
E [ Txijt ] 5 Txijt; E [ Tsijt ] 5 Tsijt ,
where the final lines hold for all elements of X across all times periods, and for all i within
the set N (meaning that expected and actual transfers of goods and power between any
two entities are equivalent). r is a discount factor and uc(Xit) the utility enjoyed by indi-
vidual i that is derived from his final consumption. In this model, the individual maximizes
his utility subject to expectations (=E[.]) that conform to reality, so in that sense he is fully
rational. The technology of exchange and power are inputs into a ‘reciprocation func-
tion’, Txjit, that can directly depend on both the first-move transfers from i to j (Txijt) and
the power applied to j by i (Tsijt). Indeed, all the elements |xit, E[Txijt] and E[Tsijt] should
be understood as functions of the other elements. Since we are not concerned here with
finding analytical steady-state solutions for transfer levels, but rather with describing a
theory of love and what it means to be a rational decision maker in a world with love,
there is no ex ante restriction we must impose on these functions.
The formulation above is a simplification of the types of utility set-ups suggested by
the extensive literature on choice behavior (for example, Neumann and Morgenstern
1944; Fishburn and Rubinstein 1982; Prelec and Loewenstein 1991): it involves linear and
intertemporal separability of particular utility items, exponential discounting, a lack of
procedural irrationality (such as an inability to calculate or limited memory), no direct
modelling of uncertainty, and no explicit utility role for procedural aspects of how the
eventual allocation of goods comes about.2 In what follows, many of the mainstream
extensions to this basic framework will emerge, but in a format different from that used
by others, using this simple and flexible model as a starting point.

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Within this formulation, the classic economic motivation of greed can be seen as a
type of direct grab, whereby an individual can invest resources that beget an immediate
payback in terms of Xit and/or sit. Such a ‘grab’ may involve a material quid pro quo, as
is the case with classic voluntary trade, but may also involve threatened or actual physical
domination, such as theft or rape, or other means of appropriation without (full market
value) compensation. In its simplest form, a choice to be greedy is based on the expecta-
tion that an investment in an attempt to make a resource grab will have a direct payoff,
that is, that a transfer of good a, Tajit, can be ‘paid for now’ by means of an investment in
a good of recognized value b, Tbijt, or by the application of power:
dE [ Tajit ] dE [ Tajit ]
. 0, .0 (12.2)
dTbijt dTsijt
The expectation of payback from the ‘grab’ strategy can be rational because the individual
expects a voluntary trade from entity j, or because he expects to get away with appropriat-
ing the desired good a from entity j.
To make this model completely standard, the only adjustment required is to assume that
power equals the market value of wealth (that is, that sit 5 g x | xit pxt , with pxt a ‘market’
price for good x that is identical and non-manipulable for everyone). However, in our use
of the model we do not want to limit the concept of power to market income, since that
would be equivalent to assuming that everything of value is for sale and that all individuals
live in perfect markets as price-takers.
Several subtle aspects of the representation above are of particular relevance to the
topic of this chapter. First, the individual doing the maximizing is completely cognizant
of his own feelings, as he is able to predict with perfection how he would feel about any
possible state of the world. The decision-maker in the above model is hence a savant
when it comes to himself, a paragon of self-knowledge that Socrates would have admired,
allowing him to perform a quite incredible maximization routine. He has perfectly rational
expectations about his future feelings when he is deciding to get married for the first time,
have a child, buy his first car, or vote for the first time, and in that sense is not undergoing
the excitement of ambiguity, nor is he discovering himself: he is calmly proceeding along
the path that brings him greater expected utility than any other path he could have chosen.
In reality, no one can be assumed to be that aware of himself or of the world that
produces the final outcomes Xit and power quantity sit for each individual (in this sense,
real individuals cannot avoid being only boundedly rational (Simon 1982)). This is unfor-
tunate empirically, as there is no baseline population that truly behaves like the model,
so the model’s use as a descriptive tool is exceedingly limited. To suggest the formulation
above as possible even by approximation means viewing this incredible self-knowledge as
an aspirational assumption – an obtainable goal for our decision-maker – rather than a
reasonable descriptive assumption.
There is an immediate and important corollary to the realization that the standard
formulation is not a description of how any actual individual truly thinks. This corollary
can be stated as the need to start with a different baseline model for any actual analysis
of choices. Because this sounds (and is) a daunting task, it is tempting to see the baseline
model as much more attainable than it really is and to present real-life behavior as, by

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contrast, ‘irrational’ or ‘anomalous’. Other authors, for example, speak of deviations

from rationality caused by perceptive or mental limitations (Simon 1955; Tversky and
Kahneman 1974). This gives far too much credit to the aspirational model, however,
which we argue should not be treated as a positive model: it merely defines a particular
notion of rationality and admirable behavior, of which vastly slimmed-down versions
may be useful in formulating analytically tractable models and empirical estimation. From
that perspective, it is a second-order question what kind of mental limitation we should
try to accommodate in extensions. Much more important is what whole class of behavior
we should try to incorporate that the standard model has assumed to be irrelevant or
beyond-scope.
We argue that the loyalty of humans to others or, in other words, their social nature
offers the simplest, most holistic, and hence most sensible direction to look towards
when considering how to expand this aspirational model of mainstream economics.
Socialization can influence individuals’ decisions of ‘what to be and what to aim for’, and
can hence radically alter our understanding of the individual’s maximization problem, if
only through the influence of parents and other groups that constrain and guide individu-
als as they develop.
If it is accepted that socialization occurs and can be partly responsible for the real-world
choices of individuals, this raises the question of whether it is truly ‘smart’ to aspire to
operate like a greedy ‘rational’ human, and hence to neither truly care for others nor
indulge in self-delusion of the sort that causes the set N to include unreal entities. From
a prima facie empirical point of view, it seems quite unlikely that in the real world, this
type of rational economic man is what a smart person would want to be: there is pervasive
evidence that very religious and overly optimistic people, that is, those who would count
as ‘self-deluded’ in the standard model, are quite a bit happier than others (Leung et al.
2005; Lewis et al. 2005). This should already give us pause for thought.
The supposed ‘smartness’ reflected in the canonical parts of the standard model, namely,
exponential discounting and rational expectations, is usually defended by pointing to the
fact that an individual would change his mind if he did not discount exponentially, and
that he could achieve better final outcomes (that is, a higher Xit at the end of period t) if he
knew better how those outcomes came about. Hence, or so the argument goes, other ways
of thinking and deciding would not be evolutionarily adaptive in a repeated setting with
learning. While these claims are in themselves not always true in the presence of strategic
considerations wherein pre-commitment matters,3 the main problem with such a defense
of ‘rational man’ is that it does not point to a means of horse-racing the standard model
against clearly articulated alternatives: in which type of operating environment should
we consider the alternatives? Implicitly, an adherent of this view must presume that Uit is
predicted perfectly by Xit (that is, that preferences are fixed), so that under perfect-market
circumstances (that is, the absence of strategic considerations that open a role for irration-
ality) we can make the best plans to maximize our utility through our choice of consump-
tion levels. Yet, having a modus operandi that maximizes consumption in a perfect market
environment will not work out so well in other environments, nor when consumption is
not the thing one aims for, nor when utility functions are flexible.
Another important hidden element in the standard formulation is that an individual’s
notion of ‘Self’ is taken to be self-evident and fixed: it is an entity towards which a person
displays absolute altruism. The Self in the standard formulation is taken as an unchanging

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entity about which an individual does, and even should, care about in the future to an
unchanging degree. As Ng (1992) and others have said, that kind of formulation presumes
the existence of something like a soul that is unchanging and that provides solidity to
the notion of Self that an individual cares about. In reality of course, this is an idealized
abstraction: people change in a myriad of ways over time and there is no a priori reason
why it should be rational or evolutionarily adaptive for them to care about their future
selves rather than, for example, just caring about the momentary pleasure obtained from
their current self’s experiences.
How strange it is, on reflection, to assume that the self is fixed. Individuals continuously
change form and even change the make-up of their bodies, as they experience a constant
exchange of fluids, solids, and even genetics with the outside world. Our genome is more
like a moving cloud than a fixed point, with our genes exchanging genetic material with
microbes and constantly changing as a result of cellular processes. Even in terms of mental
traits, individuals routinely change their minds, their attitudes, and their preferences over
time, often quite dramatically over the whole of the life course as new ideologies and reli-
gions come into being. What is fixed in reality is less the mind and body of an individual,
but more his social endowments, such as his possessions, his passport and associated
‘rights’, his kin relations with others (as father, son, and tribe member, for example), and
so on. The idea that it is somehow smart or optimal to care for some discounted flow of
benefits towards a fixed ‘Self’ is not grounded in any economic logic or underlying foun-
dation of rationality: it is itself a convention, an advocated position, a choice to buy into
a particular abstraction being offered by a group (in this case, mainstream economists).
Finally, the treatment of time in the standard model is also not as ‘rational’ as it might
seem at first glance. Not only does the model assert that an individual is wholly uninter-
ested in and unresponsive to the past, but the future is also purportedly seen as funda-
mentally different from the present: the present is taken as known, and the future is taken
as expected. ‘Rational’ economic man does not care about his history or his ancestors,
observes everything about the present with total objectivity, and is completely detached
when forming expectations about the future. Purely from a psychological and neuro-
scientific point of view, this is an odd proposal. There is no clear way for a human mind
to think in different ways about the past, present, and future. All these windows of time
can be experienced and reacted to in the same way, using the same neuronal hardware and
pathways. Consider fear, which can arouse great emotions in the present moment even
if the fear does not materialize in the future, or can arise in reaction to a remembered
childhood fairytale: the feared event is an imagined outcome that creates utility effects
in the present moment when it is held in the mind, independent of the supposed timing
of the feared event. The past, too, can therefore arouse emotions, and the image of the
past is subject to constant re-writing and re-interpretation, much like the present is only
experienced through the filter of our senses, rather than being objectively observed. The
standard model’s artificial distinctions between a future that is coolly expected, a present
that is certain, and a past that is coolly and totally ignored, are neither realistic nor obvi-
ously desirable from a welfare or evolutionary perspective.
In sum, the greedy, rational individual lives in a delusion of fixity, and has accepted that
his own current and future consumption are the only things that matter, but otherwise
sees the world as it truly is. From this starting point, our next step is to include a more
dynamic notion of Self.

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3.2 Naïve Love
How can we conceptualize a changing Self, in a way that is both realistic and amenable to
incorporation into the analytical framework of economics? Previous attempts to broaden
the Self studied by economists (for example, Ainslie 1985) have been written in philo-
sophical terms and/or focused on the formalization of only relatively small details of the
arguably very complex problem. Our proposal by contrast is to consider a large addition
– the possibility of being in love – and model this directly as an internal experience that
drives change in the Self, leading to changed loyalties. We can incorporate both the process
of change and the outcome into the economic toolkit by constructing individuals who
have the capacity to start to care about a more expansive notion of Self that includes the
feelings and experiences of others.
An individual who has come to ‘love’ (or to ‘be loyal’) is someone who cares for another
entity, j, to a degree bijt ≥ 0. Someone who loves in what we term a naïve way, but in all
other ways conforms to the supposed rationality of the standard formulation, will then
maximize
EUi 5 E c a a bijt e2rtUjt d 5 E c a a bijt e2rt uj (Xjt) d 5 a a bij0 e2rt uj (Xjt)

N N N
t j51 t j51 t j51

(12.3)
E [ bijt ] 5 bij0
This formulation denotes a situation in which the individual anticipates at time 0 a fixed
degree to which he cares for others in all periods of the remaining future (where this
degree is denoted bij0), and this expectation of the fixity of love is a mark of his naïveté.
He maximizes the streams of future utility towards those entities to which he is loyal, on
the basis that his loyalties are unchanging from today onward, without wondering where
those loyalties came from. The individual is now incredibly cognizant not only of his own
psychology, but also of the psychology of those he presently loves, being able with perfect
foresight to anticipate how they would feel under various circumstances.
The naïvely loving individual is supremely loyal to a fixed notion of Self that now
includes not merely his own ‘soul’ (via bii0, a term which is included in the summation
above over all entities N), but also those of others. Despite the ignorance it assumes
about how attachments change, this formulation allows for the same kind of rationality
as before: the individual sees the world and himself as they truly are.
3.3 Being in Love
How then does bijt develop over time? This question essentially asks for a theory of love,
not only for one’s own ‘experiencing self’ (for lack of a better word) but for any outside
entity towards which one might plausibly develop love. We have proposed such a uniform
theory of love elsewhere (Frijters and Foster 2013), which we call the love principle, and
here extract its core implications for the mathematics and intuition of the present set of
models. We simplify the argument by presuming throughout that individuals want the
good a from the entity they will end up loving, just as we used that same good a as the
desired acquisition target when describing greed.
We argue that love increases when an individual believes unconsciously that increasing

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his love for j will increase future transfers to him by j of the desired good a that cannot be
obtained from j via direct grabbing. Because being in love involves the change of self, the
individual is effectively investing part of his ‘soul’, in the expectation of reciprocity from
the loved entity in the form of the transferral of the desired good. The simplest way to
express mathematically what the loving mind perceives is as follows:
dE [ Ta jit1s ] dE [ Ta jit1s ] dE [ Ta jit1s ]

. 0, 0 bijt # 0, 0 bijt # 0 (12.4)
dbijt dTbijt dTsijt
Where the unconscious expects that the entity holding the desired good a will respond, in
terms of goods transferral, to an investment of ‘self’ (dbijt > 0). The conscious belief that
(additional units of) the desired good cannot be obtained by transferring goods or by using
power without an investment of the self ( dTb 0 bijt and dTs 0 bijt) 4 is what makes the
dE [ Ta ] dE [ Ta ]
jit 1 s jit 1 s
ijt ijt
investment of self optimal, as the usual ‘grabbing’ strategy of the conscious is thwarted.
dE [ Ta ]
Whether an individual consciously expects that d b .0 is ambiguous in our theory,jit 1 s
ijt
but we argue the generic answer is likely to be ‘no’, meaning that the resulting shift in the
Self comes as a surprise to most people. We view the period of change in loyalty thereby
much like a unconsciously regulated bodily process such as our internal circadian rhythm:
we can put ourselves in a situation where our internal clock gets reset, and can even take
substances that help with that resetting, but we cannot consciously direct the dials of our
internal clock. Purely on empirical grounds, it appears to be the same with love.
The love principle presented in Frijters and Foster (2013) contends that the individual
is not typically reflective about this expectation of the reciprocity initialized by love, and
does not wonder exactly how the supposed reciprocal transfers will come about. Part of
the evidence for this contention is the lack of interest that people show in questions about
the mechanics of things like ‘Karma’ and ‘a good afterlife’. How are these things actually
organized? How do ‘God’ and even ‘our partner’ actually come to care for us and give us
transfers? This is a subject of surprisingly little critical thinking, which we argue is because
it is not the conscious mind that does the expecting, but rather the unconscious.
Frijters and Foster (2013) suggest that our expectation of reciprocity by the entities we
love must be hidden from our critical thinking because our conscious mind would feel its
self-esteem diminished by an open admission of weakness (embodied in the inability to
‘grab’ the outside entity’s resources). This then gives rise to rational self-delusion about
the love mechanism itself: in order to submit but still feel good about it, we do not tell
ourselves that we submit, but instead pretend that love arrives unexpectedly.
Another aspect of reality that this formulation accommodates is that believed future
transfers may never actually arise. Examples are transfers that supposedly take place after
death, or that involve a cure for incurable illnesses. Actual transfers, such as when a nation
rewards its war veterans, can of course also arise. Whether the expected transfer eventually
occurs or not, our contention is that love is quintessentially about a potentially deluded
unconscious mind that craves a transfer. We argue that it is important for the mainte-
nance of love that the lover now and then sees believed confirmation of his expectation
of reciprocity, such as signs from god or tokens of goodwill, but still, no actual transfers
need ever occur in reality.
dE [ Ta ] jit 1 s
Looking more carefully at the process underlying the statement that d b . 0 we have ijt

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in mind that an individual believes the entity possessing the desired good a is interested in
our loyalty as well as other goods: it wants power over us (directly via bijt) but also actual
goods transfers from us that prove that power over us. While in love, a person will there-
fore transfer goods k at time t to the loved entity, that is, Tkijt > 0, where k includes goods
believed to be valuable to the loved entity. The bundle of {bijt, Tkijt} is then transferred in the
expectation of a reciprocal but uncertain transfer of a in the future. Transfers to the loved
entity in our theory thereby come about both from believing that the loved entity receives
utility from the gift, and as a means of quelling internal doubt about the function E[Tajit+s].
In the background, an individual will implicitly have some notion of the elements
in the utility function of the loved entity, even if that entity does not exist. Relevant to
this, Frijters and Baron (2012) use a laboratory experiment to examine gift-giving to an
abstract entity they called ‘Theoi’, which in reality was a computer algorithm randomizing
its decisions about transfers in the form of ‘market prices’. The authors hypothesized that
participants believed Theoi’s utility function was of the following form:
UTheoi,t 5 a [ 2 TaTheoi,i,t1s 1 h (TaTheoi,i,t1s 2 pk *Tki,Theoi,t) ]

i
(12.5)
hr . 0, hs , 0
where Tki,Theoi,t took the form of an allocation of real money, and TaTheoi,i,t+s the later
setting of market prices. This formulation has the key characteristic, via the function
h(.), that Theoi’s marginal utility of rewarding i with a gift of good a (=TaTheoi,i,t+s)
increases with more valuable transfers from i to Theoi (= Tki,Theoi,t), with pk just picking
up relative price effects (the locally perceived relative worth of good a compared to
good k).5
The belief system of individual i about the loved entity’s utility function is crucial in
determining the behavioral ramifications of loyalty. For example, if individual i believes
that the entity only wants particular goods (like certain Greek gods who were allegedly
only concerned with burned meat), then that is what is transferred. If the individual i
believes the entity wants loyalty (like most Greek gods purportedly did), then that is what
is invested.6 We do not discuss where such beliefs come from, because a cursory glance
at history tells us that it is highly context-dependent. We merely note the bewildering
array of things that people can believe non-existent entities care about, including adher-
ence to rules of behavior, high art, dance, sex, poetry, life, and on and on. As a general
rule we suggest that non-existing entities are often believed to care about exactly the
same things that are deemed valuable in the society from which the believer comes, and
in that sense Tki,Theoi,t will often overlap with the socially-determined notion of power
dTs
(that is, dTk . 0), such that we must transfer something of our own (purchasing)
i, Theoi, t
i, Theoi, t
power in order to make an impression on the non-existing entity. If the unconscious were
choosing optimally according to this belief, the optimizing investment would then solve
0 E[Ta
0E [ Ta ] 0EU dEU ] 50
0Tk
Theoi, i, t 1 s
0Ta
i, Theoi, t
1 dTk i
Theoi, i, t 1 s
which would thus nail down the transfer Tki,Theoi,t if
i
i, Theoi, t
Theoi, i, t 1 s
we make particular choices about the underlying functions.
3.3.1 The love bargain

If we think of all potentially loved entities j as being like the artificial entity ‘Theoi’ above
in terms of real transfers, then we can map the reaction function of these entities into the

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utility-maximization program of the rational individual. We have two choices as to how to

model this: we could focus on individuals’ belief structures surrounding the entities j and
incorporate those explicitly into the model, or we could focus on how the result of those
belief structures adjusts the Self over time, as transfers are made to the entities j, and add
the elements that this process implies to the maximization problem for individuals. We opt
here for that second approach.
We thus propose a mathematical description of how love changes in response to
transfers, themselves optimally chosen based on the unconsciously imagined reactions
of outside entities that are believed to demand our loyalty in return for entertaining a
bargain. We propose that love increases in those time periods when an individual trans-
fers more power to an entity than he receives back, where power now certainly includes
purchasing power (that is, goods) but also anything else that would be understood by the
individual to influence his environment and people around him:
bijt11 5 f ( bijt,pi,kTkijt 2 E [ Tajit ])

0 2f
f (0,0) 5 0, f r . 0, ,0 (12.6)
0bijt 0 ( pi,kTkijt 2 E [ Tajit ])
dTsijt
~ pi,k . 0
dTkijt
This formulation states that individual i’s love towards entity j is path-dependent to an
extent, but also increases when i transfers good k to entity j at a moment when j is not
perceived to transfer the desired good a back to i, with pi,k the relative price as perceived
by i (which allows for individuals to want different things). The imagined current expected
transfer is denoted as E[Tajit], again allowing individuals to believe that they are getting
transfers from non-existent entities. The investment of power is made under the expecta-
tion that the power transfer in turn engenders a transfer towards oneself in the future (in
periods s > t), but does not involve other expected trades (a form of ceteris paribus condi-
tion: there are no other benefits expected from the investment of Self).7 The dependence
on the existing loyalty is such that the higher the existing loyalty, the higher the transfer
2 dTs
must be that maintains that loyalty: 0b 0 (p Tk 0 f2 E [ Ta ] ) , 0. The assumption dTk ~ pi,k
ijt i, k ijt jit
ijt
ijt
denotes the idea that the perceived value of the transfer to the loved entity in the mind of
the person giving it is proportional to its relation with (socially defined) power: the higher
is pi,k and thus the more an individual is giving up part of his social power for an outside
entity in return for an uncertain return transfer in future periods, the faster the increase
in loyalty towards that entity.
This law of motion will vary in quality from person to person, depending on what the
person believes the outside entity will react to, which could be time, fervency, physical
goods, and so on – which we view, through the lens of the economist, as information about
the outside entity’s utility function. The actual good transferred by the loving person
reveals what that loving person believes the loved entity to care about. For instance, if the
outside entity only cares about loyalty and nothing else, then the good k would merely be
equal to bijt, but generically the outside entity will be presumed to care about loyalty as
evidenced by visible transfers.
Love of j by i, bijt, is decided upon this period on the basis of expected future transfers

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and an individual acts upon his love in this period by making transfers towards the loved
entity. The transfers can range from writing love poems for a wooed woman, to taking risks
in war for a loved cause, to burning meat for a wooed god. In a way, love is an answer to
the problem of missing markets, either for goods that do not exist at all, or among entities
that have no power to force transfers otherwise. It is intimately tied to the notion of power,
in that the individual must care about whatever it is that he is giving up to the wooed entity
dTs ijt
(and hence dTk is proportional to the relative price). If we think of power as purchasing
ijt
power, which is a highly culturally specific interpretation of how one can influence others,
then increasing love involves giving up some purchasing power (time, money, or goods) for
the supposed benefit of the loved entity. Our love principle pre-supposes that individuals are
not aware of the production technology giving rise to these expected future transfers Tajit+ s,
as it is the unconscious mind, rather than the conscious mind, that makes the love bargain.
3.4 Types of Rationality
If we take this line of reasoning a step further, different types of ‘rationality’ and notions
of Self come into view based on the degree to which an individual is aware of how loves
may ebb and flow over time. Using a simple linear parametrization, where qi will denote
a level of rhytonia (explained below), gi a level of self-rationality, and hi a level of world-
rationality, the maximization problem for individual i at t = 0 can be re-stated as:
EUi 5 E c a a b ijte2rtUjt d 5 a a b ijte2rt auj aE c Xjt 1 a TXmjt 2 a TXjmt d b b

N N
| | |
t j51 t j51 m m
| <
b ijt 5 qi bijt 1 (12qi)bij0
<
bjit 5gi bijt 1 (12gi)bij0
dE c |
xjt 1 a mTxmjt 2 a mTxjmt d d c|
xjt 1 a mTxmjt 2 a mTxjmt d
5 hij 1 (1 2 hij) eit (zi)
dZi dZi
bijt11 5 f ( bijt,pi,kTkijt 2 E [ Tajit ])
dE [ bijt ] dbijt
0 t50 5 gi
dTkijt dTkijt
0 # qi # 1,0 # gi # 1,0 # hij # 1
| < <
zi [ { bit, b it,bit,bit21,bit21,bijt21,...,TX ij,Tsij ,.. }
hi 5 [ hi1,..,hiN ] (12.7)

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In this formulation, the parameter qi relates to the degree that an individual cares
about what he will become, rather than what he is now. In this sense, part of q captures
an individual’s awareness of how his loves change, in the process changing him, over time.
An individual with qi = 0 is only interested in his loyalties bij0 at the moment of decision-
making, and has no interest in whatever feelings might arise if he cared about other enti-
ties in the future. This setting may arise due to an inability to foresee personal change
from love, and/or because the individual simply does not find it important at time t to
value the feelings of his future changed self. In contrast, a person with qi = 1 is ‘Self0-less’
in the sense that he cares today only about whatever person he will become in the future.
None of his current loyalties are taken as permanent or to be guarded in the future. The
person with qi = 1 is in this sense untethered to prior notions of Self, and simply cares for
his feelings and loves as they will arrive and be experienced over time. The labels ‘selfish’
and ‘altruistic’ do not properly capture this distinction, as both the individual with qi =
0 and the one with qi = 1 could be said to be quite loving. Rather, the person with qi = 0
is maximizing from the point of view of the current Self, while the person with qi = 1 is
maximizing from the point of view of the actual flow of future Selves. We name the level
of qi rhytonia after the Greek word rhyton that means a cup, or a holder of liquids. The
view proposed is that of an individual who is a vessel of loyalties, with qi = 0 denoting the
person who cares for the fixed part of himself (metaphorically, the cup itself at t = 0), and
qi = 1 the person who cares for the entities that will fill him, changing ‘him’, in the future.
The parameter gi measures the degree of self-rationality with respect to the investments
that the individual makes, and thus captures the degree to which the changes in bijt are
dE [ b ] db
anticipated, that is, dTk 5 gi dTk . A person with gi = 0 maximizes his utility under a veil
ijt
ijt
ijt
ijt
of complete ignorance of his own future feelings towards other entities, not anticipating
any change in the degree to which he will care for and make transfers to others. Yet, that
person still expects to receive future transfers on the basis of the level of ‘investment’ bijt
he makes towards j today, and is thus having his cake and eating it too, at least in his own
mind. Conversely, a person with gi = 1 is perfectly aware of how his love investments will
affect his own notion of Self in the future. In the sense of being aware of himself as he
will feel in the future, gi measures self-rationality.
The parameter hij measures the degree of world-rationality with respect to the entity-
specific returns on the investments that the individual is making. A person with hij = 0 is
completely ignorant of how outside entity j rewards love investments, and hence presumes
a reaction function eit(Zi) that is independent of the entity j, where Zi is simply any deci-
sion made in the past or currently by the individual (meaning that bit is the vector for bijt
over all j, and that TXij is a vector of all the transfers from i to j of any good in any time
period before the future). A person with hij = 1, on the other hand, is perfectly aware of
just what he will get back for his (love) investments into j, which may be ‘nothing’ in the
case of imaginary entities j. In the sense of knowing how the world produces transfers, hij
measures world-rationality, which is potentially different not only across individuals but
for different entities j as imagined by a given individual.8
Within this framework, the standard economic assumptions would imply that hi = 1,
gi = 1 and qi = 0: a ‘standardly rational’ person is perfectly aware of how the world pro-
duces transfers and what he will love in the future, yet only cares about the loyalties he has
today (that is, preferences are fixed). This still allows for the possibility of rational love,
but only as a well-understood quid pro quo investment of own loyalty in return for the

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actual loyalty and transfers given by another entity. We might say it is the Beckerian view
of love as a rational trade in loyalty.
The introduction of the notion of rhytonia is a radical departure from the usual eco-
nomic utilitarian depiction of what it means to be human. We know of no formulation
in economics wherein individuals can have such a fluid notion of what they identify as
their Self. Yet, from different philosophical perspectives, one could argue that high rhyto-
nia is the most rational setting to choose, for it is a choice that supports maximizing the
experienced utility of one’s own life, complete with all the transfers to others (including
imaginary entities) that happen to eventuate over time. It is arguable that the settings of
hi =1, gi = 1, and qi = 1 depict the most rational individual possible, while the person for
whom qi = 0 is rather limited, irrational, and lonely. The individual with qi = 1 is a hap-
piness-bringer, a ‘selfishly self-less’ individual who starts with no particular attachment
to own consumption levels, taking them merely as a constraint that comes from survival
considerations (that is, the endowments in following periods might be linked to his previ-
ous consumption, following processes not modeled explicitly in our formulations), but
who is self-less in the sense that the happiness of others brings him joy. We can still call
him a very selfish individual in that he does not maximize the additional happiness he is
bringing to others, but rather the happiness he is experiencing as a co-enjoyer of the hap-
piness of others. The completely selfless individual, the ultimate utilitarian, would have
to have bijt ~ N1 , thereby loving everyone else equally.
Finally, we should note here that we do not necessarily think of ∑ibijt as a fixed entity.
The happiness literature finds that people with a rich emotional life are happier, meaning
that ∑ibijt may represent a pie that can grow as our loves grow and multiply, though we
would not want to argue that we can have unbounded utility from loving everyone else to
an infinite degree.9
3.5 Rhytonian Rationality
The formulation above still has many elements that jar with both the scientific purpose of
describing what people really try to maximize, and the normative purpose of offering a
utopian vision of what we would want a grandchild to be like. It still includes the discount-
ing of utilities, and still makes the highly problematic assumption that individuals are
detached from the past and make investments because of experiences that they imagine
will be had by future entities, which negates two real possibilities: first, that individuals
care about past entities, and second, that they care about the future only because of the
joy they currently experience from anticipation (as argued by Foster et al. 2012). The
disjointedness between an entity as it exists at one time, and that same entity as it exists
at another time, makes no sense from either a descriptive or a normative standpoint. The
linearized notions of rationality are furthermore highly problematic as they by necessity
involve several layers of awareness, with some layers perfectly aware of the actual loves
in the future, and some layers not.10 The above formulation is thus only a stepping-stone
towards a more internally consistent general formulation.
Our next step is therefore to construct a general formulation of rhytonian rationality,
where an individual is truly seen as a vessel of loyalties, and aims to maximize the follow-
ing in any period t:

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(12.8)
The above equations are built from several reformulations of our previous models.
For one, the summation space is now no longer over entities 1 to N and from now
until the far future, but rather over the set of all entities that reside in the individual’s
imagination at the current period, denoted as Ωit. This set can include a notion of the
individual in each time period, both in the future and in the past, as well as all other
entities an individual is aware of or imagines at any moment in time that they are imag-
ined to exist. The previous boundaries between time, people, and abstractions are thus
erased: to the perceiving mind, all imagined entities are believed to be able to feel and to
reciprocate, with the currently experiencing individual potentially emotionally affected
by each of them. The entities in Ωit can now include things like ‘honor’, ‘science’, ‘truth’,
‘Zeus’, ‘Jerry under the waterfall in 1992’, ‘justice’, ‘my future partner’, ‘the family’,
‘my job’, ‘the future of humanity’, and any other abstraction that can be conjured in
the mind. Additional entities that individuals imagine then change the contents of the
set Ωit, meaning that new gods, memories, hopes, children, and values may perpetually
arise. The constraints on Ωit are now set by what an individual is capable of conjuring
and anticipating, such that the habits of imagination take center stage. For instance,
a child who is imagined but not yet born is a member of Ωit, while an unanticipated
child is not.
Individuals may now have imagined relationships with dead people (‘Shakespeare’),
bygone gods (‘Buddha’), and historical groups (‘the founding fathers’). The transfers
made that denote worship of those previous entities may take many forms, from distort-
ing the historical record to, quite literally, having imagined conversations with them. A
famous example is of Machiavelli who wrote about how he would dress himself up before
he entered his private study, after which he would ask men of antiquity, through analysis
of their texts, why they did certain things. Machiavelli writes, in a letter to Francesco
Vettori penned in 1513, of how these long-dead men would receive him ‘lovingly’ and

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answer him. He uses phrases like ‘I am not ashamed to speak with them and to ask them
the reason for their actions; and they in their humanity reply to me’, exemplifying how
even an arch-pragmatist like Machiavelli was perfectly able to have relationships with
dead people, many of whom might not actually have ever existed – and moreover, he
himself was apparently completely comfortable with this.
A second radical reformulation is to transition from expectations to beliefs: the relevant
transfers and levels of consumption that an individual takes into account for decision
purposes (denoted as Eit[Xjt] or E[.]) are now all believed amounts, rather than actual
amounts. This holds even for present quantities consumed by the individual himself,
where Tx*jit denotes the believed, rather than actual, transfers received this period. We
have assumed that an individual is truthful, at least on average, when assessing his own
production | xit and transfers to other entities Txijt(bijt) this period, where Txijt(bijt) reflects
the individual’s knowledge that his transfers to entities are a function of his love for them.
Nonetheless, actual consumption need not equal believed consumption from the indi-
vidual’s perspective because he is able in this formulation to give himself imaginary gifts,
via Tx *iit, which need not be ‘deducted’ from his actual endowment. It is the constraints
of the experiencing individual that place boundaries on his imagination, and hence on
the believed current consumption levels, such as when a body reminds a fantasizing mind
that the body is hungry because the food being imagined is not as nourishing as real food.
Being realistic about what is truly consumed when making plans for the future is then
taken to be an acquired habit that comes from experience and learning.
Traditional notions of rationality would anchor all beliefs to reality, but within the for-
mulation above that particular brand of rationality is a learned trait – a habit of mind that
needs advocating and ingraining. There is a liberating, expansionary quality to this for-
mulation, as it implies that a poor person can be very content simply because he imagines
himself to consume a lot: the limits of his imagination, not just those of the ‘real world’,
contain his contentment. It is also imagination that motivates individuals to invest: rather
than unemotionally taking into account the consumption of himself in a far future, the
individual cares for his internal image at the decision moment of his future self, imagining
that future self enjoying the proceeds of his current-period investment, deriving pleasure
from this image now, and at the same time loving that future self more by making more
investments. In this view of the world, people never truly work for the future, but rather
for a loved notion of a future self that is consuming a believed amount, with that believed
consumption increasing with their investments today. Becoming oriented toward future
selves is also itself a learned rather than hard-wired trait, something requiring many years
of schooling to instill.
One of the direct empirical implications of this model is that believed future consump-
tion can have measurable impacts on experienced utility now, contrary to the standard
model. A large psychological literature, as well as some of our own work, has found
believed future consumption to have direct effects (Senik 2008; Frijters et al. 2012; Foster
and Frijters 2014).
In the same way as care for oneself and adherence to reality are taken to be learned
habits, an individual’s ability to believe in almost any type of entity puts socialization
mechanisms at center stage. The particulars of utility functions become of much less
interest, and the key question moves on instead to how E[Xjt], bijt and Tx *iit come about.
Individuals are seen as vessels of loyalties and beliefs, capable of filling up with all kinds

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of entities, many if not most of which neither truly exist nor will enjoy the consumption
levels they are imagined to enjoy. In this rhytonian world, self-delusion is the norm rather
than the exception, and that self-delusion is the basis for investment into the future and
for being a happy, socialized human being.
Specific forms of rationality can be formulated in terms of the individual belief func-
tions Eit[.] which can include (or not) world-rationality, self-rationality, and so on. For
super-rational individuals, Eit corresponds to reality as socially verified (that is, as seen to
be affirmed by a combination of own observation and trusted outside signals), which in
very special circumstances might equate with the truth. We contend that it requires long
practice and particular socialization to attain ‘classical’ rationality in this limited sense,
and we doubt that it is something desirable to attain, or that anyone has ever attained it.
3.5.1 Love’s law of motion

The reformulation above also includes a different treatment of both love and greed. Our
previous arguments about how love arises are now summarized in a simple law of motion
0f
(bijt + 1 = ƒ(bijt, E[pi,kTkijt − Ta*jit])), in which all loves naturally fade ( 0b , 1) ; therefore, to
ijt
be sustained, any love must continuously receive investments. This includes love for the
experiencing individual himself, though with the expansion of the entity-set Ωit, the
notion of ‘Self’ is now entirely fluid as a person may potentially care about everything in
his imagination. The degree to which he sacrifices towards different entities determines
whether he starts to love them more, though in the background the degree to which an
individual believes that the investment will be reciprocated in the future will provide a
feedback mechanism. Perceiving that we get ‘free gifts’ from an entity reduces the degree
to which we believe ourselves to be under the power of that other entity and therefore
that we need to resort to love rather than a ‘grab’ strategy (in a purely equal direct trade,
pi,kTkijt 5 Ta*jit). Yet, again, the investment that carries utility returns need only be a
believed investment, corresponding to the idea that both consumption and action are all
in the mind. Greed is now reformulated as a worship of the individual himself, that is, a
transfer of the means to own consumption. Love is the worship of others, achieved by
being in love, which is a process characterized by making transfers to others that are not
immediately reciprocated. This implies an investment stage of love characterized by hope
and fretting by the mind that has invested part of its identity in the entity from which
future benefits are wished, but have not yet been received.
We depict an example of the investment stage of love and the two possible second stages
in Figure 12.1. As shown in this figure, depending on whether the loved entity is seen to
reciprocate, love either grows or eventually fades.
The person engaging in an attempt to get a transfer in this figure invests part of his
identity into the entity j by means of two waves of transfers (the peaks in Txijt). It is the
incessant observing and ‘fretting’ over the entity j that then, in the back of the mind of
the person i, increases bijt, the loyalty to entity j. The reality check on beliefs in the middle
of the figure is then followed by two distinct possible trajectories. In one trajectory, an
individual continues to give waves of transfers to entity j because he believes that entity
will reciprocate in the future. These transfers are accompanied by a higher and sustained
loyalty to j. Another set of lines depicts what happens if the person stops believing entity
j will ever reciprocate: transfers to j drop to 0 and the love of the individual for entity j
similarly fades to 0 over time.11

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Levels of actual and

believed transfers, and
of love
Time at which entity is
believed to reciprocate or not
Love has either taken hold, or

The unconscious has invested fades, depending upon whether
in the love strategy, but no reciprocation by the entity is
utility payoff yet occurs. believed to have occurred.
Stage of ‘love as an Stage of 'love as a motivation'
investment’ and 'fretting' or 'fading of love'
Path of love βijt if

entity is believed Path of actual
to reciprocate transfers Txijt if entity
is believed to
reciprocate
Path of love βijt if

entity is believed
not to reciprocate
Actual
Path of actual
time
transfers Txijt if entity is
believed not to
reciprocate
Figure 12.1 Path of love
A corollary of this law of motion is that all investments with high hoped-for but
uncertain returns are argued to carry an emotional connotation. This can include the
investment that whole groups (members of Ωit) make, such as their investments in wars or
prestige projects. According to our theory, individuals’ notions of self become entangled
automatically in such investments, which makes these individuals care greatly about the
future success of the investments and unwilling to hear news that casts doubt upon
the future success of the investments. This emotional connection with the investment
of outside entities is thus a primary avenue for abuse. Empirical support for this kind
of prediction comes from the finding that people are strongly affected by their nation’s
stock market performance, even if they are retired and have no financial assets them-
selves (Frijters et al. 2014). Similarly, scholars have found a marked happiness decline of
whole populations following lost wars and economic downturns (McInerny et al. 2013).
These findings are consistent with internal pain being felt by a loyal individual when the
entity to which he is loyal is seen to suffer.

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3.5.2 A note on power and the (un)conscious mind

The distinction between the conscious and unconscious minds that characterized our
earlier formulations is absent in our final formulation, where the love process has been
generalized into a law of motion that depends on transfers with believed delayed pay-
backs. In the rhytonian rationality formulation, the reason we offered previously for why
the conscious mind would logically remain ignorant of the love mechanism is now itself
part of the calculation performed by that very conscious mind itself. That prior reason had
to do with self-esteem. We argued that individuals needed to remain ignorant about the
‘submission’ element in the love mechanism in order to maintain their self-esteem. In our
final formulation, however, that self-esteem is itself simply another entity that individuals
may care about, and that may well have socially determined inputs. Self-esteem – never
explicitly modelled in the rhytonian rationality formulation – is no longer necessarily
threatened by the realization that love comes about from submitting to an outside power.
It is only a person’s adherence to abstract notions that might conflict with a recognition
of the love process, such as, for example, autonomy or scientific notions of causality, that
may give rise to an individual’s need for self-delusion about the love mechanism. In this
way, self-delusion is now merely a by-product of the possible expectation-formation tech-
nologies embodied in Eit[.], though any change in loyalties – including loyalties to abstract
notions – is still taken to be an outcome of processes rather than a rational choice, and
only indirectly manipulable.
An implication of our theory is that the most ‘rational’ and ‘individualistic’ individu-
als and groups would probably find it optimal to remain deluded about how love comes
about, precisely because the love mechanism violates many group norms about causal-
ity and autonomy. The more a person thinks of himself as a scientist who is personally
responsible for what he does, the more resistant he will be to the idea that he loves because
of a blind belief in reciprocation from some outside power that might not even exist. The
prior argument that individuals necessarily delude themselves when they love is hence
found to be a particular optimal result of group norms.12
Following this line of argument, we surmise that some groups may have different social
norms that allow and even encourage an open advocation of worship and a belief in
blind reciprocity (like ‘Karma’) as a means of loving and being loved. Frijters and Foster
(2015) talk at great length about how such self-delusion works, echoing the arguments of
psychologists that people actively ignore and screen out information that does not adhere
to their own self-image and beliefs, in line with the implications of cognitive dissonance
theory (Festinger 1957).
Power in our theory is defined as whatever is useful to control the environment and get
other humans to do something. By design, this will to a large part be a matter of group
agreement, and thus will be context specific. In societies with a strong notion of ‘pos-
sessions’ that are protected by the joint potential of violence of the whole group, power
at the individual level will largely coincide with purchasing power, that is, wealth. Yet in
other groups that lack notions of possession, other group-level agreements about how
the collective potential of violence is applied will define an individual’s power. This could
be in relation to a person’s position in a group, such that a chief has the right to dole out
punishment but an underling does not; it could be in relation to a person’s seen adherence
to group ideals, such as when the leading religious figure can channel the group’s violence
potential but others cannot; or it could be in relation to a person’s physical prowess,

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oratorical skills, or any other attribute that his group values enough to organize violence
around.
As this makes clear, our conception of power is inextricably linked to group decision-
making, and as such it does not follow from nor can it be expressed as a function of any
individual-level utility formulation in isolation from the decisions and utilities of others.
In game theoretic terms, we see group decision-making as a means of engendering the
expectations of rewards and punishment that constitute power. In highly organized
groups, power resides in official institutions, such as the police or the legal system of a
nation state, that are trusted and supported by a whole population. In small, very unor-
ganized groups, there may be no group agreements or habits at all, in which case power
reverts to being a more concrete force that mainly resides in individual persons and how
much violence and persuasion they can personally muster. In a later example we illustrate
these ideas in the context of a standard public goods game, and more on this topic can be
found in Frijters and Foster (2013).
3.5.3 A last word on rationality and love

Our final model above can be extended in many directions, and applications of its main
ideas already exist. As previously mentioned, Frijters and Baron (2012) used the main
ideas to examine the rise of religion, arguing that individuals start to sacrifice to unknown
entities when those unknown entities are presented as possibly affecting an outcome of
importance to them. Foster et al. (2012) looked at the importance of over-optimistic
health expectations and happiness, and Frijters and Foster (2015) closely examine rational
self-delusion, in the form of actively screening out unwelcome information that reduces
the ability to consume a fantasy life. Mervin and Frijters (2014) measured how strongly
individuals care about particular others, finding that women care more about the direct
emotional well-being of their partners than men, although there is also evidence that men
are strongly affected by events befalling a whole group and abstractions (for example,
financial distress; Frijters et al. 2014). Frijters and Foster (2013) discuss many aspects
of the basic view in a wider social science perspective, including the question of the evo-
lutionary rationale for this type of behavior, and the question of whether children learn
through experience what love is, or whether there is an element of hard-wiring about the
proposed mechanisms.
Still, the model above is highly stylized and, like the standard model, more meant as an
aid to thinking about love and rationality than as a totally realistic and calibration-ready
empirical model of how people truly behave, based on readily measurable inputs. We see
it as a scaffold on which we can hang clothes, rather than something that can be worn on
all occasions.
Finally, armed with these models, we return to the normative problem we started with
at the start of this section: what type of person would you want your grandchild to be?
From the rhytonian point of view, the classic greedy rationalist is lonely, limited, and in
many ways extremely irrational as he does not take advantage of his own possibilities
for consuming fantasies and caring for others. The greedy rationalist does not care for
his children, his country, his past, any values, or any gods. Such a being is not merely a
person who has never walked the Earth, but also a person who actively denies the fluid
nature of his humanity: a miserable fellow indeed, and arguably not someone to hold up
as an example for a grandchild to follow. As an aspirational model persona, the rhytonian

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rationalist looks more appealing: someone who spreads himself out over time and popu-
lations, buying into all kinds of imagined entities that give him solace, companionship,
and guidance.
The modern reader used to trading goods coolly in market exchanges might be struck
by what a strange notion it is that an entity to which we give our love would want both
goods and our loyalty: an odd bundling of the physical and the emotional. The authors
themselves, both living in highly modern societies, found this to be a vexing point. Yet,
from a different perspective, it is the emotion-free exchange that should be considered
odd. Among the small, tightly bonded groups in which we evolved (made up of close
friends, family, and close ties in general), the emotional ‘tuning out’ that is so normal while
exchanging goods in modern market transactions was arguably very rare. We imagine
that traditional hunter-gatherers would find the coolness and mental closure that typifies
money-mediated exchanges as highly alienating and un-human-like. Perhaps it is not the
bundling of ‘loyalty and goods’ that typifies the fluidity of the Self that is strange, but
rather the closing of the emotional flow in market activities. From this perspective, an
argument could be made that such emotional closing has to be learned by young children
in modern societies because it is entirely necessary for successful functioning in an anony-
mous economic system where we deal with strangers and many others on a continuous
basis. If we would be our ‘normal’ open, emotional selves while in modern public trading
spaces, we would quickly fall victim to people trying to abuse us. In that sense, rational
economic man indeed appears a normatively appealing fellow if we have to survive mainly
by means of operating in near-perfect, anonymous markets.
For the rhytonian grandparent, the question becomes what loves and belief func-
tions are optimal to advocate. Our formulation shows that this is a question that cannot
be answered without knowledge of the social environment. In a perfect market where
everyone else is perfectly greedy and all belief in non-shared entities is punished, it is prob-
ably optimal for a grandchild to act and believe in the same way. In a world in which all
others are fluid maximizers, sharing their loves in the expectation of reciprocity, having a
greedy grandchild is probably suboptimal, but the exact answer will depend on the precise
assumptions built into such hypothetical states of the world. As a statement of observa-
tion about modern life, those individuals with many loves in their lives – that is, those
with gods, friends, convictions, and care for self – seem to be the happiest in this world.
4 CONSEQUENCES OF THE IMPRECISION OF

ABSTRACTIONS
Our formulation underscores the fundamental role of humans’ ability to hold abstract
entities in their minds, with little or no reference to reality, in producing utility and binding
people to one another. The wedge between imagination and reality that thereby opens up
has significant implications for social structures and dynamics. In this section, we discuss
several of these implications.
The first insight to consider is that individuals who have already been programmed for
loyalty towards a particular abstraction do not require constant reinforcement of a par-
ticular material type in order to sustain their loyalty. Reinforcement can take the form of
any reciprocation that is merely seen to flow from that abstraction, even if in reality there

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is little or no connection between the abstraction and the supposedly reciprocated favor.
The best example here is religion, where billions of believers are ‘kept in line’ (that is, their
loyalty to the religion’s god is reinforced) via the promotion of stories about the ‘gifts’
and ‘favors’ of the god, which itself of course does not exist and hence is not providing
any gifts to anyone.
The fact that an abstraction itself is not directly observed, and need not be verified by
any sort of ‘scientific’ proof, means moreover that the abstraction need not in fact be the
same for all individuals who believe in it. This is most obvious when considering the mental
images of people to which we are loyal: Person A’s image of ‘Jane tomorrow’ may be quite
different from Person B’s image of ‘Jane tomorrow’, yet both people can simultaneously
exhibit loyalty to ‘Jane tomorrow’ and even feel closer (that is, more loyal) to each other by
virtue of their common devotion to ‘Jane tomorrow’. In the case of abstractions that have
no basis in tangible reality, such as ‘justice’ or ‘freedom’, the possibilities for variations
on the theme, in the minds of those loyal to the abstraction, are arguably even greater.
Examples from history demonstrate how fluid these abstractions can be while still serving
the purpose of binding together large groups of people. The Catholic Church, successfully
providing coordination and common purpose for hundreds of millions of people over two
millennia, is perhaps the most striking example of this. The church’s specific messages
on practical matters down through the generations have varied in line with the needs of
its members as civilization has developed, but notions such as ‘a loving god’, ‘salvation’,
and ‘redemption’, all of which can be mentally represented and interpreted differently
by different members, are among the current sources of its strength. Nation states, too,
promote stories of their allegiance to vague abstractions that feed their citizens’ loyalties,
from ‘democracy’ to ‘domination’ to ‘making America great again’.
With the imprecision of abstractions that bind people also comes the possibility for
manipulation. Confronted with an established group, a subset of would-be manipulators
has the opportunity to try to plant the idea in the minds of members of that group that
a cause favored by the manipulators is in fact related to the pre-existing abstraction to
which the group’s members are loyal. This message – if successfully planted – potentially
brings the loyalty of the whole group, and is therefore a very powerful potential means
of manipulation.
The final element that flows from the imprecision of abstractions is the social role of
what we will term ‘true believers’. The group bonded by a shared (if imprecise) abstrac-
tion maintains itself on the basis of punishment towards those who are seen to violate
that abstraction. In the models above, punishment is not explicitly discussed, but one can
implicitly view punishment as a power-related good b that negatively affects the utility
du
of someone else ( dTb , 0) , brought on by believed transfers or lack of transfers. Where
c
jit
does this punishment come from? We argue that individuals’ expectations that this pun-
ishment will occur are built upon their belief in the existence of some subset within the
group of individuals who are truly loyal to that abstraction and are prepared to mete out
this punishment. Not all members of a given group even need to be loyal to the abstrac-
tion in order for the abstraction to serve the purpose of binding the group’s members, as
long as all members believe that these true believers exist and would punish outward non-
adherence to the abstraction, and this belief only increases the potency of the abstraction
in holding together large groups. In order to sustain itself as a set of individuals with
common purpose, every group needs to be able to back up the implicit threat of punish-

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ment for non-adherence to its stated ideals, which then implies that every group needs at
least a subset of true believers.
4.1 An Illustration of True Believers and Power
To illustrate the relevance of both imprecise abstractions and true believers, we now
consider a classic public-goods game of the type analyzed in hundreds of laboratory
experiments. N individuals play the game, of whom all differ slightly on some observable
characteristic, Xi. This characteristic could be as innocuous as their name or identity
number, or as meaningful as their importance to the group or their ability to commu-
nicate. Each individual has two decisions to make, with the second decision made after
observing the first decision of themselves and everyone else. The first decision is what
proportion ri to donate to a public good from an initial endowment Yi. The distribution
of initial endowments is common knowledge, and ri can be the whole of Yi. The payoff to
each individual after the first round of play is then Wi0 = (1 − ri)Yi + 1/N∑k arkYk. This is
a public goods game in the sense that 0 < a < 1 (that is, it is not optimal to contribute to
the public good from the perspective of a selfish individual who expects no consequences
from not contributing), and Na > 1 (that is, there is a benefit to the group of contributing
to the public good). The optimal state of the world for the group in aggregate is achieved
if everyone chooses ri = 1, but there is a free-rider problem.
The second decision round involves each individual deciding whether to punish others
for their (low) contributions to the public good. As a simplification, suppose each indi-
vidual must decide whether to punish at all (di = 1 if i punishes and di = 0 if not) and on
one particular person who is punished (=Mi) in the case that punishment does occur. The
final payoff for any individual i is then as follows:
pi 5 (1 2 ri ) Yi 1 1/N a arkYk 2 edi 2 a (i 5 Mk ) (12.9)

k k
A person is therefore modelled as bearing a small positive cost, e, when punishing, and
himself faces punishment ∑k (i = Mk) from the combined decisions of others.
We now re-introduce the notion of loved entities, subscripted by j in our previous
formulations. Suppose we represent as one scalar value the collection of group-relevant
entities that is being loved by each individual, denoting this scalar Zi. The loved entity Zi
of each individual includes the individual’s adherence to norms of behavior and a plan of
punishment. The interpretation is then that proximity on the number line of one person’s
Zi to another person’s Zj reflects the similarity of the entities to which the two individuals
i and j are loyal. If Zi = Z, then everyone in the group has the same punishment plans and
believes in the same group abstraction.
True believers can now be mathematically represented as individuals who care enough
about their loved entity Zi to incur the monetary cost e if they perceive the actions of
another group member to have violated the norms inherent in Zi. Let us presume that
there are K < N true believers in the group, and that the rest are in fact ‘traditionally
selfish’ in the sense of only caring about pi. These traditional selfish individuals will
never punish because of immaterial motivations, so it is only the punishment of the true
believers we need to consider.

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4.1.1 Random group abstractions

One way to describe a situation in which a single shared group abstraction is lacking is
to say that the norms inherent in Zi include the idea that everyone should choose ri = 1,
but that there is otherwise no agreed-upon notion of ‘degrees of violation’ of this norm.
In other words, the only norm truly shared is that ri should be 1, but if there are multiple
violations of this shared norm then the punishment plan of each true believer is random
(that is, it is not based on Xi). By design, in this setting the true believers choose ri = 1 and
will randomly punish someone among those who do not adhere to this norm.
What is now the optimal choice of ri for those who are traditionally selfish when facing
K randomly punishing true believers? If we order the (N − K) selfish individuals in ascend-
ing order of endowments, then a Nash equilibrium must satisfy
K
ri 5 0 iff Yi (1 2 a) . and ri 5 1 otherwise
N 2 K 2 i* 1 1
(12.10)
i* 5 min e Yi (1 2 a) . f
K
i N2K2i11
where N 2 K K2 i* 1 1 denotes the average expected punishment by the true believers for
all those who did not contribute the full amount of their endowment, and i* denotes
the marginal individual for whom not contributing is optimal. The argument uses the
property that if not contributing is optimal for anyone at a certain wealth level, then it is
also optimal for all higher wealth levels. The equilibrium is thereby given by i*. The gain
associated with not contributing to the public good is then Yi(1 − a), since the alternative
would be to contribute everything, which is the only alternative decision that guarantees
no punishment.
Note that even in this very simple set-up, it is possible to have multiple equi-
libria, depending on the distribution of Yi. For example, if everyone has the same,
K K
(N 2 K) (I 2 a) , Yi 5 Y , (1 2 a) , then one equilibrium would have all of the traditionally
selfish individuals choosing ri = 1, and another equilibrium would have none of the tra-
ditionally selfish individuals choosing ri = 0. In that range, both i* = 1 and i* = N − K are
pure strategy equilibria. The possibility of multiple equilibria comes from the dilution of
punishment when more individuals free-ride, which is an externality on the trade-off faced
by others and thereby an integral part of the argument.
4.1.2 Precise group abstractions

When the true believers share the same norms to at least some degree, meaning that they
share some degree of common understanding about which combination of {ri ≠ 1, Xi,
Yi} constitutes the most egregious violation of the norm, then they will share to that same
degree the same punishment plan. A shared norm acts as a coordination device on the
question of who should be punished.
To make the argument simple, we presume that the shared norm Z is such that the defi-
nition of ‘violating the norm’ only depends on Xi, Yi, and whether ri = 1. This essentially
means that there is a ranking of individuals who would be punished if they do not choose
ri = 1, though we later discuss the case where the norm does include the value of ri. Any
particular individual’s violation score is thus a known fixed function f (Xi, Yi).13 By impli-
cation, this means that there is only one equilibrium left: that in which all of the tradition-

M4225-ALTMAN_9781782549574_t.indd 228 03/05/2017 08:20

K
ally selfish individuals comply unless there is at least one individual with Yi . (1 2 a) . In
that latter case, the individual who has the highest f(Xi, Yi) among the set of individuals
K
with Yi . (1 2 a) will bear all the punishment K, and every traditionally selfish individual
with a lower score f (Xi, Yi) will choose ri = 0.
We can extend this reasoning to think about what an ‘optimal norm’ would look like
from the point of view of the true believers who can choose their norms jointly ex ante
on the basis of their ex post payoffs. In order to provide maximum incentives for public
good provision, their strategy would be to threaten the pivotal individual i* with the full
punishment potential of the K true believers, but not to threaten anyone who would be
willing to bear that punishment cost. Hence the optimal norm in this particular game
would be that violations of ri = 1 are judged ‘worse’ with higher Yi, up until the point
K
that Yi . (1 2 a) , meaning that it is optimal to not care about norm violations for those
who would not fall into line, and to focus the intended punishment instead on those who
would. If we then also allow for the norms to depend upon (ri − 1), then it should be clear
that the optimal norm is ‘punish the highest incomes first among those for whom ri(1 −
K
a)Yk < K’, a norm that effectively treats (Yi 2 (1 2 )
a) as the portion of the endowment
K
that cannot be threatened, and (1 2 a) as the public good contribution level that everyone
can be forced into.
4.1.3 Ideals, true believers, and power

We can extend the illustrative model a step further still once we realize that the K true
believers have in effect transferred their individual punishment potential to a shared
institution defined by f (Xi, Yi) that now directs the joint ‘power’ of the group. Whatever
mechanism or leader coordinates the ideals of the true believers can then also be said to
have power: for example, power can be vested in deliberative institutions in which true
believers can discuss and come to a joint agreement. Moreover, the power of a small
group of true believers can be extended if it is coordinated such that the non-coordinating
‘unbelievers’ are in fact co-opted by the same power structures.
The power of the true believers could be extended if it became possible to punish on the
basis of whether or not someone else punishes – that is, if credible and visible intentions
to punish were verifiable before the punishment. If that were possible, then the true believ-
ers could coordinate on first threatening the punishment of anyone who did not intend
to punish the worst deviator, meaning that the ranking of ‘worst deviants’ would include
the non-punishers at the top of the list. The norm would move from being a function f
(Xi, Yi) to being a function f*(Xi, Yi, di). In this way, even just K true believers could force
N − 1 individuals to punish someone else,14 which would mean in turn that each group
member could be forced to allocate (N1 22 a1) of his resources, rather than just (1 2K
a) , to the
public good.
In this way, populations of millions can be exploited by a few dozen who have a
coordinating mechanism via which to decide whom to punish. Such exploitation would
break down if the exploited non-believers could coordinate against the true believers, and
Frijters and Foster (2013) discuss the circumstances in which that is likely to hold. Briefly,
these circumstances are when the exploitation lasts a long time and the true believers
cannot disrupt coordination-building among the exploited subset, a process that often
first involves the creation and implantation in the minds of the exploited of a utopian
ideal of how things could be different from the existing exploitative situation.

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The logic in this stylized example applies to many more choice and group settings.
The greater the degree of shared norms, the more focused becomes the punishment
of non-compliers, and, if well-directed, this punishment begets more compliance from
more members of previously outside groups. We may in this light see formal and infor-
mal institutions, such as laws or notions of fairness, as part of the complex mechanism
our societies use to agree upon a joint group abstraction. Second-round effects can
then emerge in which political and societal debates ensue about what the optimal group
abstraction actually is, with those intending to free-ride on others having an incentive
to advocate for a random group abstraction, or in other words to follow a ‘divide and
rule’ strategy.
5 CONCLUSION
In this chapter, we have presented a new view of what it means to be an economically

rational human, taking into account the potential of humans to love and to imagine.
We have moved from an initial ‘greedy rationalist’ model to a more general ‘rhytonian’
model of rationality in which individuals have the potential, through their loves and their
imaginations, to literally define themselves by what lies outside of themselves, in terms
of space, time, and reality. What then becomes center stage is less the possibilities of the
physical world, and more what humans can be socialized into believing, which is largely an
empirical question about the possibilities and limits of socialization mechanisms. Given
the utility flows that are unlocked via love and imagination, we contend that compared to
the ‘greedy rationalist’ model, our model not only more accurately describes how people
truly conceive of themselves but also shows the ‘rationality’ behind their self-conceptions.
We have only scratched the surface here of our model’s implications for social structures
and the development of institutions that can at once bind people together and serve as the
means of their manipulation. We refer interested readers to Frijters and Foster (2013) for
a more detailed examination of such questions, as well as encouraging future work in this
area. We simply conclude here that love need not be viewed by economists as the province
of the fool, but rather may prove to be the diametric opposite: a means of reclaiming
Economic Man’s rationality.
NOTES
1. We capitalize ‘Self’ here and elsewhere in the chapter in order to distinguish it as the all-encompassing
mental vision of the thing for which benefits are sought when the individual performs his maximization
routine at a given moment in order to allocate his scarce resources.
2. Implicitly however, the flexibility of our formulation means that any procedural elements, or for that matter
any social comparison elements, to which one wished to award utility value could be viewed as members
of the vector Xit.
3. Ignorance can be both bliss and productive in a variety of strategic circumstances, such as in many bargain-
ing situations in which a deluded notion of our outside options helps us get a bigger slice of the bargaining
pie. The canonical example is that when we can credibly threaten to explode in anger and destroy the whole
pie if we do not get most of the pie, then those who cannot make counter-threats will let us have most of the
pie. The conclusion that it is optimal to know how to produce higher final outcomes does not necessarily
hold outside a perfect market setting, in which there is no bargaining as everyone is a price-taker. This line
of argument underscores the very particular and social-system-dependent notion of rationality embedded

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in the standard formulation. We do not mean this as a critique, since abstractions are never perfect, but
one should never confuse ‘locally desirable’ for ‘globally true’.
4. The conditioning on bijt denotes the situation that an individual with a given loyalty set believes that
transferring additional goods and power to the entity from which the good a is wished will not result in
the acquisition of more a.
5. In these experiments, individuals worked for a certain amount of output whose price was variable and
determined by an unknown mechanism that in reality was purely random. Individuals were told that they
could give to ‘Theoi the market maker’ before the output price was set, and that it was unknown how Theoi
decided on the prices. The average participant was found to sacrifice some 20 percent of his output to Theoi
even after 20 rounds in which there was no relation between sacrifices and transfer levels (that is, output
prices). Giving subjects more information about the relationship between the output prices of others and
their prior sacrifices changed nothing: interested participants would pore over the large amount of data,
apparently convincing themselves that they saw some positive feedback. Neither building in negative reci-
procity, nor setting a default sacrifice amount of 10 percent on subjects’ screens, were found to change the
sacrificed amounts.
6. We hypothesize that only entities whom we believe want our loyalty become loved. Entities that we uncon-
sciously believe do not want our loyalty (such as the supermarket, a refrigerator, or a company’s stock)
then do not receive our love investments.
7. We consider later what happens to love if the individual perceives no reciprocal transfers from the entity
towards which he has sacrificed.
8. The formulation here is quite coarse and descriptive, as there is no learning and a myriad of interacting
facets have been ignored. The general idea is that individuals can imagine gods, people, inanimate objects,
and even animals to react in a human-like, reciprocal manner to love investments.
9. It is tempting, given a small population size N, to hypothesize as an empirical regularity that ∑ibijta = 1 where
a < 1, denoting a situation whereby an individual can increase ∑ibijt via a more equal distribution of bijt.
This kind of assumption breaks down when N becomes large, however, and richer assumptions might be
found to fit better.
10. Even a person with very low gi but not quite gi = 0 must to some degree, in order to be able to calculate b̆ijt,
be aware of what is actually going to happen.
11. The lines have been drawn merely in a suggestive fashion, but the lack of a down-tick in loyalty in the case
of believed reciprocation is deliberate. This is because we suspect that d(fdc0,c) 5 0 if c , 0 – that is, that
in the periods when transfers are received from the loved entity, this does not immediately reduce loyalty
towards that entity. Rather, the effect is indirect via the beliefs about reciprocation: if individual i believes
that j will transfer without additional transfers from i, then love will naturally fade as Txijt will become 0.
If the perceived transfer from j were thought to be in response to prior transfers from i, then those transfers
from j will spur i on to keep investing and increase bijt; if the perceived incoming transfer occurred in the
same period as the individual’s outgoing transfer, our argument is that this would dim the individual’s love.
This framework is consistent with the evidence of the crowding-out of altruistic donations when monetary
incentives are offered (Mellstrom and Johannesson 2008).
12. This raises the question of whether particularly disappointing or uplifting prior love experiences could
change the self-delusion part of the love mechanism. Our answer is ‘possibly, but this would require a
particularly strong motivation’. We do think of the self-delusion surrounding love as a learned trait, and
hence something that can be unlearned and altered with experience. Within the theory we have though, the
feedback mechanisms flowing from experiences to the self-delusions involved in love would have to operate
via loyalties to abstractions that are affected by reflections on love events, such as a beloved self-image of
rationality or a beloved social status to which an individual’s bond is affected by perceived unreciprocated
loves. We judge, however, that only an unusual set of circumstances would lead a person to deviate from
the dominant culture around him in this way.
13. The analysis can become quite complicated without the simplification that the value of ri does not matter
(other than whether it is 1). If the value of ri does matter, then non-compliers could rationally start playing
mixed strategies such that it is not ex ante certain who will be the greatest violator of the social norm, which
then destroys the value of the ex ante ranking-based norm. Indeed, the possibility of mixed strategies if
punishment were too depend on the degree of non-compliance may make it optimal from the point of
view of the true believers to coordinate on fixed types, rather than on degrees of violation: anything that
the true believers want to coordinate their norms on (and thus their punishment on as well) is subject to
potential randomization by the non-believers.
14. This works as long as the threatened individuals cannot profitably deviate by withholding both their
punishment and their contribution. In a Nash equilibrium, this means only N − 1 punishments can
be credible for any particular individual. We can think of various extensions here in terms of itera-
tive rationality (that is, related to the potential unravelling of the threats among the N − K − 1 other
non-believers).

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13 Behavioral economic anthropology*
Giuseppe Danese and Luigi Mittone
INTRODUCTION
Anthropology occupies a special place among the social sciences for its focus on behav-
ior observed in often remote areas of the world. In this chapter, we argue that the
behavior documented by anthropologists and ethnographers in traditional societies1
can neither be explained in terms of the rational actor model of neoclassical economics
nor in terms of un-purposeful, purely adaptive or irrational decision making. As part of
this book’s effort to document instances of ‘smart’ decision makers given circumstances
and cognitive limits, we argue that men and women living in traditional societies give
rise to institutions that serve economic functions, such as arranging marriages, trading
commodities, and establishing alliances. A discussion of the Kula of the Trobriand
Island natives shows that this arrangement acted as a source of coordination among the
natives. We also discuss possible reasons why the Kula did not evolve into a multi-asset
market and retained for long periods of time ceremonial aspects that appear wasteful
and burdensome to the eyes of a modern market participant. We point to the influence
of social factors surrounding the demand and supply of the valuables exchanged in
the Kula, as well as to environmental features, as helpful elements to understand this
puzzle.
In this chapter we are mainly interested in anthropology as a source of ethnographic
studies that document a variety of institutions being developed in human societies. Our
objective is to contribute to the understanding of the role played by these institutions
through the concept of social norm. A necessary precondition to attempt an understand-
ing of institutions in traditional societies is a discussion of what men and women living
in those societies valued, how their ‘savage mind’2 functioned, and what kind of influence
society had on their individual choices – all topics we discuss.
This chapter should be of interest to scholars of all behavioral sciences, and in par-
ticular of behavioral and experimental economics. The subject pool of ethnographic
fieldwork, that is, individuals living in traditional societies, might yield richer conclusions
about how men and women think and what they value compared to the traditional subject
pool of laboratory experiments, that is, undergraduates living in the Western world (see
Astuti and Bloch 2010; Henrich et al. 2010).
The history of twentieth-century economic anthropology has been largely shaped by
the debate on a fundamental question concerning the savage mind, which we deliberately
push to the extremes: whether people living in traditional societies were rational in their
economic decisions (as the formalist school posits), or whether their decisions were com-
pletely determined by environment, culture and society (as the substantivist school and
its offspring claim). We start our chapter with a presentation of these two contending
approaches.
233
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KARL POLANYI AND SUBSTANTIVIST ECONOMIC

ANTHROPOLOGY
Much of the disagreement between the formalists and the substantivists in economic
anthropology can be traced back to how each school understands the terms ‘economy’ and
‘economical’ (Dalton 1990, p. 253). The understanding of these two words of the formalist
school is the same as that of neoclassical economists. ‘Economical’ refers to the (rational)
choice regarding how to satisfy unlimited wants through limited means. Anthropologist
Karl Polanyi (1886–1964) was among the most outspoken and prolific critics of this
notion of ‘economic’ when applied to traditional societies. The substantive interpretation
of economic he defends ‘derives from man’s dependence for his living upon nature and his
fellows. It refers to the interchange with his natural and social environment, in so far as this
results in supplying him with the means of material want satisfaction’ (Polanyi 1957b, p.
243). He argues that his substantive view is useful in comparing political economies that
differ in temporal and spatial setting; the formalist interpretation of economic is, instead,
useful only for the study of modern market economies (Isaac 2012, p. 15).
Polanyi made two key contentions about human societies. The first is that markets
played a minor role in traditional societies, being the prevailing way to allocate resources
only in modern economies.3 He argues that ‘the anthropologist, the sociologist or the
historian, each in his study of the place occupied by the economy in human society, was
faced with a great variety of institutions other than markets, in which man’s livelihood
was embedded’ (Polanyi 1957b, p. 245). The word ‘embedded’, popularized by Polanyi in
sociology and anthropology, makes explicit the link between each trading institution and
underlying social relationships.
This leads us to Polanyi’s second key contention:
[M]an’s economy, as a rule, is submerged in his social relationships. He does not act so as to
safeguard his individual interest in the possession of material goods; he acts so as to safeguard
his social standing, his social claims, his social assets. He values material goods only in so far as
they serve this end. (Polanyi 1944, p. 46)
According to Polanyi, until the ‘great transformation’4 occurred (the Industrial Revolution)
‘social standing’, ‘social claims’ and ‘social assets’ were an overriding concern for economic
actors, who would acquire material goods only as an intermediate step in the pursuit of
this ultimate goal. Polanyi agreed with the Austrian economists that ‘catallactics’, that is,
‘the analysis of those actions which are conducted on the basis of monetary calculation’
(Mises 1949 [1996], p. 234), forms the basis of market exchanges. He denied, however,
that catallactics explained the rise and inner working of non-market trading institutions.
While the authors of the Austrian school stress the importance of haggling and bar-
gaining in exchanges, Polanyi argued that bargaining is not ‘natural’ for human beings.
Polanyi uses Aristotle’s first book of the Politics (Polanyi et al. 1957a) to argue that
exchanges of equivalents with the aim of personal enrichment are unnatural for humans.
The peculiarity of the household economy described, among others, by Aristotle is that
exchanges take place, instead, at set rates.
Polanyi did not deny that provisioning5 is a necessity in all societies,6 but argued that
provisioning was not done as part of a means–end type of calculation in traditional socie-

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Behavioral economic anthropology 235
ties, but rather as part of a social process that was aimed at increasing the status of the
economic actor.
FORMALISM IN THE HISTORY OF ECONOMIC

ANTHROPOLOGY
According to the formalist school7 the rational actor model of neoclassical economics
is valid across cultures, because economizing behavior is a universal reality for men and
women living in any place and time (Schneider 1974, p. 9). In this perspective, there seems
to be hardly any need to distinguish between the savage mind and the ‘civilized mind’
of a current market participant. Similar to neoclassical economics, formalist economic
anthropology takes preferences as given, and makes no assumption about how self-
interested behavior might be pursued: ‘[F]or one person, self-interest may be served by
storing wealth and investing it for profit; for another, it may be served by spending wealth
and incurring debt to host a feast’ (Johnson and Earle 2000, p. 18).
Few anthropologists today can be described as strictly belonging to one of the two
camps. Behavior in traditional societies, just like behavior in modern market economies,
can be explained most fruitfully by taking into considerations different motivators—
status, safety, and the need to provision in an effort-minimizing way. Allen W. Johnson and
Timothy Earle in their classic work The Evolution of Human Societies provide an example
of how the substantivist and formalist approaches can be bridged. Their approach, close
to the school of ‘human ecology’,8 posits that the main motivator of behavior is the
pursuit of health and safety. In their pursuit of health and safety, men and women give
rise to institutions and ceremonial practices, like the Kula we discuss next.
THE KULA
The Kula has been described as the ‘best-documented example of a non-Western, prein-
dustrial, non-monetized, translocal exchange system’ (Appadurai 1986, p. 18). Polish-
born anthropologist Bronislaw Malinowski (1884–1942) observed this practice involving
canoe expeditions during his journey in a group of islands off the eastern tip of Papua
New Guinea, the Trobriand Islands. The Kula is the subject of Malinowski’s masterpiece,
Argonauts of the Western Pacific: An account of native enterprise and adventure in the archi-
pelagos of Melanesian New Guinea (Malinowski 1922 [2014], hereafter AWP). Malinowski
conducted most of his ethnographic work on the island of Kiriwina (Boyowa in the local
language), the biggest of the group. Kiriwina, the islands to the east of Kiriwina,9 as well
as some other islands not formally part of the Trobriand group, such as Dobu and the
Amphlett Islands, were involved in the practice of the Kula and form the ideal shape of
a ring, whence came the name of ‘Kula Ring’ to describe the area in which this practice
takes place10 (see AWP, ch. 1, containing several maps of the area, and ch. 2). The inhab-
itants of these islands, which we refer to as simply ‘Trobriand island natives’,11 spoke
languages belonging to the same family (Scoditti 2004, p. xvii).
As typical of the area, the diet of the natives was mainly based on tubers such as yams
and taro, whose production had been intensified to the point that Malinowski found little

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uncultivated land at the time of his expedition. The Trobriand society was characterized
by the presence of chiefs (or ‘Big Men’), who collected yams in ceremonial presentations
and stored them in ad hoc houses, the most recognizable sign of their status in the village.
An important way to acquire yams was through marriage. Malinowski reports that chiefs
could have up to 40 wives.12 The yams were provided by the male members of the prospec-
tive wife’s lineage (her dala; see AWP ch. 2; Johnson and Earle 2000, pp. 274–6; Uberoi
1962). The Trobriand society was matrilineal, meaning that membership in kin and other
social groups descended from one’s mother. As a consequence of these kinship rules,
social standing derived from the status of the mother, and chiefs were always the sons of
highly ranked women (AWP, p. 287).
Unlike in other societies one could have found in nearby Papua New Guinea, trade
among the islands was an important part of the Trobriand economy (Johnson and Earle
2000, p. 272). A possible reason for this is the unavailability of certain items such as stones
for axes and clay pots on certain islands. It was also common for people to relocate to dif-
ferent islands, especially from the Northern islands to the Southern islands, in connection
to marriage (AWP, p. 300).
Each participant in the Kula had a certain number of partners located outside his origi-
nal village with whom he kulas, that is, he traded valuable objects. The valuables in ques-
tion (vaygu’a in the local language) came in two varieties: armshells13 made of white shells
(mwali) and necklaces made of red shells (soulava). During expeditions east, the natives
donated the necklaces, receiving back armshells. During expeditions west, they donated
armshells, receiving back necklaces (AWP, p. 100). The Kula valuables were usually kept
for periods up to two years, with certain districts being particularly notorious for keeping
the valuables for an unacceptably long period. Possession of these objects was, according
to Malinowski, ‘in trust’ (AWP, p. 102), that is, the temporary owner acted as a custodian
of these objects. A typical Kula valuable took two to ten years to return to the original
giver of the item (AWP, p. 102).
Little is left to improvisation in the Kula, which was a highly regulated practice involv-
ing precise protocol and etiquette. In a typical Kula expedition undertaken by men
of Kiriwina, the natives stopped in the Amphlett islands, and acquired local artifacts
(pottery in particular). Once the travelers from Kiriwina arrived in the host island (for
example, Dobu, south of Kiriwina), they lined up following their rank in the home com-
munity, and were greeted by their local hosts. The guests then dispersed to meet their
lifelong Kula partners, soliciting repayments of past gifts, or initiating new trades through
the presentation of valuables14 (AWP, pp. 360–62). Malinowski reports that common-
ers typically had only a few partners, while a chief could have hundreds (AWP, p. 99).
Typically, partners were in different points of the Kula ring, and they differed in terms of
what they offered (necklaces or armshells).
These are some of the key features of the ‘ceremonial exchange’15 of Kula objects. Other
more ‘lowly’ (or ‘utilitarian’16) objects were also exchanged in possibly less formal ways by
barter (gimwali) during the visit to the host island. Each trip reinforced or created relation-
ships that would continue when the hosts would visit the island of the current guests in a
future expedition. After three or four days on the host island the guests returned home,
not without having first made several intermediate stops where the acquired objects were
displayed. Malinowski reports that a typical expedition would take home over 600 Kula
valuables (AWP, pp. 402–3).

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Both armshells and necklaces were made of seashells that were ‘freely, though by no
means, easily’ (AWP, p. 375) available in the area of the Kula. Because of the lack of
intrinsic value of the shells, to exchange with someone else a vaygu’a might be considered
as an activity of modest significance. Malinowski reports instead that those involved in
the Kula, directly or indirectly, appeared to attribute a symbolic value to each specific
vaygu’a (AWP, p. 97). Old Kula valuables were coveted by the islanders, because these
vaygu’a had circulated for a long time.17 The value acquired by the objects increased with
time despite any other obsolescence consideration, owing to the fact that old vaygu’a had
had famous custodians in the past. The vaygu’a came to acquire a memory of their own,
an example of objects acquiring a ‘social life’ (Appadurai 1986) or a ‘spirit’ (Mauss 1954).
This opinion is reinforced by the fact that Kula objects had a name, and a renown of their
own, features that have made it possible to track valuables as they moved from island to
island over time (Damon 2002, p. 121ff.).
This mechanism of value acquisition, ignited by the previous possession of the valu-
ables by famous people, is also at work in our contemporary societies. One of the clear-
est instances is the price paid in public auctions for common items that were previously
owned by show-business stars.18 The main difference between the Kula valuables and the
current memorabilia is that the former could not be owned forever, nor could they be
exchanged for regular items or cash.
The Kula expeditions were probably a way to recreate the original sea journeys that
led these remote islands to be settled.19 The fascinating oral myth of the ‘Flying Canoe’,
recounted by Malinowski (AWP, pp. 324ff.) and by Scoditti (2004), formed the basis of
magical practices related to the Kula and sanctified this practice in the eyes of the natives
(see AWP, p. 339) – which probably helps explain the longevity of this practice.
THE KEY FEATURES OF THE KULA
Malinowski claims that, for those communities that participated in the Kula, this practice
overrides in importance all other ‘allied activities’ (AWP, p. 112).20 In this section we take
a bird’s eye view of the institution Malinowski described, with the aim of pointing out its
most peculiar features.
The first key feature of the Kula is its gift component. The role of gifts and of gift
exchanges in traditional societies is the subject of a great body of anthropological research
that we have no hope of surveying here (see, for example, Mauss 1954; Liebersohn 2010;
Yan 2012; Gregory 2015). The Boyowan language spoken on Kiriwina had several terms
for ‘gift’. The opening gift was called vaga: it could be an armshell or a necklace. In a
future expedition, the partner might have offered a return-gift that was of the same quality
of the vaga, this return-gift named yotile. If the partner did not have any adequate yotile,
he would give back a basi, an ‘intermediary gift’ (AWP, pp. 109, 365). Malinowski reports
that if A had in fact a yotile, but refused to give it to B, B was customarily entitled to take
the item by force (AWP, p. 363). If a basi was given, at a later stage another ‘clinching’ gift
would be donated (kudu), concluding this specific transaction. Even though haggling was
not part of the social etiquette of the Kula, Malinowski reports that some of the vaygu’a
were particularly coveted. The custodian of such an object was offered pokala (usually
pigs) and ‘solicitary gifts’ (kaributu, usually axe-blades, AWP, pp. 109, 367). These types

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of gifts were not only made in connection to the Kula, but also in relation to other trans-
actions such as marriage and magical practices (AWP, p. 186).
The exchange of Kula valuables as described by Malinowski had probably little in
common with the generous and disinterested character we associate nowadays to gift-
giving, such as when we donate blood or give Christmas presents.21 The great French
scholar Marcel Mauss (1872–1950) was among the first to claim in his The Gift: Forms and
Functions of Exchange in Archaic Societies that in traditional societies gifts were rarely, if
ever, free, and they usually gave rise to obligations of reciprocity. Mauss broke off with
a narrative of the Trobriand islanders, which finds some foundations in Malinowski’s
work,22 according to which the islanders ‘give because they enjoy giving’ (Lee 1940, p. 367,
original emphasis), at least for what concerns the opening gift.
Mauss discusses three different obligations related to the gift in traditional societies:
the first obligation is to give, that is, the necessary initial step for the creation of social
relationships; the second obligation is to receive, for to refuse to receive is to reject the
relationship initiated by the giver; and the third obligation is to return, to demonstrate
one’s own liberality, honor and wealth. In the Maussian approach gifts, unlike commodi-
ties, are never fully alienated from the giver, but give rise to reciprocal obligations, a feature
that makes relationships among individuals involved in the gifting process durable and
predictable. The exchange of Kula valuables in the Trobriand Islands illustrates all three
obligations, and the role of gift-giving in creating and fostering durable relationships
among members of different communities.
The second key feature of the Kula is indirect and delayed reciprocation. As we have
seen, the objects circulated in well-defined ways, and it typically took some time before
a return gift reached the original giver. Alexander (1987) points out that reciprocity can
be both direct (involving the same parties), or indirect, meaning that the counter-gift is
expected by someone who need not be the original author of the gift, or, as in the Kula,
the return gift is of a different type from the opening gift.23
Indirect reciprocation is a phenomenon that has been documented also in modern
market societies and in lab experiments. Starting from a classic case study about cash
posters by Homans (1954), Akerlof (1982) elaborated an early theory about workers’
motivations to produce effort above the minimum required by their contract based on the
notions of gift exchange and reciprocity. He conjectured that employers pay higher wages
than predicted by the interplay of demand and supply of labor in return for higher effort
exerted by the workers. Workers are not only involved in a gift-exchange relationship
with the firm, but also in a gift-exchange relationship with the co-workers. The resulting
behavior of the workers follows a norm that can be thus summarized: ‘I (the worker) do
more than the agreed because you (the firm) will reciprocate me with an above-market-
rate wage – an example of direct reciprocity – and you commit to avoid retaliation against
my low-effort co-workers – an example of indirect reciprocity.’
Another example of indirect-reciprocation, of a negative type this time, is the so-called
‘altruistic punishment’ documented in experiments by Fehr and Fischbacher (2004).
While in the Akerlof–Homans example of the cash posters, cooperation among market
participants was sustained by ‘positive’ gift giving, in the case of altruistic punishment,
cooperation is sustained by the possibility that a third party might punish ‘unfair’ behav-
ior. Fehr and Fischbacher (2004) add to standard dictator and prisoners’ dilemma (PD)
games a third player who observes the choices made by the main players and who can

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punish them. The authors report that the third players often decide to punish the ‘greedy’
dictators (dictators who send less than the 50 percent of the endowment) and the free
riders in the PD game, again an example of indirect reciprocation.
The third key feature of the Kula is the bartering of commodities (gimwali) that takes
place during the Kula expeditions. We have already remarked that etiquettes differed
for the Kula and for bartering. For instance, Malinowski reports that a typical way to
reproach a Kula participant is to say that ‘he conducts his Kula as if it were gimwali’
(AWP, p. 103). The islanders conducted Kula and gimwali with different partners (AWP,
p. 372), a feature that probably helped in not falling into inappropriate behavior while
conducting Kula.
Although Malinowski devoted to the gimwali a fraction of the attention he devoted to
the trade of the vaygu’a, more recent literature has re-evaluated the importance of barter-
ing in the Kula expeditions (Uberoi 1962). As we have already remarked, the inhabitants
of Kiriwina had to import certain items (for example, pottery) which were unavailable
at home.
The fourth key feature is informal monitoring and informal sanctions against inappro-
priate behavior in the Kula (for example, keeping the valuables for too long). Malinowski
was keenly aware that if the return gift given by a Kula partner failed to meet expecta-
tions of the original giver, the latter had no straightforward way to obtain a better-quality
item from the former (see AWP, p. 103). Even though partners were carefully selected in
consideration of their ability to reciprocate objects of equivalent value, this calculation
seems prone to mistakes. If a contract of some sort existed between the Kula partners
regarding the transfer of the valuables, this contract did not include any external forum
that would sanction non- (or partial-) compliance. The sanction against non-compliance
with the rules of the Kula seemed to be mostly of a reputational type within a ‘clublike
arrangement’ (Landa 1994, p. 204), although Mauss wondered if the person ‘hard’ in the
Kula might also incur a loss of authority in his home community (Mauss 1954, p. 24).
A typical Kula partner ‘desires to acquire and dreads to lose’ (AWP, p. 103). According
to Malinowski, the social rules concerning the Kula overrode the natural acquisitive ten-
dencies of the Trobriand islanders, keeping gifts flowing around, and the institution alive.
These social rules (or social norms, as we call them below) act to constrain self-interested
behavior through the expectation of appropriate behavior. North (1977, p. 713) pointed
out that ‘spontaneous’ reciprocation of gifts can be viewed as a least-cost response to the
lack of formal external monitoring bodies.24 The lack of an external enforcement agency
in Kula transactions does not imply, however, that the entire society of the Trobriand
Islands had no form of external enforcement whatsoever. Forms of external enforcement
did in fact exist at the level of the village (Powell 1969, p. 581). Powell (1960, p. 133) reports
that typically the village leaders were able to exclude people from the kin, and deny people
use of certain local resources and the support of other village men.
Several features of the Kula contributed to reinforce the informal sanctions against
keeping the valuables for too long. For example, some of the valuables were individually
owned in some areas of the Kula circuit (Damon 1980). The inhabitants of Woodlark
Island held the belief that all the Kula valuables were someone’s kitoum (also spelled
kitomu; see Munn 2001, p. 8176), meaning that a specific person owned the Kula valuable.
According to Damon (1980, p. 281) the Kula valuables were to some natives just circulat-
ing objects, while for the owner the valuables were also a kitoum. While the Kula valuables

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were not intended for ownership, but only for temporary keeping, kitoum could instead
be freely bought, sold, destroyed and used to purchase items, or compensate for deaths
(Damon 1980, p. 282; Godelier 1996, pp. 122–4; Munn 2001, p. 8176).
It was already clear from Malinowski’s reports that all the vaygu’a were originally
produced by artisans in specific parts of the Kula Ring. It is not surprising that in
certain vaygu’a-producing districts such as Woodlark (an armshell production site that
Malinowski never visited), the objects were originally treated by the locals as personal
possessions. The fact that the original owner of the kitoum decided to ‘inject’ these articles
into the Kula Ring reinforced the informal sanction against keeping these valuables for
too long. The original owner of the kitoum in fact renounced his ownership, probably in a
show of liberality and status, and it then would have been considered socially inappropri-
ate for others to keep these articles for too long.
The fifth key feature is the presence of ‘allied activities’ (AWP, p. 112). These are
activities related to the Kula, and which involve many people, not only the ‘Argonauts’
who physically travel to the other islands (AWP, p. 110). The building of the canoes to be
used in the expeditions was an example of an allied activity of the Kula. Anthropologist
Giancarlo Scoditti provides an eyewitness account of this activity on the island of Kitawa
in a fascinating interview published in The New Yorker (Stille 1999). He tells how a ‘cer-
emonial canoe is sixty or seventy feet long and can carry forty men. Creating a new one
is an expensive enterprise, which involves the entire village. There are lots of stories about
clans that have been ruined by commissioning a canoe’ (Stille 1999, p. 56). Malinowski
similarly remarks that ‘in studying the construction of a canoe, we see the natives engaged
in an economic enterprise on a big scale’ (AWP, p. 123). Canoe building involved both
individual and communal labor. These allied activities contributed probably to reinforcing
relations among village members in the production of an essential means (the canoe) to
take part in the Kula.
THEORETICAL APPROACHES TO THE KULA
Many studies try to explain the raison d’être of the Kula. An explanation that comes
immediately to mind is that the islanders were alert to the possibility of gains from trade
through specialization of labor. There is evidence that some islands, for example, the
Amphlett group, enjoyed a kind of monopoly over pottery. In a society based on a simple
tuber-based diet it seems unlikely, however, that the Kula was uniquely the product of
comparative advantages in the production of certain commodities.
Malinowski was a proponent of the theoretical position named functionalism (Barth
2005, p. 22), meaning that each single aspect of a society’s culture plays a role in all the
other aspects of culture. Cultural and ceremonial aspects that seem cumbersome to an
outsider can be explained in relation to other cultural aspects, and as ways to cope with
the surrounding environment (Barth 2005). Ellickson (1991, pp. 149–52), in a pioneer-
ing contribution on social norms, criticized functionalism on the basis that it does not
provide objective elements to judge whether certain aspects of culture are functional to
a community.
Johnson and Earle (2000) describe four challenges that the inhabitants of the Kula dis-
trict faced. The first challenge was the uneven distribution of certain commodities, such as

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pottery; the second was the risk of food shortages owing to the unpredictable rain cycle;
the third was intergroup warfare, a feature of many societies also on Papua New Guinea;25
the fourth was variability of agricultural output, requiring trades – usually at the local
level. The Kula in Johnson and Earle’s interpretation can be explained as an institution
that copes with these four problems.
Uberoi offers a comprehensive re-evaluation of the Kula in his Politics of the Kula
Ring (1962). He claims that ‘taken together kula activities constitute an arena of struggle
between the corporate units of Trobriand society for the working out of their relative
ranks’ (Uberoi 1962, p. 97). The corporate unit he refers to is the local lineage, or dala,
which is the basic kinship unit of the Trobriand society. He continues by noticing that the
Kula serves two functions: ‘it provides socially sanctioned occasions for the assertion of
individual self-interest; and it provides the idiom in terms of which the corporate units
of Trobriand society can work out their political relations’ (Uberoi 1962, p. 97). While
the first point is a typically formalist one, the second is surely more innovative. Uberoi
claims in fact that local ‘quarrels’ (1962, p. 108) among competing corporate groups at
home became trading rivalries in the Kula. The Kula in this perspective was both an occa-
sion for fellow village men to compete in their dealings abroad, asserting status that can
be leveraged in their own home affairs;26 and the Kula served also to suspend the ‘latent
enmity’ among different communities, improving, so to say, their foreign relations (Uberoi
1962, p. 146–147).
According to Landa (1994, p. 204), ‘the Kula ring . . . provides the functional equiva-
lent of law and order that in well-developed societies is provided by the state’. She claims
that societies without formal contract law, such as the Trobriand, develop institutions
to facilitate trades and promote cooperation, a theoretical approach that was pioneered
by Douglass North, and which we also subscribe to in this chapter.27 The Kula objects,
in Landa’s view, served the function of signaling membership to a ‘club’, a recognizable
token of one’s trustworthiness and status in the Trobriand community.
The rich and multi-purpose nature of the Kula shows that the islanders were sufficiently
rational to understand the advantages of trading and propitiating peaceful relations with
the neighbors. They were, however, unable to develop a multi-asset market supported by
a price system distinct from the ceremonial practices of society.28 Probably because of the
embeddedness of the economy into ceremonial and magical practices, the set of institu-
tions observed in these islands did not result in a fully efficient outcome (see Robinson
2013, p. 27). Malinowski provided many examples of transactions that were clearly waste-
ful of resources and time. For example, it was quite common for individual A to give yams
to B in exchange for a blade, and for the transaction to be reversed weeks after (AWP,
p. 187). Other examples were the fishing expeditions that ended up in large quantities of
fish becoming rotten (AWP, p. 198).
ON THE POSSIBILITY OF A MARKET FOR KULA VALUABLES
An interesting question is why we do not observe in the district of the Kula a multi-asset
market economy and a progressive disappearance of wasteful behaviors?29 The question
of the conditions under which markets prevail as a way to allocate resources has attracted
the attention of institutional economists and economic historians, who have focused on

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the role of contract enforcement institutions (North 1977, Greif 2005). We have previ-
ously noticed that the Kula does not feature any form of external enforcement of the
terms of contract among the parties.
We outline here a demand and supply analysis for the Kula valuables that will hopefully
lend further insights into the failure of the islanders to develop a market for, among other
items, the Kula valuables. The social stratification observed in the Kula district largely
determined the demand for these objects: commoners typically received only one or none,
while the heads of the canoe expeditions received large quantities (AWP, p. 403). The
supply of the objects was determined by ceremonies and taboos around the fishing of the
Spondylus shells out of which the necklaces were made (AWP, ch. 15) and of the Conus
shells out of which the armshells were made (AWP, p. 519). Commenting on the fact that
only certain classes of people fished for the shells, Malinowski notices that:
[T]he main reason for the exclusive monopoly . . . is the inertia of custom and usage which tra-
ditionally assigns to them this sort of fishing and manufacture. For the shells are scattered all
over the Lagoon, nor is the fishing and diving for them more difficult than any of the pursuits
practiced by all Lagoon villages. (AWP, p. 519)
Malinowski’s account does not allow any hypothesis regarding the emergence of such
customs concerning the fishing for the shells – a general weakness of Malinowski’s func-
tionalism. It is apparent, however, that the fishing of the Spondylus, far from being an
activity pursued in an entrepreneurial way by the natives, was a ceremonial practice on its
own within the Kula. A partial-equilibrium (demand and supply) approach to the Kula
valuables seems therefore laden with difficulties coming from the embeddedness of the
Kula within the social and political life of the natives.
Adam Smith was puzzled, in the Wealth of Nations, by the fact that diamonds
command many more commodities in exchange compared with water, notwithstanding
the fact that water is much more crucial to human livelihood than diamonds (Smith 1776
[1986], pp. 131–2). Smith attempted to resolve this paradox by distinguishing between
two different notions of value: water possesses ‘value in use’ while diamonds ‘value in
exchange’ (or purchasing power). The vaygu’a can never be used to purchase consumer
goods or utensils, these commodities being appropriate for bartering (gimwali) and not
for the Kula.30 The vaygu’a, therefore, did not possess any Smithian value in exchange,
once original possession had been renounced. Regarding the possibility that these objects
afforded value in use, Smith linked ‘value in use’ to the ‘utility of some particular object’
(Smith 1776 [1986], p. 131), and it is plausible that the temporary possession of the Kula
valuables was a source of utility for the islanders. Most likely this utility did not derive
directly from the possession of these objects, which were rarely worn and shown, but it is
mediated by the renown associated with possessing such objects, especially the old ones
that had circulated many times.
Whether the Kula objects possessed value in exchange or value in use, or both to some
degree, depends also on the specific environment of production and consumption of these
objects. One of the distinguishing features of the landscape of the Kula district is the
total lack of metals. This condition probably pushed the natives to look for an alternative,
which performed the role that in continental societies had traditionally been played by
metals. Adam Smith (1776 [1986], p. 276) noticed that in Western societies the demand for

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metals derived both from their utility, as resistant materials, as well as from their beauty,
for example, their ability not to deteriorate and oxidize over time (especially precious
metals like gold). While the Kula valuables might not have been as resistant as metals,
it is plausible that these objects were considered ‘beautiful’ in the eyes of the Trobriand
natives.31 At the same time the raw material – shells – used to manufacture the vaygu’a is
almost totally unaffected by oxidization and this gives to these valuables a long duration.
THE KULA AS A SOCIAL NORM
Ever since Lewis’s (1969 [2002]) pioneering work, social norms have been analyzed as
solutions to coordination problems (see also Bicchieri 2005; Guala and Mittone 2010).
Norms, which occasionally come to acquire the status of convention or custom in human
societies, can guide behavior in situations in which the agents are rational enough to
understand the benefits of trade but are unable to arrive at a shared plan of action due
to cognitive bounds, or to the absence of an effective coordinating device (see also Gintis
2009).
The Kula can be fruitfully analyzed as an institution of the social norm type. It pro-
vided a source of coordination among the Trobriand Island natives, establishing rules
that allowed gift exchanges, barters, allied activities and marriages across different kinship
groups to occur. The Kula also constituted an equilibrium norm of a game characterized
by players with complex preferences and beliefs about other players and the surrounding
environment.32 At the micro-level of the individual decision-maker, the Kula acted as a
source of expectations meant to tame the natural acquisitive tendencies of the islanders.
Some scholars (see, for example, Sahlins 1972, pp. 169–70) drew an explicit comparison
between the Kula and Thomas Hobbes’s (1668 [1994]) Leviathan, an agreement to cease
hostilities typical of a pristine ‘state of nature’.
Although Malinowski did not use the expression ‘norm’ for the Kula, this being a notion
popularized in social science by Ullman-Margalit’s book of 1977 (Ullman-Margalit 1977
[2015]), his analysis is compatible with this explanation. According to Malinowski, the
main force that governed the life of individuals living in traditional societies was ‘the love
of uniformity of behavior’ (AWP, p. 338), what we might call norm-abidance. This abid-
ance was guaranteed by many features of the Trobriandese life, such as rules of kinship,
environmental features (the unavailability of certain commodities at home), and by the
mythology of the Kula.
The Kula was certainly not the only example of coordinating social norm developed
in traditional societies. We briefly discuss here two further instances: the kaiko of the
Tsembaga Maring and the tee of the Central Enga. These two societies inhabited differ-
ent areas of Papua New Guinea, and shared linguistic roots with the Trobriand Island
natives, as well as a common geographic location. The typical size of a Tsembaga Maring
community was 200 individuals, while for the Central Enga it was approximately 350
individuals. By comparison, the size of the Trobriand Island communities was usually
between 200 and 400 individuals.
The kaiko was a ceremonial practice that usually followed a period of indecisive hostili-
ties between local Maring groups competing for productive land (see Johnson and Earle
2000, pp. 185–91 and references cited therein). The truce was sanctioned by the ceremonial

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planting of a tree. While the tree grew, for a period of five to 20 years, hostilities between
the local groups ceased. The truce then came to an end with the uprooting of the tree,
an event that was followed by inter-group ceremonies. Johnson and Earle’s explanation
of the kaiko (2000, p. 191) is that it provided both a group and an individual advantage
to participants. The kaiko promoted the formation of alliances between different local
groups, an important determinant of success in a society marked by endemic warfare. The
individual advantage is the one that accrued to each single kaiko participant thanks to the
acquisition of new allies. Finally, Johnson and Earle remark that the kaiko ‘institutional-
izes’ the local group of Maring, meaning that the ceremonies serve to define membership
and to create a living reference to shared ancestors.
The Central Enga lived in a densely populated area of the New Guinean highlands,
the high population density being associated with agricultural intensification and with
a higher degree of political integration (compared with, for example, the Tsembaga
Maring) under a local ‘Big Man’ (Johnson and Earle 2000, pp. 217–33). Like the
Tsembaga Maring, warfare was frequent among Enga clans, and it was mostly the result
of competition for high-quality land for the farming of sweet potato, which fed the Enga
as well as the large population of pigs that they raised. The tee was a ceremonial practice
that has been explicitly analyzed in opposition to warfare in this society (see Johnson and
Earle 2000, p. 232 and references therein). A clan initiated the ceremony through an ‘ini-
tiatory gift’ of small pigs and other valuables. These exchanges proceeded down the chain
of clans. Eventually, the initiators of the exchange demanded repayment in the form of
pigs, giving rise to a new wave of exchanges and to ceremonial practices that took place
under the leadership of the Big Men of the clans. In these ceremonies, other important
matters were settled, including indemnifications for warfare-related homicides. In an
environment characterized by conflict for the control of land, the tee and the Big Men
who facilitate it create the conditions for a ‘well-developed political economy. Goods are
mobilized from the constituent households to support a set of actions that are basic both
to the rise to power of an individual Big Man and to the long-term political survival of
the local group’ (Johnson and Earle 2000, p. 232).
CONCLUSION
It is our hope that the dialogue between economic anthropologists and behavioral and
experimental economists will intensify over the coming years. In this chapter, we propose
the study of institutions in traditional societies as an ideal ground for the scholars of the
two disciplines to interact. The dialogue between the two disciplines has also followed
other paths we have mentioned only briefly in this chapter: economists have gone to tra-
ditional societies to test the validity of the results from experiments carried out in Western
societies. Henrich et al. (2004) conducted experiments in 15 small-scale societies and found
evidence of behavioral variability and embeddedness of behaviors in the social and politi-
cal features of the different groups. Another strand of the literature has studied themes
that are of direct anthropological interest, such as the emergence of reciprocal exchange
relationships, in laboratory experiments (see, for example, Kaplan et al. 2012).
It is the scope of ethnographic and anthropological work ‘to arrive at invariants beyond
the empirical diversity of human societies’ (Lévi-Strauss 1962 [2004], p. 247). We have

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discussed in this chapter coordinating institutions as one such invariant. We have argued
that the members of traditional societies have developed institutions that solve economic
problems. We have also shown that these institutions might be accompanied by wasteful
and inefficient behaviors. Explaining inefficiencies in the economic life of traditional
societies purely as the results of poor judgment seems hard to justify, considering the
persistence of these behaviors. Anthropologists, as we have seen, have focused on environ-
mental, social and political embeddedness of economic (and ‘non-economic’) behaviors.
An alternative approach based on cognitive biases and heuristics to explain apparently
puzzling behaviors in traditional societies seems possible and will hopefully attract the
attention of behavioral economists in the future.
NOTES
* We wish to thank the editor and Ning Wang for helpful comments. The usual disclaimer applies.
1. We use the term ‘traditional societies’ to describe human societies from the past and the present char-
acterized by low population densities and by limited contact with ‘modernized’ industrial societies (see
Diamond 2012, p. 6). We acknowledge that it is unsatisfactory to group together in this category human
societies that differ along many dimensions such as culture and environment, but stick to this term for ease
of exposition.
2. This is the title (in English translation) of Claude Lévi-Strauss’s classic 1962 text (Lévi-Strauss 1962
[2004]).
3. This is a historical claim that requires quantifying the weight that market exchanges had on the forma-
tion of national income at different points in time in human history. North (1977, p. 706) recognizes that
‘Polanyi was correct in his major contention that the nineteenth century was a unique era in which markets
played a more important role than at any other time in history’. Silver (1983) criticizes Polanyi’s contention
and case study analysis, in particular of Babylonia, arguing that markets played a prominent role in ancient
Mesopotamia and the Middle East.
4. This is the title of Polanyi’s perhaps best known book, originally published in 1944 (Polanyi 1944).
5. ‘Provisioning’ is a term employed by anthropologists to highlight that ‘in any society there are several
possible paths for the provision of similar goods and services’ (Narotzky 2012, p. 77).
6. See Polanyi (1944, p. 30): ‘Other societies and other civilizations, too, were limited by the material
conditions of their existence . . . all types of societies are limited by economic factors.’
7. Among the exponents of the school, an important name is Harold K. Schneider (1925–87). Other refer-
ences can be found in Johnson and Earle (2000, pp. 17–20) and Wilk and Cliggett (2007, ch. 1).
8. See references in Johnson and Earle (2000, pp. 21–2).
9. These are: Kitawa, Iwa, Gawa, Kwaiwata, Dugumenu, Yanabwa, Muyuwa (also known as Woodlark) and
Nada. These islands form the group of Marshall Bennett Islands (Scoditti 2004, p. xxii).
10. Other names for the area that are popular in the literature are ‘Massim country’ or ‘Kula circuit’.
11. We are hence ignoring that some of the islands are not administratively part of the Trobriand group, and
that there are significant differences among the islands, and among the different villages of the same island
(see Scoditti 2004, p. xxii).
12. This was the case for the main chief of Kiriwina at the time of Malinowski’s expedition, named To’uluwa
(AWP, p. 66).
13. These look essentially like wristbands, the main difference being that that they are worn just above the
elbow. A picture of men wearing them, a rare occurrence, can be found in Malinowski’s text (AWP, p. 86,
plate 17,). In the past, armshells were accompanied by another article with the dignity of Kula valuable, a
circular boar’s tusks (doga). Malinowski reports that these articles had disappeared from the Kula by the
time of his field work, apparently because these articles were diverted towards Papua New Guinea, and
the Trobriand islands did not have enough availability of boars with circular tusks to produce new doga’s
(AWP, pp. 366–7).
14. The natives would not bring any vaygu’a with them if the expedition was a major one (uvalaku; AWP,
p. 222). In such expeditions, the guests set to receive gifts from their hosts, and they brought no Kula
valuable with them. The reciprocation of the gifts would happen in a later visit of the current hosts. In an
ordinary Kula expedition (Kula wala; AWP, p. 218), the guests brought instead a few vaygu’a with them,
only to be used as a repayment for a past gift (yotile). No vaga, or opening gifts, would ever be taken on a

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Kula wala (AWP, pp. 363–4). This protocol implies that opening gifts (vaga) can only be given by a Kula
participant when he acts as the host, and never when he acts as a guest.
15. The term ‘ceremonial exchange’ is discussed in Strathern and Stewart (2012).
16. This is the term used by Johnson and Earle (2000, p. 278) for the non-Kula objects that were exchanged
during the Kula expeditions. The use of this word can be traced back to that fact that these goods gener-
ated a utility, while the Kula objects would not, which seems dubious. We return later in the chapter to the
question of ‘value’ and ‘utility’ in traditional societies.
17. Other scholars have criticized the view that the value of the Kula objects is linked to the age of the objects,
pointing out that, at least on Woodlark island, objects of the highest rank were not those that had circu-
lated for a long time, but rather those that were of large size (Damon 2002, p. 114).
18. See, for example, the ruby slippers worn by Judy Garland in The Wizard of Oz, with an estimated selling
price of US$2–$3 million before they were bought by Hollywood stars, for an undisclosed price, to be
displayed in a Los Angeles museum (see http://www.telegraph.co.uk/culture/film/film-news/9099959/
Dorothys-ruby-red-Wizard-of-Oz-slippers-find-their-way-home.html, accessed 20 April 2015); or Elvis
Presley’s bible sold for about US$90,000 (see http://www.bbc.com/news/uk-england-manchester-19531917,
accessed 20 April 2015).
19. This is the opinion of Giancarlo Scoditti, quoted in Stille (1999, p. 58).
20. Malinowski did not deny that communities not participating in the Kula had an economic life of their own
and undertook sea expeditions just like the Kula ‘Argonauts’ (AWP, p. 112).
21. Malinowski would probably call those ‘pure gifts’, a category he briefly discussed in AWP, claiming that
this kind of gifts were not very common in the Trobriand Islands. According to Malinowski pure gifts
were only given within the household, either from husband to wife or from parents to children (AWP, pp.
189–91).
22. See, for example, AWP, p. 186, where Malinowski describes ‘the love of give and take for its own sake’ of
the natives.
23. The indirect-reciprocation of the Kula objects continues to attract the interest of scholars, as witnessed by
recent theoretical contributions on this topic by Corriveau (2012) and Lee (2011), and by the experimental
work by Danese and Mittone (2015).
24. See also Landa (1994, p. 79): ‘In economies where the legal framework is not well-developed, traders have
created institutional arrangements, alternative to contract law, for the coordination of plans of many
traders connected in networks of exchange.’
25. At the time of Malinowski’s expeditions, warfare was already more sporadic owing to the pacification that
was imposed by the British just before Malinowski’s arrival (see Johnson and Earle 2000, p. 268).
26. In his account of a Kula expedition, Scoditti remarks that there was an element of ‘sport and competition’
to the trade (Stille 1999, p. 58). The canoes raced to arrive first to an island, and there was an attempt by
the participants of the Kula to gather more gifts than their neighbors.
27. See also Ziegler (2012), claiming that in the Kula ‘the ceremonial exchange of gifts is an important mecha-
nism for establishing a peaceful social order’ (p. 17).
28. Even though there was no price system to signal which objects were of highest value, we have seen that
exchanges embodied a notion of congruence. For example, the most valuable objects could only be
exchanged with other similarly valuable objects.
29. Episodes of inefficient use of resources in the pursuit of status and rank are also present in modern econo-
mies (see, for example, Frank 2005). Status and rank considerations have also probably influenced the costs
of exchanges among individuals, setting the stage for different paths of developments of economies and
polities (see North 1990).
30. There are reports however that occasionally foreign money was used to acquire vaygu’a, possibly in an
attempt by certain classes of people excluded from the Kula to enter this trade. See Uberoi (1962, p. 157)
and references therein.
31. And not only by the Trobriand Island natives: ‘Spondylus shells were prized as seafood but also
invested with social and symbolic significance in many prehistoric cultures’ (Ifantidis and Nikolaidou 2011,
p. 3).
32. New Institutional scholars have long debated whether institutions and norms constrain behavior by
determining which strategies can be used (the rules of the game view associated with Douglass North)
or whether institutions are rather equilibria of games (a view with no undisputed father, see Greif and
Kingston 2011 for a discussion of these two perspectives and for references). As we explain in the text, this
distinction is not particularly useful for the Kula.

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PART III
DEVELOPMENT AND
GOVERNANCE

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14 Do changes in farmers’ seed traits align with
climate change? A case study of maize in
Chiapas, Mexico
C. Leigh Anderson, Andrew Cronholm and Pierre Biscaye
1 INTRODUCTION
Climate change is a growing problem for agricultural production, and farmers are faced
with decisions on whether and how to adapt (Smit and Skinner 2002; Maddison 2007;
Bryan et al. 2009; Moyo et al. 2012; Tambo and Abdoulaye 2012). The concept of
bounded rationality posits that decision-makers must operate under constraints related
to availability of information, individuals’ ability to process that information, and the
time available to make a decision (Simon 1982). Climate uncertainty imposes all three
of these constraints on decision-makers, as information on possible climate change
alternatives and consequences, farmers’ ability to mentally model these scenarios, and
the time in which farmers must make their farm management decisions are all limited.
Low-income farmers do not have years of data and climate modeling tools against which
their perceptions or ‘best guesses’ can be calibrated. Yet these same individuals experi-
ence climate fluctuations first-hand, often over several years, and at a smaller scale than
most climate models can predict. Hence we ask whether farmers demonstrate evidence of
smart decision-making given bounded rationality, where climate uncertainty means they
cannot determine an optimal set of farm management decisions. We consider whether
farmers assume no particular trends in climate variation and continue with the status
quo, whether they perceive trends but their subjective probabilities are biased relative to
statistical probabilities as a result of certain experienced events like a drought, or whether
field-based farm-management decisions are aligned with the predictions of complex
empirically driven climate models.
A growing literature examines how perceptions of climate change affect farmers’
agricultural decisions. A 2012 study of sub-Saharan farmers’ climate change adaptation
behaviors in 16 agroecological zones finds that farmers have adapted their agricultural
systems in line with changes in temperature and precipitation variation (Seo 2012). The
author uses spatial logit analysis to show that increases in the variation in precipitation
leads to an increase in integrated agriculture systems with both crops and livestock, and
a decrease in specialized crops-only or livestock-only systems. Climate change adaptation
measures vary depending on the type and degree of climate change perceived, but include
crop diversification, changing planting dates, soil conservation, increasing rainwater
capture, water conservation, planting trees, using shading and sheltering techniques,
accessing government programs and insurance, and moving to non-farming activities
(Smit and Skinner 2002; Maddison 2007; Gebrehiwot and van der Veen 2013).
Smithers and Smit (1997) argue that farmer adaptation responses depend on the degree
and nature of the perceived climate stress, the scale and magnitude of particular climate
251
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shocks, and the properties of the agricultural system as a whole. Smit and Skinner (2002)
observe that most adaptations are modifications to on-going farm practices rather than
major changes, but Sutherland et al. (2012) note that ‘trigger events’ such as climate
shocks or land availability can lead to major changes, such as discontinuing production
of specific commodities or diversifying away from farm activities.
Maddison (2007) states that climate change adaptation involves a two-stage process,
as farmers must first perceive that climate change has occurred, and then must decide
whether to adopt a particular measure in response. Several studies find that farmers’
adaptation decisions are primarily informed by their own perceptions of climate change
and risks rather than by external information provision, and that farmers’ perceptions do
not always align with historical climatic data or with climate forecasts (Smithers and Smit
1997; Smit and Skinner 2002; Bryan et al. 2009; Moyo et al. 2012). Some studies argue for
making climate information more accurate, accessible, and useful for farmers, pointing
to the potential for extension services to influence farmers’ climate adaptation decisions
(Bryan et al. 2009; Maddison 2007; Mase and Prokopy 2014).
Not all farmers that perceive climate change decide to adapt their farm practices in
response (Maddison 2007; Bryan et al. 2009). Several factors are found to influence
farmers’ adaptation decisions, including education, farming experience, social norms,
extension services, proximity to markets, wealth and socioeconomic position, and access
to land, credit, and climate information (Maddison 2007; Bryan et al. 2009; Tambo and
Abdoulaye 2012; Gebrehiwot and van der Veen 2013; Mase and Prokopy 2014). While
some studies find that access to technology is not a barrier to adaptation (Bryan et al.
2009; Maddison 2007), this may not be true in all contexts. A 2012 study of adoption of
drought tolerant maize in rural Nigeria finds that the key determinants of adoption by
farm households were access to the technology, complementary inputs, extension serv-
ices, and climate change information (Tambo and Abdoulaye 2012). Barriers to adoption
included household wealth and the cost of the technology and complementary inputs.
Another factor affecting climate change adaptation decisions is farmers’ risk percep-
tions (Byerlee and Anderson 1982; Burton 1997; Hansen et al. 2004). A 2012 study of
farmers in Zimbabwe finds that non-climatic factors influence farmers’ perceptions of
climate variability, and point to the fact that the majority of respondents ‘were highly risk-
averse, perceiving that most of seasons in any ten given years could be poor’ (Moyo et al.
2012, p. 1). They suggest that this risk aversion means that farmers are less likely to modify
practices to take advantage of good seasons. This finding is supported by a 2014 review
of 47 articles on farmers’ use and perceptions of weather and climate information in the
United States, Australia, and Canada which reports that farmers may employ strategies
to ensure some yield during most years and under most conditions rather than adjusting
practices seasonally to maximize short-term gain (Mase and Prokopy 2014).
This study adds to the evidence base on farmers’ climate change adaptation decisions
using panel data from farmers in Chiapas, Mexico. We evaluate whether changes in
farmers’ selection of seed traits are aligned with climate forecast models, and assess the
associations between adaptation decisions and farmer characteristics and perceptions of
climate variations. We find that farmers in different villages made statistically significant
changes in their ratings of seed tolerance or resistance to four environmental stressors,
mostly notably tolerance for drought and excess rain. These changes in seed trait ratings
are generally aligned with climate change predictions, though the degree of alignment

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Do changes in farmers’ seed traits align with climate change? 253
varies by village and climate change model. Our results suggest that farmers’ selection
of seed agronomic characteristics, whether knowingly or not, accounts for long-term
climatic fluctuations due to climate change, and thus provide some evidence that farmers
exhibit smart decision-making given bounded rationality. Further, we find that baseline
attitudes towards different stressors and farmers’ education may also play a role in selec-
tion of seed traits.
2 BACKGROUND
Maize is one of the most important crops grown globally and is, by far, the most impor-
tant crop cultivated in Mexico (Bellon et al. 2011; Mercer et al. 2012; Ureta et al. 2012).
From 2000 through 2012, Mexico produced on average 20.8 million tons of maize, making
the nation one of the top producers globally (FAO 2014). Moreover, roughly 3 million
Mexican smallholders grow maize, mainly for subsistence (Borja-Vega and de la Fuente
2013). The global and national significance of maize, like rice, wheat, and other crops,
raises important questions about how farmers are responding, or can respond, to climate
change. For smallholders, one potential adaptation is via seed selection, both through
selecting and saving seed that performs well, and through purchasing seed with improved
traits tailored to local climate conditions. Yet despite the importance of maize and the
threat of climate change, the global community has gained only a marginal understanding
in the past decade as to whether small-scale maize farmers are adapting to climate change
via seed selection.
The maize crop in Mexico is heavily dependent on climatic conditions (Conde et al.
1997) and significant bodies of literature have, for some time, suggested that the maize
crop in Mexico will be susceptible to the effects of climate change (for example, Conde
et al. 1997; Bellon et al. 2011). Nationally, nearly 80 percent of the country’s crop is rain
fed and most rain-fed land tends to be farmed by small-scale farmers (Fernández et al.
2012). Therefore, uncertain precipitation (and other factors, such as temperature and
wind) constitute a main risk factor for these farmers and their planning environments
(Bellon et al. 2011).
Smallholder maize farmers in Mexico also operate in tightly woven seed selection
systems, where the farmer saves seed from the previous harvest and/or sources it from
other local farmers, such as family or friends (Bellon et al. 2006, 2011). Smallholder
farmers may also have access to improved varieties (such as hybrids) from outside these
tightly woven systems as another way to adapt to real or perceived changes in climate.
Though these improved varieties will not contain the environmentally adapted traits of
native landraces, they may have been engineered to withstand local environmental stresses.
A farmer’s seed choice therefore depends on access and availability options, and perceived
trade-offs between yield, resilience, and other desired seed and crop traits.
Several studies have addressed what forces drive maize seed selection and perception
(Bellon and Brush 1994; Bellon et al. 2006; Bellon and Hellin 2011; Anderson et al. 2012).
Bellon and Brush’s seminal 1994 paper highlights how farmers maintain maize varieties
through seed selection. They find that despite widespread adoption of more modern,
higher-yielding varieties of seed, maize farmers in Chiapas, Mexico, continue to ‘select
maize varieties for specific soils and because of agronomic and use criteria’ (Bellon and

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Brush 1994, p. 196). Bellon and Hellin (2011) find that agricultural programs foster
hybrid seed adoption, while cultural preferences drive landrace retention for commer-
cially oriented small-scale farmers in the La Frailesca region of Chiapas, Mexico. Bellon
et al. (2006) find that small-scale, subsistence-oriented farmers in Oaxaco and Chiapas,
Mexico, have differing perceptions of the benefits of landraces versus hybrids, despite
both groupings of farmers regularly planting creolized local varieties. Lastly, findings
from Anderson et al. (2012) suggest that farmers’ choices are related to feelings of control
over risky outcomes. Farmers perceive hybrids as being able to protect against certain
environmental stressors, and feel similarly for local seed varieties, or ‘creoles’ (Anderson
et al, 2012). For example, for both creoles and hybrid seed technologies there is a statisti-
cally significant difference in the willingness to pay if the crop loss is owing to drought or
pests. However, there is no difference in the willingness to pay if the crop loss is owing to
wind lodging (Anderson et al. 2012).
Numerous studies have demonstrated the ability of maize to physiologically adapt to
climate change (Pressoir and Berthaud 2004a, 2004b; Corral and Puga et al. 2008; Bellon
et al. 2011; Ureta et al. 2012). Corral and Puga et al. (2008) suggest that some maize races
have ‘evolved adaptability’ to certain changed environments (high rainfall, low rainfall,
and hot and cold), while Ureta et al. (2012) suggest that some maize taxa may be suitable
in future climate scenarios. Pressoir and Berthaud (2004a, 2004b) show that Mexican
maize landraces contain high levels of genetic diversity and ‘may evolve in response to
altered conditions’ (Mercer and Perales 2010). Less is known about whether farmers
themselves are selecting seed in a manner consistent with climate adaptation, resulting
in seed that will perform better under altered environments. Bellon et al., in their 2011
paper, note that ‘small-scale maize farmers’ adoption of . . . improved germplasm has
been minimal to date’ (Bellon et al. 2011, pp. 13434–5) in their Mexico study area and
that, combined with tightly woven seed selection systems and a ‘relatively low influx of
outside seed’, there is a ‘strong selection’ (Bellon et al. 2011, p. 13435) for local adaption.
Moreover, contrary to their initial hypothesis, the authors note that ‘all studied commu-
nities except for the highland environment already have access to predicted novel maize
environments within the traditional spatial scope of their seed systems (10-km radius),
suggesting that traditional seed systems may be able to provide farmers with landraces
suitable for agro-ecological conditions under predicted climate-change scenarios’ (Bellon
et al. 2011, p. 13435). However, these studies, and others like them, do not test specifically
for seed adaption.
A 2011 study examining the agro-system of pearl millet in Niger, however, yields inter-
esting results about farmers’ selection of crop varieties associated with climate variations
in the Sahel region of Africa (Vigouroux and Mariac 2011). This study finds a significant
shift toward earlier flowering traits in a sample of pearl millet collected in 2003 relative to
a sample collected in 1976. These adaptive traits are coincident with a reoccurring series
of droughts that started abruptly in the early 1970s. Beyond this study, however, there is
little empirical evidence to inform the debate over whether smallholders are adapting to
climate change via seed selection.
Our work contributes to the small base of evidence on smallholder seed selection and
its relevance to climate change, using data from a survey of 120 farmers in four villages in
Chiapas, Mexico between 2005 and 2007. Assuming that a farmer’s maize seed is not phys-
iologically adapting over the two years of the survey study and that therefore changes in

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seed traits may be owing to selection of (purchased or saved) seed, we use the survey data
to explore several research questions. First, we ask whether farmers change their rating
of agronomic traits of the seeds they plant over a time period of two years between 2005
and 2007. We then compare the changes in seed trait ratings from our household survey to
climate models to ascertain if changes in seed selection are aligned with predicted climate
change. That is, despite the enormous uncertainties in the direction of climate change, we
evaluate whether local farmers are ‘getting it right’ in their selection of seed with traits that
are aligned with climate change models. Finally, though we do not have direct evidence
that changing seed traits are a climate adaptation strategy, we note that local adaptation
is often examined in terms of demographic and socio-economic constraints. To this dis-
cussion we add ‘psychological’ considerations, and in particular look at whether factors
associated with changes in seeds’ agronomic characteristics are associated with farmers’
risk perceptions or sense of control.
3 METHODS AND DATA
The study of farmers in Chiapas was part of a joint project of the Food and Agriculture
Organization (FAO) and the International Maize and Wheat Improvement Center
(CIMMYT) on seed systems, farmer access to crop genetic resources, and farm diversity.
The project included a household panel survey of 120 maize producers (30 from each of
four villages) who source seed from companies and producer groups in the region. The
first round of data was collected from small-scale farmers in 2005. The follow-up survey
was administered in April 2007. The Frailesca region of Chiapas (see Figure 14.1) was
selected because small-scale farmers in the region depend on both formal and informal
seed sources and use hybrids and landraces (‘creoles’) to produce for the market and their
own consumption, and nearly all operate rain-fed systems. Additionally, the region is
experiencing increasing episodes of extreme heat and extreme cold (SMN 2014).
Enumerators collected data on traditional socio-economic and farm household pro-
duction and labor measures (Table 14.1). The survey also asks respondents about their
attitudes towards risk and their willingness to pay for improved varieties that reduce the
frequency and amount of maize crop yield loss from particular stressors, including wind
lodging, pests, and drought. The survey also provides data on farmers’ sense of control
Villages
1 Chiapas 1. Melchor Ocampo

2
3 2. Roblada Grande
4
3. Dolores Jaltenango
Pacific Ocean
4. Queretaro
Figure 14.1 Map of the study communities included in La Frailesca region of Chiapas,
Mexico

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Table 14.1 Sample descriptive statistics (2005)
Variable Overall Dolores Melchor Queretaro Roblada

Jaltenango Ocampo Grande
Age 49.83 53.03 54.8 47.20 44.27
(15.13) (14.96) (13.42) (14.41) (15.90)
Proportion with knowledge of 0.80 0.67 0.90 0.83 0.80
reading and writing (0.40) (0.48) (0.31) (0.38) (0.41)
Years of education 3.90 3.39 4.79 3.59 3.79
(2.91) (2.89) (3.22) (2.58) (2.86)
Proportion from the 0.82 0.87 0.90 0.93 0.60
community (non-immigrants) (0.38) (0.35) (0.31) (0.26) (0.50)
Household size 4.81 5.10 3.90 4.87 5.37
(2.16) (2.01) (1.56) (1.99) (2.74)
Number of parcels seeded 2.26 2.13 2.13 1.83 2.93
with maize (1.13) (0.86) (0.90) (0.91) (1.48)
Total area of parcels 5.15 3.04 4.86 2.96 9.75
(hectares) (4.63) (1.58) (3.03) (1.76) (6.46)
Average area of parcels 2.35 1.50 2.30 1.76 3.84
(hectares) (2.11) (0.83) (1.14) (1.18) (3.38)
Average land quality of parcelsa 2.76 2.65 2.80 2.88 2.69
(0.74) (0.82) (0.95) (0.59) (0.51)
Proportion of parcels that were 0.56 0.17 0.44 0.68 0.98
intercropped (0.46) (0.32) (0.46) (0.40) (0.12)
Notes:
Standard deviations in parentheses.
a
0 5 very poor, 1 5 poor, 2 5 regular, 3 5 good, 4 5 very good.
over losses from these stressors and how much crop they have lost in the past from each
stressor.
The household survey asks farmers to rate the agronomic characteristics of the varie-
ties of seeds planted according to whether they are wind-tolerant, drought-tolerant,
rot-resistant, and excess rain-tolerant. Respondent choices included ‘very good’, ‘good’,
‘poor’, ‘very poor’, and ‘don’t know/no opinion’. The study asked for farmers’ rating
across multiple plots in their respective farms. We test for differences in seed trait ratings
on farmers’ primary plots between 2005 and 2007 across the full sample of 120 maize
producers and then broken out by village.
Our second research question is whether any changes in assessed seed traits align
with historical and predicted climate variations in the region. To address this, we rely on
publicly available weather and climate data for Chiapas, which provides us access to com-
prehensive historical baseline weather data, as well as climate change scenarios modeling
future precipitation and temperatures. We were able to collect historical baseline weather
data from a selection of small-scale farms in the Frailesca region, along with precipitation
and temperature estimates for the location of farms under two different climate change
scenarios.
Weather data to generate baseline averages on the Frailesca region of Chiapas and the

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four villages comes from two sources – the Digital Climate Atlas of México, developed
by the Universidad Nacional Autónoma de México Centro de Ciencias de la Atmósfera,
and the National Meteorological Service of Mexico. With the exact latitude and longitude
of the four villages, we use Google Earth interfaces developed jointly by both sources
to pinpoint the nearest operating weather station.1 We selected a reasonable time series
(many weather stations provide averages dating back to 1960, while the atlas provides
averages from as far back as 1903) of actual and average precipitation and temperature,
as these two indicators are most often associated with climate change scenario models.
The two different sources of baseline data are represented in the results section as two
black lines on the bar charts. Since the sources of data have different averages for the same
village locations, we chose to use both to capture the variation across both precipitation
and temperature.2
We reviewed several sources to select among climate change models. Conde et al. (2011)
provide a particularly helpful overview of regional climate change scenarios for Mexico
and report that the climate change scenarios for Mexico used in the Forth Communication
were generated using data from the ECHAM5, HADGEM1, and GFDL CM2.0 models.
Bellon and Hellin (2011) use the Hadley Centre Coupled Model Version 3 (HADCM3)3
model in their paper, as do Jones and Thornton in their 2003 paper examining the poten-
tial impacts of climate change on maize production in Latin America and Africa. As
our survey data is from Mexico, we follow Conde et al. (2011) and use the HADGEM1
and GFDL CM3.0 models available via Digital Climate Atlas of México (CM3.0 is the
improved atmospheric model of 2.0).
Both models provide precipitation and temperature estimates for some future segment
of years. The HADGEM1 model provides estimates of precipitation and temperature
for both 2030 and 2050. We chose 2050 as the future scenario year, following Bellon and
Hellin (2011). Additionally, in order to capture the uncertainty of global emission scenar-
ios, we use data from the A2 and B2 scenarios for the HADGEM1 model. The A family
of scenarios represent a future world with a greater emphasis on economic development.
The B family considers a future world where there is a greater emphasis on sustainable
development. In both the A2 and B2 scenarios, economic growth is sought through
regional development as opposed to globalization, which is the driver of economic growth
in the A1 and B1 families. The GFDL CM3.0 model captures a range of years. We use the
model estimating precipitation and temperature for 2015–39. The GFDL CM3.0 model is
referenced throughout the paper and in the summary analyses, but for the sake of brevity,
graphic analyses for the GFDL CM3.0 model for both temperature and precipitation
are located in Appendix 14.1 at the end of this chapter. The HADGEM1 model appears
throughout the main body of text.
For each climate model, we consider temperature and precipitation predictions for
specific months of the summer maize growing cycle in Chiapas for our analysis. Though
most of Chiapas does have a long unimodal rainfall season during the spring and summer
months (May through to November), there can be major variation in rainfall amounts
that are often exacerbated due to topography, soil type, etc. (FAO 2006; Waddington
2014). Generally, for the main spring–summer rain-fed maize growing season, dry spells
may be a problem for planting and establishment during the early months (May–June).
In the later months (July–September), excess moisture and even local waterlogging during
crop growth to tasseling is possible, increasing the likelihood of some water stress during

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silking, into the early grain fill months (September–October), though this is noted to
be less of a concern relative to many other maize environments in México (Waddington
2014). As July marks the beginning of the growth cycle – a vulnerable time for plants, we
use this month for both models. We also look at climate predictions for April rather than
May, the more common beginning of planting, owing to the limits of the GFDL CM3.0
model in the Digital Climate Atlas interface.
In our analysis, we present historical baseline data layered on top of the expected
precipitation and temperature levels to determine the differences farmers in each village
can expect. We then evaluate whether differences in farmers’ selection of seed traits align
with predicted climate changes, focusing on drought and excess rain tolerance, as these
potentially relate to changes in temperature and precipitation more than wind tolerance
or rot resistance.
Finally, we evaluate whether risk attitudes are associated with changes in seed trait
selection, looking at the absolute magnitude of changes in seed trait ratings for drought
tolerance across all farmer plots. We use absolute values as farmers may be changing their
selections of seed traits in response to different assumptions about which traits will be
most useful. We conduct ANOVA and OLS analyses to evaluate the association between
changes in selection of seed and several variables which may be expected to motivate seed
selection. We consider farmers’ attitudes, including willingness to take risks, measured on
a scale from 1 to 5 with 1 indicating less willingness and 5 indicating more willingness, as
farmers more willing to take risks may be more willing to change their seed selection. We
also look at farmers’ reports of how important these seed traits are in their decision to
plant a variety of maize, and consider several variables relating to farmers’ perception of
and losses from drought, as these may also be expected to influence farmers’ seed selec-
tion.4 In addition, we include farmers’ number of plots seeded with maize, age, knowledge
of reading and writing, and village.
4 RESULTS
Research Question 1: Farmer Seed Trait Rating Changes
Results of paired t-tests for the full sample (all villages) suggest that there is no statisti-
cally significant change (though they are rated less highly) in the farmer ratings of wind
tolerance, rot resistance, or excess rain tolerance for the seeds that they planted on their
primary plot, but that drought tolerance is rated significantly more highly in 2007 than
in 2005 (Table 14.2).
Results of the paired t-tests by village, however, indicate a high level of variation across
traits and villages when comparing the supply of traits used in 2005 and 2007 (Table 14.3).
For wind tolerance ratings, two villages show decreased ratings while two show increased
ratings, but the only statistically significant change is the decrease for farmers in Dolores
Jaltenango. Seed traits are rated on a scale from 1 (very poor) to 4 (very good), and
farmers in this village decreased their rating for wind tolerance by a mean of 0.3793.
For drought tolerance, results indicate increased ratings for seeds planted in all four vil-
lages, though the difference is only significant for farmers in Melchor Ocampo. We find
mixed changes in the ratings for rot resistance and excess rain tolerance, with decreases

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Table 14.2 Differences in farmers’ ratings of seed traits on primary plots, 2005–07 (full
sample)
Trait Mean Standard deviation Pr(|T| > |t|)

Wind tolerant −0.0550 0.9412 0.5427
Drought tolerant*** 0.1980 0.7214 0.0069
Rot resistant −0.0275 0.8971 0.7494
Excess rain tolerant −0.0816 0.9380 0.3911
Note: *** Significant at the .01 level.
Table 14.3 Differences in farmers’ ratings of seed traits on primary plots, 2005–07
(by village)
Trait Village Mean Standard Pr(|T| > |t|)

deviation
Wind tolerant Dolores Jaltenango** −0.3793 0.9029 0.0316
Melchor Ocampo −0.0400 0.8888 0.8237
Roblada Grande 0.0370 0.8077 0.8135
Queretaro 0.1786 1.0905 0.3938
Drought tolerant Dolores Jaltenango 0.1538 0.7317 0.2939
Melchor Ocampo** 0.3103 0.7608 0.0365
Roblada Grande 0.1538 0.7317 0.2939
Queretaro 0.1500 0.6708 0.3299
Does not rot Dolores Jaltenango 0.0357 0.9615 0.8457
Melchor Ocampo −0.2500 0.7993 0.1095
Roblada Grande*** −0.3462 0.6288 0.0096
Queretaro** 0.4444 0.9740 0.0254
Excess rain Dolores Jaltenango 0.1200 0.8813 0.5025
tolerant Melchor Ocampo* −0.3200 0.9000 0.0881
Roblada Grande*** −0.5600 0.5831 0.0001
Queretaro** 0.4783 1.0388 0.0380
Note: *** Significant at the .01 level; ** significant at the .05 level; * significant at the .10 level.
in Melchor Ocampo and Roblada Grande but increases in Dolores Jaltenango and
Queretaro. These differences may be related to geographical differences between the vil-
lages, as Dolores Jaltenango and Queretaro are located in close proximity to one another
(Figure 14.1). The decreased ratings in Melchor Ocampo are significant at the .10 level,
while those in Roblada Grande are significant at the .01 level. The increased ratings for
rot resistance and excess rain tolerance are relatively small in Dolores Jaltenango and
are not significant, but are significant at the .05 level in Queretaro and indicate increases
in the ratings for rot resistance and excess rain tolerance of nearly 0.5 on the scale from
1 to 4.
We also consider whether changes in farmers’ ratings for particular seed traits on
their main plots may differ from average ratings across all their plots, as farmers may be

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more willing to vary their selection of seed traits if they have more plots to experiment
with. The changes in average seed trait ratings across all plots are generally similar to
those presented for changes in seed traits on primary plots in Tables 14.2 and 14.3, with
a couple of notable exceptions. The average change in ratings for excess rain tolerance
across all plots for the full sample is significant at the .05 level, but the change was not
significant when considering only farmers’ primary plots. The other main difference is
that the direction of the changes in trait ratings for rot resistance and excess rain toler-
ance in Dolores Jaltenango switches, putting their average changes in ratings in line with
those of Melchor Ocampo and Roblada Grande rather than the changes in Queretaro,
its neighboring village.
Research Question 2: Alignment of Seed Rating Changes with Climate Models
Our findings indicate that farmers in different villages are responding to different factors
in their decisions of which seed traits to favor for planting maize. One potential driver of
seed selection is adaptation to climate changes. Because of limitations on including envi-
ronmental stressors in the climate change scenario modeling, we examine only whether
farmers’ seed trait changes align with climate change for two of the four traits – tolerance
of excess rain and drought. However, the results from Table 14.3 imply linkages between
trait characteristics. For example, the results from villages that had a statistically signifi-
cant change in rating for excess rain tolerance mirror the ratings for seed that does not
rot. It is logical that farmers, expecting more rain, would want seed that tolerates both
excess rain and does not rot.
Review of the future climate data for both the HADGEM1 and GFDL CM3 models
(and both scenarios A2 and B2 in the HADGEM1) suggests that average temperatures
across almost all villages will likely increase in both April and July relative to the histori-
cal baselines, sometimes drastically so. For example, Melchor Ocampo is forecasted to
experience nearly a 3-degree increase by April of 2050 in A scenario. The noteworthy
exception is Queretaro in April, forecast to experience a temperature increase with the
HADGEM1 model (Figure 14.2) but a decrease with the GFDL CM3 model (shown in
Appendix 14.1).
Figure 14.2 shows expected village temperatures in April and July of 2050 under the
two HADGEM1 scenarios,5 with baseline averages from two sources (Digital Climate
Atlas of México and National Meteorological Service of Mexico Weather Stations) indi-
cated with black lines.6 For example, the model indicates that we can expect a roughly 2.5
degree increase in temperature in April 2050 for Melchor Ocampo relative to the lower
baseline average under continued economic development (A scenario). Under a more
sustainable growth model (B scenario), we can expect a roughly 2-degree increase in tem-
perature relative to the upper baseline average.
Model
While all villages may expect increases in average temperature, the models indicate sig-
nificant variation across villages with respect to precipitation.7 Models, scenarios, and
months suggest that the villages of Queretaro and Dolores Jaltenango can expect to see
consistently higher levels of precipitation in the future. The villages of Melchor Ocampo
and Roblada Grande, however, have less certain precipitation futures. The GFDL CM3

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Expected village temperatures in April 2050

28.5
April temp in 2050 (A scenario)
28.0
April temp in 2050 (B scenario)
27.5
Temperature (C)
27.0
26.5
26.0
25.5
25.0
24.5
24.0
Queretaro Dolores Jaltenango Melchor Ocampo Roblada Grande
Expected village temperatures in July 2050

27.5
July temp in 2050 (A scenario)
27.0
26.5 July temp in 2050 (B scenario)
Temperature (C)
26.0
25.5
25.0
24.5
24.0
23.5
23.0
Figure 14.2 Expected village temperatures in 2050 under HADGEM1
model (shown in Appendix 14.1) forecasts decreased future precipitation for both months
relative to historical baseline averages in Melchor Ocampo. For Roblada Grande, the
model shows decreased future precipitation for April, but slightly elevated future pre-
cipitation in July. The HADGEM1 models (Figure 14.3) forecast slightly elevated pre-
cipitation levels for Melchor Ocampo in April and slightly decreased levels in July, when
compared to historical baseline averages. Roblada Grande’s precipitation is forecast to
be slightly higher compared to historical baseline averages for both months. Also worth
noting with the HADGEM1 model is that for all villages except for Roblada Grande,
April is predicted to be wetter, while July is expected to be drier for Melchor Ocampo
and there is no expected difference in precipitation in the other villages if we compare the
model with the higher baseline average.
Table 14.4 summarizes forecast changes in temperature and precipitation by village.
We find that three of the 16 cases do not align across models (as indicated by grey arrow
in either direction). We do not find any consistent instances of monthly variation. For

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Expected village precipitation in April 2050

90
80 Monthly precip in April 2050 (A scenario)
70 Monthly precip in April 2050 (B scenario)
Precipitation (mm)
60
50
40
30
20
10
0
Expected village precipitation in July 2050

450
400 Monthly precip in July 2050 (A scenario)
350 Monthly precip in July 2050 (B scenario)
Precipitation (mm)
300
250
200
150
100
50
0
Figure 14.3 Expected village precipitation in 2050 under HADGEM1 scenario
example, under the GFDL CM3 model, Queretaro can expect a decrease in temperatures
in April and an increase in July, but the HADGEM1 model indicates that temperatures
in Queretaro will be higher in both months.
The GFDL CM3 model suggests that farmers in Melchor Ocampo and Queretaro are
reporting changes in traits of planted seed that are aligned with climate change predic-
tions. Farmers in Melchor Ocampo report a statistically significant increase for their
rating for drought tolerance, which aligns with predictions of decreased precipitation for
both months. Melchor Ocampo farmers’ seed traits for rotting and excess rain tolerance
are also in alignment, as their ratings for both rotting and excess rain decreased.8 Farmers
in Queretaro report significant increases in ratings for both excess rain and rotting toler-
ance, which aligns with forecast increases in precipitation for both months. Results for the
GFDL CM3 climate change model for Roblada Grande are mixed. Farmers in Roblada
Grande report decreases in ratings for excess rain tolerance and rot resistance, consistent
with predictions of decreased precipitation for April but not with predicted increases for
July. Farmers in Dolores Jaltenango did not significantly change their ratings of seed

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Table 14.4 Summary of forecasted changes in temperature and precipitation by village
Under GFDL CM3 model

Village Temperature Precipitation
April July April July
Dolores Jaltenango Ï Ï Ï Ï
Melchor Ocampo Ï Ï Ð Ï
Roblada Grande Ï Ï Ð Ï
Queretaro Ð Ï Ï Ï
Under HADGEM1 model

Village Temperature Precipitation
April July April July
Dolores Jaltenango Ï Ï Ï Ï
Melchor Ocampo Ï Ï Ï Ï
Roblada Grande Ï Ï Ï Ï
Queretaro Ð Ï Ï Ï
Notes:
Ï denotes predicted increase in either temperature and/or precipitation compared to historical baseline
averages.
Ð denotes predicted decrease in either temperature and/or precipitation compared to historical baseline
averages.
Grey arrow indicates misalignment across climate models.
There are no significant differences between the A2 and B2 scenarios in the HADGEM 1 model, so those
models are not disaggregated
traits relevant to temperature or precipitation, so we cannot evaluate whether changes

align with climate change predictions.
The results with the HADGEM1 model are less straightforward. Increased rating in
seed traits for drought tolerance and decreased ratings for excess rain and rot tolerance
in Melchor Ocampo are inconsistent with April forecasts, as the model suggests slightly
increased precipitation. The July model, however, suggests slightly decreased rainfall, con-
sistent with the changes in ratings. Roblada Grande farmers’ decreased ratings for excess
rain and rot tolerance put them out of alignment for both stressors in both months, as
precipitation is expected to increase. Ratings changes for farmers in Queretaro align with
the HADGEM1 model in the same way as the GFDL CM3 model.
Table 14.5 summarizes which villages’ farmers report a statistically significant change
in their ratings for traits, and whether these changes are aligned with climate change
predictions.9
The future climate data for both models suggest that average temperatures across
almost all villages will likely increase in both April and July relative to the historical base-
lines, sometimes drastically so (the exception being Queretaro in April under the GFDL
CM3 model). Higher temperatures increase evaporation and exacerbate water con-
straints. Because the majority of the maize in the farms surveyed are rain fed, it is logical
to conclude that the maize is vulnerable to both temperature and precipitation stressors.

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Table 14.5 Summary of farmers’ rating of seed trait changes and alignment to model
predictions of climate changes
Under GFDL CM3 model

Village Drought tolerant Excess rain tolerant Rot resistant
Melchor Ocampo April July April July April July
9 9 9 9 9 9
Roblada Grande N/A N/A April July April July
9 8 9 8
Queretaro N/A N/A April July April July
9 9 9 9
Under HADGEM1 model
Village Drought tolerant Excess rain tolerant Rot resistant
Melchor Ocampo April July April July April July
8 9 8 9 8 9
Roblada Grande N/A N/A April July April July
8 8 8 8
Queretaro N/A N/A April July April July
9 9 9 9
Notes:
9 denotes farmers’ rating of seeds are aligned with climate change predictions.
8 denotes farmers’ rating of seeds are not aligned with climate change predictions.
‘N/A’ indicates that there are no significant differences in farmers’ ratings of the particular seed trait. None of
the difference in ratings for Dolores Jaltenango are significant.
There are no significant differences between the A2 and B scenarios in the HADGEM 1 model, so those
models are not disaggregated.
Moreover, plant-level productivity impacts are not only the result of single climate
factors, but also of the interactions between those factors. Temperature, precipitation,
CO2 levels, radiation, and changes in weed or pest populations can all work singularly or
in tandem to affect the environment and physiological state of the maize plant (Stokes-
Prindle et al. 2010), and subsequently affect yields. As Lobell and Burke (2008, p. 1) note,
‘understanding crop responses to temperature and the magnitude of regional temperature
changes are two of the most important needs for climate change impact assessments and
adaptation efforts for agriculture.’ The overall increase in farmers’ ratings for drought tol-
erance of their seed may therefore be motivated in part by expectations of climate change.
Research Question 3: Motivations for Changes in Traits of Farmers’ Planted Seed
Our results suggest that seed traits are changing, and evolving in a manner that is largely
consistent with climate predictions, depending on the climate model chosen. Farmers are
no less able to predict the future with certainty than climate modelers, so it is not clear
what is causing the changes in farmers’ ratings of agronomic traits, and whether these
seed trait changes are deliberate adaptations to climate change under Simon’s concept
of bounded rationality. We cannot test this directly, but we can exploit some additional

M4225-ALTMAN_9781782549574_t.indd 264 03/05/2017 08:20

survey data to evaluate other potential drivers of changes in seed ratings. In particular,
we can analyze data on farmers’ attitudes towards risk and different stressors to surmise
whether the trait changes are related to farmer attitudes. Since farmers within these vil-
lages are experiencing similar climate and have similar access to seed, differences among
households are potentially related to individual attitudes factoring into seed selection.
The degree to which farmers can be expected to take action to mitigate the effect of
environmental stressors can be expected to vary with how they perceive future risks and
the control they feel over the outcome. In turn, risk perceptions have been found to depend
on base risk attitudes, and among other qualitative dimensions, our experience or famili-
arity with the risky outcome and whether it is perceived as catastrophic or not (Bubeck et
al. 2012; Lujala et al. 2014). The 2005 household survey asked respondents to rate their
perception of the relationship between taking risks and being successful on a scale from 1
(‘one must be extremely careful when considering changes in life’) to 5 (‘it will not benefit
one at all in life if one is not adventurous and takes great risk’), with a mean of 3.04. The
survey also asked farmers to rate the importance of drought-tolerance in selecting seed,
their perception of whether drought is a chronic or catastrophic stressor, their perceived
control over losses from drought, their yield losses from drought over the past five years,
and their willingness to pay to reduce the likelihood of catastrophic losses from drought.
We know that farmers indicate seed traits are changing. We do not know if this is
because of their own seed selection decisions or some other reason (for example, a change
in the available supply of seed), though we do know that farmers select and save seed in
this region. Of interest, therefore, is whether there is any relationship between the varia-
tion among farmers reporting a change in agronomic rating and their baseline attitudes
toward risk and perceptions of particular stressors.
As drought tolerance is the only agronomic trait that significantly changes across the
overall sample and where all villages report increasing their use of seeds with that trait,
we constrain our evaluation of drivers of seed trait changes to this trait. Drought is also
reported to be responsible for the largest yield losses (Table 14.6). According to the North
American Drought Monitor, from September through to December of 2004, parts of
Chiapas, including at least two of the villages examined in this survey, experienced condi-
tions ranging from abnormally dry to moderate drought levels (USNOAA 2004). Despite
these conditions, actual precipitation levels in 2004 varied widely across villages. Year-to-
year variation of loss due to other stressors (lodging and plague) is lower for 2000–2003
and, therefore, aligns with the more chronic rating of these stressors.
Table 14.6 Mean yield loss (farmer reported) from environmental stressors across all
years (kg)
Year Loss due to drought Loss due to lodging Loss due to plague
2000 211.26 (722.40) 185.70 (595.31) 188.40 113.83 (372.19)
2001 140.97 (458.78) 132.65 (484.52) 131.75 160.13 (471.62)
2002 207.50 (642.19) 213.53 (608.23) 212.40 240.20 (620.69)
2003 1166.57 (437.11) 108.45 (399.58) 107.78 202.24 (531.19)
2004 769.36 (985.04) 75.03 (245.09) 75.75 187.33 (578.77)
Average 291.38 (297.48) 180.75 (323.93) 144.39 (297.18)

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Table 14.7 Results of one-way ANOVA for absolute changes in ratings of seed drought-
tolerance on primary plot and potential drivers of seed selection
Variable SS df MS F Prob
>F
Willingness to take risks 0.5061 3 0.1687 0.56 0.6396
Importance of drought-tolerant seed traita ** 2.4023 2 1.2012 4.39 0.0150
Perceived importance of drought stressorb * 0.9281 1 0.9281 3.24 0.0750
Average yield loss from drought over last 5 years 0.8156 4 0.2039 0.69 0.6014
Perceived control over losses from droughtc *** 2.0202 1 2.0202 7.35 0.0079
WTP to reduce likelihood of catastrophic losses from drought 0.0124 3 0.0041 0.01 0.9978
Any WTP to reduce likelihood of catastrophic losses from 0.0058 1 0.0058 0.02 0.8891
droughtd
Notes:
a
1 5 not important in selection of seed, 2 5 important, 3 5 very important.
b
0 5 chronic stressor, 1 5 catastrophic stressor.
c
0 5 none, 1 5 little, 2 5 much.
d
0 5 no WTP, 1 5 WTP is greater than 0
*** Significant at the .01 level; ** significant at the .05 level; * significant at the .10 level.
As some farmers reduced their ratings of seeds’ drought tolerance trait while others
increased their ratings, we take the absolute value of ratings changes for drought tolerance
to test for whether different factors are associated with any change in seed trait ratings.
For comparison, Appendix 14.2 includes tables with our evaluations of drivers of seed
trait changes for excess rain tolerance, as several villages had significant changes in their
use of seeds with this trait.
To test whether the correlations are significant, we first conducted one-way analyses
of variance (ANOVA) for the absolute change in ratings of seeds’ drought tolerance and
baseline measures of farmer attitudes (Table 14.7). The only non-categorical independent
variables – average yield loss and willingness to pay (WTP) – were divided into quintiles
using the egen command in Stata.
The results of the ANOVA tests (Table 14.7) indicate that there is not a statistically
significant relationship between changes in farmers’ selection of seed toward drought-
resistant seed and baseline willingness to take risks, average yield loss from drought, or
willingness to pay to reduce the likelihood of catastrophic losses from drought. Perceived
control over losses from drought, however, is significant at the .01 level, and farmers’
stated importance of drought-tolerance in seed selection and perceptions of drought as
a catastrophic stressor are also significantly associated with changes toward drought-
tolerant seed, at the .05 and .10 level, respectively.
To further test these associations, we conducted simple ordinary least squares (OLS)
regressions of the absolute change in ratings of seed drought-tolerance on farmers’
primary plots against potential drivers of seed change, retaining baseline measures of
willingness to take risks and the three variables that appear to have significant associa-
tions with changes in seed traits (Table 14.8). We also include some control variables that
may be expected to influence seed selection, including age, literacy, and number of plots
planted with maize. We hypothesize that farmers with a greater number of plots would be

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Table 14.8 Results of OLS regression for absolute change in mean rating of seed
drought-tolerance on primary plot
Variable Coeff. (std. err.) P > |t|

Willingness to take risks −0.0263 0.667
(0.0608)
Importance of drought-tolerant seed traita 0.2196 0.096*
(0.1302)
Perceived importance of drought stressorb 0.1662 0.341
(0.1736)
Perceived control over losses from droughtc 0.7486 0.024**
(0.3245)
Age −0.0045 0.276
(0.0041)
Knowledge of reading and writing −0.2844 0.058*
(0.1478)
Number of plots planted with maize 0.0038 0.944
(0.0538)
Melchor Ocampo 0.1489 0.373
(0.1663)
Roblada Grande −0.1643 0.339
(0.1709)
Queretaro −0.0813 0.666
(0.1874)
Observations 90
Adjusted-R2 0.1155
Notes:
a
b
0 5 chronic stressor, 1 5 catastrophic stressor.
c
0 5 none, 1 5 little, 2 5 much.
** Significant at the .05 level; * significant at the .10 level.
more willing to change their selection of seed traits on a given plot, as they would still be
able to use previously tested seeds on their other plots. In addition, we also include vari-
ables for farmer villages, as we have seen that farmers in certain villages have had more
significant changes in their seed trait selection.
As with the ANOVA analysis, we find no statistically significant relationship between
changes in farmers’ rating of seed traits and willingness to take risks. We also find that
the perception of drought as a catastrophic stressor is no longer statistically significant.
Farmers’ stated importance of drought tolerance in seed selection and perceived control
over losses from drought, however, remain statistically significant and associated with
larger changes in the drought tolerance of seeds on the primary plot. Perceived control
over losses from drought appears to have the largest effect on selection of seed traits, with
differences in control between ‘none and a little’, or ‘a little and much’, associated with
three-quarters of a unit change in the four-point seed rating scale.
We find that farmers’ age, village, and number of plots planted with maize are
not significantly associated with changes in drought-tolerant traits of planted seed.

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Unexpectedly, both Roblada Grande and Queretaro have negative coefficients, indicating
smaller absolute changes in seed drought tolerance from 2005–07, even though farmers
in both villages increased their ratings of their seed’s drought tolerance, on average.
This negative association may be because farmers in these villages had smaller absolute
changes in drought tolerance ratings than farmers from Dolores Jaltenango, although
these changes are not significant. Knowledge of reading and writing, however, is signifi-
cantly but negatively associated with changes in drought tolerance ratings.
To test the robustness of our findings, we also conducted regression analyses looking
at relative rather than absolute changes in drought tolerance ratings and looking at the
average change in drought tolerance ratings across all farmer plots as opposed to just on
their primary plot (not presented). The significance of different variables varies somewhat
across these models. When considering relative changes in drought tolerance ratings of
seeds on the primary plot, only the dummy variable for the village of Melchor Ocampo is
significantly associated with a change in ratings of seeds on the primary plot. For relative
changes in ratings for seeds across all plots, the Melchor Ocampo dummy variable along
with the stated importance of drought-tolerant traits and perceived control over losses
from drought are all significant. For absolute differences in seed trait ratings across all
plots, only perceived control over losses from drought is significant.
We therefore observe that farmer’s stated importance of drought-tolerant seed traits is
significantly associated with changes in selection of drought-resistant seed in two of the
four models, while farmers’ perceived control over losses from drought is significant in
three models. These findings suggest that farmers’ seed selection decisions are associated
with their perceptions of climate change and of their ability to respond to climate change,
though the association is not always clear.
The survey does not ask farmers about their perceived importance of or control over
excess rain as a stressor or about their willingness to pay to reduce losses from excess rain,
but we conducted a similar analysis as for drought tolerance considering farmers’ selec-
tion of seeds with excess rain tolerance, without these variables (Appendix 14.2). While
farmers’ stated importance of excess rain-tolerance in seeds is significant in the ANOVA
analysis, none of the variables are significantly associated with absolute changes in excess
rain tolerance ratings in the OLS regressions. In models using relative changes in excess
rain tolerance ratings, the coefficient for Queretaro is significant when considering seed
traits on all plots, while the coefficients for Roblada Grande and literacy are significant
when considering seeds on the primary plot only. This finding suggests that village-level
factors may play an important role in farmers’ seed selection decisions.
5 CONCLUSION
Our research shows that farmers in four villages of Chiapas, Mexico, changed their seed
ratings of tolerance or resistance to four environmental stressors, most notably drought
tolerance, although average changes differed by village. Changes in ratings of drought and
excess rain tolerance are generally aligned with climate change predictions for temperature
and precipitation in these villages, though the degree of alignment varies by village and
depending on the climate model we use. Not unexpectedly, farmers’ changes in seed trait
ratings do not perfectly correspond to climate change predictions, as climate variations

M4225-ALTMAN_9781782549574_t.indd 268 03/05/2017 08:20

are uncertain, and as current seed trait choices may be based on more short-term climate
change expectations than those in our models.
While we cannot test whether changes in seed trait ratings are deliberate adaptions to
climate change, we find that farmers’ baseline attitudes may partially motivate changes
in seed trait ratings. Although willingness to take risks does not appear to affect farmer
seed selection, farmers’ stated importance of drought tolerance in seed selection and
their perception of control over losses from drought in 2005 are both associated with
larger absolute changes in seed drought tolerance ratings between 2005 and 2007. On the
other hand, literacy appears to decrease the likelihood of changes in ratings for this trait,
though the possible reasons for this association are not clear.
The concept of bounded rationality suggests that individual rationality in decision-
making is constrained by information availability, individuals’ capacity to evaluate and
process information, and time available to make decisions. Our results suggest that
farmers’ selection of seed agronomic characteristics, whether knowingly or not, are
aligned with long-term climatic fluctuations owing to climate change as predicted by
climate models, and that baseline attitudes towards different stressors and farmers’
education may also play a role in selection of seed traits. Our findings are limited by
the small sample size and by the relatively short timeframe of the study when compared
with timelines for climate change, but are generally robust to several model specifica-
tions. This study lays a foundation for future investigation into what other variables may
drive farmers’ climate adaptation behaviors given rational behavior under enormous
uncertainty.
NOTES
1. Digital Climate Atlas of Mexico: http://uniatmos.atmosfera.unam.mx/ACDM/servmapas and National

Meteorological Service of Mexico Weather Stations: http://smn.cna.gob.mx/index.php?option5com_cont
ent&view5article&id542&Itemid575 (both accessed 11 January 2017).
2. Note that both sources had the same average for village of Queretaro in the HADGEM 1 temperature model
(Figure 14.2).
3. The model at that time was the predecessor to the HADCEM 3 – the HADCM 2. Note that all HAD-rooted
models stem from the Hadley Centre’s larger Unified Model, but vary depending on the necessary applica-
tion (seasonal, decadal and centennial climate predictions).
4. The survey does not include questions on perceptions of or losses from excess rain.
5. Figures showing expected temperatures for the GFDL CM3 model are included in Appendix 14.1.
6. The baseline average temperatures for Queretaro are the same for both sources, hence only one line.
7. The grey parallel lines on the bar graphs represent the baseline averages from two different sources.
8. Note that we are suggesting a relationship between excess rain and rotting, as excess rain can lead to rotting
of the maize crop, and as changes in seed ratings for these two traits appear to be associated with one
another.
9. Farmers in Dolores Jaltenango did not significantly change their ratings of seed traits with the exception of
wind tolerance, so we cannot evaluate whether changes align with climate change predictions.
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APPENDIX 14.1 GFDL CM3 MODELS

Expected village temperature in April 2015–39
27.5
27.0
26.5
Temperature (C)
26.0
25.5
25.0
24.5
24.0
Expected village temperature in July 2015–39

27.0
26.5
26.0
Temperature (C)
25.5
25.0
24.5
24.0
23.5
23.0
Figure 14A.1 Expected village temperatures under GFDL CM3 scenario

M4225-ALTMAN_9781782549574_t.indd 272 03/05/2017 08:20

Expected village precipitation in April 2015–39

60
50
Precipitation (mm)
40
30
20
10
0
Expected village precipitation in July 2015–39

450
400
350
Precipitation (mm)
300
250
200
150
100
50
0
Figure 14A.2 Expected village precipitation under GFDL CM3 scenario

M4225-ALTMAN_9781782549574_t.indd 273 03/05/2017 08:20

APPENDIX 14.2 EVALUATION OF DRIVERS OF SEED TRAIT

CHANGES FOR EXCESS RAIN TOLERANCE1
Table 14A.1 Results of one-way ANOVA for absolute changes in selection of excess rain-
tolerant seed traits on primary plot
Variable SS df MS F Prob > F

Willingness to take risks 1.0240 3 0.3413 0.68 0.5677
Importance of excess rain-tolerant seed traita ** 3.8637 2 1.9319 4.27 0.0168
Notes:
a
** Significant at the .05 level.
Table 14A.2 Results of OLS regression for absolute changes in rating of seed excess
rain-tolerance on primary plot
Variable Coeff. (std err.) P > |t|

Willingness to take risks 0.0121 0.892
(0.0890)
Importance of excess rain-tolerant seed traita 0.1783 0.112
(0.1111)
Age −0.0086 0.121
(0.0055)
Knowledge of reading and writing −0.2827 0.166
(0.2024)
Number of plots planted with maize −0.0944 0.192
(0.0717)
Melchor Ocampo 0.1321 0.543
(0.2165)
Roblada Grande −0.0246 0.913
(0.2241)
Queretaro 0.1047 0.645
(0.2266)
a
Note: 1 5 not important in selection of seed, 2 5 important, 3 5 very important.
Note
1. The survey does not ask farmers their perceptions of excess rain as a stressor. The three stressors that
farmers are asked about are drought, pests, and root lodging.

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15 Rationality, globalization, and X-efficiency among
financial institutions
Roger Frantz
1 INTRODUCTION
Rationality – that is, rational decision making – and efficiency are considered to be
good things. Rationality in orthodox theory means decision making consistent with the
maximization of expected utility. Efficiency has traditionally meant (market) alloca-
tive efficiency, that is, P 5 MC. In 1966 Harvey Leibenstein introduced the concept of
X-efficiency. X-efficiency is not about the market or P 5 MC. X-efficiency is about the
firm’s costs. An X-efficient firm minimizes its costs, and produces on its cost frontier (or
production frontier). An X-inefficient firm produces above its cost frontier (and/or below
their production frontier). An X-inefficient firm is the result of human behavior which
fails to keep costs to a minimum. A major issue is whether employees who contribute
to X-inefficiency are irrational, stupid, and lazy. An argument will be made that people
on average tend to be smart, given the opportunities and constraints they face. Herbert
Simon might call their behavior constrained by bounded rationality; Leibenstein used the
term selective rationality. Neither implies irrationality. Both may imply non-optimizing
behavior. Errors in decision making are made, but not because people are irrational,
stupid, and lazy.
Beginning in 1967, empirical research on X-efficiency appeared in the literature. From
1967 to 1995 there were approximately 55 empirical studies published in journals. Between
1995 and 2013 there were at least 150 studies. Many of these studies are about the liber-
alization of the banking sector in many countries and the effects of the global economic
crises of 2007–08. This chapter discusses only a small sample of the recent surge in the
literature to ask the question whether changes in X-(in)efficiency imply anything about
efficiency or rationality among members of firms? Again, are members of firms which
are X-inefficient irrational and/or thoughtless (the opposite of smart)? First we ask how
Leibenstein would answer that question. We also need to distinguish narrow from broad
definitions of rationality, as well as allocative from X-efficiency. A summary of some
empirical studies then illustrates the issues raised above.
2 WHAT IS EFFICIENCY? WHAT IS RATIONALITY?
It is necessary to consider the terms efficiency and rationality in the context of (the devel-
opment of) X-efficiency (XE) theory. In 1966, the year Leibenstein’s first article on XE
theory appeared in the American Economic Review, efficiency meant allocative efficiency,
and rationality meant the complete rationality of ‘economic man’. Simon was speaking
about bounded rationality and Hayek was speaking about the impossibility of complete
275
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rationality, to give only two examples, but the orthodoxy was efficiency meant allocative
efficiency, and rationality meant the complete rationality of ‘economic man’. These are
the two concepts which Leibenstein attacked with X-efficiency. For Leibenstein if the
word efficiency had any meaning then there had to be at least the possibility of ineffi-
ciency, and if rationality had any meaning then there must be at least the possibility of
irrationality.
Allocative efficiency means P 5 MC, or MPl/Pl 5 MPk/Pk 5 . . . MPn/Pn. If either or
both of these did not hold, then allocative inefficiency exists. No one took issue with this
form of inefficiency. But this was an inefficiency of the market caused by market power.
What about an inefficiency within the firm? Might firms not be cost minimizers, that is,
might they not be internally efficient? If firms are internally efficient then it must be at
least possible that they are not. Internal inefficiency is X-inefficiency. X-(in) efficiency
does not focus on prices and outputs, but on costs. More than a few economists took
exception to the possibility of this type of inefficiency. If it exists then it calls into ques-
tion whether people are rational or economic man. An economic man would minimize the
firm’s costs, but ‘X-inefficiency man’ does not. There was a lot at stake, or so it seemed.
Critics would say that if firms are not minimizing costs then it is because some con-
straint is not being taken into account. These constraints have included leisure at work,
incomplete property rights, risk aversion, and rent seeking behavior. Each constraint
can increase costs above the technological minimum, but each can be defined as being a
rational response to the environment. Hence there is no (X) inefficiency. What exists is
efficiency within a more complete set of constraints. Economists practicing this orthodox
approach believed that it was enough that there exists what sounds like a constraint and
can be used in a sentence. Engaging in empirical research to identity the causes and effects
of the constraints was not necessary.
Many others have estimated a cost function for a group of firms in the same industry
and investigated whether the firms are producing on the cost frontier. Orthodox theory
at the time stated that they will be on the frontier. Look at an intermediate micro theory
textbook; the entire emphasis is that firms are assumed to be on the frontier. However, if
they are off the frontier then are they 1 percent, 2 percent, or 3 percent from the frontier,
or 20 percent, 30 percent or more? One, 2 and 3 percent can be ignored, but 20 percent or
50 percent cannot. In the cases of 20 percent or 50 percent, X-inefficiency is a form of inef-
ficiency which is a problem for the economy. These economists also investigated, empiri-
cally, why X-inefficiency differed among firms. Having argued for at least the possibility
of the existence of (non-allocative) inefficiency and irrationality, Leibenstein then asked a
central question for his research: what are the implications of (non-allocative) inefficiency
and irrationality for economic theory?
To summarize the academic environment within which Leibenstein was responding,
allocative inefficiency occurs in a market when P ≠ MC. Non-allocative inefficiency
occurs when a firm is not on the cost and production frontiers. Firms are assumed to
be on their frontiers, minimizing their costs. That is what rational members of firms do:
economic man makes rational decisions. However, the existence of x-inefficiency means
that economic man is not ‘all there’. Members of firms are not completely rational (in the
conventional sense), they are, in Leibenstein’s (1976, p. 72) words, ‘selectively rational’.

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Rationality, globalization, and X-efficiency among financial institutions 277
3 NARROW AND BROAD RATIONALITY
We now move away from Leibenstein’s initial challenge. Let us say that a Chinese bank
owned by the state in 1980 is producing with costs 50 percent above the cost frontier. The
government starts a liberalization program privatizing banks and allows new banks, both
foreign and domestic, to enter the market. The response is that by the year 2000 the once
Chinese monopoly bank moves closer to their cost frontier. The bank is more X-efficient,
but, are the employees of the bank more rational in 2000 than in 1980? Let us speculate
a bit. The employees started to pay more attention to details about how to lower their
costs and get closer to the cost frontier. Managerial efficiency improved. According to
Leibenstein the answer would, therefore, be that they are being more rational.
In Adam Smith’s (1994) view being rational means having reasons for your behavior.
Maximizing utility or income or anything is not a criteria for rationality. Seeing a clear
advantage of doing X and acting in a way consistent with X is rational behavior. The
individual is acting consistently with what they believe to be their own self-interest. Hence
being X-inefficient can be interpreted as consistent with rational behavior given the pref-
erences of the economic agents
Herbert Simon comments: ‘The rationality of The Wealth of Nations is the rationality
of everyday common sense. It follows from the idea that people have reasons for what they
do. It does not . . . assume any consistency in what factors are taken into consideration in
moving from one choice situation to another’ (Simon 1997, p. 7).
Or consider Ludwig von Mises’s use of the term rationality: ‘The fundamental thesis
of rationalism is unassailable. Man is a rational being; that is, his actions are guided by
reason’ (Mises 2005, p, 269). Or, ‘Action is, by definition, always rational. One is unwar-
ranted in calling goals of action irrational simply because they are not worth striving for
from the point of view of one’s own valuations’ (Mises 2003, p. 3). Similar to Smith, Mises
uses a broad definition of rationality.
At the other extreme is subjective expected utility (SEU). Rational behavior, according
to SEU, first means that the person has a well-defined utility function which allows them
to assign a cardinal number reflecting the utility of future events. Second, the person faces
a clear set of alternatives they can choose from. Third, they can designate a joint prob-
ability distribution for all future events. Fourth, the person maximizes expected value or
utility. The SEU-person is not unlike an adult Simba from The Lion King who, standing
on the cliff overlooking all the land below, controls everything he sees. Alas, Simba is a
fantasy created by the writers of the story.
In The General Theory Keynes made a statement about classical theory reminiscent
of Leibenstein’s reaction to neoclassical theory: ‘Our criticism of the accepted classical
theory of economics has consisted not so much in finding logical flaws in its analysis as
in pointing out that its tacit assumptions are seldom or never satisfied, with the result
that it cannot solve the economic problems of the actual world’ (Keynes 1965, p. 178).
Likewise, Leibenstein’s criticism of orthodox neoclassical micro theory was the assump-
tion of complete rationality and the restriction of the definitions of (in)efficiency limited
to allocative (in)efficiency. Keynes challenged the (full) rationality assumption and gave
several examples: the money illusion, the formation of incorrect expectations by business
people, the minimum rate of interest needed for investment, and the presence of ‘animal
spirits’. These spirits are spontaneous urges which direct our behavior, and are contrasted

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with mathematical or rational expectations. Having asserted human lapses from full
rationality Keynes then asked what the implications for economic theory are. His answer:
deviations from full-employment. As Simon points out, a ‘cottage industry’ developed
trying to show that less than full employment was consistent with full rationality (Simon
1997, p. 15). Likewise a cottage industry, albeit a smaller cottage, developed to show how
what Leibenstein referred to as X-(in)efficiency is no in-efficiency at all; it is an efficient
solution when all the constraints are identified.
Smith’s use of the term rationality was a broad definition of rationality. To be rational
means to have reasons for what you do. Therefore, Smith would not see irrationality
everywhere in most actions. Simon refers to the broad definition as subjective or bounded
rationality. He says that rationality ‘denotes a style of behavior that is appropriate to the
achievement of given goals, within the limits imposed by certain conditions and con-
straints’ (Simon et al. 1992, p. 123). The conditions and constraints in the broad definition
are subjective or perceived characteristics of the environment or the person himself.
Keynes’s was a more narrow definition. For example, to be rational means to be free of
money illusion, and a person is either free or not free of the money illusion. Leibenstein
took a narrow definition of rationality and efficiency. Firms which are not on the cost
frontier are inefficient, and the members of those firms are not fully rational. Taken in
historical context, Leibenstein’s position is understandable because he was reacting to
a neoclassical theory which asserted the impossibility of non-allocative (in)efficiency or
irrationality. Leibenstein took the view that there are explicit criteria for both efficiency
and rationality, and the firm and its members either meet those criteria or they do not.
No excuses, no ‘because’s’ accepted. Once Leibenstein presented XE theory and empiri-
cal evidence began to pile up, the critics of XE theory decided that neoclassical micro
theory had no need of the concept because the broad definition handles all human
behaviors.
Why Does X-(in)efficiency Exist?
Some critics of X-efficiency theory insist that it does not exist. I believe that what they
mean is that it cannot exist. Critics have engaged mostly in presenting arguments which
are merely tautologies (Frantz 1997). Assuming that it does exist, what does it look like?
It looks like a firm producing below its production frontier and/or above its cost frontier.
X-(in) efficiency is not about deviations from P 5 MC, but about costs above minimum
and output below maximum. Why does it exist? Leibenstein presents several interrelated
reasons. First, the human personality contains two parts, a superego and an id. The super-
ego wants to work hard, improve itself, do things correctly, and find solutions to problems
using rational decision-making processes. The id wants to be free of work. The id employs
lazy decision rules and only moderate work effort, both of which raise costs above the
technological necessary minimum. Second, managers are only rarely the owners, creating
an ‘agency problem’. Third, workers have discretion about levels of work effort. Fourth,
monopoly power gives employees an environment in which they can pursue their own
interests rather than the firm’s interests. In what sense does this create an inefficiency?
In the sense that the firm is not doing as well as it can. Are the firm’s members less than
economic-man rational? Yes in the sense that their behaviors create (X-)inefficiency.
Again, this is rationality in a narrow sense; there are criteria for rationality and the firm’s

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members are said not to meet those criteria. Had they met them then the assumption is
that the firm would be producing on its frontiers. In the next section I present a few of
the rapidly increasing studies on X-efficiency in order to illustrate differences between the
narrow and broad definitions of efficiency and rationality.
4 ALLOCATIVE AND X-EFFICIENCY
Market power adversely affects allocative efficiency. Power gives a firm the ability to
raise price above marginal cost and to restrict output in such a way that the industry’s
output rate is below the competitive level. The price and output deviations are known as
the deadweight welfare loss or the ‘Harberger triangle’, named after Arnold Harberger
(Harberger, 1954). The market is inefficient because the optimum amount of resources
has not been allocated to the production of the commodity. However, the firm with
market power is efficient as long as it sets its output rate correctly, where MR 5 MC; sets
its price correctly, the point on the demand curve when MR 5 MC; and minimizes its
costs of production for a given rate of output. Since these three conditions are assumed,
the firm is efficient even when the market is inefficient. Stated in different terms, the firm
is always assumed to be efficient.
Since firms are assumed efficient, the only definition of efficiency which has any eco-
nomic implications is allocative – market – efficiency. These assumptions have allowed
economic theory to focus on the efficiency of markets while placing much less attention
on the internal efficiency of firms. X-efficiency is the name given to non-allocative effi-
ciency by Harvey Leibenstein.
Empirical estimates of the size of allocative inefficiency reveal that for the entire
economy allocative inefficiency is less than 1 percent of gross domestic product (GDP).
Some estimates have it between 0.001 and 0.0001 of GDP. For a $16 trillion GDP this is
equal to between $16 billion and $1.6 billion. Each year Americans spend $18 billion on
specialty coffee, and $7 billion on potato chips. Allocative inefficiency is, to use a line from
the Godfather, ‘small potatoes’. It is, for all intents and purposes, insignificant. Robert
Mundell (1962), the 1999 winner of the Nobel Prize in Economics, thus lamented that if
inefficiency is insignificant then so are economists! Fortunately inefficiency is not limited
to allocative inefficiency. X-inefficiency – internal inefficiency of the firm – costs that are
higher than technologically necessary costs – has been estimated to be in the area of 3
percent of GDP. For a $16 trillion economy this is $480 billion. (An anonymous source
reports that when Mundell heard this his blood pressure dropped 15 points.) One reason
X-inefficiency is larger than allocative inefficiency is because X-inefficiency applies to
every unit of output produced by a monopoly firm, whereas allocative inefficiency only
applies to the change in output due to the higher price charged by the monopoly firm.
The equation to calculate allocative inefficiency is:
((DQDP/2) (% national income in industries creating the misallocation)).
Leibenstein challenged some of the core assumptions around which economics is built.
He added a behavioral element to economics; the behaviors which result in efficient and
rational behavior, and the conditions which are most conducive to both. Leibenstein, as I

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have said elsewhere (Frantz and Leeson, 2013), is part of the first generation of behavioral
economists, together with Simon, Katona, Hayek, Nelson, and Winter.
5 STUDIES ON X-(IN)EFFICIENCY
The only studies included here are those in which the author(s) state that their research
is about X-efficiency. There are thousands of other studies which are almost identical in
terms of topics, research methods, and conclusions which do not mention X-efficiency.
The sample here is a small sub-sample of the more than 150 articles on China, Taiwan,
Korea, and Pakistan (Frantz 2007, 2016).
China’s Banking System
Until recently China’s financial sector was not a modern financial sector which converts
saving into investment. The financial system was a tool of the central government’s
political decisions. Transforming Chinese banks into modern commercial banks required
modern corporate governance, for example: independent bank directors; effective opera-
tional mechanisms, risk management and transparency; clear working goals, market share
and/or profits; and international competitiveness. One of the major institutions of the
Chinese banking system has been the Big Four state-owned commercial banks (SOCBs).
The SOCBs have been noticeably inefficient with negative profits and a high level of
non-performing loans (NPL). One cause is that the SOCBs provided services to state-
owned enterprises (SOEs) – one monopolistic institution servicing another monopolistic
institution – and hence there was a general lack of incentives for efficient behavior. The
banks’ behavior was more politically motivated than efficiency motivated.
Mao died in 1978 and shortly thereafter China set out to increase economic efficiency.
Beginning in 1979 China began creating a ‘two tier’ banking system: the People’s Bank of
China (PBC), and four state-owned banks (SOBs). The latter included the Bank of China
(BOC). The PBC remained China’s central bank, but commercial activities were the focus
of the four state-owned banks. Beginning in 1985 the state-owned banks had nation-wide
branches and were accepting deposits and making loans. By 1986 they were engaged in
universal banking. Small and medium-sized commercial banks were introduced in 1985
in order to promote competition.
The ‘Decision on Financial System Reform’ in 1993 promoted a competitive com-
mercial banking sector. The PBC remained in charge of monetary policy, but in 2003
the China Banking Regulatory Commission (BRC) took over the regulatory function
formerly in the hands of the PBC. The BRC allows foreign institutions to own as much as
25 percent of a Chinese financial institution. Three state-owned policy banks (PBs) were
created in 1994 to make loans formerly done by the (SOB). In 1999 China created four
Asset Management Companies (AMCs), one for each of the Big Four SOCBs. Formed as
a way to compensate the Big Four for their service to the nation, the AMCs were created
to take over the Big Four’s NPLs. In 1999, NPLs valued at about 1.5 trillion renminbi, an
amount equal to about 20 percent of China’s GDP, were taken over.
Eleven joint-stock owned banks were created in 2005. It is important that the primary
stockholders of these ‘private enterprise’ banks were the state or SOEs. There were 111

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city commercial banks owned by local public and private institutions, three rural com-
mercial banks, and 35 544 rural credit coops. By 2004 there were about 204 foreign bank
subsidiaries. Between 1992 and 2004 a significant change in both deposits and loans was
the declining (but still large) share by state-owned banks and the increase in both by joint-
stock owned banks. The Commercial Bank Law in 1995 addressed the intent to create
a modern financial system, meaning a set of institutions which would protect both the
banks and the bank’s customers, having management motivated by efficiency considera-
tions, while at the same time promoting a socialist market economy.
In 1998 the government ended credit quotas. Thereafter banks could adjust inter-
est rates within a ‘modest’ amount to take risk into account. In 2001 China joined the
World Trade Organization (WTO) and had five years to open up their banking sector
to international competition. Opening the economy to foreign interests was essential
for China’s membership of the WTO. Foreign banks were required to have unrestricted
access to the Chinese financial sector. In October 2005 the China Construction Bank
initiated an initial public offering (IPO), China’s banking sector’s first IPO. The IPO was
listed on the Hong Kong stock exchange. This was the first time that Chinese stock was
listed in an overseas stock exchange. By 2007–09 Chinese banks were the largest com-
mercial banks in the world. The various reforms have had positive effects. For example,
among the largest state-owned banks the ratio of NPLs to total loans, which was about
30 percent in 1999, dropped to 10.5 percent in 2005, then to 6.7 percent in 2007, and
further to 2.8 percent in 2008. Bank profits, measured as either return on assets (ROA) or
return on equity (ROE) increased. From 2002 to 2006 the ROE and the ROA increased
about three times, reaching levels of about 11 percent and 0.5 percent, respectively. The
recession of 2007–09 had intense effects on the world’s financial sector. On the one hand,
financial giants such as Citigroup and the Royal Bank of Scotland saw their stock prices
fall by more than 95 percent. On the other hand, China’s three large SOCBs became the
world’s three largest commercial banks. It was only two years earlier, 2005, that saw the
first Chinese bank IPO, and four years earlier that China joined the WTO. The changes
the Chinese economy went through would seem to provide a different set of incentives
to managers and other employees. Did managers and other employees become smarter,
more rational?
X-efficiency among Chinese Banks
Yao et al. (2008) look at Chinese commercial bank efficiency both before and after China
joined the WTO in December 2001. Pressure for reform came not only from member-
ship in the WTO, but also from foreign banks entering the Chinese market. Efficiency
and productivity is measured using the data envelope analysis (DEA) and the Malmquist
index. Data envelope analysis is a non-parametric method of measuring a firm’s distance
from their production or cost frontier. The Malmquist index measures productivity dif-
ferences between firms (or entire economies). The period of study is 1998–2005. Average
X-efficiency for all banks over the entire period was 0.85. Thus, on average a Chinese
bank produced 15 percent below their production frontier or 15 percent above their cost
frontier. The range by individual banks was 0.96 (Bank of China) to 0.64 (Guangdong
Development Bank, a joint equity bank). China entered the WTO in December 2001.
Average XE score from 1998 thru 2001 was 0.82. From 2002 to 2005 the score was 0.90.

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Clearly, XE increased after China entered the WTO. The average score increased over the
entire period, from 0.86 in 1998 to 0.92 in 2004.
Total factor productivity of the entire sample banks increased significantly by 5.6 per
cent per annum over the data period. Of this 5.60 percent figure efficiency growth was
2.88 percent per year and technical change growth of 2.64 percent per year. Efficiency
growth measures the extent to which banks approach the frontier, while technological
growth measures how fast the frontier is shifting out. The majority of productivity growth
among state-owned (joint equity) banks was efficiency growth. After China joined the
WTO total factor productivity grew at an annual rate of more than 10 percent. The WTO
provided strong incentives for productivity (technological growth) and (X-)efficiency
growth. The authors conclude that the Big Four need ‘minimum intervention’, managers
with ‘professional qualifications’, and mergers and acquisitions (M&A) allowing them to
take advantage of economies of scale and scope.
Rezvanian et al. (2011) investigate how entry into the WTO affected the performance of
Chinese banks. The sample, which covers the years 1998–2006, consists of 62 banks repre-
senting 66 percent of Chinese bank assets. For the entire period the average XE score was
.94. This means that the average banks produced 6 percent above their cost frontier. The
average scores for allocative efficiency (AE) – optimal factor ratio – and scale efficiency
(SE) – optimal size – were 0.98, and 0.94, respectively. As reported in most studies XE is
lower than either AE or SE. The pre-WTO period was designated as 1998–2001, while
post-WTO was 2002–06. When Tobit regressions are run separately for each ownership-
group – foreign, domestic, Big Four, joint stock commercial banks (JSCBs), and city
commercial banks (CCBs) – XE increased for each group after China joined the WTO.
One of the independent variables measures ‘regulatory quality’. Their definition is:
‘Regulatory quality measures the ability of the government to formulate and implement
sound policies and regulations that permit and promote private sector development’
(Rezvanian et al. 2011, p. 449). In a regression with ‘overall efficiency’ being the dependent
variable, although regulatory quality has a positive coefficient in two of three regressions,
none are statistically significant, which can be a product of sampling or sample size issues.
Overall technical efficiency (OTE) includes both X-efficiency and scale efficiency. The
change in OTE has two components: technological change (T), and total factor produc-
tivity (TFP). The former represents a firm catching-up to the frontier, while the latter
represents shifts in the frontier. During the pre-WTO period, banks of every ownership
form experienced lower T and TFP. During the post-WTO period, banks of every owner-
ship form experienced progress with respect to T and TFP, and XE. The WTO applied
pressure and Chinese banks responded – as expected.
Wu et al. (2009) estimate the effects of a bank issuing an IPO on ROA. Their sample
is 14 commercial banks including the Big Four for the period 1996–2004. They find that
ROA increases from the time the bank issues an IPO through to the period immediately
following the issuance of the IPO. However, over time ROA falls. Why the absence of
good long-run performance? The authors’ reasons include the following three reasons.
First, banks tend to see the stock market as a way to raise short-term funds. Second, the
relatively under-developed state of the Chinese stock market has led to decisions about
capital allocation based more on speculation and less on ‘sound fundamentals’. Third,
funds raised in the stock market are too often used to open new branches and hire more
staff; new technologies are too often ignored. A poorly functioning stock market and mis-

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guided management, even in the face of increased competitive pressures, have reduced the
ability of banks to garner long-run benefits from the stock market, and this has reduced
XE below what it would have been with a better functioning capital market and better
management.
Luo and Yao (2010) use data from 14 Chinese banks listed on a stock exchange to
investigate the effects of being listed on bank efficiency. The authors use data on three
bank ownership forms: SOBs, joint equity banks (JEBs), and CCBs. The data show that
X-efficiency increased from the year before to their IPO year. Second, one year after the
IPO, X-efficiency either remained constant or fell by a very small amount. Third, the
overall effect of the IPO is to raise X-efficiency by about 4.1 percent. Fourth, X-efficiency
among SOCBs is below CCBs and JEBs by about 2 percent. Two reasons given are overex-
pansion (too high fixed costs) and redundant staffing, implying that the marginal product
of labor is very low.
Jiang et al. (2009) estimated efficiency for all major commercial banks in China which
control more than 85 percent of bank assets for the period 1995–2005. The average
level of X-efficiency is about 0.70. Joint stock commercial banks are overall the most
X-efficient with an average level of 81 percent, and were between 8 percent and 18 percent
more X-efficient than state-owned banks. Joint stock commercial banks used their greater
levels of XE to generate profit levels closer to the maximum possible level of profits.
García-Herrero et al. (2009) investigated the causes of low profits among 87 Chinese
banks accounting for more than 80 percent of total assets for the banking sector for the
period 1997–2004. They find that banks which are less X-efficient are also less profitable;
the quality of management decision making being an intangible bank-specific factor. The
authors point out that the literature reports that state-owned banks are 8 percent to 18
percent less X-efficient than non-state-owned banks.
Fu and Hefferman (2007) studied four state-owned and ten joint-stock owned banks
between 1985 and 2002. They utilize a stochastic frontier approach (SFA). The SFA
decomposes the error term into random errors and inefficiencies. X-efficiency is meas-
ured as the cost for the best practice bank/actual cost of an individual bank. Estimates
of X-efficiency are separated for the two reform periods as they define them: 1979–92,
and 1993–2002. Their overall results show that on average banks are operating 40–60
percent below the X-efficiency frontier; the average level of X-efficiency was 0.4 to 0.6.
On average, privately owned joint-stock owned (privately owned) banks were about 20
percent more X-efficient than the state-owned commercial banks.
Yao et al. (2007) used data from 22 banks over the period 1995 to 2001, and a stochastic
frontier production function to measure the effects of ownership form and a hard budget
constraint on X-efficiency. (A hard budget constraint means that a firm which does not at
least break even will face consequences from stakeholders.) Their empirical results show
that on average X-efficiency was 0.65. On average state-owned banks were 8–18 percent
less X-efficient than private-sector banks. Not surprisingly, banks facing a looser budget
constraint tended to be less efficient than banks facing a tighter budget constraint.
Fu and Hefferman (2009) showed that SOCBs, especially the Big Four grew beyond
optimal size and into the area of diseconomies of scale. The resulting higher costs reduced
X-efficiency. State banks contributed to the decline in X-efficiency in another way. They
continued to be pressured to make loans to inefficient SOEs, which during stage 1 were
making profits. Joint stock commercial banks, whose directors/owners were SOCBs,

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were also pressured to lend money to failing SOEs. Although NPLs fell for the banking
system as a whole to 15.5 percent by 2004, the NPL ratio for the Big Four was 50 percent
to 60 percent. Politics rather than economics continued to take its toll and a loss of
X-efficiency was the result. They find that JSCBs are about 7 percent more X-efficient
than are SOCBs.
Chen et al. (2005) examined allocative and X-efficiency among 43 Chinese banks
during the period 1993–2000. The sample included four SOCBs, seven nation-wide
JSCBs, 24 regional JSCBs, and eight international trust and investment trust banks.
The authors define X-efficiency as including both technical (producing on the frontier),
and allocative efficiency (using the right combination of inputs): XE 5 TE × AE. XE is
the ratio of minimum to actual costs. Over the period 1993 to 2000 technical-efficiency
among all banks averaged 0.77, allocative efficiency averaged 0.61, and X-efficiency
averaged 0.469.
The authors also present estimates for the three forms of efficiency both before
(1993–94), and after (1996–2000) China’s 1995 financial deregulation via the Commercial
Bank Law of 1995. Before deregulation, 1993–94, the average X-efficiency score was 0.47.
Post-deregulation, 1996–97, average X-efficiency was 0.53. However, the increase was
short lived. By 2000 XE had decreased from 0.53. Deregulation had the expected effect
in the short run. Having made some initial changes which increased X-efficiency, the old
behavior patterns apparently returned. Banks may have become more X-efficient in order
to satisfy private sector lenders. Having done so, having received loans, managers appar-
ently returned to old behavior patterns.
Will all banks approach the same level of XE over time? If the market for corporate
control is functioning well then the answer would seem to be yes. Fung and Chen (2010)
investigate two major sources affecting productivity among banks, and two major theories
of productivity convergence among banks. Their sample consists of 32 Hong Kong banks
for the period 1993–2002.
The two major theories of the determination of productivity is X-efficiency and scale
efficiency. Fung and Chen (2010) focus on management’s ability to control cost, to be
more X-efficient. There are two different types of productivity convergence: absolute
and conditional convergence. Absolute convergence means that productivity differences
among banks gets smaller over time. Conditional convergence means that an initial
difference in productivity will create long-run differences in productivity, and a bank’s
long-run productivity level depends on their level of X-efficiency. In other words, every
bank approaches their own long run, steady-state, level of productivity. Their evidence is
consistent with conditional convergence; X-efficiency is a key variable in the determina-
tion of long-run productivity.
Kwan (2006) investigated causes of X-(in)efficiency among Hong Kong (HK) banks
from 1992–99. Interest rates were regulated until 1994 and the regulation gave banks some
protection from competition. Deregulation would be expected to increase pressure for a
higher level of X-efficiency. At the same time Hong Kong had a large number of banks,
and many of the medium-sized banks are private and controlled by the founding family.
The publicly owned banks had agency problems also reducing pressure for X-efficiency.
The net effect of these situations? For the full sample, average X-inefficiency declined by
36 percent (it fell from 45 percent in 1992 to 29 percent in 1999). For large banks, average
X-inefficiency fell from 37 percent to 26 percent (30 percent), and among small banks it

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fell by 26 percent (31 percent to 23 percent). Average X-inefficiency over the entire period
ranged from 16 percent to 30 percent. The fact that smaller privately held banks were more
X-efficient is consistent with the agency costs of the separation of ownership and control.
Taiwan, Korea, ASEAN, Pakistan
Chan et al. (2011) investigate the efficiency of foreign banks in four Association of South
East Asian Nations (ASEAN) countries, Indonesia, Malaysia, the Philippines, and
Thailand, for the period of 2001–08. Efficiency was measured using the stochastic frontier
analysis. In each year from 2001 to 2007 Malaysia had the highest level of X-efficiency.
In 2001 and 2007 their X-efficiency rating was 0.83 and 0.84, respectively. The nation
with the lowest X-efficiency was Thailand, with an index of 0.73 in 2001 and 0.74 in
2007. Foreign banks in Malaysia were more X and profit efficient than foreign banks in
the other countries; trade restrictions are lower in Malaysia than in the other countries.
Malaysia also had the highest ranking of economic freedom.
Chiu et al. (2010) study the effects of deregulation of the banking industry of Taiwan
during the 1980s. The deregulation took place during the early 1980s under the aegis
of the Commercial Bank Established Promotion Decree. Under the decree the number
of banks increased significantly. The increased competition raised the issue of the effi-
ciency of the banks. To answer how competition was affecting efficiency the government
placed an emphasis on the bank’s credit rating, and looked at the relationship between
a bank’s credit rating and their efficiency and productivity for the period 2001–03. The
sample consists of 34 Taiwanese commercial banks. Productivity change is measured by
the Malmquist total factor productivity (TFP) index, and is the product of efficiency
change (X-efficiency) and technological change. X-efficiency is measured by the DEA.
The results of their analysis shows that at a point in time banks with a higher credit
rating have a higher level of X-efficiency on average. Second, after the bank’s credit is
taken into account in the analysis of the bank’s level of X-efficiency, the bank’s average
level of X-efficiency is higher. This is interpreted to mean that the bank’s credit rating
is a measure of the bank’s overall (X) efficiency and the bank’s goodwill. For the entire
period average X-efficiency increased by 4.2 percent, and technological change increased
by 0.7 percent. Total factor productivity (TFP) increased throughout the period by 4.9
percent. Between increases in XE and increases in technological change, increases in XE
had a larger effect on TFP.
Chen et al. (2000) use data from 34 domestic commercial banks in Taiwan, in 1997,
to test the efficiency of commercial banks. Efficiency was measured using data envelope
analysis. Of the 34 banks, seven were publically-owned and 27 were privately owned. The
average efficiency score, the authors use the term technical efficiency in an identical way
as X-efficiency, was 0.93. Of the 11 highest scoring banks, ten were privately owned. The
publicly owned banks had an average efficiency score of 0.88, while the privately owned
banks’ average score was 0.94.
Why the difference in average efficiency scores? According to the authors, the manage-
ment of publicly owned banks do not make effective decisions. Part of this is due to the
fact that they are expected to carry out political objectives rather than restrict themselves
to pursuing economic efficiency. A second reason is that bad managers are too often kept
on the job. A third reason is that privately-owned banks are more likely to use automated

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(less labor per unit of output) banking services, and this is correlated with higher bank
efficiency.
Choi and Hasan (2005) use a sample ranging from 14 to 21 Korean commercial banks
for the period 1998–2002. This period is after Korea’s financial crises of 1997. In 1999 the
Korean parliament passed the ‘Revised Bank Law’ which required more outside board
members by Korean banks. The results of their analysis showed that after foreign owner-
ship on the board of directors reaches a certain critical mass, foreign ownership and ROA
are positively related with each other, and in a statistically significant manner. After the
critical mass is met then either superior management strategies are imported (to Korea)
or Korean management is pressured to do so on its own. The year 1999 was also the
beginning of deregulation of the banking sector. The variables for both deregulation and
foreign board members were both positive and generally statistically significant.
Shin and Kim (2011) study the effects of bank restructuring of Korean banking begin-
ning with the crises of 1997. Restructuring followed the beginning of the crises includ-
ing mergers and acquisitions, and a reduction of commercial banks from 26 to 13. The
economy recovered. From 1998 to 2007 rates of return on assets and equity, and the Bank
of International Settlements (BIS) capital adequacy increased, while NPLs decreased.
Market concentration measured by the Herfindahl–Hirschman Index (HHI) based on
assets or deposits approximately doubled.
Pure technical efficiency, or X-efficiency, averaged 0.64 for the entire period, with a
range of 1.0 to 0.25. Scale efficiency averaged 0.85 (economies of scale) with a range of
1.0 to 0.22. Higher levels of X-efficiency and scale efficiency increase both rate of return
on assets, market share and industry concentration. The effect of X-efficiency on profits
and market share is taken as evidence for the efficient markets hypothesis; firms which
survive and prosper are the more efficient firms. However, after 1997, bank profits were
increased, not by higher levels of X-efficiency, but by mergers and acquisitions increasing
scale efficiency.
An et al. (2007) used a nationwide sample of multi-branch commercial banks in Korea.
The period of study was 1987–97. The motivation was to estimate the effects of govern-
ment control of a private enterprise bank on the bank’s performance. Private enterprise
banks are still under government control since government appoints the bank’s chief
executive officer (CEO). Banks strongly influenced by the government have a relatively
high level of NPLs, and set aside a relatively small amount of capital to serve as loss provi-
sion. They also have higher cost levels, that is, lower levels of XE, and lower profits. The
authors note that these results are consistent with a bank forced to make decisions based
on political objectives rather than efficiency objectives. The authors conclude that higher
XE requires respect for private property, minimum government domination, managers
hired for their skill and not their political acumen, and free trade.
Aftab et al. (2011) study the effect of banking liberalization of the early 1990s on the
relationship between efficiency on stock performance among a sample of seven Pakistani
banks for the period 2003–07. One result of bank liberalization is that owners and inves-
tors ‘have become increasingly interested in knowing determinants of bank performance
and its relationship with share performance’ (Aftab et al. 2011, p. 3975). That is, they are
becoming more attentive to X-efficiency. Stock performance is measured by the cumu-
lative annual share returns (CASR), and X-efficiency by the DEA. Average XE scores
assuming constant returns and variable returns to scale were 0.60 and 0.80, respectively.

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Cumulative annual share returns ranged from 6 percent to 13 percent. The regression with
CASR as the dependent variable shows that XE has a positive and statistically significant
effect on CASR. About 11 percent of the change in CASR is explained by changes in
X-efficiency. In other words, more efficient banks are more successful banks, providing
support for the efficient markets hypothesis.
Akhtar (2002) investigates bank performance in Pakistan using a sample of 40 banks
for the year 1998. He defines X-efficiency as consisting of technical and allocative effi-
ciency, ‘technical efficiency, which reflects the ability of a firm to obtain maximum output
from a given set of inputs, and allocative efficiency, which indicates the ability of a firm
to use the inputs in optimal proportions, given their respective prices’ (Akhtar 2002, p.
568). For all banks, average XE was 0.8. For publicly owned, privately owned, and foreign
banks, the averages were 0.77, 0.80, and 0.75, respectively. In each case, allocative effi-
ciency exceeded XE. Of course, since XE 5 AE times technical efficiency (TE). Therefore,
AE would have to be larger than XE, the exceptions being if AE and TE were either 1.0,
or 0.0. For all banks, TE and AE were 0.86 and 0.93, respectively. For publicly owned,
privately owned, and foreign banks, TE and AE were, 0.85 and 0.90, 0.86 and 0.93, and
0.82 and 0.92, respectively. Allocative efficiency exceeds TE (XE), as it does in almost
every study. However, the difference between estimates for public and private firms is quite
small. Akhtar expected foreign banks to be more efficient when in fact they are less effi-
cient. His explanation is that, ‘most of the foreign banks in Pakistan often target a niche
market that is corporate sector which is more volatile and might make them inefficient
(Akhtar 2002, p. 574).
6 SUMMARY AND CONCLUSIONS
The sample of articles reviewed here is consistent with the vast literature on X-efficiency
over the past 15 years or so. What did we learn? Better managers, having better tech-
nology available, or being in an environment of deregulation produces higher levels of
X-efficiency. Making decisions according to political decisions reduces X-efficiency. Are
the politicians irrational? Definitely not, because they are relentlessly pursuing their goals
as well as they can, and are often successful. Issuing an IPO increases X-efficiency, at least
in the short run. Joining the WTO has the same effect: pressure for efficient behavior
produces efficient behavior. Being in an environment of economic freedom creates more
‘positive’ pressure for efficiency. Were the managers inefficient/irrational before the IPO
and/or joining the WTO? Not necessarily; they faced a different set of constraints and
given those constraints they may very well have been acting rationally. From a narrow
definition of rationality similar to the one used by Leibenstein, this is not correct. From
a broad definition it is correct. In the environment of rapid change newer banks face
tighter constraints than older banks and are more X-efficient. Managers of older banks
can enjoy the ‘quiet life’, and they often do just that: nothing irrational about that. State-
owned commercial banks are less X-efficient; income guarantees can do that. Again, the
managers/employees are pursuing their goals in a permissive environment. Their behavior
may be a rational response to the permissive environment.
Is there any inefficiency in their permissive-guided behavior? From the point of view
of the firm they will be above their cost frontier producing with ‘excess’ costs, and hence

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there is X-inefficiency. Are the managers/employees rational? They could be. Are they
thoughtless (the opposite of smart)? Not necessarily. Are they making errors in decision
making? From the point of view of the firm, yes. From their personal point of view,
maybe not.
Leibenstein’s agenda was to question the assumptions that efficiency only means alloca-
tive efficiency and that humans are fully rational. He found it necessary to use a narrow
definition of both efficiency and rationality. We can use broader definitions, and from
broader definitions X-(in)efficiency can coexist with rational behavior. Also, behavioral
economics need not be based on people being stupid. Herbert Simon told us decades ago
that human rationality is bounded. Hayek wrote about why humans can hope for nothing
more. Some are more bounded than others: size matters.
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16 The evolution of governance structures in a
polycentric system
Edward McPhail and Vlad Tarko
INTRODUCTION
A polycentric governance system is a system of several independent centers of authority

and decision-making operating under an over-arching set of formal and informal rules
(Ostrom et al. 1961; Ostrom 1991b, ch. 9, 1999; Ostrom 2005, ch. 9, 2010; Wagner 2005;
McGinnis and Ostrom 2012; Aligica and Tarko 2012, 2013; Tarko 2015; McGinnis 2016).
The overarching set of rules is necessary because the decisions of one center create posi-
tive and/or negative externalities upon others. Despite these externalities, the centers do
not merge into a single unified and centralized decision-making unit for several reasons.
First, the centers operate under heterogeneous beliefs and preferences which makes
consensus-building too difficult (McGinnis 2016). In the language of the calculus of
consent (Buchanan and Tullock 1962 [1999]), both the decision-making costs of central-
ized decision-making and the external costs of each central decision, imposed upon those
who would disagree with the centralized decisions, would be too large.
Second, the decision centers address a wide range of problems, and the solutions to
each of these problems can have very different optimal scales (Ostrom et al. 1961). This
means that decision centers have to find a way to face the problem that the scales of
operation of administrative units are rigid, while problems are fluid and come at varied,
and changing, scales. As Ostrom et al. (1961) first noted, and as Elinor Ostrom and her
collaborators later documented across a wide range of examples (Bish 1971; Bish and
Kirk 1974; Ostrom 1976; Ostrom et al. 1978; Bish and Ostrom 1979; Ostrom et al. 1988;
McGinnis 1999), the solution to this administrative rigidity problem is to have smaller
administrative units cooperate on a quasi-ad hoc basis to address larger-scale problems
as they appear. The side effect of this solution is that, rather than having a hierarchi-
cal public administration organization, we are left, by necessity, with a polycentric one.
Different decision-centers are constantly engaged in mutual adjustment, both in terms of
competing with one another and in terms of cooperating to solve larger-scale problems
(McGinnis 2016). Furthermore, in line with their heterogeneity of beliefs and preferences,
the cooperation is conditional, involving a certain degree of free entry and free exit.
A polycentric system usually does not have purely deliberate social-economic outcomes.
Similar to a market, the outcome of the operation of a polycentric system is an emer-
gent order which has certain unplanned features. These features may be desirable or less
desirable. The way in which a polycentric system addresses undesirable outcomes is by
altering the set of overarching rules, such that the emergent outcome will be improved,
for example, by limiting some negative externalities or by making broader use of the
knowledge discovered by one decision-center. Figure 16.1, adapted from the frameworks
proposed by Aligica and Tarko (2012) and McGinnis (2016), illustrates the structural
290
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The evolution of governance structures in a polycentric system 291
Multiple centers of authority
Externalities between centers

Structure:
Overarching system of rules
Heterogenous beliefs and preferences
Cooperation
Mutual adjustment:
Competition
Process: Certain degree of freedom to entry
Certain degree of freedom to exit
Outcome: Emergent order
Nature of the problem
Scale economies
Re-evaluation of
Representation
overarching rules:
Collective choice mechanisms
Information sharing
Figure 16.1 The structure and operation of a polycentric system
features of a polycentric system and the two processes involved: (1) the operational-level
process, concerned with the actual production of public goods and the emergent system-
level order; and (2) the collective-choice process, concerned with identifying problems,
giving voice to different points of view about each problem, and reforming the overarch-
ing set of rules.
The concept of polycentricity involves a generalization into the realm of public
economics of the concept of markets. Markets are one special case of polycentricity
(Ostrom 1991, pp. 229–31), but polycentricity aims to capture the characteristics of pro-
ductive and sustainable emergent orders even outside the operation of the price system.
Other examples of polycentric systems include the scientific community, competitive
local public economies, common law, and international relations (Ostrom 1991, ch. 9).
Generally speaking, the purpose of this concept is to provide insight into the conditions
under which non-market emergent orders can be expected to lead to desirable outcomes.
The concept of polycentricity was first developed by analogy to markets in the context
of the metropolitan governance debate, when the mainstream of the public administra-
tion profession was arguing in favor of consolidating the metropolitan administrations
into large centralized bodies that would take advantage of economies of scale (McGinnis

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1999; Aligica and Boettke 2009; Aligica and Tarko 2012; Boettke et al. 2013, 2016). The
Ostroms dissented from this intuition, thanks to an analogy to markets, and highlighted
the potential efficiency of local public economies:
Duplication of functions is assumed to be wasteful and inefficient. Presumably efficiency can

be increased by eliminating ‘duplication of services’ and ‘overlapping jurisdictions.’ Yet we
know that efficiency can be realized in a market economy only if multiple firms serve the same
market. Overlapping service areas and duplicate facilities are necessary conditions for the main-
tenance of competition in a market economy. Can we expect similar forces to operate in a public
economy? (Ostrom and Ostrom 1977 [1991], pp. 163–97)
From their perspective, the most likely path to efficient public administration was not
consolidation, but developing smart overarching rules that would allow productive ‘inter-
organizational arrangements’. Such arrangements ‘would manifest market-like character-
istics and display both efficiency-inducing and error-correcting behavior. Coordination
in the public sector need not, in those circumstances, rely exclusively upon bureaucratic
command structures controlled by chief executives. Instead, the structure of interor-
ganizational arrangements may create important economic opportunities and evoke self-
regulating tendencies’ (Ostrom and Ostrom 1977 [1991], pp. 163–97).
From this conceptual starting point, focused on facilitating the emergence of produc-
tive bottom-up orders in the realm of public economies, the Ostroms and their colleagues
have gathered comprehensive empirical evidence regarding the advantages, in terms of
efficiency, voice, and resilience, of such competitive public structures (Bish 1971; Bish
and Kirk 1974; Ostrom 1976; Ostrom et al. 1978; Bish and Ostrom 1979; Ostrom et al.
1988; McGinnis 1999). Half a century later, we have the empirical evidence regarding
the validity of the polycentric perspective, but a new need is felt for a deeper theoretical
understanding of the competitive aspect of polycentricity. The Bloomington studies of
local economies have shifted the debate towards much greater skepticism regarding cen-
tralization, while supporting the idea of institutional competition. However today, the
metropolitan debate, with respect to police services in particular, has reignited, owing to
the failure of ‘community policing’ (Boettke et al. 2013; 2016), and the idea that institu-
tional competition leads to a ‘race to the bottom’ still persists (for example, Geradin and
McCahery 2004).
The simplest theoretical approach has been to import into public economics the model
of perfect competition. Indeed, the Tiebout ‘voting with your feet’ model (Tiebout 1956;
Ostrom et al. 1961; Donahue 1997; Caplan 2001; Howell-Moroney 2008; Boettke and
Marciano 2016) is thought to generate efficient outcomes primarily thanks to an assump-
tion of relatively low exit costs. However, as noted by authors like Buchanan and Goetz
(1972), Donahue (1997) and Caplan (2001), such an assumption is often unwarranted
(see also Boettke and Marciano 2016). For example, capital is often difficult to relocate.
Moreover, public services and regulations are bundled into large packages and, hence,
we can rarely choose the prefered bundle of public services in the same manner as we
choose a prefered bundle of private goods. Furthermore, the payment for public services,
in terms of taxes, also does not occur in the same straightforward manner as in private
markets. Paying taxes is more similar to providing someone a grant in the hope of then
receiving a particular bundle of services. To make matters worse, the rational ignorance
of voters further diminishes their ability to constrain the public administration (Lyons

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and Lowery 1989; Lowery 1998; Boettke et al. 2011). This makes it difficult to reveal
accurately citizens’ preferences about public goods, and to establish optimal levels of
expenditure. As noted by Vincent and Elinor Ostrom (1977 [1991], pp. 163–97), while
‘[a]n expression of demand in a market system always includes reference to what is forgone
as well as what is purchased’, by contrast, ‘[t]he articulation of preferences in the public
sector often fails to take account of forgone opportunities’. As they put it, ‘[w]hereas the
income received for providing a private good conveys information about the demand for
that good, payment of taxes under threat of coercion indicated only that taxpayers prefer
paying taxes to going to jail. Little or no information is revealed about user preferences
for goods procured with tax-supported expenditures’.
These limitations do not imply that institutional competition is meaningless; they only
lead us to the conclusion that we need to model competitive public economies using oli-
gopoly and monopolistic competition models, rather than the perfect competition model.
Depending on which model of oligopoly we use (Kreps 1990, ch. 10), such as Cournot,
Stackelberg or Bertrand, and focusing on the quality of public goods rather than on
quantity, we would get different predictions with respect to the ‘price’ (that is, tax rates)
and quality of the services provided. With Cournot competition, when two (or few) com-
peting providers simultaneously choose how much to provide, we obtain a higher price
than the perfectly competitive model, but lower than the monopoly price. In the case of
Stackelberg competition, when one of the providers acts as a leader and the other as a
follower, the result is that the leader gets a higher market share. If capital costs are low,
the price under Stackelberg competition is lower than under Cournot, while the opposite
holds if capital costs are high. Under Bertrand competition, the providers compete in
terms of price rather than quality. If each jurisdiction could in principle satisfy the entire
demand (that is, no constraints of potential capacity), the outcome of Bertrand competi-
tion, even with just two providers (as long as collusion is avoided), is the same as under
perfect competition. In case of capacity constraints, some of the customers end up paying
more, while the rest of the customers pay the lowest price.
It seems to us that most public economies are better described by the Cournot and
Stackelberg models because of relatively weak constraints on tax collection – the public
sector operates under a ‘soft budget constraint’ (Kornai 1986). Even so, tax competi-
tion among jurisdictions introduces a certain element of Bertrand competition into the
picture. To the extent that Bertrand competition is present in public economies, it is
usually under capacity constraints. Such capacity constraints are partly natural, as a result
of people’s preferences against too high population densities, and partly artificial, owing
to immigration restrictions and constraints created by zoning laws (for example, leading
to higher housing prices and rents).
This brief discussion of oligopoly models shows that, although imperfect Tiebout
competition cannot be expected to lead to perfectly efficient results, we still, nonethe-
less, have reasons to believe that a certain tendency towards efficiency persists. In what
follows, we build a model of (1) interjurisdictional competition and (2) interjurisdictional
cooperation for providing larger-scale public goods, under very stringent assumptions
about knowledge and benevolence. We assume that households have no knowledge about
other jurisdictions, and decide purely on the basis of their satisfaction with their current
jurisdiction (that is, leaving decisions are blind leaps into the unknown), and we assume
that local governments operate without any inherent concern for the public interest, that

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is, as revenue-maximizing Leviathans. We can see this as a ‘robust political economy’

(Levy 2002; Farrant 2004; Leeson and Subrick 2006; Pennington 2011; Boettke and
Leeson 2012) model of the operation of a polycentric governance system. In line with
the Bloomington approach, we build a model of both interjurisdictional competition
and interjurisdictional cooperation. This allows us to model the bottom-up emergence
and evolution of governance structures, in line with the perspective first put forward by
Ostrom et al. (1961) and later elaborated both theoretically and empirically by Elinor
Ostrom and others. Our robust political economy assumptions about limited knowledge
and benevolence allow us to avoid some of the main sources of skepticism regarding the
original Tiebout model.
The next section starts by building a simple model which assumes a given scale of
jurisdictions. Section 3 relaxes this assumption describing a process by which the scale at
which a public service is provided increases or decreases, hence describing the emergence
and evolution of larger-scale governance structures. Section 4 shows that alternative
mechanisms to exit, such as voice, emerge as a consequence of some households either
not having the resources to move or still holding hope that the quality of public services
will improve. We, thus, see voice as a second-best solution: only households that find it
too costly to move (owing to a variety of costs ranging from simple moving costs all the
way to the costs of leaving behind their social networks and social capital) use voice as an
attempt to improve the public services they receive. While exit provides a direct, uncondi-
tional, benefit to the household as a result of its own action, voice provides a benefit only
conditional on what other households also agree to do.
2 A MODEL OF ENDOGENOUS QUALITY JURISDICTIONS
2.1 Assumptions
Some of the classic endogenous quality (EQ) models rely on public reputation as a quality
assurance mechanism (Klein and Leffler 1981; Allen 1984; Shapiro 1982, 1983; Rogerson
1983, 1987). By contrast, we develop here a model focused on individual household exit. A
public reputation mechanism assumes that households communicate with one another and
share their experiences of various jurisdictions. However, some of the strongest critiques of
the Tiebout model rest on the empirical observation that the amount of such information
that people in fact have is very limited (Lowery and Lyons 1989; Lyons and Lowery 1989;
Lowery 1998; Boettke et al. 2011). In the EQ model presented below, inspired by Gintis
(1989) and McPhail (1997, 2001), households know only the quality history of their own
consumption. They do not know the quality histories of other households, only their own.
Furthermore, we analyze the situation for just one public service at a time, rather than
for the bundle of all services simultaneously. At first, this may seem an odd choice, given
that public services within a jurisdiction are a package deal, and local citizens and firms
do not pay for each service individually, but only pay a unified tax. However, there are
two strong reasons for developing the model this way.
First, as long argued by the Bloomington school, from the classic Ostrom et al. (1961)
paper onward, different services are optimally provided at different scales, and the admin-
istrative structure of governance has to adapt in various ways to this diversity. In this

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chapter we are not interested in actually modeling the details of the negotiation process
between jurisdictions and the exact political mechanisms by which a given service ends
up more or less centralized. Instead, we provide only an equilibrium model highlighting
the broad presumed tendency towards which the complex underlining negotiation process
tends to lead. However, the point still holds that we need to analyze the situation issue
by issue.
The second reason is related to the issue of citizens’ limited knowledge. Boettke et al.
(2011) cite several empirical studies demonstrating that citizens have very poor compara-
tive knowledge about the public services offered by different jurisdictions and about the
tax rates in different jurisdictions. This evidence provides a strong reason to dismiss
Tiebout competition models that bundle all the services together, that is, which assume
that households do a comprehensive comparative analysis of all services across all juris-
dictions before moving. By contrast, we assume the opposite idealization, namely, that
the moving decision of a given household depends only on one service, that is, the service
they regard the most important. For example, a household that cares primarily about
the quality of the public schools will probably be informed about the public schools, but
not about many other public services. As such, the results of the surveys mentioned by
Boettke et al. (2011) are neither surprising nor relevant. Because of this more realistic
assumption about knowledge, we address the Tiebout competition with respect to each
public service separately. Each public service will have a different set of ‘marginal citizens’
who are sufficiently unsatisfied about the quality history of the public service they have
received to explore their moving options. Each such set of ‘marginal citizens’ is much
smaller than the entire population of a jurisdiction.
As this approach is based on ‘marginal citizens’, the model may not apply to all public
services, because the least important public services may not have any marginal citizens.
That is, perhaps no one’s decision to move would rest on the quality of some of these least
important services. As such, our model only covers the most important issues. The model
can be extended by assuming that individual households’ decision to move depends on
more than just a single issue, but for simplicity’s sake we do not cover such extensions here.
2.2 The Model
Suppose a jurisdiction produces an indivisible public good. Households enjoy one unit
of the good per period. For the sake of expositional clarity, we assume that households
behave according to a specific functional form. Production occurs under constant returns
to scale at a per unit cost of c(q; w), where q denotes the quality of the good, and w is the
vector of factor prices. We also assume that producing a higher quality service is more
expensive, that is, ∂c/∂q, ∂2c/∂q2 > 0 for q > 0, c(0) 5 ∂c/∂q(0) 5 0, and that there is a finite
qmax such that limq→qmax c(q) = ∞. Let T > 0 be the tax or fee paid by the household to the
jurisdiction for the good, and we denote jurisdiction’s per unit profit (rent) as p 5 T − c(q;
w). In practice, a jurisdiction collects taxes, and then has a separate fiscal decision-making
process, determining how much to allocate to fund the production of each public good.
For our purposes, it is sufficient to note that a household pays a de facto sum T for a given
service. This T is an imperfect equivalent of the price citizens pay for the service, although,
as we have mentioned in the introduction, this ‘price’ is unlikely to properly reflect the
opportunity costs of providing a particular quality of the public good.

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We define the endogenous quality model as consisting of households that behave

according to the moving-out algorithm described below and of jurisdictions that behave
as revenue-maximizing Leviathans.
2.2.1 Households moving algorithm

In what follows we focus on households ‘voting with their feet’. However, the exact same
logic applies to the movement of capital; indeed, some of the criticism of the Tiebout
model has focused on capital more than on households (for example, Caplan 2001).
Although, for simplicity, we focus on households, the results should, thus, be interpreted
in a more general fashion as referring to both households and firms.
We consider a set of households who stay with a jurisdiction for a number of periods,
and then contemplate moving when dissatisfied. These are the ‘marginal households’
for the public good under consideration, that is, those households who care about this
public good above all others and whose moving decision is influenced by the quality of
this public good. We assume that each household chooses a level of service quality qcrit
and treats the service in each period as a success if, and only if, the observed quality
is greater than qcrit. As mentioned, the critiques of Tiebout competition focus mainly
on the existence of prohibitive moving costs. In our model, moving costs simply imply
that a higher rate of failure is required before the household decides to move, that is,
moving costs cause a decline of qcrit. The household aspires to attain a certain quality
level, qasp, and faces moving costs, cmove, so that qcrit 5 qasp − cmove where qasp, cmove Î
[0,1]. The moving costs may include a wide variety of factors, from simple transporta-
tion costs and search costs, to the psychological costs due to severing local social con-
nections. If cmove 5 1 then even for very high aspiration quality such as qasp 5 1, the
household would find the costs of moving to be prohibitively high and would never
move. We assume that when qcrit ≤ 0, the district still provides some minimum level of
quality qmin > 0.
A household leaves the jurisdiction when the average number of failures exceeds the
average number of successes. Feller (1968) demonstrates that this behavior follows a
Bernoulli random walk, which becomes relevant in the jurisdictions’ calculus below.
Furthermore, in line with the empirical evidence that people have limited knowledge
about the quality of services and the tax rates in other jurisdictions, we make the weakest
possible assumption about household information: when a household decides to move
from one jurisdiction, it chooses another jurisdiction at random. That is, for people who
have very poor information about the quality of services and tax rates in other jurisdic-
tions, it is as if they are randomly choosing where to move.
2.2.2 Jurisdictions as revenue-maximizing Leviathans

Let Ft(q) be the probability that a household remains with a jurisdiction supplying quality
q for t periods. If r > 0 denotes the discount rate for the jurisdiction, so that
1
d5 [ (0,1) (16.1)
11r
denotes the discount factor, then the present value of profits from a household who stays
with the jurisdiction for exactly t periods is given by the following expression:

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1 2 dt
p (d 1 d2 1 ... 1 dt) 5 p (16.2)
r
The expected profit stream from a household that moves out after a finite number of
periods t is
`
1 2 dt
ap ␾t (16.3)
t51 r
while that from a household that never switches is
a1 2 a ␾t b
`
p
(16.4)
r t51
Thus, total expected profit is the sum of the two
␾t 1 a1 2 a ␾t b 5 a1 2 a dt␾t b
`
1 2 dt p `
p `
E [p ] 5 a p (16.5)
t51 r r t51 r t51
In accordance with the revenue-maximizing Leviathan concept (Brennan and Buchanan

1977; Buchanan and Brennan 1980, 1985; Engineer 1990; McGuire and Olson 1996),
we assume that each jurisdiction is trying to maximize its profits by collecting as much
taxes as possible and providing the cheapest possible services. However, even under such
a harsh assumption, the possibility of exit provides a check on exploitation. If there is an
interior solution for q, maximum expected profits occur when q satisfies the jurisdiction’s
first-order condition:
2 a1 2 a dt␾t b 5 0
dE [ p ] ` 0␾t 0c `
r 5 2 (T 2 c (q; w)) a dt (16.6)
dq t51 0q 0q t51
Based on equations (16.5) and (16.6) we can now derive a series of consequences.
2.3 Consequences of the EQ Model
Theorem 1: Every positive tax yields an interior jurisdiction optimum at which the tax
exceeds marginal cost and the jurisdiction earns a positive rent per unit.
Proof: Rearranging equation (16.6) and solving for T gives:
a1 2 a dt␾t b a a dt b
` ` 0␾t 21
0c
T 5 c (q,w) 2 (16.7)
0q t51 t51 0q
` t )
To sign the rent note that ∂c/∂q > 0 and that (1 2 g t51 d ␾t . 0. Hence for
a1 2 a dt ␾t b a a dt b . 0,
` ` 0␾t 21
0c
(16.8)
0q t51 t51 0q

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we need to show that

0␾t
, 0. (16.9)
0q
Recall that q denotes the probability that a unit of the good is a success. By Feller (1968)
the number of successes over failures follows a Bernoulli random walk where the transi-
tion probabilities are (1 − q) up and q down. Feller shows that the probability of stopping
at period t is the probability of a first zero crossing of a random walk at period t, which
has a generating function satisfying the following quadratic equation:
f(d) 5 (1 − q)d + qdf2(d) (16.10)
Additionally, Feller provides the solution for f(d), giving the following:
␾ (d) 5 (1 2 "1 2 4q (1 2 q) d2) /2qd (16.11)
We calculate that:
0␾ d (1 2 ␾2)
52
0q 1 2 2qd␾ (16.12)
0␾t
To show 0q , 0, we need only show that 2qdf < 1 for d, q P (0,1). However, 2qdf ≥ 1
implies that 2qdf2 ≥ f. In turn, this and f(d) 5 (1 − q)d + qdf2(d) implies that 2(f − (1
− q)d) > f, which gives f > 2(1 − q)d. Since q $ 12 in this case, this implies f > d. But this
contradicts d − f 5 (1 − 2f)qd ≥ 0. Hence the rent is positive and T ≥ c(q; w).
Discussion of theorem 1: In equilibrium, the tax equals marginal cost plus a rent. Even
with zero moving costs, the rent is still positive. The limited knowledge of households
ensures this outcome. The rent is the ratio of the expected marginal cost of quality
incurred over a household’s tenure with the jurisdiction, and the discounted marginal
change in the length of stay owing to a change in quality. It represents the tradeoff the
jurisdiction faces as it raises quality. Increasing quality means that, on the one hand, costs
rise per unit of output, but on the other hand, the expected length of time a household
stays in a jurisdiction rises as well. Because of our assumption of zero-interjurisdictional
knowledge on the part of the households, jurisdictions cannot attract more households
by raising quality, they can only retain them longer.
It is instructive to rearrange equation (16.6) as follows:
(T 2 c (q;w)) a a dt b 5 2 a1 2 a dt␾t b
` 0␾t `
0c
(16.13)
t51 0q 0q t51
p
The left-hand side is the discounted expected marginal rental stream from one household
due to an increase in quality. The right-hand side is the expected discounted marginal cost

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of quality for one household. Thus, the jurisdiction chooses quality such that the marginal
cost of quality equals the marginal profit from keeping more taxpaying citizens,
5 (T 2 c (q;w)) a 2 a dt b a1 2 a dt␾t b
` 0␾t `
0c
16.14
0q t51 0q t51
p h(q)
or,
0c
5 p (T,q,w) h (q) (16.15)
0q
The right-hand side is the additional profit the jurisdiction receives from an increase in
quality owing to the increased expected length of stay by a given household. The left-hand
side is the additional cost incurred by the jurisdiction from this increase in quality. Here,
h(q) denotes the quality elasticity of sales. It shows how responsive the length of stay of a
household is to changes in quality. Thus, it tells us how many more citizens are retained by
the jurisdiction and therefore how much the demand for public services rises when quality
rises. As mentioned, these citizens are from the ‘marginal group’ with respect to the public
service under analysis, that is, citizens who primarily care about this service.
Theorem 2: Quality is an increasing function of the tax, and a decreasing function of

factor prices.
Proof: Taking the total differential of equation (16.6), treating r as a constant, and q
and T as variables, we find that
a a d ␾t bdT 5 0
0 2E [ p ] 0 ` t
r dq 2 r (16.16)
0q 2 0q t51
and solving for dq/dT gives
a a t51dt ␾t b
0 `
dq 0q
5 .0 (16.17)
dT 0 2E [ p ]
0q 2
by the firm’s second order condition and the fact that
a a dt ␾t b , 0,
`
0
(16.18)
0q t51
as shown in the proof to theorem 1.

Costs are a function of factor prices, w, as well as quality, c(q; w). Differentiating
equation (16.6) with respect to factor price k, wk, yields

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a b,0
0q 1 0c 1 0 2c
52 1 (16.19)
0wk 0q (w,T) 0wk h (q (w,T )) 0q 0wk
0T
Discussion of theorem 2: Despite the fact that we are using the ultra-pessimistic revenue-
maximizing Leviathan concept, and despite the minimalistic assumptions about house-
holds’ knowledge, we still obtain the conclusion that jurisdictions are forced to provide
an increased benefit when raising taxes.
These results also show that if we know the tax rate or, more precisely, the fraction
from the taxes collected in the jurisdiction that go to paying for the public service we are
analyzing, and the factor prices, the model determines the quality of the service. This is
why we refer to this model as an endogenous quality model. Different jurisdictions may
differ either in terms of their implicit tax rates for each service (which is a combination of
the overall level of taxes and budget allocation decisions), or in terms of the factor prices.
Geographical and other differences between jurisdictions are captured by these factor
prices. Various federal-level policies, such as subsidizing land development in certain areas
or establishing differential policy regimes in different geographical areas, are also included
here in the factor prices.
As we would expect, if factors of production become more expensive, the quality of
services using those factors declines – unless a corresponding increase in taxes occurs. This
can have an interesting dynamic in terms of local economic development. For example,
public services such as quality roads contribute to development by reducing transaction
costs. If labor costs increase, this will have a negative effect on road maintenance. The
decrease in road quality could be prevented by an increase in taxes; however, increasing
taxes itself can have a negative impact on development. So, shocks to factor prices can
have wide-reaching consequences via a chain of effects.
Similarly, the model readily accommodates shocks to demand. Consider an especially
large outflow of households from a jurisdiction. As a result, the remaining households are
more valuable to the local government. We model this via a decrease in r or, equivalently,
an increase in d.
Theorem 3: For a given tax, a sudden outflow of households will lead, ceteris paribus,
to a rise in quality and a fall in the jurisdictional rent.
Proof: The outflow of households is modeled as an increase in d. Taking the total dif-
ferential of equation (16.2), noting that r 5 (1 − d)/d, and treating q and d as variables,
we find that
ar bdd 5 0
0 2E [ p ] 0 2E [ p ] 1 0E [ p ]
r 2
dq 1 2 2 (16.20)
0q 0q0d d 0q
and solving for dq/dd gives

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0 2E [ p ] 1 0E [ p ]
r 2 2
dq 0q0d d 0q
52 2 [ ]
.0 (16.21)
dd 0E p
r
0q 2
where
0 2E [ p ] 0E [ p ]
. 0, 50 (16.22)
0q0d 0q
by the first order condition, and
0 2E [ p ]
,0 (16.23)
0q 2
by the second order condition.

The rent, T − c(q; w), decreases because, as 0c/0q . 0, a higher quality service implies
a higher cost.
Discussion of theorem 3: Consider a jurisdiction such as Detroit which has suffered

large outflows of households. One response is for the city to attempt to provide greater
quality since each household relationship is now more valuable but, as in the case of labor
cost shocks that we discussed above, this ‘negative demand shock’ has additional effects
that can undermine the attempt to raise quality. Urban flight may well undermine the
web of social connections that made old Detroit a more attractive place to live, so, as the
number of households falls, the social capital is also destroyed, further reducing the value
of remaining in Detroit.
Interestingly, such considerations about ‘social capital’ are already implicitly included
in our model thanks to the mathematical properties of the Bernoulli random walk. We,
thus, do not need to include them as special, additional factors. The Bernoulli random
walk stipulates that the longer a household resides in a jurisdiction, the more successes it
has, and, therefore, the more failures it will take to cause the household to contemplate
moving. We can interpret this as a kind of reservoir of goodwill that the jurisdiction has
built up. The greater the number of successes, the greater the length of time a household
resides in a jurisdiction, and the more ‘forgiving’ the household is bound to be, in the
sense that it will take more failures to fully erode that goodwill. Recall that the household
considers switching only when the average number of failures exceeds the average number
of successes. So, for a household that has resided in a jurisdiction for t periods, as t grows
large, the number of failures required to prompt them to consider switching grows as well.
This stickiness or reluctance to move comes not just from the successes themselves but also
from the duration of time. We may imagine that the longer the time a household resides
in a jurisdiction the more rooted it becomes; the greater the connections – social and
economic – it has made. The Bernoulli random walk catches the flavor of this intuition,
although we have not included an explicit mechanism in our model deliberately for this
purpose. In section 4 we consider further elaborations of this idea based on the concepts
of co-production and voice. The EQ model developed so far does not allow for declines in
quality to coexist with declines in population; but, empirically, such things arguably occur.

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It is the concept of co-production, introduced in section 4, that allows us to account for

such situations.
While more work remains to be done investigating the complex interaction of these
effects, our sketch above describes some of the intuition provided by the EQ model. If
critical quality is a function of the time a household has spent in a jurisdiction, then more
structure is needed. With a more fully specified treatment we can investigate how age
composition of households, income differences, preference heterogeneity, and others have
on the provision of quality.
3 THE SCALE OF PUBLIC SERVICES
The previous section has endogenized the quality of the public services, but has not
addressed the issue of scale. Different services are best provided at different scales. To
account for the scale at which the public service is provided, we start by considering the
smallest, most local, jurisdictions as our basic unit of analysis.
For example, in Buchanan’s (1987) social contract account, the basic units are individu-
als. He noted that we should not assume ‘without inquiry, that the individual [is] locked
into membership in a political community and that the range and the scope of the col-
lective’s activities [are] beyond the control of the individual’ (Buchanan 1987, p. 306). We
need to understand ‘the conditions that must be present for the individual to find it advan-
tageous to enter into a political entity with constitutionally delineated ranges of activity
or to acquiesce in membership in a historically existent polity’ (Buchanan 1987, p. 306).
In our account, we use the smallest local jurisdictions as the basic institutional unit,
rather than individuals, but Buchanan’s point still stands, that we need to have a mecha-
nism by which the scale at which a public service is provided increases or decreases. The
previous section simply assumed that the scale at which a public service is provided is
given, and focused on endogenizing the quality of services and the rents each jurisdiction
provides. We now endogenize scale as well. We define an endogenous quality polycentric
system as consisting of EQ jurisdictions and households, and having a structure emerging
by the process described in this section.
3.1 Assumptions
We assume that larger scale provision results from smaller scale jurisdictions collaborating
to create a larger scale organization for the provision of particular services which will be
available to households in all the participating jurisdictions. We refer to the number, n, of
these smallest local jurisdictions, combining into a larger administrative unit to provide
the public service that we are analyzing. This number measures the degree to which
services are centralized. If the service is completely centralized, n 5 100 percent, that is,
all local jurisdictions have merged into a single collaborative unit, while lower n indicate
various levels of decentralization.
This way of thinking about scale fits a wide range of historical examples of both
increased centralization and increased decentralization. For example, the formation of
the United States or of the European Union (EU) involved a negotiation process among
smaller administrative units for the creation of a larger-scale association. In line with our

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model that uses jurisdictions as the unit of institutional analysis, such examples involved
the association of pre-existing jurisdictions, rather than of individuals. Similarly, exam-
ples of associations breaking up, such as the collapse of the Western Roman Empire, the
gradual reduction of the Byzantine Empire, or more recently, the break-up of the Soviet
Union or the exit of Singapore from Malaysia, also involve local jurisdictions exiting
previous associations.
The same phenomenon also happens at much more local levels. Consider a typical example
of common pool resources studied by Elinor Ostrom (1990). Following a severe overfish-
ing issue in Maine lobster fisheries in the 1920s, the local communities were able to address
the free-riding problem by appealing to a larger-scale organization, the state of Maine,
which ‘supported informal local enforcement efforts’ (Ostrom 1999a, p. 40). More recently,
the informal local fishing organizations were transformed into formalized councils with
democratic local elections and formalized authority over specified geographical areas. This
facilitated the cooperation between local communities in regard to large-scale problems and
the bottom-up emergence of larger-scale associations: ‘the formalization of local zones was
followed, almost immediately, by the creation of an informal council of councils to address
problems at a greater than-local scale’ (Ostrom 1999a, p. 40). A similar process occurred with
respect to Washington state Pacific salmon fisheries, where salmon over-fishing was solved
by means of ‘a “co-management” system that involves both the state of Washington and the
21 Indian tribes in diverse policy roles related to salmon’ (Ostrom 1999a, p. 40).
These examples show that cooperation between local communities sometimes rests on
using pre-existing larger-scale administrative units. In our simplified model, however, we
consider only the bottom-up process.
3.2 Organization Costs
In line with the above polycentric way of thinking about how larger-scale public services
are provided by an emergent collaborative agreement between smaller-scale administra-
tive units, let us define the transaction cost, F(n), involved in setting up the larger-scale
collaborative agreement. This cost is the same as the ‘decision-making cost’ from the
calculus of consent model, and, as argued by Buchanan and Tullock (1962 [1999], ch.
6), F(n) is an increasing function, F’ > 0. The larger the coalition of jurisdictions, that is,
the more centralized the provision of the public service, the greater the decision-making
cost for setting up the association. F(n) can also be understood as an entry fee that each
jurisdiction pays as a cost of becoming part of the larger collaborative association. For
example, in the case of the EU’s expansion, F is the cost of negotiating during the acces-
sion process and the costs of pre-accession reforms requested by the EU. Because of the
need for consensus in accepting a new country into the union, the larger n is, the more
difficult the entry of new countries becomes.
To develop a model of scale and equilibrium, more structure must be added to the cost
side of our model. If the only costs that a jurisdiction faces are variable, then positive
per-unit rents combined with constant returns to scale always imply positive economic
profits ex ante entry and, consequently, an indeterminate scale. As is well known in the
product quality literature, there exist various ways by which profits can be dissipated in
equilibrium.1 In our model, this is owing to the fact that as more jurisdictions join the
association, the decision-making costs increase.

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Apart from the joining fee F, we also assume that the jurisdiction incurs a per period
fixed cost, f, which we can see as an ongoing tax for being part of the larger association.
This fee accounts for things like the continued monitoring and enforcement of the rules
of the larger association.
3.3 Centralization
Our model depends on jurisdictions forming expectations about how many households
they are going to have, but does not depend on specific assumptions about how exactly
they form these expectations. This includes anything from rational expectations, to adap-
tive expectations, to utterly irrational expectations. Let h0 be the actual number of house-
holds that a jurisdiction has upon entry, and ht as the number of households a jurisdiction
has in period t. Then, for our purposes, all we need to know here is that E0(ht|h0) denotes
the jurisdiction’s expectation, formed before entry, of the number of households in period
t, given the actual number of households that a jurisdiction has upon entry.
For example, the public service may have certain economies of scale or there may be
positive interjurisdictional externalities that would be facilitated by the association (as
in the common-pool examples given above). As such, individual jurisdictions can only
provide by themselves a relatively low-quality service, and, hence, satisfy few households.
Once they form the association, the quality of the services increases, each of them keeping
more households (while jurisdictions that have not entered the association would lose
households at a higher rate). Thus, by entering the association, the jurisdiction receives
E [ p (n) ] 5 a dt c (T 2 c (q,w)) E0 (ht |h0) 2 f d

`
(16.24)
t51
p
as the expected discounted profit stream for the life of the inter-jurisdictional association.
Theorem 4: In an EQ polycentric system there exists a unique equilibrium (F*, n*).
Proof: If the present value of entry exceeds the entry fee, then the service becomes more
centralized as more jurisdictions enter. Jurisdictions join the association as long as E[p(n)]
≥ F(n). The expansion of the association ends when
a d [ pE0 (ht 0 h0) 2 f ] 5 F (n)

`
t
(16.25)
t51
Thus, in equilibrium, jurisdictions are indifferent between entering and staying out of
the association. This provides the equilibrium level of centralization, n*, and, implicitly,
the equilibrium entry fee, F* 5 F(n*).
Discussion of theorem 4: Perhaps the most surprising aspect of this model is that the
entry fee is endogenized as well. That is, the jurisdictions that are already part of the
association cannot require an arbitrarily large entry fee, nor can the new entrant require
an arbitrarily low entry fee. What happens is that the existing jurisdictions estimate a
certain increase in their individual rents as a result of accepting the new member, which

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E[π] – F(n)
10
n
5 10 15 20
–5
Figure 16.2 Equilibrium level of centralization
incentivizes them to keep the entry fee low. The costs of allowing a new jurisdiction in
depend on whether the existing jurisdictions think they are at ‘full capacity’ of households
already. If they are not, they want more immigrant households (such that tax revenues
increase). However, if joining the association improves the public services within the new
jurisdictions, fewer households would leave. This may be more than compensated by the
fact that joining the association may significantly reduce the moving costs. If the existing
jurisdictions think they are already at ‘full capacity’, they would perceive the arrival of
further immigrant households as a cost, rather than as a benefit. This, for instance, seems
to fit the perceptions driving the anti-EU campaign in Britain.
We can also have a graphical representation of theorem 3, by plotting the difference
E[p(n)] − F(n) as a function of n. The intersection with the horizontal zero axis provides
the equilibrium scale of the public service, n* (Figure 16.2).
3.4 Decentralization
Every period, a jurisdiction must decide whether to remain part of the association or
exit (Buchanan and Faith 1987). Taking the number of households as given in period t, a
jurisdiction decides to continue to be part of the association into period t + 1 by compar-
ing the expected future rents from staying in to the future stream of costs. Jurisdictions
exit when their expected profits are negative. Let h0 denote now the number of households
a jurisdiction has upon entry. Successive per period household numbers are denoted h1,
h2,. . ., and so on. A jurisdiction decides to exit the association when
p a dtE0 (ht 0 h0) ,

` f
(16.26)
t51 r
Note the role that f plays. As long as the jurisdiction is not yet at full capacity, and as
long as there remains a positive probability of attracting another household, no matter
how far off into the future this may occur, without a fixed per period cost, the jurisdiction

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would never choose to exit the association. With a fixed per period cost, a jurisdiction will
choose to exit the association if its current number of households gets below a critical
minimum2 or above the perceived full capacity level. If the membership fee, f, increases
for some reason, then the association is in danger of breaking up. This is, for example, a
common explanation of the fall of the Western Roman Empire (focused more on internal
rather than external factors) – when the costs paid by different provinces of being part of
the empire increased, they no longer had a vested interest in continuing to be part of the
empire, and the center did not have the military capacity to force them to stay (Jones 1986;
MacMullen 1990). Similarly, the recent difficulties that the EU has faced because of the
refugee crisis have suddenly increased the costs of the union, leading to moves towards
dissolution, such as suspending the open borders within the Schengen region (Alderman
and Kanter 2016; Rankin 2016).
Consider also another different example. As we have seen earlier, according to theorem
2, if the price of factors increases, the quality of the services decreases. Consequently, a
price shock to some factor markets may lead to a decline in the quality of service that
the association of jurisdictions can provide, leading to a decline in the number of house-
holds. This may push some of the member jurisdictions below their critical number of
households, leading them to exit the association, despite the fact that this will cause an
even greater reduction in quality. Thus, revenue-maximizing Leviathans can spiral into
vicious cycles.
Conversely, we can also understand the possibility of the opposite type of vicious cycle,
namely, to an over-centralization process. When centralization increases, the moving costs
increase, and, hence, the probability of moving out gets lower. As a result, once house-
holds moving costs are increased, further centralization may become profitable for the
jurisdictions. Centralization eliminates the variety across jurisdictions and, hence, benefits
the local governments providing lower quality services. That is, failing local jurisdictions,
on certain margins, are more likely to call for centralization on those margins, even if this
comes at the expense of higher quality jurisdictions.
3.5 Comparison with the Calculus of Consent Optimum
The model we developed above, from the perspective of local jurisdictions that act as
revenue-maximizing Leviathans, does not lead to the same conclusion as the calculus of
consent optimum. Buchanan and Tullock described the centralization/decentralization
optimum in the following way: ‘The group should be expanded so long as the expected
costs of the spillover effects from excluded jurisdictions exceed the expected incremental
costs of decision-making resulting from adding the excluded jurisdictions’ (Buchanan and
Tullock 1962 [1999], p. 113). As mentioned previously, F(n) corresponds to the calculus
of consent decision-making costs. Let us denote the costs of interjurisdictional spillover
externalities as S(n). Mathematically, the calculus of consent optimum level of centraliza-
tion is given by ds 5 −dF or, equivalently,
d
(S (n) 1 F (n)) 5 0 (16.27)
dn
Buchanan and Tullock (1962 [1999], pp. 44–8) refer to the total costs, S(n) + F(n), as ‘the
costs of social interdependence’.

M4225-ALTMAN_9781782549574_t.indd 306 03/05/2017 08:20

Costs
Calculus of EQ polycentric
140 consent system equilibrium
optimum
120
100
ts
cos
80 i ng
ak
- m
on
isi
60 ec
Total costs D
40
Exp
ecte
dp
rofi
ts
20 Spillov
er costs
0 n
0 20 40 60 80 100
Figure 16.3 Comparison with calculus of consent optimum
By contrast, in our model, jurisdictions decide to enter or exit a larger association based
not on interjurisdictional externalities but on their expectation of profits. That is, the col-
lective association that provides the public service gradually expands up until the entry
fee becomes higher than the expected profit, which may happen either before the calculus
of consent is reached, in which case the polycentric system remains too decentralized, or
after, in which case the polycentric system becomes too centralized (Figure 16.3).
Therefore, an important question for future research becomes: under what conditions
does the profit seeking mechanism of our Tiebout model converge with the calculus of
consent optimum? Going back to the framework of the calculus of consent, the question
is whether we can have a viable ‘invisible hand’ mechanism operating in the political realm
in the same way as we have one in the market realm:
Adam Smith and those associated with the movement he represented were partially successful in
convincing the public at large that, within the limits of certain general rules of action, the self-
seeking activities of the merchant and the moneylender tend to further the interests of everyone
in the community. An acceptable theory of collective choice can perhaps do something similar
in pointing the way toward those rules for collective choice-making, the constitution, under which
the activities of political tradesmen can be similarly reconciled with the interests of all members of
the social group. (Buchanan and Tullock 1962 [1999], p. 22 emphasis added)
We have no answer to this question here, but we highlight it as an important concern

for future research and point out that, at least prima facie, our imperfect Tiebout com-
petition model does not seem to be bounded towards the calculus of consent optimum.
As highlighted by the above quote, this may be because we have not discussed possible

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constitutional rules for constraining the Tiebout competition towards the social optimum.
Our model opens the door for conceptualizing such constitutional rules more rigorously.
4 FURTHER IMPLICATIONS
Our framework is compatible with the view that exit and voice are complementary
(Hirschman 1970; Oakerson and Parks 1988; Lyons and Lowery 1989), but, nonetheless,
exit takes precedence. This is because, in the case of exit, individual action has an immedi-
ate effect, while, in the case of voice, individual action only has an effect contingent on the
actions of others. Let us give a brief overview of how voice emerges as a strategy for the case
when the moving condition is not satisfied – either because there is still hope that the juris-
diction will perform better or because the household does not have the resources to move.
4.1 Voice and Co-production
According to the co-production model (Parks et al. 1981; Brandsen and Pestoff 2006;
Aligica and Boettke 2009; Aligica and Tarko 2013), the quality of the public service
depends not only on the local government, but also on the involvement of the households.
We can model this as a Cobb–Douglas production function (Aligica and Tarko 2013):
q 5 kHaGb (16.28)
where G is the contribution of the local government, and H is the average involvement
of all households,
1 N
H5 a hi (16.29)
N i51
with N the total number of households in the jurisdiction and hi the level of involvement
of household i.3
We now have the following implication. When one household observes that q < qcrit,
but the moving condition is not yet satisfied, that is, average number of failures is still
smaller than the average number of successes, the household is going to increase their
involvement, that is, their hi increases causing a slight increase in H. This may lead to q <
qcrit in the next period, especially if many households engage in the same kind of action,
or it may prove insufficient. If it proves insufficient for a sufficient number of periods, the
average number of failures eventually gets higher than the average number of successes,
and the household moves.
For example, suppose that the quality of education decreases below the critical level.
As a result, if they still do not move out of the jurisdiction, parents will get more involved
with education. The parents may get involved with after-school tutoring, may have fund-
raisers for the school, and they may pressure the school principal. As another example,
suppose that the quality of policing decreases below the critical level. The households may
dedicate more time to the neighborhood watch.
As we have already seen with theorem 3, as a result of the Bernoulli distribution, a long
history of past successes will make households more reluctant to leave. We can now add

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the implication that it will also determine the households to engage in more co-produc-
tion. This reflects a more specific mechanism for creating social capital. The households
that have been in the jurisdiction for longer will have greater social capital, that is, they
are more likely to engage in co-production. They act as if they have a lot more at stake in
the quality of the jurisdiction.
We may further consider possible modifications of the model that incorporate the
concept of loyalty (Hirschman 1970). One way would be through the effects that loyalty
might have on the critical quality parameter. The longer a household resides in the juris-
diction, the lower the critical quality. This is perhaps the simplest way to capture the effect
lengthening the expected stay of the household. Another way which, we believe, better
captures the intuition would leave the critical quality unchanged. Instead, as noted above,
the longer a household resides in a jurisdiction, the more likely the household is to engage
in co-production and voice to try to make the quality in the jurisdiction higher than it was
before. The household will desire to provide resources towards the provision of a public
good or goods. The longer the household has been in the community and the greater the
number of connections the household maintains with other people in the community,
the more likely they are to engage in community activism and community activities. The
longer a household resides in a particular jurisdiction, the greater the social network, the
greater the social connections, the more it feels like home.
To return to our previous discussion of Detroit, we can imagine that the large exodus
of households would adversely affect the web of social connections, making it feel less like
home, reducing social capital and causing loyalty to fall. Hence, a negative demand shock
is not the only adverse event. There are negative knock-on effects as well leading to an
additional outflow of households that will affect co-production and voice.
4.2 Income Effects
There are two types of income effects that affect moving decisions. Recall that the critical
minimal quality was defined as qcrit 5 qasp − cmove, the difference between the minimum
aspirational level and a factor that accounted for moving costs. On the one hand, income
may lower the minimum aspirational level of quality. On the other hand, households with
lower income, but high minimum aspirational quality, will be dissatisfied but will be less
able to move.
Poorer households have fewer resources to contribute to the co-production of public
services. For example, a single mother that has more than one job will have less time to
spare to contribute to her child’s education, to pay for tutoring, or to get involved to pres-
sure the public school. As a result, poorer households may have realistic expectations of
lower-quality services, which will lead them to have a lower minimum aspirational quality.
As such, low-income agents are less likely to move from their current jurisdictions even
if they could afford the moving costs. By contrast, high income agents would be more
likely to move, further reducing the quality of services because of the decline in overall
co-production participation. Consequently, those districts that initially were populated
more with low-income households would tend to keep low-income residents longer and
the higher income residents would tend to move out. We see that it is the co-production
aspect of the public goods production that is generating this sorting effect. This is a very
different mechanism from the Schelling discrimination model, and other homophily

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models, which rest on preferences about neighbors (Kossinets and Watts 2009). In our
case, households only have preferences about public services, but, nonetheless, can end
up sorting by income.
Some low-income households may nonetheless maintain a high aspirational quality.
Some may have had a very high baseline to begin with. Also, a low-income household
can have a low minimum critical quality for the package of many services, but still have
a preference for high quality of some of the services, for example, schooling. The fact
that such low-income households may find it difficult to move may counterbalance to
some extent the negative effect discussed in the previous paragraph. Unable to move
away, they will tend to use voice and the ballot box as a second best option, and they will
also be willing to engage in more co-production. These households will have a desire to
pursue co-production, community-level service provision, voice via the political system,
and other such measures whose production makes economic sense because of the lower
opportunity cost of the households. Those households do not exercise the exit option,
but instead they substitute into co-production and voice with respect to the services that
they find wanting.
This second effect is probably relatively low for most local governance issues, which
explains why lower-income jurisdictions tend to have lower-quality services, but it is a
much more significant factor for large-scale issues. When centralization is very large, the
moving costs are prohibitive for a very large segment of the population. While above
we were assuming that only the poorest households are trapped, with highly centralized
issues almost everybody is. Therefore, many will have resources to spare for using voice as
an alternative strategy for trying to improve public services. We can see this as the origins
of voice.
This relatively unintuitive prediction follows: we are more likely to see people engage
in voice with respect to highly centralized issues than with respect to local matters. This
is unintuitive because collective action is easier within smaller groups (Olson 1971).
However, exit is also easier for highly local issues.
5 CONCLUSION
We have laid out an endogenous quality polycentric system model of citizens’ behavior
and local governments’ behavior that combines:
● interjurisdictional imperfect competition, determining the quality of public goods

and tax rates within each jurisdiction as a function of citizens’ moving costs and
governments’ factor prices; and
● interjurisdictional cooperation, determining the emergent scale of public goods as
a function of organization costs.
This model is based on very weak assumptions about the knowledge of citizens and the
benevolence of governments. Citizens are assumed to know nothing except their own per-
sonal experience living within a given jurisdiction – hence, dissatisfied citizens move out
to random new jurisdictions. Local governments are assumed to be revenue-maximizing
Leviathans, taking decisions about increasing the quality of public goods or of cooper-

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ating with other jurisdictions solely on the basis of increasing their own rents (that is,
difference between tax revenues and the cost of providing public services).
We have shown that, even under such harsh assumptions, jurisdictions will not increase
taxes without increasing the quality of services, and they will respond to outflows of
citizens by increasing the quality of services. Because moving costs are not zero, citizens
will also respond to declines of quality, first by increasing their own participation in co-
production activities and by means of voice, and only as a last resort by moving out.
We have also explored various inefficiencies that can emerge within the model. Shocks
to factor prices can lead to downward spirals of quality and outflow migration. Both
under-centralization and over-centralization vicious cycles are possible under certain
conditions. Moreover, even without such vicious cycles, our Leviathan model does not
necessarily lead to the level of centralization that the calculus of consent describes as the
social contract optimum. This opens the door for further research into analyzing what
types of constitutional constraints may force the Leviathan model to converge on the
calculus of consent optimum.
NOTES
1. For example, in their seminal contribution to this literature, Klein and Leffler (1981) dissipate profits
through non-price competition: firms invest in non-salvageable firm-specific assets, such as firm logos,
expensive signs, and elaborate storefronts promoting the firm’s name, that provide the greatest direct service
value to consumers. These brand-name capital investments not only help alert consumers to the presence of
the firm’s product, but such investments also serve an important signaling role: they demonstrate the size
of the sunk capital selling costs incurred by the firm and signal to the buyer the presence of price premia.
2. To solve for critical minimum of households, the manner in which jurisdictions form their expectations must
be specified. Although we do not provide the details here, for a number of common-sense assumptions,
we obtain the intuitive conclusion that the minimum number of households a jurisdiction must expect is a
decreasing function of their probability of them moving out (see McPhail 2001 for proofs).
3. A more complex model of social capital would involve a nonlinear expression for H as a function of the
individual his. The exact non-linear expression would describe the social structure of the jurisdiction, for
example, if households i and j have a shared experience and relationship, the term hihj will appear in the
expression of H. The simple linear form in the equation above does not include any social structure, that is,
households act independently of one another.
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PART IV
TAX BEHAVIOUR

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17 Taxation and nudging
Simon James
1 INTRODUCTION
‘The art of taxation consists in so plucking the goose as to obtain the largest possible
amount of feathers with the smallest possible amount of hissing’ – a view attributed
to Jean Baptiste Colbert who served as Louis XIV’s Finance Minister for the period
1665 to 1683. The ‘art of taxation’ may be thought of in more modern terms as smart
behaviour – incorporating a comprehensive understanding of the motivation behind
individuals’ decisions regarding tax compliance. This includes not only rational decision-
making narrowly defined, which tends to focus on pecuniary rewards and punishments,
but also other factors influencing the decision-making process. Since Colbert’s time both
the economic goose and the tax feathers have grown enormously around the world, as
indicated in section 2, and perhaps it is remarkable that the hissing is not greater than it
actually is. Nevertheless tax compliance is often not as good as governments would wish
and considerable effort and resources are put into tax administration and enforcement.
The purpose of this chapter is to look beyond a tax compliance policy based on penalties
for non-compliance and to examine whether and how taxpayers may be persuaded to
cooperate by using a wider behavioural approach to tax compliance and in particular by
‘nudging’ them in the right direction drawing on the work of Thaler and Sunstein (2008)
Nudge: Improving Decisions about Health, Wealth and Happiness.
The Organisation for Economic Co-operation and Development’s Compliance Risk
Management (OECD 2004, p. 37) refers to the contribution of James et al. (2001) in out-
lining two main approaches to encourage taxpayers to comply with the requirements of
the tax system. The first of these might be referred to as the ‘rational’ economic approach
where taxpayers are assumed to respond primarily, if not exclusively, to the economic
costs and benefits of different actions. Such an approach therefore tends to focus on the
detection of tax evasion and penalties for those who are caught. The second approach
involves a wider understanding of factors influencing taxpayers’ behaviour and this
includes the application of such insights to ‘nudging’ individuals in the right direction.
This is not a completely new approach as behavioural factors have been used to encour-
age tax compliance many times in the past. For instance, the practice of withholding tax
at source rather than trying to extract it later from taxpayers can be traced back to the
sixteenth century in England (Soos 1997) and this arrangement took advantage of phe-
nomena now described in the modern behavioural literature as the endowment effect, loss
aversion and status quo bias.
Both approaches are necessary to the development of successful tax compliance strate-
gies. Unlike resource allocation through markets, where goods and services are generally
received only in return for payment, individuals might be able to receive the benefits of
public expenditure even if they avoid their tax obligations. Taxpayers may also collectively
express their unwillingness to pay tax, and there are many examples over the centuries. In
317
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England, King John’s demands for more taxation precipitated the crisis of 1215 that led
to the King’s submission and the issue of Magna Carta, and subsequently taxation was a
major influence on the development of Parliament. Its role in the American Revolution
– ‘no taxation without representation’ – is well known, although one might agree with
Callender (1909, p. 23): ‘That a great reluctance to pay taxes existed in all the colonies,
there can be no doubt. It was one of the marked characteristics of the American people
long after their separation from England.’
However, many taxpayers are willing to pay their allocated share of taxation without
being coerced by heavy-handed legal and administrative action. As Posner (2000, p. 1782)
put it, the penalty for ordinary tax convictions is usually modest, the chance of detection
often trivial and yet most individuals pay their taxes. Hence some further explanation
is required. One of the basic reasons for compliance with tax obligations is, of course,
that many taxpayers are willing to support public expenditure, even at the historically
high levels of modern times. Such basic willingness to cooperate may be reinforced using
behavioural insights to encourage or ‘nudge’ taxpayers to meet their obligations in full
and without recourse to generally less pleasant and often much more costly methods of
enforcement.
A distinction is often made between tax avoidance and evasion. Tax avoidance refers
to behaviour of individuals or businesses designed to reduce tax liability by legal means,
for example, by taking advantage of tax concessions for particular activities. Tax evasion
refers to action to reduce tax paid by illegal means, for example, by failing to disclose
taxable income. Tax evasion is the primary concern of policies to improve tax compli-
ance but developing and applying understanding of taxpayer behaviour to tax compli-
ance policy may also reduce the acceptability of ‘aggressive’ and ‘artificial’ forms of tax
avoidance.
To examine the role of behavioural factors in tax compliance the chapter begins with
section 2 on taxation to describe how large and pervasive taxation is in modern econo-
mies. Section 3 presents a summary of the contribution of behavioural economics to
improving tax compliance and indicates areas where developing nudges may have consid-
erable potential. Section 4 then specifically examines nudging and section 5 outlines some
further applications to tax issues. Finally, some conclusions are drawn.
2 THE SIZE AND EXTENT OF MODERN TAXATION
The Taxes
The relatively smooth operation of modern tax systems, and the rather limited amount
of audible hissing involved in removing the tax feathers from Colbert’s goose, may mean
many are not aware of the full extent of taxation in modern economies. It is therefore
worth examining briefly the scale of modern taxation. The figures for total tax revenue as
a percentage of gross domestic product (GDP) for members of the OECD are presented
in Table 17.1. There is some scope for variations in the way tax revenue is measured and
an important issue is whether or not social security contributions should be classed as
taxes. A useful definition of a tax is ‘a compulsory levy made by public authorities for
which nothing is received directly in return’ (James 2012, p. 247, original emphasis) and

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Taxation and nudging 319
Table 17.1 Total tax revenue as a percentage of GDP in OECD countries 2011
Including social security Excluding social security

contributions contributions
Denmark 47.7 (1) 46.7 (1)
Sweden 44.2 (2) 34.1 (2)
Belgium 44.1 (35) 29.9 (7)
France 44.1 (35) 27.4 (11)
Finland 43.7 (5) 31.1 (6)
Italy 43.0 (6) 29.6 (8)
Norway 42.5 (7) 33.0 (3)
Austria 42.3 (8) 27.8 (10)
Netherlands 38.6 (9) 23.7 (175)
Hungary 37.1 (105) 24.1 (16)
Slovenia 37.1 (105) 22.1 (21)
Luxembourg 37.0 (12) 26.0 (14)
Germany 36.9 (13) 22.7 (20)
Iceland 36.0 (14) 31.9 (4)
United Kingdom 35.7 (15) 29.1 (9)
Czech Republic 34.9 (16) 19.5 (30)
Portugal 33.0 (17) 23.7 (175)
Israel 32.6 (18) 27.0 (12)
Estonia 32.3 (195) 20.4 (25)
Poland 32.3 (195) 20.9 (24)
Spain 32.2 (215) 20.1 (265)
Greece 32.2 (215) 21.6 (225)
New Zealand 31.5 (23) 31.5 (5)
Canada 30.4 (24) 25.8 (15)
Slovak Republic 28.7 (25) 16.5 (34)
Japan 28.6 (265) 16.8 (33)
Switzerland 28.6 (265) 21.6 (225)
Ireland 27.9 (28) 23.3 (19)
Turkey 27.8 (29) 20.1 (265)
Australia 26.5 (30) 26.5 (13)
Korea 25.9 (31) 19.8 (29)
United States 24.0 (32) 18.5 (31)
Chile 21.2 (33) 19.9 (28)
Mexico 19.7 (34) 16.9 (32)
Source: OECD (2013b, Pt. II Tax levels and tax structures, table 1, p. 90).
this covers many social security contributions as they are usually compulsory and the
link between paying contributions and entitlement to benefits is often a loose one at best.
If social security contributions are included, then tax revenue as a percentage of GDP
is as high as 47.7 per cent for Denmark and over 40 per cent for Austria, Belgium, Italy,
Finland, France, Norway and Sweden. The figures for most of the remaining OECD
members are over 30 per cent. Although some countries have significantly lower tax
ratio figures they still represent enormous amounts of tax revenue. Even if social security

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contributions are excluded from the figures, six OECD countries still have tax revenues
over 30 per cent and most of the rest over 20 per cent of GDP.
In addition to the enormous amount of taxation in modern economies, the effects of
taxation throughout the economy may be more extensive than is commonly realized.
For example, even those with incomes too low to bring them into personal income tax
are still likely to pay significant amounts of taxes on goods and services. This means, of
course, that almost everyone in modern economies bears some part of the tax burden.
Furthermore, the study of the incidence of taxation shows that even the prices of goods
and services that are not directly subject to taxation may be affected by taxation on other
things. An obvious example is ‘duty free’ products at airports which are rarely priced so
as to pass on the full benefit of their tax free status to the final consumer. More generally,
the effects of taxation work their way through an economy by changes in prices, outputs,
incomes and government expenditure.
The Tax Authorities
Not surprisingly revenue authorities around the world have spent a great deal of effort
in researching factors affecting compliance. For example, in her 2014 Annual Report to
Congress, the National Tax Advocate Nina Olson commented on tax compliance research
relating to sole proprietors – a group Internal Revenue Service data show are responsible
for the greatest portion of the shortfall in tax revenue. For sole proprietors it was found
that trust in the government, the Internal Revenue Service and in the fairness of the tax
system is ‘the greatest corollary to tax compliance behaviour’. She continued: ‘Specifically,
the factors that appear to have the greatest influence on whether a taxpayer is compliant
or noncompliant are the norms of the taxpayer’s community and the provision of tax-
payer service’ (National Tax Advocate 2014, p. xi).
More generally, taxpayer cooperation will be influenced by a range of factors and
taxpayer attitudes. Tax authorities have long recognized differences in taxpayers in these
respects and the importance of developing an appropriate compliance strategy to address
them. For example, both Australia (Australian Tax Office 2002) and New Zealand (2003)
developed a ‘Compliance Model’ that links different types of taxpayer motivation and the
appropriate official response. The model incorporates a range of taxpayer attitudes at four
levels – from a definite decision not to comply to a willingness to do the right thing and
may be summarized with the appropriate compliance strategy as follows:
Attitude to compliance Compliance strategy

Have decided not to comply Use full force of the law
Don’t want to comply Deter by detection
Try to, but don’t always succeed Help to comply
Willing to do the right thing Make it easy
Tax authorities have used many ways to increase compliance in addition to possible
legal sanctions. Although it has proved very difficult to simplify tax systems, it has often
been possible to simplify tax administration as far as many taxpayers with straightforward
affairs are concerned, for example, with the one-page US return the 1040EZ. Furthermore
there has been general recognition that many taxpayers need assistance with their tax

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affairs. There have also been initiatives drawing on insights from behavioural economics to
‘nudge’ taxpayers in the right direction and behavioural economics is therefore the subject
of the following section.
3 BEHAVIOURAL ECONOMICS
Behavioural economics has recognized applications to taxation (see, for example, James
2006; Congdon et al. 2009; Leicester et al. 2012) and the potential for many more.
Behavioural economics has been described by Camerer and Loewenstein (2004, p. 3) as
increasing the explanatory power of economics by basing it on ‘more realistic psychologi-
cal foundations’ though it should be added it also draws on other academic disciplines.
Putting it another way, Camerer and Malmendier (2007, p. 235) suggested that behav-
ioural economics modified ‘the standard economic model to account for psychophysi-
cal properties of preference and judgement, which create limits on rational calculation,
willpower and greed’. However, it has become a very wide field of study and the Cabinet
Office and Institute for Government (2010, p. 16) stated one ‘weakness of the literature
around behavioural economics is there are now literally hundreds of different claimed
effects and influences’. To identify the most important topics, the present author (James
2015) surveyed three behavioural economic texts, Camerer et al. (2004), Schwartz (2008)
and Wilkinson (2008) adding the number of pages referenced for each behavioural topic.
This was not intended to be a precise exercise since many of the concepts overlap and
there are significant differences in the way each book is referenced. Nevertheless, this
exercise gave a clear indication that some behavioural topics attract far more attention
than others. Three such topics – fairness, prospect theory and emotional factors – were
referenced on over 100 pages of the three books together, and all those referenced on more
than 50 pages are shown in Box 17.1. The issue referenced to the largest number of pages
was fairness and, if ‘inequality aversion’ is included as well, fairness stands out as easily
the most prominent topic.
Fairness is one of the key aspects of a successful tax compliance policy. There have been
many cases of collective non-compliance when taxpayers’ perceptions of fairness have
not been taken into account, from the ‘no taxation without representation’ view and the
BOX 17.1 FREQUENTLY REFERENCED BEHAVIOURAL TOPICS
Fairness – opinions on the relative position of different individuals.

Prospect theory – examines decision-making involving risk and probabilities.
Emotional factors – rather than carefully thought through views.
Mental accounting – individuals may have separate accounts mentally for psychologically separate
outcomes.
Loss aversion – Losses cause more pain than equivalent gains cause pleasure.
Time preference, including myopia – preference for utility to be received sooner rather than later.
Reciprocity – responses to the behaviour of others.
Framing – the way choices are presented may influence decision-making.
Source: James (2015).

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Boston Tea Party of 1773 (see, for example, Labree 1964) to the UK’s failed community
charge or ‘poll tax’ which was a factor in the resignation of the Prime Minister Margaret
Thatcher in 1990 (Gibson 1990).
Behavioural economics has much to contribute to understanding the importance of
fairness in tax policy as it does to many other issues. All the behavioural topics in Box 17.1
have been shown to have effects on tax compliance and there is only space for some illustra-
tions from the substantial literature. Evidence indicating the importance of fairness in tax
policy is presented by James (2014). Dhami and al-Nowaihi (2007) argue that tax evasion
is more satisfactorily explained by prospect theory than it is by expected utility theory.
Murphy and Tyler (2008) found that even emotions can play an important part in tax com-
pliance behaviour. Ashby and Webley (2008) presented evidence that mental accounting
was relevant to tax compliance since it might affect whether individuals thought particular
forms of income should be taxed or not and therefore whether they were reported. Rees-
Jones (2014) showed how loss aversion is an explanation for tax avoidance. In terms of
time preference, Chorvat (2007) argued that tax compliance might be improved if tax did
not have to be paid at the same time as tax returns had to be filed. Luttmer and Singhal
(2014, p. 157) took reciprocity to mean situations where willingness to comply with the tax
system depends on the person’s relationship with the state, which includes views that taxes
are part of a social contract where taxes pay for public expenditure as well as perceptions
of legitimacy and fairness. Finally, the way issues are framed may affect public perceptions
relevant to the tax system and this may have implications for compliance (McCaffery and
Baron 2004). To summarize, each of the behavioural issues found to be most prominent
in the behavioural texts surveyed, namely, fairness, prospect theory, emotional factors,
mental accounting, loss aversion, time preference, reciprocity and framing, have implica-
tions for tax compliance and, therefore, at least a potential role in developing nudges that
might encourage taxpayers even further in meeting their fiscal obligations.
A modern concept incorporating behavioural effects and providing a useful framework
for understanding tax compliance is ‘tax morale’. This has been defined as the ‘intrinsic
motivation to pay taxes’ (James 2012, p. 262). A thorough account appears in Torgler
(2007) and an analysis of public opinion surveys relevant to tax morale is provided by the
OECD (2013c). Specific issues relating to tax morale are addressed in particular publica-
tions such as cultural differences (Alm and Torgler 2006), direct democratic rights (Torgler
2005) and religious faith and activity (Torgler 2006). Frey and Torgler (2007) found a high
correlation between tax morale and perceived tax evasion and there is other evidence that
a higher level of tax morale and institutional quality, such as government effectiveness and
regulatory quality, can lead to a smaller shadow economy (Torgler and Schneider 2007).
An important point made by Alm et al. (2004) is that taxpayers’ sense of civic duty and
therefore tax morale are more likely to be encouraged if they are treated like clients rather
than offenders. One way of doing this might be the greater use of nudging techniques
rather than legal coercion.
4 NUDGING
‘Nudging’ might be taken to mean anything designed to change individual behaviour

short of a legal obligation. In that sense tax systems are already used extensively through

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the use of tax concessions to encourage ‘good behaviour’ – such as saving in a pension
plan – and extra taxation for ‘undesirable’ behaviour – such as consuming alcohol and
tobacco or causing pollution. Individuals may not behave in the ways intended but there
would be financial consequences to their actions.
However, in their influential book Nudge, Thaler and Sunstein (2008, p. 6) defined
‘nudge’ in a more precise way: ‘A nudge . . . is any aspect of the choice architecture that
alters people’s behaviour in a predictable way without forbidding any options or signifi-
cantly changing their economic incentives.’ They suggest that to be considered a nudge a
measure should be easy and cheap to avoid. They give an example of a nudge as encourag-
ing the consumption of fruit by putting it at eye level. In contrast banning junk food does
not count as a nudge because it removes choice. They also go on to differentiate between
homo economicus or ‘Econs’ from homo sapiens or ‘Humans’. An Econ can ‘think like
Albert Einstein, store as much memory as IBM’s Big Blue, and exercise the willpower
of Mahatma Gandhi’ (Thaler and Sunstein 2008, pp. 6–7). A Human cannot behave in
such a way and can be expected to make mistakes. A nudge is anything ‘that significantly
alters the behaviour of Humans, even though it would be ignored by Econs’ (Thaler and
Sunstein 2008, p. 8). Econs primarily respond to financial incentives – such as tax conces-
sions for pension saving – and humans respond to both incentives and nudges.
Thaler and Sunstein sketch out six principles of good choice architecture. They include
for this purpose financial incentives of the sort not included in their definition of nudge
but the other five principles are consistent with that definition. These are defaults (that
people will take the line of least resistance), expect errors, provide feedback, ‘map’ the
relationship between choice and the ultimate outcome and structure complex choices to
assist decision-making. By rearranging the six key points as iNcentives, Understanding
mappings, Defaults, Give feedback, Expect errors and Structure complex choices, the
authors offer the mnemonic NUDGES illustrated in Box 17.2.
Measures based on nudging have been adopted extensively with respect to such issues as
health, pensions, personal finance and charitable giving where it is considered individuals
might make better decisions but statutory regulation is not considered appropriate (see,
for example, James 2015). In such areas, there has been much discussion about nudging
as a policy instrument concerning such matters as liberty, paternalism, fairness and prac-
tical issues – see, for example Amir and Lobel (2008), Goodwin (2012), Hausman and
Welch (2010), Sunstein and Thaler (2003), Vallgårda (2012) and Whyte et al. (2012, p. 32).
However, with regard to such issues, unlike health and so on where individual choice is
BOX 17.2 NUDGES
iNcentives – this refers to financial incentives.

Understanding mappings – the relationship between choices and outcomes.
Defaults – people tend to take the option that requires the least effort.
Give feedback – the best way to help Humans improve.
Expect error – a system should be designed to expect mistakes.
Structure complex choices – to help Humans with numerous alternatives.
Source: Based on Thaler and Sunstein (2008).

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BOX 17.3 MINDSPACE
Messenger – who delivers the message may be important.

Incentives – affect behaviour in different ways.
Norms – individuals try to conform to group norms.
Defaults – inertia is an important factor in behaviour.
Salience – the more specific and salient the more influence.
Priming – previous awareness may increase acceptability.
Affect – the emotional dimension of a response.
Commitments – trying to stick to promises and reciprocate.
Ego – behaviour towards promoting image of self.
Source: Based on Cabinet Office and Institute for Government (2010).
important, taxation is not normally voluntary but a legal obligation which is based on
collective rather than individual decision-making in each country. In taxation the issue is
not whether the state should influence individual decision-making about whether or not
to pay tax but how best to encourage individuals to do so.
Nudging is not, of course, a new phenomenon. Marketing fits the Thaler and Sunstein
(2008) definition if it does not include financial incentives for consumers. Marketing
professionals have been far ahead of academic commentators in understanding and using
behavioural factors to influence consumer choice. Governments have also used such tech-
niques to support policies designed to influence behaviour and it is not surprising that
some governments have done so with enthusiasm. For example, in the UK, the Behavioural
Insights Team (BIT) was established in 2010 in the Cabinet Office at the centre of govern-
ment specifically with the aim of helping the government develop and apply lessons from
behavioural economics and behavioural science to public policy (Cabinet Office 2010).
Perhaps it is not surprising that the BIT became widely known as the ‘Nudge Unit’ (James
2015). This initiative led to a number of developments including the Cabinet Office and
Institute for Government (2010, p. 6) publication which focuses on ‘nine robust influences
on human behaviour’ which ‘have been repeatedly found to have strong impacts on behav-
iour’ (Dolan et al. 2012, p. 265). This was condensed into a manageable ‘checklist’ which
took the form of the mnemonic MINDSPACE shown in Box 17.3.
The Nudge and Mindspace contributions cover similar ground and both explicitly
incorporate incentives defaults. However, the NUDGE mnemonic also gives prominence
to important aspects of process – such as expecting errors and structuring complex
choices – which are particularly relevant to taxation. MINDSPACE explicitly includes
norms which have a particular role in tax nudges as well as the delivery of the message,
salience and priming which also have explicit tax applications.
5 TAX NUDGES
NUDGE and MINDSPACE both offer incentives and defaults as key headings and
MINDSPACE also highlights norms. All three have particular relevance for taxation so
this section will concentrate on incentives, defaults and norms in turn.

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Incentives
Incentives cover the first of the two main approaches to tax compliance summarized in
the introduction: that taxpayers are ‘rational’ and make decisions on the basis of mon-
etary outcomes. Such taxpayers fit Thaler and Sunstein’s (2008) concept of an Econ – a
person motivated only by financial incentives and disincentives and capable of precise
calculations of advantage and disadvantage. A tax compliance policy based on such
assumptions would concentrate on such factors in the form of detection and penalties
for non-compliance. However, most, if not all, taxpayers at least partly fit Thaler and
Sunstein’s model of Humans who are motivated by a wider range of factors. Such taxpay-
ers are not necessarily motivated by monetary considerations alone, are not very good at
complex calculations and make mistakes.
The main difficulty with the first approach to compliance is that too much reliance
on the assumption that taxpayers are Econs may have adverse effects on Humans. In
principle at least, the purpose of taxation is to improve well-being, and the benefits of
public expenditure should therefore exceed the costs of taxation. If a system based on
penalties is implemented too zealously it can lead to additional costs in terms of ‘pain
and suffering’ as described by Payne (1993) who presents evidence that anxiety has been
deliberately used to promote tax compliance. Among other things, Payne (1993, p. 130)
quotes a former official of the US Internal Revenue Service (IRS) who begins his book
(Strassels 1981, p. 3) by claiming that the IRS has worked hard to create ‘a state of fear
and loathing’ among taxpayers and that nothing ‘is more central to the IRS strategy of
tax collection than scaring you, the taxpayer, and keeping you that way’.
Furthermore, if taxpayers are Humans rather than Econs, an unduly harsh policy of
enforcing tax compliance may produce undesirable and unnecessary side effects such as
taxpayer resistance. For instance, both Schmölders (1970) and Strümpel (1969) described
German taxation at the time as being very rigid in its assessment procedures which led
to an effective but expensive and confrontational system. A notable outcome ‘of the
relatively coercive tax-enforcement techniques is the high degree of alienation from the
state . . . [which] negatively influences the willingness to cooperate’ (Strümpel 1969, p. 29).
Furthermore, there may be an unwillingness to undertake legitimate commercial activities
if there is a risk of heavy-handed treatment by the tax authorities. If this leads to a reduc-
tion in the level of economic enterprise it might not only reduce the amount of taxation
paid, so directly undermining such a harsh policy, but there might also be wider implica-
tions such as making a country less productive and competitive in all sorts of ways – an
increasingly important consideration in a global economy.
Instead of depending too much on such an approach, it might be better to develop the
behavioural approach which might improve compliance without the undesirable effects.
Defaults
Thaler and Sunstein (2008, p. 83) describe defaults as ubiquitous and powerful and this is
certainly true in tax administration. One of the main defaults is withholding tax at source
so the tax does not even pass through the hands of taxpayers but instead goes directly to
the tax authority. As pointed out in the introduction, withholding can be traced back to
sixteenth-century England (Soos 1997) and is a standard feature of many tax systems. The

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OECD (2013a), in compiling information on OECD and some other selected countries,
found that withholding tax at source is very widespread for personal income tax and, in
most countries where applicable, for social security contributions as well. Many countries
also have withholding arrangements for interest and dividend income. It is possible that
withholding tax might encourage an underground economy but for most employees and
other taxpayers this is not a realistic option. A further nudge to comply is that there are
widespread mandatory reporting arrangements for a wide range of payments.
Such mandatory reporting together with technological developments has led to an even
bigger nudge with pre-filled or ‘pre-populated’ tax returns. These are returns incorporat-
ing information received from third parties about the taxpayer’s income and other details,
and the development of pre-filled returns has been examined by Highfield (2006). The role
of the taxpayer in this process is to confirm that the information on the return is correct
or amend it and to supply any other information required. Pre-populated returns have
been used for some time. Denmark first introduced such arrangements in 1988 though
originally the system was quite primitive since the amount of information that could
be collected and processed was limited. However, the arrangements were progressively
enhanced during the 1990s and similar arrangements were introduced in Sweden in 1994
and Norway in 1998. As the application of technology to tax administration progressed,
other countries have also introduced pre-filled returns, for example, Australia in 2006
(Evans and Tran-Nam 2010) and these developments are being considered elsewhere.
Such returns can contain details of most major sources of income together with the tax
withheld, asset purchases and sales, specific deductions that are obtained from third party
sources or calculated according to a formula, personal tax allowances, tax credits and,
even, calculations of tax payable or overpayments of tax to be refunded.
Norms
The observation that individuals conform to social or group norms was one of the head-
ings in MINDSPACE. Although it was not included in the acronym NUDGE, Thaler and
Sunstein (2008) not only discuss a social norms approach but actually give a tax example.
This consisted of experiments conducted in 1995 by the Minnesota Department of
Revenue to assess different strategies for increasing voluntary compliance with personal
income tax. Four strategies were tested. Three of these were the examination or audited
tax returns with prior notice to the taxpayers, improved customer service and the redesign
of the tax form but these strategies were found to lead to modest or no improvement in
tax compliance. The fourth strategy involved sending two information letters. One of the
letters described the public expenditure funded by taxation – health, education and so
on – but it did not lead to any improvement in compliance. The other letter pointed out
that perceptions of widespread tax evasion were incorrect and, according to the available
data, there was a high level of compliance. This letter reinforced social norms about tax
compliance and had a significant and positive effect (Coleman 1996). This had not been
anticipated but clearly could be an effective improvement in the decision-making envi-
ronment for compliance so the Minnesota Department of Revenue undertook a second
randomized controlled experiment with the letter the following year which confirmed
the original findings (Coleman 2007). The letter also attracted much wider attention and
became known as the ‘social norms letter’. Further evidence that perceptions of social

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norms influence tax compliance behaviour has come from a range studies including Bobek
et al. (2007, 2013), Posner (2000) and Wenzel (2005). A particular study by Hallsworth
et al. (2014) used two large natural field experiments involving over 200 000 individuals
in the UK to demonstrate that tax compliance was considerably improved by including
social norms and public goods messages in standard reminder letters about tax payments.
An important dimension is whether taxpayers prepare their tax returns themselves or
use a professional tax preparer. A study by Hasseldine et al. (2007) in the UK used actual
taxpayer returns of sole proprietors who, as indicated in section 2 above, have been iden-
tified as a group associated with particular compliance risks. This study distinguished
between sole proprietors who prepared their own returns and those who used paid pre-
parers and examined the comparative effects of letters containing a range of normative
and sanctions based messages. Of the two normative letters, the first offered taxpayers
assistance and the second indicated that the norm is to comply and reminded individu-
als that their taxes are spent on ‘things like hospitals, schools and pensions’. The three
sanctions-based letters mentioned in turn increased risk of audit, possible penalties and,
the third letter, that the taxpayer had already been selected for audit. When compared
with a control group who did not receive any of these letters, all the letters had signifi-
cant effects but they differed between the self-preparers and those using paid preparers;
for example, the letter based on norms and public spending was more effective with the
self-preparers. This seems to lead to the reasonable conclusion that nudges adapted to the
circumstances of particular taxpayers are likely to achieve the most success.
6 CONCLUSIONS
The size and pervasiveness of taxation in modern economies makes tax compliance an
important part of government policy. There are two main approaches to promoting com-
pliance, one based on the assumption that taxpayers make ‘rational’ economic decisions
and the other taking into account a wider range of behavioural factors. The economic
approach to compliance will always be necessary as there is a legal obligation to pay
taxes which ultimately has to be supported by a system of penalties for non-compliance.
However, too much reliance on such an approach and over-zealous enforcement can result
in unduly heavy costs of compliance, the possibility of alienating individuals from the
state and, perhaps, a reluctance to undertake economic activity if there is perceived to be
a risk of inappropriate and severe responses from the tax authorities.
Therefore there is a strong case to supplement the economic approach to compliance
with a more comprehensive approach, and it is particularly helpful to draw on the insights
available from behavioural economics in general and the literature on ‘nudging’ in par-
ticular. A whole range of possible ways in which a behavioural approach may support tax
compliance are discussed in the chapter but, given Thaler and Sunstein (2008, p. 100) came
up with the mnemonic NUDGE and the Cabinet Office and Institute for Government
(2010) with MINDSPACE, this chapter offers a third mnemonic to summarize the
contribution to tax in the form of COMPLIANCE shown in Box 17.4.
Box 17.4 indicates how choice architecture can make significant improvements to the
lives of others through the design of ‘user-friendly environments’ (Thaler and Sunstein
2008, p. 11). ‘Opt-out’ rather than ‘opt-in’ reflects default arrangements which are widely

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BOX 17.4 COMPLIANCE
Choice architecture – creating a user-friendly environment.

Opt-out rather than ‘opt-in’ policy – or defaults.
Mental accounting.
Preference (time).
Loss aversion.
Incentives – financial.
Assistance for taxpayers.
Norms.
Cultural factors which affect tax morale.
Equity – fairness.
Source: Author.
used in tax administration particularly by withholding tax at source. The roles of mental
accounting, time preference and loss aversion were among the topics included in the
summary of the contribution of behavioural economics in section 3. Incentives represent
the financial factors involved in the economic approach to compliance. Assistance to
taxpayers was included in the discussion of tax authorities in section 2. Norms turn out
to be an important factor in taxpayer decision-making, as is tax morale, and probably
the single most important factor is equity or fairness. As mentioned above, there are
hundreds of behavioural effects and influences and it is clear that many of them have at
least the potential to play a useful role in successful tax compliance strategies. A narrow
definition of rationality leading to a focus on penalties to enforce compliance is not suf-
ficient to develop successful arrangements regarding tax compliance policy. Instead, a
wider definition of rationality is required involving smart behaviour incorporating a more
comprehensive understanding of the motivation behind individuals’ decisions regarding
tax compliance.
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18 Income tax compliance*
Erich Kirchler, Barbara Hartl and Katharina Gangl
INTRODUCTION
Tax evasion and aggressive tax avoidance are significant problems in most societies
and represent an important source of a potential loss of revenue for governments.
Understanding taxpayers’ behavior and fostering tax compliance are therefore important
challenges for the state. The traditional economic approach to tax behavior assumes that
taxpayers are rational decision makers trying to maximize their utility while filling in their
tax returns. From the individual perspective, the smartest thing to do would be to evade
taxes as long as the probability of getting caught is low and the expected fine is small.
This assumption is also reflected in the public opinion that tax evasion is a game won by
the clever and the intelligent (Kirchler 1998). Honest taxpayers are perceived to be hard
working, but not as intelligent as tax evaders. This is puzzling, as in many countries in
the world tax honesty is rather high compared with the low audit rates (Kirchler 2007).
Citizens value public goods and comprehend the necessity of tax collection to finance
them, but are at the same time often reluctant to accept the full burden of their taxes.
Indeed, since the beginning of tax collection, taxpayers have complained, and their com-
plaints survive in the hieroglyphics of ancient Egypt and in the work of scholars from
medieval times until today. For instance, Thomas Aquinas (1225–74) is said to have coined
the description of taxes as ‘legal theft’; and Peter Sloterdijk (2010) wonders why the public
has not engaged in a civil rebellion against the prodigious enlargement of the tax base,
which he perceives as the equivalent of socialist expropriation.
In a recent survey in Germany, taxpayers show an ambivalent attitude towards taxa-
tion and taxes: although the majority of respondents maintain that paying taxes is a
duty which must be respected, a vast majority complain that the tax burden is much too
high, the legal and bureaucratic procedures of filing taxes are complex and too time-con-
suming, and politicians spend tax money wastefully (Deutsche Wirtschafts-Nachrichten
2014). Tax attitudes vary among taxpayers: the self-employed appear to hold more
negative attitudes than white collar workers or civil servants (Kirchler 1998), and citizens
expressing preferences for liberal and right-wing political parties also express preferences
for ‘less state’ and lower taxes as compared to those who typically vote for left-wing parties
(Lozza et al. 2013; Sussman and Oliviola, 2011).
The desire to reduce taxes can be even stronger than rational maximization of one’s
own income, leading to the selection of suboptimal options. Sussman and Oliviola (2011)
presented scenarios describing two stores selling television sets which the participants
were to imagine purchasing. They were invited to choose either buying the television at
full price in a store nearby or to take a 30-minute drive to a store offering a discount. In
one scenario the discount was related to taxes (tax-free discount equivalent to 8 percent
discount); in the other scenario, taxes were not mentioned but the discount was slightly
larger (9 percent discount). Willingness to take the 30-minute drive was significantly
331
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higher if the discount was related to taxes, even if the discount was smaller. If taxes can be
avoided, people are also willing to wait longer for a commodity, to invest in riskier assets,
and express higher acceptance when confronted with moving to a country with a longer
daily commute (Sussman and Oliviola 2011).
People perceive tax evasion as illegal and unacceptable, whereas they endorse tax avoid-
ance, defined as the legal reduction of taxes (Kirchler et al. 2003). Tax avoidance refers
to the reduction of the tax burden within the limits of the law, for instance, through the
exploitation of tax loopholes. Tax avoidance can be perceived as a positive and clever act
(Kirchler et al. 2003). In contrast, tax evasion is seen as immoral, illegal and as a form
of fraud associated with the shadow economy (Kirchler et al. 2003). Also, tax avoidance
in the form of aggressive tax planning against the spirit of the tax law, such as the cross-
border money shifting of international companies, is seen as unfair by many taxpayers
and provokes protests by the media and the citizens. For example, in 2011, the information
technology company Apple made a profit of US$22 billion, but owing to aggressive tax
planning, the company paid less than 1 percent of its profit in taxes (Szigetvari 2014).
When Starbucks was accused of aggressive tax planning in the United Kingdom by the
media, consumers took to the streets in protest of this non-cooperative behavior and
boycotted Starbucks stores (Cambell 2012).
In this chapter, we start with the economic perspective on tax behavior which has tra-
ditionally dominated tax research. Tax-paying decisions are conceptualized as decisions
under uncertainty, shaped by the probability of audit and the severity of punishment in
case of detected wrongdoing. We then present the results of psychological tax behavior
research and consider different segments of taxpayers and their respective attitudes
towards taxes. In the following section, tax behavior is discussed as a behavior in a social
dilemma situation with decisions influenced by rational utility maximization and beliefs
about other taxpayers’ behavior. In this section, we briefly present a survey conducted on
emotions, the perceived power of authorities and compliance. In the penultimate section,
we illustrate how the interaction between taxpayers and tax authorities determines coop-
erative interaction climates and corresponding forms of tax cooperation. We conclude
with a discussion of current developments in the field and future research directions for
tax psychology.
2 THE ECONOMIC APPROACH
The neoclassical economic approach to tax behavior is based on the assumption that tax-
payers, aiming to maximize their utility, are confronted with a decision under uncertainty.
It is suggested that taxpayers calculate which of the two options – paying taxes honestly
or evading taxes – provides the greatest value. If effective audits with severe fines are in
place and the probability of audit is high, a taxpayer should be honest because the risk of
being caught and fined outweighs the small chance of gain through evasion. In contrast,
if audits are rare and fines low, a rational taxpayer would choose to evade taxes because
the risk of being caught is low and, even if that were to happen, the fine is low. Since
taxpayers seek to accrue higher profits, they would always evade if audits and fines were
absent (Allingham and Sandmo 1972; Srinivasan 1973). Audits and fines are the keys to
ensuring tax compliance.

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Income tax compliance 333
Empirical research suggests that the effect of audits and fines is more complex than
assumed in the economic theory of crime (Becker 1968). Indeed, the effect of audits
and fines is smaller than theoretically expected and sometimes in the opposite direction
(Andreoni et al. 1998; Kirchler et al. 2010). In many countries in the world, the probabil-
ity of audit is low, which should result in low tax honesty; however, tax honesty is rather
high compared to the low audit rates (Kirchler 2007). For instance, the Internal Revenue
Service in the United States (IRS) audited only about 1 percent of the more than 137
million returns filed by taxpayers in 2008 (Bible 2010). Despite the low audit probability,
about 80 percent of total reportable income is assumed to be reported correctly, while
18–23 percent of reports are incorrect (Cebula and Feige 2012).
The contradictory effects of audits may be due to the fact that it is hard for people
to deal with uncertainty. They often underestimate or overestimate the likelihood of
events. Therefore, the perceived and objective probability of audit may differ significantly
(Fischer et al. 1992). The effect of audits seems to vary more with their perceived severity
than with their actual severity. The more severe audits and fines are perceived to be, the
stronger their impact on tax compliance (Alm et al. 1992; Kirchler 2007; Mulder et al.
2009). For instance, frequent audits at the beginning of an individual’s professional life
in contrast to later audits may increase a taxpayer’s perception of high audit probability
and lead to sustainable tax compliance. Tax experiments in which participants file taxes
on earned income over a ‘lifespan’ of 60 filing periods showed that audits conducted at the
beginning of the 60 rounds (in contrast to later audits) lead to an increase in tax compli-
ance and keep tax compliance high even if the frequency of audits decreases in the later
rounds (Guala and Mittone 2002).
Misperception of chance can also lead to the opposite of the intended effects. The
same tax experiments also showed that tax compliance decreases immediately after an
audit takes place (Guala and Mittone 2002; Kastlunger et al. 2009). It seems that after an
audit, taxpayers feel safe from another audit in the next round and choose risk-seeking
behavior. This phenomenon is referred to as the ‘bomb crater effect’ (Guala and Mittone
2002) following the observation in World War One that soldiers under heavy fire believed
themselves to be safe in the craters of recent explosions, assuming it would be unlikely for
two bombs to fall in the same spot. Likewise, taxpayers may underestimate the likelihood
of upcoming audits immediately after they have been audited (Kastlunger et al. 2009) and
therefore evade. Instead of the objective audit probability, it seems that the perceived audit
probability determines tax compliance.
Beside audits, fines are assumed to be a useful measure to diminish tax evasion.
According to classical economic assumptions, the amount of a possible fine has a posi-
tive effect on taxpayers’ willingness to pay taxes honestly (Allingham and Sandmo 1972).
This effect might be undermined by causing reactance instead of subordination (Kirchler
2007), that is, taxpayers become motivationally aroused by the tax law as a threat to
their behavioral freedom (Brehm 1989). The implementation of fines per se may lead to
reactance and negative attitudes towards the tax authority. As such, the imposition of a
fine can also crowd out the intrinsic motivation to comply (Feld and Frey 2002). Gneezy
and Rustichini (2000) studied parents’ behavior in Israeli daycare centers before and after
the introduction of a fine for late picking up of their children. After the introduction of
a monetary fine for latecomers, delayed picking-ups increased rather than went down.
Instead of feeling guilty about their late picking-ups, parents had a clear conscience about

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leaving their children longer under custodial care and made less of an effort to be punc-
tual. Rather than being perceived as a fine, the payment was gladly accepted as a ‘price’
for prolonged custody.
Generally, audits and fines impact tax compliance positively, but the effect is smaller
than theoretically expected, and sometimes audits and fines backfire (Alm et al. 1995;
Gangl et al. 2013). Audits might be perceived as an unpleasant experience whose prob-
ability of occurrence decreases immediately after an audit has occurred; fines sometimes
might be perceived as a ‘price’ people are willing to pay. Audits and fines can also be per-
ceived as a signal of mistrust from the tax authority and elicit mistrust in the authorities
and non-cooperative behavior (Alm et al. 2012; Feld and Frey 2007).
3 DIFFERENTIAL EFFECTS
Taxpayers are not a homogeneous group of people trying to evade taxes. Instead, based
on different socio-demographic characteristics and experiences with the tax authorities,
taxpayers can be assumed to differ in their motivation to pay taxes and in their compli-
ance. Women and older taxpayers as well as employees taxed at source are found to be
more compliant than men, younger taxpayers, and self-employed taxpayers (Kirchler
2007; Torgler 2006). Based on such differences, tax authorities could segment taxpayers
into groups and take a different approach with each group. Audits and fines may be most
appropriate to enforce compliance among taxpayers intentionally evading, whereas they
should assist and educate those who want to comply but fail to do so owing to the com-
plexity of tax law (Braithwaite 2003b).
Women are often found to be more compliant than men. This effect seems to have
social rather than biological reasons (Kastlunger et al. 2010). The classic social role of
women is typically associated with pro-social and cooperative behavior, in contrast to the
social role of men (Fallan 1999; Kastlunger et al. 2010). Empirical research shows that
it is only those women who identify with the classical gender role that differ from men
in their tax compliance (Kastlunger et al. 2010). However, self-employed women, who
seem to identify less with the classical role and more with their occupational role, which
is associated with values such as competitiveness and dominance, do not seem to be more
compliant than self-employed men (Gangl et al. 2013). As a consequence, gender could be
a criterion for tax authorities to differentiate among employed taxpayers but not among
self-employed taxpayers.
Tax compliance seems to increase with age. Older taxpayers are consistently found to
be more tax compliant than younger taxpayers (Frey and Torgler 2007; Kirchler 2007;
Lewis 1978; Sidani et al. 2014). The reason might be that age correlates with knowledge
about taxes, experiences with taxes, and a better understanding of the tax law, which in
turn enhances trust in tax law. Moreover, knowledge about taxes enhances the opportu-
nities for a taxpayer to legally reduce their taxes instead of illegally evading them. For
instance, younger taxpayers with less experience might not put money aside during the
year in order to pay their taxes at the end of the year (Muehlbacher and Kirchler, 2013).
In contrast, based on ‘mental accounting’, older taxpayers are more likely able to separate
gross income into net income, tax duties and social security payments and consequently
put tax money at least ‘mentally’ aside, which ‘prepares’ them to pay taxes. Rather than

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having the feeling that they are paying out of pocket, and thus experiencing a loss when
paying taxes, mental accounting leads to the perception of a forgone gain in addition to
the net income when paying taxes, and thus, to less risk-seeking behavior. While younger
taxpayers may experience an unpleasant surprise when filing and paying taxes, older
taxpayers are aware of their tax liability and know approximately how much money they
have to put aside for taxes (Muehlbacher and Kirchler 2013). Based on these assumptions,
it can be assumed that tax authorities who provide young self-employed people and less
experienced businesspeople with services introducing them to the tax law and tax proce-
dures would increase tax knowledge while improving money management related to taxes,
which would lead to higher compliance.
Income has been investigated as a potential moderator of tax compliance. From a
theoretical perspective, high-income earners could be either more or less compliant than
low-income groups, and empirically, income has been found to be both related and unre-
lated to compliance (Allingham and Sandmo 1972; Srinivasan 1973). High income might
increase an individual’s willingness to take the risk of evading taxes because possible fines
might be seen as easy affordable. Conversely, low income might also increase the motiva-
tion to evade taxes because the money spent on taxes might represents a larger fraction
of available income. The results of empirical studies are inconclusive (Pickhardt and Prinz
2014). It seems that factors related to income, such as source of income, might play a
relevant role (Durham et al. 2014). For instance, experiments show that taxes on windfall
gains are more likely to be evaded than money earned through hard work (Muehlbacher
et al. 2008).
Occupation has been tested as an essential determinant of tax compliance and an
important segmenting criterion. Employed and self-employed taxpayers differ in their
opportunities to evade taxes. Also, in many countries, employed taxpayers’ income is
taxed at source as compared to the self-employed, who take home their gross income and
pay taxes out of pocket (Antonides and Robben 1995; Engström and Holmlund 2009;
Webley et al. 1991, 2001). Self-employed people who pay taxes out of pocket not only face
more opportunities to engage in ‘creative’ tax planning, in the concealment of income
and the exaggerated deduction of expenditures, but also have a tendency to exhibit more
risk-seeking behavior as they often perceive paying taxes as a loss (Antonides and Robben
1995). According to the prospect theory (Kahneman and Tversky 1979), taxpayers are
expected to either be risk averse or to take the risk and evade, depending on whether
taxpayers conceive of their tax decision as within a forgone gain frame or a loss frame.
Prospect theory also explains withholding phenomena: it is to be expected that people
who have, for example, already paid taxes in advance in the form of monthly contributions
and then have an additional sum to pay at the end of the fiscal year experience this balance
as a loss and are reluctant to pay additional taxes. In contrast, taxpayers with the same
total amount of tax liability who have already paid all of their taxes in advance, resulting
in a year-end refund, may experience their taxes when filing at the end of the year as a
gain and tend to be loss averse, resulting in willingness to declare revenue and expenses
correctly. A study by Cox und Plumley (1988, cited in Webley et al. 1991) shows that
these assumptions might be accurate. The authors investigated 50 000 tax declarations in
the US and found that willingness to pay taxes depended upon whether a taxpayer was
expecting a refund from the tax authorities or faced a balance due. For wage earners, it
has been demonstrated that willingness to pay taxes reaches 96 percent when a refund is

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100
Wages and salaries
95
Compliance rate in percentage
90
Business income
85
80
75
70
65
< –1000 < –500 < –100 <0 >0 > –100 > –500 > –1000
Size of refund or balance due ($)
Source: Cox and Plumley (1988), cited in Webley et al. (1991, p. 84).
Figure 18.1 Willingness to pay taxes as dependent upon the type of tax and the size of
refund or balance due at the end of the fiscal year
expected. On the other hand, when a balance due is expected, willingness to pay drops to
89 percent. People with business income act even more clearly according to the predictions
of prospect theory: willingness to pay varies from 96 percent to 70 percent, depending on
whether they expect to receive a refund or make an additional payment. Figure 18.1 illus-
trates the results of Cox and Plumley’s (1988, p. 84) study. Similar results were achieved
by Schepanski und Kelsey (1990) and Schepanski und Shearer (1995) as well as by Elffers
and Hessing (1997) and Kirchler et al. (2005).
Taxpayers do not only differ in their socio-demographic characteristics, but also in
their experiences and relationship with the tax authorities, factors which are also sug-
gested to result in differences in individual motivations to be honest. Braithwaite (2003a)
distinguishes among five motivational postures of tax compliance based on the social
distance taxpayers perceive towards the tax authority. Two motivational postures (com-
mitment, capitulation) represent an overall positive orientation to the tax authority. The
motivational posture of commitment describes taxpayers who feel morally obliged to pay
taxes; they are open to admitting mistakes and want to correct them. Taxpayers holding
the motivational posture of capitulation are not as committed; rather, they accept the tax
authority as a legitimate authority and give in to this authority. The other three motiva-
tional postures (resistance, disengagement, game playing) express a negative tendency to
cooperate. Resistant taxpayers doubt that the tax authority intends to behave coopera-
tively and keep their guard up. Disengaged taxpayers see no sense in cooperating and try
to keep their distance from the tax authorities. ‘Game playing’ reflects a motivational
posture and attitude toward laws, whereby the law is seen as something that can be used
for one’s own advantage (Braithwaite 2003a).

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Motivational postures Strategies to promote tax Regulatory strategies

compliance
Command regulation
Disengagement (non-discretionary;
(individuals, groups evade taxes) Prosecution exhaustion of all legal means)
Resistance
Audit
(individuals, groups Command regulation
with/without penalty
do not want to be tax compliant) (discretionary; tax audits)
Real time
Capitulation Enforced self-regulation
business examinations;
(individuals, groups (support and assistance
record keeping reviews
try to be tax compliant) with tax declarations)
(tax and business data)
Commitment Self-regulation
Education;
(individuals, groups (simplification of the tax
record keeping (tax and business data);
feel a moral declaration in order to
service delivery
obligation to be tax facilitate and ease
(convenience, access, choice, control)
compliant) correct behavior)
Source: Adapted from Braithwaite (2003b, p. 3).
Figure 18.2 The responsive regulation approach based on different motivational postures
of taxpayers
Based on these motivational postures, the Australian Tax Office has proposed a system of
responsive regulation in order to address taxpayers effectively (Braithwaite 2003b). The
responsive regulation approach requires tax authorities to apply different strategies to
ensure tax compliance for taxpayers with differing motives to comply or not to comply.
The regulatory pyramid (Figure 18.2) serves as a guide for a tax authority’s response to
non-compliance and is based on the opinion that it is less costly to resolve a problem
at the bottom of the pyramid than to allow it to escalate to the top of the pyramid
(Braithwaite 2003b). Instead of treating all taxpayers alike, the tax authorities should
approach taxpayers depending on their motivational posture. Taxpayers who intention-
ally evade taxes should be confronted with the full rigor of the law. In contrast, taxpay-
ers who hold positive motivational postures of commitment and capitulation should
get assistance and support from the tax authorities (Braithwaite 2003b). Figure 18.2
conceptualizes the responsive regulation approach. The bottom of the pyramid mirrors
empirical findings indicating that most taxpayers hold motivational postures reflecting
a compliance-minded attitude (Braithwaite 2003b). The appropriate strategy of the tax
authorities for most taxpayers would be to facilitate compliance by educating taxpayers
and providing services. Conversely, the tax authorities should apply the full force of the
law only for the minority of intentional resistant evaders, represented by the top of the
pyramid (Braithwaite 2003b, 2009).

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4 SOCIAL NORMS AND SOCIAL DILEMMAS
Taxpayers do not pay taxes in a social vacuum (Mittone and Patelli 2000) and do not
only consider the balance between the tax burden and the provision of public goods, but
also orient their behavior on other taxpayers’ behavior. Taxpayers’ conceptions of the
attitudes and activities of other taxpayers impact their decision on whether to pay taxes
honestly or not. As people feel part of social groups, their decisions are often motivated
by group norms (Frey and Torgler 2007; Wenzel 2007). In this vein, social norms consist-
ently prove to be a strong regulator of behavior since one’s own tax compliance is related
to the perceived noncompliance of others (Wenzel 2005). The term ‘social norm’ is either
defined as what is commonly done in a community (descriptive norm) or what is com-
monly approved and disapproved by the community (injunctive norm; Kallgren et al.
2000). Individuals will comply as long as they believe that other people pay taxes honestly
and that compliance is the social norm for the group they identify with.
Wenzel (2005) shows that people overestimate others’ acceptance of tax evasion. An
intervention whereby participants are informed about the actual social norms on tax
evasion could reduce tax cheating. In addition, a large-scale field experiment in the United
Kingdom by Hallsworth et al. (2013) shows that social norm messages increase compliance.
Over 100 000 taxpayers received letters from the tax authority which varied only in the
inclusion of a short phrase after the first sentence. Some of these letters contained mes-
sages based on social norms (for example, ‘Nine out of ten people pay their tax on time’,
Hallsworth et al. 2013, p. 34). The results show that including norm messages in a standard
tax payment reminder letter enhances tax compliance, with the greatest effect obtained
from the ‘minority norm’ treatment, where taxpayers were informed that ‘Nine out of ten
people in the UK pay their tax on time. You are currently in the very small minority of
people who have not paid us yet’ (Hallsworth et al. 2013, p. 34). Similar to perceived social
norms, tax morale, civic duty, taxpayer identity, appeals to patriotism or conscience, and
feelings of altruism and morality also impact tax compliance (Torgler 2007).
As taxes are used to finance public goods for the good of the community, taxpaying
represents a social dilemma. The term ‘social dilemma’ refers to a situation in which the
interest of an individual is opposed to the interest of the community or the group (Dawes
1980). When people use a public resource, they are individually better off when they make
use of it without contributing in return – for instance, without paying taxes. They can
benefit by acting selfishly as ‘free riders’. However, if most people maximize their own
utility and act selfishly, the outcome can be a disaster for everyone (Kollock 1998). Public
goods will not be provided and as a consequence everyone will be harmed.
Experimental evidence indicates that communication between individuals, opportuni-
ties to participate in setting up the rules of the game, and the public announcement of
defection increase cooperation in social dilemma games (Kollock 1998). Emotions also
seem to play an important role in social dilemmas and are assumed to influence people’s
tendency to choose individual interests over collective interests (Polman and Kim 2013).
An investigation concerning the effect of anger, disgust and sadness on people’s willing-
ness to give shows that angry people give fewer shared resources to others, whereas the
recall of disgusting and sad experiences lead to more resource-giving (Polman and Kim
2013). Coricelli et al. (2010) measured skin conductance and self-reports to show that
emotional arousal is associated with cheating behavior: a high degree of emotional arousal

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correlates with the likelihood of tax evasion and the amount evaded. Further, tax compli-
ance was higher when the pictures of evaders were made public. The impact of shaming
on tax compliance remains beneficial over the long term if the contravener is reintegrated
into the group after evading, but leads to higher levels of evasion when reintegration
fails (Coricelli et al. 2014). Nevertheless, participants were initially less likely to evade in
the treatment without reintegration, possibly because they anticipate negative emotions
related with stigmatization. Tax decisions therefore may be driven by the willingness to
avoid negative emotions, which may occur, for instance, during public denouncement.
Emotions also play a role when taxpayers perceive the tax authority as unjust. People
differ in their affect intensity, so they react more, or less, emotionally to their treatment by
the tax authorities (Murphy 2009). When people feel unfairly treated by an authority, they
feel anger and, in turn, reduce compliance (Murphy and Tyler 2008). Those who feel that
the authority used procedural justice during its enforcement action are less likely to feel
anger, and are therefore also less likely to evade taxes (Murphy 2009). Although research
on emotions in the context of taxpaying is relatively scarce, the existing evidence indicates
that the interplay of cognition and affect moderates the effectiveness of key economic
variables like audit probabilities and fines (Maciejovsky et al. 2012).
BOX 18.1 SURVEY ON EMOTIONS RELATED TO TAXES, PERCEIVED

PROTECTIVE POWER AND COMPLIANCE
We conducted a survey investigating the relationship between emotions, authorities’ perceived use
of their power to detect and punish evasion, and tax compliance. A representative sample of 500
Austrian self-employed taxpayers (61 percent men, Mage = 44.46 years, SDage = 10.55 years) were
presented with PANAS (20 items; Watson et al. 1988), an instrument to measure 20 qualities of emo-
tions, and six additional items based on the PANAS-X (Watson and Clark 1994). Respondents were
asked to indicate their emotions when thinking of the tax authority on a 7-point Likert scale (7 = high
emotional intensity). They were also asked how likely it was that they had paid their taxes honestly in
the past year (7-point Likert scale; 7 = very likely) and to indicate whether they feel that the tax authori-
ties exert power in an undifferentiated way to combat tax evasion or in a well-targeted way towards
wrong-doers in order to protect cooperative citizens (7-point Likert scale). The items read as follows:
1. As the tax authority takes targeted action against tax evaders, I feel protected by the authority.
2. As the tax authority indiscriminately takes action against all taxpayers, I feel like I’m being har-
assed by the authority.
3. People who pay their taxes honestly do not have to fear audits and fines.
4. Even people who pay their taxes honestly have to fear indiscriminate audits and fines.
We computed the mean response to these four items, labeled as perceived protective power, and
computed Pearson correlations between the 26 emotions, past tax compliance and protective power.
Table 18.1 shows means, standard deviations and correlations. Respondents who perceive tax authori-
ties as exerting protective power have a greater interest in taxes and indicate that they do not feel hostile,
irritated, disgusted, upset, scornful, scared, afraid, nervous, sad, distressed, confused, ashamed, or
guilty. Also, they indicate higher past compliance. In sum, although protective power seems unrelated
to positive emotional qualities, the opposite, untargeted power, is related to strong negative emotions. If
taxpayers perceive actions taken by the tax authority as illegitimate random threats, negative emotions
towards the tax authority are evoked, like hostility or disgust. On the other hand, taxpayers react positively
when they have the feeling they are protected by the tax authority’s power. The present survey shows
that tax authorities therefore need to be careful in how they apply power in terms of audits and fines.

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Table 18.1 Protective power, tax compliance and emotions
Quality of emotion M (SD) Protective power Past compliance

Interested 2.99 (1.64) .17* −.03
Proud 2.05 (1.39) .06 −.21*
Active 2.93 (1.72) .05 −.06
Strong 2.40 (1.40) .03 −.18*
Excited 1.74 (1.18) .02 −.23*
Enthusiastic 1.87 (1.27) .01 −.21*
Inspired 2.24 (1.46) .01 −.21*
Attentive 3.54 (1.83) −.00 −.05
Unburdened 2.21 (1.40) −.03 −.24*
Determined 2.89 (1.70) −.09 −.06
Alert 3.20 (1.73) −.12 −.06
Unemotional 3.41 (2.03) −.16 −.06
Surprised 2.29 (1.51) −.16 −.19*
Guilty 1.92 (1.43) −.22* −.31*
Ashamed 1.98 (1.39) −.24* −.31*
Confused 2.36 (1.59) −.29* −.25*
Distressed 3.08 (1.75) −.30* −.15
Sad 2.34 (1.77) −.31* −.13
Nervous 2.48 (1.67) −.34* −.23*
Afraid 2.28 (1.64) −.35* −.23*
Scared 2.46 (1.67) −.38* −.21*
Scornful 2.40 (1.75) −.47* −.19*
Upset 3.61 (1.89) −.49* −.06
Disgusted 2.94 (2.04) −.49* −.12
Irritable 3.39 (1.94) −.51* −.08
Hostile 2.69 (1.77) −.51* −.17*
Protective power 4.55 (1.38) .17*
Past compliance 1.65 (0.48)
Note: N 5 500; 7-point Likert-type scales; r > .16 significant at p < 0.01 (Bonferroni corrected).
5 INTERACTIONS BETWEEN THE TAX AUTHORITY AND

TAXPAYERS
Tax behavior can be viewed as the result of a ‘psychological contract’ which regulates
the interactions between taxpayers and the tax authority (Feld and Frey 2007). This
relational contract involves strong emotional ties, building on a norm of reciprocity that
goes beyond legal regulations. Commitments from taxpayers, on the one hand, require
an equivalent commitment from the tax authority, on the other hand. The psychological
contract approach assumes that as long as taxpayers are treated like equal partners instead
of ‘robbers’ or subordinates, taxpayers will cooperate.
The slippery slope framework (Kirchler 2007; Kirchler et al. 2008, 2014), presented in

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Enforced Voluntary cooperation

compliance
Maximum
Tax compliance
Minimum
Maximum
Maximum
Power of Trust in
authorities authorities
Minimum Minimum
Source: Kirchler et al. (2008, p. 212).
Figure 18.3 The slippery slope framework of tax compliance
Figure 18.3, suggests that the relationship between tax authorities and taxpayers can be
described in terms of the power of tax authorities and taxpayers’ trust in tax authorities.
The power of tax authorities is the perceived ability of the tax authorities to prosecute
tax evasion, whereas trust in the tax authorities is defined as the tax authorities’ per-
ceived benevolence and competence in working for the common good. Whereas power is
assumed to lead to an antagonistic interaction climate in which tax authorities and tax-
payers work against each other and taxpayers only comply out of a fear of enforcement,
trust in the tax authorities is believed to foster a synergistic and cooperative tax climate
and taxpayers’ voluntary cooperation (Kirchler et al. 2008, 2014). Experimental evidence
from different countries suggests that, independent of cultural differences, power and
trust determine enforced and voluntary tax cooperation (Kogler et al. 2013).
The transformation from an antagonistic climate with enforced compliance to a syn-
ergistic climate with voluntary and committed tax cooperation can be described on the
basis of the distinction between different qualities of power, that is, coercive power and
legitimate power, and different qualities of trust, that is, reason-based trust and implicit
trust (Gangl et al. 2015). Coercive power based on audits and fines creates a hostile,

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antagonistic climate and fuels a vicious cycle of distrust between tax authorities and
taxpayers. However, if coercive power is combined with legitimate power – that is, exper-
tise, the provision of information, and following accepted procedures – coercive power
might be perceived as a safeguard for the compliant majority and taxpayers develop
reason-based trust in the competence, motivation, and benevolence of the tax authori-
ties (Hofmann et al. 2014). Hence, a synergistic service climate develops in which the tax
authorities and taxpayers interact in a professional relationship with each other, like a
service provider and its clients. Further, over time and through positive experiences, trust
initially based on rational consideration might become implicit and automatic, and tax
authorities and taxpayers can come to mutually trust and respect each other. The syn-
ergistic climate deepens from a service climate to a confidence climate. In a confidence
climate, tax authorities avoid coercive power and taxpayers, in turn, are committed and
pay their taxes automatically.
The dynamics between power and trust illustrate why it is difficult and time-consuming
to build up trust and a synergistic tax climate and also, vice versa, why the destruction
of a synergistic relationship between tax authorities and taxpayers can happen easily
and quickly. A confidence climate can easily decay, transforming back to an antagonistic
climate, if strong power measures alienate taxpayers, particularly if coercive power is
applied without legitimate power. Although a service climate is assumed to be more stable
than a confidence climate, it can also be destroyed if coercive power is applied without
legitimate power (Gangl et al. 2015). Hence, coercive power in combination with low legit-
imate power easily destroys a synergistic tax climate and leads to an antagonistic climate.
These assumptions on the dynamics between power and trust have gained empirical
support from experiments with taxpayers (Hofmann et al. 2014). Taxpayers were asked
to imagine a tax authority in a fictitious country wielding either low versus high coercive
power or low versus high legitimate power as well as a combination of low versus high
coercive and legitimate power. Results showed that coercive power as well as legitimate
power and its combination ensure high tax compliance. In addition, the results support
the assumption that the coercive power of authorities as well as perceived low or high
legitimate power might determine whether an interaction climate is perceived as antago-
nistic or synergistic (Hofmann et al. 2014). These results highlight the practical value of
high coercive power in combination with high legitimate power. In combination with
legitimate power, coercive power seems to be perceived as a targeted safeguard of coop-
eration rather than a hostile threat, as protective power as described in the survey and in
Table 18.1. Therefore, it is recommended that tax authorities enhance legitimate power by
establishing professional and comprehensible tax procedures, web and telephone services
and by having competent, motivated, and friendly tax officers to assist taxpayers (Alm
and Torgler 2011).
The attempt to describe tax behavior as a consequence of the relationship between tax
authorities and taxpayers represents the latest development which has fueled research
in tax psychology. The benefits of this approach are twofold. First, existing research on
economic and psychological determinants of taxpaying behavior has been integrated.
Second, theoretical and practical conclusions can be drawn and tested as to how a change
in interaction climate between tax authorities and taxpayers can be accomplished in order
to foster voluntary and committed tax compliance.

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6 CONCLUSION: FROM COMMAND AND CONTROL TO

COOPERATIVE RELATIONSHIPS
Traditionally, tax authorities applied a command and control approach to enforce taxpay-
ers’ cooperation, assuming that all taxpayers would otherwise evade taxes. However, there
is hope that tax authorities can move on to establishing a cooperative relationship with
taxpayers. In doing so, tax authorities avoid seeing taxpayers as potential criminals but
instead as customers and partners. Tax authorities invest in their service provision and
improve their assistance to reduce the time and effort required for taxpayers to comply
with the law. Taxpayers, on the other hand, are believed to reciprocate this cooperative
approach in the form of positive attitudes towards taxes and increased tax compliance.
Currently, tax authorities in countries such as the Netherlands, the Scandinavian coun-
tries, Austria, Slovenia, and New Zealand are expanding their approaches to include trust-
building measures to build a confidence climate with ‘enhanced relationships’ (OECD
2013). According to the Organisation for Economic Co-operation and Development
(OECD), the concept of enhanced relationships requires tax authorities to dispense with
audits of committed taxpayers going back several years. Instead, the tax authorities
should resolve and settle uncertainties on the tax issues of a taxpayer immediately. On
the other hand, taxpayers are required to fully disclose their tax files to the tax authorities
and to sign a voluntary code in which they agree to not engage in aggressive tax planning
(OECD 2013). For both tax authorities and taxpayers, such an arrangement involves trust
which can be harmed; however, it pays off in the form of lower auditing costs for the tax
authorities and in enhanced planning reliability for the taxpayer.
Measures to increase voluntary and committed tax compliance are more important
than ever. Tax avoidance among globally operating corporations has grown to a giant
problem overshadowing tax evasion (Garside 2014). These global players do not evade
taxes but legally avoid taxes through aggressive tax planning. Hence, classical command
and control approaches fail to enforce cooperation. Research needs to further examine
how the willingness of taxpayers to refrain from exploiting tax havens and to follow the
spirit of the law rather than the letter of the law can be increased.
Future research on tax behavior needs to recognize even more that tax behavior is
embedded in the social world and includes many actors. Thus, not only the role played
by other taxpayers or by the tax authorities needs to be examined, but also the impact of
the government or of tax practitioners on individual tax decision-making. Likewise, more
clarification is needed as to the cognitive and emotional processes involved in tax evasion,
tax avoidance, or perceived fairness of the tax system. How do the self-employed mentally
account for and represent the tax decision, and what emotions are involved when they
decide to cheat or to avoid taxes? Tax research in the past has focused on income tax com-
pliance. Future research needs to go beyond that and should theoretically and empirically
analyze the determinants of compliance with other taxes, such as value added tax (VAT)
or inheritance tax. Furthermore, the effects of tax amnesties on perceived fairness of the
system among honest taxpayers versus the effects of integrating former tax evaders back
into the formal system needs further examination.
Democratic societies depend on the voluntary tax compliance of their citizens in order
to be able to afford public goods. Psychological tax research shows that dealing with tax-
payers on an equal footing might not only reduce negative attitudes towards paying taxes

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but might also increase the number of taxpayers who feel like responsible citizens willing
to actively engage in their society.
NOTE
* This study was partly financed by the Austrian Science Fund (FWF), project number P24863-G16, and
partly by the Jubiläumsfonds-project number 16042.
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PART V
SMART MACROECONOMICS
AND FINANCE

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19 Financial decisions in the household
Bernadette Kamleitner, Till Mengay and Erich Kirchler
1 INTRODUCTION
What decisions are ‘about’ can influence the way decisions are made. When deciding
about money, most people aim to make particularly ‘smart’ decisions. Mere reminders of
money suffice to elicit decisions that are geared towards maximizing personal economic
benefits (for example, Vohs et al. 2008; Kouchaki et al. 2013).
Many decisions are in fact about money and of a financial nature. This also holds for
decisions that are made at the household level (for example, Kirchler et al. 2008). Private
households dispose of larger amounts of financial resources than any other ‘institution’
in the state; yet, financial literacy supposedly enabling smart decisions is surprisingly
low (for example, Lusardi and Mitchell 2007). Financial decisions in a household focus
on what money is used for, when, how, and by whom. These decisions range from small
scale to large scale and from short term to long term. Notably, household decisions often
involve a varying set of actors. Beyond leading to economic outcomes, they can also influ-
ence the relationship quality of household members. As a consequence, smart financial
decision making in a household entails the need to balance social and economic aspects.
Eventually these decisions play a key role for the financial and psychological well-being
of individuals and households.
In this chapter we provide an overview of the scope of financial household decisions
and the complexity of the underlying dynamics. We do so by using a comprehensive
framework of financial decision making as a starting point and by focusing on its key
components in turn. We first provide a brief review of the different types of financial
decisions made by individuals. We then extend the lens to multiple players in household
decisions.
One of the key questions in household decision making is which of these lenses, individ-
ual or joint, is more suitable. When are decisions made jointly by the household members,
when are they made autonomously, and when does which member dominate (see Davis
and Rigaux, 1974)? These questions are challenging because answers are influenced by the
way people live together in a household. Given that concepts of family, gender and roles
are changing over time, we conclude this chapter by an empirical look at what has been
and what may be. We do so by contrasting the perceived decision dynamics observed from
parents and the ideal decision dynamics striven for by students. Results provide insights
into which lens tends to be best suited for which type of decision. Moreover, they allow
for a glimpse into potential changes in the future.
349
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2 A COMPREHENSIVE FRAMEWORK OF FINANCIAL

DECISION MAKING
The framework depicted in Figure 19.1 reflects the scope of financial decisions. A modi-
fied version of Kamleitner and Kirchler’s (2007) process model on credit choice highlights
the interplay of what Ferber (1973) identified as the principal types of financial decisions:
(1) spending decisions (that is, purchase decisions about acquiring goods), (2) decisions
about saving and credit use (that is, decisions about whether to make an acquisition
when funds are currently lacking and whether to hold money back for future spending
decisions), (3) investment decisions (that is, decisions on whether and how to accumulate
material wealth), and (4) money management (that is, decisions on how to budget avail-
able money).
As shown in the framework, spending decisions are the starting point to understand
and explain financial decisions in the household. Credit and saving decisions are second-
ary decisions: they are decisions made in order to ensure that enough money is available
for more or less specified spending decisions. Once the decision is about the choice of
saving or credit options, financial products take on the role of the ‘product’. For example,
when buying a new car on a loan two potentially extensive decision processes – about the
car and the loan – can be involved. Investment decisions, too, tend to follow the process
of extensive spending decisions. Finally, money management can be seen as an underlying
mechanism that tends to be involved in all other financial decisions.
The framework also stresses the role of surrounding factors under which financial
decisions take place (see Kamleitner et al. 2012). Among them there are general influ-
ences such as the individual situation persons are in (for example, social status and family
background; Ashby et al. 2011) and their individual characteristics including factors such
as financial literacy (for example, Dvorak and Hanley 2010; van Rooij et al. 2011), and
personality characteristics (for example, Donnelly et al., 2012) like delay of gratification
(for example, Norvilitis et al. 2006; Pyone and Isen 2011).
Notably, the model is not necessarily specific to individuals as decision makers. It could
just as well apply to the household as a decision making unit. The framework indicates
the possibility that multiple members may be directly or indirectly involved in all steps by
an arrow influencing the entire model.
3 INDIVIDUAL FINANCIAL DECISIONS
Following the logic of the framework, we first provide a review of previous findings on
decisions about individual expenditures before moving on to individual credit use and
saving decisions as well as individual investment decisions. Finally, we discuss money
management as a financial decision in itself and as an important factor in other decisions.
3.1 Spending Decisions
The literature on the process of purchase decisions is vast. In particular, in consumer

research several encompassing models of the individual decision-making process have
been developed. Many of these models date back to the early days of consumer research

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Needs Market information
Desire for (financial) product/
M4225-ALTMAN_9781782549574_t.indd 351
investment
Habitual purchase
Type of product/
Spontaneous purchase investment
Extensive decision process

Alternatives,
information search,
evaluation, choice
351
Household members
Abandonment Choice Delaying Saving
(e.g., financial literacy, personality)
Situation and individual characteristics
Credit use Immediate purchase
Use available funds
Purchase/
investment
Money management
Figure 19.1 A framework of financial decision making in households

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and they focus on depicting the decision process as faced by an individual decision maker
(for example, Nicosia 1966; Howard and Sheth 1969; Borcherding 1983; Kroeber-Riel
1992; Engel et al. 1993, 2007). The framework offered in Figure 19.1 reflects some of the
key premises that these models tend to share.
Usually decision processes start with the need for a product or service that can be
prompted by stimuli from the individual sphere or outside factors like social influences
or market offers. The type of good desired (for example, Kotler 1982 distinguishes on the
basis of the expected lifetime of a product between durable goods, convenience goods and
services) plays a key role in how a decision process unfolds, whether multiple options are
searched and how deeply different choice options are elaborated. Some acquisitions are
made spontaneously in a shortened and impulsive decision process. Others, in particular
expenditures for regularly purchased convenience goods, are made habitually. They do
not involve a decision process as such. People tend to engage in extensive decision proc-
esses for products that are rarely purchased or involve risks (for example, expensive items
such as washing machines). An extensive decision process is characterized by informa-
tion search and comparison. It is only after an evaluation of multiple alternatives that a
decision is made. Notably, the distinction of different types of decision processes is not
restricted to the acquisition of goods. Financing decisions, too, vary in terms of level of
involvement and depth of processing (for example, Kamleitner et al. 2012).
3.2 Decisions about Credit Use and Saving
If a desired good is not attainable with the currently available means, consumers are
left with three options (see Figure 19.1). Either they abandon the acquisition, they
borrow the money, or they postpone the acquisition and save until the desired good
becomes attainable. These three paths are inherently linked. Research on when which
path (saving or credit) would be taken has primarily been conducted by economists (for
example, Duesenberry 1949; Modigliani 1966; Prelec and Loewenstein 1998; Shefrin and
Thaler 1988). Simplified, the conclusion has been that credit use is preferred if (1) the
(discounted) net benefits of borrowing outweigh the (discounted) net benefits of saving
and if (2) income expectations turn credit use into a means of smoothing out lifetime
income. The possibility that consumers would forgo acquisitions entirely has largely been
neglected.
Instead of viewing credit and saving as two explicit sides of the same coin, other – in
particular, psychological – contributions focused on these decisions in isolation (for
reviews see, for example, Lunt and Livingstone 1991; Berthoud and Kempson 1992;
Groenland 1999; Kamleitner and Kirchler 2007; Kamleitner et al. 2012; Webley 2014).
The propensity for credit use varies as a function of the product; with it being particularly
acceptable for durable goods and investment products (for example, Engel et al. 1993;
Prelec and Loewenstein 1998). This, however, only holds for those forms of credit that
make the borrowing process salient. It does not hold for cases in which consumers are
not fully aware that they are borrowing money and do so spontaneously or habitually,
such as in the case of credit card usage (for instance, Lo and Harvey 2011; Thomas et
al. 2011). For example, while people would mostly be averse to taking out a loan for a
holiday, they may use their credit cards to do so without a second thought. This variability
in decisions across credit vehicles is a fundamental factor in credit decisions. It is one of

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Financial decisions in the household 353
the main reasons why research on credit use, including reviews (for example, Kamleitner
et al. 2012), tends to focus on specific credit vehicles.
Saving decisions are less influenced by variability in terms of saving vehicles. In these
decisions time horizons play a major role (Fisher and Montalto 2010; Rabinovich and
Webley 2007). The more proximate a saving goal feels, the more likely people are to decide
to save (for example, Hershfield et al. 2011 increased saving by using age-progressed ren-
derings of participants). Whether a saving goal feels proximate and within reach is also a
matter of the nature of this goal (for example, Canova et al. 2005; Ülkümen and Cheema
2011). People save for concrete (for example, a new car) and unspecific (for example, for a
rainy day) purposes alike. The nature of saving goals is one of the key factors determining
whether consumers can eventually implement saving decisions (for example, Rabinovich
and Webley 2007).
3.3 Investment Decisions
Investment decisions are similar to saving decisions in that money is put aside for a future
purpose. In abstract terms, the purpose, however, is not variable. The aim is wealth protec-
tion and accumulation rather than acquisition and usage. This goal can be achieved by
investing in a wide range of investment vehicles which have to be purchased. Investment
thus follows a similar process to extensive spending decisions. However, given that prod-
ucts are chosen because of their monetary value, potential fluctuations in value, that is,
the perception of risks, move center stage. Consequently, risk preferences, that is, the
extent of risk a person feels comfortable with, are a key determinant of the choice between
investment options (for example, Dimmock and Kouwenberg 2010; Sachse et al. 2012).
Notably, risk preferences may not always translate into adequate product choice. This is
because risk perception is prone to biases. For example, when simultaneously focusing on
potential gains and losses, the loss probability may sometimes be underestimated, yielding
riskier decisions than intended (Diacon 2004).
Another factor that sets investment decisions apart is that decisions often concern port-
folios rather than individual options. Such ‘diversification’ makes it possible to balance
the inherent risk of several products against each other. Similarly, time horizon takes on a
special meaning in investment contexts. The general assumption is that longer investment
horizons reduce the risk of losses (but see, for example, Strong and Taylor 2001 for results
that do not entirely support this assumption). It is, however, not entirely clear whether
decision makers truly understand the consequences of time horizons and diversifica-
tion. Most evidence suggests that people struggle to fully understand the extent of these
effects. For example, Goetzmann and Kumar (2008) find that a surprisingly high number
of investors (75 percent) hold under-diversified portfolios that entail worse risk–return
trade-offs than benchmark market portfolios (for example, the S&P 500 containing stock
values of the 500 biggest US companies).
3.4 Money Management
People need to manage the funds available for all these decisions to be made. To a large
extent this happens mentally. Thaler (1985) hence coined the term ‘mental accounting’.
In several experiments he found that people establish so called mental accounts to keep

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track of their expenditures within a specific time period and/or for a specific purpose.
Mental accounts (for example, €100 per month for eating out) are useful rules of thumb
for budgeting and tracing available funds. Mental accounting, thus, can help to decide
between competing usages of funds and acts as a self-control mechanism (Thaler 1980,
1999). However, these advantages do not hold universally. Mental accounts can equally
be malleable and self-delusional (Cheema and Soman 2006; Shafir and Thaler 2006).
For example, habitual expenditures such as the daily cup of coffee may be booked into a
vague ‘other spending’ account and people can trick their own mental system by refram-
ing decisions; for example, luxury goods can be ‘booked’ as ‘investments’ which justifies
expenditures and turns eventual consumption ‘free’ of charge (Shafir and Thaler 2006).
Mental accounting is perhaps the most prevalent money management practice and
it permeates and blends with all other financial decisions (for instance, Kamleitner and
Hölzl, 2009). For example, in the case of loans consumers can mentally link the pleasure
of consuming the acquired good and the pain of paying back the loan (for example, Prelec
and Loewenstein 1998; Kamleitner et al. 2009). In case they establish such a mental link
and ‘book’ pain and pleasure on the same account, debt aversion for non-durables (that is,
products for which repayment may extend beyond the time of product use) becomes more
likely (Prelec and Loewenstein 1998). What is more, mental accounts may influence the
decision to save or borrow. If an acquisition does not fit well with a mental saving account,
credit use may be preferred despite available savings (Karlsson et al. 1997).
Beyond mental, factual money management practices, such as the frequency with which
accounts are checked or the amount of actual or symbolic accounts held, matter (Lea et al.
1995; Kidwell et al. 2003; Donnelly et al. 2012). Money management appears to be most
effective when mental and factual practices align and reinforce each other (Kamleitner et
al. 2011; Soman and Cheema 2011).
4 HOUSEHOLD FINANCIAL DECISIONS
The majority of insights on financial decisions regard individual decision makers. Yet,
in reality, multiple household members may be involved in different ways (Kirchler et al.
2008). The question of whose needs are considered becomes as important as the question
of how decisions about products are made. This opens the door for additional consid-
erations such as relational power, relationship quality, and role stereotypes (for example,
Kirchler 1988). It also puts a spotlight on formal practices such as money distribution and
pooling by couples (for example, separate versus joint bank accounts in which partners’
incomes are pooled).
In the following we briefly review key insights arising when the four financial decisions
are viewed from a joint rather than individual decision makers’ point before moving on to
an analyses of when which viewpoint may be most appropriate.
4.1 Spending Decisions in the Household
Living together mostly implies that many products are acquired for the household rather
than for individual household members. Individual and potentially conflicting prefer-
ences of household members as well as their relationships add complexity to the decision

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process. Bizarrely, individual preferences tend to be stronger for everyday spending deci-
sions than other financial decisions. Whereas most people are indecisive as to which kind
of blue chip stock or bank bond they prefer, the color of a car or even the topping of a
pizza can be a crucial test for a relationship.
Kirchler (1989) provided one of few household decision models that incorporates the
dynamics found in most individual decision models as well as insights on decisions by
couples (for example, Pollay 1968; Sheth 1974; Corfman 1987; Scanzoni and Polonko
1980). Similar to individual decisions, the decision process begins with the desire for
a good by at least one of the partners. Product type, relational aspects (in particular,
quality of and power in a relationship), and the impact of the decision on the relation-
ship determine whether the ensuing decision is spontaneous, habitual or extensive; joint
or individual. This last aspect, that is, the degree to which partners are involved, was the
topic of interest in a seminal paper by Davis and Rigaux (1974). They provide a clas-
sification for household decisions that holds across all financial decisions. Basing their
analyses on married couples, they distinguished between: (1) autonomous decisions by
one of the spouses, (2) husband or wife dominated decisions, and (3) jointly made or
syncratic decisions.
In particular, extensive decisions open up the potential for syncratic decisions because
they enable the partners to become differentially involved in information search, the
evaluation of alternatives, and the eventual decision.
Notably, a partner’s involvement in a decision does not have to be active. Even if only
one partner is in charge of a decision, he or she is likely to account for the assumed prefer-
ences1 of the partner – even in an exploitative relationship (Maccoby 1986).
A key aspect in decisions for more than one person is the potential of disagreement
and conflict. Multiple types of household conflict have been identified by Kirchler et
al. (2001). Depending on the type of conflict the partners are more or less motivated to
solve the problem in a way that either reduces the negative impact on their relationship or
maximizes their benefit (Ben-Yoav and Pruitt, 1984).
Probability conflicts relate to judgments about objective truths and outcomes and the
likelihood with which they will happen. For example, partners may agree about the social
significance of an item and have similar design preferences. Yet, they may be finding the
joint decision difficult because they hold different views on the quality of alternatives. In
such probability conflicts, partners are not seeking to influence each other. Rather they
are having an objective disagreement in which the crucial elements are items of informa-
tion. Normative pressure is kept to the background.
The situation is very different for value conflicts for which there is no verifiably correct
solution. Value conflicts exist if there are fundamental differences in goals and values
between the partners. Purchasing decisions present a value conflict if partners have
fundamental differences with regard to the symbolic power of a product rather than the
specific features. Value conflicts are genuine conflict situations, in which partners try to
persuade each other (March and Simon 1958; Madden 1982) or even impose their views
on each other, using several influencing tactics (for an overview of commonly used tactics,
see also Kirchler 1990).
The third type of conflict is distributional. A distributional conflict exists if the discus-
sion revolves around the division of costs and benefits. Even if both partners are con-
vinced that a particular product represents the optimal alternative and is desirable, so that

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there is no value conflict, one partner may still argue against the purchase on the grounds
that the product largely benefits the other partner or would mainly be used by them. In
distributional conflicts, partners will try to reach a compromise using their negotiating
skills. (Kirchler et al. 2001, p. 75). These types of conflicts can occur for all types of finan-
cial decisions, including credit and saving decisions.
4.2 Decisions about Credit Use and Saving in a Household
Research that looks at decisions about credit use and saving from a household perspective
is scarce. Actual money management practices (for example, do partners hold individual
credit cards) but also role specialization and quality of a relationship will influence the
way a household saves and uses credit. For example, the breadwinner role affects credit
card usage. Pahl (2008) has shown that an observed higher rate of credit card usage by the
male partner disappears when employment status is taken into account.
4.3 Investment Decisions in the Household
Investment poses a particular challenge for joint decision making because partners’ risk
preferences are likely to diverge. In a study by Mazzocco (2004), only half of the exam-
ined couples held similar risk preferences. The question then arises of how couples come
to a joint risk preference. As, for example, Abdellaoui et al. (2013) show, couples do not
simply average their individual risk preferences. In one study the man had more influence
initially, whereas the woman’s influence rose over the course of investments (de Palma et
al. 2011). This may match with insights by Meier et al. (1999) who found that the spouse
believed to be more experienced had more influence on the decision.
The type of relationship also plays an important role. Decisions in egalitarian relation-
ships are more likely to be autonomous and dominated by the female spouse than deci-
sions in relationships with traditional attitudes toward marital roles (Meier et al. 1999). To
some extent this may also be caused by differences in bargaining power (see Yilmazer and
Lich 2015) which determines who of the partners has more say in terms of the risk taken.
4.4 Money Management in the Household
A purely mental money management system is unlikely to work for an entire household.
Formal ways of managing the household finances have to be established and responsi-
bilities have to be assigned. The answer to the question ‘Who manages the household’s
finances?’ is informed by marital and breadwinner roles, relationship satisfaction, power
in the relationship, equity perceptions, and the meaning of money for each partner (for
example, Jasso 1988; Burgoyne and Kirchler 2008).
The most common way in which households manage their money is through pooling
(Pahl 2008) which refers to the uniting of both partners’ income on a joint banking
account. However, in blended and patchwork families (that is, couples that are in a
new relationship after a divorce or separation, with at least one child from the previous
relationship) an increase of the practice of separate banking accounts (Raijas 2011) and
separate money management has been observed.

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5 WHICH DECISIONS ARE MADE JOINTLY? AN EMPIRICAL

INVESTIGATION
As this review has shown, financial decisions are complex phenomena – in particular
when they are made jointly by household members. A crucial question therefore asks
which decisions are being made jointly. Already in the 1970s Davis and Rigaux (1974)
addressed this question. They investigated which product categories are decided upon
primarily by one partner of a particular gender, autonomously by both partners, and
jointly. In addition, they distinguished between the respective influence of partners
across the different stages of a decision process (need recognition, information search
and final decision). Results were reported in the so-called decision triangle (see Figure
19.2 for an exemplar with data from this study). The y-axis depicts whether, if any, of
the partners dominates the decision (1 5 male dominated to 3 5 female dominated
with 25 joint decisions in the middle). The extent of role specialization is displayed
on the x-axis. It reflects the percentage of participants stating that a specific phase has
been decided on jointly. The phases of the decision process are displayed in form of a
line flowing from problem recognition (rhomb) to information search (dot) to the final
decision (triangle).
As discussed, the role of partners in the decision process is influenced by gender dynam-
ics, breadwinner and marital roles and partners’ bargaining power (for example, Burgoyne
and Kirchler 2008). All of these aspects have seen at least some changes in the past
decades (for example, Gere and Helwig 2012; Lewis and Sussman 2014). For instance,
Pahl (2008) observed a decrease in the number of couples pooling their money.
Here we empirically examine the way decisions are made in all four domains of finan-
cial decisions. Moreover, we aim to capture what is and what may yet come. We assess the
decision processes observed from parents as well as the ideal decision processes striven
for by their children.
5.1 Sample and Procedure
Overall, 300 Austrian business students (mean age 5 23.51 years, 54.7 percent female) par-
ticipated in a laboratory-based survey on decision making in partnerships. Participants
were first asked to report how 13 financial decisions were made by their parents.
Subsequently, they reported on how they anticipated to make those decisions once they
share a household with a partner. The target decisions were chosen so as to reflect all four
areas of financial decision making. In addition, goods that had emerged as particularly
prone to be decided on by the husband or wife in the original Davis and Rigaux study were
used. For all 13 decisions participants were asked to indicate who (man, woman, jointly)
would usually recognize the need for a product, who would search for information, and
who would make the final decision.
To keep insights comparable with the original studies (for example, Negrusa and
Oreffice 2011 find some differences across couples’ sexual orientations), only heterosexual
relationships were taken into account. Controlling for the actual relationship status of
students did not change results of students’ anticipated decision roles.

M4225-ALTMAN_9781782549574_t.indd 357 03/05/2017 08:20

3 G - Groceries 3 S - Saving book
CP - Cleaning products L - Loan
H - Holidays C - Creditcard
CP
L - Living room furniture LI - Life insurance
C - Car
G I - Internet connection
Female dominant Female dominant
M4225-ALTMAN_9781782549574_t.indd 358
CP
2.5 2.5
L
CP
G
L
L C
H LI
H
G I S S
S C
2 Autonomous H Syncratic Autonomous Syncratic
2 C
LI
L
L L
C
358
I LI
Relative influence
Relative influence
C
I
1.5 1.5
Problem recognition Problem recognition
Information search Information search
Male dominant
Male dominant Final decision Final decision
Parents Parents
Female Female
Male Male
1 1
0% 25% 50% 75% 100 % 0% 25% 50% 75% 100 %

a) % Joint decision b) % Joint decision
Figure 19.2 Observed (parents) and intended patterns of spending decisions (a) and saving and credit use (b) across genders
03/05/2017 08:20
5.2 Results and Discussion
To facilitate interpretation of results and following Davis and Rigaux (1974), each role-
triangle is separated into four sections: female-dominated decision steps are in the upper-
right corner, male-dominated decisions in the lower-right corner, autonomous decisions
that are equally likely to be independently taken by either of the partners are in the middle
of the triangle and truly syncratic (or joint) decisions are in the outer-right corner of the
triangle. The discussion of results has been split according to the four financial decisions.
5.2.1 Decision roles involved in spending decisions

Figure 19.2a shows parents’ observed actual (dotted line) and students’ ideal (grey for
females and black for males) decision processes for seven different spending decisions.
Focusing on parents’ decision processes, it becomes evident that, as already observed by
Davis and Rigaux (1974), all four sections of the triangle are populated. As in the 1970s,
cleaning products and groceries are still female dominated. Moreover, cars still tend to be
male dominated, primarily during the phase of information search. Unlike in the 1970s,
the decision for a car is likely to be made syncratic.
Getting an Internet connection seems to be the task for either one of the partners.
Despite being a technological topic it is not necessarily male dominated. The decision
about living room furniture is autonomic during problem recognition and information
search, but the final decision is made jointly. The decision process about which holidays to
go on is similar to that for furniture. However, for holidays, problem recognition appears
more likely to be a joint process.
In sum, reports on parents’ spending decisions are similar to those observed in earlier
research (Davis and Rigaux 1974). The final decision, however, seems to have become
more syncratic. Interestingly, the stereotypical female domains have remained untouched
but the male domains have made some way for joint decisions.
Moving on to how students described the way they anticipate making decisions in their
own future households, a glance at Figure 19.2a proves revealing. First, the fact that the
black lines tend to be lower in the graph than the grey lines suggests that each gender
assigns itself slightly more say in decisions. The perhaps surprising exception is cars. At
least when it comes to information search, many women appear happy to leave that task
to their future partner.
Second, ideals cluster more strongly in the syncratic section of the triangle. This sug-
gests that students intend to make less autonomous and gender-dominated decisions than
observed by their parents. In fact, students’ ideals see barely any autonomous decisions.
Cleaning products are the only product category for which both genders expect that one
person will decide it all.
5.2.2 Decision roles involved in credit use and saving

Figure 19.2b depicts decision roles for credit (credit cards and loans) and saving (saving
book and life insurance) decisions. It shows that students’ ideals and parents’ reality tend
to crowd together in the syncratic section of the decision triangle. Even the decision about
a product focusing on one individual’s life, that is, life insurance, has become more syn-
cratic than in the 1970s. It is only during the information search that one of the partners
is in charge.

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Overall, female ideals are clearly syncratic across all decision phases. Male ideals and
parents’ actual behaviors are also mostly syncratic except for the information search phase
in which they are situated at the edge to autonomous decisions.
5.2.3 Decision roles involved in investment decisions

Figure 19.3a shows decision patterns for investment decisions in general and stock in
particular. A first glimpse reveals that investment decisions are more prone to be made
autonomously (specifically during problem recognition and information search) than
saving and credit decisions. While both partners appear to recognize the need to save or
borrow, recognizing the need to invest seems often to be down to one of the partners.
Moreover, Figure 19.3a reveals that the general decision to invest is more likely to be
syncratic than the decision about stocks as an actual investment vehicle. In particular for
men, the decision to acquire stocks seems to lie in their domain. Women generally expect
to have more influence on investment decisions than either their mothers have or their
male colleagues and potential future partners anticipate.
Results suggest that couples are likely to decide on an investment strategy jointly but
that the choice for a high-risk investment product may be male dominated; in particular
in the perception of men themselves.
5.2.4 Decision roles involved in money management

Figure 19.3b depicts decision patterns with regard to money management. Participants
were asked to indicate who would express the need to decide on whether to pool the
respective funds available, who would think about possible distributions of money, and
who finally decides which kind of distribution is implemented.
Interestingly, in this decision parents are observed to decide more syncratically than
their adult sons’ intent to do. Parents were observed to, and female participants would
like to, jointly go through all decision stages. Male participants differ in that they consider
problem recognition and information search as the domain of only one of the partners.
6 CONCLUSION
These results provide a glimpse at contemporary financial decision making in the house-
hold and reveal some general patterns across the four main areas of financial decision
making: spending decisions, saving and credit use, investment, and money management.
Despite increasing degrees of financial autonomy of the spouses, most financial decisions
tend to be made jointly and the future generation intends to further increase this trend.
Notably, this intention differs across the genders. In particular with respect to decisions
that involve money only (that is, money management, investment, saving and credit use),
male students anticipate that the decision process would be more autonomous than female
participants. It is only with regard to spending decisions, that is, decisions that involve
non-financial products, that female participants considered autonomous decisions at least
as likely as their male counterparts. Given substantial variations in the ways that decisions
are made across contexts, knowledge about individual decisions is as necessary as it is
limited in order to understand financial decision making in the household.
Admittedly, there is no way to know whether our samples’ intended practices will reflect

M4225-ALTMAN_9781782549574_t.indd 360 03/05/2017 08:20

3 3
I - Investment desicion
M - Meaning of
S - Stocks
month’s income
Female dominant
Female dominant
2.5 2.5
M4225-ALTMAN_9781782549574_t.indd 361
I M
M
2 Autonomous Syncratic 2 Autonomous Syncratic
Relative influence
Relative influence
I
361
I
S
1.5 1.5
Problem recognition Problem recognition
S
Information search Information search
Male dominant Male dominant
Final decision Final decision
Parents Parents
Female Female
Male Male
1 1
0% 25% 50% 75% 100 % 0% 25% 50% 75% 100 %
a) % Joint decision b) % Joint decision

Figure 19.3 Observed (parents) and intended patterns of investment decisions (a) and money management decisions (b) across
genders
03/05/2017 08:20
their decision making once they have been sharing a household with a partner for some
time. The lack of longitudinal insights is, however, not a limitation that is specific to the
study at hand. There is very little evidence on how decision dynamics change within a
relationship (for cross-sectional evidence on couples’ dynamics, see Scheibehenne et al.
2011) and on the extent to which a potentially observed change is due to the maturation
of the relationship and societal trends, respectively.
Although we have no means of ensuring that results generalize to different samples,
they do hold an important message. The increase in financial independence of women,
which has been observed in many industrialized countries, does not necessarily entail
more autonomous financial decisions. In fact, nearly all stereotypical financial decisions
were deemed syncratic and this appears to be an aspired practice by the future generation
of (well-educated) households. The only exception appears to be spending decisions; in
particular about everyday goods and services. Yet, even for groceries, students seem to
aspire to joint decisions. However, whether this is a valid prediction of what will be prac-
ticed in the future remains to be seen. This finding may be the result of romantic expecta-
tions of limitless ‘togetherness’ or of a generally perceived choice overload. Given that
many goods and services (including financial services) are marketed to individuals rather
than couples there seems to be a mismatch between what is offered and what is actually
needed by households. Especially the differential influence across the three stages of the
decision process, in particular the tendency to search autonomously, may hold implica-
tions for marketers.
Our results also imply a noteworthy asymmetry between the factors that likely matter
to decision makers and the factors that occupy decision researchers. A short glimpse
into the latest issues of journals such as the Journal of Consumer Research, the Journal
of Economic Psychology, and Judgment and Decision Making suffices to reveal that most
disciplines involved in the study of financial decision making tend to overlook the fact
that decisions happen on a household as well as on an individual level.
Topics inherent to household-level decisions such as relationship quality, power,
resource distribution, gender dynamics, and conflicts may be more relevant than ever
before. It seems high time that academic research on financial decisions systematically
considers (and asks) who is making them.
NOTE
1. Note that couples do not tend to be good at making these predictions and that the ability to predict a part-
ner’s preferences does not improve with relationship duration (Scheibehenne et al. 2011).
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20 Employing priming to shed light on financial
decision-making processes
Doron Kliger
Economic decision-making under risk and uncertainty is conventionally modeled within

the cognitive framework, using expectation-based calculus which is performed on an
underlying utility function. Presumably, this function describes all the relevant informa-
tion regarding individual preferences, the individual’s ‘type’ (expected utility, EU; von
Neumann and Morgenstern 1944). Recently, descriptive models deviating from economic
rationality have been devised and employed. Often, these models also rely on sets of cog-
nitive rules. A prominent modeling taking this approach is manifested by the celebrated
prospect theory (PT; Kahneman and Tversky 1979) and cumulative prospect theory
(CPT; Tversky and Kahneman 1992).
The cognitive, rational, framework builds on the notion that deciding advantageously
in complex situations requires decision makers to utilize declarative knowledge and
employ overt reasoning. That is, rational individuals arrive at decisions by a process of
contemplating facts regarding assumptions, and considering the outcomes of each pos-
sible action. However, an alternative process may take place, namely, that the overt reason-
ing phase is primed by a phase of nonconscious biasing that employs neural systems other
than those that support declarative knowledge. In a gambling task given by Bechara et
al. (1997) to two groups, one consisting of normal participants and the other consisting
of patients with prefrontal damage, the normals began to choose advantageously before
realizing which strategy worked best, while the prefrontal patients continued to choose
disadvantageously even after they knew the correct strategy. Moreover, the normals’
actions were preceded by anticipatory skin conductance responses (SCRs) whenever they
pondered a risky choice, before knowing explicitly that it was, indeed, risky. The lesson
from the experiment conducted by Bechara and colleagues is that, normally, noncon-
scious biases guide behavior before conscious knowledge does. Importantly, without the
help of the nonconscious biases, overt knowledge might be insufficient to bring about
advantageous behavior.
This chapter employs priming to shed light on financial decision-making processes.
Priming is an implicit memory process, where exposure to stimuli or events affects the
availability of specific information categories and, thus, the response to subsequent events
(Baron and Byrne 1997, ch. 3). Priming may also be viewed as changes in preliminary
conditions that impel the probability that the stimulus will be followed by a particular
response (see Cramer, 1968). According to Tulving (1983), priming consists of facilitation
of performance in one task on following identical or similar tasks.
Priming processes are routinely activated by individuals. An illustrative example might
be provided by considering the activity of watching a horror movie, a stimulus which may
intensify attention and modify interpretation and reaction to subsequent stimuli, such
as a squeaking gate, causing the exposed individual to act as in alarming situations. The
366
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Employing priming to shed light on financial decision-making processes 367
same situation, while not taking place after the exposure to the horror movie, may be left
consciously unnoticed, or interpreted in a different, unexciting manner.
Studying priming effects in the laboratory is usually devised in two successive stages,
exposure and testing. In the exposure stage, the subjects are exposed to the priming
stimulus, and in the testing stage, they are requested to perform particular actions, make
decisions, or interpret the meaning of some given substance. The exposure stage may be
subconscious, also known as automatic priming (for example, briefly flashing words or
pictures such that the subjects are not aware of seeing them), or conscious, gaining the
awareness of the participating subjects.
Next, I describe several research projects involving priming and financial decisions, and
then I suggest some insights about the underlying decision-making process.
Gilad and Kliger (2008) explored priming effects on financial decisions by reinforcing
participants’ risk-seeking behavior under uncertainty. In addition to investigating the
conduct of economics undergraduates, the actions of professionals (commercial banks’
investment advisors and accountants in certified public accountant, CPA, firms) were also
investigated. The results detect priming effects on risk attitudes and investment decisions
in both participant groups. Further, the decisions made by the professionals were affected
more than the decisions made by the undergraduates, suggesting that the former employ
a more intuitive and less analytic approach in making their decisions.
Kliger and Gilad (2012) explored the role of colors as a priming substance. Colors are
prevalent in the financial industry, with red and green prominently employed. A between-
subject experimental analysis was employed to expose the participants to financial infor-
mation on colored backgrounds and investigate the effect on their investment decisions.
The results indicate that red color, compared to green, emphasizes value losses of the
underlying asset: the participants who were exposed to red assigned higher valuations
and probabilities to events involving the loss domain than to events involving the gain
domain.
Cohn et al. (2015) employed priming to delve into the issue of investors’ countercyclical
risk aversion, a feature used in many asset pricing models to explain economic puzzles
such as time variation in risk premia and high volatility of asset prices. Empirical evidence
on this issue is scarce, due to the difficulty to control for a host of factors that change
simultaneously during financial booms and busts. Specifically, they devised a couple of
experimental investment tasks to prime financial professionals with either a boom or a
bust scenario and measured their subsequent risk aversion. They found that professionals
who were primed with a financial bust manifested increased risk aversion, compared to
those who were primed with a financial boom. Cohn et al. (2015) have also found that their
treatments evoked different emotional reactions, which were related to the investment
decisions: the financial professionals who were primed with a bust were more fearful than
those that were primed with a boom condition, and their fear was negatively related to
investments in the risky asset. They conclude with a suggestion that fear reduces investors’
willingness to take risk, even when that fear is unrelated to economic events.
As a basis for suggesting some insights about the underlying decision-making process,
we now delve into some details of the first experiment reported in Gilad and Kliger (2008).
Design. The experiment was constructed in a 2 × 2, between-subject, design, of two
populations (investment advisors in large commercial banks and accountants in CPA
firms – hereafter, professionals – versus economics undergraduates) and two priming

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treatments (risk seeking, RS, versus risk aversion, RA). The participants from each popu-
lation were randomly split between the two priming treatments, enabling the investigation
of within-population priming of risk attitudes, and comparative analysis of the extent of
effect between the populations.
At the introduction of the experiment, all the participants received the following
general description:
In the experiment, you will be requested to answer two questionnaires. The first contains
economics questions, and the second memorization questions. For the first questionnaire, we
will show you financial information of a specific stock, whose name is kept with us, which was
published in economics sites. In this questionnaire, you will be requested to answer several ques-
tions regarding investment in the stock. In the second questionnaire you will be asked to identify
adjectives from a short story which we will show you. The story will be presented before the first
question set. Please note, in the memorization questionnaire (the second questionnaire in the
experiment) you will be asked to recollect as many adjectives as you can, while coping with the
time gap between reading the story and marking your answers.
The stories given to the RS and RA groups primed risk-seeking and risk-averse behav-
ior, respectively. The RS story described a daring person who has chosen to gamble in
a casino, and consequently gained a lot of money, whereas the RA story was about a
responsible person who has chosen to avoid taking risk at the casino, an action which pre-
vented a large monetary loss. The financial questions, presented to all of the participants
in an identical manner, regarded investments which depended on the stock of MagStar
Technologies Incorporated (MGST.OB), without revealing the stock’s identity. As a basis
for the financial decisions, the participants received: financial information, which was
extracted from Yahoo! Finance (http://finance.yahoo.com), consisting of the company
profile (MagStar is a prototype developer and manufacturer of centrifuges, conveyors,
medical devices, spindles and subassemblies); short financial reports (for example, balance
sheet and income statement); and a graph exhibiting the stock’s price fluctuations in
the preceding 330 days, compared to the Standard and Poors (S&P) and the National
Association of Securities Dealers Automated Quotations (NASDAQ) indices.
The economics questionnaire, which followed the priming substance, consisted of five
stock related investment questions (an additional question, not discussed here, requested
the participants to rank the degree of risk they attributed to investing in the stock). In each
of the stock related investment questions, the participants of all groups were requested to
choose between (1) investing in a binomial lottery yielding NIS 75 (approximately US$17,
at the time the experiment was conducted) or 0, depending on the stock’s return by the
subsequent month, and (2) getting certain sums of money ranging from NIS 0 to NIS 75.
Then, the participants were requested to assign the certain amount for which they were
indifferent between the two alternatives, as well as to assess the probability the investment
would end up yielding NIS 75 (for more details, see Gilad and Kliger (2008)). Formally,
the indifference values assigned by the participants are their certainty equivalents (CEs)
of the respective investments, that is, represent the investments’ subjective valuations by
these participants. The stock related investment questions were constructed according to
two cutoff returns, of –15 percent and 18 percent (see Figure 20.1).
The memorization questionnaire which concluded the experiment contained a list
of adjectives the participants were asked to check according to their recollection of the

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Question 5
Question 4
Question 3
Question 2
Question 1
–15 0 18
Note: The figure portrays the conditions for the binomial lotteries stated in the stock related investment
questions to yield NIS 75. The lottery described in each of the five questions would yield NIS 75 (otherwise,
0) in case the stock return by the subsequent month belongs to the interval marked by the respective segment.
Figure 20.1 A schematic description of the stock related investment questions
adjectives in the version of the story they have read. Some of the adjectives in the stories
were extracted from Erb et al. (2002).
Hypothesis. Overall, the two stories, RS and RA, were expected to prime risk seeking
and risk aversion, respectively. That is, the activation of risk attitudes via priming was
hypothesized to make the participants in the RS group willing to state higher CEs for the
gambles on the stock’s performance, as well as to assign higher probabilities to the events
making the investments profitable.
As regards the comparison of the two populations (professionals and students), the
professionals’ decisions were expected to be affected by the priming manipulation more
than the students’ (see Haigh and List 2005; Abbink and Rockenbach 2006), possibly
because professionals tend to use a less analytic and more intuitive approach in decision-
making. We delve into this aspect later on, in a discussion of the underlying decision-
making process.
Results. The main results of the experiment are summarized in Table 20.1. The left- and
right-hand sides of the table describe the replies to the stock related investment questions
by the professionals and the undergraduates, respectively. Evidently, both populations’
risk attitudes were affected by the priming stimuli. This is seen in the participants’ overall
willingness to take risky positions, as reflected by the aggregated CE they assign to the
investments across all the investment questions. The aggregated amount of the RS par-
ticipants was significantly higher than that of the RA participants, for the professionals
(NIS 42, prob. 0.01), as well as for the students (NIS 24, prob.0.04). Further, checking each

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Table 20.1 Some experimental results from Gilad and Kliger (2008)
Stock related investment questions, average monetary certainty equivalent

Professionals Students
Question RS RA Difference Prob. RS RA Difference Prob.
1 49.52 40.55 8.97 0.02 39.68 35.02 4.66 0.16
2 54.90 41.67 13.23 0.02 37.84 36.50 1.34 0.40
3 32.57 23.92 8.65 0.08 28.14 25.27 2.87 0.31
4 53.72 43.86 9.86 0.03 50.79 44.71 6.08 0.10
5 50.07 48.48 1.59 0.41 58.68 49.69 8.99 0.04
Aggregated 240.77 198.46 42.31 0.01 215.13 191.19 23.94 0.04
question separately, the average monetary CEs of the RS participants were always larger
than those of the RA participants, for both populations, the effect manifested by the
replies of the professionals being more pronounced, as all the differences but one (ques-
tion 5) were larger than those of the undergraduates, and more significant. Considering
the size of the priming effect, we note that the professional and student participants who
were given the RA treatment were valuing the risky investments, on average, roughly the
same (that is, total value of NIS 198 and NIS 191, respectively). The RS treatment, in
comparison to the RA treatment, increased the students’ average valuation considerably,
by 13 percent. The picture emerging from inspecting the effect on the professionals’ valu-
ation is even more overwhelming, amounting to a corresponding increase of 21 percent.
We turn now to discussing the underlying decision-making process. To convey the idea
in a simple manner, we refer to a static, one-period setup. Figure 20.2 provides a sketch of
the rational decision-making process. Trivially, under the rational framework, the process
starts when the decision maker is confronted by a decision-making problem. The decision
maker then enters a phase of information recollection, yielding cognitive evaluation in
which probabilities of the possible realizations are assessed. For instance, in the case of
contemplating the purchase of a specific stock, the phase yields the assessed distribution of
possible future states of nature, and related stock returns. Then, depending on the decision
maker’s shape of utility function (‘type’), a decision (that is, whether to purchase the stock
given its current price) is arrived at. Finally, the state of nature is realized, that is, the stock
gains a specific return, determining the payoff to the action the decision maker has taken.
A prominent contribution of psychology to the understanding of decision-making
and behavior takes the shape of two-system models. Noteworthy, Kahneman (2011) has
adopted terms, originally coined by Stanovich and West (see Stanovich and West 2000;
they now prefer speaking of type 1 and type 2 processes), and refers to two systems in the
mind, namely, system 1 and system 2. System 1 functions in a quick, automated manner,
exerting little or no effort from the decision maker, hence bearing no sense of voluntary
control. System 2 involves effortful mental activities, such as complex computations,
thus the operations involving it are often associated with choice and concentration.
Figure 20.3 depicts the behavioral decision-making process. Specifically, it appends a
channel of behavioral evaluation alongside the cognitive evaluation channel, in accord-
ance with two-system models. Roughly speaking, we may link the behavioral evaluation

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Decision-making process
=>Rational model
Decision-making
problem
Information
recollection
Cognitive evaluation
Probability assessment Util. function (‘TYPE’)
Decision
Payoff realization
1¢
Figure 20.2 Rational decision-making
=> Behavioral model
Decision-making
problem
Information
recollection
Cognitive evaluation Behavioral evaluation
Value
Decision Weights (PWFs) (‘TYPE’)
function
Decision
Payoff realization
1¢
Figure 20.3 Behavioral decision-making

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=> Behavioral model , under priming
Decision-making
Exposure (priming)
problem
Information Perception/
recollection info processing
Cognitive evaluation Behavioral evaluation
Value
Decision weights (PWFs) (‘TYPE’)
function
Case dependent!
Decision
Which evaluation channel is more active?
For students?
Payoff realization
For professionals?
1¢
Figure 20.4 Behavioral decision-making, under priming
channel and cognitive evaluation channel with system 1 and system 2, respectively. Thus,
the assessment of probabilities of the possible realizations is generalized to the assignment
of decision weights, possibly in the shape of probability weighting functions (PWFs).
The carrier of values is also modified, for example, in the case of prospect theory, the
traditional utility function is replaced by a value function (VF). A prominent difference
between the utility function and the value function lies in the definition of the latter on
gains and losses, compared with the definition of the former on wealth levels. From this
point on in the decision-making process, the flow meets again the rational model, pre-
sented in Figure 20.2. That is, a decision is arrived at depending on the decision maker’s
‘type’ and decision weights and, subsequently, the state of nature is realized, determining
thereby the payoff to the decision maker. For the sake of accuracy, it is worth mention-
ing here that decision makers may also assign different subjective decision weights, so we
may choose to append the properties of PWFs (in addition to the properties of VFs) to
the decision maker’s ‘type’.
Figure 20.4 presents the dually channeled behavioral decision-making process, under
priming. Incorporating priming exposure effects into the analysis explains how seemingly
irrelevant information may enter the decision process. Specifically, the priming substance
affects the decision maker’s perception and information processing and, thereby, the two
components that play a role in arriving at decisions, namely, the shapes of the PWF and

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VF. The resulting decisions are, therefore, case dependent. That is, we may argue that the
traditional notion of the decision maker’s ‘type’ is insufficient, and has to be augmented
to incorporate the effects of surrounding information on the decision maker, as well as
the decision maker’s subjective sensitivity to priming stimuli.
Having established a sketch of the dually channeled behavioral decision-making process
under priming, we turn now to the discussion on the differential priming effect between
students and professionals. The explanation suggested here involves the relative promi-
nence of each channel (cognitive or behavioral) in the decision-making process of the two
populations. More specifically, the increased sensitivity to priming by the professionals
may be owing to their relative reliance on the behavioral evaluation channel being more
prominent than that of the students. To elucidate the difference between professionals and
students, ponder the following question: what does the situation of answering a question-
naire resemble in students’ lives? Or, in which event in a typical academic learning envi-
ronment are the students welcomed into a class and given a questionnaire to be answered
within a short time frame? An associative reply you may have arrived at is that the event
in question is a course’s examination. And what are students implicitly requested to do
in exams? Commonly, to search for the relevant model that was introduced in the course
material, detect the relevant information, and employ the model on the information to
arrive at answers to the examination’s questions. Putting this reply in the boxes of the
decision-making process presented in Figure 20.4, the students are requested to activate
the cognitive evaluation channel.
Now consider the case of the professionals. Would it be conceivable to assume that,
when operating in their vastly changing, information-swamped, working environment,
the professionals would activate the cognitive evaluation channel as intensely as do stu-
dents in examination-like situations? To answer this question, consider the students again,
and their (justified) reaction to a situation where their lecturer enters in the middle of the
examination in order to apologize for a typographical error in one of the examination’s
questions, which should be corrected before answering. Having relied on the (slow) cogni-
tive evaluation channel, the students would have to erase the answer they have arrived at,
and start the answering procedure all over again. Would professionals, in their crowded
working environment, be able to act as the students did in the examination situation?
Apparently not. They would probably have to resort to a faster, less effortful, decision-
making process, hence to activate (relatively more than the students) the behavioral evalu-
ation channel.
To summarize, comparing professionals and students, the decisions of the former par-
ticipants were affected by the priming manipulation more than the students. Seemingly,
the differential effect may be attributed to the professionals’ tendency to practice less
analytic and more intuitive decision-making. Presumably, professionals’ decisions are
based more heavily on experience. Nevertheless, keep in mind that the pricing relevant
information given to both groups was identical, and the effect was detected with each
group. We should not deduce from the analysis presented here any conclusions regarding
the quality of the decisions made by the two populations. Merely, the relative prominence
of the cognitive and behavioral channels each population has adapted is commensurate
with the characteristics of their ‘natural’ decision-making environments. To conclude, we
find that individuals’ financial decisions, whether these individuals be students or profes-
sionals, involve aspects beyond utilization of declarative knowledge and employment of

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overt reasoning. Specifically, overt reasoning may be continuously affected by exposure to

priming substance. Arguably, this exposure is guiding behavior before conscious knowl-
edge does, playing thereby an important role in the decision-making process.
REFERENCES
Abbink, K. and B. Rokenbach (2006), ‘Option pricing by students and professional traders: a behavioural inves-
tigation’, Managerial and Decision Economics, 27 (6), 497–510.
Baron, R.A. and D. Byrne (1997), Social Psychology: Understanding Human Interaction, 7th edn, Boston, MA:
Allyn & Bacon.
Bechara, A., H. Damasio, D. Tranel and A.R. Damasio (1997), ‘Deciding advantageously before knowing the
advantageous strategy’, Science, 275 (5304), 1293–5.
Cohn, A., J. Engelmann, E. Fehr and M.A. Maréchal (2015), ‘Evidence for countercyclical risk aversion: an
experiment with financial professionals’, American Economic Review, 105 (2), 860–85.
Cramer, P. (1968), Word Association, New York: Academic Press.
Erb, H.P., A. Bioy and D.J. Hilton (2002), ‘Choice preference without inferences: subconscious priming of risk
attitudes’, Journal of Behavioral Decision Making, 15 (3), 251–62.
Gilad, D. and D. Kliger (2008), ‘Priming the risk attitudes of professionals in financial decision making’, Review
of Finance, 12 (3), 567–86.
Haigh, M.S. and J.A. List (2005), ‘Do professional traders exhibit myopic loss aversion? An experimental
analysis’, Journal of Finance, 60 (1), 523–34.
Kahneman, D. (2011), Thinking Fast and Slow, London: Penguin Books.
Kahneman, D. and A. Tversky (1979), ‘Prospect theory: an analysis of decision making under risk’,
Kliger, D. and D. Gilad (2012), ‘Red light, green light: color priming in financial decisions’, Journal of Socio-
Economics, 41 (5), 738–45.
Stanovich, K.E. and R.F. West (2000), ‘Individual differences in reasoning: implications for the rationality
debate’, Behavioral and Brain Sciences, 23 (5), 645–65.
Tulving, E. (1983), Elements of Episodic Memory, New York: Oxford University Press.
Tversky, A. and D.E. Kahneman (1992), ‘Advances in prospect theory: cumulative representation of uncer-
tainty’, Journal of Risk and Uncertainty, 5 (4), 297–323.
Von Neumann, J. and O. Morgenstern (1944), Theory of Games and Economic Behavior, Princeton, NJ:

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21 Experimental asset markets: behavior and bubbles
Owen Powell and Natalia Shestakova
1 INTRODUCTION
The efficiency of markets is a topic of both popular and academic discussion. The
long-standing debate is to what extent market prices reflect underlying preferences of
society. This is important because prices serve as economic indicators of the relative,
or fundamental, values of assets. When markets operate efficiently, they help channel
investment and resources into assets which society values the most. On the other hand,
when they fail, misallocation of resources that leads to unnecessary waste and loss can
result.
While the actual degree of mispricing remains a matter of debate (see Shiller 2003 for
a review), even the potential presence of mispricing has strong implications for optimal
individual behavior. In particular, in markets with fully rational and informed agents (and
common knowledge thereof), there is no reason for anyone to speculate: assets will be
bought and sold at their fundamental values. However, once the possibility of deviations
of prices from fundamentals is introduced (either through imperfect rationality, informa-
tion, or common knowledge thereof), it may become optimal for even fully rational and
informed participants to engage in speculative behavior. Thus the behavior of ‘smart’
agents, who may have perfect information about the relative value of assets, may induce
mispricing that they know to be at odds with the actual value of the assets.
One particular pattern of mispricing is a price bubble. Under such a scenario, prices
consistently increase over a period of time relative to the underlying fundamental value,
until eventually falling precipitously back to efficient levels. In addition to the concern
that these episodes of mispricing can often last for long periods of time, the large swings
in asset prices often mean extreme trading losses are concentrated in the hands of a few
market participants. This can create additional problems when, for example, moral hazard
causes market participants to assume too much risk (Farhi and Tirole 2012).
Such bubble scenarios are at odds with traditional economic theories of market equi-
librium. With fully rational agents and common knowledge thereof, equilibrium prices
should adjust quickly and accurately to represent underlying preferences. Trade should
occur only insofar as agents seek to rebalance their initial portfolios. However, in various
situations bubble episodes may arise due to speculation, lack of common knowledge of
rationality and/or imperfect information (Blanchard 1979; Abreu and Brunnermeier,
2003).
Regardless of the exact pattern and cause of mispricing, judging the efficiency of
markets remains a difficult problem. As in other areas of economics, the experimental
method offers the advantage of being able to isolate and examine specific issues of inter-
est. Experiments are particularly useful in the case of market behavior because underly-
ing fundamentals are typically unobservable in the field, meaning that empirical tests of
market efficiency are in fact joint tests of efficiency and a set of assumptions regarding
375
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fundamentals.1 In the laboratory setting, asset values are defined (and hence observed) by
the experimenter, making it possible to unequivocally compare them to prices.2
Although market experiments have a rich history in economics, this chapter focusses
exclusively on the behavior of experimental asset markets. For the purposes of this
chapter the defining feature of an asset market is that the monetary value of the asset
is homogeneous across all agents.3 The implicit value of the asset comes from the cash
revenue generated by holding the asset. When, as is often the case, this takes the form
of periodic dividends and is perfectly known to all traders, this creates a fundamental
value that decreases steadily over time. The baseline for market experiments of this type
is given in Smith et al. (1988). In spite of the fact that fundamental values decrease over
time, prices in these markets tend to persistently increase for a large portion of the market,
before crashing to near fundamental value at the end of the market.
This clear evidence shows that market bubbles can occur, even in relatively simple
environments. Subsequent work showed that this was robust to a wide variety of factors,
and sparked an interest in determining both the institutional factors and the associated
trading behaviors underlying bubbles, and how well the results extend to more realistic
market settings.
The literature on experimental asset markets has been reviewed before, most recently by
Palan (2013a). This chapter concentrates on the results of recent publications and divides
the analysis into the following threads of research: the characteristics of traders (section
2), the properties of the traded asset (section 3) and the structure of the market (section
4). Measurement issues are discussed in section 5, and the chapter ends with a discussion
of useful tools and concluding remarks.
2 TRADER CHARACTERISTICS
One line of research investigates how mispricing is affected by characteristics of market

participants and their understanding of market structure. The effects that have been
studied are summarized in Table 21.1.
Table 21.1 Effects of trader characteristics on bubbles
Characteristic Effect
Indirect learning Reduces mispricing
Common knowledge Reduces mispricing
Mixed-experience markets Under complete knowledge of fundamental value (FV), sensitive
to the past success of experienced traders; increases mispricing
relative to experienced markets under incomplete knowledge of FV
Ethnic diversity Reduces mispricing
Gender Markets populated by males have higher mispricing
Risk aversion Lower mispricing with higher risk aversion
Loss aversion No effect
CRT/intelligence Lower mispricing in homogeneous markets; higher mispricing in
heterogeneous markets
Individual trading strategy Mispricing increases with proportion of speculators

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Experimental asset markets 377
2.1 Market Experience
One of the most consistently replicated results in experimental asset market research is
that repeated participation in identical markets eventually eliminates mispricing (Smith
et al. 1988; King 1991; Haruvy et al. 2007). There are a few caveats to this result: chang-
ing the parameters of the market may reintroduce mispricing (Hussam et al. 2008) and
the speed of adjustment to fundamentals is faster under some fundamental value regimes
than others (Noussair and Powell 2010). Nevertheless there is substantial evidence that
experience, as well as training and understanding in general, play a key role in achieving
efficient prices.
2.2 Indirect Learning
Direct experience is only one way in which subjects may improve their understanding of
the market setting. Allowing experienced traders to leave advice to subsequent cohorts
of traders reduces bubble size proportional to the number of traders who receive advice
(Alevy and Price 2014). In a similar vein, Cason and Samek (2015) devise a treatment
where subjects observe and are rewarded according to the trading behavior of another
subject in a previous market. Again, the results suggest that subjects learn to the same
degree from observing another trader as they do from participating in a market themselves.
2.3 Common Knowledge/Expectations
A related line of research deals with the role of expectations and common knowledge.
Common knowledge about the use of training in a market significantly reduces mis-
pricing above and beyond the effect of training itself (Cheung et al. 2014). Two other
studies look at the effect of knowledge about the presence of computer traders on market
outcomes. Traders react to the mere possibility that robot traders might be active in the
market (Farjam and Kirchkamp 2015). Elicited price forecasts show that a significant pro-
portion of mispricing in mixed human-robot markets is due to strategic uncertainty about
the behavior of others, rather than individual irrationality alone (Akiyama et al., 2013).
2.4 Mixed-experience Markets
The evidence so far clearly points to experience having a dampening impact on bubble
formation. However, in the traditional setup all traders in a market gain experience at the
same rate, whereas the distribution of experience in real-world markets is certainly more
heterogeneous. One series of studies considers the ‘inflow effect’, which looks at hetero-
geneously experienced markets. In these markets a proportion of traders are periodically
replaced with new inexperienced traders. Dufwenberg et al. (2005) show that markets
populated by even a small proportion of experienced traders can operate efficiently.
Subsequent work reveals that experienced traders act as price stabilizers when inexperi-
enced traders enter the market (Akiyama et al. 2014). However, this result is sensitive to
the previous success of experienced traders. Bubbles are larger when experienced traders
are those with the most extreme (both highest and lowest) earnings (Gladyrev et al. 2015).
In an overlapping generations setting, bubbles are formed every time a new generation

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enters the market and brings additional liquidity, while crashes occur every time an old
generation exit the market and withdraw some cash (Deck et al. 2014). These two ingre-
dients of a shock, inflow of traders and inflow of cash, seem to both be necessary to
trigger market inefficiency, at least in the constant fundamental value setting (Kirchler
et al. 2015).
2.5 Socio-demographic Characteristics
Populating experimental markets with traders who are familiar with real world financial
markets still results in a typical bubble-and-crash pattern (Smith et al. 1988; King et al.
1993). However, market outcomes have been shown to be sensitive to other socio-demo-
graphic characteristics of traders.
Ethnically homogeneous markets produce substantially larger bubbles and more severe
crashes than markets where at least one trader is of a different ethnicity, regardless of
whether this ethnicity is population majority or minority (Levine et al. 2014). This might
be the case because in ethnically homogeneous markets traders are overconfident in the
others’ decisions and, conversely, they scrutinize the others’ behavior in heterogeneous
markets.
The fraction of female traders is negatively correlated with the resulting deviation of
markets prices from fundamentals (Eckel and Fullbrunn 2015).
2.6 Risk and Loss Preferences and Other Personality Traits
It is often speculated that non-zero trade volume is observed in the standard experimen-
tal asset market due to the diversity in traders’ risk and loss preferences. Breaban and
Noussair (2015) reveal a significant negative correlation between the average risk aver-
sion of traders weighted by their market power and price bias for markets in which the
fundamental value increases over time, but no strong relation in other fundamental value
regimes. The same study also finds essentially no evidence for the correlation between the
average loss aversion of traders and market dynamics. At the individual level, more risk-
averse traders tend to sell to those who are less risk averse and more loss-averse traders
tend to engage in fewer trades.
Eckel and Fullbrunn (2015) find smaller and shorter bubbles in sessions with more risk-
averse subjects, although this cannot be disentangled from a gender effect, which is their
main focus. Their markets with more competitive participants produce higher bubbles
even though their male and female participants do not differ in competitiveness score.
2.7 COGNITIVE ABILITIES
Much of the previous research on experimental asset markets indicates that market
efficiency improves with traders’ understanding of the market rules and structure (Lei
and Vesely 2009; Kirchler et al. 2012). It is natural to assume that such understanding
is easier for traders with better cognitive abilities. One way of measuring cognitive abili-
ties of traders is the cognitive reflection test (CRT), and the available evidence suggests
that prices stay closer to fundamentals when the average CRT-score of traders is higher

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(Breaban and Noussair 2015; Noussair et al. 2014; Bosch-Rosa et al. 2015), and that
traders with higher CRT-scores earn more (Gladyrev et al. 2015).
2.8 EMOTIONAL STATE
A number of studies induce moods on their subjects and consistently find that increas-
ingly positive moods lead to higher prices (Heap and Zizzo 2011; Lahav and Meer 2012).
Analysis based on software-based emotion recognition shows that price level is positively
correlated with a more positive emotional state before the market opens and negatively
correlated with the average trader’s fear before the market opens (Breaban and Noussair
2013). On the individual level, traders who exhibit greater neutrality during a crash
achieve higher earnings.
2.9 TRADING STRATEGIES
Another explanation for the bubble-and-crash phenomenon is a speculation motive

pursued by some traders. To this end, patterns in mispricing have been explained by clas-
sifying trader behavior according to different models of speculation. The model of De
Long et al. (1990) classifies traders as fundamental value traders, momentum traders,
and rational speculators. Estimates of the distribution of types based on behavioral rules
vary across studies, but are generally consistent with the model predictions and change as
traders gain market experience (Haruvey and Noussair 2006; Haruvy et al. 2014). Trading
strategies also tend to be correlated with the traders’ risk and loss preferences and cogni-
tive abilities (Breaban and Noussair 2015; Baghestanian et al. 2014a).
3 ASSET PROPERTIES
Mispricing has also been shown to be sensitive to various properties of the assets traded
in the market. These effects are summarized in Table 21.2.
Table 21.2 Effects of asset properties on bubbles
House-money No effect on mispricing
Fundamental value Higher variance in fundamental value (FV) increases
mispricing; mispricing sensitive to structure of FV
Asset supply Relative price of an asset decreases with its relative supply
Information provision Mispricing decreases with private information. Individual
earnings lowest with intermediate level of private information

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3.1 House Money
A well-documented finding in various experimental settings is a house money effect. This

refers to the fact that subject behavior is in many cases sensitive to whether or not subjects
perceive that they are making decisions with their own or the experimenter’s (the house)
money. Of course, in many market settings it is normal for principals to make decisions
with other people’s money, but there is nevertheless concern that experimental subjects
may be especially careless with experimental endowments. There is evidence that market
bubbles are similar in magnitude regardless of whether subjects play with earned or
endowed money (Paul et al. 2013; Corgnet et al. 2015), even though some differences in
other market attributes (such as transaction volume) are observed. It would appear then
that aggregate market prices are relatively robust to different endowment regimes.
3.2 Fundamental Value
In the original design by Smith et al. (1988), the asset pays a periodic dividend to its
owner, which creates a monotonically declining fundamental value over the course of the
market. This is at odds with many popular classes of assets, which tend to maintain or
even increase in value over time; therefore, various authors have studied alternative time
paths for the fundamental value.
Several studies include markets with a constant fundamental value but do not allow for
the identification of whether mispricing is sensitive to the actual time path of fundamen-
tals. For example, Smith et al. (2000) change other aspects of the market (dividend timing)
across treatments, and Noussair et al. (2001) do not include a baseline treatment. Bostian
and Holt (2009) present the results from a non-incentivized classroom experiment, and
Kose (2016) studies a market with an indefinite horizon, which means that market length
and subject experience are not constant across observations. Nevertheless, the results
suggest that markets may behave differently when fundamentals follow a non-decreasing
time path, and further work comparing treatments within one study firmly establishes
that markets with constant fundamentals have very little mispricing, especially compared
with the case of declining fundamentals (Kirchler et al. 2012; Cheung and Coleman 2014).
More generally, research has shown that market efficiency tends to increase with the
amount of variation in fundamentals (Noussair and Powell 2010; Stöckl et al. 2015). In
particular, markets are efficient under constant fundamentals, and prices tend to be flatter
than fundamentals in markets with non-constant fundamentals, regardless of whether fun-
damentals increase or decrease and do so deterministically or stochastically over time. This
echoes the results of Kirchler (2009) which considers only the case of random fluctuations.
Most of the previous studies use a combination of taxes, dividends and final buyouts
to vary the path for fundamental values. There is some evidence that bubble episodes are
robust to an increase in the frequency of dividend payments (Smith et al. 2000; Jaworski
and Kimbrough 2016). Alternatively, interest on cash has also been used to induce declin-
ing or increasing fundamentals in the risky asset. In contrast to Stöckl et al. (2015), who
study an interest-free environment, Giusti et al. (2013) find less price inflation when inter-
est on cash is used to induce an increasing fundamental value. Giusti et al. (2014) also
consider several treatment variations that include a debt swap that increases fundamental
values, and show evidence that this action is conducive to bubble formation.

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Business cycles are often discussed phenomena in economics and finance, and they
are characterized by regular reversals in the time trend of economic activity. The study
of asset values whose values mirror this reversal in trend has identified significant asym-
metries in the performance of markets during these episodes of recovery and down-
turn (Noussair and Powell 2010). By considering treatments in which the assets value
reaches either a peak or a minimum at a certain point in the market, the authors are
able to show that markets adjust more quickly to efficient pricing during a downturn
than during a recovery. Breaban and Noussair (2015) extend this idea to the study of
markets with a period of constant fundamental values, followed by either an increase
(bull market) or decrease (bear market) in value. In contrast to the case of a constantly
increasing or decreasing fundamental value, they conclude that increasing markets
have a harder time tracking fundamentals than in the standard declining fundamental
design.
Laboratory assets typically have a predetermined fundamental value, as the time path
of fundamentals is fixed by design. Endogenizing the value of the asset by placing it under
the control of a subject has no effect on initial bubble sizes, although the ability of experi-
ence to mitigate mispricing is diminished (Jaworski and Kimbrough 2016).
3.3 Asset Supply
In a completely rational model, demand for assets is determined only by underlying

fundamentals. However, various studies have shown that demand in experimental asset
markets depends critically on the relative supply of cash and other assets (the so-called
cash-to-asset ratio). In the standard experimental design, dividends are paid out through-
out the lifetime of the asset, which implies that over time the supply of cash available for
trading increases relative to the supply of the asset. This has been shown to be a significant
driver of bubbles, under both declining (Kirchler et al. 2012) and constant (Noussair and
Tucker 2014) fundamental value regimes. This is consistent with the effect of nominally
changing the value of currency in the middle of a market (Noussair et al. 2012).
3.4 Information Provision
In the typical asset market setting, all information regarding the fundamental value is
known to all participants; however, this is clearly a special case that is not satisfied in many
real world-scenarios. One strand of literature focusses on the ability of markets to dis-
seminate and aggregate private information efficiently. To address this issue, it is natural
to distribute information asymmetrically among market participants. As long as the asset
value is the same for all traders, price convergence to the fundamental value is observed
in such markets (Plott and Sunder 1988; Oechssler et al. 2011).
Allowing the purchase of information on dividend realizations does not eliminate
bubble-and-crash patterns (King 1991; Hey and Morone 2004; Alfarano et al. 2011).
Providing traders with information on dividend realizations helps in preventing bubbles
and subsequent crashes, regardless of whether this information is provided to all subjects,
or only to a subset of them, potentially because traders’ decisions are more thought-
ful when they are aware that others have an advantage over them (Sutter et al. 2012).
However, it has been shown that noisy information signals are heavily over-weighted by

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traders (Smith 2012). Overall, it appears that price efficiency of the market is improved by
providing traders with better information, either in terms of quality or quantity.
In terms of individual performance, private information has a non-monotonic effect
on earnings, even when the information level is endogenous (Stöckl and Kirchler 2014;
Huber et al. 2011). In particular, those with intermediate levels of information tend to fare
worse than the completely uninformed. With the option to purchase price information,
the existence of informed traders has no effect on aggregate market prices; however, it
produces lower price volatility (Alfarano et al., 2006).
Market-based messages that compare current prices with the fundamental value have
been shown to reduce market mispricing (Corgnet et al. 2010). This is not simply a coor-
dination mechanism, since uninformative messages generally have no or only a weak effect
(Stoian 2014). The evidence suggests that both prices and forecasts underreact to public
messages that sequentially reveal the dividend value, and the under-reaction is generally
stronger for positive information than negative information (Gillette et al. 1999; Stevens
and Williams 2004; Palfrey and Wang 2012). Under-reaction is stronger the more asym-
metrically information is distributed in the market (Kirchler 2009).
4 MARKET STRUCTURE
More generally, various properties of the market can influence price efficiency. This is
summarized in Table 21.3.
4.1 Information Presentation
Perhaps not surprisingly, presenting information in graphical format, rather than as tables
of text, increases the efficiency of the market (Cason and Samek 2015). This finding
is consistent with the idea that increased knowledge and subject understanding of the
market increase efficiency (Lei and Vesely 2009; Kirchler et al. 2012). Recent work also
shows that minimal visual anchoring of prices, irrespective of how far they are from
Table 21.3 Effect of market structure on bubbles
Information presentationPrices respond to the use of informative graphical (versus textual)
information
Trading institution Mispricing is highest in double auctions, smaller in call markets, and
lowest under tatonnement
Trading restrictions Prices of an asset are decreasing in the ability to borrow that asset.
Performance incentives Bonus schemes increase prices
Multiple markets Additional assets and futures markets do not eliminate mispricing
Market interventions Endogenous interest rate policy does not affect mispricing. Prices
respond to share repurchases and new issues. Pre-trading auction
phases consistently underpriced
Coordination mechanisms Aberrant orders decrease mispricing. Public messages have no effect

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fundamental values, can have long-lasting effects on market behavior (Caginalp et al.
2000; Baghestanian and Walker 2015).
4.2 Trading Institution
One defining feature of a market is the means by which trade is conducted. Two of the
most popular options are a double auction and a call market. Continuous double auctions
allow traders to make offers in real-time that remain open until they are either accepted
by another party or explicitly cancelled by the originating trader. Conversely, call markets
typically require that offers be submitted simultaneously. After offers have been submit-
ted, an equilibrium price is calculated and trades are determined. Various studies (van
Boening et al. 1993; Gillette et al. 1999; Baghestanian et al. 2014b) find that mispricing
bubbles are equally likely under each of the two institutions. The tatonnement trading
institution produces significantly lower bubbles than a double auction by reducing specu-
lative behavior (Baghestanian et al. 2014b).
4.3 Trading Restrictions
An indirect way of increasing relative supply of assets in a market is through trading

restrictions. Borrowing and lending have been shown to play important roles during
recessionary periods (Ivashina and Scharfstein 2010). As such, regulatory agencies have
returned periodically to the question of whether to allow activities such as short-selling
and trading on the margin.
Several studies have looked at the role of trading restrictions in experimental asset
markets. Short-selling is found to significantly decrease prices towards, but not beyond,
fundamentals (King et al. 1993; Haruvy and Noussair 2006). Ackert et al. (2006) find
similar results in markets where multiple assets are traded simultaneously. Recent work by
Fellner and Theissen (2014) extends this result to a one-period setting with an uncertain
fundamental value. Margin trading (borrowing cash) is shown to have an equal and oppo-
site effect as short selling in Ackert et al. (2006), however, the precise type of restriction
used in the above studies is sometimes arbitrary. Füllbrunn and Neugebauer (2012) use a
design in which borrowing is only restricted by margin requirements. This allows them to
compare the relative size of the two effects, suggesting that margin trading may outweigh
the effect of short selling when both types of borrowing are simultaneously permitted.
Asset holding caps have also been shown to restrict bubble formation (Lugovskyy et al.
2014) Specifically, early prices decrease with permanent caps, however, overall mispric-
ing stays the same since prices subsequently fall below fundamentals later in the market.
Surprisingly, temporary caps eliminate both types of mispricing and result in an efficient
market.
4.4 Performance Incentives
In many economics experiments, including the standard design by Smith et al. (1988), sub-
jects are compensated proportional to their own personal performance market earnings.
However, in many real-world settings, compensation packages include non-linear and rela-
tive payment mechanisms. Holmen et al. (2014) design a treatment in which traders receive

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a guaranteed base salary combined with a bonus proportional to earnings above a certain
amount. Such convex incentive schedules significantly increase both risk-taking and prices
of the traded assets. Kleinlercher et al. (2014) build on this design to allow for bonus caps
and penalties, and find that both types of mechanisms tend to reduce overpricing. These
results show that aggregate market behavior may deviate from rational equilibrium, even
though individual agents tend to respond rationally to different incentive schemes.
Certain types of markets are best described as contests among agents, where perform-
ance is rewarded according to relative, rather than just absolute, performance. Cheung
and Coleman (2014) study an environment in which traders are regularly rewarded based
on the market value of their current portfolio. In this setting, while bubbles initially do not
differ between compensation schemes, a large asymmetry exists as compared to markets
with once-experienced traders. With tournament incentives and declining fundamental
values, bubbles fail to dissipate with repetition of the market setting, although this effect
appears to be sensitive to the time path of fundamental value. Finally, there is some evi-
dence that knowledge of relative performance alone is enough to affect individual behav-
ior (Baghestanian et al. 2015).
4.5 Multiple Markets
In the real world, markets do not operate in isolation. Multiple markets, for the same or
distinct assets, may operate and simultaneously influence each other.
Futures markets allow market participants to hedge against future price changes by
buying and selling ownership of the asset in the future, as opposed to the spot market
in which trades are executed immediately. Consistent with theory, the presence of these
markets tends to decrease overall mispricing in the current spot market when a single
futures market is available (Porter and Smith 1995; Noussair et al. 2014), however the effi-
ciency gains in the spot market are offset by mispricing in the futures markets themselves
when a full set of futures markets are open (Noussair and Tucker 2006).
Mispricing has also been shown to increase proportionally with the level of the funda-
mental value in markets with multiple assets (Chan et al. 2013). Such markets also show
that relative asset prices for similar assets remain close to parity, but deviations increase as
the mean and variance of one of the asset values increases (Fisher and Kelly 2000; Childs
and Mestelman 2006; Childs 2009).
4.6 Market Interventions
The actions of economic agents in asset markets are not restricted to trading. Both private
and public entities engage in various forms of non-trading behavior that can influence
market behavior. A classic form of intervention is the actions undertaken by central
banks. Fischbacher et al. (2013) examine how mispricing is affected by central bank inter-
est rate policy by including an interest-paying bond as an additional asset. In general, the
interest-bearing assets do not significantly affect mispricing, although they do reduce
the liquidity of the market. This finding is robust to several variations: the rule for fixing
interest rates (exogenous or adaptive to prices), the precise timing of interest payment and
type of information provided. The one treatment that is found to have an effect on prices
is the potential presence of reserve requirements.

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Publicly traded shares represent a significant source of funding for many private com-
panies, and firms regularly seek to repurchase from or float new shares in the marketplace.
Haruvy et al. (2014) study a standard asset market in which shares are either sold to or
bought and removed from the market at a predetermined moment in time in the market.
These market interventions are shown to have significant impacts on prices: bubbles
increase following a repurchase, and decrease following a share issue. The results are con-
sistent with a downward sloping demand for the asset, although they also suggest that the
effects are asymmetric because of resistance of prices to fall below the fundamental value.
Firm takeovers are an additional source of market activity which may affect mispric-
ing. Füllbrunn and Haruvy (2014) design an asset market setting where firm profits are
uncertain and dividend payments are endogenously chosen by a manager. Shareholders
periodically have the opportunity to sell the firm for an exogenously given price if they
believe that the manager is not sharing enough of the profits. Prices in these markets
indicate initial overvaluation of the firm, yet with repetition prices eventually reach the
fundamental value.
The underpricing of initial public offerings (IPOs) is an established empirical regularity.
This has been studied in experimental markets by adding an initial auction phase to deter-
mine the initial allocation of shares in the market. Füllbrunn et al. (2014) consider three
different choices for the auction mechanism: a closed book auction, in which all bids are
made privately; an open book auction, where traders observe and are able to react to bids
and the implied equilibrium price; and a book-building approach, which consists first of a
closed-book auction, followed by a second stage in which actual quantities purchased are
determined. Independent of auction mechanism, prices in the auction stage are shown to
be persistently lower than both fundamental values and prices in the aftermarket. These
differences are reduced but not completely eliminated with experience.
4.7 Coordination Mechanisms
While the causes of price increases are still being determined, an equally important part
of the bubble-and-crash puzzle is the cause of the crash. For whatever reason, prices begin
to increase, and this may be followed by further destabilizing speculation, resulting in a
feedback loop that drives prices even further away from fundamentals. At some point,
the feedback loop is broken, and the trend in prices is reversed. It is unclear whether this
break occurs because of nominal events or as a function of underlying market properties.
Ackert et al. (2014) consider the possibility of aberrant orders. At a predetermined
point in the market (chosen to be a point where significant mispricing typically exists),
an order to buy or sell a large number of shares at an obviously irregular price is entered
into the market. In line with expectations, orders to buy tend to increase prices compared
to orders to sell. However, their results suggest that the coordinating ability of the aber-
rant order, independently of its actual details, can serve to dampen bubbles. This means
that out-of-the-ordinary signals may act as circuit breakers that have larger than expected
effects on market performance.
Another type of potential coordination device is public messages. Various public enti-
ties, such as central banks and regulators, regularly state their opinions regarding the
current state of markets. These messages may contain new information regarding inten-
tions and beliefs, but at the same time they may also increase the likelihood of traders

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re-evaluating the market and thus breaking a feedback of mispricing. Stoian (2014)
compares a regular asset market with a market in which a message re-affirming publicly-
known information about the fundamental value is released at a predetermined time in
the market. No clear pattern emerges, suggesting that public messages may not be so
important in promoting the end of a bubble.
5 MEASURING MISPRICING
For the most part, measures can be classified into one of four types described by two
factors (see Table 21.4).
It is clear in a general sense what is meant by the phrase ‘bubble-and-crash’. In practice,
however, a precise definition is hard to come by. Even focusing on the simpler problem
of defining ‘mispricing’ given a set of price indices and fundamental values, we can
imagine various definitions. For the most part, measures can be classified into one of four
types described by two factors: (1) whether they attempt to measure a temporal or price
amount, and (2) whether they consider the absolute (mispricing) or signed (overpricing
or underpricing) deviation of prices from fundamentals.
There are arguments to be made in favor and against each type of measure – each
represents a different way of representing market performance. However, even within a
given type there are multiple ways to measure efficiency. We have reviewed the literature
and identified no fewer than 18 such measures that have been used. Additional dimensions
to the problem (such as how prices are averaged to arrive at an index and the length of
indexing period) multiply the set of measures. This is not an ideal state of affairs, since
it is not clear which results are most relevant and to what extent they are sensitive to the
choice of measure.
To this end, a strand of literature has developed that seeks to identify reasonable condi-
tions for restricting the set of admissible measures. The conditions identified in Stöckl et
al. (2010) require that a measure relates prices and fundamentals and that it is independ-
ent with respect to various quantities (the number of periods and average fundamental
value). As a result, the new measures they propose are essentially scaled versions of previ-
ous measures. Powell (2016) continues in this vein but shows that the measures analyzed
and proposed by Stöckl et al. (2010) are not independent with respect to one important
variable: the choice of units used to represent prices. Prices and fundamental values have
multiple equivalent representations since they are in fact rates of exchange, where each
Table 21.4 Bubble measures by type
Time- or price-based Price level or mispricing Examples

Price-based Price level Bias; amplitude
Mispricing Dispersion
Time-based Price level Boom duration; bust duration
Mispricing (none)
Note: Measure definitions are given in Haruvy and Noussair (2006).

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representation is defined by the choice of an appropriate numeraire. This motivates the

requirement that a measure of mispricing is independent from the nominal choice of
price numeraire, and it is shown that all arithmetic-mean based measures fail this test. As
a result, the geometric average deviation (GAD) is proposed as an alternative (although
still not unique) measure of mispricing that satisfies both the condition of numeraire
independence and the original conditions from Stöckl et al. (2010).
5 SUMMARY AND FUTURE RESEARCH
This study has reviewed the latest research on asset market experiments. The main result,
that market bubbles can readily occur in simple settings, has been widely replicated. The
propensity of markets to bubble has been shown to be sensitive to a variety of factors.
Markets populated with less risk-averse traders tend to have higher prices, and overall
uncertainty about the knowledge and intelligence of other traders increases mispricing. In
terms of the assets themselves, market prices have a tendency to exhibit less variation than
underlying fundamentals, and there appears to be a non-monotonic relationship between
private information and individual earnings. Finally, the structure of the market plays an
important role: trading restrictions tend to impact prices, the double auction environment
seems to be especially conducive to speculative behavior, and compensation schemes can
create an especially bubbly environment that does not even disappear with repetition.
The previous sections show that much has been learned about experimental asset
markets, but also that many open questions remain in the field. There are several resources
available to those looking to further investigate the topic. In addition to the various
surveys of the literature, Palan (2013b) includes a structured database of bubble measures
from many of the studies mentioned above. The same author has also developed special-
ized software for running asset market experiments (Palan 2015). Finally, the website
maintained by Powell (2015) contains a comprehensive list of studies related to the topic.
This chapter has reviewed work that shows that market bubbles can occur for a com-
bination of reasons. A combination of irrationality and the lack of common knowledge
thereof create an atmosphere that lends itself to the bubble-and-crash phenomena. The
research reviewed above shows that this phenomenon is sensitive to various factors, both
at the individual level, the assets being traded and the market. The continued importance
of markets as mechanisms for potentially aggregating information about preferences sug-
gests that this topic will continue to be an active research area for the near future.
NOTES
1. Although rare, exceptions do exist. See, for example, Xiong and Yu (2011), who study bubbles in essentially
worthless Chinese put warrants.
2. Naturally, asset values defined in terms of expected monetary value may not exactly describe their value to
individuals (owing to idiosyncratic risk and wealth preferences, for example). However, as a first approxima-
tion, they may still be useful.
3. In contrast, markets populated with heterogeneous agent values and specialized roles tend to behave rela-
tively efficiently (Chamberlin 1948; Smith 1962). Recent work has shown that specialization plays a key role
in generating efficient prices (Dickhaut et al. 2012).

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22 To consume or to save: are we maximizing or
what?
Tobias F. Rötheli*
1 INTRODUCTION
One of the most important relationships in macroeconomics is the so-called consump-

tion function. It relates aggregate consumption to other macroeconomic variables such
as income and wealth. Understanding the forces driving consumption is very important
for two reasons. First, changes in consumption are key determinants of changes in aggre-
gate income in the short term and, second, savings – the difference between income and
consumption – by affecting the accumulation of capital (physical and human) is a crucial
determinant of the longer-term course of an economy. As documented in this chapter,
economists have considered various explanations of the consumption–savings behavior.
It is remarkable that practically all of these approaches attribute some basic rationality
to economic decision makers. However, scientific explanations of consumption differ
significantly in the complexity of the decision making that various theories consider to
be the basis of behavior.
Currently popular theories of consumption portray the individual as solving a dif-
ficult intertemporal maximization problem that requires trading off utility from current
consumption against expected utility derived from future consumption. This is difficult
to believe and – in its specific implications – hard to square with empirical facts. As a
response, some behavioral economists have explored the notion that behavior is guided by
simple heuristics that perform almost as well as maximization routines. In this account,
simple behavioral rules are structured to lead agents to approximate fully rational behav-
ior. We develop a different explanatory strategy and see humans as endowed with prefer-
ences that are both straightforward to balance and conducive to survival. In the words of
theory, nature has provided us with a utility function that is simple to maximize and that
makes us behave in a smart way. The resulting human behavior may look to be heuristic
driven (that is, rule of thumb behavior) when in fact it is optimal given a smart and solv-
able decision problem.
Figure 22.1 illustrates in general terms the difference between the standard heuristics
approach and the approach of simple behavioral rules derived from maximization devel-
oped here. Decision rules vary with respect to the performance achieved (utility attained)
and computational complexity (that is, required information processing capacities). In
the standard interpretation of rule-of-thumb behavior (depicted on the left) maximiza-
tion leads to a high level of utility but comes at a high (and often unmanageable) level
of complexity. Heuristics are seen to yield a performance somewhat short of what the
maximization routine can achieve but they are significantly less demanding in terms of
complexity.1 The competing approach which we develop here for the purpose of explain-
ing consumption behavior is depicted on the right hand side of Figure 22.1. Here we see
392
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To consume or to save 393
(a) The heuristics approach (b) The alternative approach
Performance Performance
Maximization
Maximization
Simple rule-following
Heuristics
Complexity Complexity
Figure 22.1 Maximization and simple rule-following behavior
the decision maker as endowed with a utility function that is computationally straightfor-
ward and thus implies that behavior follows a simple rule. Here, maximization and simple
rule-following behavior are the same.
The text starts with a description of theoretical and empirical studies that have shaped
the field. In particular we focus on the life-cycle permanent income hypothesis of con-
sumption. This backbone of analysis will be used to discuss various issues of bounded
rationality, such as errors regarding expectations or problems of self-control. Thereafter,
the text explores an alternative explanation of the consumption–savings relationship that
strictly relies on variables currently observed and felt by the individual, that is, consump-
tion and wealth. It is argued that such a form of atemporal maximization is biologically
plausible and the theories’ predictions concerning aggregate behavior are in line with
empirical observations.
2 A REVIEW OF THEORETICAL DEVELOPMENTS
The typical starting point for a discussion of consumption is Keynes’s fundamental psy-
chological law that states that humans tend to increase consumption (C) with a rising
income (Y) but not by as much as the increase of income (Keynes 1936, p. 96). Although
Keynes acknowledges that a host of other factors influence the consumption–savings
decision, his consumption function as presented in countless textbooks can be displayed
in a simple two-dimensional C–Y chart with a positive intercept and a slope of less than
one. This functional relationship is the basis of presentations of the well-known multi-
plier effect of consumption. Within a few years of Keynes’s contribution, critics such
as Kuznets pointed out that one of the implications of this simple model of consump-
tion appeared to be at variance with empirical observations. According to the simplest
Keynesian consumption function an increase in income should lead to an increase in the
savings rate (a decrease in C/Y) over time as income rises because consumption would

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increase less than proportional to income. Evaluation of long time series of income and
consumption tended to contradict this implication of the Keynesian consumption func-
tion. At least over the period 1870 to 1940 savings as a proportion of income in the US
appeared to remain remarkably stable (Kuznets 1946).
Several theoretical developments have helped to explain this empirical regularity and
have come to form the core of the modern understanding of consumption and savings.
The crucial first element is Fisher’s notion of the individual (or the household) as being
engaged in an intertemporal assessment of consumption possibilities. According to
Fisher (1930), people constantly compare utility derived from current consumption with
the utility derived from extra consumption made possible in the future when today’s
consumption is curbed. This intertemporal tradeoff is seen to be just the generalization
of the timeless utility maximization determining, for example, the demand for apples
and bananas. Fisher’s understanding of intertemporal utility tradeoffs led to two major
developments or variants of consumption theories. In the version of Modigliani and
Brumberg (1954, 1979) agents are seen to maximize utility over a finite lifetime.2 In
Friedman’s (1957) contribution the focus is on a consumer living indefinitely who faces
changes in income that can be either permanent or transitory. The former concept has
come to be known as the life-cycle model of consumption and savings and the latter as
the permanent income hypothesis. Both concepts propose that to understand consump-
tion we need to look at more than just the current level of income. In the following I will
first concentrate on the life-cycle hypothesis. The life-cycle hypothesis appears to be the
more plausible account of behavior since it does not assume – as the permanent income
hypothesis does – that people in general show intergenerational altruism.3 Hence, the new
formulation of the consumption function introduced in section 4 will be compared with
implications of the life-cycle theory.
The basic insight of Modigliani and Brumberg into the determinants of consumption
and savings are most easily understood by imagining an individual who faces a (certain)
remaining lifetime of L years and a retirement age N years into the future. In the absence
of discounting, and with a constant income Y until retirement, no income afterwards and
a current level of wealth, W, a utility maximizer as proposed by Fisher would distribute
consumption evenly over his remaining life. Hence, in each period the individual would
consume (YN 1 W) /L. This in turn would imply positive savings before retirement (with
a steady increase in wealth) followed by dissaving during retirement with a steady decline
in wealth.4 An economy populated with individuals of this kind but of different ages
would not necessarily generate aggregate savings at all. Instead, the savings of the young
would just be offset by the dissaving of the old. Only in a growing economy would there
be positive savings which would be the greater the higher the growth rate. With positive
population growth there are more young people who save than older people who dissave.
Abstracting from complications owing to uncertainty, the described life-cycle approach
can deal with the key empirical challenge to the simplest version of the Keynesian theory
of consumption. Simply put, consumption of the individual is a function of income
(current and future) and of financial wealth. In the basic version of the theory described
above the propensity to consume out of income would be N/L<1 and the propensity to
consume out of wealth would be 1/L. While the term N/L provides the slope, the term
W/L captures the intercept of the Keynesian consumption function if it is understood to
describe the behavior of an individual. Consumption of a nation is additionally a func-

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tion of the age structure and growth rate of its population as well as of technology and
possibly the income distribution.5
The appeal of the life-cycle model depends on the predictability of income changes. As
regards income changes over the life-cycle of work and retirement, the basis for such a
predictability may exist. However, people often face the problem of having to assess the
consequences of unpredicted income changes. This leads us to the perspective of Friedman
and his concept of the permanent income. In Friedman’s view the consumer bases his con-
sumption–savings decision on all future expected income payments. Moreover, already
accumulated assets raise the consumption level. Friedman’s concept of permanent income
can best be understood as the highest level of time-invariant income that is equivalent to
the sum of the present value of the uncertain future income stream and the accumulated
wealth of an individual. Not surprisingly then, the consumer will synchronize his or her
consumption with changes in permanent income. Hence, temporary changes in income
will affect consumption much less than changes judged to be permanent. An interesting
point is the fact that maximization of expected utility can imply that consumers engage
in precautionary savings (Zeldes 1989; Carroll 1997; Cagetti 2003). In technical terms
among the von Neumann Morgenstern utility functions that display risk-aversion there
exists a (presumably empirically relevant) subgroup of functions that induces the inter-
temporal utility maximizer to hold a financial buffer against income loss. However, the
fact that people hold financial buffers (and as an implication leave unplanned bequests)
does not necessarily support the theoretical approach just outlined. The same behavior
can be rationalized quite differently, as shown in section 4.
3 ELEMENTS OF BEHAVIORAL ECONOMICS
For the behavioral economist, modern theories of consumption present several interest-
ing issues. First, consumers might not be able to rationally evaluate their future income
stream. Then, even if they were to function like intertemporally optimizing economic
agents they would be subject to possible under- or over-savings. A subject overestimating
future income would, at some point, find him or herself confronted with an unpredicted
and unpleasant, but necessary, drop in consumption. By contrast, a subject underestimat-
ing future income would die with unused wealth (that is, leave unplanned bequests). The
literature has considered the rationality of income expectations of consumers and has
found several forms of systematical forecast errors (Himarios 2000). Second, there is a
potential problem with time-consistent behavior or self-control. If an individual discounts
the immediate future more strongly than the more distant future then he will tend to sub-
optimally delay savings (Laibson 1997). Consumption paths chosen by such individuals
will not maximize their lifetime utility. Third, and most important, the computation of
optimal consumption as suggested by the permanent income hypothesis can become very
challenging. Only given certain specific combinations of utility functions, stochastic proc-
esses of income and interest rates does consumption follow a rule in which it is a fraction
of lifetime resources and where this fraction depends on currently observable variables.
That is, in general there exists no consumption function even for the single individual
where his or her current consumption would be a function of wealth as well as of current
and lagged income.

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The complication just described has led empirical research away from estimating con-
sumption functions and to the testing of Euler equations.6 The Euler equation relating
current consumption to consumption in the immediate past is just a necessary optimality
condition for the consumption stream indicating that the marginal utility of one further
unit of consumption today must be equal to the discounted marginal utility possible if
consumption is deferred by one period. Hall (1978) opened this strand of research with
his proposition that the consumption of rationally forward-looking consumers should
follow a random walk.7 Much of the empirical work on consumption in macroeconomics
over the past decades has focused on testing the validity of Hall’s proposition and discuss-
ing departures from it. Some of these departures as, for example, the excess sensitivity
of consumption to current income (according to Hall a predictable change in income
should not lead to a change in consumption) have led researchers to consider, among
other factors, limitations of some consumers in their access to credit markets (Campbell
and Mankiw 1989; Jappelli and Pistaferri 2010). An entire class of contributions which
may be termed behavioral has investigated the welfare losses of consumers who, instead
of correctly choosing the optimal consumption path, follow one or other simple rule of
thumb to guide their decisions. The findings of Cochrane (1989), Winter et al. (2012)
and Howitt and Ozak (2014) suggest that simple consumption rules, such as consuming
current income in general, result in only small losses of utility compared with the ideal of
perfect stochastic optimization.
4 AN ALTERNATIVE THEORY
Here I propose an alternative to the Fisherian tradition of seeing agents as continu-

ously making intertemporal comparisons of utility from consumption at different times.
The lead here is given by earlier writers’ notions that consumption is governed by more
hedonistic motives than the consideration for future utility. Before the field of economics
embraced Fisher’s idea of deferred utility, precursors such as Senior (1836 [2002]) and
Jevons (1871) had suggested that decisions were anchored in immediately experienced
emotions (see Loewenstein 1992 for an account of these developments). Hence, an
approach to modeling the consumption–savings decision in this vein should build on the
two readily observed sources of gratification, that is, (1) the level of consumption and
(2) the level of wealth. That consumption provides utility and positive emotions is self-
evident. However, a higher level of wealth also induces feelings of comfort or a reduction
of anxiety.8 It should be apparent that this approach has links to biological models of
behavior. In biology, studies on animal hoarding or caching abound (see Vander Wall
1990). Besides detailed descriptions of behavior of many different species (for example,
squirrels and many birds) the field has developed theoretical explanations based on cost–
benefit optimization. Of particular interest for our discussion here is the insight into the
variety of physiological processes and morphological structures that support the control
or decision process. An overview of such approaches indicates that these ‘models do not
require cognitive functions such as memory, consciousness, or forethought, but they do
not preclude them either’ (see Ydenberg 2007, p. 274). Decision mechanisms in this realm
appear to integrate sensory information and internal indicators of state as, for example,
hunger. Hence, the assumption that humans, too, trade off levels of indicators observed

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and felt in time is well founded. It would appear plausible that the consumption–savings
decision of humans should be similar to that of animals.
Further, the alternative I propose builds on several elements or theoretical tools that
are standard fare in economics. First, we think of aggregate behavior as aggregated over
individuals’ behavior. Second, we make use of the concept of maximization. I argue
that utility maximization has a considerable plausibility when it focuses on the tradeoff
between present consumption and present wealth. Third, we use an intertemporal budget
constraint: savings today increase wealth and finance future consumption. To state this
once again, we do not build on the notion of the individual as comparing the utility
derived from a dollar’s worth of consumption today with the discounted stream of future
utilities possible if this dollar is not spent today. Instead we see the individual as being
concerned with two variables, both of which give him or her direct pleasure or utility, that
is, consumption and wealth.9
A utility function flexible enough to capture interesting consumption–savings charac-
teristics is the following:
U(Ct, Wt) 5 alnCt + lnWt (22.1)
Disutility increases as both C and W move closer to zero. While the former effect captures
the fact that life without consumption becomes miserable if not impossible, the latter effect
reflects the fact that wealth cannot become negative.10 This does not preclude that the
individual can become financially indebted as long as the present value of future income
payments exceeds the level of debt. According to this proposition the economic agent
simply maximizes contemporaneous utility. Hence, intertemporal maximization is absent
here. However, the tradeoff between consumption today and consumption tomorrow is
embodied in the utility function (22.1) and the dynamics of wealth which we clarify next.
Essentially, valuing wealth besides consumption is important because delaying consumption
in favor of wealth accumulation means a higher level of possible consumption in the future.
With respect to wealth we have to make a distinction between financial wealth and non-
financial wealth as the discounted stream of future income. Whereas the former can turn
negative (that is, showing financial indebtedness), the latter will always be non-negative.
Wealth (Wt) is the sum of financial and non-financial wealth:
Wt 5 Wtf 1 Wtnf (22.2)
Financial wealth is
Wtf 5 (1 1 i) Wt21
f
1 Yt21 2 Ct21 (22.3)
and non-financial wealth is
Wtnf 5 a a b Yt
n t
1 e
(22.4)
t 5t11 1 1 r
Here n denotes the horizon of foresight concerning future incomes and r is a discount
factor that can be influenced by the uncertainty of the future income stream. Maximization
of utility with respect to Ct leads to the following simple consumption function:

M4225-ALTMAN_9781782549574_t.indd 397 03/05/2017 08:20

Ct 5 aWt (22.5)
In total we have introduced the two behavioral parameters a and r and one variable to
be modeled, that is, Ye. In a rational expectations version expected income is represented
by the unbiased forecast of future income. In summary, the stated simple consumption
rule follows from the tradeoff between consuming today and deferring income into the
future (wealth accumulation allowing consumption in the future). The next step will show
that this model can capture a wide range of interesting consumption–wealth profiles over
the lifetime of an individual.
5 INDIVIDUAL AND AGGREGATE CONSUMPTION

FUNCTIONS
Let us start with the basics and address two key questions. First, is the model at variance
with the empirically documented characteristic that consumption follows a process close
to a random walk (see Hall 1978)? A (near) random walk behavior is implied by our model
if wealth (the sum of financial and non-financial wealth) follows a (near) random walk
process. This in turn gives results (1) for non-financial wealth if (as in the basic setup
followed here) income expectations are rational and (2) if, as is likely, financial wealth
follows a (near) random walk.11 Second, how does the derived consumption function
compare to the life-cycle model of savings? To answer this question it is best to begin by
considering an individual as outlined by Modigliani and described in section 2. The only
two differences to Modigliani’s stripped-down setup are that we consider the fact that
the individual’s income rises over his or her working life and that the interest rate is posi-
tive. Assume that on an annual basis the income of a typical individual rises by a growth
rate g. After retirement the individual has to live on his or her savings. Assume further
rational expectations as a working assumption, that is, we take the decision maker in this
basic version to perfectly foresee his or her future income stream. The horizon concerning
future income payments encompasses all future payments until retirement.
Figure 22.2 displays the time paths of consumption and income for six combinations
of parameters. For all cases g is taken to be 3 percent per year which is the historical
average of growth of US real gross domestic product (GDP). Further, we base all calcula-
tions on an annual interest rate of 3 percent. The three displays to the left show graphs
based on a value of the discount rate r of 0.10 and for three different values for a from
0.05 to 0.07 to 0.09. The chosen magnitude of a–values generates a variety of interesting
consumption and wealth patterns. Furthermore, when turning to estimation, in section
6, we find empirical values of a in this range. The lower left panel shows a case where
the individual goes into debt in the early part of his life. The case just above shows no
indebtedness early in life whereas the chart at the top left shows a case where consump-
tion before retirement is always below income and in the early years almost moves parallel
to income. Anticipating the findings in the empirical section of this chapter we point to
the parameterization with an a of 0.07 and an r of 0.10 as being empirically relevant
for the US.
The graphs on the right-hand side are computed based on a higher discount rate r of
0.15. Here, consumption is lower than on the left-hand side in the first half of life while

M4225-ALTMAN_9781782549574_t.indd 398 03/05/2017 08:20

450 450
Y Y
400 400
C C
350 350
300 300
250 250
200 200
150 150
100 100
α = 0.050, ρ = 0.10 α = 0.050, ρ = 0.15
50 50
0 0
20 40 60 80 20 40 60 80
450 450
Y Y
400 400
C C
350 350
300 300
250 250
200 200
150 150
100 100
α = 0.07, ρ = 0.10 α = 0.07, ρ = 0.15
50 50
0 0
20 40 60 80 20 40 60 80
450 450
Y Y
400 400
C C
350 350
300 300
250 250
200 200
150 150
100 100
α = 0.09, ρ = 0.10 α = 0.09, ρ = 0.15
50 50
0 0
20 40 60 80 20 40 60 80
Figure 22.2 Individual consumption profiles for different parameterizations of the model

M4225-ALTMAN_9781782549574_t.indd 399 03/05/2017 08:20

3000
W financial
2500 W non-financial
2000
1500
1000
α = 0.07, ρ = 0.10
500
0
20 30 40 50 60 70 80
–500
–1000
3000
W financial
2500 W non-financial
2000
1500
1000
α = 0.09, ρ = 0.10
500
0
20 30 40 50 60 70 80
–500
–1000
Figure 22.3 Time paths for financial and non-financial wealth for two parameterizations
consumption towards the end of life is higher. Note that in all cases shown the individual
will leave bequests, that is, will not use up his wealth by the time of his death.
The dynamics of wealth accumulation become even clearer when we consider the paths
for financial and non-financial wealth for two of our parameterizations. Figure 22.3

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shows the two forms of wealth over time calculated with (upper panel) an a of 0.07
and (lower panel) an a of 0.09 both given a r of 0.1. These two cases correspond to the
lower two left-hand panels shown in Figure 22.1. In the case with the lower a (meaning
consumption is valued less and wealth accumulation more) the individual never goes into
debt, while in the case with the higher a the individual goes into debt early on in life. Note
that even in the case with indebtedness the overall level of wealth (including financial and
non-financial wealth) is always positive.12
Next we consider how deviations from the working assumption of rational expectations
tend to change the consumption profile of the individual. We limit the analysis here to
one concrete scenario, that is, the case of static income expectations. Under this scenario
the individual does not expect any income increase in the future and instead at any point
in time judges the current level of income to continue until retirement. This could be
termed an overly prudent income expectation. The outcome here is that in all cases the
age with the highest consumption is moved forward in time because savings early in life
are higher with static income expectations than with correct (that is, rational) expecta-
tions. However, the described bias in expectations appears to have only marginal effects on
consumption in later years. Furthermore, the consumption paths in the two cases with a5
0.07, r 5 0.10 under rational expectations and a5 0.09, r5 0.10 under static expectations
are very similar. This indicates that the identification of the process governing income
expectations in econometric estimates of consumption data may be difficult to achieve.
Figure 22.4 shows the various simulated paths for static income expectations.
6 CAN THE NEW THEORY MATCH EMPIRICAL

REGULARITIES?
This section opens an empirical window on the proposed model for the consumption–
savings relationship. We start out by investigating in the first subsection how well the pro-
posed new model is able to replicate empirical consumption–income and wealth–income
ratios for the US. Subsection 6.2 then treats the time-series dimension by checking how
well the model is able to track aggregate consumption data.
6.1 Matching the Consumption Rate and the Wealth–Income Ratio
This exercise addresses the following question: can the proposed model explain key eco-
nomic data at the aggregate level? For the present purpose we focus on the US economy.
In concrete terms we are interested in finding model parameters to match observations
regarding the savings rate, that is, the saving–income ratio and also the wealth–income
ratio. The ease with which the life-cycle model replicates the aggregate wealth–income
ratio has always been identified as being one of the impressive features of this model (see
Modigliani 1986; Deaton, 2005).13 Modigliani took the empirical W/Y ratio (based on
earlier work by Goldsmith 1956) to be around a value of 5. Recent work by Piketty and
Zucman (2014, p. 1285) puts a value of 4.31 on this ratio. This is the value we attempt
to match with our model. The second empirical observation to be accounted for by
the model is the consumption rate, that is, C/Y. Here we rely on data published by the
Organisation for Economic Co-operation and Development (OECD). For the US savings

M4225-ALTMAN_9781782549574_t.indd 401 03/05/2017 08:20

450 450
Y Y
400 400
350 C 350 C
300 300
250 250
200 200
150 150
100 100
50 α = 0.050, ρ = 0.10 50 α = 0.050, ρ = 0.15
0 0
20 40 60 80 20 40 60 80
450 450
Y Y
400 400
350 C 350 C
300 300
250 250
200 200
150 150
100 100
50 α = 0.07, ρ = 0.10 50 α = 0.07, ρ = 0.15
0 0
20 40 60 80 20 40 60 80
450 450
Y Y
400 400
350 C 350 C
300 300
250 250
200 200
150 150
100 100
50 α = 0.09, ρ = 0.10 50 α = 0.09, ρ = 0.15
0 0
20 40 60 80 20 40 60 80
Figure 22.4 Individual consumption profiles with static income expectations

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Table 22.1 Sensitivity analysis for W/Y concerning the parameters a and r
r, a 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12 0.13 0.14
0.04 3.463 −0.438 −3.304 −5.448 −7.079 −8.343 −9.339 −10.14 −10.79 −11.32 −11.77
0.05 5.759 1.965 −0.855 −2.987 −4.628 −5.911 −6.933 −7.758 −8.435 −8.998 −9.472
0.06 7.618 3.914 1.136 −0.985 −2.630 −3.928 −4.968 −5.814 −6.512 −7.095 −7.589
0.07 9.140 5.513 2.771 0.663 −0.984 −2.292 −3.346 −4.208 −4.922 −5.522 −6.030
0.08 10.40 6.839 4.130 2.034 0.387 −0.927 −1.992 −2.866 −3.594 −4.206 −4.727
0.09 11.45 7.950 5.270 3.186 1.540 0.221 −0.851 −1.735 −2.472 −3.095 −3.625
0.10 12.34 8.889 6.235 4.162 2.519 1.198 0.119 −0.772 −1.517 −2.148 −2.687
0.11 13.10 9.691 7.060 4.998 3.358 2.034 0.952 0.055 −0.697 −1.334 −1.879
0.12 13.75 10.38 7.771 5.719 4.082 2.758 1.672 0.771 0.014 −0.629 −1.180
0.13 14.32 10.98 8.388 6.346 4.713 3.388 2.300 1.395 0.634 −0.013 −0.569
0.14 14.81 11.50 8.928 6.895 5.265 3.940 2.851 1.943 1.178 0.527 −0.032
rate the historical (1970 to 2014) average value for the savings rate is 0.077 and hence the
consumption rate we are matching with our model is 0.923. For the computations of the
model-based indicators we compute the aggregate values of C, Y and W by weighting
individual measures according to US Census data on the single year age distribution.14
For the US economy the two parameters r and a are estimated here by a numerical
search minimizing the sum of the squared percentage deviations of the theoretically
implied C/Y and W/Y ratios from their empirical values. We find an r-value of 0.10 and an
a-value of 0.07.15 The estimated subjective discount rate is in the range considered plau-
sible in the literature.16 In order to build intuition regarding the effect of different values
of r and a on W/Y and C/Y, we report the results of sensitivity analyses in Tables 22.1
and 22.2. Table 22.1 indicates that the W/Y ratio monotonously increases with a higher r
and a lower a. With respect to the C/Y ratio (Table 22.2) there exists a monotonous (and
positive) relationship only with respect to r. By contrast, the effect of a on C/Y is first
positive and then reverses its sign. The mechanism behind this effect is the following: at
low rates of a an increase of this parameter leads to higher overall consumption whereas
an increase beyond a critical level implies that the high consumption during the early years
of life leaves little wealth in later years and thereby lowers average consumption when
seen over all ages of consumers. Another way to use the two tables is by considering what
a possible revision of the empirical measures of, say, C/Y would mean for the estimated
parameters. Consider, for example, what a downward revision of the empirical value of
C/Y, for example, to a value of 0.90 would imply. With an unchanged W/Y of 4.31 this
would indicate a change in parameter values to about 0.08 for r and 0.06 for a. If instead
the W/Y-measure were corrected for the US to, say, a value of 5.0 then a combination of
a slight decrease of a and a slight increase of r (by less than 0.01 each) would be implied.
Overall then, the reported parameter estimates appear robust to a possible mismeasure-
ment of W/Y and C/Y.

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Table 22.2 Sensitivity analysis for C/Y concerning the parameters a and r
r, a 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12 0.13 0.14
0.04 0.803 0.809 0.799 0.782 0.763 0.745 0.728 0.713 0.700 0.688 0.678
0.05 0.819 0.834 0.831 0.821 0.807 0.792 0.778 0.765 0.753 0.742 0.733
0.06 0.831 0.853 0.857 0.851 0.841 0.830 0.818 0.806 0.796 0.786 0.778
0.07 0.839 0.868 0.877 0.876 0.869 0.860 0.850 0.840 0.831 0.822 0.814
0.08 0.846 0.880 0.893 0.896 0.892 0.885 0.877 0.868 0.860 0.852 0.845
0.09 0.852 0.889 0.906 0.912 0.910 0.905 0.899 0.891 0.884 0.877 0.870
0.10 0.856 0.897 0.917 0.925 0.926 0.922 0.917 0.911 0.904 0.897 0.891
0.11 0.859 0.903 0.926 0.936 0.938 0.937 0.932 0.927 0.921 0.915 0.909
0.12 0.861 0.908 0.933 0.945 0.949 0.949 0.945 0.941 0.935 0.930 0.924
0.13 0.863 0.912 0.939 0.953 0.958 0.959 0.957 0.953 0.948 0.943 0.938
0.14 0.865 0.916 0.944 0.959 0.966 0.968 0.966 0.963 0.959 0.954 0.949
6.2 The Time-series Behavior of Consumption
In this subsection we report results of regression analyses using quarterly US data for the
period from 1952 to 2013. We use nominal values of total personal consumption expendi-
tures (for C), disposable personal income (for Y) and total financial assets of households
and non-profit organizations (for Wf). The specification used here is the following:
D (Ct ) 5 b0 1 b1 D (Yt ) 1 b2 D (Wtf ) 1 et (22.6)
The variable Yt is included here on the assumption that non-human wealth is a function
of the currently observed level of income. There are several obstacles to a structural inter-
pretation of the b1 parameter. In particular, we do not address the issue of how income
expectations are formed and how future income values should be proxied econometrically.
Hence, we will not attempt to identify the discount rate here. However, the theoretical
parameter a is clearly identified and can, in principle, be estimated. It is measured by the
value of parameter b2 in our regression equation (22.6). We apply a two-stage least squares
procedure with lagged terms of the exogenous variable as instruments.17 Estimating (22.6)
over the whole sample period from 1953 to 2013 leads to the following result:
D (Ct ) 5 10.466 1 0.280D (Yt ) 1 0.084D (Wtf ) (22.7)

(4.326) (0.135) (0.018)
Standard error of estimate (SEE) 5 52.63, Durbin Watson (DW) 5 1.96
The numbers in parentheses below the coefficients are the standard errors of the param-
eter estimates and indicate that both the income and the wealth variables are statistically
highly significant. The implied estimate of a is 0.084. We also report estimation results
for a further specification where a lagged dependent variable is included. The estimation
result for this version is
D (Ct ) 5 3.638 1 0.526D (Ct21) 1 0.031D (Yt ) 1 0.065D (Wtf ) (22.8)

(5.888) (0.211) (0.233) (0.020)

M4225-ALTMAN_9781782549574_t.indd 404 03/05/2017 08:20

SEE 5 41.60, DW 5 2.14
Thus, the two documented estimates of the effect of wealth on consumption we have from
the econometric analysis of US time series (0.084 and 0.065) give us a range similar to
that reported (0.07) in the calibration exercise. The econometric analysis here is very pre-
liminary in many dimensions. Nevertheless, these results further support the plausibility
of the theoretical model.
7 CONCLUSIONS AND OUTLOOK
This chapter presents a survey of both older and more recent literature on the con-
sumption–savings decision from a macroeconomic perspective. Starting with the
Keynesian consumption functions and the extensions proposed by Modigliani and
Friedman, we discuss limitations and extensions of the currently dominant variant of
the rational choice approach. We further propose an alternative approach that gets by
without the notion that decision makers evaluate and trade off utility of consumption
today and consumption at different points in the future. This approach takes us away
from a course of economic theorizing proposed by Irving Fisher that has dominated
research on consumption and savings for almost a century. The model of consumption
proposed here sees the decision maker as trading off the utility derived from consump-
tion today with the utility (or comfort) derived from an increase in wealth. Clearly a
decision maker who values wealth does so with a view to consumption in the future,
made possible by his or her accumulated wealth. Thus, the model presented here is
a behavioral economics alternative to the life-cycle permanent income hypothesis of
consumption.
On a methodological level, the approach proposed here is in contrast to an interpretation
of simple rule-following as behavior guided by a heuristic that approximates a complex
(for example, intertemporal) maximization problem. Smart behavior in our interpretation
means that economic decision makers are guided by preferences that help them survive not
least because the balancing between these preferences does not absorb all of their scarce
information-processing capacities. In the theory of consumption outlined here agents
solve a manageable maximization problem. People are seen as maximizing utility which
is determined by the two observable variables consumption and wealth. The solution of
this problem is a simple rule that makes consumption a function of the sum of financial
and non-financial wealth. Our simulation, calibration and estimation exercises document
that this model can account for key features of consumption and wealth data of the US.
An extension of the model planned for future research consists of a refinement for
the purpose of time-series estimates. In particular, a behaviorally more accurate model
of income expectations following contributions by Watts (1957) and Batchelor and Dua
(1992) should be explored. Such a development will make use of the concept of pattern-
based expectations (Rötheli 2017) which offers a novel approach to empirically modeling
short- and long-term expectations. Furthermore, empirical analyses with data from other
countries as well as with disaggregated data (household data) could shed light on the
validity of the hypothesis proposed here.
Future work will also have to address the question of whether the methodological

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approach proposed here can be made fruitful for other questions in economics. In particu-
lar, it seems that theorizing in behavioral economics has cut itself off from the principle of
maximization too quickly when instead the scientific challenge is to find utility functions
that are smart for people to maximize.
NOTES
* I would like to thank Morris Altman, Christoph Mölleken, Karlhans Sauernheimer, and Hugh Schwartz
for comments and the German Research Foundation (DFG) for financial support.
1. A crucial question, typically dodged by proponents of heuristics, is how exactly agents come to choose
heuristics. If the solution of the maximum problem is not computable for the decision maker, how should
he or she know which heuristic is closer to the maximum. This critique to the standard heuristic approach
is particularly important in the context of intertemporal choice covered here.
2. See Deaton (2005) and Attanasio and Weber (2010) and for review articles.
3. With perfectly predictable income the life-cycle theory and the permanent income theory predict the same
consumption behavior. Since the typical version of the permanent income hypothesis assumes infinite
life times (in more realistic terms a generalized bequest motive), the life-cycle model would need to also
include consumption by the offspring in the utility function of the decision makers to make it equivalent
with Friedman’s theory. One major difference between the two approaches, hence, turns around the role
of bequests in wealth accumulation. Modigliani (1988), in his review of empirical studies, comes to the
conclusion that bequeathed wealth is not the dominant part of wealth as some authors claim. Further he
concludes that, except for individuals in the highest income and wealth brackets, bequests are in significant
proportion the result of the precautionary saving captured by the life-cycle model.
4. Clearly, a high starting level of wealth (for example, from inheritance) could lead to negative savings over
the entire life span.
5. Evidence regarding the importance of the income distribution on aggregate consumption is mixed.
Musgrove (1980), for example, studying a cross section of countries, finds no systematic evidence while
Frank et al. (2014), building on Duesenberry’s (1949) relative income theory, find changing income distri-
bution an important determinant of the decline in the US savings rate of recent years.
6. See Spanos (1989), Blinder et al. (1985) and Thomas (1989) for surveys of econometric work on the
consumption function.
7. The apparent simplicity of this property masks the difficult problem for the individual optimizer who must
find out at what level consumption should follow a random walk.
8. The approach proposed here is very different from another recent approach of considering wealth as a
determinant of consumption. In an interpretation of the German sociologist Max Weber (exploring the
so called ‘spirit of capitalism’ hypothesis), researchers have considered wealth as an additional element in
the intertemporal maximizing framework discussed in sections 2 and 3 of the present chapter (Luo et al.
2009).
9. Thore (1961) can be seen as a precursor of this approach since he presented a model for empirical research
in which a utility index is made a function of income and next-period wealth. Empirical specifications of
the consumption functions with wealth as an explanatory variable have been proposed in different forms
(Lydall 1963; Projector 1968; Mayer 1972).
10. Theoretical purists might point out that this latter effect should be modeled as a restriction instead of a
feature of the utility function.
11. For more on this point see Hall (1978, p. 976).
12. Clearly, an individual who cannot borrow would not be able to run a level of consumption higher than his
or her current income even if he or she were to expect a future increase in income.
13. The impressive part of the life-cycle model is that it explains the W/Y ratio without estimating any
parameters. The W/Y ratio simply depends on the average length of retirement.
14. See the data appendix for links to the population data.
15. While earlier studies have estimated the propensity to consume out of wealth to be around 0.03 to 0.05
(that is, somewhat lower than our 0.07) a recent study by Carroll et al. (2011) presents estimates in the range
proposed here.
16. In particular, our estimate here is well below estimates reported in some earlier studies with consumption
data which report very high discount rates. Graham and Himarios (1996), for example, report estimates
of the rate consumers discount their future income stream as high as 0.34.
17. The instruments are the explanatory variables lagged by two, three and four quarters.

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APPENDIX 22.1 DATA SOURCES
Age distribution of U.S. population: United States Census Bureau, available at http://
www.census.gov/population/international/data/idb/informationGateway.php.
Time series data for C (personal consumption expenditures), Y (disposable personal

income) and W (total financial assets of households and non-profit organizations):
Federal Reserve Bank of St Louis, available at http://research.stlouisfed.org/fred2/.

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PART VI
DIMENSIONS OF HEALTH

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23 Time orientation effects on health behavior
Jannette van Beek, Michel J.J. Handgraaf and
Gerrit Antonides
Many everyday choices have an intertemporal character, which manifests itself in the
trade-offs that have to be made between outcomes that will appear at different moments in
time. This is what apparently different choices, such as saving or spending money, taking
or refusing vaccinations, and eating a healthy or an unhealthy meal, have in common.
Each of these decisions involves a trade-off between a sooner, but often smaller, outcome
(for example, enjoying a tasty dinner) and a later, but often larger, outcome (for example,
being in good health). Predictions regarding such intertemporal choices may differ sub-
stantially between the standard economic model and the behavioral economic model,
especially with regard to the human tendency to attach disproportionally high value to
present outcomes (as compared to future outcomes). Such behavior may be beneficial in
times of food scarcity, but is suboptimal in contemporary Western societies in which food
is abundantly available. Stanovich (2010) points to Type 1 processes (fast and automatic)
as being related to such suboptimal behavior, whereas Type 2 processes (slow and analytic)
are being useful in overriding Type 1 processes. Both tempting situations and individu-
als’ bounded rationality seem to act as barriers to the use of Type 2 processes. Hence,
it appears to be smart to distinguish situations in which suboptimal behavior cannot
be harmful (for example, in terms of future health) from situations that are potentially
harmful. For instance, in a situation in which a dietician decides about an individual’s
food choice, he can freely satisfy his immediate desires. However, in situations in which
commercial motives drive product offerings, he has to be careful and take into account
the future consequences of his actions. Consequently, such choices are influenced by
individual differences in time orientation, which is our orientation toward and concern
with the present and the future.
In this chapter, we first give a brief overview of three different, yet related, concep-
tualizations of time orientation. We discuss discounting (section 1.1), time perspective
(section 1.2) and consideration of future consequences (section 1.3) and provide some
examples of instruments to measure these concepts. Additionally, we provide an over-
view of studies on the relations between various time orientation measures (section 1.4).
Subsequently, we discuss the extent to which time orientation varies across domains,
such as money, health and the environment, but also within domains, such as across
various types of health behavior. Differences across domains have mainly been examined
in studies on discounting (section 2.1), whereas differences within domains have mainly
been examined in studies on time perspective and consideration of future consequences
(section 2.2). Finally, we discuss the predictive capacity of various time orientation meas-
ures with respect to health behavior (section 3.1) as well as some measurement issues that
impede interpretation of the relationship between time orientation and health behavior
(section 3.2).
413
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1 CONCEPTUALIZATION AND MEASUREMENT OF TIME

ORIENTATION
Time orientation can be defined and operationalized in various ways. Generally, a dis-
tinction can be made between economic concepts (for example, time preference and dis-
counting) and psychological concepts (for example, time perspective and consideration of
future consequences). In this chapter, we use time orientation as an overarching concept
and define this concept as a general orientation toward either the present or the future.
This definition does not include an orientation toward the past. Although it is possibly
beneficial to also focus on past orientation in future research (Griva et al. 2015), to date
the majority of studies have focused on present versus future orientation. In this section
we discuss and compare three major conceptualizations of time orientation: discounting,
time perspective and consideration of future consequences. We do not discuss a range of
other concepts, such as delay of gratification (for example, Mischel et al. 2003), impulsiv-
ity (for example, Ainslie 1975), psychological distance and construal level (for example,
Trope and Liberman 2010) and elaboration of potential outcomes (Nenkov et al. 2008),
because, even though they are to some extent related to time orientation, they do not spe-
cifically focus on the concept of time. The three concepts that we do discuss cover both
economic and psychological literatures on time orientation. Additionally, these concepts
are widely used in research on domain differences in time orientation (see section 2) as
well as in studies on time orientation and health behavior (see section 3).
1.1 Discounting
Discounting generally refers to the phenomenon that future outcomes are valued less than
present outcomes. Several terms, such as temporal discounting, time discounting, delay
discounting and time preference, are used interchangeably to refer to this phenomenon,
but subtle differences in meaning and usage across disciplines exist (Frederick et al. 2002;
Doyle 2013). In this chapter we consistently refer to this phenomenon with the overarch-
ing term discounting. In addition to the various terms used to describe discounting, many
different models of discounting exist (for an overview, see Doyle 2013). Here, we briefly
discuss two of the main variants of discounting: exponential discounting and hyperbolic
discounting. Exponential discounting assumes a constant decline in the perceived value
of an outcome as the outcome materializes further into the future. For example, the dis-
count rate may be ten percent in each year of a period of ten years. Thus, in continuous
time, the discount rate is captured by an exponential function. Although this is generally
considered to be the standard form of discounting, empirical research showed that indi-
viduals’ actual behavior deviates from the assumption of a constant discount rate (Read
2004). For example, the discount rate may be 10 percent in the first year of a period of ten
years and less than 10 percent in the years thereafter. This is captured in a hyperbolic func-
tion, which resembles more closely an individual’s high discount rate in the near future
and lower discount rate in the distant future. Research has established several additional
deviations from standard discounting, including delay, magnitude and sign effects (Thaler
1981), direction effects (Loewenstein 1988), sequence effects (Loewenstein and Prelec
1993) and interval effects (or subadditive discounting; Read 2001), as well as interactions
between these effects (Read 2004). Such effects can be considered as sensible or smart,

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Time orientation effects on health behavior 415
but incompletely rational, behavior. This may lead to suboptimal outcomes in a rational
sense, but satisfactory outcomes in the human sense.
A common approach to elicit discount rates is direct measurement by means of time
trade-off measures, consisting of choices between a smaller, sooner (SS) reward and a
larger, later (LL) reward. Time trade-off measures can be constructed in various ways
(Hardisty et al. 2013). Open questions basically ask for the lowest amount at which the
LL-reward is preferred. Cascade questions ask for a series of forced choices between a
specific SS-reward and a specific LL-reward, consecutively narrowing down the difference
between the rewards (Fuchs 1982). An example of a validated measure to elicit discount
rates is the Monetary Choice Questionnaire (Kirby et al. 1999), which consists of 27
choices between monetary SS- and LL-rewards (for example, $14 today or $25 in 19 days’
time). All of these measures can be either incentivized or non-incentivized. Incentivized
choices have direct consequences for the decision maker, because the chosen option is paid
off. Alternatively, one of the choices or one of the decision makers may be paid out at
random after all choices have been made (Harrison et al. 2002). Non-incentivized choices
are in fact hypothetical, because the chosen option is not paid off. However, several studies
suggest that hypothetical rewards are discounted in the same way as real rewards (for
example, Madden et al. 2003).
Some studies do not measure discount rates directly, but infer them from behavior. For
example, in choosing between cheap, but energy-consuming, equipment and expensive,
but energy-saving, equipment consumers have to trade off current costs and future ben-
efits. Consequently, implicit discount rates have been estimated from consumers’ choices
of air conditioners (Hausman 1979) and refrigerators (Gately 1980). Also, proxies of the
discount rate have been inferred from behavior. For example, smokers are assumed to
have a higher discount rate than non-smokers. This method is often used when research-
ers make use of existing datasets, for example, the DNB Household Survey (Borghans
and Golsteyn 2006). In this case, questions about financial management, saving behavior
and risk-taking behavior can be used as proxies for the discount rate. In another study,
variables such as education level, smoking, exercising, use of nutrition labels and motiva-
tion to acquire nutrition knowledge were used as proxies for the discount rate (Huston
and Finke 2003). Subsequently, this inferred discount rate was used to predict healthy
eating behavior. Although this method is sometimes the only possibility and uses rea-
sonable indicators, it still poses problems. For example, when discount rates are inferred
from smoking, it becomes impossible to use the same discount rate to predict smoking.
Nevertheless, it is possible to predict different behaviors than the one from which the
discount rate is inferred. For a more extensive discussion of intertemporal choice and
discounting, we refer to Loewenstein and Prelec (1992), Frederick et al. (2002), Berns et
al. (2007) and Scholten and Read (2010).
1.2 Time Perspective
Time perspective is a relatively stable individual trait that refers to the extent to which
individuals orient themselves toward the past, the present and the future. Whereas early
studies on time perspective often used projective techniques to elicit an individual’s time
perspective (for an overview, see Teuscher and Mitchell 2011), later studies measured time
perspective directly through questionnaires. Although various other instruments exist, the

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Zimbardo Time Perspective Inventory (ZTPI) is currently the most widely used measure
of time perspective. The ZTPI was developed by Zimbardo and Boyd (1999) in order to
comprehensively measure the multidimensional construct of time perspective in a valid
and reliable way. In addition to distinguishing between the past, the present and the future,
Zimbardo and Boyd (1999) made distinctions between different variants of these orienta-
tions. As a result, the ZTPI consists of five subscales, each measuring a distinct temporal
orientation. The Past-Negative subscale reflects a negative view on the past (for example,
focusing on painful past experiences), whereas the Past-Positive subscale reflects a posi-
tive view on the past (for example, feelings of nostalgia). The Present-Hedonistic subscale
reflects a positive view on the present, without concerns about future consequences (for
example, acting impulsively), whereas the Present-Fatalistic subscale reflects a negative
view on the present (for example, feelings of hopelessness). Finally, the Future subscale
reflects a general view on the future (for example, focusing on obtaining future goals).
Recent research has added several dimensions to these five dimensions (for an overview,
see Stolarski et al. 2015, p. 8). The original ZTPI consists of 56 items, but various short
forms are being used as well. Although Zimbardo and Boyd (1999) reported that the ZTPI
has acceptable reliability, later studies have reported lower reliability, which is probably
due to the inclusion of items that are not directly related to time perspective (Crockett et
al. 2009). For an extensive overview of research on time perspective, we refer to Stolarski
et al. (2015).
1.3 Consideration of Future Consequences
Whereas most conceptualizations of time orientation are fairly general, consideration

of future consequences (CFC) is a much more specific concept. It reflects ‘the extent to
which people consider the potential distant outcomes of their current behaviors and the
extent to which they are influenced by these potential outcomes’ (Strathman et al. 1994,
p. 743). To measure this construct, Strathman et al. (1994) developed the Consideration
of Future Consequences scale. Originally, both the construct and the scale were one-
dimensional. At one end of the continuum, individuals would be completely present-
oriented (that is, focusing solely on the immediate consequences of their behavior while
neglecting the future consequences) and at the other end of the continuum, individuals
would be completely future-oriented (that is, focusing solely on the future consequences
of their behavior while neglecting the immediate consequences). Later studies showed
that the CFC scale actually captures a two-dimensional construct. Petrocelli (2003) was
the first to examine the factor structure of the CFC scale and recommended the use of an
eight-item short version of the original twelve-item scale. Subsequent studies showed that
the CFC scale actually consists of two factors (Joireman et al. 2008, 2012; Rappange et al.
2009; Toepoel 2010; Adams 2012; Bruderer Enzler 2015; Vásquez Echeverría et al. 2015).
One of these factors reflects consideration of future consequences (labeled CFC-future,
consisting of five items), whereas the other factor reflects consideration of immediate
consequences (labeled CFC-immediate, consisting of seven items; Joireman et al. 2008).
Some studies have found different factor solutions (that is, either one factor or more than
two factors; Crockett et al. 2009; Hevey et al. 2010; Ryack 2012; Ainin et al. 2015; McKay
et al. 2015a, 2015b; Zhang et al. 2015). Generally, the CFC scale has good reliability,
although this could be partly due to the fact that respondents who have difficulties with

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understanding the items tend to consistently use the midpoint of the scale (Crockett et
al. 2009). Recently, two items have been added to the CFC-future subscale to increase its
reliability, resulting in a new CFC-14 scale (Joireman et al. 2012).
Although scores on the CFC-future and CFC-immediate subscales are often negatively
correlated, this does not necessarily have to be the case. Additionally, it is important to
note that CFC-future and CFC-immediate are both theoretically and empirically distinct
concepts (Arnocky et al. 2014). For example, CFC-immediate predicts both trait self-
control (Joireman et al. 2008) and body mass index (Adams 2012), whereas CFC-future
does not. For more background on consideration of future consequences, we refer to
Strathman et al. (1994) and Joireman et al. (2006).
1.4 Relations between Time Orientation Measures
Research on the relations between different time orientation measures is limited.

Therefore, Teuscher and Mitchell (2011) reviewed studies on discounting and time per-
spective as a way of establishing indirect evidence on the empirical relations between the
two constructs. The authors conclude that discounting and time perspective are conceptu-
ally similar and have shared associations with a range of behaviors; yet the relationship
does not seem to be strong. Charlton et al. (2011) employed an item-level analysis in order
to gain a better understanding of discounting and its relation with the CFC scale. Results
showed that discounting was mainly related to items about immediate decisions (and less
to items about future decisions).
Even though only a few studies directly compare measures of time orientation, many
studies employ two or more time orientation measures. A study by Daugherty and Brase
(2010) showed that higher scores on ZTPI Future are related to less discounting, whereas
higher scores on both ZTPI Present-Hedonistic and ZTPI Present-Fatalistic are related to
more discounting. Similarly, higher scores on CFC-future are related to less discounting,
whereas higher scores on CFC-immediate are related to more discounting (Joireman et
al. 2008). Together, these studies indicate that individuals who are future-oriented and/
or care about the future consequences of their behavior exhibit less discounting, whereas
individuals who are present-oriented and/or care about the immediate consequences of
their behavior exhibit more discounting. Generally, correlations between discount rates,
on the one hand, and both the ZTPI and CFC scale, on the other hand, are small in size
(for an overview, see Table 23.1, column 3).
Some studies employed both the ZTPI and CFC scale, but not all of them distinguished
between the three most relevant ZTPI subscales (Future, Present-Hedonistic and Present-
Fatalistic) and between CFC-future and CFC-immediate. A recent study (Milfont and
Schwarzenthal 2014) showed that CFC-future was positively related to ZTPI Future and
negatively related to ZTPI Present-Fatalistic, but not related to ZTPI Present-Hedonistic.
In addition, CFC-immediate was positively related to both ZTPI Present-Hedonistic and
ZTPI Present-Fatalistic and negatively related to ZTPI Future. As would be expected,
these correlations indicate that future-oriented individuals care more about the future
consequences and less about the immediate consequences of their behavior, whereas the
opposite is true for present-oriented individuals. Generally, correlations between the ZTPI
and CFC scale are moderate in size (for an overview, see Table 23.1, column 4).

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Table 23.1 Overview of studies reporting correlations between discount rate, ZTPI and
CFC scale
Study Measure Discount rate ZTPI

Adams and Nettle (2009) ZTPIa 2.15 −
CFC scale 2.21 .45
Bruderer Enzler (2015) ZTPI − −
CFC scaleb 2.27−.23 −
Carmi (2013) ZTPIa − −
CFC scale − .34
Charlton et al. (2011), Study 2 ZTPI − −
CFC scale 2.23−.24 −
Crockett et al. (2009), Study 1 ZTPIc − −
CFC scale − 2.40−.38
Crockett et al. (2009), Study 2 ZTPIb − −
Dassen et al. (2015) ZTPI − −
CFC scaled nse −
Daugherty and Brase (2010) ZTPIf 2.13−.18 −
CFC scale .16 2.46−.44
Epstein et al. (2014) ZTPIa not reported −
CFC scale not reported .64
Johnson et al. (2010) ZTPI .29 −
CFC scale ns not reported
Joireman et al. (2005), Study 2 ZTPI − −
CFC scale − 2.23
Keough et al. (1999), Study 2 ZTPIg − −
Milfont and Schwarzenthal (2014) ZTPI − −
CFC scaled − 2.34−.47
Perry et al. (2015) ZTPIh − −
Strathman et al. (1994), Study 2 ZTPI − −
CFC scale − .36
Vásquez Echeverría et al. (2015) ZTPI − −
Wininger and DeSena (2012) ZTPIa − −
CFC scale − .56
Worrell et al. (2015) ZTPIi − −
Zhang et al. (2015), Study 2 ZTPI − −
CFC scale 2.14−.11 −
Notes:
We do not claim that this table presents an exhaustive overview. Positive correlations indicate relations
between similar (sub)scales (for example, between ZTPI Future and CFC-future). Negative correlations
indicate relations between dissimilar (sub)scales (for example, between ZTPI Future and CFC-immediate).
In case of a range of correlations, the left side of the range always indicates a negative correlation and the
right side of the range always indicates a positive correlation. All correlations are significant at p < .05, unless
otherwise indicated.
ZTPI 5 Zimbardo Time Perspective Inventory; CFC 5 Consideration of Future Consequences.
a
ZTPI Future.

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Table 23.1 (continued)
b
Nine items.
c
Twenty-two items.
d
Fourteen items.
e
Behavior-specific versions of the discount rate (that is, discount rate for snack food) and CFC scale (that is,
CFC-food) were also included; these measures were significantly correlated (r 5 2.16).
f
ZTPI Future, ZTPI Present-Hedonistic and ZTPI Present-Fatalistic.
g
Twenty-one items.
h
Twenty-five items.
i
Fifteen items.
2 DOMAIN DIFFERENCES IN TIME ORIENTATION
An emerging issue in the time orientation literature is whether or not the construct is uni-
versal across domains (for example, money and health) as well as various types of behavior
within a domain (for example, eating and exercising). Whereas it is already widely known
that time orientation varies between individuals, a growing number of studies focuses on
differences in time orientation within individuals. To illustrate this development, we first
discuss studies on domain differences (mainly across domains) in discounting. Thereafter,
we discuss studies on domain differences (mainly within domains) in time perspective and
consideration of future consequences.
2.1 Domain Differences in Discounting
Domain differences in discounting can be assessed in various ways. One way is to estimate
absolute differences in discount rates across domains (for example, Hardisty and Weber
2009). In doing so, it is possible to identify whether individuals have higher discount rates
in one domain than in another (for example, money versus health). This is referred to
as the domain effect (Tsukayama and Duckworth 2010). However, absolute differences
between discount rates across domains do not mean that discounting in these domains is
completely independent (Weatherly et al. 2010). In order to assess whether discount rates
are (in)dependent of each other, we have to identify how discount rates across domains
vary in relation to each other. This is referred to as domain independence (Chapman
1996). It is also possible to combine the two approaches by simultaneously determin-
ing absolute differences across domains and identifying correlations between discount
rates across domains (Weatherly et al. 2010). The latter method was used by Lim and
Bruce (2015) when they compared discount rates for money and weight-loss. First, they
developed an adapted version of the Monetary Choice Questionnaire (Kirby et al. 1999)
with weight-loss, instead of money, as a reward (Weight-loss Choice Questionnaire).
Subsequently, they showed that the two discount rates were significantly different from
each other and were moderately correlated. A third approach is to investigate domain spe-
cificity, which means that an individual has a relatively high discount rate in one domain
and a relatively low discount rate in another domain, as compared to other individuals
(Tsukayama and Duckworth 2010).
Studies on the domain effect have yielded mixed findings. For example, whereas most
studies found higher discount rates for health than for money, some studies found the

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opposite or no difference at all (Chapman 2003). Other studies have found that discount
rates differ between some domains, but not between others. For example, Hardisty and
Weber (2009) showed that discount rates for money and the environment did not differ
from each other, but that the discount rate for health differed from the discount rates for
either money or the environment. Studies on domain (in)dependence have also resulted
in mixed findings. Several studies have found that there is little or even no correlation
between discount rates across the domains of money and health (Fuchs 1982; Chapman
1996; see also Jimura et al. 2011). However, similar to findings regarding the domain
effect, it has been found that discounting is dependent for some domains, but independent
for others. For example, one study found domain dependence between the domains of
health and vacation (that is, correlated discount rates), but domain independence between
the domain of money, on the one hand, and the domains of health and vacation, on the
other hand (that is, uncorrelated discount rates; Foxall et al. 2011).
In addition to comparing discount rates in the domains discussed before, several studies
have distinguished discount rates for primary, consumable rewards and monetary, non-
consumable rewards. The majority of these studies showed that discount rates for primary
rewards are higher than discount rates for monetary rewards (Charlton and Fantino 2008;
Reuben et al. 2010; Tsukayama and Duckworth 2010; Odum 2011). Nevertheless, several
studies found positive relations between discount rates for primary and monetary rewards
(Reuben et al. 2010; Tsukayama and Duckworth 2010; Odum 2011). Despite the similarity
in results across these studies, researchers draw various conclusions from these findings.
Tsukayama and Duckworth (2010) suggest that discounting is at least partly domain-gen-
eral and that this could be explained by factors such as time perspective, domain-general
decision rules and working memory capacity. Odum (2011) concludes that discounting is
a trait variable (instead of a state variable), but qualifies this conclusion by stating that the
trait character of discounting does not imply that discounting is unchangeable. In con-
trast, other researchers conclude that discounting is not a trait, but varies according to the
discounting context or other domain-specific characteristics (Foxall et al. 2011; Weatherly
and Terrell 2011). All in all, it seems that although discounting has characteristics of a
trait, it nevertheless varies according to the context or domain in which it is measured.
Yet another approach to establish domain differences is to present participants with
a series of discounting scenarios and to derive domains, if any, from the responses. For
example, Charlton and Fantino (2008) asked participants to respond to a series of dis-
counting scenarios, including food, money, books, CDs and DVDs. The results suggested
that these commodities clustered into three groups, with food being discounted the most
and money being discounted the least. Discount rates for books, CDs and DVDs did
not differ from each other and were in between the discount rates for food and money.
Similarly, several studies by Weatherly and others (Weatherly et al. 2010; Weatherly and
Terrell 2011) showed that although some commodities are discounted similarly, at least
two different domains of discounting exist. One of these domains could be labeled as
tangible and/or consumable (for example, money or cigarettes), whereas the other domain
could be labeled as non-tangible and/or non-consumable (for example, body image or
medical treatment; Weatherly and Terrell 2011). This clustering of commodities into
different domains indicates that the discount rate of a commodity within a particular
domain can predict the discount rate of another commodity within the same domain, but
cannot predict the discount rate of a commodity within a different domain. This implies

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that discount rates in different domains do not represent an individual’s overall discount
rate (Weatherly et al. 2010).
An advantage of this final method is that it does not use pre-defined domains. Pre-
defining domains is not as straightforward as it might seem which becomes apparent from
findings showing that correlations between discount rates vary greatly in strength within
domains (Foxall et al. 2011). This is possibly owing to the fact that even if a domain has a
common denominator (for example, health) it can still consist of fairly different behaviors
(for example, eating, smoking and getting vaccinations). Thus, measuring a discount rate
for the domain of health is based on the assumption that no differences exist between
the various behaviors belonging to this domain. Research on domain differences in time
perspective and consideration of future consequences, which we will discuss in the next
section, shows that this assumption does not always hold true.
2.2 Domain Differences in Time Perspective and Consideration of Future Consequences
Only a few attempts at domain-specific measurement of time perspective and consid-

eration of future consequences have been made. For example, several behavior-specific
versions of the Time Perspective Questionnaire (TPQ) have been developed. The exercise
version (TPQ-E; Hall et al. 2012) measures the extent to which individuals consider the
long-term consequences of their current exercising behavior. Similarly, the diet version
(TPQ-D; Hall et al., 2012) measures the extent to which individuals consider the long-term
consequences of their current eating behavior. Both behavior-specific scales have shown
better predictive capacity than the domain-general TPQ (Hall et al. 2012). For example,
whereas the domain-general TPQ did not predict physical activity at all, the TPQ-E posi-
tively predicted physical activity (Hall and Epp 2013). The scale has also been adapted to
alcohol consumption (TPQ-A) and smoking (TPQ-S; Hall and Fong 2013).
Behavior-specific versions of the CFC scale have been developed for eating and exercis-
ing behavior (van Beek et al. 2013). These CFC-food and CFC-exercise scales have been
adapted from the domain-general CFC scale in order to enable specific measurement of
the extent to which individuals consider the present and future consequences of their
current eating and exercising behavior. Empirical research confirmed that CFC-food and
CFC-exercise are different constructs (even though both belong to the health domain)
and that these constructs differentially predict eating and exercising behavior (van Beek
et al. 2013). One study has compared the predictive capacity of CFC-food to that of the
domain-general CFC scale (Dassen et al. 2015). This study showed that CFC-food was
not only correlated with healthy eating behavior (in contrast to the domain-general CFC
scale which was not correlated with healthy eating behavior), but also predicted healthy
eating behavior. No studies have yet compared the predictive capacity of CFC-exercise to
that of the domain-general CFC scale. However, given the results of similar studies with
the Time Perspective Questionnaire (Hall et al. 2012; Hall and Epp 2013), it is expected
that CFC-exercise outperforms the domain-general CFC scale in predicting exercising
behavior.

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3 TIME ORIENTATION AND HEALTH BEHAVIOR
Several field studies show that choosing for the present or the future influences how
healthy our choices are. For example, a classic study showed that whereas half of the par-
ticipants made an unhealthy snack choice in advance (that is, one week before they would
actually get the snack), more than 80 percent of the participants chose an unhealthy snack
one week later (Read and van Leeuwen 1998). In addition, results showed that about 75
percent of the participants made a switch from a healthy snack in the advance choice to
an unhealthy snack in the immediate choice. Also, it has been found that the longer in
advance consumers order groceries in an online supermarket, the more healthy foods they
buy (Milkman et al. 2010). These findings can probably be explained by an individual’s
time orientation. It is, however, important to realize that variations in time orientation will
never account for all variation in health behavior. Individuals engage in health behavior
for various reasons; the potential benefit on their future health is just one of these (Adams
and Nettle 2009).
Although increasing numbers of studies on the relationship between time orientation
and health behavior are being performed, results continue to be inconsistent. Generally,
future orientation predicts healthy behavior (for example, exercising), whereas present ori-
entation predicts unhealthy behavior (for example, smoking). However, individual studies
differ greatly regarding the (combinations of) results being found. This could be partly
due to the variety of samples used, the many ways in which time orientation is operation-
alized and measured as well as to the health behaviors that are studied. In this section, we
first discuss studies that compare measures of time orientation when predicting a range
of health behaviors. Thereafter, we discuss why the results of studies on the relationship
between time orientation and health behavior are sometimes difficult to interpret.
3.1 Predictive Capacity of Time Orientation Measures
Only a few studies compared the predictive capacity of various measures of time orienta-
tion. In one study, time orientation was operationalized as discount rate, CFC scale, the
Future subscale of the ZTPI, subjective probability of living to age 75 and time period
for financial planning (Adams and Nettle 2009). When controlling for both demographic
and personality characteristics, only scores on the CFC scale predicted smoking and
body mass index. Higher CFC scores were associated with a lower probability of being
a smoker and a lower body mass index. In fully controlled analyses, no measures of time
orientation predicted the frequency of either moderate intensive or vigorous intensive
physical activity. Scores on the CFC scale did, however, predict both types of physi-
cal activity in uncontrolled analyses, indicating that higher CFC scores are associated
with higher frequency of physical activity. Overall, the CFC scale (as compared to the
other four measures) showed the most consistent relations with various health behav-
iors (Adams and Nettle 2009). In a similar study, discount rate, ZTPI Future, ZTPI
Present-Hedonistic, ZTPI Present-Fatalistic and the CFC scale were used to predict
health behaviors varying from alcohol use to sunscreen use (Daugherty and Brase 2010).
Results showed that the five time orientation measures together improved the prediction
of most health behaviors above and beyond demographic and personality characteristics.
In addition, it was found that ZTPI Future uniquely predicted most health behaviors,

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followed by ZTPI Present-Hedonistic, ZTPI Present-Fatalistic, the CFC scale and the
discount rate.
Although these two studies do not provide a definite answer to the question of which
measures have the best predictive capacity for health behavior, they do give some direc-
tion. Both studies indicate that questionnaires, such as the ZTPI and CFC scale, out-
perform discounting measures when predicting health behavior. This could imply that
questionnaire measures are to be preferred over discounting measures. However, it should
be noted that in both studies self-reported behavior was used. Thus, discounting was the
only performance-based measure, which could partly explain the fact that discounting did
predict behavior less well than the questionnaire measures.
3.2 Interpretation and Measurement Issues
Both time perspective and consideration of future consequences are related to a wide
variety of behaviors (for example, Joireman et al. 2006; Stolarski et al. 2015). In addition,
these constructs predict a range of health behaviors, including substance use (Keough
et al. 1999), drinking alcohol (Beenstock et al. 2011), smoking (Adams and Nettle 2009;
Adams 2012), preventive behavior (for example, getting vaccinations and participation
in screening; Crockett et al. 2009; Nan and Kim 2014), body mass index (Adams and
Nettle 2009; Adams 2012; Griva et al. 2015), healthy eating attitudes, intentions and
behavior (Joireman et al. 2012; van Beek et al. 2013; Gick 2014; Mullan et al. 2014;
Dassen et al. 2015), exercising attitudes, intentions and behavior (Hall and Fong 2003;
Adams and Nettle 2009; Joireman et al. 2012; Wininger and DeSena 2012; Hall and
Epp 2013; van Beek et al. 2013; Griva et al. 2015) and perceived health status (Griva
et al. 2015).
Despite the increasing amount of literature, relations between time orientation and
various health behaviors are still inconsistent and often difficult to interpret. This could
be partly owing to differences between, or even within, domains (see section 2.2). Another
reason could be that a variety of time orientation measures are used and that results often
strongly depend on the measure being used (see section 3.1). In addition, even studies
employing the same measure can be difficult to compare, because measures are being
used inconsistently. For example, whereas some studies distinguish between CFC-future
and CFC-immediate, many studies still do not make this distinction, which leads to
inconclusive results. The use of one CFC score is problematic in two ways. First, a high
CFC score could mean that an individual is highly concerned with future consequences,
lacks concern with immediate consequences, or even both (Arnocky et al. 2014). Second,
positive relations between CFC and behavior could indicate that individuals high in
CFC-future are more likely to engage in a particular behavior, but also that individuals
high in CFC-immediate are less likely to engage in a particular behavior (Joireman et
al. 2012; Arnocky et al. 2014). These problems can be illustrated by two studies on CFC
and body mass index (BMI). Adams and Nettle (2009) showed that higher CFC scores
are negatively related to BMI, which seems to indicate that a stronger tendency to con-
sider the future consequences of our current behavior is related to a lower BMI. Adams
(2012) showed that it is actually CFC-immediate (and not CFC-future) that is positively
(instead of negatively) related to BMI. This indicates that a stronger tendency to consider
the immediate consequences of our current behavior is related to a higher BMI. Thus, in

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order to be able to understand the relationship between CFC and behavior, it is essential
to make an empirical distinction between CFC-future and CFC-immediate.
Another reason for clearly distinguishing between these two dimensions is that this
enables investigations of the differential effects of present and future orientation. Whereas
many previous studies mainly focused on future orientation, increasing numbers of
studies now underline the importance of present orientation. For example, some studies
show that present orientation is an even more important indicator for health behavior
than future orientation (Crockett et al. 2009). In addition, some studies have shown that
CFC-future and CFC-immediate differentially predict behavior (Joireman et al. 2012; van
Beek et al. 2013) or found only effects of CFC-immediate and not of CFC-future (Adams
2012). In this way, it became clear that sometimes differences in CFC-immediate (instead
of CFC-future) are driving the relations between CFC and behavior. Therefore, it is also
important to simultaneously investigate the effects of present and future orientation, in
order to unravel the relative importance of both constructs. For example, a study showed
that present fatalistic time perspective was a strong predictor of health behavior, when
no other dimensions of time perspective were included in the model. However, when
both future time perspective and present hedonistic time perspective were also included
in the model, present fatalistic time perspective did not predict behavior, whereas future
time perspective did (Henson et al. 2006). Finally, it is important to clearly distinguish
and compare healthy and unhealthy behavior. For example, Henson et al. (2006) found
that future time perspective was related to more protective and less risky health behavior,
whereas present hedonistic time perspective was related to less protective and more risky
health behavior. Similar differential effects could be found when comparing other healthy
and unhealthy behaviors (for example, consumption of vegetables versus consumption
of snacks).
4 CONCLUDING REMARKS
Time orientation comprises a range of economic and psychological concepts which can
be measured in multiple ways. Correlations between those measures are low or moderate
on average (Table 23.1; see also Teuscher and Mitchell 2011). In addition, time orientation
measures show highly varying correlations with health behavior. Generally, questionnaire
measures seem to correlate with a broader range of behaviors than discounting measures.
Also, differences across domains, and even within domains, have been found. Together,
these findings undermine the idea that discounting future outcomes is a universal phe-
nomenon. Instead, time orientation should be considered domain specific or behavior
specific and may also comprise various underlying dimensions (that is, present versus
future).
One explanation for the low correlations between time orientation measures could be
that both performance-based and self-report measures are being used, which may not
be directly comparable. In addition, the differential success of time orientation measures
in predicting behavior may be explained by a lack of compatibility between time ori-
entation measures and the type of behavior. Whereas questionnaire measures are more
compatible with self-reported behavior, discounting measures are more compatible with
actual behavior. This could explain why measures such as the ZTPI and the CFC scale

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often outperform discounting measures. Still, time orientation measures also differ in
their effectiveness in explaining different behaviors. Enhancing the compatibility of the
scales even more by developing behavior-specific scales that are in accordance with the
behavior studied may further increase correlations between time orientation measures
and behavior (see also Wininger and DeSena 2012). In addition, the use of actual behav-
ior would provide evidence on the suggestion that discounting measures outperform
time orientation measures when predicting actual behavior. The lack of compatibility
could also explain why differences across domains are found. For example, monetary
discounting measures and saving behavior are more compatible than monetary discount-
ing measures and health behavior. Therefore, discounting measures may be used more
effectively to predict saving behavior than health behavior. Overall, measures that are
highly compatible with the behavior that is being predicted seem to have the best predic-
tive capacity.
Both discounting measures and time orientation measures have faced difficulties in
dealing with intertemporal inconsistency. For discounting measures, this problem has
been addressed by the use of hyperbolic discount functions; for time orientation measures,
multidimensionality (that is, present versus future) has been assumed (see also Carmi
2013). Still, the weight of these dimensions in decision making depends on the timing of
the outcomes (that is, near versus distant future) and the type of behavior to be explained.
Another issue with the two types of measures is their interpretation. Both discounting
and time orientation measures result in numerical outcomes. However, in contrast with
discount rates, scores on time orientation measures have no economic interpretation,
because the exact present value of a future outcome cannot be assessed.
In summary, even though research on time orientation and its relationship with health
behavior can be improved in various ways, as we discussed in this chapter, this type of
research provides promising avenues to improve our understanding of health behavior.
Consequently, knowledge on the many ways in which the intertemporal character of
health behavior influences individuals’ choices and decisions can be used to promote
healthy behavior.
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24 Behavioral aspects of obesity
Odelia Rosin
1 INTRODUCTION
This chapter analyzes the phenomenon of obesity from a behavioral economic perspec-
tive, showing that overweight and obesity can be the result, either intended or unintended,
of a decision-making process based on opportunities, costs and constraints, where the
decision makers are intelligent boundedly rational individuals.
Obesity has been identified for some years as one of the foremost global health prob-
lems. Obesity is a complex physiological condition that has medical, environmental, social,
psychological and economic dimensions. It affects people of all ages and socioeconomic
groups, and of both genders, and is not restricted to developed countries. Obesity is a
major risk factor for many chronic diseases and is associated with significant increases in
disability, premature morbidity and mortality rates.
Much focus has been placed on obesity owing to its high prevalence and the costs it
imposes on society. Individuals’ choices affect others (thus, there are externalities). In
addition, agents may not act with the assumption of full information and rational behav-
ior, such as in the case of food choices made by children (Loureiro and Nayga 2005).
There is a recent and growing economic literature on obesity, most of it trying to
identify various behavioral, biological and environmental factors which contribute to
adult and childhood obesity and address the questions of why people overeat, what has
caused the worldwide escalation of body weight and what has upset the balance between
energy intake and energy expenditure in recent decades. There is also a growing economic
literature on the consequences of obesity and on policies and interventions designed to
curb the global trend.
Neoclassical economics views obesity as the outcome of rational choices that reflect
conscious willingness to trade off, given the proper incentives, some future health for the
present pleasures of less restrained eating and lower physical activity. Nevertheless, the
fact that rational modeling yields an equilibrium of overweightness does raise some ques-
tions. Do these rational agents really want to stay in this equilibrium for the long run? Had
it been so, the phenomenon of weight loss dieting would not exist. In fact we see quite the
opposite: billions of adults and youth in the Western world attempt some form of weight
loss dieting. Considerable physical, mental and financial efforts are expended on dieting
(Rosin 2012). When asked, many people say they do care about their future health more
than their actions seem to indicate and that they actually would like to make better food
choices. By their own reckoning, they fail to meet their goals and reach outcomes that
seem to be suboptimal from the viewpoint of a self-interested decision maker.
Accumulating evidence that the new neoclassical models of consumer decision-making
provide an inadequate description of human behavior in many economic situations stimu-
lates growing interest in the field of psychology and economics (Bernheim and Rangel
2008). This chapter provides background on obesity and covers its behavioral dimensions,
429
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seeking to explain why people may behave in ways that contradict some standard assump-
tions of economic analysis. The focus of this chapter is on economic literature that
addresses the individual’s decision to overeat while rationally taking into account the
adverse effects on health or life expectancy, as well as psychological mechanisms behind
food consumption and obesity-inducing features in our environment.
2 BACKGROUND
2.1 The Prevalence of Obesity
Obesity and overweight have increased dramatically over several decades. The preva-
lence of overweight and obesity in the US started to increase around 1980, rose about
threefold over the next 20-year period and has remained high since then. Roughly two-
thirds of adults in the US are currently considered overweight or obese. Results from
the 2011–12 National Health and Nutrition Examination Survey (NHANES), using
measured heights and weights, indicate that an estimated 6.4 percent of US adults aged
20 and over are extremely obese, 35.1 percent are obese and 33.9 percent are overweight
(Ogden et al. 2014).1 The distribution of Body Mass Index (BMI) has become more
skewed over time, meaning that the growth rate of extreme obesity has been twice that
of moderate obesity. Data for children and adolescents, though based on different defi-
nitions, show the same patterns. About 32 percent of youth aged 2 to 19 in the US are
overweight or obese, with 16.9 percent being obese, triple the rate from just one genera-
tion ago (Ogden et al. 2014).
Obesity is not just a US problem but exists in other developed and undeveloped
countries as well. Figure 24.1 presents obesity rates in Organisation for Economic
Co-operation and Development (OECD) countries. The data demonstrate that obesity
has not stopped spreading; it continues to grow globally, yet faster in emerging economies.
Rates of overweight and obesity are increasing at a slower pace than before; they have
almost stabilized in Italy, the UK and the US, and have grown modestly in Canada, Korea
and Spain. Nevertheless, growth of obesity continues to be robust in France, Australia
and Switzerland. Emerging countries such as China, India, Mexico and Brazil are seeing
obesity rates grow in epidemic proportions (OECD 2014).
2.2 Health Consequences
Height and weight have been increasing since the eighteenth century, as income, educa-
tion and living conditions gradually improved over time. While weight gains were largely
beneficial to the health and longevity of our ancestors, an alarming number of people
have now crossed the line beyond which further gains are dangerous.
Obesity is a major risk factor for many chronic conditions, including type-2 diabetes,
cardiovascular disease (CVD), hypertension, hypercholesterolemia, certain types of
cancer, stroke, asthma, sleep apnea, musculoskeletal diseases, stomach ulcer, gallblad-
der diseases (gallstones) and chronic liver disease (Rosin 2008). Out of these conditions,
type 2 diabetes is most closely linked to obesity. At the same time as obesity rates have
escalated, diabetes rates display a concurrent trend; for example, the overall incidence and

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Behavioral aspects of obesity 431
2.1 India
Self-reported data
2.4 Indonesia
Measured data 2.9 China
3.6 Japan
4.6 Korea
10 Norway
10.3 Switzerland
10.4 Italy
11.8 Sweden
12 Netherlands
12.4 Austria
13.4 Denmark
13.8 Belgium
14.5 France
14.7 Germany
15.4 Portugal
15.7 Israel
15.8 Finland
15.8 Poland
15.8 Brazil
16 Russian Fed.
16 South Africa
16.6 Spain
16.9 Slovak Rep.
18.3 Slovenia
18.4 OECD (34)
19 Estoria
19.6 Greece
21 Czech Rep.
21 Iceland
22.3 Turkey
22.7 Luxembourg
23 Ireland
24.7 United Kingdom
25.1 Chile
25.4 Canada
28.3 Australia
28.5 Hungary
31.3 New Zealand
32.4 Mexico
35.3 United States
40 30 20 10 0
% of population aged 15 years and over
Source: OECD Health statistics (OECD 2014).
Figure 24.1 Obesity in an international perspective

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prevalence of diabetes in the US have doubled during 1990–2008 and leveled off with no
significant change since then (Geiss et al. 2014).
Obesity, particularly extreme obesity, is associated with an increase in early mortality
and disability rates, and with a significantly lower health-related quality of life. Obesity
has approximately the same association with chronic health conditions as 20 years of
aging and it is currently considered the number one preventable cause of death in the
US.2
2.3 Economic Consequences
Western governments spend a high share of their total expenditures on health: 20 percent
in the US in 2012 (compared with 17 percent in 2000), 14.5 percent in the European region
in 2012 (compared with 14 percent in 2000).
Health expenditures have outpaced economic growth in many Western countries,
putting pressure on government budgets and attracting increasing concern from govern-
ments. For example, in the US, total expenditures on health as a share of gross domestic
product (GDP) were 17 percent in 2012 (compared with 13 percent in 2000), and 47
percent of them were publically funded (compared with 43 percent in 2000). In the
European region, total expenditures on health (as a share of GDP) were about 9 percent
in 2012 (compared with 8 percent in 2000), and 74 percent out of them were publically
funded (compared with 73 percent in 2000).3
As obesity rates have escalated over the past decades, they are contributing noticeably
to the increases in health expenditures. Obesity is estimated to be responsible for 1–3
percent of total health expenditures in most countries (5–10 percent in the US) and these
costs are expected to rise rapidly (OECD 2014). The costs of obesity are not only borne
by governments. Obese adults in the US (under age 65) incur annual medical expenditures
that are 36–37 percent higher than adults of normal weight incur, primarily because of
prescription drugs (Sturm 2002; Finkelstein et al. 2005; Raebel et al. 2004).4
In addition to its significant impact on demand for and supply of health care, obesity
has an impact on markets of food, restaurants, advertising, exercising, dieting and labor.
Higher body weights may lead to lower wages, either directly (via effects on productiv-
ity) or indirectly (via employment discrimination). As especially women experience great
social and psychological pressure with regard to body size, there is evidence on lower-
economic status of obese women, explained mostly by differences in the marriage market
(marriage probabilities and spouse’s earnings) and partly by labor market weight-based
discrimination of women in both wages and employment.5
3 BEHAVIORAL ASPECTS
Body weight is gained by food intake and lost through expenditure of calories. Food is
the fuel that creates energy needed for the human body to function. Energy (in the form
of calories) is burnt in the process of daily functioning and in physical activity. Unburnt
energy is accumulated in the body as fat tissues that increase bodyweight.6 Obesity thus
results from a long-term sustained imbalance between energy intake and energy expendi-
ture. Although the basic way to avoid it is well known, namely, eat less, reduce high-calorie

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foods and stimulate fat oxidation by promoting physical activity, weight loss is difficult to
achieve and maintaining achieved weight loss represents an even greater challenge.
Obesity may perhaps be explained by genetic differences that are not influenced by
economic incentives.7 However, genetics alone cannot explain the escalation of obesity in
recent decades. If the reasons were genetic transmission, such a change would be much
slower than observed, as the gene pool does not change rapidly. Thus the genetic compo-
nent of obesity may only explain cross-sectional differences. It would be more reasonable
to attribute the global phenomenon of obesity to other factors affecting diet or physical
activity level, combined with genetic susceptibility.8
Economists have studied the determinants of BMI and have modeled explanations
of obesity, relating to various factors that affect energy intake and energy expenditure.9
Both calorie intake through food consumption and calorie expenditure through physical
activity are subject to choice. Economists have pointed out that, like any other consumer
behavior, choices about diet and exercise can be viewed from the perspective of rational
decision theory, subject to the influence of variation in prices and income, where being
overweight is a possible outcome of such rational utility-maximizing models. We present
rational models, however, to seek to explain why people behave in ways that contradict
standard assumptions of economic analysis.
3.1 Rational Lifetime Planning
Rational consumers maximize their satisfaction from eating, subject to their personal
constraints. Levy (2002a) set out a dynamic model in which consumers are rational life-
time planners who balance marginal satisfaction from food consumption against marginal
deterioration of health. That is, consumers reduce consumption of food when their physi-
cal health and appearance become critically inadequate and increase it when their physical
health and appearance are improved. They maximize expected lifetime utility derived
from food consumption:
T t
3 p (W (t) 2 W *) e 3 e u (c (t)) dt f dt,

2 2rt
(24.1)
0 0
where T is life expectancy, c is food consumption, (0 ≤ t ≤ T) and r is rate of time prefer-

ence. Body weight influences life expectancy: the probability of dying at time t, p(t), rises
with the quadratic deviation of weight at time t, W(t), from the optimal weight (W*).
Consumers maximize utility subject to motion equation of weight:
W 5 c(t) − dW(t), (24.2)
where d is a positive scalar indicating the marginal effect of weight on burning calories.
Levy uses a specific utility function in order to reach the optimal solution. The anticipated
stationary state for an expected rational lifetime-utility maximizer is overweight, above his
or her health and appearance desirable weight, even though being overweight increases
the probability of dying and yields disutility. The optimal weight increases with rate of
time preference and decreases with rate of calorie burning and probability of staying alive.
Levy incorporates norms into the basic model and shows how the existence of

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sociocultural norms of appearance decreases the rationally stationary weight of fat people
and increases the rationally stationary weight of lean people.
3.2 Rational Lifetime Planning with Two Types of Food
Economic models of obesity usually consider one source of energy, which is food in
general. However, different kinds of food vary in their calorie content. In particular, junk
food is high in calories, whereas healthy food is usually low in calories. Levy (2002b, 2003)
sets out another dynamic model in which consumers obtain satisfaction from eating junk
food, and maximize their expected lifetime utility:
t
3e
2rt
u (t) dt, (24.3)
0
where t is consumer’s life expectancy and r is rate of time preference. Utility is derived
from consuming two types of food, junk food and health food:
u(t) 5 u(cj(t), ch(t)), (24.4)
where cj is consumption of junk food and ch is consumption of health food. It is assumed

that junk food is cheaper and tastier than health food, and that income is fully spent on
these two kinds of food. The consumers balance the marginal satisfaction from junk-food
consumption against marginal deterioration of health, and adapt their consumption
of junk food to their physical health and appearance. The model shows that junk-food
consumption over time is affected by aging, rate of time preference and relative price of
junk food.
3.3 Rational Choice with Weight Consciousness and Physical Activity
An individual may be either physically active or inactive; either weight conscious or

weight unconscious.10 Weight-conscious individuals are fully aware of the adverse effects
of obesity on their physical appearance and health, and take them into account, whereas
weight-unconscious individuals ignore the adverse effects of obesity.
Yaniv et al. (2009) introduce a food-intake rational-choice model that distinguishes not
only between junk food and healthy food, but also between three types of individuals:
weight unconscious, weight conscious but not physically active, and weight conscious
who is physically active. The model focuses on an overweight individual, who optimally
determines the time he devotes to physical activity, x, his consumption of junk-food meals,
F, and his consumption of healthy meals, H. Healthy meals are prepared at home with
purchased ingredients and time input, whereas junk-food meals are purchased from a
restaurant. Obesity, S, is defined as the weight gain during a given period of time:
S 5 dF + eH − μx − BMR, (24.5)
where d and e represent calorie intake per junk-food meal and healthy meal, respectively
(d > e), μ represents calorie expenditure per instant of physical activity, and BMR is the

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Basal metabolic rate.11 A few assumptions allow obesity to be expressed as a function of

F and x alone, S(F, x), into which healthy meals do not enter explicitly albeit moderate the
calorie contribution of junk-food by substituting junk food in satiating hunger.
A weight-unconscious individual determines his consumption composition and alloca-
tion of time so as to maximize his utility:
U 5 U(C, ), (24.6)
where C is consumption of meals (composed of both junk-food meals and healthy meals)
and is genuine leisure. A weight-conscious individual chooses differently, so as to maxi-
mize his net utility:
NetU 5 U(C, ) − S(F, x). (24.7)
The authors examine the outcomes of two alternative policy measures for combating
obesity, a fat tax on the purchase of junk-food meals and a thin subsidy to the purchase
of ingredients for the cooking of healthy meals. The motive behind fat tax is to increase
the cost of high-calorie low-nutrition foods in order to reduce their high accessibility to
the public, and also to find a way to finance public health initiatives with respect to diet
and exercise. It is believed that a fat tax would decrease the demand for high-fat foods and
would subsequently decrease the weight of the population. However, there is no evidence
that taxes on food affect obesity.
Yaniv et al. (2009) argue that even if a fat tax decreases fat consumption, and even if
it were technically feasible to apply a fat tax, it is not clear how much success such a tax
would have in reducing obesity levels. Their model shows that a fat tax will unambiguously
reduce junk-food consumption and the obesity level of a weight-unconscious individual,
however, it will not necessarily do so for a weight-conscious individual. Furthermore, for
a weight-conscious individual who is physically active, a fat tax may even increase obesity.
This is because a fat tax generates substitution away from junk-food meals towards
healthy meals. The preparation of healthy meals necessitates time for cooking and health-
ingredient shopping, thereby leaving less time for physical activity. Hence not just the
consumption of junk food will be reduced, but also the time devoted to physical activity.
Although calorie intake will fall, calorie burning may fall by more. Consequently, obesity
might rise in spite of the fall in junk-food consumption, exacerbating the problem the fat
tax proposal intended to eliminate.
A thin subsidy is even more problematic, as it will unambiguously increase the
junk-food consumption and the obesity level of a weight-conscious physically inactive
individual. Otherwise, the effect of a thin subsidy is ambiguous. This is so because the
substitution effect acts to increase the purchase of cooking ingredients (at the expense of
junk-food consumption), whereas the income effect acts to increase leisure, reducing the
time left for cooking. It is only by adopting a specific utility function that clear-cut results
can be obtained.

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3.4 Rational Addiction
Addiction to food could present a logical explanation for why consumers persist in pur-
chasing and consuming more food than is necessary for survival. Becker and Murphy
(1988) develop a theory of rational addiction, which models rationality as a dynamic
maximization of utility from stable preferences, and can be used to explain a wide
variety of addictive behaviors, including overeating. A consumer is considered rationally
addicted if an increase in his current consumption increases both future consumption
and marginal utility from future consumption. That is, he takes costs and benefits into
account and does not overeat out of some pathological obsession. According to the
model, the addicted person reaches an unstable steady state of growing consumption
over time.
Several researchers apply the rational addiction model to food consumption and
provide evidence of rational addiction to caloric intake (Cawley 1999), specific food
nutrients (fat, protein, carbohydrates and sodium) with a particularly strong addiction to
carbohydrates (Richards et al. 2007), and carbonated soft drinks (Liu and Lopez 2012).
Despite the empirical evidence, Auld and Grootendorst (2004) criticize this, raising the
difficulty in implying that nearly half of the population of developed countries became
addicted to food. They claim that time series data are often insufficient to differentiate
rational addiction from serial correlation, and show that rational addiction can be demon-
strated even for consumption of non-addictive goods (such as milk and eggs). Therefore,
it seems that addiction is not the root cause of individuals losing control of their eating
behavior.
3.5 Long-term and Short-term Inconsistencies
While the incidence of obesity has been steadily increasing in Western societies, there
has been a parallel rise in sales of healthy low-fat foods and in recreational exercising.
It therefore seems that, on the one hand, people become heavier and increase their risk
of suffering from diet-related illnesses but, on the other hand, they eat better and have
a healthier lifestyle. Mancino and Kinsey (2004) point to this inconsistency and suggest
that individuals attempt to incorporate beliefs about healthy eating into their food choices
but then forgo good intentions for more immediate gratification owing to situational
factors such as time pressure, hunger, and demand for convenience. Their calorie-choice
model reveals elements that induce actual behaviors contrary to personal long-term health
objectives and self-interest: consuming food prepared away from home, less knowledge
about health and nutrition, high opportunity cost of time, and low price savings from
food preparation.
3.6 Time Preference
Time preference is equal to the rate at which people are willing to trade current utility
for future benefit, and is influenced by various social, cultural, and psychological factors.
Time preference can impact current food consumption decisions, as immediate gratifica-
tion from eating is forgone in order to gain future potential health benefits. A higher rate
of time preference can reduce investment in exercise and increase caloric intake, therefore

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an increase in the marginal rate of time preference may be a contributing factor to the
rise of obesity.
Komlos et al. (2004) build a model in which individuals maximize lifetime utility:
T
3e
2st
U (Ct,Ht ( Ht21,It21)) dt, (24.8)
0
where C is consumption of goods and services, T is expected life time and s is marginal
rate of time preference. Health status, H, depends on past investments in health, I, and on
past levels of health. The lifetime budget constraint equals the present value of lifetime
income:
T
3e
2rt (PctCt 1 PIt,It) , (24.9)
0
where r is the market interest rate, Pc is the price of consumption and PI is the price of
health investment. The model shows that individuals with high rates of time preference
prefer current utility to future potential health benefits. They therefore consume more
high-calorie foods and invest less in physical exercise, at the expense of lower levels of
health and utility in the future. With saving rate and consumer debt as indicators of the
rate of time preference, Komlos et al. (2004) do not rule out a positive link between obesity
and the marginal rate of time preference.
Smith et al. (2005) provide evidence of a positive link between time preference and BMI
among American youth, using savings data as proxies for time preference. They examine
the data by gender and find that a higher time preference is associated with a greater mean
body weight among men and to a lesser extent among women. Breaking the data down
by both gender and ethnicity, they find that time preference is positively associated with
BMI among black and Hispanic men and black women. Zhang and Rashad (2008) also
find evidence of a positive association between time preference for the present and BMI,
particularly for males.
Borghans and Golsteyn (2006) conclude that being overweight might be related to
the way people discount future health benefits; however, the increase in BMI is more
likely explained by shifts in other parameters that determine the intertemporal decisions
regarding the trade-off between current health, future health and satisfaction.
3.7 Hyperbolic Discounting
Weight gain could be explained by time-inconsistent present-biased preferences, in the

sense of O’Donoghue and Rabin (1999).12 Eating is an immediate-reward activity as
it involves immediate gratification, whereas the costs of gaining weight are delayed.
Furthermore, weight-loss dieting is an immediate-cost activity as it involves immediate
costs, whereas the reward of being slimmer is delayed. However, it is not only that people
are impatient, which means they want to receive rewards sooner and delay costs until later;
when considering trade-offs between two future points in time, present-biased preferences
give stronger relative weight to the earlier point as that point is approached. The present-
bias effect affects people in two opposite ways: when actions involve immediate costs, the

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present-bias effect causes people to procrastinate (that is, wait instead of acting); when
actions involve immediate rewards, the present-bias effect causes people to act before the
proper time.
Another behavioral distinction is between naive and sophisticated people. Sophisticated
people correctly predict their future behavior. For example, they foresee that they will have
self-control problems in the future. Naive people do not foresee their self-control prob-
lems. They always believe they will be time-consistent in the future. They plan to behave
one way but in fact behave differently.
Rosin (2012) presents a model that explains weight cycling, which means a repeated
loss and regain of body weight over time, using the above distinctions and assuming that
most people are naïve regarding weight-loss dieting as they are incorrectly optimistic
about their future behavior.13 The model considers an individual who obtains satisfaction
from the consumption of food and other goods, has disutility from being overweight and
makes a decision to start a weight-loss diet. The individual is rational in the sense that
he compares his costs and benefits and selects the best alternative to maximize his utility.
However, his naivety prevents him from foreseeing that the next diets will demand exert-
ing more and more effort.
The model shows that dieting efforts do not fully offset a higher initial body weight or
metabolic slowdowns attributed to aging and menopause.
3.8 Technological Change
People in developed countries might have gained weight as a result of technological

changes that caused overall physical activity to decline. Employment has shifted from
manufacturing and mining to services and sedentary jobs that involve less on-the-job
exercise, and caloric expenditure in household work has been reduced owing to labor-
saving devices. As a result, people must pay for undertaking physical activity, in terms of
forgone leisure.
Philipson and Posner (1999) claim that technology has lowered the cost of food through
agriculture innovation and raised the cost of physical activity, causing more calories to be
consumed but fewer calories to be expended. They define utility as:
U 5 U(W(F, S), F, C) (24.10)
where W is weight, F is food intake, S denotes calorie expenditure in physical activity, and
C is alternative consumption. Utility is maximized under the budget constraint:
C + rF ≤ I, (24.11)
where r is the relative price of food and I is income. The optimal choice of calories bal-
ances the joy of eating, plus the effect of the weight change induced by eating, against
the forgone consumption of alternative goods. Beyond a certain caloric intake level, the
utility loss from gaining weight dominates the joy of eating. The model demonstrates
that obesity is technologically induced, but also predicts that the growth in obesity is self-
limiting. As technological change lowers the price of food and thereby frees up time to
raise income by other forms of production, weight will not continue to grow indefinitely.

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Leisure devoted to off-the-job exercise may offset the rise in obesity owing to work-related
technological change.
Cutler et al. (2003) argue that the rise in obesity in the US is primarily a result of
increased food consumption rather than reduced exercise. The increase in food consump-
tion itself is related to technological innovations in food production (for example, food
processing, food packing, deep freezing, artificial flavors, preservatives, and kitchen
appliances such as microwaves) and transportation. Technology has made it increasingly
possible for firms to mass prepare food and ship it to consumers for ready consumption,
thereby taking advantages of scale economies in food preparation. The result has been
a significant reduction in time spent cooking and cleaning at home, thus a reduction in
the time costs of food, that has led to increased quantity and variety of foods consumed.
Their theory is nicely illustrated by consumption data of potatoes. Before the techno-
logical innovations in food production, people usually prepared baked, boiled or mashed
potatoes at home. From 1977 to 1995, total potato consumption in the US increased by
about 30 percent, accounted for almost exclusively by increased consumption of potato
chips and French fries.
Cutler et al. (2003) present evidence that the increase in caloric intake mainly came from
snacks consumed at home, and also that especially married woman who experienced a
large reduction in the time spent preparing food had large increases in BMI. Increases in
energy expenditure activities, such as sports or walking, were offset by decreases in energy
spent on-the-job and by increases in sedentary activities, such as watching television.
The authors reject several theories that explain the trend of rising obesity, and propose
a theory based on the division of labor in food preparation. Utility is derived from con-
sumption and lost from being overweight:
Ut 5 Ct + U(Kt) − h·Weightt, (24.12)
where C is consumption of durable composite commodity, K is caloric intake, and the

costs that underlie utility loss are linear with slope h. The income constraint is:
Ct 5 Y − P·Kt, (24.13)
where Y is income and P is the cost of food. A rational consumer will consume food until
the marginal consumption benefit is equal to the marginal cost.
Technological innovation that allows mass preparation of food affects consumption
through reducing two variables: the cost of food (including both time and money costs),
and the time delay before consumption, which is the time taken to prepare the food.
Thus, the benefits of consumption are discounted for that interval of time. Hyperbolic
consumers, who are very sensitive to changes in time delay, will gain more weight with
further improvements in food technology. Therefore, the dramatic time savings in food
preparation, that are supposed to lead to a pure economic benefit, may actually be welfare
reducing in the presence of self-control problems.
Lakdawalla and Philipson (2009)14 examine the increase in weight that has resulted
from technological changes over the last few decades, and decompose it into supply and
demand components. They find that about 40 percent of the increase in weight was owing
to expansion in the supply of food through agriculture innovation that has lowered food

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prices, while 60 percent was owing to demand factors through more sedentary market
and household work.
3.9 Relative Prices
Variations in relative prices may underlie the variations in weight. French et al. (1997,
2001)15 bring some experimental evidence from vending machines, showing that price
reduction strategies which change the price differentials between high-fat and low-fat
snacks may cause people to alter their consumption behavior.
Chou et al. (2004) examine changes in prices of food consumed at home, meals in fast-
food and full-service restaurants, cigarettes and alcohol, and show that, controlling for
age and race, relative prices affect obesity and explain a substantial amount of its trend:
(1) weight rises when relative prices of food at home decline; (2) the demand for conven-
ience food and for unhealthy fast food is to a large extent a response to expanded labor
market opportunities for women, which increase the value of household time; and (3)
increases in the relative price of cigarettes reduce smoking and contribute to increased
body weight.
The effects of relative prices on obesity are also examined by Rashad et al. (2006). They
find that the rapid increase in obesity over time, especially during the 1980s, is due in part
to a great increase in the per capita number of restaurants, and is partly an unintended
consequence of the campaign to reduce smoking, as female BMI is responsive to changes
in cigarette taxes.16
Courtemanche (2011) finds that increases in gasoline prices are associated with addi-
tional walking and a reduction in the frequency with which people eat at restaurants,
therefore affecting weight. His estimates imply that 8 percent of the rise in obesity between
1979 and 2004 can be attributed to the concurrent drop in real gas prices.
3.10 Economic Predispositions to Obesity
It is well known that poverty undermines health and that health inequality is linked to
income inequalities. Obesity as well is not evenly distributed across socio-demographic
groups. In Western countries, the highest rates of obesity are observed among popula-
tion groups with the lowest levels of education and the highest poverty rates, and in the
most deprived areas, especially among women.17 Consequently, obesity may be related to
changes in the economic environment over the past few decades, which affect diet struc-
ture and diet costs (Drewnowski 2009). Since food insufficiency and overeating seem to
contradict each other, researchers tried to explain how it is that obesity often coexists with
food insecurity and even with undernutrition.
Drewnowski and Specter (2004) find that poverty and food insecurity are associated
with lower food expenditures, low fruit and vegetable consumption, and lower-quality
diets. They also find an inverse relation between energy density and energy costs, such that
energy-dense foods represent the lowest cost option. Moreover Baum and Ruhm (2009)
find that excess body weight is inversely related to socioeconomic status at all observed
points of the lifecycle and these disparities increase with age.
As incomes drop, cheap foods become the best way to provide daily calories. Diets
based on refined grains, added sugars and fats are more affordable than diets based on

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lean meats, fish, fresh vegetables and fruits. As the lowering of energy costs through tech-
nological innovation has been most marked for highly processed foods containing added
sugars and fat, food-insufficient people consume energy-dense nutrient-poor foods, and
hence gain weight. Moving to a nutrient-rich and healthier diet implies increasing food
expenditures.18
Inequitable access to healthy foods is one mechanism by which socioeconomic factors
influence diet and health. Another aspect of poverty is limited accessibility to physical
activity. Sallis and Glanz (2006) show that not only do low-income neighborhoods have
fewer supermarkets with fresh fruits and vegetables, but they also have fewer recreational
facilities and more environmental barriers to physical activity.
Smith et al. (2009) propose that weight gain is an optimal physiological and behavioral
response to the presence of economic insecurity, just as in ancient times storing food
was the response to the presence of food scarcity and starvation risk. Using data on
American working-age men, they find that weight gain is positively related to increases
in the probability of becoming unemployed and drops in annual income. The mechanism
also appears to work in reverse, with health insurance and intra-family transfers protect-
ing against weight gain.
Offer et al. (2010) state that affluent market-liberal countries, with high levels of com-
petition, uncertainty, and inequality, tend to have the highest prevalence of obesity. They
analyzed 96 body-weight surveys from 11 countries and found that economic insecurity,
measured in several different ways, is a much more powerful indicator of economic stress
compared to inequality.
Smith (2012) further argues that economic stress and economic household-level inse-
curity promote seeking comfort foods, which are carbohydrate-rich and fattening. In his
view, it is no coincidence that obesity has increased in parallel with the rise in economic
insecurity in the US and around the world, and that consumption of fast foods and
sweetened beverages, in which caloric density is paired with a strong glycemic effect, has
increased at the same time. These studies suggest a promising path to better understand-
ing of the causes of obesity and effective measures of dealing with it, and request more
research in this direction.
3.11 Information
Unhealthy food choices and weight gain could be explained by information problems,
either a lack of information on the nutritional value of food or misleading information
on health consequences of poor eating habits. Nayga (2000) finds a significant effect of
individual health knowledge on decreasing the probability of being obese.
Food labeling is an important source of nutritional information. It may influence health
beliefs and purchase intentions, and is expected to help consumers choose more healthful
and nutritious diets that can help reduce obesity.19 So far most demographic groups do not
seem to benefit from food labeling, at least in terms of body weight. Many countries have
implemented mandatory nutrition labeling regulations, yet the trend of rising obesity has
continued. However, Variyam and Cawley (2006) show that the release of food-labeling
regulations in the US in 1990 were only effective in decreasing body weight among non-
Hispanic white women.
Loureiro et al. (2012) also find that nutritional labels play a role in reducing BMI among

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users of nutritional labels, notably among women, who are considered more frequent
users of nutritional labels. They estimate that men who read labels have 0.36 points lower
BMI than men who never/rarely read them, whereas women who read labels have 1.93
points lower BMI than women who do not read them. Considering the average American
height and weight, these reductions in BMI correspond with a loss of 1.2 kilograms for
men and 5.05 kilograms for women.
Loureiro et al. (2012) further find a considerable gap in the effect of labels on BMI
reduction across races. For women, the highest BMI reduction is seen in white women –
those who read labels have a BMI of 2.18 points lower than those who do not read them.
The second largest effect of nutritional labels on BMI is seen in black women – those who
read labels have 1.10 lower BMI than those who do not read labels. The smallest reduction
in BMI is found for women of other races who read labels, with a 0.74 lower BMI than
those who do not read labels.
These findings imply that nutrition and health education campaigns can employ
nutritional-label use as one of the instruments for reducing obesity.
Hedley et al. (2004) are concerned with the risk that low-fat labels may lead to overcon-
sumption of nutrient-poor and calorie-rich snack foods by consumers who are already
overweight. Wansink and Chandon (2006) show that all consumers in a laboratory overeat
more calories of snack food during a single consumption occasion when it is labeled as
‘low fat’. Low fat nutrition claims decrease feelings of guilt and also cause consumers to
underestimate calorie content of snacks and increase their perception of the appropri-
ate serving size. These findings are robust across both hedonic (chocolate candies) and
utilitarian (granola) snacks, young and old consumers, self-reported nutrition experts
and novices, in public and private consumption settings and regardless of whether people
serve themselves or not.
Interestingly, people who are overweight seem to be more sensitive to low-fat labeling.
For normal weight people, low-fat labels increase consumption most with foods that are
believed to be relatively healthy, whereas for overweight people, low-fat labels increase
their consumption of all foods. The authors further demonstrate that salient objective
serving-size information (for example, ‘contains 2 Servings’) reduces overeating among
guilt-prone, normal weight consumers but not among overweight consumers. Objective
serving-size information prevents normal weight people from overestimating serving sizes
and from overeating foods labeled as low fat, nevertheless does not influence overweight
people.
Cawley (2006) notes that consumers typically have less information about the calorie
content of foods they eat away from home, which are exempted from mandatory labeling.
Another important source of information is advertising. Advertisements of high calorie
food and fast-food restaurants may influence food purchasing patterns and eating pat-
terns of adults and children.20 Smith (2004) hypothesizes that food advertising provides
information that once, in the pre-industrial world of food scarcity, served as a signal of
nutritional value and product quality: foods that are eaten by others, taste sweet or salty,
and are associated with post-ingestive satiety; all these were social and chemical signals
that meant that the foods were safe and nutritionally valuable. Our food preferences have
been designed by these signals and cannot be altered within the span of a single lifetime.
Current food producers, fast-food restaurants have learned to isolate these signals and
have featured a variety of sweetened, salty, calorie dense foods.

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Chou et al. (2008) state that in the period during which childhood obesity increased so
drastically, the share of fast-food restaurant advertising in total food product advertis-
ing has increased (from 5 percent in 1980 to 28 percent in 1997), hence the number of
restaurant and fast-food advertisements viewed by children has increased. Chou et al.
explore this causal link and find that increasing exposure to fast-food advertising by half
an hour per week will increase the probability of children ages 3–11 being overweight by
2.2 percent for boys and by 1.6 percent for girls. This translates to a 15 percent increase
in the number of overweight boys in a fixed population, and 12 percent for girls. For ado-
lescent boys and girls ages 12–18, they obtain an increase of 2.5 percent in the probability
of being overweight for boys and 0.6 percent for girls. This translates to a 17 percent
increase in the number of overweight adolescent boys in a fixed population, and 4 percent
for adolescent girls.
Grossman et al. (2012) find further that the exposure to fast-food restaurant advertising
causes changes in body composition, namely, increases body fat percentage.
These results can be used to justify policy measures such as a fast-food restaurant
advertising ban on television, or an elimination of the tax deductibility of food advertis-
ing costs, which will increase the price of advertising.
3.12 Misperceptions and Consumption Norms
Cues or norms that are present in the environment, such as plate size, package size, variety
of foods, eating atmospherics, and the presence of other people, may contribute indirectly
to consumption volume by influencing self-monitoring or by suggesting consumption
norms. Such effects seem to be relatively automatic and may often occur outside of con-
scious awareness.
Young and Nestle (2002) provide evidence for a significant increase in portion sizes in
the US. Food portions began to grow in the 1970s, rose sharply in the 1980s, and have
continued in parallel with increasing body weights. Wansink (1996) discusses the ways
in which large packages and portion sizes raise consumption. A common explanation
is that they cause people to underestimate their consumption and suggest a lower cost
per unit. Unfortunately, this explanation does not explain more than 21 percent of the
variance in consumption, nor does it explain increased consumption in environments
where food is abundant and provided at no charge (such as receptions, parties, and all-
you-can-eat buffets). A more robust explanation as to why large packages and portions
increase consumption may be because they suggest larger consumption norms. That
is, the amount of food on a plate or in a bowl may implicitly, or at least perceptually,
suggest what might be construed as an appropriate or an acceptable amount to consume,
therefore might determine how much people expect to consume and how much they
eventually consume.
Using self-refilling soup bowls, Wansink et al. (2005) examined whether visual cues
related to portion size influence intake volume, estimated intake, and satiation. This was
done by serving soup in bottomless bowls and refilling them through concealed tubing
that ran through the table and into the bottom of the bowls. Participants who were
unknowingly eating from these self-refilling bowls ate 73 percent more soup than those
eating from normal bowls. Moreover, despite consuming more they did not believe they
had consumed more nor did they perceive themselves as more sated. It seems as though

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they use their eyes to estimate food intake and not their stomachs. Paradoxically, people
who tend to be most focused on food consumption and weight control may be particularly
susceptible to such environmental factors.
Also in the context of misperceptions, Wansink (2004) reviews psychological mecha-
nisms behind consumption and reveals how various environmental cues influence
eating duration and food intake. Aside from hunger, people start eating because they
see or smell food, or because they want to be with other people, or because eating
provides them with something to do (while watching television or reading). Aside
from satiety, people stop eating because of the completion of the meal by others that
serves as external signals that the meal should be over, or when they ran out of food,
or because their television program finished. People might continue to eat if they are
given more food or more time to eat. Wansink also discusses eating atmospherics, which
have an indirect or mediated impact on eating duration and consumption volume. It
is known that cold temperatures lead to higher consumption compared with warm
temperatures. In addition, dimmed or soft lighting, and soft or preferred music, make
it comfortable or enjoyable for a person to spend more time eating, and encourages
a slower rate of eating and a longer meal duration. People are less inhibited and less
self-conscious, and therefore are likely to consume more food and drinks than they
otherwise would.
Variyam et al. (2001) estimate the degree of consumer misperception regarding our own
diet quality, and find that 40 percent of household meal-planners perceived the quality of
their diets to be better than the actual diet quality.
4 CONCLUSION
This chapter presents a number of ways in which overweight and obesity can be caused by
decision-making of intelligent boundedly rational individuals. The models and empirical
research reviewed in this chapter indicate that obesity is not solely, or perhaps primarily,
a medical problem. Diverse factors have been suggested in the literature as possible con-
tributors to rising obesity over time, some of them remain under debate and are still open
to further research.
An understanding of the causes and consequences of obesity provides us with the
theoretical and empirical basis for considering effective policy responses. Decisions are
required about whether government intervention is at all justified. This requires, among
others, forecasts as to whether obesity rates are likely to continue to rise or to reverse in
the future without government regulation. The possible answers determine the role of
government in reducing obesity levels and provide input for evaluating the feasibility and
cost-effectiveness of different policy measures that might be used, either through prices
(taxes and subsidies that change the expected future costs and benefits), or through
information (advertising and education campaigns).

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NOTES
1. The common classification of weight is based on Body Mass Index (BMI), calculated as a person’s weight
in kilograms divided by the square of their height in meters (kg/m2). Being overweight is defined as having
a BMI from 25 to 30. Being obese is defined as having a BMI of 30 and above. Being extremely obese is
defined as having a BMI of 40 and above. For more details, see Rosin (2008).
2. For more on health consequences of obesity, see, for example, Sturm (2002), Sturm et al. (2004), and Flegal
et al. (2005).
3. See global health indicators in World Health Organization (2015).
4. For more on economic consequences of obesity see, for example, Ludwig and Pollack (2009), Cawley and
Danziger (2005), and Bhattacharya and Bundorf (2005).
5. For more on the impact of obesity on the labor market see, for example, Barkin (2010), Wada and Tekin
(2010), Gates et al. (2008), Baum and Ford (2004), Cawley (2004), Zagorsky (2004, 2005), Cawley and
Danziger (2005), Averett and Korenman (1996).
6. For further explanations, see Yaniv et al. (2009).
7. For example, an ability to produce more fat tissue from given calorie intakes, a susceptibility to chronic
overfeeding or a sensitivity to negative energy balance.
8. Anderson and Butcher (2006) explain that it is difficult to differentiate the parents’ influence between
genetics and behavior. Children’s food selection is affected by their parents. In addition, children’s physical
activity can be affected by how active their parents are.
9. For a broad survey on the explanations of obesity in the economic literature, see the literature survey of
Rosin (2008).
10. ‘Weight conscious’ is largely a synonym for ‘health conscious’.
11. Basal metabolic rate (BMR) reflects the amount of calories needed to sustain life in a resting individual.
BMR is determined by physical characteristics (such as gender, age, weight and height) and is actually the
largest source of energy expenditure.
12. Identical preferences were used by Laibson (1997), who used the term hyperbolic discounting.
13. Diets always start tomorrow, meaning that people continually delay their diet yet another day. However,
while naive people believe that when tomorrow comes, they will really start dieting, sophisticated people
know that they are lying to themselves when they say they will start dieting tomorrow.
14. See also Lakdawalla et al. (2005).
15. See also French (2003).
16. For more on the link between smoking and obesity, see, for example, Courtemanche (2009), Fang et al.
(2009), and Gruber and Frakes (2006).
17. By contrast, in poor or early societies the obese are relatively wealthier.
18. See also, for example, Drewnowski (2003, 2009), Hayden and Blisard (2008), Shahar et al. (2005), Loureiro
and Nayga (2005), and Basiotis and Lino (2002).
19. For more on labeling regulations, see Variyam (2008).
20. Note that in addition to the exposure to advertisements, television watching is a sedentary behavior and
provides cues for snacking, hence contributes to weight gain in several ways (see, for example, Taras et al.
1989; Gore et al. 2003).
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25 Time inconsistent preferences in intertemporal
choices for physical activity and weight loss:
evidence from Canadian health surveys
Nazmi Sari
1 INTRODUCTION
It has been consistently shown that healthy lifestyles such as participation in sports and
exercise, healthy diet, and non-smoking practices give substantial short-term and long-
term benefits to individuals. For instance, studies show that physical activity decreases the
likelihood of any use of healthcare services (Sari 2009, 2010, 2011, 2014), and improves
individuals’ labor market (Lechner 2009; Lechner and Sari 2015) and health outcomes in
the short run as well as in the long run (Sari and Lechner 2015). There is similar literature
for smoking and healthy diet (US Department of Health and Human Services 2004).
Although the benefits of healthy lifestyles including participation in sports and exercise
have been widely known, we have an increasing number of people1 who are not follow-
ing the healthy lifestyles recommended by the national and international health agencies
(World Health Organization 2010). Given their direct impacts on individuals’ health (US
Department of Health and Human Services 2010; Warburton et al. 2006), why people are
not following these recommendations has been an ongoing interest in the research and
policy world. Is this simply owing to a lack of interest in improving their health, or a self-
control and commitment problem? If individuals are aware of the health consequences
of not following the recommended guidelines, does this mean that they are not rational
decision makers?
The purpose of this chapter is to shed some light on the questions raised above. Using
cross-sectional representative health surveys in Canada, I examine individuals’ intentions
to improve their health among Canadians adults. Given that a Canadian survey provides
specific information regarding the individuals’ intentions to improve their health, we use
this dataset. The issue studied here is not specific to the Canadian context, and therefore
our findings can easily be generalized to population groups across the developed world.
This dataset shows that more than half of the Canadian population aged 20–59 has
reported that they will do something to improve their health during the next year. When
asked for the specific type of health improvement, 34 percent reported that they will
start to or increase exercise during the next year. This is followed by improving diet (11
percent), losing weight (8 percent), and quitting smoking (8 percent). In spite of a sub-
stantial proportion of people reporting that they will improve their health during the next
year, we have not seen any substantial change in health behavior in the form of higher
participation in sports and exercise, decrease in body weight or smoking rate. It seems
that individuals, for the most part, fail to follow the plans they make today for a specific
period in the future. That is, their future behavior is inconsistent with their optimal plan
determined as of today.2
449
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There has been growing literature emphasizing the time inconsistent preferences in the
context of intertemporal decision making. As consistently noted in behavioral economics
in the context of saving behavior, intertemporal decisions concerning physical activity
and weight loss are other examples of time-inconsistent preferences people exhibit that
require economic models departing from standard assumptions. For instance, a model of
intertemporal choices that is based on an assumption of exponential discounting or not
incorporating self-control and commitment problems does not predict time-inconsistent
preferences.
One approach would be to insist that we should still use economic models with stand-
ard assumptions to examine the behavior of individuals regarding their health choices.
This approach would simply assume that individuals who exhibit behavior that deviates
from the predictions of these models are not rational. Instead of relying on this line of
argument, we offer alternative arguments in which individuals still tend to be ‘smart’
in the decision-making process given the constraints and opportunities they face. For
instance, individuals who predict that their future selves would deviate from the decisions
made for future behavior could choose to use some self-limiting devices for their future
selves in order to achieve long-term benefits of their healthy lifestyles. These alternative
approaches (that is, incorporating more general discounting, self-control and commit-
ment problems into economic models) that are consistent with time-inconsistent prefer-
ences are discussed in section 4 of this chapter. We offer these alternatives as additional
directions that can improve our understanding of intertemporal choices in the context of
health behavior.
2 BEHAVIORAL INTENTIONS TO IMPROVE PHYSICAL

HEALTH AMONG CANADIAN ADULTS
There are specific times of the year that we decide to make commitments to change our
behavior in the future (that is, New Year resolutions). Some of these promises could
be related to behavioral changes related to healthy eating and improving diet, quitting
smoking or participating more in sports and exercise. Although we have anecdotal
evidence for this type of behavioral promises, there are no population-based estimates
showing the extent of these intentions. In this section, I present evidence from a large
sample of Canadians to show the level of promises reported to improve health in general
and specifically for diet, smoking and exercise. These are illustrated in Table 25.1 for
selected types of health improvement that are intended to be undertaken during the next
year following the year of the corresponding health survey.
The descriptive statistics reported in Table 25.1 are computed using the Canadian
Community Health Survey 3.1 (CCHS 3.1) conducted in 2005. The CCHS is a survey
conducted every other year to collect rich information related to various aspects of indi-
viduals’ health including general health status, health behavior (that is, diet, exercise, and
smoking), and the utilization of healthcare services. The survey also includes detailed
variables on socioeconomic and demographic backgrounds of Canadians. The sample
includes around 130 000 individuals covering all Canadians aged 12 and older. In addition
to standard survey questions administered in each cycle, Statistics Canada includes an
additional module to each cycle focused on a specific topic. For Cycle 3.1, there is an addi-

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Time inconsistent preferences in choices for physical activity and weight loss 451
Table 25.1 Reported intention to improve own health by planned actions for the following
year (percentage)
Intention Types of health improvement

to improve
More Diet Lose Quit
health
exercise weight smoking
All (ON, MB, NFL) 53 34 11 8 8
Sex
Female 56 36 12 10 7
Male 50 31 10 6 9
Marital status
Married/common law partner 54 35 11 9 7
Not married 53 32 11 7 9
Household income
Less than $15 000 51 29 10 8 11
$15 000–$29 999 50 29 9 8 10
$30 000–$49 999 53 32 10 9 9
$50 000–$79 999 56 36 11 9 8
$80 000 and above 57 38 11 8 7
Education
Less than secondary graduate 45 23 7 8 12
Secondary graduate 50 30 10 8 9
Some post-secondary 59 36 12 7 11
Post-secondary graduate 56 37 11 8 6
Notes: The results reported in the table are my own computation based on a sample that includes all survey
respondents aged 20–59, who live in ON, MB, or NFL. These are the participants’ completed optional
module of the CCHS 3.1.
tional module comprising a section related to individuals’ perceptions, and intentions/

plans to improve their health during the following year. This section of the survey was
asked of the survey participants in three provinces (Ontario, Manitoba, Newfoundland
and Labrador – NFL), that is a large sub-sample, and representative for the population
in these three provinces (Statistics Canada 2005).
There are two sets of questions in this module that are particularly relevant to the
topic of this chapter. The first question was asked of all participants of this module: ‘Is
there anything you intend to do to improve your physical health in the next year?’ For
those respondents who reported an affirmative answer to this question, there are a set
of questions regarding the types of actions that the respondents have planned to do to
improve their health. Eight explicit types of actions that are listed in the follow-up ques-
tion in order are: (1) start/increase exercise, sports and physical activity, (2) lose weight,
(3) improve eating habits, (4) quit smoking, (5) drink less alcohol, (6) reduce stress level,
(7) receive medical treatment, (8) take vitamins, and other (needs to be specified by the
respondent). The survey respondents were asked to answer each follow-up question inde-
pendently (that is, ‘Do you intend to start/increase exercising to improve your health in

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the next year?’). Therefore, the respondents could have multiple action plans to improve
their health (that is, exercising, losing weight and improving their diet).
Based on these survey questions, I computed the percentage of individuals who reported
that they intended to take action to improve their health. This is shown in the first column
of Table 25.1 for individuals aged 20–59. For specific types of actions, I report the results
for the top four action types (exercising more, improving diet, losing weight, and quitting
smoking). Table 25.1 presents health improvement intentions by types of actions for all
participants as well as by selected socioeconomic and demographic characteristics.
The first particularly striking observation is that more than half of the population aged
20–59 has reported that they will do something to improve their health during the fol-
lowing year. When asked by types of specific actions that will be undertaken, 34 percent
reported that they will start to or increase exercise more during the next year. This is
followed by improving diet (11 percent), losing weight (8 percent), and quitting smoking
(8 percent). When we examine it by selected set of socioeconomic characteristics, we can
observe that females and individuals with higher income and education are more likely to
report that they intend to improve their physical health.
In order to examine underlying factors, and to understand major determinants of
health improvement intentions, I estimate probit models using two dependent variables,
and present the results in Table 25.2. The table shows the regression results from probit
models that examine the determinants of intention to improve physical health for age
group 20–59. In the first model, the dependent variable is whether the individual intends
to do something to improve physical health during the course of the next year. The second
model, however, is specific to physical activity. In this case, the dependent variable meas-
ures the individual’s intention to start or increase participation in sports and exercise to
improve his or her physical health. In both models, we use location, and the most impor-
tant socioeconomic and demographic characteristics as independent variables. Table 25.2
shows the estimated coefficients and corresponding p-values for statistical significance of
the coefficients.
The results from the probit models show that some of the factors such as location, being
an immigrant and income have no association with individuals’ intentions to improve
their physical health. However, other factors such as age, being male or level of education
have statistically significant associations. While males (about 8 percentage points), whites
(2–3 percentage points), or married people (1.5 percentage points) are less likely to report
that they have any intention to do something (or specifically exercise more) to improve
their health, more educated people are 5–10 percentage points more likely to have any
intention to improve their health during the next year. The results in these regressions
are consistent with the descriptive statistics. Among all factors mentioned above, level of
education and being male is one of the factors consistently associated with individuals’
intentions to do something to improve their health.
As shown in this section, the majority of Canadians plan to do something to improve
their health during the next year, and the intention to increase physical activity is at the
top of their action plan. Given that 34 percent of Canadians living in one of the three
provinces report that they will increase or start to exercise during the next year, this should
lead to a considerable reduction in insufficient participation in physical activity, and body
weight. Is this what we observe based on population surveys on physical activity and body
weight? This issue is examined in the following section.

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Table 25.2 Determinants of intention to improve physical health: results from probit
regressions
Dependent variable: Dependent variable:

Improve health More exercise
ME p-value ME p-value
Province (reference group: Newfoundland and Labrador)
Ontario −0.013 0.28 −0.011 0.46
Manitoba 0.004 0.78 0.005 0.77
Age (reference group: 20–24 age group)
25–29 0.004 0.78 −0.009 0.60
30–34 −0.008 0.55 −0.033 0.06
35–39 −0.010 0.47 −0.031 0.07
40–44 −0.020 0.14 −0.055 0.00
45–49 −0.011 0.42 −0.046 0.01
50–54 −0.028 0.05 −0.066 0.00
55–59 −0.026 0.07 −0.044 0.02
Education (reference group: less than secondary school graduate)
Secondary graduate 0.009 0.49 0.041 0.02
Some post-secondary 0.059 0.00 0.097 0.00
Post-secondary graduate 0.048 0.00 0.108 0.00
Household income (reference group: less than $15 000)
$15 000–$29 999 −0.023 0.16 −0.028 0.19
$30 000–$49 999 −0.009 0.57 −0.003 0.88
$50 000–$79 999 0.009 0.55 0.032 0.10
$80 000 or more 0.008 0.59 0.036 0.07
Other socio-demographic variables
Male −0.067 0.00 −0.089 0.00
Married/common law partner −0.015 0.05 −0.010 0.32
Immigrant −0.005 0.60 0.010 0.44
White −0.023 0.02 −0.030 0.02
Household size 0.002 0.42 0.003 0.37
Sample size 19869 14471
Note: ME stands for marginal effects.
3 BODY MASS INDEX (BMI) AND PARTICIPATION IN SPORTS

AND EXERCISE IN CANADA
The previous section presents evidence from the population-based survey in regard to
Canadians’ intentions to change or modify their unhealthy behavior. Given that these
promises have implications for body weight and participation in exercise and sports
activities, I present the pattern of changes in body weight and participation in sports and
exercise in Canada during the last decade.

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The primary dataset for this analysis is various cycles of the Canadian Community
Health Survey, a cross-sectional survey conducted in 2001, 2003, 2005, 2007 and 2008 with
a sample size of more than 100 000 individuals. The survey has detailed questions related
to the participation in sports and exercise and other health behaviors (that is, dietary
details, smoking and alcohol consumption), as well as health-related information (BMI,
chronic conditions, and self-reported health).
There is a series of questions in the CCHS related to 23 types of leisure time physical
activities (LTPAs). The participants have been asked whether they have participated in
each activity during the past three months. For those individuals who have participated in
the corresponding LTPA, there are follow-up questions related to the frequency (episode)
and the typical duration of each episode. Using this detailed information, a summary
variable for total daily energy expenditure from all LTPAs is computed and included
with the survey. This variable is calculated by multiplying hours of daily activity by the
equivalent energy expenditure from this activity, expressed as daily kilocalories (kcal) per
kilogram (kg) of individual’s body weight.3 Then the daily energy expenditure from each
LTPA is summed over all LTPAs to obtain the summary measure.
This summary variable is used to compute the pattern of participation in sports and
exercise in Canada from 2001 to 2008. The participation pattern in sports and exercise is
displayed for the Canadian adult population (Figure 25.1) by men and women. The verti-
cal axis indicates the total daily energy expenditure (kilocalories) from all types of LTPAs
per kilogram of body weight while the horizontal axis shows the corresponding year that
2.5
2.0
1.5
1.0
0.5
Female – energy expenditure from all LTPAs
Male – energy expenditure from all LTPAs

0
2001 2002 2003 2004 2005 2006 2007 2008
Year
Note: Own calculations using the Canadian Community Health Surveys for the years 2001, 2003, 2005,
2007, and 2008. Values for other years are linearly interpolated. Population is Canadians aged 20 to 59 in any
given year. Vertical axis indicates the energy expenditure from all LTPAs measured by kcal/hour per kilogram
of body weight.
Figure 25.1 Participation in LTPA for adult men and women in Canada

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the information is estimated. For those years that the information is not available, the
values are linearly interpolated.
Figure 25.1 presents that the level (intensity) of physical activity is higher for men
than women in all years suggesting that there are substantial variations between men and
women in terms of their participation in sports and exercise. As displayed here, and also
consistently shown in the literature, men are more active than women. The figure indicates
that for both groups physical activity has an increasing trend in the period 2001–03. Then
it stays the same until 2005 and then shows a declining trend after 2005. This declining
trend is very clear from 2005 to 2007 for men and women, suggesting that there seems
to be some inconsistency between Canadians’ intentions related to their health behav-
ior (discussed in the previous section), and their actual behavior. Overall intensity of
physical activity is slightly higher than the benchmark daily energy expenditure of 1.5
kcal.kg−1 recommended by the agencies such as the Centers for Disease Control and
Prevention (CDC), and the American College of Sports Medicine (ACSM). This recom-
mended benchmark level of physical activity that is also consistent with the World Health
Organization (WHO) guidelines corresponds to about a ‘30 minutes or more of moder-
ate intensity physical activity on most, preferably all, days of the week’ (Pate et al. 1995:
p. 404; for an update and clarification on 1995 recommendations, see Haskell et al. 2007).
For the same period, I also present the BMI that is measured by an individual’s body
weight in kilograms divided by the square of an individual’s height in meters. This trend
in BMI is illustrated in Figure 25.2 in which the vertical axis indicates the BMI while
the horizontal axis shows the corresponding year in which the information is estimated.
I follow the same approach and linearly interpolate the values for those years that the
information is not available.
There are two conclusions that can be reached with data illustrated in Figure 25.2. The
first is about the differences in BMI between men and women. The figure shows that men
are heavier than women during this period, and the difference stays the same. The second
observation, which is more striking, is related to the alarming public health implications
of this issue. Figure 25.2 shows that the BMI is stable at around 25, with an upward trend
over time reaching 26.6 for men and 25.1 for women in 2008. This estimate suggests that,
on average, Canadian men and women have an overweight problem that is alarming given
that obesity is identified as an important public health issue around the world.
As presented in Figure 25.1 and Figure 25.2, participation in sports and exercise, as well
as the BMI, in Canada have not changed substantially. The change in BMI or participa-
tion in sports and exercise over time that is not even substantial has not aligned with the
intentions of health improvement reported by Canadians as presented in the previous
section. We observe that the level of physical activity has not increased, and the BMI has
not decreased over time. This aggregated information in Figure 25.1 and Figure 25.2 has
been illustrated for the entire country. As we described in section 2, the data for the level
of health improvement intentions come from three provinces (Ontario, Manitoba and
NFL) in 2005. Therefore, to be consistent with the data period, and sub-sample, I present
the sports and exercise participation as well as the BMI in 2005 and the next available year
(2007) using two cycles of the CCHS. These results are presented in Table 25.3.
Table 25.3 presents the participation in physical activity and BMI for those aged
20–59. The upper panel of the table provides this information for the entire country while
the lower panel shows it for those living in Ontario, Manitoba or NFL. As shown in the

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30
20
10
Female – BMI
Male – BMI
0
2001 2002 2003 2004 2005 2001 2001 2001
Note: Own calculations using the Canadian Community Health Surveys for the years 2001, 2003, 2005,
2007, and 2008. Values for other years are linearly interpolated. Population is Canadians aged 20–59 in any
given year.
Figure 25.2 Body Mass Index for adult men and women in Canada
Table 25.3 Physical activity and body mass index in Canada (aged 20–59)
Average in Average in Difference p-value for

CCHS 3.1 CCHS 4.1 (2) – (1) mean difference
(1) (2) test
All Canada
Physical activity 2.11 2.06 −0.05 0.00
Body Mass Index (BMI) 26.11 26.36 0.25 0.00
ON, MB and NFL
Physical activity 2.17 2.10 −0.07 0.00
Body Mass Index (BMI) 26.30 26.55 0.25 0.00
Note: The indicator for physical activity shows the daily kilocalories burned from all types of LTPAs
measured by per kilogram of body weights of individuals. The bottom panel of the table shows the results for
the residents in Ontario (ON), Manitoba (MB), and Newfoundland and Labrador (NFL). The right-hand
column shows the corresponding p-values for the mean difference test for the average differences between
cycles 4.1 and 3.1.

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table, both for the entire country and for the three provinces, the level of physical activity
has decreased from 2005 to 2007 while the BMI has increased in the same period. The
difference in change is comparable between the entire country and the three provinces
listed above. As indicated in the last column of the table, the change from 2005 to 2007 is
statistically significant. The table shows that the BMI increased (rather than decreased)
by 0.25 points (0.95 percent increase), while the intensity of participation in sports and
exercise decreased by 3.23 percent. As we can see, the direction of the change from 2005
to 2007 is not consistent with the large proportion of Canadians in the three provinces
reporting that they have intentions to do something including physical activity, diet, and
weight loss to improve their health during the next year. Our estimates for these relevant
health outcomes do not support the fact that individuals keep their promises regard-
ing health improvement intentions.4 In fact, the evidence reported in the table suggests
that the individuals’ actual behavior is not consistent with their intentions about their
behavior reported a year ago. This is a good example for time inconsistent preferences
in which individuals deviate from their earlier decisions made for that time period when
that time arrives, and have a tendency to pursue immediate gratification at the expense
of long-term health benefits.
There are series of questions arising from this inconsistency that cannot be explained
using a standard economics models. Does this inconsistency imply that individuals are
not optimizing, and therefore are not rational? Could this still be decision making consist-
ent with the rationality assumption of economic theory but inconsistent with standard
economic modeling? Are they simply anomalies that should be ignored for the field of
economics or are there lessons that we can all learn from this inconsistency? These are just
a subset of interesting questions that can be articulated better elsewhere. The direction
that I follow in the next section is to offer explanations derived from behavioral economics
that provide alternative ways to model individual choices which conforms to the observed
time-inconsistent preferences.
4 ALTERNATIVE APPROACHES CONSISTENT WITH TIME-

INCONSISTENT PREFERENCES
In this section, I offer explanations in which the case described above could still be rational
decision making in spite of its inconsistency with standard economic models. The source
of the inconsistency could be related to the simplifying assumptions continuously made
in standard economic models. For instance, discount rates and individuals’ preferences are
assumed to be constant when modeling intertemporal decisions. As illustrated in behavio-
ral economics literature, the models with these assumptions do not fit well with observed
behavior and experimental data. Among several alternative explanations that would
explain the behavior described in the previous section, I restrict the discussion related
to discounting, present-day bias and self-control and commitment issue. The purpose
is to offer a set of alternative approaches in which the decision making of the individu-
als for the scenario described in the previous section could still be rational in spite of its
inconsistency with the standard models in economic theory. The aim, however, is not to
provide a comprehensive review of this literature but to derive some lessons from the field
of behavioral economics for the economics of physical activity, and obesity.

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4.1 Discounting and Time Inconsistency
Discounted utility models (DMUs) have been widely used in economics to study indi-
viduals’ behavior that requires potential trade-off for costs and benefits not necessarily
accrued in the same time period. In these models, individuals are assumed to maximize
their present discounted sum of utilities with utility in each period depending on con-
sumption of goods and services. In standard models on intertemporal decisions, it is
common practice to use a constant discount rate and to weigh the future utilities by
an exponentially declining discount factor. As also shown for other types of consumer
behavior, the data presented in the previous section regarding physical activity, diet, and
weight loss do not support an exponentially declining constant discount rate assumption
(for more discussion on this issue see Loewenstein and Prelec 1992; Frederick et al. 2002;
Rabin 2002; Nyhus and Webley 2006). Despite its lack of applicability to real-life choices
requiring intertemporal decision making, this assumption has still been widely used in
economics.
Among others, Thaler (1981) also examined whether the discount rate is constant,
using a sample of students at the University of Oregon. In his experiment, the students
were instructed to imagine that they had won some money in a lottery held by their
bank. They were given a choice to take the money now or to wait and earn interest. The
experiment had follow-up questions asking the subjects the amount of money that they
would require to make waiting just as attractive as getting the money now. Based on the
responses, Thaler computed implicit discount rates for different money amounts and time
delays. The results showed that implicit discount rates decrease as the length of time delay
increases. Following Thaler’s contribution, others also studied the same issue and showed
that discount rates decrease with an increase in time delay (see Frederick et al. 2002 for a
comprehensive review of this literature).
As shown in economics experiments as well as in cognitive psychology literature, the
predictions regarding intertemporal choices made based on utility functions with con-
stant discount rates are inconsistent with what we observe in real-life applications. In an
earlier work, Strotz (1956) is one of many who emphasizes the time-inconsistent prefer-
ences, and incorporates alternative discount function in his model. The model developed
in his paper predicts that an individual deciding now for future consumption of goods
and services could deviate from her optimal plan. As a result, the individual’s future
behavior becomes inconsistent with her optimal plan determined as of today. Given that
the discount function in his model depends on the time distance of the future date from
the present moment, it shifts due to a change in the time distance. As a result, individuals
may deviate from their optimal plan decided now for the future date. As he argued ‘there
is nothing patently irrational about the individual who finds that he is in an intertemporal
tussle with himself except that rational behavior requires he takes the prospects of such a
tussle into account’ (Strotz 1956, p. 171). As clearly indicated here, a rational individual
is expected to take this conflict or ‘tussle’ into account when making intertemporal deci-
sions. In the context of exercise and diet, this becomes especially relevant given that the
individuals face a conflict between short-term temptations, and long-term health goals.
We will discuss this in the context of self-control and commitment after introducing
present-day bias and hyperbolic discounting as an alternative form of discount function
in economic models.

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4.2 Present Biased Preferences and Hyperbolic Discounting
As consistently argued in the recent literature, a simple hyperbolic time discounting fits
well with experimental data as opposed to standard exponential discounting (Laibson
1997; O’Donoghue and Rabin 1999). Laibson states that hyperbolic discount functions
are characterized by a relatively high discount rate over short horizons and a relatively
low discount rate over long horizons. It therefore creates a conflict between today’s pref-
erences, and the preferences of the future. The discount rate between time t and t + 1
does not stay the same but it changes based on the time distance to time t. For example,
from today’s perspective the discount rate between time t and t + 1 is the long-term low
discount rate, but it becomes the short-term high discount rate from time t’s perspective.
As a result, the change in discount rate creates contradiction in the way that the decisions
are made for the same time period. The decision made for time t + 1 as of today becomes
suboptimal for the individual at time t. Therefore, the individual may deviate at time t from
the decision made as of today for time t + 1.
Although it is not present in standard discount function, hyperbolic time discounting
creates a time inconsistency in intertemporal choices owing to systematic changes in pref-
erences. Given the same information, and the choice set, an individual with exponential
discount function makes the same decisions prospectively with the one that she would
make when the decision actually arrives. It is not the same with someone who has hyper-
bolic time-inconsistent discounting. The individual who makes a decision for the future
takes far-sighted actions; but when the future arrives he or she behaves against his or her
earlier decisions, and pursues immediate gratification (that is, following an unhealthy diet,
and avoiding exercising) rather than long-run well-being.5 This behavioral shift fits well
with individuals’ behavior related to sport and exercise, and diet. Hyperbolic discounting,
therefore, is a more consistent assumption than the widely used exponential discounting
assumption to study individuals’ preferences for participation in sports and activity and
behavioral change to improve their health.6
4.3 Self-control and Commitment Problem
Although hyperbolic discounting would be an improvement over exponential discount-

ing in explaining time-inconsistent intertemporal decisions discussed above, this may not
be sufficient to analyze and explain individuals’ intertemporal behavior. The discussions
related to present-biased preferences predict that a path of action that will take place at t +
1 seems utility enhancing as it is chosen at time t, but it becomes not so when the decision
is re-analyzed at time t + 1. Then the relevant question to ask would be why would you
make this type of intertemporal choices at time t given that they might know (perhaps with
earlier experience) that they will not commit to the path of action that they have decided
at time t for time t + 1. There is a growing theoretical literature to deal with this issue by
incorporating self-control and commitment/temptation into economic models. We will
provide a summary of the general approach below.
Although incorporating hyperbolic discounting would be a potential way to improve
economic models in studying intertemporal choices, we also need to consider self-control
and temptation/commitment as additional issues to be included in economic models to
explain and make predictions in decision making when it has immediate costs and only

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long-term benefits. While it might be relevant with many other intertemporal consump-
tion decisions, it certainly is the case for health behaviors, that is, exercise and diet that
have immediate costs with potential long-term health benefits.
Several earlier studies have incorporated self-control and commitment issues to model
economic decision making with present-biased preferences. In these models, hyperbolic
discounting is assumed with exponential discounting being a special case. In addition to
that, the general strategy is to model time-inconsistent preferences as if there are ‘separate
agents’ choosing individual’s current behavior to maximize his or her current utility based
on his or her current preferences, and letting the future selves to control his or her future
behavior. In these models that incorporate self-control into economic decision making, a
person is assumed to maximize lifetime utility based on his or her preferences today and
predicted preferences for the future selves. As a result, a path of action decided at time t
for time t + 1 could be followed if the future selves would obey the decision made today.
That is, it depends on the power of the prediction for true preferences of future selves (that
is, whether the present selves correctly predict what future selves might want to do), or the
level of awareness about his or her self-control problem, and therefore the mechanisms
developed to follow the path of action determined today.
There are several alternative assumptions introduced in economic modeling to incor-
porate the idea of ‘separate agents’ to economic models. As illustrated in O’Donoghue
and Rabin (1999), it can be modeled based on two extreme assumptions for the person’s
awareness of his or her self-control problem: (1) a person fully knows his or her self-
control problem (that is, has perfect knowledge about preferences of his or her future
selves), therefore may commit/limit himself or herself to a smaller set of future choices
through binding (legally or socially) pre-commitments – in this framework, they are called
sophisticated individuals; (2) at the other extreme, a person is assumed to be naive, that
is, she believes that her future preferences will be identical with those he or she has now.
Even after failing at time t + 1 to follow the path of action decided at time t for time t +
1, he or she does not learn from this shift in his or her future preferences, therefore still
stays optimistic about his or her self-control problem that the future selves would impose
on him or her. There are, of course, continuums of other types in between.
In an alternative but similar approach, Shefrin and Thaler (2004) introduce a frame-
work in which a person is assumed to have two sets of coexisting and mutually incon-
sistent preferences: one concerned with long-run (planner) and the other with short-run
(doer) outcomes of the choices made. We could also interpret this in the framework of the
‘separate agents’ model mentioned above. In this comparison, the sophisticated individual
would be the one with dominant ‘planner’ preferences while the naive individual would
be the one with dominant ‘doer’ preferences.7 There are other possibilities in between
these two extreme assumptions. A person could understand the self-control problem but
systematically underestimate the degree of present-biased preferences, and therefore con-
sistently fail to follow a path of action decided at time t for time t + 1.
In the case of health behavior mentioned in this chapter (more exercise, quitting
smoking or following a diet), people may fail to follow their intention to improve their
health because of being overly optimistic about their future selves’ commitment for
healthy behavior in the future. This intention to put the behavioral change off to the
next period could accumulate substantial delay costs (that is, obesity and developing
chronic diseases) from postponing it regularly. In order to deal with their commitment

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and self-control problem, individuals with sophisticated preferences may choose to use
various devices to self-limit themselves for a path of action decided at time t for time t +
1. For those individuals interested in improving their health by exercising more and losing
weight, there are several market products available (fat farms, all-inclusive resorts, or
intense boot camps, and exercise classes) that offer a variety of packages to meet individu-
als’ needs. These devices simply offer pre-packaged programs with diet and exercise focus
for a certain time period (from a week to a few months) at a certain location (hotel or a
resort) simply to enforce a set of behavioral changes. For these types of services, individu-
als are ready to pay a substantial amount of money for what, we could argue, individu-
als could do without enrolling in these programs. It is hard to argue that such decision
making is not rational, although it is a decision against the preferences of future selves. A
sophisticated individual with planner preferences would make self-limiting decisions for
their future selves in order to achieve long-term benefits, and there is nothing irrational
about this decision making despite its inconsistency with narrowly defined understand-
ing of economic theory. This is precisely the point stated in Strotz (1956): that a rational
individual who aims to achieve long-run health benefits takes the possibility of a deviation
from the path of action decided today in the future by their future selves into account.8
5 CONCLUDING REMARKS AND IMPLICATIONS
In this chapter, I provide evidence from attitudes related to physical activity and obesity in
Canada to show that time-inconsistent preferences are a widespread phenomenon among
Canadian adults. As presented in the chapter, about 55 percent of the people surveyed
stated that they will do something to improve their health during the next year. In the fol-
low-up question regarding the type of specific actions to be undertaken, about 65 percent
of those reported that they will start to or increase exercise during the next year. This is
followed by reported intention to improve their diet and lose weight (about 40 percent).
Given the substantial level of reported intention to increase exercise, improve diet, and
lose weight, we would expect an observable change in the level of activity and body weight
of this population group during the year following the survey. However, this is not what
we find in the data, suggesting that time-inconsistent preferences are more widespread
phenomena than we imagined. Following this observation in the data, we offer alterna-
tive ways to incorporate this behavioral shift into economic models. As indicated in the
previous section, we could learn more from models taking present-day bias, self-control
and commitment issues into account when studying economics of health behavior owing
to its intertemporal nature. These alternative models allow us to examine the possibility of
individuals’ deviation from predicted behavior based on models with unrealistic assump-
tions related to preferences.
They are also useful for studying the role of public policy in the context of sports
and exercise and healthy lifestyle choices. As discussed in the previous section, there are
continuums of consumers with preferences varying from naive to sophisticated, and the
sophisticated individuals would make self-limiting decisions for their future selves in order
to achieve long-term benefits. For other individuals who do not use self-limiting devices,
there could be mechanisms in which healthy behavior could be encouraged through
group-based approaches specifically designed to achieve behavioral changes. One strategy

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in these group-based approaches would be to explore potential effects of social interac-

tions (social mechanism) for behavioral changes (Leibenstein 1950; Bernheim 1994).
Examples are community-level organized sports and exercise activities, and amateur and
community level sports leagues. There could be other effective policies that aim to help
the people understand their degree of optimism, and to help them to develop strategies to
achieve behavioral changes to improve their long-term health outcomes. Further research
studies to uncover the effectiveness of alternative social mechanisms developed to encour-
age behavioral changes would certainly be needed, and have the potential to extend our
understanding on this particularly relevant public health issue.
NOTES
1. For instance, in Canada, the UK and the USA about two-thirds of people are not meeting the recommended
level of physical activity (World Health Organization 2010).
2. What is not known is whether individuals express their ‘true’ preferences in survey data. It is likely that there
could be reporting bias in survey data regarding their preferences.
3. The equivalent energy expenditure from the corresponding activity is calculated using the corresponding
metabolic rate (MET) for each activity type. The METs are multiples of the resting rates of oxygen con-
sumption during the activity. For instance, 1 MET represents the approximate rate of oxygen consumption
of a body at rest, and the equivalent energy expenditure of 1 MET is 1 kilocalorie in an hour per kilogram
of individual’s body weight (kcal.hr−1.kg−1).
4. Given that the data reported here come from cross-sectional representative surveys, we do not compare
the same individuals’ reported intentions and actual behavior in the next year. The samples in both years,
however, are representative for the corresponding provinces; therefore, we would expect to observe a sizeable
change in direction that would be consistent with such a large proportion of the population reporting that
they have intentions to do something to improve their health in the next year.
5. It is likely that individuals are constrained by time owing to work- and non-work-related obligations, as well
as income. The deviations from earlier decisions could be due to these constraints but not a shift in their
preferences.
6. In an interesting paper, Rubinstein (2003) offers an alternative explanation to understand time inconsist-
ent choices made by the individuals. He presents experimental evidence to show that they are incompatible
with the hyperbolic discounting while compatible with the procedural approach that is defined as decision
makers’ approach to identify similarity relations in determining the dominance of one option over others.
7. This idea is similar to the two-system dichotomy introduced in Kahneman (2011) in which he argues that
there are two systems simultaneously operating in our mind. They can be considered as two agents with their
individual abilities, limitations, and functions. As system 1 operates quickly and with little effort, system 2
operates more carefully by allocating attention to the effortful mental activities.
8. We could only take this into account if he or she can correctly predict the preferences of future selves. If
we cannot make correct predictions about the future, then the possible deviations would not be considered
irrational acts.
REFERENCES
Bernheim, B.D. (1994), ‘A theory of conformity’, Journal of Political Economy, 102 (5), 841–77
Frederick, S., G. Loewenstein and T. O’Donoghue (2002), ‘Time discounting and time preference: a critical
review’, Journal of Economic Literature, 40 (2), 351–401.
Haskell, W.L., I.M. Lee, R.R. Pate, K.E. Powell, S.N. Blaire, B.A. Franklyn et al. (2007), ‘Physical activity and
public health: updated recommendation for adults from the American college of sports medicine and the
American heart association’, Medicine and Science in Sports and Exercise, 39 (8), 1423–34.
Kahneman, D. (2011), Thinking Fast and Slow, Ottawa: Doubleday Canada.
Laibson, D. (1997), ‘Golden eggs and hyperbolic discounting’, Quarterly Journal of Economics, 112 (2), 443–77
Lechner, M. (2009), ‘Long-run labour market and health effects of individual sports activities’, Journal of Health
Economics, 28 (4) 839–54

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Lechner, M. and N. Sari (2015), ‘Labor market effects of sports and exercise: evidence from Canadian panel
data’, Labor Economics, 35 (August), 1–15
Leibenstein, H. (1950), ‘Bandwagon, snob, and Veblen effects in the theory of consumers’ demand’, Quarterly
Journal of Economics, 64 (2), 183–207
Loewenstein, G. and D. Prelec (1992), ‘Anomalies in intertemporal choice: evidence and an interpretation’,
Nyhus, E. and P. Webley (2006), ‘Discounting, self-control, and saving’, in M. Altman (ed.), Handbook of
Contemporary Behavioural Economics, New York: M.E. Sharp, pp. 297–325.
Pate, R.R., M. Pratt, S.N. Blair, W.L. Haskell, C.A. Macera, C. Bouchard et al. (1995), ‘Physical activity and
public health: a recommendation from the Centers for Disease Control and Prevention and the American
College of Sports Medicine’, Journal of the American Medical Association, 273 (5), 402–7.
Rabin, M. (2002), ‘A perspective on psychology and economics’, European Economic Review, 46 (4–5), 657–85.
Rubinstein, A. (2003), ‘Economics and psychology? The case of hyperbolic discounting’, International Economic
Review, 44 (4), 1207–16.
Sari, N. (2009), ‘Physical inactivity and its impact on healthcare utilization’, Health Economics, 18 (8), 885–901.
Sari, N. (2010), ‘A short walk a day shortens the hospital stay: physical activity and the demand for hospital
services for older adults’, Canadian Journal of Public Health, 101 (5), 385–9.
Sari, N. (2011), ‘Does physical exercise affect demand for hospital services? Evidence from Canadian panel data’,
in P.R. Guerrero, S. Kesenne and B.R. Humphreys (eds), The Economics of Sport, Health and Happiness: The
Promotion of Well-being through Sporting Activities, Cheltenham, UK and Northampton, MA, USA: Edward
Elgar Publishing, pp. 81–100.
Sari, N. (2014), ‘Sports, exercise and length of stay in hospitals: is there a differential effect for chronically ill
people?’, Contemporary Economic Policy, 32 (2), 247–60.
Sari, N. and M. Lechner (2015), ‘Long-run health effects of sports and exercise in Canada’, Canadian Center
for Health Economics Working Paper No. 150018, University of Toronto.
Shefrin, H.M. and R.H. Thaler. (2004), ‘Mental accounting, saving and self-control’, in C.F. Camerer,
G. Loewenstein and M. Rabin (eds), Advances in Behavioral Economics. Princeton, NJ: Princeton University
Press, pp. 395–428.
Statistics Canada (2005), ‘Canadian Community Health Survey 3.1’, accessed 10 January 2016 at http://www23.
statcan.gc.ca/imdb/p2SV.pl?Function5getSurvey&Id522642.
Strotz, R.H. (1956), ‘Myopia and inconsistency in dynamic utility maximization’, Review of Economic Studies,
23 (3), 165–80.
Thaler, R. (1981), ‘Some empirical evidence on dynamic inconsistency’, Economics Letters, 8 (3), 201–7.
US Department of Health and Human Services (2004), The Health Consequences of Smoking: A Report of
the Surgeon General, Atlanta, GA: US Department of Health and Human Services, Office of the Surgeon
General.
US Department of Health and Human Services (2010), The Surgeon General’s Vision for a Healthy and Fit
Nation, Rockville, MD: US Department of Health and Human Services, Office of the Surgeon General.
Warburton, D., C.W. Nicol and S.S.D. Bredin (2006), ‘Health benefits of physical activity: the evidence’,
Canadian Medical Association Journal, 174 (6), 801–9.
World Health Organization (WHO) (2010), Global Recommendations on Physical Activity for Health, Geneva:
WHO Publications.

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26 Suicide among smart people
Bijou Yang and David Lester
This chapter reviews what impact intelligence might have on suicide from the perspective
of behavioral economics. We see, in this chapter, that suicide is less common in those who
are smart as measured by intelligence tests. Thus, suicide does not appear to be a ‘smart’
decision, and this is in line with the predominant view of suicide as the result, in part, of
psychiatric disorder and irrational thinking.
The research on the association between intelligence and suicide1 is examined first, fol-
lowed by a review of two behavioral economic theories of suicide, namely, Hamermesh
and Soss’s utility maximization theory of suicide and Yang and Lester’s cost–benefit
theory of suicide, in order to see whether intelligence would be expected to have an impact
on suicide as an outcome. Next, the evidence that delay-discounting is associated with
both suicidal behavior and intelligence is reviewed, followed by our conclusions.
INTELLIGENCE AND SUICIDE
Intelligence evolves over an individual’s life and is affected both by the individual’s innate
abilities and by their experiences from infancy on. Once suicides are identified, it is obvi-
ously too late to obtain measures of their intelligence using standardized measuring
instruments, and few suicides have data available on their scores from prior intelligence
tests. In order to obtain methodologically sound data on the impact of intelligence on
suicide, longitudinal follow-up studies are required. Such studies are rare and typically
carried out only in Scandinavia where records on citizens are centralized and open to
investigators.
In one of these studies, Allebeck et al. (1988) followed up 50 465 young men (born in
1949–51) who were conscripts in Sweden in 1969–1970 when aged 18–20, 247 of whom
died by suicide during a 13-year follow-up, which indicates a suicide rate of about 38 per
100 000 per year.2 Low intelligence test scores predicted subsequent suicide in the univari-
ate model and, together with 11 other variables in a multiple regression, contributed to
the prediction of suicide.
Using a much larger sample, which probably included those in the previous study,
Gunnell et al. (2005) studied 987 308 men born in Sweden during 1950–76 who were tested
during conscription procedures in 1968–94 and who had intelligence test scores recorded.
The only young men excluded from conscription during this period were those who had
foreign citizenship, a severe chronic medical condition, or a handicap. Four basic tests
covering different aspects of intelligence were given: (1) logic, (2) identifying synonyms,
(3) visuospatial and geometric perception, and (4) mechanical skills and mathematics
problems. Of these men, 2811 later died by suicide.3 Better performance on each of these
tests was associated with a lower rate of subsequent suicide. Among these four tests,
the largest difference was on the test of logic. Dividing intelligence test scores into nine
464
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Suicide among smart people 465
groups, the suicide rate of the lowest scoring group was three times the suicide rate of the
highest scoring group, clearly indicating that a higher intelligence test score was associ-
ated with a lower suicide rate. The age-adjusted hazard ratios4 for suicide were 0.88 for
the logic test, 0.90 for the synonym test, 0.90 for the spatial test and 0.90 for the technical
test, all statistically significant. In addition, focusing on the logic test, Gunnell et al. found
that the association between intelligence and suicide remained even after controlling for
education, pre-existing psychiatric illness, and the educational level of the parents of the
men, and therefore the association between intelligence and suicide was robust.5
Because the association between intelligence and suicide was found after controlling
for psychiatric illness, Gunnell et al. (2005) suggested that the association was most likely
caused by the fact that, in times of crisis, people with lower intelligence test scores are
less able to identify adaptive solutions to their problems and, therefore, suicide becomes
a more viable solution.
The conclusion seems to be that, in the general population, high intelligence test scores
are a protective factor for suicide. Smart people make better decisions and are less likely
to make the decision to die by suicide.
THE RELEVANCE OF INTELLIGENCE IN BEHAVIORAL

ECONOMIC THEORIES OF SUICIDE
The potential impact of intelligence on suicidal behavior might arise because smart people
would be expected to have careers in which they earn more, and they would be expected to
be more successful in these careers. Lifetime income has played a role in several economic
theories of suicide, notably Hamermesh and Soss’s lifetime utility theory and Yang and
Lester’s cost–benefit analysis of suicide.
Hamermesh and Soss’s Microeconomic Theory of Suicide
The economic theory of suicide developed by Hamermesh and Soss (1974) is based on
a utility function which is determined by the permanent income and the current age of
the individual. The permanent income is the average income expected over a person’s
lifetime. In the calculation of permanent income, Hamermesh and Soss follow a formula
that includes the real income of the current year plus the rest of the years of working life
of an individual. Thus, this brings in a concept of opportunity cost, that is, by complet-
ing suicide,6 an individual forgoes the opportunity of earning income during the rest of
his or her life. The permanent income and the current age of an individual determine
the consumption level from which an individual will derive satisfaction. The current age
also determines the cost of maintaining the day-to-day life of the individual, which is a
negative attribute of the utility function. A third element relevant to suicide is the taste
for living or distaste for suicide, which is assumed to be a parameter normally distributed
with a zero mean and constant variance. When the total discounted lifetime utility (which
includes the taste for living) remaining for a person reaches zero, an individual will com-
plete suicide.
This economic model of suicide contains the following assumptions. (1) The older the
current age, the lower the total satisfaction, because the cost of day-to-day living increases

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with age. (2) The greater the permanent income, the higher the total satisfaction, since a
higher income level warrants a higher consumption level. However, the additional satis-
faction brought forward by additional income decreases with higher income.
Based on the principle of utility maximization in this economic model, we can derive
several theorems about the suicide rate of a society. First, the suicide rate will increase
with age. Since the marginal utility of lifetime income decreases with increased permanent
income, the older that individuals become, the less additional satisfaction they are going
to derive from consumption. This should increase the probability that they will choose
suicide. Secondly, the suicide rate will be inversely related to permanent income. If indi-
viduals receive a greater amount of lifetime income, they are expected to have a greater
amount of consumption and, therefore, a greater satisfaction from life. This should
decrease the probability of completing suicide.
Hamermesh and Soss tested the usefulness of their theory by using an econometric
approach that places more weight on the efficient prediction of the target variable. The
equation used was:
S(A,t) 5 a0 + a1I(A,t) + a2I2(A,t) + a3A + a4A2 + a5A3 + a6UN(A,t) + a7UN(A,t) • A +

vA,t
where A is the age group, t is the year, I is the discounted permanent income of age group
A at time t, UN is the unemployment rate of age group A at time t, ai are constants and
v is a disturbance term. Note the presence of higher order powers in some of the terms.
Rather than conducting separate time series analyses for each age group, Hamermesh
and Soss pooled the data for a 21-year period and for the nine age groups, giving 189
pooled observations. The empirical results presented by Hamermesh and Soss (1974)
showed that permanent income was negatively related to the suicide rate, while the unem-
ployment rate had a positive association with the suicide rate and an increasing effect on
suicide as workers become older, as predicted. Yet as income rose in the postwar period,
the male suicide rate fell for most age groups. Only for the youngest three age groups
(those aged 20–34 years) did the suicide rate rise with rising incomes, a result that is in
contrast with the theory’s prediction. Hamermesh and Soss explained this by arguing
that the expansion in the number of people pursuing education into their twenties and
the consequent postponement of consumption by an increased fraction of the people in
these groups could affect the prediction. The decline in suicide rates for older people as
their income has increased may be especially strong because of the decrease in variability
of income resulting from the expansion of Social Security benefits. Indeed, Hamermesh
and Soss pointed out that there was a sharp drop in the relative suicide rates of groups
over age 55 in the late 1930s coincident with the introduction of Social Security benefits.
A Cost–Benefit Analysis of Suicide
In Yang and Lester’s cost–benefit analysis of suicide (Lester and Yang 1997; Yang and
Lester 2006), completing suicide is considered to be a rational act. Individuals are acting
‘rationally’ if, given a choice between various alternatives, they select what seems to be
the most desirable or the least undesirable alternative. The decision to commit suicide
depends upon the benefits and costs associated with suicide and with alternative actions.

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An individual will be less likely to commit suicide if the benefits from suicide decrease,
the costs of suicide increase, the costs of alternative actions decrease, or the benefits from
alternative activities increase. The benefits from suicide include escape from physical or
psychological pain (as in the suicide of someone dying from terminal cancer), the antici-
pation of the impact of the suicide’s death on other people (as in someone who hopes to
make the survivors feel guilty), or restoring his or her public image (as in the suicide of
Antigone in Sophocles’ play of the same name).
There are several costs in completing suicide. These include the money and effort spent
in obtaining the information and equipment needed for the act of suicide, the fear and
pain involved in preparing to kill oneself and in the process of completing suicide, the pos-
sible drawbacks as a result of dying by suicide such as the expected punishment predicted
by most of the major religions of the world, and the opportunity costs (that is, the net gain
to be expected if other alternative activities were chosen and life continued). An individual
will choose suicide only if its benefits are greater than all of the costs mentioned above.
Suicide can also be examined as if it were a commodity or a service that we buy.
However, it is immediately obvious that suicide is very different from the typical objects
that we purchase. For example, when we buy an object, we pay a specific price to obtain it
and then we enjoy it. Suicide results in death, and as a result we have to conceptualize our
enjoyment of it quite differently. Suicide is somewhat similar to the purchasing of health-
care services. In both, we pay a price to get rid of something, life in the case of suicide
and sickness in the case of health care. Yet there is a basic difference between suicide and
health care in that suicide leads to death, while health care (hopefully) leads to further life.
Of course, for those who believe that there will be a ‘life after death,’ suicide also leads to
further life, but of a different kind.
Looking at matters from a demand-side perspective, when we purchase a commodity
(or a service), the price we pay for the commodity (or service) reflects the benefits we
expect to receive from consuming that commodity. From a demand-side perspective,
beef costs more than chicken because the public desires beef more than chicken, and
their stronger desire for beef reflects their expectation of greater satisfaction from eating
beef than from eating chicken. In a demand-side analysis of suicide, the notion of its
‘price’ is different from the ordinary price of a commodity. The benefit expected by a
suicide is the relief of unbearable distress, and so a scale of distress is used to measure the
benefit expected by the suicidal individual. This benefit expected by suicidal individuals
is reflected in the ‘price’ they must pay for their suicide. In essence, the demand curve for
suicide is a relationship indicating the probability of completing suicide as a function of
the amount of distress felt by the individual. As the amount of distress increases, the prob-
ability of completing suicide increases. The demand for suicide is, therefore, an upward-
sloping curve, which is quite different from the typical downward-sloping demand curve
applicable, for example, in economic analyses of commodity markets.7
On the supply side, the probability of completing suicide is related to the cost of
completing suicide. The cost of completing suicide includes the cost of losing your life,
collecting information about how to commit the act, purchasing the means for suicide,
and so on. While the latter two items have a clear-cut scale of measurement, the cost of
losing life is much harder to measure. It includes at least three components, namely, the
psychological fear of death, the loss of income in the future which otherwise would have
been earned by the suicide, and the loss of any enjoyment that would be experienced

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Price/cost of committing suicide
SE
P1 PE P2 1
Probability of committing suicide
Figure 26.1 A demand and supply curve for suicide
during the rest of your ‘natural’ life. The higher the cost of completing suicide, the lower
the probability that individuals will actually kill themselves. Therefore, the supply curve
should be a downward-sloping curve.
Both the demand for suicide and supply for suicide are shown in Figure 26.1. The verti-
cal axis indicates the price (or the cost) of completing suicide, while the horizontal axis
represents the probability of completing suicide (with a range of 0 to 1). The demand
curve is an upward-sloping curve which begins from the origin8 and ends at the point when
the probability of completing suicide is equal to 1. The price level for completing suicide,
which corresponds to the point where the probability is equal to 1, refers to the threshold
level of distress that an individual can no longer tolerate. Under these circumstances,
suicide becomes inevitable.
The intersection of the demand and supply curves represents an equilibrium for an
individual. For that equilibrium level of distress and the corresponding costs of complet-
ing suicide, there is an equilibrium probability of completing suicide. As the supply curve
might intersect any section of the demand curve, the equilibrium probability of complet-
ing suicide can, therefore, range anywhere from 0 to 1.
Given the aforementioned economic framework for suicide, what needs to be deter-
mined is how to measure the psychological variables (for example, level of distress and
future pleasure) in monetary units so that an equilibrium can be obtained through equat-
ing the demand and supply for suicide. For example, the level of distress can be opera-
tionalized as the cost of the psychological services required to eliminate the distress that
the suicidal person is experiencing. Since there is a typical price for psychological services,

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each level of distress could be converted into a monetary measure representing the cost of
psychological services needed to eliminate the distress. The higher the cost of treatment,
the greater the level of distress.
Another issue concerns converting future pleasure for life into monetary units so that
future pleasure can be made comparable to that of the level of distress, and so on. This
may be accomplished by compiling a list of major categories of activities that produce
pleasure for individuals.
By definition, the equilibrium probability of completing suicide is determined by
the intersection of the supply and demand curves. Owing to the peculiar nature of the
demand and supply of suicide, the equilibrium so obtained is not a stable one. Since the
demand for suicide is an upward-sloping line, the higher the distress level, the more likely
the probability of completing suicide. Since the supply curve is downward sloping, the
higher the cost of completing suicide, the less likely the probability of doing so. Let us
label the equilibrium level of distress and the cost of completing suicide SE and the cor-
responding equilibrium probability PE (see Figure 26.1).
Let us examine the implications of such an unorthodox combination of supply and
demand curves. If the probability of completing suicide is initially at P1, which is lower
than the equilibrium probability PE, this corresponds to a low level of distress from the
perspective of the demand side and a high cost of completing suicide from the perspective
of the supply side (see Figure 26.1). From the demand side, the amount of distress created
by life is smaller than the corresponding cost of treating the distress. This will motivate
the individual to further reduce the distress created by life. As a result, the situation will
lead to an even lower probability of completing suicide, and the individual will eventually
withdraw from the suicidal situation.
On the other hand, if the probability of completing suicide initially is higher than the
equilibrium probability PE, say at P2, this corresponds to a high level of distress from the
demand-side perspective and a low cost of completing suicide from a supply-side perspec-
tive (see Figure 26.1). This situation refers to a group of individuals at high risk of suicide
because they have high levels of distress and because the cost of completing suicide for
them is manageably low, since ending their lives will relieve their continuing suffering.
Thus, this situation will lead to an even higher probability of completing suicide.
Both situations, whether the initial probability of completing suicide is higher or lower
than the equilibrium level, result in movement away from the equilibrium. If the initial
probability of completing suicide is lower than the equilibrium level, then the individual
becomes less likely to choose suicide; while, if the initial probability of completing suicide
is higher than the equilibrium level, the individual becomes more likely to choose suicide.
In short, this economic model of suicide implies that suicidal behavior is an unstable
behavior.
Comment
Since smart people will earn more in their lifetimes, increasing both permanent income
and the cost of suicide, the prediction from the utility maximization and cost-benefit
theories of suicides is that smart people should have a lower suicide rate, a prediction
confirmed by the research reviewed in the first section of this chapter.

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DELAY DISCOUNTING
Delay discounting is a phenomenon in which individuals decrease the value of an outcome

if its receipt is delayed. There are three features related to the impact on decision making
from delay discounting, two related to the ‘time’ variable and one related to the size of
the ‘outcome’:
1. Now versus later in the time dimension. Individuals are more inclined to accept an
outcome of lesser utility (or value) now rather than an outcome of greater utility (or
value) later, for example, choosing a smaller amount of money immediately versus a
larger amount later.
2. A shorter versus a longer length for the outcome. Delay discounting is often hyperbolic,
that is, small delays for the receipt of the outcome have a proportionately greater
impact on value than do longer delays.
3. A small versus a large outcome. Delay discounting may lead to impulsive behavior
because individuals choose a smaller but quicker outcome over a larger but later
outcome.9
Since delay discounting can be a stable personality trait (Odum 2011), it is likely
to have many manifestations in people’s behavior. Research has shown that delay dis-
counting is associated with a variety of problem behaviors including smoking, drug
use, over-eating, failure to exercise, and taking on large amounts of credit card debt
(da Matta et al. 2012). For example, research has indicated that delay discounting as a
trait is associated with antisocial personality disorder (for example, Finn et al. 2009),
while Kirby et al. (1999) found that heroin addicts showed delay discounting more than
controls from the community matched for age, sex and education. However, measures of
delay discounting do not always correlate with measures of impulsivity, perhaps because
self-report scales of impulsivity measure different aspects of impulsivity (Odum 2011).
Nonetheless, in a survey of over 42 000 British television viewers who were given a single
delay-discounting choice of ₤45 in three days versus ₤70 in three months, Reimers et
al. (2009) found that those choosing the smaller amount in three days were younger,
had less income and less education, and were more likely to have engaged in impulsive
behavior measured by variables such as age at first sexual activity, relationship infidelity
and smoking.
Is delay discounting associated with intelligence, that is, are smarter people less likely
to engage in delay discounting? The answer is positive. For example, Shamosh and Gray
(2008) reported a meta-analysis of 24 eligible studies on this issue and concluded that
individuals with greater intelligence were indeed less likely to engage in delay discounting,
particularly in studies in which the payoffs were real.
Application to Depression
Lempert and Pizzagalli (2010) administered undergraduate students a choice test in which
they had to choose between $10 to be received after a delay of 1, 2, 40, 180 and 365 days or
$2 immediately. Delay discounting was not associated with scores on a general impulsive-
ness scale, but students who obtained higher scores on a measure of anhedonia (a lack of

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reactivity to pleasurable stimuli) were more likely to choose a larger delayed reward over
an immediate smaller reward.
Using a similar task, Takahashi et al. (2008) found that psychiatric patients with a
diagnosis of affective disorder, with the most recent episode being depression, were more
impulsive compared with controls for both gain and loss. Takahashi et al. related this
result to impaired neural processing of reward and punishment. In line with this, Must
et al. (2006) found that patients with a major depressive disorder showed an increased
sensitivity to reward which resulted in them making poor decisions. It seems, therefore,
that a tendency toward delay discounting is associated with depression.
Application to Suicide
Cutler et al. (2001) speculated that delay discounting might explain the rising rate of youth
suicide since youths are less able to discount present pain with the possibility of future
pleasure, but they did not test this empirically. Pittel and Rübbelke (2009) hypothesized
that suicide bombers forgo utility from future life in order to acquire present utility from
their present actions. The present utility for suicide bombers includes status for them-
selves, as well as material utility for their families. They may feel anticipatory feelings
of pride and accomplishment, as well as the expectation of rewards from God or Allah.
The intertemporal utility of their shortened lives exceeds the utility for lives lived to their
natural end. Since Lankford (2013) has convincingly documented the miserable current
lives of many suicide bombers, their choice makes even more sense.
In an empirical study on delay discounting in suicidal individuals, Dombrowski et al.
(2011) gave individuals over the age of 60 a choice between smaller, immediate monetary
rewards ($25–$35) and larger delayed monetary rewards ($75–$85). Delay discounting
was greatest in those who had made low-lethality suicide attempts, less in those with only
suicidal ideation, and least in depressed but non-suicidal individuals and those making
high-lethality suicide attempts. Delay discounting was not associated with hopelessness or
depression scores or with intelligence test scores. This result is surprising, but it suggests
that the more seriously suicidal elderly have a lesser tendency toward delay discounting.
It may be, however, that the more serious suicide attempters (who had, therefore, required
hospitalization) were making an effort to appear hypernormal in the hospital in order to
obtain their release from the hospital.10
Liu et al. (2012) gave a monetary rewards task11 to patients with a diagnosed substance
abuse disorder (primarily cocaine or opioid dependence) and found that those with no
history of a suicide attempt discounted small delayed rewards more than large ones,
whereas those with a prior suicide attempt showed no difference in discounting rates for
small versus large rewards. Overall, delayed discounting was not associated with a history
of attempted suicide.
More speculatively, Van Heeringen et al. (2011) concluded from their review of func-
tional and structural brain studies in suicidal individuals that suicidal individuals are more
likely than non-suicidal individuals to have abnormal functioning in the orbitofrontal and
dorsolateral parts of the prefrontal cortex, areas of the brain that Gray (1975) thought
were the basis for sensitivity to punishment. Van Heeringen et al. (2011) concluded from
their review that suicidal individuals might be overly sensitive to social disapproval and
more willing to choose options with immediate reward.

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The conclusion seems to be that intelligent people show less delayed discounting which
protects them against suicide.12
OTHER CONSIDERATIONS
Neuropsychiatric Considerations
Neuropsychologists have explored the role of the executive function in human behavior.
Executive function refers to a set of higher-order mental processes primarily governed
by the frontal lobes of the cortex. These functions include initiation, planning and self-
regulation of goal-directed behavior. To a large extent, therefore, smart people would be
expected to have more effective executive functioning.
In general, suicidal individuals have been found to have executive dysfunction as
compared to non-suicidal comparison subjects. For example, Keilp et al. (2001) studied
depressed, non-medicated patients and found that those who in the past had made serious
attempts at suicide performed worse on tests of executive functioning (including general
intellectual functioning, attention and memory). Homaifar et al. (2012) recommended,
therefore, that routine assessment for suicidal potential in patients should always include
measuring executive function.
Creative People
Although ‘smart’ typically refers to having a high level of intelligence, creative people are
also smart, albeit in a different sense. Cox (1926) tried to estimate the intelligence quotient
(IQ) scores of famous historical individuals based on information in their biographies,
such as the age at which they talked, learned languages, and so on. For example, John
Stuart Mill, a philosopher, was estimated to have an IQ of 190. He began to study Greek
at the age of 3, could read Plato in the original Greek at age 7, and wrote a history of
Rome at the age of 6.
Cox’s estimates of average IQ scores were:
Philosophers 170 Musicians 145

Poets, novelists 160 Artists 140
Scientists 155 Military leaders 125
Thus, creative individuals, such as writers, musicians and artists, are found to have high
levels of intelligence.
Cox also reported that psychological disturbance was most common in the poets, novel-
ists, musicians and artists (and less common in revolutionaries, statesmen and religious
leaders). Modern research has confirmed this. Andreasen (1987) found a greater incidence
of psychiatric disorder in contemporary writers compared with matched controls, espe-
cially bipolar affective disorder (manic depression). This has been confirmed by Jamison
(1993) who found that creative individuals were especially productive during their periods
of mania, such as the Pulitzer Prize winning poet, Anne Sexton.13 Goodwin (1988) noted
the high incidence of alcohol abuse in creative writers, suggesting either than alcohol use

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facilitates creative writing or that creativity increases stress which is relieved by using and
abusing alcohol.
Affective disorders (both major depression and manic depression) and alcohol abuse
are risk factors for suicide. Creative people, therefore, have an increased risk of psychiatric
problems that increase their risk of suicide. Since they typically have high levels of intel-
ligence, it appears that the protective factor of high intelligence does not outweigh the risk
factors arising from their creativity.
Are Richer People Happier?
In studying suicidal behavior, the role of happiness and depression appear to be central,
and so, from an economic viewpoint, it is relevant to ask whether higher incomes are
associated with greater subjective well-being (or happiness). Forty years ago, Easterlin
(1974) argued that increased income did not raise subjective well-being, but more recent
research has shown that Easterlin was wrong. For example, Stevenson and Wolfers (2013)
found that residents of wealthier countries have greater life satisfaction and, in addition,
for the 25 most populous countries, they found the same relationship at the individual
level. Furthermore, Stevenson and Wolfers failed to find a satiation effect. For example,
using a sample of 1014 respondents in the United States in 2007, they found a monot-
onic relationship between income (from <$10k to >$500k) and both happiness and life
satisfaction.
Therefore, it appears that richer people are happier, and so we may also conclude that
more smart people (who should be richer) should be happier and, therefore, less likely to
be depressed and suicidal.
CONCLUSIONS
This review of research has indicated that higher intelligence and its associated traits of
reduced delay-discounting and better neuropsychological executive functioning are each
empirically associated with reduced rates of suicide and of the risk factors for suicide
(such as depression). This conclusion ties in nicely with two economic theories of suicide,
proposed by Hamermesh and Soss and by Yang and Lester, which predict that more intel-
ligent people should be less prone to suicide because they have an increased lifetime utility
and because their suicides would entail increased costs.
NOTES
1. This chapter focuses on completed suicide (that is, acts in which the person dies) and does not consider
non-fatal suicidal behavior.
2. In Sweden in 1980, the suicide rate for men aged 25–34 in the general population was 33.3 per 100 000.
3. Gunnell et al. (2005) did not calculate a suicide rate for this sample but, given that the follow-up period
averaged 15.5 years, the estimated suicide rate is 18.4 per 100 000 per year, which is lower than the suicide
rate for all Swedish males during this period (for example, 37.6 per 100 000 per year for men aged 35–44
in 1980; Lester and Yang 1998). Remember that conscripts excluded men with medical and psychiatric
problems and handicaps.
4. Hazard ratios are calculated by dividing the subjects into those above the median score and those below

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the median score and calculating the number of suicides in the higher scoring group divided by the number
of suicides in the lower scoring group.
5. Previous studies in other countries were based on only a small number of suicides, as in an Australian study
based on only 76 suicides (O’Toole and Cantor 1995).
6. The preferred term in suicidology is ‘dying by suicide’, and ‘committing suicide’ is unacceptable. We use
‘completing suicide’ in the present chapter.
7. In typical analyses, the quantity demanded is inversely related to the cost of the product or service, and so
the typical demand curve is downward sloping.
8. The initial point of the demand curve means a logical origin of ‘zero distress’ and ‘zero probability of
suicide.’
9. Another way to illustrate the unique features of delay discounting is to compare it with the laws of dimin-
ishing marginal utility developed to illustrate basic consumer behavior in which the marginal satisfaction
from each new object steadily declines.
10. Interestingly, in another study, Dombrowski et al. (2010) found that elderly individuals who had made
suicide attempts in the past (and who were currently psychiatric inpatients with major depressive disorders)
discounted previous experiences to a higher degree, reacting more than control patients to what happened
most recently in an experimental task.
11. Such as $5 now versus $10 one week from now.
12. There is a small subset of suicides who appear to make impulsive decisions, but impulsivity in suicidal
behavior appears to be much more common in those individuals who make suicide attempts but who do
not die than in completed suicides.
13. Sexton (1928–74) refused to take the recommended medication for manic depression because it suppressed
her creativity, and she died by suicide in 1974 (Lester 1993).
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Dombrovski, A.Y., K. Szanto, G.J. Siegle, M.L. Wallace, S.D. Forman, B. Sahakian et al. (2011), ‘Lethal fore-
thought’, Biological Psychiatry, 70 (2), 138–44.
Easterlin, R.A. (1974), ‘Does economic growth improve the human lot?’, in P.A. David and M.W. Reder (eds),
Nations and Households in Economic Growth, New York: Academic, pp. 89–125.
Finn, P.R., M.E. Rickert, M.A. Miller, J. Lucas, T. Bogg, L. Bobova and H. Cantrell (2009), ‘Reduced cognitive
ability in alcohol dependence’, Journal of Abnormal Psychology, 118 (1), 100–116.
Goodwin, D.W. (1988), Alcohol and the Writer, Kansas City, MO: Andrews McNeel.
Gray, J.A. (1975), Elements of a Two Process Theory of Learning, London: Academic.
Gunnell, D., P.K.E. Magnusson and F. Rasmussen (2005), ‘Low intelligence test scores in 18 year old men and
risk of suicide’, British Medical Journal, 330 (7484), 167.
Hamermesh, D.S. and N.M. Soss (1974), ‘An economic theory of suicide’, Journal of Political Economy, 82 (1),
83–98.
Homaifar, B.Y., N. Bahraini, M.M. Silverman and L.A. Brenner (2012), ‘Executive functioning as a component
of suicide risk assessment’, Journal of Mental Health Counseling, 34 (2), 110–20.
Jamison, K.R. (1993), Touched with Fire, New York: Free Press.
Keilp, J.G., H.A. Sackheim, B.S. Brodsky, M.A. Oquendo, K.M. Malone and J.J. Mann (2001),
‘Neuropsychological dysfunction in depressed suicide attempters’, American Journal of Psychiatry, 158 (5),
735–41.
Kirby, K.N., M.N. Petry and W.K. Bickel (1999), ‘Heroin addicts have higher discount rates for delayed rewards
than non-drug-using controls’, Journal of Experimental Psychology: General, 128 (1), 78–87.
Lankford, A. (2013), The Myth of Martyrdom, New York: Palgrave.

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Lempert, K.M. and D.A. Pizzagalli (2010), ‘Delay discounting and future-directed thinking in anhedonic
individuals’, Journal of Behavior Therapy & Experimental Psychiatry, 41 (3), 258–64.
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Lester, D. and B. Yang (1998), Suicide and Homicide in the 20th Century, Commack, NY: Nova Science.
Liu, R.T., J. Vassileva, R. Gonzalez and E.M. Martin (2012), ‘A comparison of delay discounting among sub-
stance users with and without suicide attempt history’, Psychology of Addictive Behaviors, 26 (4), 980–85.
Must, A., Z. Szabo, N. Bodi, A. Szasz, Z. Janka and S. Keri (2006), ‘Sensitivity to reward and punishment and
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Threatening Behavior, 25 (4), 475–88.
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Shamosh, N.A. and J.R. Gray (2008), ‘Delay discounting and intelligence’, Intelligence, 36 (4), 289–305.
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598–604.
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impulsive and inconsistent in intertemporal choice behavior for monetary gain and loss than healthy subjects’,
Neuro Endocrinology Letters, 29 (3), 351–8.
Van Heeringen, C., S. Bjittebier and K. Godfrin (2011), ‘Suicidal brains’, Neuroscience & Biobehavioral Reviews,
35 (3), 688–98.
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Handbook of Contemporary Behavioral Economics, Armonk, NY: M.E. Sharpe, pp. 543–59.

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PART VII
SOCIOLOGICAL
DIMENSIONS OF SMART
DECISION-MAKING

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27 Seeing and knowing others: the impact of social
ties on economic interactions*
Astrid Hopfensitz
1 INTRODUCTION
Most economic interactions concern situations where two or more people meet and
interact. A seller is approached by a buyer either on a market, in a store or over the
Internet. An employer bargains with his employee. A group of fishermen meets in the
harbor before going to sea. During some of these interactions the involved parties might
have a long history together and might know each other well. In other interactions the
involved people might never have met before but see the face, dress and body language of
their interaction partner. In other situations they might not see each other but hear the
other person’s voice (over the telephone) or see their photograph on a website (over the
Internet). The different pieces of information we gather about our interaction partners
are used to help us build an image of him or her.
Psychologists have long known that men are treated differently than women, that more
beautiful and healthy-looking individuals have an advantage and that we act differently
with respect to people who look similar to ourselves compared with people who look
‘foreign’. Economists often treat such effects as biases that impede rational decision-
making. As a result, economists usually focus on situations where agents are anonymous,
and a number of policy recommendations concern methods to create anonymity, for
example, for job candidates.
In this chapter I discuss the different ways in which information about the other might
influence choices and the rationale that might lie behind some of these behaviors. I argue
that many of these seeming biases might have evolutionary rationales that help humans
make smarter decisions when interacting with others.
In some cases the influence might be due to us ‘learning’ something about possible skills
or abilities of our interaction partner (that is, statistical discrimination). In other cases the
influence might be due to an impact on our own concerns for this person (that is, other
regarding preferences). In yet other situations we might learn about the payoffs for the
other and use this to predict how he or she will act (for example, observing the others’
emotions). Again in other situations the exchange of information will serve to create
some common knowledge among the involved parties that can help to coordinate them.
Disentangling these different underlying motives is crucial for a good understanding of
how social interactions might influence human behavior.
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2 INFORMATION AND REPUTATION
Social interactions have traditionally been modeled as games by economists. Such games
can involve various people and can concern problems as different as cooperation (for
example, prisoners’ dilemma and the public good game), competition (for example, zero-
sum games) or coordination (for example, coordination games and battle of the sexes
game). While a game concerns one interaction, interactions between the same group of
people might occur more than once. Thus players in a game might either have information
from past interaction or anticipate future interactions.
Game theory has traditionally distinguished ‘one-shot’ games from ‘repeated games’.
Repeated games in this context mean interactions that have no clear end-point and where
after each interaction a positive probability of a future interaction exists. Since it is
assumed that after the game is played, outcomes are revealed to the participating players,
these future interactions will thus introduce concerns for reputation among all involved
members. In contrast a one-shot interaction means that after the game no future interac-
tion between the involved parties is going to happen and thus concerns for reputation or
punishment cannot influence choices in this case. In many cases also, any series of interac-
tions that has a clear end-point of this type is treated similarly to a one-shot interaction
owing to the principle of backward induction.1
The experimental literature in economics has in this context mainly focused on situa-
tions where cooperation or helping in a game is possible (for example, prisoners’ dilem-
mas, and helping and public good games). Cooperative acts are generally costly for the
individual but provide a benefit for the receiver. In one shot interactions, such acts are,
from an individual point of view, not beneficial. However, in repeated interactions, strate-
gies might be based on the previous choices by interaction partners and thus players who
previously cooperated will be rewarded in the future by further cooperation opportunities
(Trivers 1971). The superiority of such strategies was famously demonstrated by Axelrod
in 1984 when matching various game strategies against each other in a tournament of
repeated prisoners’ dilemma games. The clear winner of these studies was the very simple
strategy of ‘tit-for-tat’ – do to your partner as he or she has done to you in the past.
Experiments have confirmed that direct reciprocity is a prominent strategy in settings
where small groups of individuals interact repeatedly (Trivers 1971; Binmore 1992).
However, in many settings groups are large, and therefore interactions between the
same two members are rare. In such settings, indirect reciprocity might start to influence
players’ interactions. Indirect reciprocity concerns situations where an agent (i) has no
first-hand experience about another agent’s (j) behavior, but has information about behav-
ior by this agent (j) when interacting with a third party (k). Such information has been
modeled as ‘image scores’ (Nowak and Sigmund 1998), that is, a number that summarizes
an agent’s previous actions in a game. Experimental studies have confirmed the idea that
humans base their choices on the image score of their interaction partner.
A number of laboratory experiments have studied behavior when previous behavior by
interaction partners is observable, specifically indirect reciprocity (for example, Wedekind
and Milinski 2000; Milinski et al. 2002). Seinen and Schram (2006) studied the effect of
observing the final six previous decisions made by an interaction partner in a helping
game. In this game a ‘helper’ can give some money to a ‘recipient’ with the benefit being
larger than the cost of giving. Since players were randomly re-matched each period, the

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Seeing and knowing others 481
observed information was about interactions with a third party. Giving rates were sig-
nificantly higher when it was common knowledge among players that information about
previous-round behavior would be available than in a control treatment without this infor-
mation. Also the amount of help received increased with the number of previous helpful
choices made by a participant. Thus, reputation is clearly taken into account by others;
however, reputation is also used strategically by agents who know that their reputation
will matter in the future.
Whether such strategic motives are taken into account when seeing reputation infor-
mation is another interesting question concerning indirect reciprocity. Engelmann and
Fischbacher (2009) investigate this question in an experimental setting where agents had,
in only half of the periods, an observable reputation score. In the remaining half of the
periods strategic reputation building was thus not possible. About half of the participants
can be classified as strategic, that is, helping mostly in the periods where their behavior
will be visible to others. Strategic reputation building also pays off. Participants playing
strategically earn significantly more than players who are categorized as ‘weakly’ strategic.
While most of these experiments are structured such that either only direct or only
indirect reputation is available to participants, real human interactions are usually charac-
terized by a mix of reputation information and first-hand experience. The interaction of
direct and indirect reciprocity has been studied by Molleman et al. (2013). In their setup,
participants in a helping game can either use information based on direct interactions or
on reputation information. Not surprisingly, first-hand experience is weighted stronger,
especially when the two types of information provide conflicting evidence.
The importance of image scoring for real economic interactions is nicely illustrated
by reputation systems created by various online communities. Most online communities
provide the possibility to give publicly visible ‘grades’ to previous interaction partners
or to reward community members. A grading system is used on platforms such as eBay;
other platforms (such as Wikipedia) use awards that can be given to others. The impact
of receiving good grades or rewards on future interactions has been studied by a number
of different researchers. For example, van de Rijt et al. (2014) studied how receiving one
initial reward (controlled by the experimenters) influences the probability of receiving
future rewards (from other users) for Wikipedia. To study this question, a random sample
of 208 Wikipedia editors among the top 1 percent of all editors (based on edit counts)
were endowed by the researchers with a customized award. Ninety days later the editor
pages of the 208 treated editors were sampled and compared with the pages of 313 non-
treated editors that were initially similarly ranked. While 31 percent of the control editors
received another award in this period, 40 percent of the treated editors received another
award. However, it is unclear whether these effects were due to an increase in motivation
for the participants receiving positive feedback or solely based on the increased reputa-
tion score of these people. To control for this and to focus on situations that actually
require some kind of cooperation, van Apeldoorn and Schram (2014) focused on ratings
and behavior in an online community where members volunteer to host others (free of
charge) who are travelling to their city. Specifically, a number of artificial profiles were
created that differed solely with respect to how many times the member had previously
offered the service to others from the community. Ratings were therefore not a signal of
trustworthiness of the member, but a sign of previous cooperative acts of the member.
The studied online community had, at the time of the study, about 5.5 million members

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worldwide and can thus be considered a great success. As theories of image scoring would
suggest, the profiles that showed a history of previous contributions to the online com-
munity received more than double the number of positive responses when sending out a
request themselves, compared with a neutral profile.
The importance of reputation in public good situations is also illustrated by Yoeli
et al. (2013) who study willingness to participate in a campaign to prevent blackouts
(SmartAC). This program aims at residents of Northern California to volunteer to restrict
their demand from central air conditioners on days of unusual high demand or unexpected
plant failures. Participating in this program is voluntary and participants contribute at
a cost of comfort to themselves to a public good of their community. The study varied
whether participants were signing up for this program on sheets on which their own name
and address was visible to others or where they signed up with an anonymous identifier.
Observability tripled participation in the program. The effect was approximately seven
times larger than offering a $25 cash incentive. The effect was particularly large among
people living in apartments (compared to houses) and for owners (compared to renters).
This is in line with the idea that reputation should matter especially in situations where
interactions are frequent or repeated for a long time, as is the case of inhabitants of an
apartment block or residents who bought their home.
3 SEEING THE OTHER
Is the used car seller going to cheat me? Is the employee going to be able to perform the
required tasks? Is the creditor going to pay back his loan?
Many immediate questions in social interaction turn around the expected behavior of
others. Behavior might be due to a specific strategy followed by the other or to constraints
and abilities of the other. Collecting information about an interaction partner very often
has the goal of informing us about likely behavior by the other.
When no verifiable information is available, people often use statistical extrapolation
to infer likely behavior. If women or foreigners are more likely to possess a specific trait,
seeing a woman or hearing a foreign name might trigger beliefs that this specific person is
also going to have these traits. Statistical discrimination is most likely to occur with respect
to groups that have a clear reputation and where group membership can be observed
easily. Not surprisingly the literature of statistical discrimination has mainly focused on
gender and race. Both gender and race are easily deduced from seeing or hearing another
person, and even more abstract information, such as the person’s name, handwriting or
address, can be used. However, seeing or hearing another person also leads us to use ‘non-
verbal’ communication transmitted by gestures, mimic or tone of voice to anticipate the
interaction partner’s behavior. Studying these impacts is especially interesting for econo-
mists, who traditionally tend to consider such information to be either ‘cheap talk’ (that
is, messages that are aimed at convincing the other party to do something, with no real
commitment behind it) or as uninformative noise. However, people are surprisingly con-
sistent in evaluations of others based on seeing them and there is now increasing evidence
that they are also better than chance in predicting the true underlying strategies that will
be used by the other player (in certain interaction settings).
The most commonly investigated setting concerns the judgment of other people’s trust-

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worthiness. Specifically, if we assume that trust is increasing overall welfare but can get
exploited by untrustworthy others, individuals who can detect trustworthiness will have
an advantage over those that cannot. Interesting evidence for a real-world application of
this ability is a study on vote-buying behavior in Paraguay (Finan and Schechter 2012). In
many countries where ideological differences between parties are small, vote-buying can
have a large impact on election outcomes. Vote-buying describes the exchange of small
personal gifts in return for a promise to vote for a specific party. If votes are anonymous,
the person ‘buying’ the vote has to believe that the promise will be kept. Thus it is in a
candidate’s interest to focus on those voters that are likely to reciprocate the gift. Finan
and Schechter investigate data from a household survey and a middleman survey (those
who actually do the vote-buying for politicians) for the case of Paraguay. Based on the
household survey, reciprocity was measured for voters based on the share they returned
as second mover in a trust game. This measure of reciprocity was significantly influenc-
ing the probability that this individual was offered something in exchange for their vote.
Thus middlemen seem able to detect reciprocal individuals and use this information when
targeting their vote buying activities.
Trustworthiness judgments based on seeing human faces are made quickly. When
seeing a face for less than 100 milliseconds, ratings are essentially the same as when
given unlimited time to look at the face (Willis and Todorov 2006; Todorov et al. 2009).
Generally photographs of faces seem to be consistently rated concerning their trustwor-
thiness, that is, people in general agree on what a trustworthy face looks like. Even 5- to
6-year-old children are at the same level of adults’ consistency (Cogsdill et al. 2014).
Agreement can also be observed across cultures. Rule et al. (2010) asked American and
Japanese participants to rate faces of US and Japanese political candidates. Ratings of
faces showed large agreement, regardless of culture.
Trustworthiness judgments, based on facial features also influence real choices; for
example, by influencing the decision to send money to the depicted person in a trust
game (Van’t Wout and Sanfey 2008). In this one-shot game, one player is endowed with a
sum of money, and informed that he has the opportunity to transfer part of that money
to another player. If he does so, the amount he transfers is multiplied by a factor (for
example, 3) and given to the second player. The second player can now choose to transfer
back some of this multiplied amount. The first player’s decision thus amounts to deciding
whether he will trust the other player with his money.
The effect persists to influence choices even after direct experience. In a repeated setup,
initial trustworthiness ratings were observed to be updated by own experience but keep
influencing decisions even after multiple rounds (Chang et al. 2010).
The facial features influencing character ratings are often triggered by cues that carry
some valid information about the person: for example, facial symmetry as a signal of
fitness (Zebrowitz and Rhodes 2004). However, conclusions about the actual informa-
tion content of such signals often have to be critically viewed. For example, facial width
to height ratio is often referred to as a signal of aggressiveness (Carré and McCormick
2008; Stirrat and Perret 2010), however, recent data has been questioning this relationship
(Deaner et al. 2012; Gomez-Valdes et al. 2013).
Whether actual trustworthiness can be reliably detected from faces is still contro-
versial (for example, Yamagishi et al. 2003; Verplaetse et al. 2007; Efferson and Vogt
2013). Trustworthiness detection might be based on signals about the thought process or

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preferences of an actor that are mirrored in his face while contemplating the choices. For
these types of signals it is necessary to study the effect of photographs or movies taken
while the interaction partner takes his decision. Indeed some studies have observed this
ability (Willis and Todorov 2006; Verplaetse et al. 2007). Trustworthiness detection might
also use cues that are related to the interaction partner’s personality and general disposi-
tion to be trustworthy. In this case any kind of observation about the other should carry
useful information. Experimental studies have observed an ability to detect trustworthi-
ness in photographic material that was not taken during the decision period. Thus some
underlying characteristics seem to be visible in an agent’s face. However, it seems that the
signal is only detected when information is limited by eliminating visual distractors such
as clothing or hairstyle (Bonnefon et al. 2013). The same study shows that trustworthiness
detection is a so-called ‘modular process’, since intelligence is not enhancing it nor does
cognitive load decrease it.
Strongly related to trustworthiness judgments are the expressed emotions in a person’s
face. Specifically smiling faces (photographs and videos) elicit high trust. Scharlemann
et al. (2001) used still pictures and observed that participants trust more when seeing a
smiling image of their partner. Johnston et al. (2010) use video clips and observe more
trust in response to enjoyment smiles. Enjoyment or ‘genuine’ smiles are not under
straightforward voluntary control. Since the work of Duchenne de Bologne (1862)
and Darwin (1872), many researchers have attempted to identify objective measures of
‘honest’ smiles, concluding that genuine smiles are characterized by use of the orbicularis
oculi (the muscle surrounding the eyes) in combination with the zygomatic major (raising
the corners of the mouth); symmetry is also an important characteristic. More recent
research focuses on the importance of temporal dynamics such as smile onset, apex, and
offset durations (Krumhuber et al. 2007).
Mehu et al. (2007) assess which characteristics are associated with honest smiles by
rating 50 faces across ten attributes. It turns out that Duchenne de Bologne smiles play
a significant role in the assessment of generosity and extraversion. Smiles perceived as
genuine not only influence choices, but also seem informative about the possible gains
from trust. Centorrino et al. (2015) study the impact of short video messages recorded
by a trustee in a trust game. Trustees were aware that this was their only opportunity to
convince their interaction partner to trust them and were thus motivated to give a trust-
worthy ‘impression’. This is a typical situation for cheap talk, since interaction partners
did not know each other and thus a breach of trust would never be punished. The text in
the video message was standardized, thus trustees only had their tone and face to convince
the other to send them money. As predicted, the authors observe that trustees who are
perceived to have more genuine smiles are more trusted. In addition, on average, trusting
those whose smiles were rated as more genuine led to higher earnings for trustors. Trustees
who were rated as smiling more genuinely return more money, on average, to senders. This
was mainly owing to the fact that genuine smiles are informative of the situation of the
trustee (here the amount of money the trustee has available to share with the trustor).
As far as situations requiring trust are concerned, non-verbal communication might
thus be informative with respect to personality characteristics, the current decision process
of the decision maker and to the constraints that the decision maker is facing. Trust evalu-
ations are mainly influential for situations in which contracts cannot be enforced and
thus where penalizing a norm or contract violator is not possible. Another problem arises

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in situations where punishment is possible. Indeed, punishment of norm violators who

free-ride on others has been observed to be a very powerful instrument to motivate pro-
social behavior (for example, Fehr and Gaechter 2000). However, punishment can also
lead to welfare losses (Egas and Riedl 2005), especially if punishment is unconstrained
and those who feel treated unfairly can retaliate with counter-punishment (Nikiforakis
2008). Punishment in these settings is usually costly to the individual punishing and can
thus not be explained from an own material welfare-maximizing point of view. However,
norm violations have been observed to very reliably trigger emotions, specifically anger
(Bosman and van Winden 2002; de Quervain et al. 2004), which under certain conditions
can be inhibited by feelings of guilt or shame (Hopfensitz and Reuben 2009). An ability to
detect an interaction partner’s disposition to feel such emotions might thus be informative
to judge the ‘probability’ of being punished. The ability to judge an interaction partner’s
costs and abilities for punishment might be informative to judge the potential expected
‘damage’ from punishment. The two dimensions seem not uncorrelated. Sell et al. (2009)
hypothesize that individuals with enhanced abilities to inflict costs have a better bargain-
ing position in conflicts and, consequently, they might be more prone to anger.
The face seems to carry information that enables participants to detect who will reject
a low offer in an ultimatum game (van Leeuwen et al. 2014). The same study observed
that own facial asymmetry is positively correlated with getting angry after receiving a low
offer, as well as with the decision to reject a low offer. Furthermore, observers correctly
perceive facial asymmetry as a cue for getting angry after norm violations, though they
underestimate the magnitude of the correlation.
4 TALKING TO THE OTHER
When agents talk many things happen. Most obviously information is transmitted from
the speaker to the listener. However, this information might consist of much more than
the meaning of the words that are exchanged. The tone of the voice might carry many
additional signals. That these signals are informative and detected by others has been
observed for the voice of women over the menstrual cycle. Pipitone et al. (2008) recorded
voice samples by women at different moments of their menstrual cycle. Results showed
a significant increase in voice attractiveness ratings as the estimated risk of conception
increased across the menstrual cycle in naturally cycling women. In line with this, there
was no effect observed for women using hormonal contraceptives. While men find higher
pitch voices in women to be more attractive, feminine and healthier (for example, Feinberg
et al. 2008), women have been observed to find men with low pitch to be more attractive
(for example, Collins 2000). Lower voice pitch in men has even been observed to be related
to higher reproductive success in a population of hunter gatherers (Apicella et al. 2007).
Preference for low-pitched voices in men has also been observed in respect of political
candidates (Tigue et al. 2012) and might influence behavior in many other circumstances.
In addition to the explicit and implicit information transmitted by speech, public
announcements might even be informative when all implied parties already had the
announced information. Specifically, speech is very well suited to generating common
knowledge. Not only does each agent possess some information, but also all agents know
that all the others have this information and that these others know that others also have

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the information, and so on. Common knowledge is especially useful in coordination

games. In a coordination game Alice will try to act the same way as Bob, but at the same
time she knows that Bob will try to act the same way as Alice. To break through this
cycle, information that is common to all players might act as a coordination device. Many
real-life situations involve coordination. Also, what might otherwise be considered as
not-informative communication (for example, advertising) might serve to create common
knowledge. Advertising broadcast during the Super Bowl (that is, advertising that many
people will see and that people know that many others will see) comes especially often
from products that would profit from common knowledge (for example, a new technology
that is only interesting if many others also use it; see Chwe 2013).
Hearing someone speak something out loud further informs us about how committed
that person will be in the future to do what he or she said. Most people are much more
likely to stick with a decision once it has been announced loudly. Reasons for this are a
motivation to keep a reputation of being consistent and reliable, but also an avoidance
of situations generating cognitive dissonance. This has been modeled by economists as
‘guilt aversion’; the anticipation of feeling bad after breaking a promise and the subse-
quent tendency to stick with what was said during cheap talk (for example, Charness and
Grosskopf 2004; Charness and Dufwenberg 2006).
Ideally the study of cheap talk concerns ‘how people skeptically, but reasonably and
mostly conventionally, interpret language. It is the study of rational people who know how
to communicate in the ordinary way’ (Farrel and Rabin 1996). This implies that messages
that are ‘cheap’ (that is, by not influencing the players’ payoffs) can nevertheless influence
players’ choices in what they communicate and how they react to it. This, in turn, can
also influence payoffs.
5 KNOWING THE OTHER
Besides hearing gossip, seeing and talking with others, most importantly we ‘know’ many
of the agents we interact with. This knowing implies that we have information about
preferences, skills and habits of the other with much less error proneness than from the
previously discussed indirect channels. Note that these translate into information about
the other’s payoffs for different outcomes (preferences), his or her strategy set (skills)
and the to-be-expected strategy (habits). However, knowing the other player will also
influence our own preferences, such as when we play with someone we really care about
(and thus his or her utility will positively influence our utility) versus interacting with
someone we dislike (with an inverse relationship between utilities). We thus have to dif-
ferentiate between interactions between unknown players and between players who have
a history of previous interactions. Having such ‘social ties’ does not necessarily imply
that the players will cooperate more or trust each other more. Depending on the previ-
ous interaction history, a novel interaction will be influenced in one or the other way (for
example, van Dijk and van Winden 1997). The valuation of others has been observed to
be positively influenced, for example, by a history of successful interactions in a public
good environment (van Dijk et al. 2002).
Harm done to someone we care about can feel like harm to ourselves. So-called ‘mirror
neurons’ for people with strong social ties can lead to emotional experiences very similar

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to the actual experience of an observed person (Singer et al. 2004; Singer and Frith 2005).
For example, when one partner of a couple received slight electric shocks, neuroimaging
confirmed that actual pain was experienced by the observing partner. Thus what econo-
mists call ‘other regarding preferences’ might be reinforced by biological factors making
the other’s pain our own.
Although we are influenced when our interaction partner is a friend, colleague or
acquaintance, similar mechanisms are at work when we interact with a person from a
specific group that we know. This ‘in-group’ versus ‘out-group’ bias has received much
attention in economics and psychology. The observation that such biases exist even
in situations where grouping is more or less arbitrary led to the development of the
so-called ‘minimal-group paradigm’ (Tajfel et al. 1971). The work by Tajfel et al. was
initially studying behavior between ‘meaningless’ groups to be able to sequentially add
relevant group information in order to find which characteristics actually lead to dis-
crimination between groups. The surprising finding was that even when group identity
is based on quasi-arbitrary allocation (for example, picture preferences or a coin flip),
group discrimination was observed. Since then, the paradigm has been used in a mul-
titude of studies to investigate the mechanisms of group discrimination (for example,
Brewer 1979, 1999; Tajfel and Turner 1979; Yamagishi and Kiyonari 2000). Evidence
now converges to the insight that biases mainly lead to in-group favoritism and less
often to out-group punishment, and such behavior has been linked to the presence of
the neuropeptide oxytocin.
Oxytocin plays an important role during and after childbirth, facilitating birth, mater-
nal bonding and lactation. Oxytocin has been observed to play a role in pair bonding and
situations requiring mutual trust, and is therefore sometimes referred to as the ‘bonding
hormone’. In studies on minimal groups, oxytocin has been observed to lead to ‘a “tend
and defend” response in that it promoted in-group trust and cooperation, and defensive,
but not offensive, aggression toward competing out-groups’ (De Dreu et al. 2010, p. 1408).
Thus a biological mechanism linked to bonding is, through its impact on in-group favorit-
ism, also a cause of intergroup biases. Favoritism easily triggers negative emotions and
protest in those that feel disfavored and thus oxytocin might trigger a chain reaction
leading to between-group conflict. Ethnocentrism is thus to a certain degree the result
of an adaptive process that helps individuals and their groups, but that also has negative
consequences by generating intergroup bias and conflict (De Dreu et al. 2011).
A very specific group of interaction partners are members of our own family. Biology
and anthropology have long studied the theoretical and actual interactions between genet-
ically related individuals, but also family economics has in recent years departed from the
traditional view that a household is simply ‘one’ economic decision maker. Economic
models are traditionally much less concerned with the actual genetic relatedness but see
the household as a social structure based on institutions such as marriage and legal con-
tracts. The biological approach is mainly based on the concept of kin selection, that is,
that individually costly behavior might benefit the individual’s genes if beneficiaries are
genetically related. Hamilton’s rule popularized this concept in mathematical terms and it
specifies that genes can increase in frequency when the genetic relatedness of a recipient to
an agent multiplied by the benefit to the recipient is greater than the reproductive cost to
the agent. Kin selection is often cited when explaining individual costly altruistic behavior.
Helping others at a cost or fighting to protect the life of others might be costly for the

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individual but the cost is outweighed by the benefits to the individual’s genes carried in
those that receive the help.
If ‘genetically related’ is thus generating one sort of group, the corresponding out-
group can be seen as those that are ‘not genetically related’. While this concept is obvi-
ously less clearly defined, since even with individuals who are not direct relatives we do
share a majority of our genes, it nevertheless can influence behavior. Specifically repro-
duction partners should ideally not be close relatives, as so-called ‘inbreeding’ increases
the chances of offspring being affected by recessive or deleterious traits. Also, portraits
that are modified to seem ‘less’ related to the individual are generally rated as more attrac-
tive (DeBruine et al. 2011), and the body smell of individuals with dissimilar genotypes
has been observed to be preferred. This mechanism is linked to a set of genes (the major
histocompatibility complex, MHC) that plays an important role in the human immune
system. Humans have been shown to prefer the body odor of potential partners that have
a different MHC, which will thus result in offspring benefiting from two different types
of immune systems (Wedekind et al. 1995). The impact of this preference can be also
observed with respect to artificial smells, such as perfumes. Notably large individual dif-
ferences concerning perfume preferences exist among humans. These preferences are also
remarkably stable over the lifetime. When participants are asked to report perfumes they
would like to use them themselves, ingredients in the preferred perfumes have been shown
to imitate and enhance signals from the person’s natural smell (Milinski and Wedekind
2001).
Family members are a combination of people who are closely related (parents, siblings
and children) but who are also unrelated individuals (our partner and the partners of
our siblings and children). That nevertheless all family members are part of a specific
group is related to legal and cultural constraints that apply to it. Family members have
specific rights but also obligations with respect to each other. Consequently, economists
have long modeled the family as one decision-making unit, without investigating how
preferences or choices of a family come about. Specifically, most models assume that a
household is able to reach a Pareto efficient allocation, that is, that it is not possible to
find another allocation that could increase simultaneously the welfare of all household
members. Relatedly many models assume that households do ‘income-pooling’, that
is, the income of all household members is pooled and then allocated to its members
according to a household specific sharing rule. Experimental evidence is now suggesting
that households do not always reach efficient outcomes and that they do not always aim
at maximizing the household income pool. Relatedly, sociological studies often confirm
that family members frequently have conflicting preferences. Contributions in a public
good game, for example, are observed to be higher among family members than among
strangers, but not at the full level of cooperation (for example, Peters et al. 2004). Spouses
were more willing to invest in a public good when they considered themselves as having
more control over the final allocation across partners (Mani 2010). Whether spouses
aim at maximizing the household’s total income seems to be related to possible fairness
issues. Specifically some spouses are observed to prefer equal but less efficient allocations
when this means avoiding a very unequal outcome (Beblo et al. 2015). That is, spouses
seem to be willing to pay a cost to avoid situations that are likely to lead to conflict and
disagreements. A strategy that might in the long run help the couple, even if it comes at
a monetary cost.

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6 CONCLUSION
Gossip, seeing, hearing and knowing our interaction partner are often dismissed by
economists as uninformative noise or cheap talk. In this chapter I have tried to give an
idea of why many of the influences and ‘biases’ that have been observed in respect of our
interaction partners might be actually more than that. Owing to its importance in almost
all interactions, we need to take into account what agents ‘assume’ they know about their
interaction partner and what they ‘do’ know (through previous interactions). Doing so
might turn many seemingly irrational biases into behaviors adapted to make us interact
with the right people at the right time (in the right way).
NOTES
* Support from the ANR–Labex IAST and funding through the ANR-TIES (ANR 2010 JCJC 1803 01) is
gratefully acknowledged. For helpful comments and discussions, I also thank the participants in three work-
shops on social ties in Toulouse and members of the Institute for Advanced Study in Toulouse: especially
Ernesto Reuben, Eva van den Broek, Aljaz Ule, Francois Cochard, Giuseppe Attanasi, Frederic Moisan,
Emiliano Lorini and Boris van Leeuwen.
1. Exceptions are games where the Nash prediction for the stage game (that is, the one-shot game) leads to a
payoff superior to the minimax payoff.
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28 Weakness of will and stiffness of will: how far
are shirking, slackening, favoritism, spoiling
of children, and pornography from obsessive-
compulsive behavior?*
Elias L. Khalil
1 INTRODUCTION
This chapter studies phenomena as diverse as malaise, favoritism, the spoiling of children,
pornography-imaging, and shirking. The chapter argues that these phenomena, despite
their diversity, are different instances of weakness of will. However, this argument can
be easily made once we depart from the standard view of weakness of will. The stand-
ard view traces weakness of will to biased preferences – as if the main issue is a conflict
between supposed present and future preferences or putative present and future selves (for
example, Strotz 1956; Laibson 1997; O’Donoghue and Rabin 1999, 2001).
By tracing it to supposed biased preferences, the economics literature has mistakenly
coupled weakness of will with time preferences per se, where the agent ‘naturally’ favors
one apple today over one apple tomorrow. Also, with weakness of will, the favoring is pre-
sumed to be more excessive, that is, the product of extra-favoring of present preferences.
In contrast, this chapter aims to provide a different view. The chapter couples weak-
ness of will with impulsivity – a proclivity that has little to do with time preferences
(see DeYoung 2010). As defined here, impulsivity arises from whatever the reason that
seduces the agent to deviate from the optimal decision. Some of these reasons can be
whimsical or erratic, which are ignored here since they cannot be analyzed systematically.
Other reasons, the focus here, can be grounded systematically on beliefs on the riskiness
of choice, where such beliefs are biased beliefs. As defined here, the term ‘biased beliefs’
denotes suboptimal beliefs where the agent misrepresents to the self.
So, if we ignore the importance of erratic or whimsical causes, we can identify weak-
ness of will with biased beliefs. Such identification affords a broad platform to analyze
diverse phenomena such as malaise, favoritism, pornography-imaging, and so on.
The proposed coupling of weakness of will with biased beliefs has a more important
payoff. It sheds light on biased beliefs in the other direction, towards what is called
here ‘obsessive-compulsive behavior’ or, in short, ‘compulsivity.’ Compulsivity differs
from its pathological excess, known as ‘obsessive-compulsive disorder,’ as explained
below. Examples of compulsivity includes over-saving, over-checking locked door, over-
checking turned off stoves, over-washing the hands, and so on. Compulsivity amounts
to excessive caution, where the person is over-afraid of falling into weakness of will.
Parallel to how impulsivity arises from weakness of will, compulsivity stems from
what can be coined as ‘stiffness of will’.1 While stiffness of will involves anxiety-ridden
safety procedures and security-enhancement actions, weakness of will involves slipshod
492
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Weakness of will and stiffness of will 493
procedures and actions, such as under-saving, under-washing of hands, under-checking

stoves and doors, and so on.
Despite the difference in behavior, impulsivity and compulsivity are analytically alike.
Weakness of will (impulsivity) entails recklessness based, at a deeper level, on higher-
than-optimal prior beliefs about success in the face of risk. In contrast, stiffness of will
(compulsivity) entails excessive precautionary actions based, at a deeper level, on lower-
than-optimal prior beliefs about success in the face of risk. So, the difference between
weakness of will and stiffness of will is about the direction of the biased belief – whether
it is towards pessimism or optimism.
Aside from the two promised payoffs, how could economists, accustomed for so long to
commencing analysis of weakness of will with biased preferences, change their ways and
commence analysis instead with biased beliefs? The next section facilitates such a transi-
tion on the basis of three claims:
1. Shirking has little to do with principal–agent conflict – and, at a deeper level, it has
more to do with intra-individual conflict.
2. Intra-individual conflict, in turn, has little to do with present-biased preferences –
and, at a deeper level, it has more to do with impulsive–calm conflict – where the
impulsive (over-confident) self operates according to a higher probability of success
than the probability used by the calm (impartial) self.
3. Impulsive–calm conflict, in turn, has little to do with bio-psychological givens – and,
at a deeper level, it has more to do with endogenous formation of beliefs as heuris-
tics. While people, in general, adopt heuristics as a result of bounded rationality, the
heuristics are usually smart in the sense of being the best or the optimal. However, in
some situations, the heuristics may become non-smart, stray away from the optimal
heuristics. These situations can be categorized into two kinds. There is the situation
when the heuristics stray away in the direction of over-confidence, giving rise to
impulsivity (weakness of will). There is the situation when the heuristics stray away
in the direction of under-confidence, giving rise to compulsivity (stiffness of will).
We need to be clear about the terms of ‘bounded rationality’ and ‘smart decision-
making’. This chapter uses the terms interchangeably. Herbert Simon (1957) coined
the term ‘bounded rationality’ and Gerd Gigerenzer (2000; see Gigerenzer and Selten,
2001) developed it further. The term, as used by Simon and Gigerenzer, differs from the
neoclassical sense. This chapter follows the neoclassical sense, as opposed to Simon and
Gigerenzer’s sense, of the term ‘bounded rationality’ and, correspondingly, the term
‘smart decision-making’.
Simon and Gigerenzer’s notion of bounded rationality is unrelated to rationality in the
neoclassical sense of responding to changing incentives (Khalil 2011b). For Simon and
Gigerenzer, people do not respond to incentives not because of some critical threshold
that some actions need as proposed by the neoclassical sense. For them, bounded ration-
ality is about the priority of habits and routines, which is unrelated to any neoclassical
account of critical threshold. Simon and Gigerenzer take habits and routines as the
entry-point of any explanation of behavior. For them, humans are, by default, attached
to the status quo as long as the habits and routines are functional. Humans do not have
a concept of what is optimal because, to start with, the optimum cannot be theoretically

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defined. Humans rather accept the status quo because it is the nature of how humans, and
all living organisms, conduct their behavior. Such organisms accept the status quo, and
whatever routines and habit they entail, as long as the status quo ‘satisfices’ a minimum
level of needs. Humans start to question the habits and routines, and reject the status quo,
when the routines and habits become dysfunctional, that is, fail to satisfice the minimum
level of needs. For Simon and Gigerenzer, humans are smart decision-makers (that is,
boundedly rational) in the sense of adopting routines and heuristics that are functional in
the habituation sense, not in the optimal sense.
This chapter, to the contrary, uses the term ‘smart decision-making’ and ‘bounded
rationality’ in the neoclassical sense. According to the neoclassical sense, people adopt
habits, heuristics, and beliefs as generalizations. Such generalizations are needed since
people do not have the time or the resources to undertake deep and scientific assessment
of every risk or opportunity that they encounter. It is always true that generalizations are
costly when they turn out to be wrong. But they are optimal, in the neoclassical sense,
when the cost exceeds the benefit when they succeed. When a generalization succeeds,
the person, in effect, avoids the enormous cost of coming up with a more accurate belief.
So, a belief is smart as long as its expected benefit exceeds its expected cost. Given such
neoclassical-based boundedly rational or smart belief, the rational agent would resist
updating the belief with each minor change of incentives. The agent may uphold a belief,
contrary to incentive or factual evidence, because the incentive or evidence can be the
product of noise or temporary, and it would be more efficient to stay the course with the
habitual belief. But if the change of incentives is no longer minor, or the factual evidence is
no longer the outcome of noise, the person would change the habit or the routinized belief.
Put differently, the rational agent upholds a belief within reason, where such reason is
defined by the expected costs and benefits of changing one’s belief. Otherwise, if the agent
updates a belief with every mistake arising from minor change of incentives or facts, it
would be a ‘perfectly Bayesian belief’, a belief that is updated constantly. However, the
perfectly Bayesian belief would not be a smart (optimal) belief. The rational agent would
rather avoid constant updating, and hence incur the cost of some mistakes, because con-
stant updating would involve even greater cost than the incurred cost of mistakes.
Given such neoclassical understanding of smart decision-making, it is now possible
to define over-confidence and under-confidence. They are dispositions that give rise to
non-smart beliefs, that is, to beliefs that the person should not adopt. However, people
do adopt them and, consequently, succumb to weakness of will (in the case of over-
confidence) or succumb to stiffness of will (in the case of under-confidence).
The following section reviews the literature. Then the chapter analyzes how shirking,
the canonical case, is better understood as weakness of will, rather than via the principal-
agent framework. This is possible once weakness of will is modeled via biased beliefs,
that is, the outcome of impulsive–calm conflict. It also shows the condition of how such
conflict can take the opposite route, a compulsive–calm conflict that originates stiffness
of will. The chapter proceeds to show how slackness (malaise), favoritism, the spoiling of
children, and pornography-imaging are, similar to shirking, instances of impulsive–calm
conflict. In each case, the chapter identifies the opposite case, the compulsive–calm con-
flict that occasions stiffness of will.
So, the task here is the exposition of the isomorphic structure that underpin diverse
phenomena of weakness of will and stiffness of will. Given the task, this chapter differs

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broadly from papers in the economics literature. This chapter, unlike such literature, does
not aim to expose the necessary conditions under which shirking as opposed to coopera-
tion takes place. The task is rather conceptual, namely, to expose the common structure
of weakness of will or stiffness of will that underpin varied and seemingly unrelated
phenomena.
2 THE CORE ARGUMENT
The proposed confidence-biased belief approach can be summed up in three propositions:
Proposition 1: Shirking as weakness of will It is usually supposed by the principal-agent

framework that agents shirk in order to maximize benefit at the expense of the principal.
This chapter argues the contrary: the conflict is an intra-individual conflict rather than a
principal-agent conflict – even in the case of shirking.
Proposition 2: Weakness of will as over-confidence It is usually supposed by the standard

present-biased preferences framework that weakness of will is the outcome of quasi-
hyperbolic discounting. This chapter proposes an alternative framework: the issue is an
intra-individual conflict not in the sense of present-biased preferences – but rather in
the sense of confidence-biased beliefs – specifically in the direction of optimism, that is,
over-confidence. The confidence-biased beliefs can take an opposite direction, namely,
the formation of under-confidence beliefs that underpin compulsivity (stiffness of will).
Such compulsivity is behind obsessions and excessive care – the apparent opposite of
slackening, under-saving and other instances of weakness of will. Either over- or under-
confident beliefs trump the beliefs of impartial (calm) self. The impartial self is ‘calm’
in the sense that the self updates its beliefs – namely, the probability of success in risky
behavior – in a Bayesian fashion, which is neither the case with the impulsive self nor with
the compulsive self.
Proposition 3: Confidence-biased belief as sub-rational representativeness heuristic It is

commonly supposed that over-confidence (impulsivity or weakness of will) and under-
confidence (compulsivity or stiffness of will) are given traits of the bio-psychological
profile. Such explanation is unsatisfactory. Confidence-biased beliefs can arise endog-
enously: the agent experiences or selects, in a biased way, a sample of events that exag-
gerates the incidences of either success or failure in risky behavior. The sub-rational
agent (the impulsive and the compulsive) generalizes from the biased sample to form sub-
rational representativeness heuristic. While a generalization or a representative heuristic,
given bounded rationality, is normally rational (smart), it becomes sub-rational (non-
smart) when one propounds it when one should have ditched the heuristic.
The proposed analytical similarity between weakness of will (impulsivity) and stiffness
of will (compulsivity) is unexpected. As stated above, the two phenomena, as observed by
others (for example, Kalis et al. 2008, p. 410), are opposite ends of the pole: While both are
suboptimal behavior, weakness of will amounts to excessive carelessness and obsessive-
compulsive behavior amounts to excessive carefulness.

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Obsessive-compulsive behavior, as studied here, is ubiquitous, almost every human

being exhibits stiffness of will on some occasions as often as he or she exhibits weakness
of will. Many anthropologists regard a great deal of rituals linked usually to religious
practices – ranging from fasting, self-deprivation, self-mutilation, excessive hygienic
rituals – as disproportionate acts of precaution to fend against the risks of disease,
natural disasters, and famine. Such cultural rituals correspond to hard-wired psychologi-
cal mechanisms at the individual level, which they call ‘hazard-precaution systems’ (see
Dulaney and Fiske 1994; Fiske and Haslam 1997; Liénard and Boyer 2006; Boyer and
Liénard 2006). So, stiffness of will (compulsivity) should not be confused with pathologi-
cal compulsivity, what psychologists diagnose as obsessive-compulsive disorder (OCD)
or obsessive-compulsive personality disorder (OCPD).
This chapter is not about pathological compulsivity – nor about how to differentiate
OCD and OCPD (see Pinto et al. 2014). Even when mild, we can judge that obsessive-
compulsive behavior – ranging from over-washing of hands, certainty effect, to over-
avoidance of air travel – involves excessive or suboptimal actions of carefulness, that is,
responses to exaggerated perception of risks (see Davis 2008). As Anthony Pinto et al.
(2014) document, at least with respect to OCPD, people with compulsive behavior have
great capacity to delay reward, the extreme opposite of impulsive behavior (weakness
of will). They maintain that impulsivity and compulsivity are extreme ends of the same
continuum.
3 REVIEW OF LITERATURE
It is appropriate for economists, then, to advance a single model that can analyze simul-
taneously stiffness of will (compulsivity) and weakness of will (impulsivity). Economists
have so far, unfortunately, focused on weakness of will. This could be for two reasons.
First, weakness of will has, more than stiffness of will, debilitating effects on future
welfare in terms of under-saving for retirement (Laibson 1997). Second, given the entry-
point of biased preferences, which invokes the issue of time preferences, it is hard to
explain stiffness of will. It just does not seem intuitive or natural to suppose that people
have a biased preference towards future consumption when they have been teaching about
discounted future revenues. So, as expected, the literature has ignored stiffness of will –
and does not provide a single theory that links it to weakness of will.
The focus on preferences has led researchers to pursue a misleading path of questions:
why do agents have present-biased preferences? This led them to distinguish between
two supposedly different kinds of utility: the reasonable or optimal preferences and the
myopic or suboptimal preferences. The proposition that we have two kinds of utility has
taken different forms. At the hand of psychologists such as Daniel Kahneman et al. (1997;
Kahneman, 1994), it took the form of distinguishing between putatively ‘experienced
utility’, which captures hedonic sensation of consumption, and ‘decision utility’, which
captures anxiety and anticipation prior to consumption as well as rejoice and regret after
consumption. So, while experienced utility captures the myopic or suboptimal prefer-
ences, decision utility approximates the reasonable or optimal preferences.
Such a dualism is not a necessary conclusion for every advocate of the biased-preferences
approach. For instance, George Ainslie (2012), who subscribes to the biased-preferences

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approach, does not support the dualism conclusion. However, the dualism conclusion is
gaining ground. For instance, George Loewenstein (1996) attributes experienced utility
to visceral factors that enslave the present self and make it deviate from what is rational
(see also Bernheim and Rangel 2004; McClure et al. 2004; Ditto et al. 2006). In particu-
lar, Loewenstein and O’Donoghue (2004) suppose a disjunction between two different
systems in the brain, where the ‘affective system’ is triggered by hedonic sensations while
the ‘deliberative system’ takes into consideration future interest. Colin Camerer (2006),
and before him Berridge (2003), argues that there are two kinds of utility, which he calls
‘wanting’ and ‘liking’, respectively. He traces them back to two separate neural systems.
However, neuroscientists (for example, Kable and Glimcher 2007) find that the known
reward valuation centers (ventral striatum, medial prefrontal cortex, and posterior cingu-
late) all respond in tandem at the point of consumption. That is, there is no conflict of
two separate systems of utility. Of more importance, the appeal to two systems actually
begs more questions than it solves. For instance, how does one system of utility relate to
the other? This question raises the old ‘body–mind’ problem that has risen in light of the
Cartesian dichotomy between the emotions and reason. New discoveries in neuroscience
dispute the Cartesian dichotomy and, hence, avoid the problematic issue of how to relate
one system of utility to the other (for example, Damasio 1994). Long ago, Adam Smith
(1759 [1976]) argued that rational decision is nothing other than confronting one senti-
ment, which arises from the myopic heat of the moment, with a calm sentiment that takes
into consideration the emotion or interest of the future self (see Khalil 2010, 2015a).
Smith’s view, adopted here, portrays the individual as involved in an internal dialogue.
The dialogue is between a calm or rational self, what Smith called the ‘impartial spectator’
that resides within the breast, and the partial or sub-rational self. The sub-rational self
can be impulsive, which gives rise to weakness of will, or compulsive, which gives rise to
stiffness of will. The dialogue between the two selves concerns the probability of succeed-
ing in the face of risk.
George Ainslie (2001, 2012), with little reference to Smith, marches along with Smith’s
approach, namely, the self must be seen as unified, in his analysis of weakness of will.
Ainslie is a psychologist whose early work (Ainslie 1975) alerted economists about hyper-
bolic discounting (see also Ainslie 1992). For Ainslie, the person can be aware of how the
impulsive self can be over-confident, which prompts the calm or rational self to set up
internal rules, what Smith called ‘self-command’, about behavior.
The proposed confidence-biased preferences open up a new vista that supersedes the
well-entrenched divide between positive and normative theories of rationality. For posi-
tive theory, as expressed in present-biased preferences view, what matters is the descrip-
tion of behavior. Such methodological agenda neglects the fact that what is hidden is
that behavior is the outcome of an inner dialogue, or conflict, and hence misses what lies
deeply below apparent phenomena. For normative theory, as in recent developments of
decision theory (Gul and Pesendorfer 2001, 2004a, 2004b), the deviations from rationality
are not deviations if we construct new axioms.
This chapter proposes an alternative framework, which can simultaneously explain
diverse instances of weakness of will as well as account for its antithesis, stiffness of
will. As such, this chapter does not offer a mathematical model – nor an axiomatic one.
It focuses instead on outlining the alternative that relies on confidence-biased beliefs,
instead of present-biased preferences. The payoff of the proposed framework consists of

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shedding light on the unifying structure underpinning diverse phenomena ranging from
shirking and slackness to pornography-imaging. As important, the proposed framework
shows the analytical similarity, despite being opposite ends of the pole, between weakness
of will (impulsive behavior), at one extreme, and obsessions and excessive care (compul-
sive behavior), at the other.
4 TO SHIRK OR TO COOPERATE?
It is shown here that shirking beyond an optimal level would amount to an example of
succumbing to weakness of will. Let us suppose a partnership made up of two individuals.
For instance, two roommates agree on how to divide the tasks of cleaning their shared
apartment, where one cleans the kitchen while the other cleans the shower room.
4.1 Assumptions
Let us assume the following, which should apply to all cases of weakness of will:
1.Each actor sacrifices the same amount of leisure, which they value equally, in per-
forming the task.
2. Each actor values his or her own leisure more than a half-cleaned apartment, but
less than a fully cleaned apartment.
3. This is an indefinitely repeated game, where both have the incentive to cooperate.
4. At each round of the game, though, only the partner under focus has a sub-rational
(or irrational) impulse to shirk, while the partner is free of such impulse – that is, the
partner acts as the ‘principal’ who can only cooperate, that is, the partner can never
shirk.
5. The partner (principal) decides to monitor the actor under focus (agent), but such
monitoring cannot be complete since it is costly – but not too costly to the point that
partnership is made impossible. Such cost is common knowledge to both players.
6. At the start of each round of the game, prior to actor’s expenditure of the effort, a
shock strikes, which is binary and can only be totally obstructive or totally benign
in reference to output. For example, if obstructive, such as bad weather or sickness,
the shock totally nullifies the fruit of the actor’s effort.
7. Both the actor and the partner do not know the frequency of the shock. Both cannot
learn the frequency because of ‘irresolvable ignorance’, that is, the shock is pulled
from an unknown distribution that is a part of a set of infinite kinds of distributions.
But say that q denotes the unknown frequency of benign shocks, that is, (1 – q) the
frequency of the unknown obstructive shocks.
8. If otherwise, that is, the two players commonly know the frequency, there would be
no need for monitoring because, in an indefinitely repeated game, it would not be
possible for the actor to shirk. On average the actor would have to claim obstructive
shocks as many as allowed by the known frequency.
9. While the actor under focus knows whether the shock is benign or obstructive, the
partner does not know.
10. At the start of the stage, the shock occurs. If obstructive, the actor would not

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Timeline of actor under focus:

T0 T1
Shock Actor: produce/shirk
Timeline of partner:
T1 T2 T3
Partner: monitor/not monitor Output revealed to monitor Partner: cooperate/retaliate
Figure 28.1 Asymmetric timelines of choices
produce – which would not be shirking. If benign, the actor decides whether to
produce or shirk. The partner decides, without being cognizant yet of the product,
to monitor in the sense of checking out the nature of the shock. After the partner
sends the monitor to check the shock, the partner becomes cognizant of the product.
That is the monitoring decision is prior to the revelation of the product.
Given the last assumption, Figure 28.1 provides a sketch of the timeline of the actor
under focus as well as the timeline of the partner. The discrete time (T) proceeds sequen-
tially in each round from T0 to T3.
The player is only aware of his or her own timeline. At T1, both the actor and partner
take simultaneous decisions. That is, when the actor decides at T1 whether to produce or
shirk, he or she is unaware of the monitoring decision of the partner. Likewise, the partner
at T1 is unaware of the actor’s decision – and also unaware of the nature of the shock that
is only revealed in the actor’s timeline.
The mere fact that output of the actor at T2 (O2) is zero, that is, half of the apartment
that falls under the responsibility of the actor is unclean, does not necessarily indicate to
the partner that the actor had shirked,
O2 5 f(D1, s0)
where D 5 {0,1}
and where s 5 {0,1}
where D is binary action of either work (D 5 1) or abstain (D 5 0), and s is binary shock
of either obstruction (s 5 0) or benign (s 5 1) with, respectively, the unknown frequency
of (1 − q) and q. The unclean half can be the outcome of an obstructive shock (s 5 0),
irrespective of whether D 5 1 or D 5 0. In this case, there could not have been shirking.
If for some reason the partner decides not to monitor, and then finds a half-unclean
apartment, the partner could not rescind the decision and decide to monitor. The partner
can only, given the strong assumption that the partner does not shirk even without moni-
toring or punishment, fulfill his or her commitment and clean the other half. The partner
would retaliate only under three conditions: (1) if there was monitoring; (2) if the product
turns out half unclean apartment; and (3) monitoring reveals that the shock is benign. It
is only then possible for the partner to conclude that the actor has shirked.
In this model, the actor can get away with shirking on some occasions because, first,
the asymmetry of information about the shock and, second, the partner’s monitoring is
costly. The cost entails that the partner, acting rationally, cannot monitor every instance

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– that is, monitoring is incomplete. So, shirking is possible – and this should accomplish
the task. The task, again, is not to define the conditions under which shirking is necessary.
The task is, rather, to lay out the common structure that underpins diverse and apparently
unrelated phenomena of weakness of will.
4.2 The Model
In equilibrium, given the cost of monitoring and expected benefit, the partner decides on
the frequency of monitoring. The actor under focus, knowing the same information about
cost and benefit of monitoring, decides on the optimum amount of shirking.
Such shirking, at a deeper level, is not a conflict between two persons, an agent (actor)
and a principal (partner). It is, rather, an intra-individual conflict if we view the actor
as the myopic self or agent who is sub-rational, while the partner as the calm self or
principal who is rational. Such a principal–agent framework departs from the standard
principal–agent approach (Schelling 1960; Thaler and Shefrin 1981; Fudenberg and
Levine 2006). The standard approach consists basically of dual-self theories: the conflict
is between the actual present self and the actual future self – where both stand symmetri-
cal to each other. In contrast, the proposed approach presents the conflict as between
the myopic self and the calm self. Both are constructs of the present moment. While
the calm self is rational, and can be obligated and committed to a course of action, the
myopic self tries to direct an action contrary to the command of the rational self. The
calm self, again, is not the future self. It, rather, expresses the optimal decision taken
at present. The calm self is rational insofar as it presents an optimal plan in light of ex
ante decisions.
Further, the proposed approach of intra-individual conflict is the result of asymmetry
of information concerning beliefs – as well as the opportunity for shirking afforded by
a reasonable cost of monitoring. The intra-individual conflict has nothing to do with
preferences.
In any case, let us denote (1 − p) probability as the likelihood of the partner, under
the above three conditions, to catch the actor under focus shirking. That is, the actor
under focus can get away with lying or shirking with p probability. If the actor abides by
such probability, the shirking frequency would be optimal: shirking would be limited to
a certain number of occasions such that the expected utility from leisure equals at the
margin the expected loss of unclean apartment in the case of getting caught.
So, shirking is rational as long as it maximizes utility – that is, shirking is not necessar-
ily indicative of succumbing to weakness of will. For the shirking to become weakness of
will, the frequency of shirking must exceed the optimal level. In this case, we must suppose
that the actor under focus (present self) is impulsive – and impulsive in the direction of
over-estimating the probability of getting away with shirking as opposed to the direction
of under-estimating such a probability.
While the calm self (partner) is always impartial, the myopic self (actor), insofar as
it succumbs to weakness of will, must be partial in the direction of shirking above the
optimum. This can also be characterized as acting according to optimistic beliefs of
getting away with cheating, which would be contrary to the beliefs held by the impartial
calm self (partner). The beliefs of the impartial calm self, even when the impartial calm self
faces an accidental series of successes, are not swayed or prejudiced by the small sample

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of successes. The impartial self rather forms a probability (pp) of successes that is based
on a large sample and, hence, rational. This does not mean pp 5 p., that is, the impartial
self may not recommend a frequency of shirking according to the objective probability
of success of shirking (p). But, as a result of Bayesian updating, pp must be optimal given
the information and, with greater information, must approach p.
In contrast, the assessment of the probability of success of the impulsive agent (pa) is
based on a biased, small sample. While the sample is not necessarily in the direction of
optimism (belief in the success of shirking), it must be in such a direction in the case that
the consequent behavior involves weakness of will. Thus, the case of weakness of will
dictates the following condition: pa > pp, where the (pa − pp) gap can be called the ‘degree
of over-confidence’ or ‘degree of optimism,’ which is defined here as sub-rational.
4.3 Sub-rational Representativeness Heuristic
To recap, the first claim stated at the outset, namely, shirking is intra-individual conflict,
is shown. The second claim, namely, intra-individual conflict concerns a conflict of beliefs
between partial and impartial selves concerning the probability of success, is also shown.
The third claim, namely, the over-confidence belief of the present self (pa) is endogenous,
cannot be fully discussed here (see Khalil 2015b, 2017). To state it briefly, though, the
belief of the impulsive self, which can be over- or under-confidence, need not be ingrained,
that is, given by immovable biological or psychological factors. It rather arises from a small
sample that is non-representative – which, in addition, is non-representative in a biased
or selected manner in a particular direction. If the bias of the non-representative sample
is in the direction of including exaggerated instances of successes, the partial present
self that selects the sample wants to be over-confident or optimistic. If the bias is in the
direction of including mostly instances of failures, the partial present self wants to be
under-confident or pessimistic.
In the case of optimism, the actor’s belief over-estimates the probability of success.
In the case of pessimism, the actor’s belief under-estimates the probability of success of
getting away with cheating. Either case is the outcome of how people generalize. However,
we have to be careful and distinguish between two types of generalization. The first, which
cannot give rise to weakness of will, can be a rational generalization, sometimes called
in the literature ‘representativeness heuristic’ (Tversky and Kahneman 1973, 1974; Plous,
1993). The second, which gives rise to weakness of will, is a sub-rational generalization,
where the representativeness heuristic is selective or biased in the direction of optimism.
To elaborate on the first type of generalization, the rational agent finds it useful to
form smart (rational) heuristics as a result of bounded rationality. As explained previ-
ously, smart heuristics differ from how Simon (1957) and others conceive heuristics (for
example, Gigerenzer 2000; Gigerenzer and Selten 2001). As conceived here, the heuris-
tics are smart in the neoclassical sense: They arise in order to economize on the costly
(bounded) operations of cognitive process. The rational agent should economize on exam-
ining all the population of experiences and deliberate frugally. That is, the rational agent
should avoid examining a representative and large sample when the expected benefit from
such examination is lower, at the margin, than the expected cost. In this case, the agent is
justified in forming smart beliefs on the basis of a non-representative sample. That is, the
agent, to optimize benefits, should be ready to generalize from a biased number of cases.

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This inevitably leads to making mistakes on some occasions, but the cost of such mistakes
is less than the benefit derived from using rough and smart generalizations.
Some of these mistakes include mis-steps in logical deduction. As discussed above with
regard to bounded rationality, the actor would find it inefficient to employ a certain cog-
nitive capacity to undertake flawless logical deduction or to examine non-biased samples
if not justified by the expected benefit. So, the agent may rationally ignore a series of a
small number of successes as indicative of a higher probability of success than is the case,
or ignore a series of a small number of failures as indicative of a lower probability of
success than is the case.
If the agent is rational, we face an anomaly: given that the representative heuristic is
rational (smart), any deviation of the heuristic from smartness should be an aberration
that can go in either direction with equal probability. That is, the frequency of over-
confidence should equal the frequency of under-confidence for the same actor. So, on
average, the two kinds of erroneous generalizations should offset each other. Therefore,
on average, the actor need not suffer from a chronic case of weakness of will or a chronic
case of stiffness of will.
However, empirically, the frequency of over-confidence (optimism) is greater than
the frequency of under-confidence (pessimism) (see Baron 2008, ch. 6). That is, human
actions tend to exhibit sub-rational behavior in the direction of weakness of will because
of imbalance: there is a deficiency of under-confidence that may rectify our behavior.
The preponderance of weakness of will stems from a biased or selective representative-
ness heuristic in the direction of over-confidence, that is, where optimistic beliefs domi-
nate pessimistic beliefs. Such biased direction in favor of optimism cannot be merely the
product of bounded rationality, the simple formation of generalizations. The dominance
of over-confidence might be related to ambition, that is, the innate desire to succeed.
The analysis of ambition or the desire to succeed falls outside the scope of this chapter.
Stated briefly, though, the desire to succeed is probably the main motive of entrepreneur-
ship, as analyzed by William Baumol (2010). However, we need to distinguish the desire
to succeed from ‘wishful thinking’ in the sense of over-confidence. While wishful thinking
might be the product of the desire to succeed, they are different. The desire to succeed can
be seen as a preference or a taste and, hence, cannot be judged whether it is rational or sub-
rational. The desire to succeed would be judged as rational only if it operates within rea-
sonable cognition of one’s ability. The desire would become irrational if the desire starts
to manipulate one’s assessment of ability. This usually involves hubris and self-delusions.
It is important to avoid the conflation of hubris or delusion, on the one hand, with
wishful thinking (over-confidence), on the other. While hubris and over-confidence are
suboptimal and could be traced to the desire to succeed, they differ with regard to the
object of the manipulated or sub-optimal belief. Hubris or delusion involve beliefs con-
cerning self-ability, while over-confidence involves beliefs concerning one’s environment,
that is, the chances of certain environmental shocks.
To say that over-confidence arises from wishful thinking would amount to tautology
because both involve the manipulation of belief concerning our environment. To say that
wishful thinking (over-confidence) arises from the desire to succeed is insufficient. The
desire, in itself, cannot fully explain wishful thinking.
One possible way to explain wishful thinking (over-confidence) is evolutionary. Natural
selection may favor organisms with a trait of strong wishful thinking more than with a

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trait that favors caution. However, for the wishful thinking trait (impulsivity) to survive,
we must presume that natural selection is not operating efficiently. In an efficient envi-
ronment, impulsivity is destructive on average. So, for carriers of such a trait to survive
and reproduce successfully, the natural environment, which is undertaking the editing
and selection, must have crevices and niches that protect the organisms from elimination.
This evolutionary reasoning need not concern us here. It is sufficient to add, though,
the same evolutionary reasoning a priori can explain compulsivity, that is, the evolution
of traits that nurture pessimistic, sub-rational beliefs. If the environment is efficient,
optimistic beliefs should not survive because they are, on average, destructive. So, the
environment must not be inefficient to allow for such a trait to survive.
However, to examine simultaneously the frequency of both traits in a population, an
efficient environment allows for the rise of both pessimism and optimism as long as they
balance each other. Such balancing may also explain extreme cases on both ends: where
excessively impulsive people are equal in number to excessively compulsive people.
As for the case of compulsivity, we may hypothesize that OCD is merely a pathological
or an exaggerated form of stiffness of will – where OCD arises when under-confident, pes-
simistic beliefs go awry into anxiety, fear, and worries about safety and health. This is not
the place to discuss theories of OCD, why some people suffer from it or how widespread it
is (see Schwartz and Beyette 1997; Emily 1998; Osborn 1999; Baer 2002; Veale and Wilson
2005; Davis 2008). This is also not the place to explain how daily, non-pathological stiff-
ness of will may or may not evolve into OCD.
It is sufficient to note that the analytical structure of the impulsive self, which is behind
weakness of will, can shed light in understanding the compulsive self, which is behind
non-pathological obsessions. The only difference is the direction of the biasness of
sub-rational representative heuristics – whether it is towards impulsive over-confidence
(optimism) or compulsive under-confidence (pessimism).
4.4 Three Moments of Shirking
To recapitulate, in the first moment, shirking is rational when it is recommended by mar-

ginal calculation in light of (1) asymmetric information about whether the shock is benign
or obstructive; (2) costly monitoring.
In the second moment, shirking is rational as a result of bounded rationality that occa-
sions rational representative heuristics, that is, when deliberation over a representative
sample is cognitively costly.
In the third moment, shirking is sub-rational – and sub-rational in the direction of opti-
mism that encourages us to succumb to weakness of will – when the actor becomes impul-
sive. Such sub-rational behavior must be, for weakness of will to arise, impulsive, that is, in
the direction of over-confidence rather than in the direction of under-confidence.
To provide a precise definition of shirking at the third moment, let us define first shirk-
ing at the first moment. Let us specify a critical threshold where the expected net benefit
(ENB) of shirking, or any kind of cheating, equals zero. At such a threshold, the indi-
vidual finds the expected benefit (EB) from cooperation to equal the EB from shirking,
that is, ENB 5 0. Let us take shirking as the default option. If an individual, acting as the
calm principal, finds the ENB from shirking to be positive, ENBp ≥ 0, it would be optimal
for the individual to shirk. Otherwise, it would be suboptimal to shirk. If it is suboptimal

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to shirk for the principal, that is, ENBp < 0, but it is optimal for the impulsive agent, that
is, ENBa ≥ 0, the opportunity for weakness of will (suboptimal shirking) arises.
We can presume that the discount rate of future utility is unitary. However, even if it is
less than one, it would have a nil effect on the analysis.
The impulsive agent would not shirk if ENBa < 0, that is, even fools are not absolutely
foolish. So, the necessary condition for shirking as sub-rational weakness of will is ENBa
> 0 > ENBp. Summed up, weakness of will entails that (1) the impulsive self (agent)
finds additional leisure optimal; and (2) the calm self (principal) finds the same choice
suboptimal.
On the other hand, in the case of stiffness of will, the opposite of shirking is over-work-
ing to the point of allowing oneself to be exploited, which includes self-exploitation. The
necessary condition for the antithesis of shirking, such as over-working, as sub-rational
stiffness of will is ENBa < 0 < ENBp. Stated tersely, obsessive behavior entails that (1) the
compulsive present self (agent) finds additional leisure suboptimal; and (2) the calm self
(principal) finds the same choice optimal. That is, the compulsive agent would continue
to be compelled to work harder or be excessively diligent.
However, the above set of inequalities should not mean that the individual would
definitely succumb to the suboptimal choice – whether weakness of will or obsession.
The inequality that recommends weakness of will, whose extent is a function of the
over-confidence gap (pa − pp), rather defines the range through which the succumbing
to weakness of will is possible. Symmetrically, the inequality that recommends obsessive
behavior, whose extent is a function of what can be called the ‘under-confidence gap’ (pp
− pa), rather defines the range through which the compelling act of obsession is possible.
There is the possibility that the agent, as a result of internal constraints as well as
external institutions, may not succumb to weakness of will. As a result of education
and reflection, the individual may develop internal constraints, what Adam Smith calls
‘self-command,’ to prevent the individual from undertaking reckless or weakness of will
actions (Khalil 2010). In case of the failure of self-command, the individual may adopt
external institutions or constraints, known as precommitments (Elster 2000), to deflate or
restrain beliefs that are formed out of a limited sample and, hence, misrepresent the true
Bayesian process of updating.
In summary, shirking is not, ultimately, a conflict between two separate individuals.
Insofar as the roommate or partner can punish the actor under focus, the conflict is intra-
individual. Second, while the conflict is intra-individual, it is not about present-biased
preferences. Rather, it is about two different assessments of the probability of success;
one held by the calm (impartial) self and the other held by the sub-rational (partial) self.
Third, the gap between the beliefs of the calm and impulsive selves is not the outcome of
some ingrained or biologically immovable traits. Rather, the gap is partially the outcome
of bounded rationality that give rise to representativeness heuristics – where such heuris-
tics move in a selective direction that favors optimism or over-confidence. Thus, weakness
of will is never fixed concerning some goods as opposed to others. But rather it varies
with the variation of the over-confidence gap (pa − pp), as slackening (malaise) and other
phenomena illustrate.

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5 TO SLACKEN OR TO WORK?
When we cheat, but the injured party is none other than our future self, we would be
involved in self-cheating. Self-cheating is usually called indolence, sloth, malaise, or slack-
ening. Slackening, in itself, need not be an example of succumbing to weakness of will.
Only after an optimal level does slackening become such an example.
There are many examples of slackness: over-eating, indulging, under-saving, under-
exercising, under-investing in our education, and under-diligence. In these examples, the
person takes the easy road, over-consumes leisure and food, or simply enjoys present
consumption that undermines the optimal plan of consumption.
The shirking model, useful to study inter-individual conflict, can be imported in toto
to capture the intra-individual conflict of slackening. This chapter suggests, with respect
to shirking, that the impulsive actor under focus (agent) is the present self, while the calm
partner (principal) is the future self. (This should not suggest the opposite: the present self
is necessarily impulsive and the future self is calm.) However, such importation faces two
apparent difficulties. First, in shirking, the punishment is leveled by the injured partner
(the principal) by withholding cooperation. In slackening, while the injured party is the
future self, it cannot level punishment in the same manner. At a deeper level of examina-
tion, though, the future self (principal) can retaliate by leveling penalties on the present
self in the form of psychological pain such as self-blame, stressful worries, or the feeling
of low self-esteem. The intensity of such punishment, as in the shirking model, can be
supposed to be high enough to offset the present self’s pleasure arising from slackening.
The second difficulty concerns the shocks. To be clear, the shocks, as in the shirking
model, are generated from ‘irresolvable ignorance’. Also, as in the shirking model, the
obstructive shock can be fatigue or sickness that fully negates the productive action of the
present self. Such a shock would justify if we over-eat or relax because any disciplinary
work would not benefit the individual. If the obstructive shock were hunger, if we refrain
from over-eating, we would be too distracted to produce output.
The difficulty arises because of one critical difference: in shirking, it is feasible to
suppose that the timelines of the shocks in Figure 28.1 can be asymmetric. The actor and
the partner can have different knowledge of whether the shock is benign or obstructive.
We cannot maintain such asymmetry in slackening because the future self and the present
self make up the same individual.
However, if we assume self-deception, we can overcome the second difficulty, that is,
maintain the asymmetry of information in slackening. The present self or, generally, the
myopic self can keep the future self or, generally, the calm self in the dark concerning the
nature of the shock (Khalil 2011a, 2016). The future self could not know, if it does not
initiate monitoring, whether the shock is benign or obstructive.
So, we can import in toto the asymmetric timelines of Figure 28.1, where the present or
myopic self (agent) and the future or calm self (principal) have different information about
the nature of the shock. As in shirking, if the future self chooses at the start of his or her
timeline, in the indefinitely repeated game, to withhold monitoring, it has to cooperate.
It cannot level punishment in the form of self-blame or stressful worries even when the
product is zero. The future self can retaliate, as in shirking, under three conditions: (1) the
product is zero; (2) the shock is benign; and (3) there is monitoring.
The future self may monitor the nature of the shock in many forms: meditation,

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self-reflection, and even spiritual exercises such as prayers. Such monitoring devices would
expose the misleading fibs or lies put forward by the present self. Such devices would
uncover whether the zero output is the outcome of slackening or the outcome of obstruc-
tive shocks such as sickness. However, given that such monitoring is costly, it is optimal for
the future self to conduct occasional monitoring, capturing only (1 − p) of all the cases of
self-deception. Also, it is optimal for the present self to self-cheat, such as to under-save,
to over-eat, or to under-exercise, insofar as the expected benefit from slackening exceeds,
at the margin, the expected cost if the present self gets exposed.
As in the shirking model, for slackening to be suboptimal, that is, involving weakness
of will, the present or myopic self must be sub-rational – and sub-rational in the direction
of forming impulsive beliefs amounting to over-confidence of getting away with cheating.
Here, the belief of the present or myopic self or agent (pa) is higher than the belief of the
future or calm self or principal (pp). As in the shirking model, the necessary condition for
slackening as sub-rational weakness of will is ENBa > 0 > ENBp. That is, the expected net
benefit from slackening (additional leisure) would be tempting only if it is suboptimal for
the principal (0 > ENBp), while optimal for the agent (ENBa > 0).
In the case of stiffness of will, the opposite of slackening is over-working, over-
diligence, and over-alertness. The necessary condition for the antithesis of slackening,
such as miser-like saving, to be an example of sub-rational obsessive-compulsive behavior
is ENBa < 0 < ENBp. That is, the expected net benefit from additional leisure or relaxation
would be compelling only if ENB is optimal for the principal (0 < ENBp), while subop-
timal for the compulsive agent (ENBa < 0). That is, the compulsive agent would continue
to be compelled to be ever careful and over-save as a miser.
Under the above range of inequality behind slackness, the impulsive agent would take
reckless risks, under-saves, under-invests, over-sleeps, and so on, relying on the over-
confident belief of success, that is, getting away with self-cheating. Also, under the above
range of inequality behind over-working, the compulsive agent would check a protective
measure many times, forgo relaxation and vacations, and under-sleeps, and so on, relying
on the under-confident belief of success, that is, getting away with self-cheating. Again,
individuals usually resort to internal and, if need be, external constraints to re-align the
over- or under-confident belief with the impartial belief.
6 TO PLAY FAVORITES OR TO ACT FAIR?
If favoritism exceeds an optimal level, it becomes an instance of weakness of will. In

a team that consists of a director and subordinates, the director may desire to shower
favors on a particular subordinate, and no other. Such favoritism would be definitely
unfair only if we assume that property rights are well established and, hence, fairness is
clearly defined. Under such an assumption, the director’s unfair action could potentially
draw retaliation from the rest of the subordinates, that is, who did not receive the same
treatment.
The director here would be an agent who has duties towards the principal, that is, the
rest of the subordinates. As in the shirking case, if the principal (that is, the rest of the
subordinates) finds out, via monitoring, that the director has favored a subordinate,
the principal would suffer from withheld cooperation.

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We can import the assumptions of the shirking model in toto to explain favoritism. Let
us assume that the director gains ‘altruistic utility’ upon knowing that the favored subor-
dinate is enjoying a day off, a perk, or an unmerited promotion. The director’s altruistic
utility would be similar to the actor’s leisure utility gained from shirking. For cooperation
to continue in an indefinitely repeated game, the director’s altruistic utility must exceed the
director’s loss as a result of the subordinate’s forgone productivity. However, the retalia-
tion by the rest of the subordinates must be painful enough to more than offset the gained
altruistic utility from favoritism.
As in the shirking model, we have shocks that inflict the favored subordinate. They can
be of two kinds: benign and obstructive. The benign shock means a fake sickness or a fake
fatigue is claimed to have inflicted the favored subordinate. The obstructive shock can be
true sickness/fatigue that fully negates the favored subordinate’s productive action. With
obstructive shock, the director would be justified to shower leisure or another favor on
the favored subordinate.
Following the asymmetric timelines of Figure 28.1, the favored subordinate and the
director know the nature of the shock. It is useful to think of both as a single ‘agent’ –
who can potentially be sub-rational. On the other hand, the principal (that is, the rest of
the team), who is rational according to the shirking model, can only become aware of
the nature of the shock if the principal had chosen already to monitor the shock in that
round. If the principal, at the start of his or her timeline, chose to withhold monitoring, he
has to cooperate. That is, he cannot level punishment even when the product is zero. The
principal, to specify again, can retaliate under three conditions: (1) the product is zero; (2)
the shock is benign; and (3) there is monitoring.
As in shirking, monitoring is costly. So, it is optimal for the principal to conduct occa-
sional monitoring, capturing only (1 − p) of all the cases of deception. Also, it is optimal
for the actor (the favored subordinate and director) to cheat, that is, to claim that the
shock is obstructive when it is not, insofar as the expected benefit from cheating exceeds,
at the margin, the expected cost if the actor gets exposed.
As in the above models, for the cheating to be suboptimal, that is, involves weakness of
will, the actor must be sub-rational – and sub-rational in the direction of forming impul-
sive, over-confident beliefs. Here, the belief of the actor or agent (pa) is higher than the
belief of the principal (pp). Again, the same necessary condition holds for favoritism as
sub-rational weakness of will is ENBa > 0 > ENBp. That is, the expected net benefit from
deception would be tempting only if it is suboptimal for the principal (0 > ENBp), while
optimal for the agent (ENBa > 0).
In the case of stiffness of will, the opposite of favoritism is excessive harshness towards
relatives, acquaintances, and other ones that provide altruistic utility to the director.
The necessary condition for the antithesis of favoritism, such as excessive harshness, as
sub-rational obsessive-compulsive behavior is ENBa < 0 < ENBp. That is, the expected
net benefit from additional leniency towards relatives or favored subordinates would be
compelling only if it is optimal for the principal (0 < ENBp), while suboptimal for the com-
pulsive agent (ENBa < 0). That is, the compulsive agent would continue to be compelled
to treat favored subordinates with excessive harshness.
Under the above range of inequality behind favoritism, the impulsive director would
take reckless risks and shower undeserved favors to ones from whom the director can
derive altruistic utility. The director would be relying on the sub-rational, over-confident

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belief of getting away with cheating. Under the above range of inequality behind exces-
sive harshness, the compulsive director would level additional deprivations and punish-
ment on the favored subordinates. The director would be relying on the sub-rational,
under-confident belief of getting away with deception. Also, individuals usually resort
to internal and, if need be, external constraints to re-align the over- or under-confident
belief with the impartial belief.
7 TO SPOIL OR TO DISCIPLINE CHILDREN?
The spoiling of children, if it goes beyond an optimal level, would be another instance of
succumbing to weakness of will. The parent or caretaker would be involved in spoiling
– which is not necessarily sub-rational – when the parent or caretaker decides to shower
unmerited benefits – in the sense of excessive attention – on the child when the situation
actually calls for disciplinarian ‘tough love’. If the adult showers the child with undeserved
attention, it could undermine the productive human capital of the child, which would hurt
the future income of the child.
In this case, the caretaker and the child are better considered as a single actor, the
sub-rational agent. The future child, that is, the future grown-up, is the future or calm
principal. So, the favoritism case resembles the slackening model because the present
child and the caretaker would enjoy spoiling the child. However, excessive, sub-rational
spoiling would increase the chance of lowering the future income or health of the future
grown-up.
The spoiling case presented here differs from Gary Becker’s (1976) model of the ‘rotten
kid’. Becker argues that it is in the self-interest of the rotten kid, insofar the kid is rational,
not to extract excessive benefits from the parent. Such extraction would rob the parent
of the ability to produce more goods and, hence, undermine the future income of the
rotten kid. The difference lies with the question of who suffers from the spoiling of the
rotten kid. In Becker’s model, the future grown-up suffers, but only because the spoiling
undermines the production ability of the parent. In the following analysis, the future
grown-up suffers directly, that is, because the spoiling undermines the production ability
of the future child.
We can import the assumptions of the slackening model in toto to explain spoiling as
weakness of will. The caretaker must derive some utility, altruistic or otherwise, from
spoiling the child. However, given that such spoiling cannot be in the optimal interest of
the child, it is difficult to suppose that altruistic utility is the motive of the caretaker. More
likely, the caretaker derives ‘reflexive utility’ upon knowing that the child is enjoying the
attention. Reflexive utility amounts to vicarious utility, that is, we enjoy the enjoyment
of the other by assuming that such enjoyment is happening to ourselves (see Khalil 2004,
2005). In this case, the caretaker would be using the child as a medium to actually spoil our
own self. This hypothesis is plausible because, from rational calculation, the caretaker’s
responsibility includes not only the present state of the child but also the long-term well-
being of the child. The caretaker should discipline the child in some cases if he or she is
altruistic, that is, care about the child’s full human capital development. The spoiling, as
such, may hinder the flourishing of the child’s full human capital potential.
As in the case of slackening, in the case of the caretaker is spoiling, that is, cheating,

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the future grown-up (principal) cannot retaliate in the usual sense of punishment. The
principal can retaliate through self-blame, sense of shame, and remorse.
The caretaker’s reflexive utility would be similar to the actor’s leisure utility gained from
slackening. For cooperation between the caretaker and the future grown-up to continue in
an indefinitely repeated game, the caretaker’s reflexive utility must exceed the caretaker’s
sense of self-blame for the loss of income for the future grown-up. However, the self-blame
leveled by the future grown-up must be painful enough to more than offset the gained
reflexive utility from spoiling.
As in the slackening model, we have shocks that inflict the child. They can be of two
kinds: benign and obstructive. Let us say that the child misbehaves and the caretaker
spoils rather than disciplines the child. It would be a benign shock if the caretaker appeals
to a fake shock – such as hunger or exhaustion that has supposedly befallen the child – as
an excuse for the spoiling. Here the spoiling resembles the stolen leisure in the shirking
and slackening models. On the other hand, it would be an obstructive shock if the shock
inflicting the child were non-fake. Thus, in light of the misbehavior of the child, the care-
taker justly accords the child attention and affection.
Following Figure 28.1 concerning the asymmetric timelines, the sub-rational caretaker
(actor or agent) knows the nature of the shock. On the other hand, the future grown-up
(principal), who is rational according to the shirking model, can only become aware of the
nature of the shock if the principal had chosen already to monitor the shock.
In case there is no monitoring, though, how could the future grown-up, who actually
resides in the mental fabric of the caretaker, be kept unaware of the shock, given that the
caretaker knows? As in the case of slackening, the future grown-up is kept in the dark via
self-deception. Namely, the actor invents fibs and excuses that block the future grown-up,
that is, the principal within the breast of the caretaker, from knowing about the nature
of the shock.
If the principal, at the start of his or her timeline, had chosen to withhold monitoring,
he has to cooperate in the form of congratulating the caretaker for attention showered
on the child. That is, he cannot level self-blame even when the consequent attitude of the
child, that is, the child’s incremental human capital in the form of disciplined behavior, is
zero. The principal, to specify again, can retaliate under three conditions: (1) the product
is zero; (2) the shock is benign; and (3) there is monitoring.
But monitoring is costly. So, it is optimal for the future grown-up (principal) to conduct
occasional monitoring, capturing only (1 − p) of all the cases of self-cheating by the care-
taker. It is optimal for the actor (the caretaker) to cheat, that is, to claim that the shock
is obstructive when it is not, insofar as the expected benefit from spoiling exceeds, at the
margin, the expected cost if the actor suffers from self-blame.
As in the above models, for the spoiling to be suboptimal, that is, involving weakness
of will, the actor must be sub-rational – and sub-rational in the direction of forming
impulsive beliefs in the sense of optimism or over-confidence. Here, the belief of the actor
or the agent (pa) is higher than the belief of the future grown-up or principal (pp). Again,
the same necessary condition holds for the spoiling of children as sub-rational weakness
of will is ENBa > 0 > ENBp. That is, the expected net benefit from spoiling would be
tempting only if it is suboptimal for the principal (0 > ENBp), while optimal for the agent
(ENBa > 0).
In the case of stiffness of will, the opposite of spoiling is excessive harshness or abusive

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behavior towards the child. The necessary condition for the harshness to be sub-rational,
obsessive-compulsive behavior is ENBa < 0 < ENBp. That is, the expected net benefit
from additional affection towards the child would be compelling only if it is optimal for
the principal (0 < ENBp), while suboptimal for the compulsive agent (ENBa < 0). That is,
the compulsive agent would continue to be compelled to inflict harsh punishment on the
child, motivated to mold a well-disciplined future grown-up.
Under the above range of inequality behind the spoiling of children, the impulsive
caretaker would shower undeserved attention on the child. The caretaker would be relying
on the sub-rational, over-confident belief of getting away with spoiling. Under the above
range of inequality behind excessive harshness, the compulsive caretaker would inflict
extra deprivation, which would amount to child abuse. The caretaker would be relying
on the sub-rational, under-confident belief of getting away with the excessive harshness.
Also, individuals usually resort to internal and, if need be, external constraints to re-align
the over- or under-confident belief with the impartial belief.
8 TO CONSUME PORNOGRAPHY-IMAGING OR TO
REFRAIN?
Pornography-imaging, beyond an optimal level, could become another example of suc-

cumbing to weakness of will. The proposed confidence-biased belief model can shed light
on such an example. It can provide a precise differentiation between erotica-imaging and
pornography-imaging, a long elusive distinction. It has been elusive for a good reason.
Once researchers start with present-biased preferences approach, such as Dan Ariely and
George Loewenstein (2006), what is erotica-imaging and what is pornography-imaging
would be a matter of preferences, that is, in the eyes of the beholder.
In both imagings, the actor under focus (agent) seeks sexual utility with a partner
(principal) with the aid of an imaginative set-up. As before, let us assume that the partner
(principal) is rational and would not cheat, that is, would reciprocate justly and invest in
erotica-imaging during the sexual interaction. The partner, though, would retaliate, by
withholding effort in erotica-imaging, in case the partner finds out that the actor under
focus is cheating, that is, employing only pornography-imaging.
Either player can invest in erotica-imaging, defined as the investment in a rousing
romantic atmosphere, the presentation of flowers, the use of special aromas, or the selec-
tion and the watching of a well-executed sex film. Otherwise, the player would be investing
in pornography-imaging, defined as hasty construction of an atmosphere, little effort to
arouse the other, and the use of short and cheap sex film. Such little effort, to normalize,
can be assumed to be ‘zero effort’ as the case of the actor’s shirking in the shirking model.
We can import the assumptions of the shirking model in toto to explain pornography-
imaging as cheating in effort expenditure. When the actor cheats with pornography-
imaging, the actor steals leisure utility. For cooperation to continue nonetheless in an
indefinitely repeated game, the actor’s leisure utility in each round must exceed the actor’s
partial loss of sexual pleasure as a result of failing to set-up erotica-imaging. However,
the retaliation by the sexual partner, which would make such loss total, must be painful
enough to more than offset the actor’s leisure utility from pornography-imaging.
As in the shirking model, the actor suffers from shocks of two kinds: benign and

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obstructive. If the shock is benign, the actor’s ability to set-up erotica-imaging is not
impeded, but if the shock is obstructive, such as true sickness or fatigue, such ability is
hindered. That is, irrespective of the choice of the actor, the actor’s output would be zero
as if produced by cheap, pornography-imaging. With obstructive shock, the actor under
focus would be justified to avoid wasteful investment in erotica-imaging.
Following the asymmetric timelines of Figure 28.1, the actor knows the nature of
the shock, while the sexual partner (principal), who is rational and cannot cheat, can
only become aware of the nature of the shock if the principal had chosen already to
monitor the shock in that round. If the principal, at the start of the round, had chosen
to withhold monitoring, it has to cooperate, that is, invest in erotica-imaging. That is,
it cannot level punishment in the form of pornography-imaging even when the actor’s
product is zero. The principal, to specify again, can only provide pornography-imaging
under three conditions: (1) the product is zero; (2) the shock is benign; and (3) there
is monitoring.
As in shirking, monitoring of whether the actor is suffering from genuine shock is
costly. So, it is optimal for the principal to conduct occasional monitoring, capturing
only (1 − p) of all the cases of deception, and it is optimal for the actor to deceive, that
is, to claim that he or she is inflicted with an obstructive shock when it is not, insofar as
the expected benefit from deceiving exceeds, at the margin, the expected cost if the actor
gets caught.
As in the above models, for the pornography-imaging to exceed the optimal level, that
is, to succumb to weakness of will, the actor must be sub-rational – and sub-rational in
the direction of forming impulsive, over-confident beliefs. Here, the belief of the actor
or agent (pa) that he can get away with deception is higher than the belief of the rational
calm self. Such rational calm self of the actor actually holds the same rational belief
as the principal (pp). Again, the same necessary condition holds for the appearance of
pornography-imaging as sub-rational weakness of will, ENBa > 0 > ENBp. That is, the
expected net benefit from pretending that the shock is obstructive would be tempting only
if ENB is suboptimal for the principal (0 > ENBp), while optimal for the agent (ENBa > 0).
In the case of stiffness of will, the opposite of pornography-imaging is excessive invest-
ment in erotica-imaging, even when the actor is struck by genuine fatigue. It is possible
to characterize sexual fetishism as an example of sub-rational obsessive behavior. The
necessary condition for sexual fetishism or other antithesis of pornographic-imaging as
sub-rational obsessive-compulsive behavior is ENBa < 0 < ENBp. That is, the expected net
benefit from freeing ourselves from investment in erotica-imaging would be compelling
only if it is optimal for the principal (0 < ENBp), while suboptimal for the compulsive
agent (ENBa < 0). That is, the compulsive agent would continue to be compelled to invest
feverishly in erotica-imaging.
Under the above range of inequality behind pornography-imaging, the impulsive actor
would become careless, investing less in erotic approach to his or her partner. The actor
would be relying on the sub-rational, over-confident belief of getting away with cheating.
Under the above range of inequality behind obsessive behavior, the compulsive actor
would become obsessed with erotica-imaging, which is probably behind sexual fetishism.
The actor would be relying on the sub-rational, under-confident belief of getting away
with deception. Again, individuals usually resort to internal, and if need, external con-
straints to re-align the over- or under-confident belief with the impartial belief.

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9 CONCLUSION
This chapter grounds the confidence-biased beliefs approach on three propositions. It

first argues that conflicts between two individuals, as demonstrated in the case of shirk-
ing, are ultimately an intra-individual conflict. Second, it argues that intra-individual
conflicts concern the different assessments of the probability of success in the face of
risk. They need not express conflicts between present-biased and non-myopic preferences.
Third, it shows that the intra-individual conflict concerning probabilities of success arises
endogenously, from a small sample of experiences. Such conflict would die out if the small
sample were prompted only by bounded rationality.
The small sample, in the case of weakness of will, seems to be prompted, additionally,
by the desire to succeed (ambition). Note, as mentioned above, the desire to succeed need
not lead to wishful thinking, over-confidence, or the impulsivity behind weakness of will.
That is, the dominance of impulsivity over compulsivity may arise from the fact that
people do not have a desire to fail, but have a desire to succeed. If desire is the reason for
the rise of weakness of will (impulsivity), we should witness fewer cases of stiffness of
will (compulsivity). The fact that stiffness of will is ubiquitous may force us to conceive
the desire to succeed in a broader light: in some cases it might propel the agent to take
excessive risks (impulsivity), but in other cases, when the person is frustrated with many
disappointments, it might propel the agent towards excessive cautiousness (compulsivity).
So, there is a need for a more general theory of sub-rationality, a theory that can account
for the endogenous development of weakness of will vis-à-vis stiffness of will.
The goal of this chapter is more preliminary: We need to commence with biased beliefs,
rather than biased preferences, if we want to understand how weakness of will and stiff-
ness of will are analytically similar phenomena.
NOTE
* Earlier drafts benefited from the comments of Harold Demsetz, Joel Sobel, Eric Schliesser, Leonidas
Montes, James Buchanan, Steven Gardner, participants of a seminar at Monash University, and especially
Ian McDonald and Haiou Zhou. The current version benefited from the comments of Alain Marciano,
George Ainslie, and the editor, Morris Altman. The chapter benefited from a grant from Monash
University’s Faculty of Business and Economics. The usual caveat applies.
1. I prefer to use the term ‘stiffness of will’ rather than the ‘strength of will’ because the term ‘strength of will’
connotes rational choice. The term ‘stiffness of will’, on the other hand, connotes sub-rational choice in the
sense that the will is not flexible enough. I want to use a term that is opposite to ‘weakness of will’ while
still suggesting that the will enacts sub-rational choices.
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29 The role of identity, personal and social capital in
community crime prevention
Ambrose Leung and Brandon Harrison
1 INTRODUCTION
Community crime prevention (CCP) is based on collective action by citizens to reduce

criminal opportunities through surveillance and vigilance of their community (Schneider
2007). The success of CCP hinges critically on a community’s characteristics that form
unique opportunities and constraints faced by members of the community. A smart
decision that concerns the level of CCP participation for residents in crime-ridden areas
is likely different from that of residents in low-crime areas. This chapter shows that the
type of smart decisions made by individuals can vary between communities with different
characteristics that determine the success or failure of CCP.
From the 1920s to 1960s, police practice followed mainly the ‘professional model of
policing’, which emphasizes the role of police as crime fighters and citizens as passive
recipients of police services (Smith et al. 1997). Changing economic and social conditions
during the 1960s proved such police practice ineffective as crime rates continued to rise.
Alternative solutions were called for and crime prevention entered the era of community
crime prevention (Vallée 2010).
Since the 1970s, the professional model of policing has received various criticisms.
First, it is an expensive practice that appeared ineffective as crime rates increased during
the 1960s. Second, a ‘gap’ had been created between police and citizens as citizens took a
passive role in crime prevention. Encouraging active citizen participation in crime fight-
ing became the natural solution for two reasons: (1) to help lessen the burden on police as
fully responsible for fighting crime, and (2) to improve police–citizen relations as citizens
become partners with police in crime prevention. Community-based policing first began
in the United States in the early 1970s and was swiftly introduced to other countries such
as England and Canada by the early 1980s (Solicitor General Canada 1984; Hourihan
1987; Vallée 2010). Community crime prevention programmes such as Neighbourhood
Watch has continued to be a popular strategy advocated by governments to complement
formal law enforcement efforts by police (Garofalo and McLeod 1989; Lewis 1996).
Since the mid-1980s, a large body of literature has emerged to discuss the effectiveness
of CCP programmes in reducing crime as well as the extent of citizen involvement in such
programmes. Evidence on CCP effectiveness has been mixed at best. The consensus is that
various community-based crime prevention programmes have either no, or only limited,
effects to reduce crime at local levels (Garofalo and McLeod 1989; Lewis 1996; Smith et
al. 1997; Schneider 2007). With regard to CCP participation, evidence generally suggests
that high-crime neighbourhoods that are most in need of CCP efforts often experience
the least success in implementing and maintaining programmes such as Neighbourhood
Watch, of which typical participants tend to be long-term residents who are home owners
515
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with high income, education, and socioeconomic status in affluent suburban areas
(Skogan 1989; Lewis 1996; Kang 2011; Becker 2013). Demographic factors such as age,
gender and ethnicity appear to have no consistent relationship with participation in com-
munity crime prevention (Schneider 2007).
The rest of this chapter begins with a description of the theoretical explanations that
have been used to motivate the discussion of CCP. The role of identity, personal and social
capital in CCP is then examined from a behavioural economics perspective, followed by
an application of a game theoretical approach to integrate the various theories used to
explain CCP. The chapter concludes with some policy implications.
2 COMMUNITY CRIME PREVENTION: THE SOCIOLOGICAL

TRADITION
During the 1960s, crime rates surged in countries such as the United States, the United
Kingdom and Canada. By the 1970s, police started to recognize the need to modify
existing police practices by paying more attention to community relations. Community
crime prevention was formulated as a response to the changing social conditions such
that citizens began to take a more active role in crime prevention (Schneider 2007; Vallée
2010). Community crime prevention programmes, such as Neighbourhood Watch, that
are considered examples of situational crime prevention intervention, began to develop in
the 1980s. Situational crime prevention is predicated upon the idea that opportunities for
criminal activity can be reduced or eliminated by manipulating the environment, such as
through improving the built environment or social relationships among residents (Clarke
1983). The basis for this form of crime prevention is founded on the rational choice model,
which assumes that individuals will weigh both the costs and benefits of criminality, and
proceed if they perceive the benefits of engaging in crime as high and the costs as low
(Clarke 1995). Another prominent criminological theory tied to CCP is routine activity
theory, which posits that the convergence of a motivated offender, suitable target and
absence of capable guardians will lead to an increased likelihood of a criminal event
occurring (Cohen and Felson 1979). The formation of social groups and structures such
as Neighbourhood Watch thus act to deter individuals from criminality owing to collec-
tive action against crime which raises the costs of engaging in delinquent and criminal
activities and ensures that capable guardians are in place to aid in deterring crime.
A main purpose of CCP is to mobilize collective action by citizens to complement
police efforts in reducing opportunities for crime within a community. A natural starting
point for CCP analysis is the concept of community. Within the sociological tradition, the
theory of social disorganization explains communities (for example, Chicago in the 1920s)
that experience rapid urban growth as characterized by unstable social conditions such
as high residential mobility, racial diversity, broken homes and low socioeconomic status
(Shaw and McKay 1942). Under such chaotic conditions, traditional social institutions
such as family, school, and church start to fail in their functions to uphold social norms
and informal social control, giving rise to higher rates of crime and delinquency (Leung
and Brittain 2009). The theory of social disorganization serves as the background for the
emergence of CCP because social institutions play an important role in determining the
strength of informal social control within a community.

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Role of identity, personal and social capital in community crime prevention 517
Collective efficacy, defined as the combination of trust, shared values and expectations
of informal social control (Pattavina et al. 2006; Schneider 2007; Sampson and Graif
2009), is a concept often cited in the literature to explain the emergence and maintenance
of CCP. An important element in CCP analysis is the common values shared among
members within a community. Social cohesion along with shared social norms are con-
sidered necessary requirements to mobilize joint social action such as CCP. Effective com-
munications and network connections as well as mutual trust between members of the
community are essential components to realize the joint activities for crime prevention.
Once the joint activities have materialized, for CCP to be successful it will still require an
effective system of informal social control such as citizens’ willingness to intervene and
punish deviant behaviour (Becker 2013). Community crime prevention will remain inef-
fective to reduce crime if the level of willingness to tolerate crime by citizens is too high.
For example, some communities with abundant gang activities and high crime rates may
be otherwise socially cohesive. In this case, many gang members are local residents who
commit crime in their own neighbourhood; money made from crime is often injected back
into the same community as financial resources to support their own families or even the
larger community. Various forms of investment made by the criminals to the community
enhance the social ties between the criminals and the community, which in turn decreases
the willingness of residents to punish criminal activities. This kind of positive social inter-
action between criminals and law-abiding citizens is known as ‘negotiated coexistence’
between the two groups, which serves as a possible explanation for why some socially
cohesive communities experience high crime rates (Browning 2009).
Community crime prevention effort such as Neighbourhood Watch has been shown to
have only modest impacts in reducing crime. The maintenance of any CCP programme
often faces difficulties at both the organizational and the participation levels. At the
organizational level, programmes such as Neighbourhood Watch often emphasize the
importance of reporting criminal activities to police instead of confronting the criminals
directly, thus encouraging a passive role of citizens in crime prevention. Furthermore,
some CCP programmes are initiated in response to certain isolated criminal events in
a neighbourhood and participants lose interest after a while, causing many CCP pro-
grammes to become inactive or dormant (Garofalo and McLeod 1989). A given level of
crime might be necessary for a Neighbourhood Watch programme to remain active (Huck
and Kosfeld 2007). At the participation level, opportunities to engage in CCP activities
are unequally distributed across neighbourhoods and individuals. Socially cohesive neigh-
bourhoods with low crime rates are often in a better position to experience successful CCP
than crime-ridden neighbourhoods with weak social ties (Skogan 1989). For some CCP
programmes that enjoy active participation, bias exists regarding individual participation,
especially among communities with high degrees of racial and cultural diversity. In such
communities, residents from different backgrounds tend to behave and live according to
different cultural norms. For example, Becker (2013) shows that white males can become
the dominant force that limits CCP participation of females and non-white members in
a community. Such differential opportunity structures often create an insiders–outsiders
phenomenon that has a detrimental impact on social cohesion within the community.
As suggested by Schneider (2007), social interaction, cohesion and informal control are
three elements that are invoked by successful CCP, but at the same time are essential for
successful implementation of CCP.

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In sum, the CCP analysis from the sociological tradition is built upon the idea of
common values on crime prevention shared by members of a socially cohesive community
with an effective system of informal social control that community members are willing
to exercise. In the next section, the CCP analysis is extended to incorporate a behavioural
economics perspective.
3 EXTENSION TOWARDS A BEHAVIOURAL ECONOMICS

PERSPECTIVE
The study of economics examines how rational individuals maximize their own well-
being. Behavioural economics further considers the role of psychological and social
factors in affecting rational decision-making. A behavioural economic approach therefore
fits well with the CCP analysis as CCP is a type of situational crime prevention interven-
tion that is formulated as a rational response shaped by social and psychological factors
to deal with the problem of crime.
Consider the conditions and characteristics under which CCP is most likely to be
effective that include social cohesion, common values, trust, social networking, and effec-
tive informal social control. Each of these characteristics can be thought of as a type of
useful resource for successful CCP operations. However, the simultaneous presence of the
various characteristics is required to realize the goal. For example, a high level of trust
on its own is not sufficient to guarantee successful CCP without effective informal social
control such as willingness of residents to sanction deviant behaviour. The various CCP
requirements in this case can be considered different forms of social capital, defined as
productive resources that people can build through social interactions (Leung 2002). For
instance, a person’s active participation in CCP increases the social capital stock of both
the person and the community as stronger social ties and higher levels of social cohesion
are being developed (Ren et al., 2006).
In the seminal paper of Coleman (1988), three forms of social capital were suggested:
(1) trust and expected obligations, (2) information channels, and (3) effective norms and
sanctions. All three forms of social capital are useful resources to facilitate social cohesion
and collective action. Trust built between individuals enhances social cohesion within a
community, thus providing an environment conducive for the formation of social rela-
tions and networks between people. Effective social norms are developed and thrive in a
community where members share common values and goals, and fulfil the expected obli-
gation of sanctioning norm-violating behaviour. The literature further distinguishes two
types of social capital. Bridging social capital refers to personal relationships built upon
direct interaction with other people, while bonding social capital is based on identifying
oneself with a specific group (Putnam 2000; Brisson and Usher 2007). For example, inter-
acting and networking with a fellow member of an organization is considered a form of
bridging social capital; identifying oneself with other members of the organization strictly
by membership without personal interaction is considered a form of bonding social
capital. In addition to social capital, another type of capital discussed in the literature is
personal capital, defined as productive resources gathered by a person through his or her
own activities without interpersonal interaction (Becker and Murphy 2000; Leung and
Brittain 2015). The main difference between personal capital and social capital lies in the

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fact that personal capital can be gathered strictly based on one’s own activity, while social
capital can only be gathered through interactions with other people.
Both types of social capital as well as personal capital all contribute to the shaping of
an individual’s personal identity as well as social identity (Davis 2014; Jiang and Carroll
2009). As people continue to establish their identities, labels are attached. The distinction
between members (or insiders) and non-members (or outsiders) is often an inevitable
product of identity formation (Akerlof and Kranton 2010). Social identity theory sug-
gests that people’s choice to identify with certain groups defines who they are (personal
identity) and what social category they belong to (social identity). People’s behaviour is
then shaped by the social norms and sanctions of the social groups they belong to (Jiang
and Carroll 2009; Akerlof and Kranton 2010). Hence, people who belong to different
social groups are expected to behave differently. By continuing to identify with certain
groups and observing the same set of group norms and sanctions over time, the personal
and social identities of people as well as the distinction between insiders and outsiders
are further reinforced.
In the traditional microeconomic analysis of consumer behaviour, consumers derive
satisfaction or utility from the consumption of goods and services. Identity utility can
be similarly derived when a person establishes personal and social identity. Akerlof and
Kranton (2010) explain the relationship between identity and utility with a three-step
process. First, personal and social identities place a person in a certain social category.
Second, norms associated with the social category are defined. Third, a person gains or
loses utility from each decision and action they make based on the defined identity and
norms. A person’s identity and social category are important determinants of behav-
ioural patterns. Insiders and outsiders, as defined by different groups or social categories,
behave differently to increase their respective utility. Consider a population of high school
students that is made up of different peer groups such as ‘brains’ and ‘partyers’, where
‘brains’ spend most of their free time studying and ‘partyers’ spend most of their free
time partying (Erskine et al. 2006). Suppose the main purpose of school is designed for
increasing individual productivity through the consumption of education (Becker 1964).
A student who is identified with the peer group ‘brains’ gains identity utility by spending
time studying as individual productivity increases at the same time. A student identified
as a ‘partyer’ gains identity utility by spending time partying as individual productivity
remains low or decreases owing to limited or no time devoted to studying and practising
skills relevant for improving productivity.
The formation of identity often interacts with the capital accumulation process to
affect a person’s utility. For example, a person who joins a religious group can experience
a change in the process of personal and social capital accumulation through identifying
himself or herself with the group. The group identity may allow the person to realize a
better purpose for life (an increase of personal capital stock), and at the same time to
develop new relationships and networks through interaction with other members in the
group (an increase of social capital stock) – all of which bring the person a higher level of
utility. Furthermore, group identity can solidify the stock of social capital such as trust
and cooperation within the group and increase the utility of all group members, but can
also at the same time create conflict between groups with different norms or between
insiders and outsiders within a same group (Davis 2014).
The various concepts of capital as well as identity formation are important building

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blocks for understanding CCP from the behavioural economics perspective. Consider a
community that attempts to engage in community crime prevention through the initia-
tion of a Neighbourhood Watch programme. Whether such an attempt will be successful
or not depends on the structural characteristics of the community and the individual
characteristics of its residents, of which the two characteristics often impact each other in
determining the outcome. For example, a neighbourhood with mostly homeowners who
are long-term residents is more likely to be socially cohesive than a neighbourhood with
mostly transient renters. Social identities of neighbourhoods often develop in relation
to the personal identities of residents, both of which interact with the process of capital
accumulation to determine the outcome. Residents of a neighbourhood with strong posi-
tive social identity tend to have more incentive to identify with their community and to
become socially cohesive as residents develop trust and relations with each other. As a
result, the stock of personal and social capital within the neighbourhood continues to
grow, which will further reinforce the positive social identity of the area. A strong nega-
tive social identity acquired, like the label of a ‘ghetto’, provides incentives for residents
not to identify with the community and to move elsewhere that has a more positive social
identity (Temkin and Rohe 1998), which in turn has a detrimental effect on the stock of
personal and social capital within the neighbourhood as residents fail to develop trust and
social ties with each other.
4 A GAME THEORETICAL ILLUSTRATION
Community crime prevention is a form of collective action that requires cooperative

behaviour from members to be successful which is largely determined by community
characteristics and social relationship among residents (Clarke 1983). In such a situation,
which entails people behaving strategically and making smart decisions to maximize their
own interest, the potential free-rider problem can arise at both the organization and the
participation levels. For instance, who should initiate the Neighbourhood Watch pro-
gramme in a community? Who should monitor the daily operation of the programme?
How can it be assured that residents actively participate in the programme? Game theory
is a useful tool for analysing strategic interactions between people as well as gaining
insights on the free-rider problem (Nash 1953).
Empirical evidence suggests that certain types of communities are more likely than
others to have success in CCP. Consider two communities, Eastville and Westville, with
the following characteristics:
1. Eastville is a high-crime area that is made up of a large number of transient rental

residents with diverse cultural backgrounds. Other characteristics of Eastville include
crowded living conditions, a high proportion of single-parent households, and a high
unemployment rate.
2. Westville is a low-crime neighbourhood with residents who are professionals and
own their homes. The residents, for the most part, share the same ethnic and cultural
backgrounds and are active participants in community activities.
Suppose the police propose a certain sum of start-up funds to initiate Neighbourhood

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Table 29.1 Strategic interaction in Eastville
Lee (L)
Cooperate (c) Deviate (d)
Jones (J) Cooperate (c) J 5 10, L 5 10 J 5 −5, L 5 15
Deviate (d) J 5 15, L 5 −5 J 5 0, L 5 0
Watch in both Eastville and Westville. In the following analysis, game theory is applied to
analyse how self-interested residents make smart decisions and respond to Neighbourhood
Watch participation from strategically interacting with each other. To keep the analysis
simple and clear, a two-household game is used to analyse the interaction. The results can
be generalized to the case with n-household.
Let Jones and Lee be two households in Eastville. Both Jones and Lee choose one of
two strategies regarding participation in Neighbourhood Watch:
1. Cooperate – active participation in Neighbourhood Watch, or

2. Deviate – free-ride with no active participation in Neighbourhood Watch.
With the simple case of two households and two possible strategies for each, there exist
four possible outcomes as a result of the strategic interaction between the two households.
Each outcome will yield each household a certain level of satisfaction or utility. First
consider the case of Eastville as summarized in Table 29.1.
Table 29.1 shows that the best possible outcome is for the two households to cooperate
so that joint utility is maximized at 10 units for each (for a joint utility maximization of 20,
which yields the highest joint values among the four possible outcomes). To achieve this
outcome, the two households must share at least some common interest in crime preven-
tion and trust each other. Unfortunately, the characteristics of Eastville are not condu-
cive to realizing this cooperative and potential best outcome. The transient nature of the
neighbourhood implies that residents are not likely to identify themselves with Eastville,
especially with its social identity of being a high-crime area. For the same reason, it is
also difficult for Eastville residents to identify, let alone to develop relations and networks,
with each other. That is, Eastville residents are likely to identify themselves as ‘outsid-
ers’ and will not gain positive identity utility from cooperation. In such a chaotic living
environment with broken homes and high unemployment, traditional social institutions
such as family, school and church are not likely to maintain conventional social norms
and informal social control for personal and social capital to develop.
If the cooperative outcome cannot be realized for Eastville residents, what other
outcome can be reached through strategic interaction between the residents when they
do not trust each other? Consider the decision strategy of the Lee household. Lee knows
that Jones has two choices, cooperate or deviate. The Lee family will ask themselves the
following question: ‘If the Jones family chooses to cooperate, is it the best strategy for us
to cooperate or deviate?’ Given the information on utility from Table 29.1, Lee will get
10 units of utility from choosing to cooperate and 15 units of utility from choosing to
deviate by assuming the Jones family chooses to cooperate. As such, the smart decision
is for the Lee family to deviate. Then Lee will also consider the case if the Jones family

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Table 29.2 Strategic interaction in Westville
Lee (L)
Cooperate (c) Deviate (d)
Jones (J) Cooperate (c) J 5 16, L 5 16 J 5 1, L 5 9
Deviate (d) J 5 9, L 5 1 J 5 −6, L 5 −6
chooses to deviate, in which case Lee will get –5 from choosing to cooperate and 0 from
choosing to deviate. The smart decision is for the Lee family again to deviate such as to
minimize potential loss. Therefore, ‘deviate’ is the dominant strategy for Lee as ‘deviate’
is the smart decision for Lee regardless of Jones’s choice. The Jones family can similarly
rationalize their smart decision to ‘deviate’. Hence the final equilibrium outcome derived
from strategic interaction, which is referred to as the Nash equilibrium in the game theory
literature, is for both households to deviate from involvement in Neighbourhood Watch.
In the case of Eastville, both households end up choosing to deviate as their best
strategy when each settles with 0 units of utility, which is a much worse outcome than
the best possible outcome of both families choosing to cooperate. This means that
Neighbourhood Watch will not be successful in Eastville when there is lack of both trust
and cooperation between residents. There also exists the free-rider problem in Eastville
when residents try to rely on other residents to participate in Neighbourhood Watch
without their own participation as their smart responses.
We now proceed to Westville. The values of utility associated with the cooperation
and deviation strategies in Westville (as shown in Table 29.2) are different from those of
Eastville (as shown in Table 29.1). The positive social identity of Westville as a low-crime
neighbourhood along with its homogeneous ethnic and cultural background provides a
socially cohesive environment for Westville residents to share social norms and to develop
trust with each other. The presence of a stable home environment (long-term homeown-
ers) coupled with active community participation allows residents to easily build personal
and social capital that further reinforces the positive social identity of Westville. The
characteristics of Westville provide an environment that is conducive for residents to
cooperate with each other and identify themselves as ‘insiders’, implying that the utility
value associated with cooperation is high in Westville as Westville residents gain posi-
tive identity utility from cooperation. The common norms and trust serve as informal
social controls to penalize deviating behaviour, causing the utility value associated with
deviation in Westville to be low as Westville residents lose identity utility from deviation.
Consider again the simple case with two households, Jones and Lee in Westville. Based
on the utility values shown in Table 29.2 for Westville, a similar strategic interaction
analysis can be performed as shown for the case of Eastville. In the case of Westville, the
dominant strategy for each household is to cooperate and the Nash equilibrium is where
both households choose to cooperate as their smart responses with a utility value of 16
for each. Neighbourhood Watch is therefore a successful operation in Westville.
For CCP to be successful in a place such as Westville, a basic criterion is that residents
have crime prevention as the collective goal. In addition, similar preferences for CCP
organization of and participation must be at least similar, if not identical, among residents.
For instance, when different residents have vastly different ideas on how Neighbourhood

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Watch should be run, the programme will not succeed even if residents share the common
goal of crime prevention. Smart decision-makers in a crime-ridden area will cooperate
and succeed in CCP only when residents are ready to collectively identify with their own
community by sharing a set of common social norms and values.
5 CONCLUSION
Community crime prevention efforts are based on the assumption that a collective social
energy emphasizing pro-social norms and values will serve to reduce crime in a given
area. While CCP may appear to be a straightforward crime prevention initiative, social
capital, personal capital and identity structures all converge to either hinder or advance
CCP efforts. Thus, individual and community characteristics play a role in whether or not
effective CCP initiatives will be recognized. As addressed previously, communities with a
strong social identity and which seek to uphold positive norms and values are more likely
to succeed in implementing effective CCP than communities with weak social relations
and support of law-abiding behaviours and attitudes. To illustrate how individuals may
strategically interact in relation to their CCP input in different communities, the frame-
work of game theory was utilized. In communities characterized by weak social relations,
high unemployment and a disordered environment, the dominant strategy for individuals
is to deviate from cooperating in CCP activities regardless of whether or not they believe
that other individuals will either cooperate or deviate from CCP efforts. As such, disor-
ganized and chaotic communities will, in theory, fail to initiate and carry out appropriate
CCP programmes such as Neighbourhood Watch. On the other hand, communities with
strong social ties which emphasize and promote positive norms and values will likely be
successful in terms of CCP implementation. Individuals in these tight-knit communities
are likely to cooperate in CCP activities regardless of their beliefs about whether or not
their neighbours will cooperate or deviate from such activities.
Taken as a whole, community crime prevention efforts are highly dependent on the
community nature and structure in which they are being implemented. Thus, communities
with strong social bonds will likely embrace CCP to a significant extent, while communi-
ties with weak social bonds will likely experience difficulty in implementing and carrying
out such activities. Understanding which environments will and will not embrace CCP is
crucial in determining which crime prevention efforts should be implemented in certain
areas. Knowing this, efficient and effective crime prevention initiatives can be instituted
according to community characteristics.
An important consideration to have a more complete understanding of CCP analysis
is the size of the community. Communication between residents is made easier in a small
community where common values and goals are more likely to be shared by residents.
In larger communities, cultural diversity with different value systems is more likely the
reality where collective activities such as community crime prevention become more dif-
ficult to implement and maintain. For example, the theory of clubs from the public choice
literature (Buchanan 1965) suggests that the chances of individuals cooperating with
each other decrease as the number of members in a group increases. The optimal size of
a group (or community in our case) is determined by the benefit compared with the cost
of adding a new member. Further research can therefore extend the behavioural economic

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analysis of community crime prevention presented here by incorporating ideas from the
theory of clubs. The framework presented in this chapter has shown that concepts such
as identity, personal capital and social capital play an important role in the application
of the behavioural economic approach to explain community crime prevention. Smart
decisions of individuals vary in response to a community’s unique characteristics. For
residents of a crime-ridden area, a set of common values and shared goals are necessary
for any kind of crime prevention effort to be successful. In addition, a sense of belonging
and positive identity towards their own community is also an important element for any
kind of cooperative CCP effort to exist among citizens.
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30 Norms, culture, and cognition
Shinji Teraji
1 DECISION-MAKING IS INSTITUTIONALLY CONSTRAINED
People follow rules of behavior in society. These rules indicate what people should or
should not do under some circumstances. Douglass North once defined institutions
simply as ‘humanly devised constraints that shape human interaction’ (North 1990, p. 3).
The existence of rules implies constraints. However, such a constraint may enable choices
that otherwise would not exist. Rules include social norms as well as legal rules. There is
a distinction between formal institutions (constitutions, laws, property rights, and so on)
and informal institutions (sanctions, taboos, customs, traditions, codes of conduct, and so
on). Formal rules are made explicit or written down, particularly if they are enforced by
the state, whereas informal rules are implicit and enforced endogenously by the members
of the relevant group. Social norms enforced by the community can be viewed as informal
constraints. ‘While formal institutions can be changed by fiat, informal institutions evolve
in ways that are still far from completely understood and therefore are not typically ame-
nable to deliberate human manipulation’ (North 2005, p. 50). An understanding of social
norms is critical to predict and explain human behavior.
In the 1990s, North initiated the cognitive approach to the study of institutions. It is
the study of how humans use mental models to explain and interpret the world and how
learning in response to new experiences can produce an incremental process of change
in beliefs and preferences. For Denzau and North (1994) and North (2005), institutions
are the external (to the mind) mechanisms that individuals create to structure and order
the environment. Individuals with common backgrounds and experiences will share rea-
sonably convergent mental models. Agents who belong to the same group are exposed to
the same external representation of knowledge, which produces shared mental models.
Radical reforms are often constrained by societies’ inherited belief systems. There are indi-
viduals who are resistant to altering their belief systems and hence the resulting behavior.
The sticky nature of beliefs helps explain why imported rules, laws, and constitutions have
been so unsuccessful. However, shared beliefs sometimes change.
In The Sensory Order (1952), Friedrich A. Hayek provided a theory of the process by
which the mind perceives the world around it. Hayek’s The Sensory Order is in no way a
direct economic or social analysis, but it can be looked at in the context of the cognitive
problems related to the conceptualization of institutions.1 For Hayek, ‘psychology must
start from stimuli defined in physical terms and proceed to show why and how the senses
classify similar physical stimuli sometimes as alike and sometimes as different, and why dif-
ferent physical stimuli will sometimes appear as similar and sometimes as different’ (Hayek
1952, pp. 7–8). According to Hayek, knowing the world is a classification of sensory quali-
ties by the mind: ‘the classification of the stimuli performed by our senses will be based
on a system of acquired connections which reproduce, in a partial and imperfect manner,
relations existing between the corresponding physical stimuli’ (Hayek 1952, p. 145).
526
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Norms, culture, and cognition 527
What we know at any moment about the external world is determined by the order
of the apparatus of classification which has been built up by previous sensory linkages.
The qualitative differences in perceptions that people experience depend on the specific
pattern of neuron firings that a given stimulus produces within various neural networks.
The experiences of individuals will differ according to the pattern of neuron firings that
each develops. Every perception of external data depends on the subjective characteristics,
which in turn depends on original paths of interpretation. Hence, human perceptions
emerge according to self-reinforcing processes that are likely to accumulate in a specific
path of action. That is, individuals’ decision processes continue to reproduce one particu-
lar choice pattern, not switch to some previously plausible alternatives.
Hayek’s cognitive theory explains how different magnitudes of different pieces of
cognitive information cause different perceptions and therefore actions. New linkages
are established, depending on the pattern of ongoing neural activity. The structure of
linkages governs our cognitive processes. For Hayek, the central element in the cognitive
process is the feedback between individual and environment. The apparatus by means
of which we learn about the external world ‘is shaped by the conditions prevailing in
the environment in which we live, and it represents a kind of generic reproduction of
the relations between the elements of this environment which we have experienced in the
past; and we interpret any new event in the environment in the light of that experience’
(Hayek 1952, p. 165).
Hayek’s concept of perception as classification has a counterpart in his concepts of
rules and rule-following behavior. Homo sapiens is ‘a rule-following animal’ (Hayek 1973,
p. 11). Relying on rules is a device we have learned to use because our reason is insufficient
to master the detail of complex reality. Therefore, ‘what we refer to as knowledge is mainly
a system for rules of action supported and modified by rules indicating similarities and
differences between combinations of stimuli’ (Hayek 1978, p. 41). For Hayek, rules make
it possible for individuals to classify stimuli. The order of a group can be generated by
the rules of conduct adhered to by its members. How the mind classifies stimuli deter-
mines how individuals act on the external world. Much of our knowledge is embedded
in institutions.
The mind is shaped not only by experience but also by custom. This feature relates to an
interpretation of rules as behavioral patterns or regularities of conduct. If rules are rec-
ognized as recurrent patterns of behavior, individuals act according to rules of conduct.
The diffusion of shared behavioral patterns is necessary to obtain the social order. Shared
rules facilitate the decision-making in complex situations by limiting the range of circum-
stances to which individuals have to pay attention.
This chapter considers a relationship between the sensory order and the social order.
Hayek’s theory of mind sheds light on the process of choice. The sensory order is fun-
damental in the sense that the explanation of social order begins with the human mind.
The central element in the cognitive process is the feedback between individual and envi-
ronment. The chapter considers cultural evolution as an endogenous phenomenon from
a cognitive viewpoint. The remainder of the chapter is organized as follows. Section 2
presents some reasons why people comply with social norms. Section 3 is a brief overview
of Hayek’s cognitive theory. Section 4 focuses on culture from a cognitive viewpoint.
Section 5 presents a perspective on the relationship between cognition and cultural
evolution. Section 6 is the conclusion.

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2 NORMS
Social norms are informal rules, as opposed to formal rules promulgated by a court or a
legislature. There are widespread expectations of proper and acceptable behavior within
a group. A social norm is a behavior characterized by its being prevalent among group
members. Social norms often direct individuals to undertake actions that are inconsistent
with selfish actions. For example, in the dictator game, 50–50 division is generally viewed
as norm-compliant (Andreoni and Bernheim 2009). However, people may deviate from
such norms.
In the case of legally compliance, individual incentives most often refer to deterrence
(Becker 1968). That is, individuals are deterred from criminal activities by a higher fine
and by a higher probability of conviction. In the rational choice approach, legal com-
pliance is accounted for by standard economic incentives of self-utility maximization;
compliance is in a person’s self-interest. Thus, the rational choice approach predicts that
the frequency of crimes will decrease if the perceived benefits associated with offending
decisions are reduced, and the perceived cost associated with offending decisions are
increased. Unlike legal rules, social norms are not supported by formal sanctions. Why do
people obey norms? There are some reasons why people comply with norms:
1. Individuals hold a preference for conformity to a behavioral pattern through sociali-

zation (Teraji 2007). The internalization of norms can guide a certain form of behav-
ior. Once a norm has been internalized through socialization, many people tend to
follow it routinely. Then, without checking the soundness of reasons of internalized
norms, people may comply with norms. Simon (1993) supposes that human choice
is driven by a number of motives, not limited to economic gain. Cheap adequate
solutions are often preferred to costly perfect ones. Rationally limited agents cope
with a problem by adopting simplifying strategies for its solution. Individuals have
a tendency to act on advice and respect social norms. Social norms are standards
of behavior that indicate what people should or should not do under some cir-
cumstances. As Simon (1993) points out, in large measure, people do what they
do because they have learned from those who surround them, not from their own
experience, what is good for them and what is not. Behaving in this fashion contrib-
utes heavily to the fitness of human beings in evolutionary competition. As a con-
sequence, people exhibit a very large measure of ‘docility’. Here, docility means the
tendency to depend on suggestions, recommendations, persuasion, and information
obtained through social channels as a major basis for choice. Docile persons often
make choices under social advice to do so. Certain kinds of common understand-
ings among individuals are required to produce the common associations of ideas
that allow conventions to emerge and to reproduce themselves. Social interaction
will lead individuals to behave in a more similar manner. The society is sustained
by processes favorable to individuals endowed with some docility in following rules.
Smith (2003) develops the concept of an order as an undesigned ecological system
that emerges out of economic, cultural, and biological evolutionary processes.
He introduces the distinction between ‘constructivist’ rationality and ‘ecological’
rationality to capture this point. According to constructivism, institutions have
been deliberately designed in order to accomplish human purposes. In Hayek’s view,

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this is an erroneous conception and has dangerous effects as a guide for political,
social, and economic interventions. Deliberately organized forces of society may
destroy spontaneous forces which have made advance possible. On the other hand,
ecological rationality uses reason to discover the possible intelligence embodied in
the rules and norms that are created from human interactions but not by deliberate
human design. Ecological rationality is an evolutionary-oriented notion of rational-
ity. Through a process of social evolution, institutional arrangements emerge from
human interactions that enable individuals to better coordinate their behavior. This
evolutionary process takes place despite their imperfect knowledge of the structure
of their environment.
2. Norms that involve pecuniary disadvantages for people adhering to them do not
necessarily disappear. Akerlof (1980) develops an economic model to show that
disobeying a norm may involve a loss of reputation. Certain groups of individuals
can maintain a strong reputation over time. People want to achieve the reputation
of being fair. People are fair because they care about their reputation. They may not
be genuinely fair. They have to be rewarded for good reputation, and they have to be
willing to comply with the norm. Individuals are influenced in their convictions by
what they think others will do. Conformity to the norm is conditional on expecta-
tions about other people’s behavior. Norms are constituted by expectations shared
by members in a population and are jointly recognized among them. Social norms
can be sustained if the pecuniary advantage from breaking norms is not sufficient to
offset the forgone reputation effect. This is related to indirect reciprocity. According
to Alexander (1987), indirect reciprocity is arranged in the form of a chain; a person
is eventually helped by someone else who may not have been directly helped by him or
her. Altruistic actions can be sustained if people who support others receive support
in turn. To achieve such indirect reciprocity, building up a positive reputation is
needed.
3. People comply with norms because the threat of punishment makes it in their interest
to do so. The importance of decentralized punishments (that is, punishments carried
out by individuals without the intervention of a central authority) is documented in
experimental studies. Ostrom et al. (1992) show the existence of such punishment
opportunities in a common-pool resource use game. The fear of punishment has a
positive effect on cooperation. In public goods experiments, subjects begin by con-
tributing on average about half of their endowments to the public account. However,
the level of contribution decays over the course of multiple rounds. When costly
punishment is permitted, cooperation does not deteriorate. Fehr and Gächter (2000)
indicate that many individuals are willing to punish unfair behavior at a personal cost
in public goods games. Potential punishers are not themselves the victims but have
merely witnessed unfair behavior. This is called altruistic punishment as individuals
sacrifice for no direct benefits. It suggests that cooperation has evolved through the
sacrifice of altruistic punishers who are ready to incur some costs to prevent unfair
behavior. The existence of such altruistic punishers constitutes a threat that acts as
a deterrent against norm violations. A norm is regarded as a rule governing an indi-
vidual’s behavior. Norms are enforced due to the expectations that norm violations
will be punished.
4. Norms are represented as Nash equilibria of games played by rational agents, and as

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such they are self-enforcing (Lewis 1969). The equilibrium account of norms must
be supplemented with a story of how agents learn to recognize a behavioral pattern,
how they settle on a stable pattern, and what sort of behavior is more likely to be
sustainable. Norms are supported by shared expectations about what should or
should not be done in a population (Bicchieri 2006). Let R be a behavioral regular-
ity in a population P. Each member of P knows that a certain behavioral regularity
R exists. Then, R is a norm if and only if R depends on the beliefs and preferences
of the members of P in the following way: (1) almost every member of P prefers to
conform to R on the condition that almost everyone else conforms to R, too; and (2)
almost every member of P believes that almost every other member of P conforms
to R. A social norm is a rule of action that exists whenever an agent expects others
to follow it and believes that others expect him or her to follow it as well. Thus,
a norm is an equilibrium in the game-theoretic sense of being a combination of
strategies, one for each player, such that each player’s strategy is a best response to
others’ strategies.
5. Correlated equilibrium allows players’ actions to be statistically dependent on some
random signals external to the model (Aumann 1987). Correlated equilibrium only
requires rationality and common priors, while Nash equilibrium requires stronger
premises. Different players can potentially take different actions. However, their
actions are conditional on some external signal. Nature first gives a publicly observ-
able signal. Players’ strategies assign an action to every possible observation. If no
player has an incentive to deviate from the recommended strategy, the distribution is
a correlated equilibrium. Social norms play the role of a ‘choreographer’ who leads
people to take actions according to some commonly known probability distribution
(Gintis 2009). A social norm prescribes which strategy every player should choose
depending on the observed signal, in such a way that it is rational for him or her to
follow the suggestion knowing that others are following it, too.
3 COGNITION
A choice is a selection among numerous possible behavioral alternatives. A decision is a

process through which this selection is performed. Conventional economic theory is about
choices actually made, not about decision-making processes leading to the choices. That
is, conventional economic models include only variables that condition ‘what an agent
chooses’ and none that condition ‘how an agent chooses’. This entails a ‘black box’ view
on the individual, meaning that it does not matter analytically how that behavior is actu-
ally generated. It is no doubt to exclude a need of psychological inquiry from economics.
Following Hayek’s theory of mind, however, economics needs to build on the charac-
terization of processes that contribute to decision-making. Hayek’s theory of mind sheds
light on the process of choice; it describes the human mind as an adaptive classification
system by which individual behavior is shaped. Furthermore:
What we call mind is not something that the individual is born with, as he is born with his brain,
or something that the brain produces, but something that his genetic equipment . . . helps him to
acquire, as he grows up, from his family and adult fellows by absorbing the results of a tradition
that is not genetically transmitted. (Hayek 1988, p. 22)

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In The Sensory Order (1952), Hayek provided a theory of the process by which the mind
perceives the world around it. The brain must digest information in a way to simplify
data and stimuli that would otherwise be infinitely complex and confusing. The basic
structure of the system is in the form of a network of components which interact via the
transmission of electrical impulses. The sensory order is a classification that takes place
via a network of impulse connections. The essence of Hayek’s attempt in theoretical
psychology is to show how a structure can be formed which discriminates between dif-
ferent physical stimuli and generates the sensory order that we actually experience.2 The
sensory order is a system of qualities that do not simply represent physical properties of
the external world. The sensory order is even an incomplete and imperfect representation
of the physical world. The subjectivity of individual knowledge finds its foundation in
the construction of the mind. Through learning and updating, the sensory order evolves
into a gradual approximation of the physical order. The mind operates by assembling new
sensory data into associations with our accumulated inventory of knowledge. Knowledge
is forged by the connection of new sensory information to previous sensory experiences.
People form expectations of future events by recalling what has followed in the past after
the type of events they now perceive around them. After the processes of interpreting their
perceptions, individuals have to think of alternative courses of action and of probable
consequences in each of the alternatives. Individuals then try to do the same in a given
situation by acting in a way that has proved to produce satisfying outcomes in similar
situations of the past.
Hayek’s (1952) ‘map’ provides a framework for evaluating impulses; it is an apparatus
by means of which we learn about the external world. Experience shapes the map. The
map represents the individual’s past. The map ‘is formed by connections capable of trans-
mitting impulses from neuron to neuron’ (Hayek 1952, p. 115). Operating within the map
is a dynamic and changeable ‘model’. The model is ‘the pattern of impulses which is traced
at any moment within the given network of semi-permanent channels’ (Hayek 1952,
p. 114). The map is similar to a set of implications waiting to happen, and the model pulls
out the implications relevant to the current environment from this set. The model refers
to the current interpretation of the environment. The map–model structure is subject to
continuous change and can be updated. As a person learns, a new interpretation of reality
takes over the old interpretation through re-classification. The brain is an adaptive system
interacting with and adapting to its environment by performing a multi-level classification
on the stimuli it receives from the environment.
Individuals in the real world are often ignorant of the consequences of their choices.
However, they may form expectations of future events and make good decisions on the
basis of beliefs in the correctness of their expectations. An agent makes a decision by
assessing past situations that resemble those in question right now and by recalling the
consequences of acting in each of them. The agent compares any particular instance with
a large number of different sets of cases that he or she has experience of, each having some
qualities of relevance to the current case. Each case can produce a tendency to a kind of
action. As Hayek (1978) suggests:
The important point is that only very rarely if ever will a single signal sent out from the highest
levels of the nervous system evoke an invariable action pattern, and that normally the particular
sequence of movements of particular muscles will be the joint result of many super-imposed dis-
positions. A disposition will thus, strictly speaking, not be directed towards a particular action,

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but towards an action possessing certain properties, and it will be the concurrent effect of many
such dispositions which will determine the various attributes of a particular action. A disposi-
tion to act will be directed towards a particular pattern of movements only in the abstract sense
of pattern, and the execution of the movement will take one of many different possible concrete
forms adjusted to the situation taken into account by the joint effect of many other dispositions
existing at the moment. (Hayek 1978, p. 40)
The mind is an order of relations. At the level of neurons in the brain, the classification of
primary sensory impulses, and further impulses they evoke, can take place on many suc-
cessive levels. As a result of the multiple classification process, the human mind produces
a highly complex mental order.
There are three parallels between Hayek’s cognitive and institutional theories (Wenzel
2010). First, knowledge is limited. The sensory order is an imperfect representation of
the physical order. Second, learning at the cognitive level and generation of knowledge
are important. The mind updates its understanding of the environment. Third, knowl-
edge has a social dimension. Much of our understanding of the world comes through the
human mind. In addition, the mind learns from its environment. Much of our knowledge
is thus embedded in institutions, norms, and custom. According to Hayek (1948), the
knowledge that an individual can possess is dispersed, and each person can just possess
a little piece of all the knowledge available in society. The dissemination of knowledge
is crucial in society. Interactions of people in society make adaptation possible. At an
individual level, actions are based on subjective perceptions of what exists. However, a
correspondence between individual actions and an overall order is inherently problematic.
People live in a world of expectations about interactions with others’ actions. Interactions
between people in society make adaptation possible. If the fragments of knowledge exist-
ing in different minds were justified true beliefs, there could be no need for their resolu-
tion via coordination. Dispersed knowledge required for coordination can be facilitated
by a set of inter-subjectively shared rules. Individuals learn and act upon the information
that is dispersed throughout institutional environments. Social coordination requires
institutional structures that encourage the use of dispersed knowledge. Human action is
purposeful in the sense that individuals attempt to reach their goals. It is meaningful to
discuss the social order only when all agents share the same perception of existing reality
which includes others’ actions.
North (2005) interprets Hayek’s approach to institutions as closely connected to his
theory of mind. For Denzau and North (1994) and North (2005), individuals construct
mental models to interpret and produce expectations about their social environment. That
is, Hayek’s mental ‘map’ is the ‘mental models’ as used by Denzau and North (1994) and
North (2005) to justify the importance of institutions. In order to avoid confusion, we use
‘mental models’ to refer to Hayek’s ‘map’. All experiences are organized from particular
points of view. Owing to the variety of mental models, there are multiple possible fram-
ings of any given situation. There are different consequences depending on the way people
frame the situation. Mental models might be hypothetical constructs of a certain set of
experiences, through which individuals process information.

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4 CULTURE
Human actions are imprinted by their history in a way. Culture refers to the set of learned
traditions and living styles, shared by the members of a group. Conceptualization of
culture varies across disciplines. A broad definition of the term culture is provided as
follows: ‘Cultures are patterns of behavior, thought and feeling that are acquired or
influenced through learning and that are characteristics of groups of people rather than
individuals’ (Harris 1971, p. 136). Culture includes the specific ways of thinking, feeling,
and behaving of a group. Culture, as a system of shared beliefs, provides collective under-
standings in forming people’s choices.
According to Richerson and Boyd (2005), culture is ‘information’ capable of affecting
individuals’ behavior that they acquire from others through teaching, imitation, and other
forms of social transmission. The term ‘information’ means any kind of mental state,
conscious or not, that is acquired or modified by social learning, and affects behavior.
Social learning is the mechanism whereby information is transmitted. For Richerson and
Boyd (2005), the most basic type of micro-event in cultural evolution is the adoption by
an individual of some cultural variant. The collective phenomenon of culture is taken to
be the evolving outcome of the aggregation of these micro-events.
The existence of culture presupposes a population capable of mental representations.
People are likely to perceive bits of information that are germane to existing schemata ‒
knowledge structures that represent objects or events and provide default assumptions
about their characteristics, relationships, and entailments under conditions of incomplete
information (DiMaggio 1997). People experience culture as schematic structures that
organize that information. As suggested by Denzau and North (1994, p. 15), culture may
be regarded as ‘encapsulating the experiences of past generations of any particular cultural
group’. Culture collectively accumulates partial solutions to frequently encountered prob-
lems of the past and works as a filter for processing and interpreting new sensory data.
Culture can be understood as heterogeneous and changeable. There is cultural varia-
tion in the way people think about themselves and about other agents. These differences
are responsible for differences in the way people behave. Cultural differences are, to a
large extent, due to environmental differences. Therefore, patterns of social interactions
affect the structure of cultural systems. Axelrod (1997) argues that culture is taken to be
what social influence influences. In Axelrod (1997), two groups that are already cultur-
ally similar are more likely to interact and, therefore, to be even more culturally similar.
Alternatively, two neighboring groups with zero cultural similarity are unlikely to inter-
act and, therefore, will have no tendency to be more culturally similar. The emergence
of conventions can be accelerated if the population has a neighborhood structure, and
individuals adjust their behavior over time by imitation within their own neighborhood.
Humans acquire large parts of their behavioral repertoire via forms of social learning
(basically imitation). Understanding how people learn from others is important not only
for understanding individual decisions, but also for comprehending patterns of change
and variation among human groups.
Differences among individuals can exist because they acquire different behavior as a
result of some form of social learning. Henrich (2004) proposes culture as the mechanism
reducing ‘intra-group’ differences and maintaining ‘inter-group’ differences, by biasing
individuals in favor of copying the common beliefs. As Henrich (2004) suggests, cultural

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evolution is likely to proceed much more rapidly than genetic evolution because cultural
transmission can spread novel behavior, ideas, and practices among populations within
a single generation. The transmission of culture involves learning from others. Once a
cultural trait is acquired and internalized, it tends to direct actions without significant
cognitive effort or reflection.
Individual actors’ expectations and actions somehow seem to achieve the quite remark-
able level of coordination regularity witnessed in many aspects of social life. Culture
coordinates the expectations of many agents about the actions, and it shapes and struc-
tures our daily patterns of behavior, guiding much of what we should do by prescribing
what behavior is acceptable. Agents who belong to the same cultural group are exposed
to the same external representation of knowledge, which produces shared mental models.
Culturally shared mental models expedite the process by which people learn directly from
experiences, and facilitate communication between people. Culture thus provides shared
collective understandings in shaping individuals’ actions.
Path dependence includes features such as persistency and lock-in. Arthur (1989)
explains increasing returns in technology by using a model of path dependence.3 North
(1990) applies increasing returns arguments to institutions more broadly. Established
institutions generate powerful inducements that reinforce their own stability. Path
dependence in the evolution of belief systems results from a ‘common cultural heritage’
which ‘provides a means of reducing the divergent mental models that people in a society
possess and constitutes the means for the intergenerational transfer of unifying percep-
tions’ (North 2005, p. 27). Cognition may have more subjective aspects, while culture
enables individuals to develop inter-subjectively shared mental models. Societies that
are more complex than tribal communities are characterized by different and compet-
ing interpretations of the social environment. Because culture reflects habituation which
individuals acquire in their group, it is slow to change. Some individuals are resistant to
altering their belief systems and hence the resulting behavior. Belief systems are the ideas
and thoughts common to individuals that govern social interaction. Thus, different cul-
tures may imply different belief systems.
Traditions and customs have evolved and are upheld in social interactions. Individuals
in the real world are often ignorant of the consequences of their choices. However, they
may form expectations of future events and make good decisions on the basis of beliefs
in the correctness of their expectations. For Hayek (1973), one of the main characteristics
of human behavior consists of following rules of conduct. We can understand the actions
of others who are equipped with similar systems for producing action patterns:
The question which is of central importance as much for social theory as for social policy is thus
what properties the rules must possess so that the separate actions of the individuals will produce
an overall order. Some such rules all individuals of a society will obey because of the similar
manner in which their environment represents itself to their minds. Others they will follow
spontaneously because they will be part of their common cultural tradition. But there will be
still others which they may have to be made to obey, since, although it would be in the interest
of each to disregard them, the overall order on which the success of their actions depends will
arise only if these rules are generally followed. (Hayek 1973, p. 45)
Rules of conduct are shared by individuals having a common cultural tradition. ‘This
matching of the intentions and expectations that determine the actions of different indi-

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viduals is the form in which order manifests itself in social life’ (Hayek 1973, p. 36). If
people have widely divergent expectations, some of their actions will invariably fail and
need to be revised. Culture limits the range of actions that people are likely to take in
a particular situation, making their conduct more predictable and thereby facilitating
the formation of reliable expectations. Shared mental models can give rise to behavioral
regularities, to the extent that they can be observed in the population. As a consequence,
following rules of conduct mutually reinforces sets of expectations to maintain a degree of
social order. Patterns emerge endogenously, reflecting a socially constructed reality. Given
the human need for rules, there is a tendency to repeat those patterns as a guideline for
action in future instances of similar behavior.
In real life, people are skilled at coordinating their actions. This is because there are
attractors for their strategies. Schelling (1960) has developed the study of mechanisms
allowing people to coordinate. Schelling’s focal-point idea is important as an explanation
of how players coordinate. Each member of the population expects every other member
to behave in accordance with the relevant regularity. A shared vision of what should be
obvious to each player leads to the emergence of a focal point. Individuals may be aware
of convergent expectations indicating where the focal points are settled. By harmonizing
expected responses, focal points reduce uncertainty despite the presence of imperfect
information, enabling individuals to coordinate their activities towards the achievement
of their goals (Leeson et al. 2006).
Lewis (1969) has given more formal structure to characterize coordination problems.
In pure coordination games, individuals’ interests roughly coincide. In general, in order to
have a sufficient reason for choosing a particular action, an agent needs to have a sufficient
degree of beliefs that the other agent will choose a certain action. For Lewis (1969, p. 36),
coordination may be achieved with the aid of ‘concordant mutual expectations’ about
action. Past experience of a convention, or ‘precedent,’ is the source of such expectations.
5 CULTURAL EVOLUTION
Many traditional rules suppress our behavior, and may well seem irrational to us. A rule
suppressing some behavior will be effective only if people generally expect others to act in
a way which makes it effective. ‘Most of the steps in the evolution of cultures were made
possible by some individuals breaking some traditional rules and practicing new forms of
conduct – not because they understood them to be better, but because the groups which
acted upon them prospered more than others and grew’ (Hayek 1979, p. 161). As Hayek
(1976) put it:
There are, undoubtedly, many forms of tribal or closed societies which rest on very different
systems of rules. All that we are here maintaining is that we know only of one kind of such systems
of rules, undoubtedly still very imperfect and capable of much improvement, which makes the
kind of open or ‘humanistic’ society possible where each individual counts as an individual and
not only as a member of a particular group, and where therefore universal rules of conduct can
exist which are equally applicable to all responsible human beings. (Hayek 1976, p. 27)
Hayek’s (1988) concept of the ‘extended order’ refers to the process by which a human
society develops the capacity to cope with increasing degrees of complexity. The growing

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complexity is built on the foundations of social rules that coordinate the disparate inter-
ests, actions, and knowledge of individuals across society. Coordination of groups larger
than hunting and gathering bands requires cultural evolution of learnt rules of conduct.
In cultural evolution, the things getting varied or retained are not genes, but ways of
acting. Rules cannot be constructed in a discretionary manner outside a particular his-
torically grown order. They emerge in evolutionary processes which are not guided by
explicit reason.
According to Hayek (1988, p. 25), ‘cultural evolution operates largely through group
selection’. The concept of group selection is a weak point in Hayek’s system of ideas
(Sugden 1993). It is the idea that cultural traits and behavioral features are naturally
selected on the basis of advantages and disadvantages for the groups of people who
practice them. The theory of group selection implicitly assumes that specific conventions
are tied to specific social groups. Thus, a convention can spread only as a consequence of
the expansion of the social group to which it belongs. The main criticism is that Hayek’s
analysis of cultural evolution that operates at the group level is inconsistent with his
methodological individualism (Vanberg 1986). Vanberg (1986) defines methodological
individualism as the guiding principle that aggregate social phenomena can be and should
be explained in terms of individual actions, their inter-relations, and their (largely unin-
tended) combined effects.
In Hayek’s theory of cultural evolution, however, societies are not only subject to group
selection but have developed through a process in which individuals choose the rules that
form the social order (Gick and Gick 2001).4 ‘Individual selection refers to the perception
of rules that are slightly different from already existing ones and hence leads to the crea-
tion of new rules’ (Gick and Gick 2001, p. 156, original emphasis). In the evolutionary
process, there is no central mechanism which coordinates a shift in the rules perceived
by individuals. New rules undergo some kind of decentralized selection process, as a
consequence of which some spread through the population. The role of individuals is
necessary to innovate practices. That is, individual minds conceive of problems and new
ways to solve those problems, and individuals choose whether or not to follow a new
rule. Cognition takes place by structuring individual minds in social context, and systems
of rules literally ‘epitomize’ the cognitive capabilities of humans that evolve socially.
‘Individual action and social emergence of rules appear to be two sides of the same coin:
the mind’ (Rizzello and Turvani 2002, p. 199).
As individuals interact with members of the other group, they may learn how to behave
from those other cultural members. Then, individuals become connected and integrated
into larger social networks. Alternatively, a particular form of culture may lead to social
connections that are sustained by a restricted form of social ties. Institutional change is
an endogenous phenomenon that starts in the mind of individuals. Individuals may coor-
dinate to new behavioral patterns, realizing an inconsistency between following original
rules and the expected results from their action plans. Individual behavior in the same
group shows a high degree of similarity because of common perception of the environ-
ment. Human action obeys action plans made by individuals in accordance with their
mental models. To trade with agents in the other group needs the establishment of new
sets of rules. While people want to follow their original conventions, new sets of rules may
enhance social interactions and facilitate economic exchanges. Once the different courses
of actions have been desirable to their goals, people select some of them.

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Changes are caused by the violations of original practices and the development of
new ones. In the beginning, individuals face the choice of whether or not to support a
change in existing rules. The expected costs and benefits associated with institutional
change (change in rules) play an important role. The original conventions constrain the
repertoire of possible reactions to changes in the environment. Information on expected
benefits from alternative sets of rules and the costs of changing existing rules affect the
likelihood of institutional change. Individuals may modify their mental models and alter
their perceptions of the effects of alternative rules. Shifts in mental models change indi-
viduals’ action plans, which in turn leads to cultural evolution. Cultural evolution is an
endogenous phenomenon with a cognitive dimension.
In the first instance, the sensory representation of the environment, and of the possible goal to be
achieved in his environment, will evoke a movement pattern generally aimed at the achievement
of the goal. But at first the pattern of movement initiated will not be fully successful. The current
sensory reports about what is happening will be checked against expectations, and the difference
between the two will act as a further stimulus indicating the required corrections. The result of
every step in the course of action will, as it were, be evaluated against the expected results, and
any difference will serve as an indicator of the corrections required. (Hayek 1952, p. 95)
Hayek’s cognitive theory provides an account of a particular adaptive classifier system

that produces a classification over a field of sensory inputs. Individual knowledge is the
adaptive response based on the classification the brain has generated. Hayek explicitly
points to the mind–institution link. Perception involves the capacity to identify regulari-
ties or patterns. Cognitive activity functions as a mechanism of adaptation. Expectations
are formed endogenously by virtue of an individual adapting behavior to achieve a closer
fit with external reality. Therefore, expectations will ordinarily correspond with rules of
conduct geared toward an individual’s successful adaptation to the environment. Even
though some rules of conduct are given and known, they may not be followed in the dual
processes of cultural and individual changes that take place as a result of contact between
different cultural groups. Coordination of these groups requires individual selections of
rules of conduct. The evolution of the order of actions, which can yield new rules, can lead
to corresponding changes in the mind. Then the mind will rearrange sensory experiences
into new configurations that allow better predictions to be made about social reality. The
criterion of fitness is confirmation of expectations as indicated by the success of indi-
vidual actions. Expectations more consistent with social reality give an advantage to the
individuals holding them. Players’ new action choices based on such expectations generate
satisfactory payoffs, and a new pattern of plays of the game becomes collectively recog-
nized as the way the game is now being played. Thus, the key story is as follows: perceived
social reality S mental models S actions S payoffs S altered perceived social reality. It is
a discovery procedure where there are unexploited opportunities in the form of new rules.
Cultural evolution is the result of an interaction between individuals’ perceptions
of alternative rules and their action plans according to these rules. The coordination
acts as an inter-subjective learning procedure in which various ideas dispersed among
individuals are constantly tested against one another. New rules are discovered and
disseminated through decentralized adjustment processes. Any agent will discover only
opportunities related to his or her own prior knowledge. To some extent, the concept of
ignorance accounts for the gap between the opportunities available in society and the

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opportunities perceived by individual agents. The gap exists because of the dispersion
of knowledge between agents who are considered to be subjective. The discovery of
opportunities can be considered as the perception of a new framework about how to
adapt in particular contexts. The agent’s ability to identify opportunities depends upon
his or her subjective understanding of environment conditions. As individuals gain
new experiences and update their stock of knowledge, those ways of doing things will
crystalize over time into institutions where new specific meanings are derived from the
interactions between the parties involved. Mental models can be modified by feedback
from altered perceived reality as a consequence of people’s altered actions. A key to
understanding cultural evolution is an understanding of how individuals modify their
mental models.
6 CONCLUSION
This chapter has argued that there is a relationship between the sensory order and the
social order. Hayek’s theory of mind can shed light on the process of choice. Individuals
build up an understanding of the world based on their views of that world. The sensory
order is fundamental in the sense that the explanation of social order begins with the
human mind (Teraji 2014). This is illustrated through ideas relating to understanding
culture from a cognitive viewpoint.
For Hayek, the mind is a weave of old and new sensory data in a network of connec-
tions. A classification takes place via a network of impulse connections. There are limits
to what individuals can know, and the sensory order within the mind is an imperfect
representation of the physical order. The central element in the cognitive process is the
feedback between individual and environment. The mind updates its understanding of
the environment.
In Hayek’s social theory, the single individual, without rules and ties, would lose
common understanding. Coordination of groups requires cultural evolution of learnt
rules of conduct. This chapter draws on ideas of co-evolution of individuals’ mental
models and their actions. Shifts in mental models change individuals’ action plans, which
in turn leads to cultural evolution. Thus, a key to understanding cultural evolution is an
understanding of how individuals modify their mental models. Cultural evolution is an
endogenous phenomenon with a cognitive dimension.
NOTES
1. Some researchers (Butos and Koppl 1993; Streit 1993; Rizzello 1999; Caldwell 2000, 2004; Horwitz 2000)
argue that Hayek’s cognitive theory spilled over to his later work on political and social theory.
2. For further discussions of Hayek’s cognitive theory, see his essay ‘Rules, perception and intelligibility’
(Hayek 1967, pp. 43–65).
3. In a world of increasing returns to scale, initial and trivial circumstances can have important and irreversible
influences on the ultimate market allocation of resources. An inefficient outcome can persist. The form of
path dependence conflicts with conventional economics, where efficient outcomes are attained. Switching
cost must include the uncertainty concerning the cost of adopting the superior technology. It would be more
efficient to adhere to the current technology than switch to the superior one.
4. Vromen (1995) presents a reinterpretation of Hayek’s statements on cultural evolution in individualistic

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terms. When Hayek uses the term ‘group,’ it should really be read as ‘order’. This reinterpretation allows
for individual processes of not only between-group migration but also between-group imitation and within-
group imitation.
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PART VIII
MORALS AND ETHICS

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31 Rational choice in public and private spheres
Herbert Gintis
1 INTRODUCTION
Behavioral economics has doubtless been one of the most important innovations in eco-
nomic theory ever. One strand of this theory, however, has gone seriously beyond the pale
in interpreting the results of experiments, arguing that human subjects are systematically
irrational (Ariely 2010). In virtually every case, however, it is not people who are defi-
cient in rationality but rather experimenters who apply inappropriate models of human
decision-making (Gintis 2009). Our theoretical task is to develop new models of personal
and social rationality that explain the observed behavior. In this chapter I approach this
task by developing a rational model of voting behavior in democratic elections.
2 THE IRRATIONALITY OF THE CLASSICAL RATIONAL

ACTOR VOTING MODEL
Estimates of the probability that a single voter’s decision will determine the outcome of a
large election are between 1 in 10 million and 1 in 100 million (Gelman et al. 1998). In a
compendium of close election results in Canada, Great Britain, Australia, and the United
States, no election in which more than 40 000 votes were cast has ever been decided by
a single vote. In the Massachusetts gubernatorial election of 1839, Marcus Morton won
by two votes out of 102 066 votes cast. In the Winchester, UK, general election of 1997,
Mike Oaten won by two votes out of 62 054 votes cast. The result was annulled and in a
later by-election, Oaten won by 21 000 votes. In smaller elections, a victory by a very small
margin is routinely followed by a recount where the margin is rarely less than 25. There is
thus virtually no loss in accuracy in modeling voting behavior in large elections as purely
non-consequential in the sense that a single individual’s decision to vote or abstain, or
for whom to vote, has no effect on the outcome of the election (Downs 1957a; Riker and
Ordeshook 1968).
By a canonical participant in a decision process I mean an individual whose choice
is non-consequential: his or her behavior affects the outcomes infinitesimally or not at
all. According to the data presented above, voters in a large election are canonical par-
ticipants. Individuals who participate in a large collective action are similarly canonical
participants, as are those who volunteer to fight or otherwise contribute to one side
in a war between nations. There are some public-sphere activities that are potentially
consequential and hence non-canonical, such as running for office, organizing a voter
registration drive, or contributing considerable amounts of money to a particular party
or candidate, but most activities in the public sphere are virtually non-consequential, and
hence canonical. Ignoring the infinitesimal probabilities that canonical participants affect
outcomes is a useful and harmless simplification, akin to ignoring the force of gravity in
543
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analyzing the electronic circuitry of a computer or ignoring the light from distant stars in
calculating the effectiveness of a solar panel.
The private sphere is the locus of everyday transactions in civil society. The public
sphere is the locus of canonical and consequential political activities that create, main-
tain, and transform the rules of the game that define society itself. The private and public
spheres are interrelated in individual decision-making. A public-sphere transaction may
have private-sphere costs and benefits that a canonical participant in the public sphere
may take into account in deciding how to act. For instance, an individual may not vote
if queues at the polling station are very long, or may decide to skip a collective action in
which the probability of physical harm is very high.
Non-consequential public sphere activities are at the center of the structure and dynam-
ics of modern societies. If citizens did not vote, or voted in an uninformed and random
manner, liberal democratic societies could not operate. Moreover, modern liberal democ-
racy was achieved through collective actions over centuries. These collective actions have
been successful because of the collective impact of canonical participants who incurred
significant personal costs, often death, in opposing illegitimate authority.
Canonical participants consider their behavior as rational goal-oriented behavior. If
you ask people in a queue at the polling booth why they are standing there, or if you ask
a group protesting political corruption why they are chanting and holding signs, they
will think the question absurd. They are there, of course, to register their support for
various candidates for office, or to help topple a corrupt government. If you point out
to canonical participant Alice that her personal contribution will make no difference to
the outcome, Alice will likely respond that you are guilty of faulty reasoning because if
everyone followed your reasoning, no one would vote and no one would fight to topple a
corrupt regime. If you persist in asking why Alice personally votes, noting that the other
participants do not follow your (faulty) reasoning, and Alice’s abstention will not affect
the decision of others, Alice may well judge you mentally ill, unless she realizes that your
concept of rationality conforms to the classical axioms of rational choice theory (Savage
1954), while the behavior of canonical participants in the public sphere does not. Indeed,
canonical participants are rational, pace the Savage axioms, in the sense their behavior
does determine who is elected, and may determine whether a corrupt regime is or is not
toppled.
How, then, might we account for rational, non-consequential behavior? One possible
answer is that people believe their public sphere behaviors are consequential even when
they are not, so they act as though their actions effectively determine the outcome, at least
with some substantially positive probability. From my reading of the literature on canoni-
cal political behavior, this is the most common, though rarely explicitly stated, assump-
tion. For instance, Duncan Black’s famous median voter theorem (Black 1948) implicitly
assumes that a self-interested citizen will vote and this vote will register his personal
preferences. Similarly, Anthony Downs, a pioneer in the application of the rational actor
model to political behavior (Downs 1957a) describes his model as follows: ‘Every agent
in the model—whether an individual, a party or a private coalition, behaves rationally at
all times; that is, it proceeds toward its goals with a minimal use of scarce resources and
undertakes only those actions for which marginal return exceeds marginal cost’ (Downs
1957b, p. 137). Yet, almost immediately after stating this assumption, he writes: ‘[We
assume that] voters actually vote according to (a) changes in their utility incomes from

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Rational choice in public and private spheres 545
government activity and (b) the alternatives offered by the opposition’ (Downs 1957b,
p. 138).These two assumptions are compatible only if agents believe that their votes are
consequential.
However, canonical participants generally do not believe that their behavior is con-
sequential. For instance, Enos and Fowler (2010) report a study in which the median
respondent to the question as to the chance their vote will change the outcome of a presi-
dential election gave the answer 1 in 1000, which although small, is in fact too large by a
factor of at least 10 000. The authors write: ‘However . . . over 40% of regular voters know
that the chances of a pivotal vote are less than one in a million. . ..[Moreover], the less
likely you are to think your vote will actually matter, the more likely you are to vote’ (Enos
and Fowler 2010). Thus, although voters behave strategically (Fedderson and Sandroni
2006), they know that their behavior is non-consequential (Edlin et al. 2007; Hamlin and
Jennings 2011).
Another possible answer is that people consider voting a social obligation, or they
consider themselves part of a ‘team’ dedicated to a particular cause, and not voting is
an unethical act of free-riding on the altruism of others. Doubtless some individuals are
so motivated, but it then must also be a social obligation to vote intelligently and non-
randomly. This notion would be perhaps plausible if one vote made a difference, but
it is surely a bizarre social obligation for a non-consequential action. Moreover, many
individuals consider being politically literate and voting as a positive contribution to their
well-being rather than an onerous duty, and it is these individuals that render a liberal
democracy possible and effective. Finally, committed canonical participants often become
angry with or annoyed by friends who vote differently from themselves, even though they
realize that their friends’ behavior is non-consequential.
A third possibility is that many voters are altruistic and vote out of concern for the well-
being of others who will be affected by the outcome of the electoral process. Although if
voting is non-consequential, a single voter cannot affect the well-being of others, in this
case, where there may be many millions of others, the 1 in 10 million or 1 in 100 million
chance of changing the outcome of the election, when multiplied by the number of people
thereby affected, becomes a significant quantity. Certainly, however, no voter thinks in
this bizarre way, and many canonical participants have interests that are far narrower than
the citizenry as a whole, and often act to promote the interests of one group of citizens
at the expense of another. Indeed, it is common to hear a small group of voters deemed
‘selfish’ because they promote their own parochial interest above the good of society as
a whole.
To model the rationality of the canonical participant in the political sphere, we must
revise the standard axioms of rational choice (Savage 1954). In a related paper, I have
explored the implications of replacing Savage’s assumption that beliefs are purely per-
sonal ‘subjective probabilities’ with the notion that the individual is generally embedded in
a network of social actors over which information and experience concerning the relation-
ship between actions and outcomes is spread. The rational actor thus draws on a network
of beliefs and experiences distributed among the social actors to which he is information-
ally and socially connected. By the sociological principle of homophily, social actors are
likely to structure their network of personal associates according to principles of social
similarity, and to alter personal tastes in the direction of increasing compatibility with
networked associates (McPherson et al. 2001; Durrett and Levin 2005; Fischer et al. 2013).

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To this principle of distributed cognition we may add a principle of distributed inten-

tionality in which canonical participants consider their actions as effective contributions
to social outcomes when they do their part as a member of a network of loosely linked
individuals with consonant objectives distributed across the network. In this framework,
the behavior of a canonical participant is not a costly choice with no benefits, but rather
a voluntary, costly but personally enriching, participation in a collective effort. With this
notion in place, a theory of canonical participant behavior must elucidate how individual
preferences over political outcomes are formed, and how agents trade off between public
and private sphere objectives.
The principle of distributed intentionality appears closely related to the notions of
team reasoning and team intentionality as developed in an extensive philosophical and
economics literature (Bacharach 1987, 1992, 2006; Gilbert 1987, 1989; Bratman 1993;
Searle 1995; Tuomela 1995; Hurley 2002; Sugden 2003; Colman et al. 2008). However,
the behavior explored in these contributions is generally socially structured cooperation
and collaboration, in which actions are highly consequential. We approach the problem
of distributed intentionality by considering canonical participation as a form of moral
behavior.
3 BEHAVIORAL MORALITY
Behavioral morality is the set of moral rules we attribute to people by virtue of their
actions. We contrast this with normative morality, the set of rules that philosophers
consider that moral individuals are obliged to obey. The content of both behavioral and
normative morality are contested, and the appropriate relationship between the two is
complex. I deal with behavioral morality alone.
Traditional social science embraces a rather straightforward understanding of the
relationship between human biological evolution and behavioral morality. This is the
venerable notion of tabula rasa (Tooby and Cosmides 1992; Pinker 2002), according to
which the brain is empty at birth but filled with moral principles through social learning.
This idea is famously expressed by Thomas Hobbes (1651 [1968]), who writes: ‘The state
of men without civil society (which may be called the state of nature) is nothing but a war
of all against all . . . Where every man is enemy to every man, the life of man is solitary,
poor, nasty, brutish, and short.’
We find the same sentiment some three centuries later in the prominent biologist
Richard Dawkins (1976), who writes: ‘We are survival machines–robot vehicles blindly
programmed to preserve the selfish molecules known as genes . . . Let us try to teach
generosity and altruism, because we are born selfish’ (original emphasis). Morality, then,
is an elaborate veneer hiding our basically selfish natures.
A more plausible approach to behavioral morality is based on evolutionary biology, the
rational actor model and experimental game theory. The basic principles are:
● Behavioral morality is the product of an evolutionary dynamic extending over

hundreds of thousands of years in the hominin line involving the interaction of
genes and culture.
● In this dynamic, hominin societies transformed culture, and the new culture made

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new behaviors fitness-enhancing, transforming the gene pool of the hominin line
itself. Thus, gene-culture coevolution: in humans, genes are the product of culture
and culture is the product of genes.
● Behavioral morality, in particular, is predicated upon a set of human, on balance
prosocial, evolved predispositions inherited from our experience in small-scale
hunter-gatherer societies.
● At some point our ancestors began to devise games and play according to their
agreed-upon rules. It then became possible to conceive of society itself as a social
game, the rules of which are determined in a new arena of social life, which we have
called the public sphere.
● Humans thus evolved two modes of social behavior, a private persona of personal
preferences, located within social networks of distributed cognition and intentional-
ity, regulating everyday life in civil society, and a public persona of personal prefer-
ences, again rooted in social networks of distributed cognition and intentionality,
regulating their behavior in the public sphere.
● At the heart of our moral capacities, both as private and public persona, is the
capacity to conceptualize a higher moral realm that leads us to protect social values,
to feel satisfaction at ‘doing the right thing,’ and to feel degraded when we have not
done the right thing.
4 SELF-REGARDING, OTHER-REGARDING, AND

UNIVERSALIST RATIONAL ACTION
Rational actors exhibit three types of motives in their daily lives: self-regarding, other-
regarding, and universalist. Self-regarding motives include seeking personal wealth,
consumption, leisure, social reputation, status, esteem, and other markers of personal
advantage. Other-regarding motives include valuing reciprocity and fairness, and con-
tributing to the well-being of others. Universalist motives are those that are followed for
their own sake rather than for their effects. Chief among universalist goals are character
virtues, including honesty, loyalty, courage, trustworthiness, and considerateness. In the
private sphere such universalist goals have consequences for those with whom we interact,
and for society as a whole. However, we undertake universalist actions for their own sake,
beyond any consideration of their effects.
Agents will generally trade off among these various motives. For instance, being honest
may be personally costly or reputationally rewarding, and may either hurt or benefit
others whose well-being we value. Universalist motives thus do not reduce to self- or
other-regarding motives, but they do trade off against these other motives.
Self- and other-regarding behavior is well documented in the literature, but universalist
behavior is far less so. I present an example, as revealed by laboratory experiments using
experimental game theory.
4.1 The Universalist Principle of Honesty
Universalist moral actions are performed, at least in part, because it is virtuous to do so,
apart from any effects these actions have on yourself, others, or society in general. For

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instance, we can be honest in dealing with another agent without caring at all about the
effect on the other agent, or even caring about the impact of honest behavior on society
at large. Similarly, we can be courageous in battle because it is the right thing to do, inde-
pendent from the effect of one’s actions on winning or losing the battle. Of course, the
value of honesty in a transaction may be lessened or turned negative if it is personally
costly or it harms others about whom one cares.
Many studies have shown that people exhibit considerable degrees of honesty even
when this is costly and there is no chance that they could be discovered cheating (Mazar
et al. 2008; Bucciol and Piovesan 2011; Houser et al. 2012; Shalvi et al. 2012; Cohn et al.
2014; Fischbacher and Follmi-Heusi 2014). A particularly clear example of the value of
honesty is reported by Gneezy (2005), who studied 450 undergraduate participants paired
off to play three games of the following form, all payoffs to which are of the form a; b,
where player 1 (Alice) receives a and player 2 (Bob) receives b. In all games, Alice was
shown two pairs of payoffs, A:(x; y) and B:(z; w) where x, y, z, and w are amounts of
money with x < z and y > w, so in all cases, B is better for Bob and A is better for Alice.
Alice could then say to Bob, who could not see the amounts of money, either ‘Option A
will earn you more money than option B,’ or ‘Option B will earn you more money than
option A.’ The first game was A:(5,6) versus B:(6,5) so Alice could gain 1 by lying and
being believed, while imposing a cost of 1 on Bob. The second game was A:(5,15) versus
B:(6,5) so Alice could gain 10 by lying and being believed, while still imposing a cost of 1
on Bob. The third game was A:(5,15) versus B:(15,5), so Alice could gain 10 by lying and
being believed, while imposing a cost of 10 on Bob.
Before starting play, the experimenter asked each Alice whether she expected her advice
to be followed, inducing honest responses by promising to reward her if her guesses were
correct. He found that 82 percent of Alices expected their advice to be followed (the actual
result was that 78 percent of Bobs followed their Alice’s advice). It follows that if Alices
were self-regarding, they would always lie and recommend B to their Bob.
The experimenters found that, in game two, where lying was very costly to Bob and the
gain to lying for Alice was small, only 17 percent of subjects lied. In game one, where the
cost of lying to Bob was only one but the gain to Alice was the same as in game two, 36
percent lied. That is, subjects were loath to lie, but considerably more so when it was costly
to their partner. In game three, where the gain from lying was large for Alice, and equal
to the loss to Bob, 52 percent lied. This shows that many subjects are willing to sacrifice
material gain to avoid lying in a one-shot, anonymous interaction, their willingness to lie
increasing with an increased cost of truth-telling to themselves, and decreasing with an
increase in their partner’s cost of being deceived. Similar results were found by Boles et al.
(2000) and Charness and Dufwenberg (2006). Gunnthorsdottir et al. (2002) and Burks et
al. (2003) have shown that a social-psychological measure of ‘Machiavellianism’ predicts
which subjects are likely to be trustworthy and trusting.
5 THE PUBLIC SPHERE
The social life of most species, including mating practices, symbolic communication, and
power relations, is expressed in genetically grounded stereotypical form (Alcock 1993,
Krebs and Davies 1997). Homo sapiens is unique in adapting its social life in highly flex-

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ible ways to environmental and social challenges and opportunities (Richerson and Boyd
2004). This flexibility is based on two aspects of our mental powers. The first is our ability
to devise new rules of social life, and to base our social interactions on these new rules.
This capacity, absent in other species, makes us Homo ludens, Man the game player. This
capacity is possessed even by very young children who invent, understand, and play games
for fun. In adult life, this same capacity is exercised when people come together to erect,
maintain, and transform the social rules that govern their daily transactions. Broadly
speaking, we can define the public sphere as the arena in which society-wide rules of the
game are created, evaluated, and transformed, and politics as the cooperative, conflict-
ual, and competitive behaviors through which rules are established and individuals are
assigned to particular public positions.
Humans evolved in hunter–gatherer societies consisting of a dozen families or so
(Kelly 1995), in which political behavior was a part of daily life, involving the sorts of
self-regarding, other-regarding, and universalistic motivations described above (Gintis et
al. 2015). In particular, political activity was strongly consequentialist: a single individual
could expect to make a difference to the outcome of a deliberation, a conflict, or a col-
laboration, so that our political morality developed intimately entwined with material
interests and everyday consequentialist moral sentiments (Boehm 1999).
In the transition from small-scale hunter–gatherer societies to modern mass societies
with millions of members, the public sphere passed from being closely embedded in daily
life to being a largely detached institutional arena, governed by complex institutions con-
trolled by a small set of individuals, and over which most members have at best formal
influence through the ballot box, and at worst no formal influence at all. Political activity
in modern societies has thus become predominately non-consequentialist.
Canonical participants in the public sphere appear to follow a non-consequentialist
logic that may be summarized as rule-consequentialism: in public life, choose a rule that
like-minded people might plausibly choose, and, if followed by all such like-minded
people, it will lead to the most desirable outcome (Harsanyi 1977; Roemer 2010; Hooker
2011). Rule-consequentialism explains why people are perfectly reasonable in assenting to
such assertions as ‘I am helping my candidate win by voting’ and ‘I am helping promote
democracy by demonstrating against the dictator’. Because rule-consequentialism is so
ingrained in our public persona, canonical participants untrained in traditional rational
decision theory simply cannot understand the argument that it is irrational to vote or to
participate in collective actions, even when they can easily be persuaded that their actions
are non-consequential.
Rule-consequentialism can also explain many stylized facts of voter behavior. First,
when the cost of voting increases, fewer people vote. The rule here is something like:
‘My unusual personal situation means voting would be very costly to me today. I would
not expect anyone in my position to vote, so I am comfortable with not voting.’ Second,
it explains why voter turnout is higher when the issues to be decided have greater social
impact. Third, it explains why turnout is higher when the election is expected to be close.
Finally, it explains why, in a two-party election, turnout is likely to be higher among
voters for the side that is not expected to win. Indeed, it is reasonable to speculate that
rule-consequentialism leads voters to act in very large elections in much the same way they
would in very small elections, although in very small elections consequentialist issues (for
example, self-interested) may trump the non-consequentialist rule.

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We conclude that the individual immersed in consequentialist everyday life expresses

his or her private persona, while his or her behavior in the public sphere reveals his or her
public persona. Individuals acting in the public sphere are, then, a different sort of animal,
which Aristotle called ‘zoon politikon’ in his Nicomachean Ethics.
6 PRIVATE AND PUBLIC PERSONA
The concept of a non-consequentialist public persona suggests a two by three categoriza-

tion of human motivations, as presented in Figure 31.1. In this figure, the three columns
represent three modes of social interaction. The self-regarding mode represents the indi-
vidual whose social behavior is purely instrumental to meeting his or her personal needs,
while the other-regarding represents the individual who is embedded in a network of sig-
nificant social interactions with valued others, and the universal represents the individual
who values moral behavior for its own sake. The two rows represent the agent’s private
persona of social relations in civil society, and the agent’s public persona of political rela-
tionships in the public sphere.
Homo economicus is the venerable rational selfish maximizer of traditional economic
theory, Homo socialis is the other-regarding agent who cares about fairness, reciproc-
ity, and the well-being of others, and Homo vertus is the Aristotelian bearer of non-
instrumental character virtues. The new types of public persona are Homo politicus who
behaves publicly just as Homo economicus does privately, while Homo parochialis votes
and engages in collective action reflecting the narrow interests of the demographic, ethnic
and/or social status groups with which he identifies. Finally, Homo universalis acts politi-
cally to achieve what he considers the best state for the larger society, perhaps reflecting
John Rawls’s (1971) veil of ignorance, John Harsanyi’s (1977) criterion of universality, or
John Roemer’s (2010) Kantian equilibrium.
Homo politicus is the political entrepreneur who acts purely to enhance his personal
stature and wealth. Curiously, the individual whose private persona is other-regarding
is generally considered altruistic, whereas the individual whose public persona is other-
regarding is often considered selfish and narrow-minded, acting in a partisan manner on
behalf of the specific interests of the social networks to which he belongs. Of course Homo
parochialis is in fact altruistic, sacrificing on behalf of these social networks.
Self-regarding Other-regarding Universalist

Private Homo Homo socialis Homo vertus
persona economicus
Public Homo Homo parochialis Homo universalis

persona politicus
Figure 31.1 A typology of human motivations

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7 THE EVOLUTIONARY EMERGENCE OF PRIVATE

MORALITY
By cooperation we mean engaging with others in a mutually beneficial activity.

Cooperative behavior may confer net benefits on the individual cooperator, and thus can
be motivated entirely by self-interest. In this case, cooperation is a form of mutualism.
Cooperation may also be a net cost to the individual but the benefits may accrue to a close
relative. We call this kin altruism. Cooperation can also take the form of one individual’s
costly contribution to the welfare of another individual being reliably reciprocated at a
future date. This is often called reciprocal altruism (Trivers 1971), although it is really just
tit-for-tat mutualism. However, important forms of cooperation impose net costs upon
individuals, the beneficiaries many not be close kin, and the benefit to others may not be
expected to be repaid in the future. This cooperative behavior is true altruism.
The evolution of mutualistic cooperation and kin altruism is easily explained.
Cooperation among close family members evolves by natural selection because the ben-
efits of cooperative actions are conferred on the close genetic relatives of the cooperator,
thereby helping to proliferate genes associated with the cooperative behavior. Kin altruism
and mutualism explain many forms of human cooperation, particularly those occurring
in families or in frequently repeated two-person interactions. But these scenarios fail to
explain two facts about human cooperation: that it takes place in groups far larger than
the immediate family, and that both in real life and in laboratory experiments, it occurs in
interactions that are unlikely to be repeated, and where it is impossible to obtain reputa-
tional gains from cooperating. These forms of behavior are regulated by moral sentiments.
The most parsimonious proximal explanation of altruistic cooperation that is sup-
ported by extensive experimental and everyday-life evidence is that people gain pleasure
from cooperating and feel morally obligated to cooperate with likeminded people. People
also enjoy punishing those who exploit the cooperation of others. Free-riders frequently
feel guilty, and if they are sanctioned by others, they may feel ashamed. We term these feel-
ings social preferences. Social preferences include a concern, positive or negative, for the
well-being of others, as well as a desire to uphold ethical norms (Bowles and Gintis 2011).
7.1 The Roots of Social Preferences
Why are the social preferences that sustain altruistic cooperation in daily life so common?
Early human environments are part of the answer. Our Late Pleistocene ancestors inhab-
ited the large-mammal-rich African savannah and other environments in which coop-
eration in acquiring and sharing food yielded substantial benefits at relatively low cost
(Boyd and Silk 2002). Human longevity, including an extended period of dependency of
the young, also made the cooperation of non-kin in child rearing and provisioning ben-
eficial (Hrdy 1999). As a result, members of groups that sustained cooperative strategies
for provisioning, child-rearing, sanctioning non-cooperators, defending against hostile
neighbors, and truthfully sharing information had significant advantages over members
of non-cooperative groups.
There are several reasons why these altruistic social preferences supporting cooperation
outcompeted amoral self-interest. First, human groups devised ways to protect their altru-
istic members from exploitation by the selfish. Prominent among these is the collective

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punishment of miscreants (Boyd et al. 2010), including the public-spirited shunning,

ostracism, and even execution of free-riders and others who violate cooperative norms.
Second, humans adopted elaborate systems of socialization that led individuals to
internalize the norms that induce cooperation, so that contributing to common projects
and punishing defectors became objectives in their own right rather than constraints on
behavior. Together, the internalization of norms and the protection of the altruists from
exploitation served to offset, at least partially, the competitive handicaps born by those
who were motivated to bear personal costs to benefit others (Gintis 2003).
Third, between-group competition for resources and survival was and remains a deci-
sive force in human evolutionary dynamics. Groups with many cooperative members
tended to survive these challenges and to encroach upon the territory of the less coopera-
tive groups, thereby both gaining reproductive advantages and proliferating cooperative
behaviors through cultural transmission. The extraordinarily high stakes of intergroup
competition and the contribution of altruistic cooperators to success in these contests
meant that sacrifice on behalf of others, extending beyond the immediate family and even
to virtual strangers, could proliferate (Turchin and Korotayev 2006; Choi and Bowles
2007; Bowles 2009).
Between-group competition accounts for the fact that humans are extraordinarily
group minded, favoring cooperation with insiders and often expressing hostility toward
outsiders. Boundary maintenance supported within-group cooperation and exchange by
limiting group size and within-group linguistic, normative and other forms of heterogene-
ity. Insider favoritism also sustained the between-group conflicts and differences in behav-
ior that made group competition a powerful evolutionary force (Choi and Bowles 2007).
In summary, humans have social preferences because in the course of our evolution as
a species, cooperation was highly beneficial to the members of groups provided they were
able to construct social institutions that compensated for the disadvantages of those with
prosocial preferences regarding fellow group members, while heightening the group-level
advantages associated with the high levels of cooperation that these prosocial preferences
generated. These institutions proliferated because the groups that adopted them secured
high levels of within-group cooperation, which in turn favored the groups’ survival as
biological and cultural entities in the face of environmental, military and other challenges.
8 THE EVOLUTIONARY EMERGENCE OF THE PUBLIC

PERSONA
Non-human species, even if highly social, do not engage in activities that structure the
social rules that regulate their lives. Therefore there is no politics and no public sphere in
these species, and hence its members have no public persona. How, then, might a public
persona with a prominent position for canonical participation have arisen in the hominin
line leading up to Homo sapiens?
In a related paper, Carel van Schaik, Christopher Boehm, and I (Gintis et al. 2015)
supply an answer grounded in the information available to us from a variety of fields,
including paleontology, primatology, the anthropology of contemporary hunter–gatherer
groups, animal behavior theory, and genetics. We propose that the emergence of bipe-
dalism, cooperative breeding, and lethal weapons (stones and wooden spears) in the

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hominin line, together with favorable climate change, made the collaborative hunting and
scavenging of large game fitness enhancing. Lethal weapons are the most unique of these
innovations, for other predators, such as lions, tigers and other big cats, wolves, foxes and
other canines, use only their natural weapons – sharp claws and teeth, powerful jaws and
great speed – in hunting, while none of these endowments was available to early hominins.
Lethal hunting weapons, moreover, transformed human sociopolitical life because they
could be applied to humans just as easily as to other animals.
The combination of the need for collaboration and the availability of lethal weapons
in early hominin society undermined the social dominance hierarchy characteristic of
primate and earlier hominin groups, which was based on pure physical prowess. The suc-
cessful sociopolitical structure that ultimately replaced the ancestral social dominance
hierarchy was an egalitarian political system in which lethal weapons made possible group
control of leaders – group success depended on the ability of leaders to persuade and
motivate – and of followers to contribute to a consensual decision process. The heightened
social value of non-authoritarian leadership entailed enhanced biological fitness for such
leadership traits as linguistic facility, ability to form and influence coalitions, and indeed
for hypercognition in general.
This egalitarian political system persisted until some 10 000 years ago when cultural
changes in the Holocene involving settle trade and agriculture entailed the accumulation
of material wealth, through which it became possible once again to sustain a social domi-
nance hierarchy with strong authoritarian leaders who could buy a modicum of protec-
tion and allegiance from well-rewarded professional soldiers and clansmen (Richerson
and Boyd 2001). Yet, despite the power of authoritarian states, the zoon politikon that
social evolution had nourished over tens of thousands of years was not erased by a few
thousand years of Holocene history. Indeed, the extremely high level of tribal and clan
warfare prevalent until recent centuries doubtless favored groups whose members con-
served the hunter–gatherer mentality of political commitment and the desire for personal
political efficacy (Pinker 2011).
9 CONCLUSION
This chapter has provided evidence for a model of human behavior based on the rational
actor model, in which individuals have both private and public persona, and their pref-
erences range over self-regarding, other-regarding, and universalist modes in both the
private and the public sphere. Morality in this model is defined in behavioral terms:
moral choices are those made in social and universalist modes. The public sphere in this
model is an arena where preferences and actions are primarily non-consequentialist. The
other-regarding preferences of Homo Socialis and the character virtues of Homo Vertus
are underpinnings of civil society, while Homo Parochialis and Homo Universalis make
possible the varieties of political life characteristic of our species.
This taxonomy of human motives has several important implications for a theory of
political behavior:
● Despite the ubiquity of the assumption that rational individuals have personal
interests which they register through electoral processes and collective actions, the

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notion is incoherent, ineluctably entailing faulty reasoning. Private persona indi-

viduals, whether Homo economicus, Homo socialis, or Homo vertus, will simply not
participate in such processes, and those who do are canonical participants whose
political preferences are constituted by the social networks in which they are embed-
ded as Homo parochialis, and the higher-level moral principles to which they adhere
as Homo universalis.
● Private sphere costs and benefits may play a large role in whether an individual par-
ticipates in electoral processes or collective actions, but they have little or no effect
on his electoral preferences or which collective actions he supports. Thus we should
not be at all surprised when abstract moral principles appear to trump economic
interests in individual economic decisions.
● The fact that the canonical participants are a mix of Homo parochialis and Homo
universalis explains why political movements are sensitive to issues of justice and
fairness and insensitive to issues of social efficiency when the latter conflict with
the former. For instance, voters typically care about corruption, workers’ rights,
graft, and unemployment but not rates of economic growth or measures of wealth
dispersion.
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32 Ethics and simple games
Mark Pingle
INTRODUCTION
Among the roughly 6100 words which George Washington left to American posterity in
his farewell address were these: ‘Of all the dispositions and habits which lead to political
prosperity, religion and morality are indispensable supports.’ How does morality support
prosperity? This is an interesting general question, but not one receiving much attention in
economics, even though understanding the causes of prosperity is an important aspect of
economics. This chapter provides some understanding of how morality supports prosper-
ity, illustrating that the impacts of morality on decision making can be considered using
the most simple and standard games of game theory.
The prosperity of interest here is general well-being, not the political prosperity of
interest to George Washington. A key insight is that well-being not only depends upon
outcomes but also upon how outcomes are obtained. In many decision contexts, ethics
are not an issue because the ‘way of behaving’ is not an issue. However, instances do arise
when different decision alternatives are associated with different ways of behaving, and
the different ways of behaving have different moral connotations. In these instances, moral
considerations may influence choice.
Because game theory seeks to explain the decisions of interacting individuals, and
because much of morality involves how to behave when interacting with others, game
theory provides a useful framework for considering morality. In a Nash equilibrium, no
individual can benefit by changing strategies, so the Nash equilibrium implicitly assumes
decision makers maximize their own interest. This assumption is maintained in the mod-
eling below, which includes various ethical concerns. The approach, which is now common
in behavioral economics, is to recognize that interests providing individual satisfaction
may extend beyond own material self-interest.
A few simple games have been the focus of much theoretical and experimental inter-
est, both because they model the potential cooperation and conflict people face in the
real world and because players often do not play as the Nash equilibrium predicts. Many
ethical considerations relate to how we should behave in situations with the potential for
cooperation or conflict. Thus, it is reasonable to think these considerations may influ-
ence decision makers as they play these simple games. The material payoffs of the games
translate into Nash equilibrium predictions, but they will not fully characterize the game
actually being played if the decision maker is also being influenced by moral consid-
erations. The approach taken here is to model the transformation of payoffs that moral
considerations might cause, and then apply the Nash equilibrium concept to identify the
predicted choice inclusive of moral considerations.
One theme of this book is that behavioral economics is not just a set of social theories
that arise because people make mistakes when they make decisions. In the models pre-
sented in this chapter, decision makers do not make mistakes. However, people without
557
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ethics who make rational decisions in their own interest are not smart in that they can
achieve better outcomes. With ethics, reason and self-interest lead people to the better
outcomes. That is, in a real sense, ethics make people smarter because they rule out inferior
outcomes that will otherwise tend to occur as people interact.
The chapter is organized as follows. The next section reviews literature on morality,
virtues, and ethics, including a focus on their definitions, a focus on how they arise, and a
focus on how they may influence the games people play. The third section examines many
standard two-player games (coordination game, stag hunt game, prisoner’s dilemma,
battle of the sexes game, and hawk–dove game), illustrating how ethical considerations
might reasonably influence behavior by transforming these games. The concluding section
summarizes what is learned.
DEFINING MORALITY, VIRTUES, AND ETHICS
Moral principles distinguish right behavior from wrong, good behavior from bad. A
virtue is a good way of behaving, while a vice is a bad way. Ethics, or moral philosophy,
is a branch of social science which studies morality and seeks to construct sets of moral
principles, principles distinguishing virtue from vice.
In his Theory of Moral Sentiments, Adam Smith (1759 [2000], pp. 393–4) contends
‘virtue . . . must either be ascribed indifferently to all our affections . . . or it must be con-
fined to some one class or division of them’. Explaining himself further he said: ‘If virtue
. . . does not consist in propriety, it must consist either in prudence or in benevolence.’
Among moral philosophies, Adam Smith’s idea that virtue is propriety is relatively
unique. He speaks of both ‘the man in the breast’ and the ‘impartial spectator’ as impor-
tant determinants of what is appropriate (that is, virtuous) behavior. The man in the
breast is your own perspective, your conscience, deciding what is proper. ‘We approve of
another man’s judgment, not as something useful, but as right: . . . and it is evident we
attribute those qualities to it for no other reason but because we find that it agrees with our
own’ (Smith 1759 [2000], p. 21). The impartial spectator is your belief about what other
people tend to think. The ‘passions of human nature seem proper and are approved of
when the heart of every impartial spectator entirely sympathizes with them, when every
indifferent by-stander entirely enters into, and goes along with them’ (Smith 1759 [2000],
p. 97).
Adam Smith’s alternative, that virtue amounts to exhibiting a particular type of behav-
ior, is standard, though other thinkers have included more classes of behavior than just
prudence and benevolence. Plato, in his Republic, introduced what have become most
commonly known as the four ‘cardinal virtues’: courage, prudence, temperance, and
justice. Plato identified fortitude (courage), wisdom (prudence), and temperance as good
behaviors respectively associated with three classes of people: soldiers, rulers, and produc-
ers. Temperance was a bit special to Plato because he recognized it as a virtue important to
all classes, even though he saw it as a distinguishing feature of the producing class. Justice
was also a special and separate virtue to Plato because he did not view it as being associ-
ated with a particular class. Rather, justice, Plato contended, regulates how the different
classes should treat each other.
In its catechism (Catholic Catechism 2015), the Roman Catholic Church recognizes

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Ethics and simple games 559
the four cardinal virtues, labeling them ‘human virtues’, but it also recognizes three
additional ‘theological virtues’ (also known as the ‘Christian virtues’): faith, hope, and
love. Theologian James Stalker combined the seven virtues and labelled all seven cardinal
because ‘among the countless excellences with which human character may be adorned
[these are the] seven which overtop the rest, and from which all the rest are derivable’
(Stalker 1902, p. 2). McCloskey (2006, ch. 26) also presents an ethical system which
consists of these seven virtues, contending, like Stalker, that any other virtue one might
identify is some combination of the seven.
Historically, thinkers have most commonly viewed morality as being primarily con-
cerned with how our own actions affect others. McCloskey (2006, p. 308) notes that
Immanuel Kant viewed morality this way. Stigler (1981, p. 189) described ethics as ‘a set of
rules with respect to dealings with other persons’. Love, as virtuous behavior, is the foun-
tain of this moral perspective, out of which flows Adam Smith’s beneficence, and other
attractive behaviors, such as charity, kindness, generosity, and friendliness. Baumard et al.
(2013, p. 60) conclude that recent work on the evolution of human altruistic cooperation
suggests ‘human morality is first and foremost altruistic’.
However, McCloskey (2006, p. 255) stresses virtue also includes attending ‘to the self
and the transcendent’, so it goes beyond just being good to others.
Being wholly altruistic, and disregarding the claims of that person also in the room called Self,
about whose needs the very Self is ordinarily best informed, is making the same mistake as being
wholly selfish, disregarding the claims of that person called Other. In both cases, the mistake is
to ignore someone. (McCloskey 2006, p. 255)
Aristotle identified a ‘good life’ as an end goal. You are being imprudent and cannot attain
a good life if you opt for the extreme of disregarding yourself.
McCloskey also contends you cannot attain the good life if you ignore the transcend-
ent. ‘We humans cannot get along without transcendence – faith in a past, hope for a
future, justified by larger considerations. If we don’t have religious hope and faith, we’ll
substitute hope and faith in art or science or national learning. It’s a consequence of the
human ability to symbolize’ (McCloskey, 2006, p. 183). People are motivated by the hope
of making a difference. There is satisfaction in sacrificing self for something that is bigger
than self, something transcendent.
A number of writers emphasize temperance as a virtue, in one form or another. Smith
(1759 [2000], p. 214) describes ‘the man of the most perfect virtue’ as possessing ‘the most
perfect command of his own original and selfish feelings’. Stigler (1981, p. 189) notes that
the rules in ethical systems ‘in general prohibit behavior which is only myopically self-
serving, or which imposes large costs on others with small gains to oneself’. Atran (2013)
summarized Darwin’s view as of virtue as being self-sacrifice of the type that occurs in
war which allows for the survival of the group.
Amartya Sen identifies commitment as a particularly important form of self-sacrifice.
‘A committed man,’ as Sen (1977, p. 327) defines him, ‘[chooses] an act that he believes
will yield a lower level of personal welfare to him than an alternative that is also available
to him’. Sen (1977, p. 342) connects commitment with morals, concluding ‘commitment
sometimes relates to a sense of obligation going beyond the consequences [so] . . . the
lack of personal gain in particular acts is accepted by considering the value of rules of
behavior’.

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Ordinary goodness is not virtue in one sense, yet virtue taken to an extreme can also
be vice. Adam Smith (1759 [2000], p. 28) proposed that ‘virtue is excellence, something
uncommonly great and beautiful, which rises far above what is vulgar and necessary’.
Conversely, Aristotle (350 BC [2015], ch. 9), in his Nicomachean Ethics, described ‘moral
virtue’ as ‘a mean between two vices, the one involving excess, the other deficiency’.
Aristotle describes confidence as the virtue between cowardice and rashness, for example.
The mean, Aristotle said, is praiseworthy, while the extremes are blameworthy. Adam
Smith did not necessarily disagree, for Smith felt the man in the breast and impartial
spectator would determine what is praiseworthy and blameworthy, and praiseworthiness
might well lie between extremes. McCloskey (2006) repeatedly makes the point that the
seven different fundamental virtues check and balance each other, meaning a person living
the good life will not tend to specialize in any one virtue but rather will exhibit all seven.
Nonetheless, virtue is also often associated with exceptionalism, for example, exceptional
courage, exceptional self-control, or exceptional self-sacrificing love for another.
Fairness is a particular type of morality, regarding how we should share, reasonably
considered a combination of love, temperance, and justice. Rawls (1971) characterizes
society as a cooperative venture undertaken for mutual interest, but notes conflict is inevi-
table because the benefits of cooperation can be distributed in varying shares to individu-
als and groups. Baumard et al. (2013) see morality, fairness in particular, as emerging to
guide the distribution of gains resulting from cooperative interactions so there will not be
so much conflict. The next section more generally considers how virtues arise.
HOW MORALITY, VIRTUES, AND ETHICS ARISE
To Adam Smith, the foundation of morality is the empathy we naturally feel for others.
‘By the imagination we place ourselves in his situation, . . . we enter as it were into his
body, and become in some measure the same person with him, and thence form some
idea of his sensations . . ..[This] is the source of our fellow-feeling for . . . others’ (Smith,
1759 [2000], p. 4). Recognizing people empathize, we obtain satisfaction when others feel
what we feel and experience dissatisfaction when they do not: ‘[The] correspondence of
the sentiments of others with our own appears to be a cause of pleasure, and the want of
it a cause of pain’ Smith (1759 [2000], p. 11). The pleasure obtained from a corresponding
sentiment is positive reinforcement, helping to solidify a particular notion of propriety as
virtuous in the mind of the man in the breast. Alternatively, the pain of contrasting senti-
ments is punishment, an indication that the impartial spectator has a different notion of
propriety, an encouragement to evolve toward what others think is proper.
Smith (1759 [2000], p. 224) describes in some detail how an ethical standard is developed:
Our continual observations upon the conduct of others, insensibly lead us to form to ourselves
certain general rules concerning what is fit and proper either to be done or to be avoided . . . It is
thus that the general rules of morality are formed. They are ultimately founded upon experience
of what, in particular instances, our moral faculties, our natural sense of merit and propriety,
approve, or disapprove of. We do not originally approve or condemn particular actions; because,
upon examination, they appear to be agreeable or inconsistent with a certain general rule. The
general rule, on the contrary, is formed, by finding from experience, that all actions of a certain
kind, or circumstanced in a certain manner, are approved or disapproved of.

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To Adam Smith, a morality is sustained by the satisfaction people derive from others
when virtuous behavior is rewarded with approbation:
Humanity does not desire to be great, but to be beloved. It is not in being rich that truth and
justice would rejoice, but in being trusted and believed, recompenses which those virtues must
almost always acquire . . . the practice of truth, justice, and humanity is a certain and almost
infallible method of acquiring what those virtues chiefly aim at, the confidence and love of those
we live with. (Smith 1759 [2000], p. 236)
In his book, Invariances, Robert Nozick (2001, p. 244) proposes, ‘Ethics exist because at
least sometimes it is possible to coordinate actions to mutual benefit’. Similarly, Baumard
et al. (2013, pp. 60–61) propose that ‘morality . . . emerged to guide the distribution of
gains resulting from cooperative interactions’. They suggest morality has co-evolved to
support an evolution of cooperation that could not have occurred absent the morality.
In many contexts morality is selfishly instrumental, being chosen because other people
favor individuals who are cooperative. However, Baumard et al. (2013, p. 65) contend that
a ‘genuine concern for fairness’ can evolve as competition for partners selects the instru-
mentally selfish for extinction.
Kenneth Binmore (1998, p. 367) similarly proposes that, ‘Morality evolved in the
human race to coordinate human behavior on Pareto improving equilibria in the game
of life’, but his perspective is somewhat unique. In Binmore’s game of life, life generates
games with multiple Nash equilibria, and morality evolves as a means of selecting one
of these. Morality does not pay directly, nor does it pay by facilitating cooperation when
it would not otherwise arise. Morality, from this perspective, plays a pure coordination
role, providing a ‘focal point’ that leads to the choice of one Nash equilibrium over
another.
Relative to capturing the benefits of cooperation, Amartya Sen (1977, p. 332) quotes
Leif Johansen: ‘No society would be viable without some norms and rules of conduct.
Such norms and rules are necessary for viability exactly in fields where strictly economic
incentives are absent and cannot be created.’ Sen (1977, p. 336) contends ‘the purely eco-
nomic man is indeed close to being a social moron’. He notes that it is difficult to explain
why the purely economic man would vote, or contribute to any public goods game. Yet,
real humans do vote and do not always free-ride, and they are better off for it because the
benefits of cooperation are captured. Sen proposes that people recognize the value of fol-
lowing rules. Specifically, he explains why commitment is a form of morality with fitness.
He proposes that we can move beyond the purely economic man by assuming people not
only have preferences over outcomes, but they also have a ‘meta-ranking’ of preferences
such that moral considerations are evaluated.
McCloskey (2006, p. 395) proposes that virtues (that is, ways of behaving) are merely
preferences if they cannot be connected to self-interest, and she contends virtues are
meaningless if they are merely preferences. Suppose, for example, I prefer to keep my
commitments as a matter of pure preference, as I might prefer vanilla ice cream. How is
it meaningful to say keeping a commitment is good? It is good because I say it is good,
just like I say vanilla ice cream is good. To meaningfully say a particular way of behav-
ing is good, I must have a reason, and to have a reason indicates the virtuous behavior is
instrumental, accomplishing something.
Yet, as Gauthier (1986, p. 1) says: ‘Were duty no more than interest, morals would be

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superfluous.’ Evolutionary theory offers means of explaining morality that is between

preference and choice. From this perspective, moral behavior is a cultural preference,
roughly speaking, but one which has evolved because it has fitness (Camerer 2003, p.
268). Gintis (2003) identifies morality as being important for fitness, noting that once
humans evolved the capacity to internalize self-regarding virtues the same psychological
mechanisms could be ‘hijacked’ for other purposes, including inculcating social prefer-
ences. Binmore (1998, p. 354) notes that ‘moral naturalism’ is an evolutionary perspective,
proposing that what is moral in a given society depends upon the history the society has
experienced.
McCloskey (2006, p. 255) suggests ethical systems arise so people can intentionally
pursue a good life. Humans are distinguishable from other animals by the fact that
humans can act with intention, setting goals and pursuing them. You cannot pursue a
good life, unless you first define it. One way to think about an ethical system is a definition
of a good life. Such a system can offer the opportunity to live for self, live for others, live
for something that transcends self and others, or some combination of these. McCloskey
(2006, p. 272) indicates ethics come from stories, characters, and experience, not from
reasoning.
HOW MORAL CONSIDERATIONS MAY MODIFY THE GAMES

PEOPLE PLAY
If people carry ethical considerations into a decision situation, which is likely, then models
of decision making which ignore ethical considerations may be inaccurate predictors of
behavior, or the model may be wrongly attributing causations to factors which should be
attributed to ethical motivations. This section reviews some relevant literature, especially
Adam Smith’s Theory of Moral Sentiments, presenting how moral considerations might
modify the games people play.
People care about what others think. Adam Smith (1759 [2000], p. 311) proposed
‘obtaining . . . credit and rank among our equals, is, perhaps, the strongest of all our
desires’. Smith (1759 [2000], p. 171) contended that nature has endowed mankind ‘with an
original desire to please and an original aversion to offend’. We love praise or the ‘favour-
able sentiments of our brethren’, and we love praise-worthiness which is being ‘the proper
objects of those sentiments’ (Smith 1759 [2000], p. 183). Conversely, we hate blame and
blameworthiness.
People are self-interested, or as Adam Smith (1759 [2000], p. 120) put it, ‘every indi-
vidual, in his own breast, naturally prefers himself to all mankind’. However, Smith went
on to say no man dares to ‘look mankind in the face, and avow that he acts according to
this principle’. When a man acts, ‘He is conscious that others will view him, [and] he sees
that to them he is but one of the multitude in no respect better than any other in it’ (Smith
1759 [2000], p. 120). What prompts us
to sacrifice [our] own interests to the greater interests of others . . . [is] . . . the inhabitant of the
breast, the man within, the great judge and arbiter of our conduct . . . who . . . calls to us . . .
that we are but one of the multitude, in no respect better than any other in it; and that when we
prefer ourselves so shamefully and so blindly to others, we become the proper objects of resent-
ment. (Smith 1759 [2000], pp. 193–4)

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Virtuous ‘rules of conduct, when they have been fixed in our mind by habitual reflec-
tion, are of great use in correcting the misrepresentations of self-love concerning what
is fit and proper to be done in our particular situation (Smith 1759 [2000], p. 226). Sen
(1977, p. 329) describes the commitment to such rules a ‘fact that it drives a wedge between
personal choice and personal welfare’. Rochat and Robins (2013, p. 99) find that, by
age 5, children ‘start inhibiting their inclination to self-maximize resources’, adopt ethical
stances toward others, ‘resist conforming to a partner’s way of sharing, and engage in
costly punishment, what can be equated to strong reciprocity’.
Because we recognize it is not easy to inhibit self-interest, we esteem those who are
generous, benevolent, or beneficent. ‘To feel much for others, and little for ourselves, that
to restrain our selfish, and to indulge our benevolent, affections, constitutes the perfection
of human nature’ (Smith 1759 [2000], p. 27). Recognizing people generally admire benefi-
cence and desiring the favorable sentiments of others, we learn to love others. ‘If to be
beloved by our brethren be the great object of our ambition, the surest way of obtaining
it is by our conduct to show that we really love them’ (Smith 1759 [2000], p. 27).
People do not value cheap praise as much as they value praise that is deserved. (Smith
1759 [2000], p. 123) notes that praise feels especially good when we are confident that we
are praiseworthy, when we are ‘conscious of merit, or of deserved reward’. We can become
the ‘natural object of love and gratitude’, of ‘esteem and approbation’ by performing a
‘generous action’ . . . ‘from proper motives’. Smith (1759 [2000], p. 154) helped identify
proper motives when he noted: ‘Benevolent affections seem to deserve most praise, when
they do not wait till it becomes almost a crime for them not to exert themselves.’
Adam Smith (1759 [2000], p. 125) contends ‘beneficence . . . is less essential to the exist-
ence of society than justice’, and he identifies ‘resentment . . . [as] the safeguard of justice’
(Smith 1759 [2000], p. 113). The resentment of injustice
prompts us to beat off the mischief which is attempted to be done to us, and to retaliate that
which is already done; that the offender may be made to repent of his injustice, and that others,
through fear of the like punishment, may be terrified from being guilty of the like offence. (Smith
1759 [2000], p. 113)
Gintis (2006, p. 21) notes: ‘Individuals who have rewarded those who help them, or hurt
those who have hurt them, do not later regret having fallen prey to irrational emotionality.
Rather, they generally affirm the morality of their behavior.’ It is the satisfaction obtained
from enforcing justice which is at work here. Adam Smith (1759 [2000], p. 95) notes we feel
obligated to those who help us and ‘it does not content our gratitude . . . till we ourselves
have been instrumental in promoting his happiness’. Conversely, Smith (1759 [2000], p. 95)
notes ‘hatred and dislike . . . often lead us to take a malicious pleasure in the misfortune
of the man whose conduct and character excite so painful a passion’.
Not only will unjust actions of others cause us moral disapprobation, but also inap-
propriate intentions. Adam Smith (1759 [2000], p. 17) contends the ‘whole virtue or vice
[of an action] must ultimately depend [upon] the sentiment or affection of the heart’ and
the ‘effect which [the action] tends to produce’ matters, but so does ‘the motive which
gives occasion to it’.
Our natural love and admiration for some virtues is such, that we should wish to bestow on them
all sorts of honours and rewards, . . . [while] our detestation, on the contrary, for some vices is

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such, that we should desire to heap upon them every sort of disgrace and disaster. (Smith 1759
[2000], p. 237)
Smith identifies ‘Magnanimity, generosity, and justice’ as possessing an especially ‘high

degree of admiration’, while he identifies ‘fraud, falsehood, brutality, and violence’ as
especially deserving ‘scorn and abhorrence’. Gratitude for good treatment ‘most imme-
diately and directly prompts us to reward’, while ‘resentment’ for bad treatment ‘most
immediately and directly prompts us to punish’ (Smith 1759 [2000], p. 94).
Self-interest and ethics may conflict, so that a decision maker may gain personally
by being less ethical or lose personally by being more ethical. Smith (1759 [2000], p. 88)
noted: ‘Candidates for fortune too frequently abandon the paths of virtue; for unhappily,
the road which leads to the one, and that which leads to the other, lie sometimes in very
opposite directions.’ Smith (1759 [2000], p. 84) identified ‘wealth and greatness as one
‘road’ leading to ‘respect’ and ‘being respectable’, while he viewed ‘the study of wisdom
and the practice of virtue’ as the primary alternative road. Smith (1759 [2000], pp. 221–2)
perceived that ‘our passions magnify our self-love’ at the moment of action, while ‘we
can more ably enter the perspective of the impartial spectator’ once our actions are over.
That is, it is easier to say we should sacrifice personal wealth for virtue than to do it when
the opportunity arises. Stigler (1981, p. 176) agrees, contending: ‘Where self-interest and
ethical values . . . are in conflict . . ., most of the time . . . self-interest theory . . . will win.’
Yet, Sen’s (1977) ‘commitment’ involves choosing an ethical rule over self-interest.
What Sen labelled commitment Adam Smith (1759 [2000], p. 229) labelled duty: ‘Duty is
a regard to a general rule of conduct.’ Smith (1759 [2000], pp. 230–31) describes ‘adher-
ence to duty’ as being ‘what makes a man dependable’, distinguishing ‘an honorable man
of principle from a worthless fellow’. Immanuel Kant associated character with doing
one’s duty and described the ultimate desire as ‘having a good character’, where having a
good character means being ‘in need of no other incentive to recognize a duty except the
representation of duty itself’ (Thorpe 2010, p. 10).
Honor is traditionally associated with doing what a society has come to view as one’s
duty, and maintaining one’s honor can be a tremendous motivator. Kant’s famous quote
is, ‘In the kingdom of ends everything has either a price or a dignity. What has a price can
be replaced by something else as its equivalent; what on the other hand is raised above all
price and therefore admits of no equivalent has a dignity’ (McCloskey 2006, p. 410). In
some situations, a person might increasingly sacrifice virtue as the price that must be paid
increases. However, the notion that there is dignity which will not be sacrificed indicates
there are situations where some principles, some virtues, some rules that are so firmly
attached to honor and the maintenance of good character that the rule will be followed
regardless of cost. In such instances, ‘Human virtue is superior to pain, to poverty, to
danger, and to death’ (Smith 1759 [2000], p. 83).
A SIMPLE MODEL INCORPORATING ETHICS
Camerer (2003, p. 23) notes: ‘When behavior does not conform to analytical game theory
[a common reaction is to claim] subjects were playing a different game than the adminis-
trator created.’ The general claim made here is that ethical considerations often influence

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decisions, so the incentives explicitly present in the game are not the only incentives
present. Camerer (2003, p. 23) evaluates ‘such explanations’ contending they ‘are useful
if they can be tested and falsified’. Space limitations preclude any test of theory here.
However, an important aspect of this work is that it does suggest hypotheses about ethical
considerations can be tested in future work using modifications of simple games.
Consider a game played by players A and B. Let pA(ai, bj) denote the material payoff of
player A when player A chooses strategy ai, i 5 1, 2, . . ., NA and player B chooses strategy
bj, i 5 1, 2, . . ., NB,. Let pB(ai, bj) for player B be defined analogously. Assume ethical
considerations can be related to the strategies chosen, so that the payoff experienced by
player A is the sum of the material payoff and an ethical transformation payoff. Letting
fA(ai, bj) denote the ethical transformation payoff of player A, it follows we can present the
payoff of player A as uA(ai, bj) 5 pA(ai, bj) + fA(ai, bj). Analogously, the payoff of player
B is uB(ai, bj) 5 pB(ai, bj) + fB(ai, bj).
This representation of ethics is comparable to the representation of intentions used by
Rabin (1993). Rabin introduces intentions into the game by postulating that intentions
transform the payoffs. Here, we similarly introduce ethical considerations by assuming
they transform the payoffs.
The notion that it is good to follow tradition is an ethical consideration. In America,
it is tradition to drive on the right, while in England it is to drive on the left. As Binmore
(2004, p. 6) notes, the pure coordination game is sometimes called the ‘driving game’
because coordination yield benefits relative to non-coordination. The pure coordination
game, displayed in Figure 32.1, has two Nash equilibria: (a1, b1) and (a2, b2). Schelling
(1960) first suggested people will look for a ‘focal point’ in such situations, which would
suggest coordinating on one choice rather than the other. To illustrate, Mehta et al. (1994)
found more than 75 percent of participants chose heads over tails as a focal point when
seeking to match what others would choose on a coin flip. Here, we are interested in the
idea that a moral code will transform this game so no focal point is necessary.
Figure 32.2 is a transformation matrix which translates ethical considerations into
strategy rewards and penalties. The simple assumption employed here is strategy 1 is
rewarded with one extra payoff unit, while strategy 2 is penalized one payoff unit. In terms
Player B
b1 b2
a1 1, 1 0, 0
Player A
a2 0, 0 1, 1
Figure 32.1 The pure coordination game
Player B
b1 b2
a1 1, 1 1, –1
Player A
a2 –1, 1 –1, –1
Figure 32.2 A transformation matrix capturing ethical considerations

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Player B
b1 b2
a1 2, 2 1, –1
Player A
a2 –1, 1 0, 0
Figure 32.3 A coordination game transformed by tradition
Player B
b1 b2
a1 2, 2 0, 0
Player A
a2 0, 0 1, 1
Figure 32.4 A coordination game with a Pareto dominant equilibrium
of our modeling notation this implies fA(a1, b1) 5 fB(a1, b1) 5 1, fA(a1, b2) 5 fB(a2, b1) 5 1,
fA(a1, b1) 5 fB(a1, b1) 5 −1, and fA(a2, b1) 5 fB(a1, b2) 5 −1. For our coordination game,
strategy 1 can be considered the choice supported by tradition, where society rewards fol-
lowing tradition and penalizes not following tradition.
Adjusting the Figure 32.1 coordination game payoffs by adding the Figure 32.2 trans-
formation matrix payoffs, we obtain the game presented in Figure 32.3. No longer are
there two Nash equilibria. Rather, strategy 1 is now payoff dominant for each player, so
the ‘traditional choice’ (a1, b1) is the unique Nash equilibrium.
The coordination game in Figure 32.4 is impure in that Nash equilibrium (a1, b1) Pareto
dominates the Nash equilibrium (a2, b2). The Pareto dominance of strategy 1 might well
provide a sufficient focal point that would lead people to choose strategy 1 over strategy
2. However, we are again interested in the idea that an ethic might transform the game,
so no focal point is necessary.
The Stanford Encyclopedia of Philosophy (2015) defines ‘utilitarianism’ as an ethic
with ‘the view that the morally right action is the action that produces the most good’.
It is one form of the broader consequentialism ethic, which contends the right action is
understood entirely in terms of consequences produced. Egoism is a more focused form
of consequentialism. Whereas egoism restricts the scope to the consequences for self, utili-
tarianism’s broader scope includes the consequences for self and others. Egoism contends
it is right to put self above others, while utilitarianism contends it is right to be impartial
between self and others. Jeremy Bentham’s utilitarian mantra was ‘the greatest good for
the greatest number’, with no preference for self.
Suppose culture reinforces a consequentialist ethic with the Figure 32.2 transformation
matrix, positively reinforcing the pursuit of the most good and negatively reinforcing the
alternative. The result is the Figure 32.5 game, which again has a single Nash Equilibrium,
the outcome (a1, b1). What have we learned? The imposition by culture of a consequential-
ist ethic can motivate people to coordinate in a way that brings about the greater good.
The stag hunt game, shown in Figure 32.6, is just a slight modification of the Pareto
dominant coordination game shown in Figure 32.4, but it is fundamentally different. The
stag hunt dilemma, attributed to Jean-Jacques Rousseau, can be described as follows. If

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Player B
b1 b2
a1 3, 3 1, –1
Player A
a2 –1, 1 0, 0
Figure 32.5 A coordination game transformed by a consequentialist ethic
Column player
b1 b2
a1 2, 2 0, 1
Row player
a2 1, 0 1, 1
Figure 32.6 Stag hunt game
two hunters work together, they can kill a stag. If they do not cooperate, the stag will get
away. Any hunter who abandons the stag hunt to hunt a hare will be successful. If both
abandon the hunt, both eat hare, which is something but not as good as eating stag. If a
hunter does not abandon the stag hunt but the other does, then the hunter not abandoning
the stag hunt does not eat. Thus, any hunter engaging in the stag hunt risks not eating,
hoping the other will not abandon the stag hunt.
The stag hunt game is interesting because, unlike the pure coordination game, its two
Nash equilibria imply a risk–return tradeoff. The Nash equilibrium (a1, b1) is payoff
dominant and is supported by a max–max decision criterion. Alternatively, the Nash
equilibrium (a2, b2) is risk dominant and is supported by a max–min decision criterion.
Seeking a high return and seeking less risk are two fundamental types of prudence which
can be in conflict. Real world outcomes, as outcomes in the stag hunt game, will depend
upon individual morality regarding how much risk one should take in order to pursue a
higher rate of return.
The stag hunt game also informs us about courage. Courage is required to pursue the
higher return because there is risk. Were there no potential gain, taking the risk would not
be courageous but rather would be merely imprudence, a vice. Courage involves facing a
fear, generated by the potential for loss, so a gain can be obtained.
The stag hunt game also informs us about hope. In standard analysis, hope is not recog-
nized. However, in reality, people might get some satisfaction from aspiring for the higher
payoff for self and for another. In the stag hunt game this would imply an extra payoff
would be associated with strategy 1. The stag hunt game also contains a particular form
of trust, a type of hope, in that the risk a player experiences when choosing strategy 1 is
dependent upon the other player. For example, the choice of strategy 1 may indicate the
player trusts that the other is courageous.
Suppose society positively reinforces courage and hope, and negatively reinforces the
opposite in stag hunt game situations. A transition matrix like Figure 32.2 might capture
such cultural reinforcements, which implies the stag hunt game of Figure 32.6 becomes
the game shown in Figure 32.7. The transformation just eliminates the risk associated
with choosing strategy 1, and strategy 1 weakly dominates strategy 2.

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Column player
b1 b2
a1 3, 3 1, 0
Row player
a2 0, 1 0, 0
Figure 32.7 A transformed stag hunt game
Column player
b1 b2
a1
Row player
a2
Figure 32.8 A general game
Consider now the game shown in Figure 32.8, where the strategy 2 payoff to the other
is the variable e. When e 5 0, we have the Figure 32.4 coordination game with a Pareto
dominant equilibrium. When e > 2, we have a prisoner’s dilemma.
With regard to ethics, it is interesting to compare the case 0 < e < 1 to the case 1 < e <
2. As the payoff increases from 0 to 2, the Nash equilibria for the game remain the same,
that is, (a1, b1) and (a2, b2), but the ethical issues do not remain the same. Consider a pair
of players coordinating on the Pareto inferior equilibrium (a2, b2). If only one player
deviates, the deviating player is worse off, explaining why (a2, b2) is a Nash equilibrium.
However, whether the other player is worse off or better off depends upon whether 0 <
e < 1 or 1 < e < 2. The stag hunt game, with e 5 1, is special in that there is no change
in the wellbeing of the other player as only one player deviates from the Pareto inferior
equilibrium. When e ≠ 1, there is a new ethical consideration in the game, the well-being
of the other player.
This game helps us define love or benevolence. When 0 < e < 1, a deviation from strat-
egy 2 for either play not only hurts self, but it also hurts the other. Thus, while approbation
for courage or hope may elicit a deviation from strategy 2, love for the other does not play
a role. However, when e > 1, a unilateral move from strategy 2 involves sacrificing self
while ensuring a gain for the other, so love may also play a role.
The Figure 32.8 game becomes a prisoner’s dilemma when e > 2. The single Nash equi-
librium is (a2, b2), which is Pareto inferior to the outcome (a1, b1). A Nash equilibrium
only recognizes a single incentive, the desire to maximize our own material outcome,
given the choice of the other. This love for self is not unethical, but the ethical considera-
tions beyond a love for self might transform the prisoner’s dilemma into another game.
In addition to the courage or hope that might transform the stag hunt game, love for the
other might transform the prisoner’s dilemma. That is, when mutual cooperation is being
observed in a prisoner’s dilemma, it may be courage, hope, love, or some combination of
these that is sustaining the cooperation.
The prisoner’s dilemma also helps us think about faith, which can be defined as belief
which is grounded in an identity. The Nash equilibrium is supported by the belief that all

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Column player
b1 b2
a1 3, 3 1, 2
Row player
a2 2, 1 0, 0
Figure 32.9 A transformed prisoner’s dilemma game
Column player
b1 b2
a1 2, 1 0, 0
Row player
a2 0, 0 1, 2
Figure 32.10 A battle of the sexes game
players are materially self-interested. There may be identities which support this belief.
However, a player may choose the cooperative strategy 1 because society has enculturated
an identity with which is associated the belief that all in society are courageous, hopeful,
and/or loving.
In summary, the payoffs of a prisoner’s dilemma might be transformed because a
culture reinforces courage, hope, or love. The degree to which these ethical considerations
influence the perceived payoffs of the game will depend upon the situation and back-
grounds of the people playing the game. Figure 32.9 presents a game where the Figure
32.8 game is made a prisoner’s dilemma with e 5 3, but then transformed with the transi-
tion matrix of Figure 32.2. The result is a game where strategy 1 is Pareto dominant and
the outcome (a1, b1) is a unique Nash equilibrium.
The battle of the sexes game, an illustration of which is presented in Figure 32.10, is
a coordination game, but the payoffs to the coordinating players are not the same. The
outcomes (a1, b1) and (a2, b2) are Nash equilibria. Row player receives a higher outcome if
the two players coordinate on strategy 1, while column player receives a higher outcome
when the coordination is on strategy 2.
When this game is played in the laboratory setting, a lack of coordination is more
common than coordination (Cooper et al. 1990). Camerer (2003, p. 356) interprets this
lack of coordination as representing a situation where ‘the players crave any tie-breaking
feature that distinguishes one player from the other’. Camerer (2003) reviews the literature
and finds coordination can be improved with numerous mechanisms, including communi-
cation, an outside option, the external suggestion or ‘assignment’ of a strategy, and allow-
ing one player to choose first. Of interest here is the idea that an ethic might transform
this game so that the coordination problem is resolved.
Tradition again can provide a coordination device, this time by providing a traditional
pecking order. If two arrive at a door at the same time, who should go first? In golf, who
should hit their shot first? When two cars arrive at an intersection, which car should go
first? Everyone loses in these situations if there is no coordination. Tradition provides
a pecking order that benefits one over the other, though both benefit relative to no

M4225-ALTMAN_9781782549574_t.indd 569 03/05/2017 08:20

Column player
b1 b2
a1 3, 2 1, –1
Row player
a2 –1, 1 0, 1
Figure 32.11 A transformed battle of the sexes game
Player B
b1 b2
a1 2, 2 0, 3
Player A
a2 3, 0 –1, –1
Figure 32.12 A hawk–dove game
coordination. If culture favors the row player in the situation, it would point each player
to the strategy that is of relative benefit to the row player, which in the Figure 32.10 game
is strategy 1. Adding the transition matrix of Figure 32.2 to the Figure 32.10 game yields
the transformed game in Figure 32.11, in which the unique Nash equilibrium is strategy 1.
It is worth noting that ‘taking turns’ can also be thought of as a tradition, feasible when
the battle of the sexes game is played repeatedly and the two have memory.
The prisoner’s dilemma game becomes the hawk–dove game when the mutual defection
profile (a2, b2) payoffs are less than the payoffs for either player in the uncoordinated con-
ditions (Figure 32.12). The hawk–dove game is called an anti-coordination game because
the two uncoordinated profiles (a1, b2) and (a2, b1) are Nash equilibria. The hawk–dove
game is interesting ethically because it contains the ethical elements of the Prisoner’s
dilemma game and the battle of the sexes game.
As in the prisoner’s dilemma, the ‘cooperative’ outcome (a1, b1) is not a Nash equilib-
rium because either player can obtain a higher individual outcome by deviating. However,
this ‘hawk’ strategy involves seeking to benefit self at the expense of the other, the opposite
of love. Thus, as in the prisoner’s dilemma, a love ethic can transform the hawk–dove
game. Because the choice of strategy 2 in the hawk–dove game reduces the outcome which
can be achieved by the other more so than in the prisoner’s dilemma game, it is more clear
in the hawk–dove game that strategy 2 is an especially unloving choice.
Another difference in the hawk–dove game, compared with the prisoner’s dilemma and
stag hunt games, is that the cooperative strategy 1 in the hawk–dove game is the max–min
strategy or risk dominant strategy. Thus, prudence in the form of seeking less risk may
influence a player to choose strategy 1 over strategy 2. That is, strategy 2 in the hawk–dove
game is not only less loving, it is also more risky.
Faith and hope are interesting to consider in the hawk–dove game. Suppose a father
(row player) and daughter (column player) are playing this game. If we relate faith to
the identities we expect each to bring to the game, if we expect the identity of father to
be associated with a willingness to sacrifice self for daughter, and if we expect the iden-
tity of daughter to be associated with the belief that father sacrifices for daughter, then
we can confidently predict the outcome (a1, b2). Here, father might be expected to gain

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Player B
b1 b2
a1 3, 3 1, 2
Player A
a2 2, 1 0, 0
Figure 32.13 A transformed hawk–dove game
satisfaction in hoping for daughter, while daughter might be expected to gain satisfaction
by hoping for self.
Figure 32.13 presents a transformed hawk–dove game, where the transition matrix of
Figure 32.2 has been added to the Figure 32.12 hawk–dove game. The transition matrix
negatively reinforces the more risky and more self-interested strategy 2, while it positively
reinforces the more loving and more hopeful strategy 1. In the father–daughter example
of the previous paragraph, the transition matrix recognizes the identities of each and the
satisfaction each will obtain from acting under the faith and hope associated with these
identities. In the transformed game, the mutual cooperation strategy 1 is again the single
Nash equilibrium, again illustrating that the ethical considerations inculcated in a popula-
tion by culture can resolve dilemmas and promote well-being, in this case a hawk–dove
game situation.
CONCLUSION
The morality literature indicates that moral considerations influence behavior, not only
because people gain satisfaction from receiving the praise of others and from being
praiseworthy but also because people lose satisfaction from being blamed by others and
from being blameworthy. The literature also indicates morality contributes to prosperity
in society by facilitating coordination and cooperation. Support for these theories has
been illustrated here using a series of simple games.
Tradition facilitates coordination by encouraging a particular behavior and discour-
aging others. Courage and hope can facilitate cooperation when cooperation is risky.
Beneficence, or love, can facilitate cooperation by offsetting self-interest that may discour-
age cooperation. In the simple examples considered here, it has been shown that moral
considerations can also resolve dilemmas and transform games with multiple equilibria
into a game with a single Pareto dominant equilibrium.
Space limitations have prevented the examination of some games and some virtues. In
particular, the ultimate game, dictator game, and trust game are promising for examining
justice, which was not addressed here in the modeling section. However, it is well under-
stood that concerns about ‘fairness’, clearly a form of justice, help explain deviations from
Nash equilibrium conditions in these games.
The modeling illustrations presented here make it clear that more creative experimental
work could help enhance the understanding of the morality plays in decision making.
The prisoner’s dilemma is interesting because its structure spawns multiple moral con-
siderations, and a particular morality can resolve the dilemma. However, multiple moral
considerations imply confounding when people play. To identify and gauge the impacts

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of particular distinct virtues, new and specially designed experiments are needed. The
illustrations presented here provide some insights that should be helpful in that regard.
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M4225-ALTMAN_9781782549574_t.indd 572 03/05/2017 08:20

Index
1/N heuristic 108 Backhouse, R.E. 61, 64, 65

bad jokes model (rational mistakes) 43–52
ABC research program 122, 124, 125 banks, studies on x-efficiency 281–7
Ackert, L.F. 385 Baron, J.D. 214, 224
activity and weight loss, see physical activity bartering 239
and weight loss, intertemporal choices Bates, R.H. 82–3
adaptation decisions, farmers and climate Baum, C.L. 440
change 251–2, 254, 264–8 Baum, S. 181
addiction, food consumption 436 Baumard, N. 561
adult development 147–9 Beach, L.R. 112
advertising, and obesity 442–3 Bechara, A. 366
Aftab, M. 286–7 Becker, G.S. 3, 127, 436, 508
age, and taxation compliance 334–5 Beek, J. van 421
agents, typical 15–16 behavioral economic anthropology, see
aggregate demand 35–6, 37 anthropology, behavioral economic
aggregation bias, ecological correlations behavioral economics
87–8 frequently referenced topics 321, 322
agricultural decision-making case study, see not a paradigm shift 64–6
climate change case study (farmers’ principles of 68
decision-making) smart decision-making, summary 1–7
Ainslie, G. 496–7 Behavioral Insights Team (BIT) 324
Akerlof, G.A. 35, 36, 111, 238, 519, 529 behavioral morality 546–7
Akhtar, M. 287 behavioral strategy 157–63, 170–71
Alchian, A.A. 13, 15, 74–5 innovation and entrepreneurship 162–3,
Alexander, R.D. 529 165–6, 167
Allais paradox 193–4, 195 organizational identification 158–9, 161–2,
Altman, Morris 23, 24–5, 29–30 164–5, 168
altruism 551–2 organizational routinization 159
and gender 181–4 organizational transformation 159, 166–7,
punishment 238–9, 529 169
and voting 545 uncertainty 168
altruistic utility 507 US Marine Corps 163–9
An, J. 286 beliefs 494, 568–9
Anderson, C.L. 254 and culture 534
Anderson, E. 177 loyalty models 220–21, 226–30
Andreoni, J. 182 overconfidence 58
anthropology, behavioral economic 233–5 and punishment 226–30
Kula exchange system 235–44 see also will, weakness and stiffness of
Apeldoorn, J. van 481–2 Bell, D.E. 196
Ariely, D. 144 Bellon, M. 253–4
Aristotle 560 Berg, N. 55, 56, 57, 58, 59, 65
asset markets, see experimental asset Bewley, T.F. 35
markets bias-variance 55, 108, 123
Atran, S. 559 biased-preferences approach 496–7
Auld, M.C. 436 biases
Aumann, R.J. 125–6 behavioral strategy 160–61, 162, 163
Axelrod, R. 533 gender 176–7, 180–81
axiomatization program 61–6 in-group versus out-group 487
573
M4225-ALTMAN_9781782549574_t.indd 573 03/05/2017 08:20

unconscious 366 climate change case study (farmers’ decision-

see also heuristics and biases approach; making) 251–5, 268–9
social interactions; will, weakness and methods and data 255–8
stiffness of results 258–68
Binmore, K. 561, 562 Coase, R. 70–71, 74, 79, 83
biological development 139–40 cognitive bounds, and behavior 127
birth rates, and unemployment 86–7, 88–9 cognitive development 138, 139, 146–7
Black, D. 544 cognitive illusions 122
Boehm, C. 552–3 cognitive reflection test (CRT), traders 378–9
Boettke, P.J. 295 cognitive theory, Hayek 526–7, 530–32,
bonding 487 537–8
Borghans, L. 437 Cohn, A. 367
borrowing decisions, individuals and Coleman, J.M. 518
households 352–3, 356, 359–60 colors, and priming 367
bounded rationality 1, 2–3, 19–21, 145, 493–4 commitment 559, 561, 564
Boyd, J.N. 416 and self-control 459–61
Boyd, R. 533 community crime prevention (CCP) 515–16,
brain, development of 140, 141, 145–6 523–4
Braithwaite, V. 336–7 behavioral economics perspective 518–20
Breaban, A. 378, 381 game theoretic illustration 520–23
Brooks, D. 151 sociological tradition 516–18
Brumberg, R.H. 394 competency traps 162
Buchanan, J. 77–8, 79–80, 302, 306, 307 COMPLIANCE (mnemonic) 327–8
Budig, M. 178 compulsivity, and stiffness of will 492–3,
Burke, M. 264 495–6, 503, 504
business and finance favoritism 507
banks, studies on x-efficiency 280–87 pornography 511
fast and frugal heuristics 107–9 shirking 504
see also experimental asset markets slackening 506
business cycles spoiling children 509–10
and asset values 381 confidence-biased beliefs, see will, weakness
theory 34–5 and stiffness of
consequentialist ethic 566
Callender, G.S. 318 Consideration of Future Consequences (CFC)
Camerer, C.F. 321, 564–5, 569 scale 416–17, 421, 422–4
cancer screening (nudging) 110 consumption 392–5
Cantor, George 62, 63 behavioral economics elements 395–6
catallactics 71, 234 consumption-savings model 396–405
Centorrino, S. 484 inefficiencies 29–34
central banks, and asset markets 384 norms, and obesity 443–4
centrally planned economies 78–80 rationality and efficiency 14–15
Chan, S. 285 simple rule-following 392–3
Chandon, P. 442 conventional economics 2, 3, 6–7, 70
Chen, A. 284 core assumptions 4, 5, 18–19
Chen, T. 285–6 economic man 68–9, 142–3
Chen, X. 284 efficiency 12–16
children, spoiling (weakness of will) 508–10 institutions 16–18
China, banking system 280–85 macroeconomic choices 34–8
Chiu, Y. 285 preferences 29
Choi, S. 286 rationality 12–16, 18–19, 20–21
choice, and cognitive theory 530 x-efficiency 23
choice architecture 31–2, 323 cooperation 551–2
choice x-efficiency 29–31 coordination devices 199–200, 385–6, 535,
choice x-inefficiency 30 569–70
Chou, S.Y. 440, 443 Coricelli, G. 193, 338–9

M4225-ALTMAN_9781782549574_t.indd 574 03/05/2017 08:20

Index 575
correlated equilibrium, coordination devices compatibility with economics 124–8

199–200 development of 122–3
correlations, ecological, see ecological open questions and challenges 128–30
correlations economic crises 28
cost–benefit analysis, of suicide 466–9 economic growth, institutional path
courage 567 dependence 80–81
Courtemanche, C. 440 economic man
Cox, C.M. 472 compared to smart person 151
Cox, D. 335–6 and conventional economics 68–9, 142–3
creativity, and suicide 472–3 and nudging 323
credit use decisions, individuals and psychological 143–4, 151
households 352–3, 356, 359–60 and social norms 561
crime prevention, see community crime and tax compliance 325
prevention (CCP) and time 211
Croson, R. 179, 180 see also human decision-making
cross-validation 126 Eddy, D.M. 112
cultural evolution 535–8 educational development 139
culture 533–5 Edwards, W. 112
Cutler, D.M. 439 efficiency, see rationality and efficiency;
x-efficiency
Damasio, A.R. 191, 192 efficiency wage theory 35
Damon, F.H. 239–40 effort discretion 23–6, 27
Davis, H. 355, 357, 359 egoism 566
Dawkins, R. 546 El Farol bar problem 126
decisions-from-description (DfD) 124 Ellickson, R.C. 240
decisions-from-experience (DfE) 124 emotions 188–9, 190, 485
defaults 33, 325–6 and consumption 396
delay discounting, and suicide 470–72 mirror neurons 486–7
depression, and delay discounting 470–71 neurobiology 191–4
development, human, see human development and priming 367
discounting 414–15, 417, 419–21, 422–3, 437–8 and risk 367
delay, and suicide 470–72 and social choice 201–2
hyperbolic 437–8, 459 and tax compliance 338–40
and time inconsistency 458 traders 379
discrimination, statistical 482 endogenous quality jurisdictions model
distributed intentionality 546 294–302
distributional conflicts 355–6 income effects 309–10
docility 528 scale of public services 302–8
Downs, A. 544–5 voice and co-production 308–9
Dreu, C. De 487 Engelmann, D. 481
Drewnowski, A. 440 England, P. 174, 178, 183
duty 564 Enos, R. 545
entrepreneurship 162–3
Earle, T. 235, 240–41, 244 environment
Eckel, C. 179, 378 and human development 139
ecological correlations 86–7, 97–8 and simple decision rules 127
aggregation bias 87–8 Erikson, E.H. 148, 149
smart potential behind 93–7 errors 43, 143–4; see also mistakes, rational
use by lay people 88–92 estimates (Knight) 106–7
ecological rationality 15, 20, 56, 60 ethics 557–8, 559, 562–4
applied lessons 109–14 game theoretic model 564–71
and heuristics 103, 104 ethnicity, and asset trading 378
ecological rationality program (ERP) 122–3, Etzioni, A. 144
131 Euler equations, consumption 396
accomplishments of 123–4 exchange, Kula system 235–44

M4225-ALTMAN_9781782549574_t.indd 575 03/05/2017 08:20

executive functioning, and suicide 472 joint decisions, empirical investigation

exercise and weight loss, see physical activity 357–60
and weight loss, intertemporal choices financial decision-making, priming 366–74
expectations, and cognitive theory (Hayek) 537 Fiorina, M.P. 200
expenditure decisions, individuals and firms
households 350–52, 354–6, 359 and allocative inefficiency 279
experimental asset markets 375–6 economic efficiency, requirements for 27
asset properties 379–82 production inefficiency 23–9, 276
characteristics, traders 376–8 profits 13
cognitive abilities, traders 378–9 rationality and efficiency 13, 276
emotions, traders 379 survival 13, 14, 20
future research 387 see also x-efficiency; x-inefficiency
market structure 382–6 Fischbacher, U. 238–9, 384, 481
mispricing, measuring 386–7 Fisher, I. 394
trading strategies 379 Folbre, N. 174, 178, 184
experimental economics 4 Foster, G. 213, 223, 224, 229, 230
Fowler, A. 545
fairness 560 framing 32–3, 54
taxation 321–2, 339 freedom of choice 30–31, 111
family 487–8, 551 French, S.A. 440
farmers’ decision-making case study, see Freytag, P. 90
climate change case study (farmers’ Friedman, Milton 12–13, 35–6, 394, 395
decision-making) Frijters, P. 213, 214, 223, 224, 229, 230
fast and frugal heuristics 5, 20, 101–2, 114–15 Frisch, Ragnar 63
as adaptive tools 105–7, 125–6, 128–9 Fu, X. 283–4
applied lessons from study of ecological Füllbrunn, S.C. 378, 385
rationality 109–14 functionalism 240
development of 123–4, 125 fundamental value, assets 380–81, 382, 383,
economic rationality and psychology, 384, 385, 386–7
overlaps between 102–5 Fung, M. 284
in finance and business 107–9 futures markets 384
nudging and uncertainty 109–11
open questions and challenges 128–30 Gächter, S. 529
risk literacy 111–14 García-Herrero, A. 283
favoritism (weakness of will) 506–8 gaze heuristic 55, 107
Fehr, E. 238–9, 529 gender 176–7
Feller, W. 296, 298 and altruism 181–4
feminist economics 173–4, 176–7, 185–6 and asset trading 378
attitudes to risk, gender differences in and attitudes to risk 179–81
179–81 BMI and participation in sports and exercise
institutional analysis and development 454–5
framework 173, 174–7 and financial decision-making 356,
preferences and behavior, observed gender 357–62
differences in 177–8 and labor market 176, 178, 184
and studies of altruism 181–4 and obesity 432, 437, 440, 442
Ferber, M. 173, 177 preferences and behavior, observed
Ferejohn, J.A. 200 differences in 177–8
Fiedler, K. 90, 92 and taxation compliance 334
finance and business generalizations 494, 501–2
banks, studies on x-efficiency 280–87 gifts, traditional societies 237–8, 239
fast and frugal heuristics 107–9 Gigerenzer, Gerd 5, 15, 20, 65, 103–5
see also experimental asset markets disagreement with Kahneman and Tversky
financial decision-making, household 349–50, 122
354–6, 360, 362, 488 errors 43
individual decisions 350, 352–4 habits and routines 493–4

M4225-ALTMAN_9781782549574_t.indd 576 03/05/2017 08:20

Index 577
memory 54–5 and time orientation 413, 422–4

perception 54 see also obesity; physical activity and weight
probabilistic reasoning 112 loss, intertemporal choices; suicide, and
repair program 62 intelligence
social planning 57 Hefferman, S. 283–4
Gilad, D. 367 Henrich, J. 244, 533–4
Gintis, H. 552–3, 562, 563 heuristics
Glanz, K. 441 1/N 108
Gneezy, U. 179, 180, 333–4, 548 gaze 55, 107
Gode, D.K. 127 hiatus 108
Goldstein, J. 86 priority 107
Golsteyn, B.H.H. 437 regret as 200
governance structures, polycentric system representative 501–2
290–94 see also fast and frugal heuristics
endogenous quality jurisdictions, model of heuristics and biases approach 3, 6, 21–2, 31,
294–302 119–20
income effects 309–10 choice architecture 32
scale of public services 302–8 development of 121–2
voice and co-production 308–9 probabilistic reasoning 112
government policy, and smart decision-making Hewstone, M. 91
approach 6 hiatus heuristic 108
Gray, A. 163, 166–7, 168, 169 Hilbert, David 62, 63–4, 65–6
‘greedy rationality’ 207–11, 224 Hobbes, Thomas 546
Grootendorst, P. 436 Hoffrage, U. 56, 112
Grossman, P. 179 Hofmann, E. 342
group selection 536 Hogarth, R.M. 121
groups Homo economicus, see economic man; human
cooperation 551–2 decision-making
and culture 533–4 homophily 160, 162
and identity 519 honesty, universalist principle of 547–8
negotiated coexistence 517 Hong Kong, x-efficiency of banks 284–5
size of 523 honor 564
and social interactions 487–8 hope 567, 570–71
Gunnell, D. 464–5 house money effect 380
Güth, Werner 62 households, see financial decision-making,
household
habits 493–4 human decision-making 68–70, 82–3
Hall, P.A. 421 imperfect institutions and path dependency
Hall, R.E. 396 78–82
Hallsworth, M. 338 rational choice proponents 70–76
Hamermesh, D.S. 465–6 rule level of analysis 76–8
happiness human development 137–41
ecological correlations 93–7 adult developmental stages 147–9
and income 473 economic man 142–4
‘Harberger triangle’ 279 failures 146
Harris, M. 533 non-cognitive versus cognitive 146–7
Harsanyi, J. 29, 30 smart person 144–7, 149–52
Hart, S. 199 in transitional periods 147, 148
Haruvy, E. 126, 385 virtues 149–51
Hasan, I. 286 Humean fallacy 12–13
Hasseldine, J. 327 Huy, Q.N. 160
Hayek, F.A. 73, 77, 82, 526–7, 530–32, hyperbolic discounting 437–8, 459
534–8
health identity 519, 520–23
expenditure 432 identity utility 519

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impulsivity, and delay discounting 470–71 investment decisions 353, 356, 360, 367–70
impulsivity, and weakness of will 492–3, 495, Iowa gambling task 191, 192
496–7
favoritism 506–8 James, S. 317, 318, 321, 322
pornography 510–11 Jiang, C. 283
shirking 498–504 Johnson, A.W. 235, 240–41, 244
slackening 505–6 jokes model (rational mistakes) 43–52
spoiling of children 508–10 justice 563
incentives
asset markets 383–4 Kahneman, D. 3, 21–2, 112
tax compliance 325 and development of heuristics and biases
income approach 121, 122
effects, endogenous quality jurisdictions errors 144
model 309–10 slow and fast thinking 5–6
and happiness 473 two-system decision-making process 370
and obesity 440–41 utility, forms of 496
and suicide 465–6, 473 kaiko (ceremonial practice) 243–4
and taxation compliance 335 Kamas, L. 181–2
income and consumption 393–6 Kameda, T. 58–9
consumption-savings model 396–405 Kant, I. 564
income tax, compliance 317–18, 327–8, 331–2, Karlsson, N. 197
343–4 Keynes, J.M. 34–5, 36–7, 69
behavioral economics 321–2 classical theory 277
differential effects 334–7 consumption 393–5
neoclassical approach 332–4 rationality 277–8
nudging 317–18, 322–8 Keynesian school 36
responsive regulation approach 337 Kheirandish, R. 105
social norms 326–7, 338–40 Kim, B. 286
tax authorities 320–21, 337, 340–42 Kim, J.Y. 59
inconsistency, elimination of 63 kin altruism 551
inefficiency Kinsey, J. 436
allocative 279 Kirchler, E. 340–41, 355
consumption 29–34 Kirzner, I. 72
firms 23–9, 276, 279 Kliger, D. 367
production 23–9 Knight, F.H. 73–4, 106–7
rational 12–16, 17–18 knowledge 532
see also x-inefficiency common 377, 485–6
inertia (organizations) 162 and decision-making 105–7
information and rules 527
and asset markets 381–3 Komlos, J. 437
cognitive bounds 127 Kranton, R.E. 519
culture as 533 Kula exchange system 235–44
more not necessarily better 56–7 Kutzner, F. 91, 92
natural frequencies 114 Kwan, S. 284–5
and nudging 111
and obesity 441–3 labor market, and gender 176, 178, 184
innovation 162–3, 165–6, 169 Laibson, David 68, 83, 459
institutional analysis and development laissez-faire 69
framework 173, 174–7 Lakdawalla, D. 439–40
institutions 16–18, 73–4, 75, 76 Landa, J.T. 241
cognitive approach 526, 532 Larkin, J.H. 114
path dependency 78–82, 534 lateness model (rational mistakes) 52–4
rule level of analysis 76–8 leadership, and social evolution 553
intertemporal choices, see physical activity and learning
weight loss, intertemporal choices indirect 377

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Index 579
simple heuristics of 130 Mervin, M. 224

social 533–4 Milner, B. 192
see also human development MINDSPACE (mnemonic) 324
Leavitt, H. 162 minimal-group paradigm 487
Leibenstein, H. 23–4, 35, 275–6, 278, 279–80 Mintzberg, H. 169
Lester, D. 466 Mises, Ludwig von 68, 70, 71, 72, 82–3, 277
Lester, Richard 72–3 mistakes, rational 68
Levinson, D.J. 147, 148–9 absence of paradigm shift in behavioral
Levy, A. 433–4 economics 64–6
Lewis, D. 535 axiomatization program in mathematics
Lien, D. 58 61–6
life-cycle hypothesis 394–5, 398, 401 bad jokes model 43–52
List, John 68, 83 best organ in the human body example
Lobell, D. 264 60–61
Loewenstein, G. 321, 497 bias-variance trade-off 55
Loomes, G. 197 games and nature 54–5, 56–7
Loureiro, M.L. 441–2 lateness model 52–4
love 568, 570–71 lexicographic preferences 56
models of 212–25 markets and social systems 57–9
loyalty 205–7 and memory 54–5
and abstraction 225–6, 228–9 and perception 54
models of 207–25, 227–30 singular versus plural norms 59–60
organizational identification 158–9, 161–2, strategic games against self-interested
164–5, 168 competitors 57
Luo, D. 283 Modigliani, F. 394
money illusion 36–7
Machlup, Fritz 73 money management, individuals and
macroeconomic choices 34–8 households 353–4, 356, 360
Malaysia, x-efficiency of banks 285 morality 546–7, 551–2, 557, 559, 560–62
Malinowski, B. 235–8, 239, 240, 241, 242, 243 Mousavi, S. 103, 105
Malmendier, U. 321 Moyano-Diaz, E. 196
‘mammography problem’ 112, 113, 114 Moyo, M. 252
management, and behavioral strategy 157–71 Mundell, R. 279
management science, and ecological rationality Murphy, K.M. 436
program 129
managerial slack 24–5 Nash equilibrium
Mancino, L. 436 and morality 557, 561
Mandler, M. 125 public goods games 58–9
Manzini, P. 125 and social norms 529–30
March, J.G. 19, 162 see also ethics, game theoretic model
marginal decision-making 72–3 National Tax Advocate 320
Marginal Revolution 70–71 negotiated coexistence 517
Marine Corps (US), behavioral strategy 163–9 Neighborhood Watch 516, 517, 520
Mariotti, M. 125 game theoretic illustration 520–23
market failure, and true preferences 30 Nelson, J. 173, 177, 178, 179–81
markets, experimental, see experimental asset neurodevelopment 140, 141, 145–6
markets Newcomb problem 197–9
Markowitz, H.M. 108 norms, social, see social norms
Maslow, A. 139 North, Douglas 16–17, 78, 80–81, 526, 532,
mathematization of economics 63 533, 534
Mauss, M. 238, 239 Noussair, C.N. 378, 381
McCloskey, D.N. 149–50, 559, 560, 561, 562 Nozick, R. 198
Meiser, T. 91 NUDGE (mnemonic) 323, 324
memory, and rational mistakes 54–5 nudging 31–2, 322–4
mental accounting 353–4 versus boosting 129

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and taxation 317–18, 322–8 intentions to improve health 450–53

and uncertainty 109–11 time inconsistent preferences 450,
Nussbaum, M. 31, 34 457–61
Plato 558
obesity 429–30 Plumley, A. 335–6
behavioral aspects 432–44 Polanyi, K. 234–5
causes 432–3 policing, and crime prevention 515
economic consequences 432 polycentricity, see governance structures,
health consequences 430, 432 polycentric system
prevalence 430 pornography (weakness of will) 510–11
see also physical activity and weight loss, Posner, R.A. 28, 438–9
intertemporal choices poverty, and obesity 440–41
obsessive-compulsive behavior 496, 503, 504; Powell, H.A. 239
see also compulsivity, and stiffness of will Powell, O. 381, 386–7
occupation, and taxation compliance 335 Powell, T. 160, 161, 170
O’Donoghue, T. 460 power
Offer, A. 441 and beliefs 227–30
oligopoly 293 and the mind 223–4
Oliviola, C.Y. 331–2 and tax authorities 339–42
Olson, Mancur 14, 17–18 see also loyalty, models of
optimality, decision-making 1–2 praise 562, 563
organization science, and ecological rationality Prasch, Robert 72, 73
program 129 preference ordering, axiomatization program
organizational identification 158–9, 161–2, 62, 63
164–5, 168 preferences
organizational routinization 159 biased-preferences approach 496–7
organizational transformation 159, 166–7, 169 and gender 177–8
organizations, behavioral strategy 157–71 revealed 29–30, 32
Ostrom, Elinor 75–6, 77, 78, 81, 174–5 social 551–2
administrative rigidity problem 290 time, and obesity 436–7
common pool resources 302–8 time inconsistent 450, 457–61
efficient public administration 292 true 29–30, 31, 32
public goods, preferences for 293 Preis, T. 88
punishment 529 Preston, A. 181
Ostrom, V. 292, 293 price bubbles, see experimental asset markets
overconfidence 58; see also impulsivity, and prices, and obesity 440
weakness of will priming, financial decision-making 366–74
oxytocin 487 priority heuristic 107
private persona 550, 554
Pakistan, x-efficiency of banks 286–7 private sphere (rational actor model) 544, 547,
path dependency, institutions 78–82, 534 554
Payne, J.L. 325 probabilistic reasoning 111–14
Pejovich, S. 80 probability conflicts 355
perception 54, 526–7, 531 procedural models, ecological rationality
permanent income hypothesis 394, 395 program 127–8
and suicide 465–6 process rationality 21
Perry, B. 145–6 production inefficiency 23–9
personal capital 518–19 profits, assumptions 13, 74–5
Peterson, C.R. 112 property rights 81
Philipson, T.J. 438–9 prospect theory
Phillips, L.D. 112 axiomatization program 62–3
physical activity and weight loss, intertemporal taxation compliance 335–6
choices 449–50, 461–2 psychosocial development 139–40
BMI and participation in sports and exercise public administration, see governance
453–7 structures, polycentric system

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Index 581
public economics regret 188–91, 202

competition, models of 292–3, 295 as coordination device and social mechanism
markets, concept of 291–2 199–202
scale of public services 302–8 in decision-theory 194–9
public goods 58–9 neurobiological basis of 191–4
public messages, as coordination device relationships
385–6 bad jokes model 43–52
public persona 550, 552–3 lateness model 52–4
public sphere (rational actor model) 543–4, religion 496, 559
547, 548–50 and loyalty 226–30
punishment 485, 529 representative heuristic 501–2
altruistic 238–9, 529 reputation 480–82, 529
and beliefs 226–30 Reskin, B. 178
slackening versus shirking 505 revealed preferences 29–30, 32
purchasing decisions, individuals and Rezvanian, R. 282
households 350–52, 354–6, 359 rhytonian rationality 216–21, 223, 224–5
Richerson, P.J. 533
Rabin, M. 460 Rigaux, B. 355, 357, 359
randomization 58 Rijt, A. van de 481
Rashad, I. 437, 440 risk
rational actor model and adaptation decisions 252, 265, 266–7
motives 547, 550 experimental asset markets 378
private and public persona 550 gender-based differences in attitudes to
public persona, evolutionary emergence of 179–81
552–3 and investment decisions 353, 356, 367–70
public sphere 543–4, 547, 548–50 literacy 111–14
social preferences 551–2 and priming 367–70
universalist principle of honesty 547–8 rituals 496
voting 543–6, 553–4 Roberts, R.C. 149, 150
rational choice, human element, see human Robinson, W. 87
decision-making Rosin, O. 438
rational inefficiency 12–16, 17–18 routines 493–4
rational lifetime planning, obesity 433–4, 437 Ruhm, C.J. 440
rational mistakes, see mistakes, rational rule-consequentialism 549
rationality 3 rules 76–8, 526, 527, 528–9
bounded 1, 2–3, 19–21, 145, 493–4 and culture 534–5
calculation of deviations from 126–7 evolution of 535–8
core assumptions 18–19 simple rule-following 392–3
‘greedy rationality’ 207–11, 224 see also social norms
rhytonian 216–21, 223, 224–5 Russell, Bertrand 62, 63
Smith, Adam, on 497 Rustichini, A. 333–4
types of 18–22, 39–40, 216–18
see also ecological rationality; ecological Sallis, J.F. 441
rationality program (ERP) sampling, and mistakes 58
rationality and efficiency 11–16, 38–40, 275–6 satisficing 19, 20
consumption inefficiency 29–34 and regret 196–7
institutions 16–18 social welfare improvements 57
macroeconomic choices 34–8 Savage, L.J. 195
narrow and broad rationality 277–9 savings
production inefficiency 23–9 and consumption 393–4, 395
Rawls, J. 560 consumption-savings model 396–405
reasoning by similarity 128 decisions, individuals and households 352–3,
reciprocity 238–9, 480–81 356, 359–60
Reder, M.W. 121 scale, public services 302–8
reflexive utility 508–9 Schaik, C. van 552–3

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Schelling, T.C. 535 Smith, T.G. 441, 442

Schmölders, G. 325 Smith, Vernon 19–20, 76, 102–3, 104, 105, 121,
Schram, A. 480–81, 481–2 528
Schwartz, B. 196–7 smoking, and discounting 415
Scoditti, G. 240 social capital 518–19
seed selection, see climate change case study social cohesion 517, 518
(farmers’ decision-making) social control 74
Seinen, I. 480–81 social dilemmas 338–9
Self, notion of 210–11, 559 social evolution 552–3
changing 212 social identity 519, 520
dual-self theories 500 game theoretic illustration, community
and models of love 212–13, 221 crime prevention (CCP) 520–23
and types of rationality 216–18 social interactions 479–80, 548–50
self-control, and commitment problem 459–61 knowing others 486–8
self-interest 71–2, 74, 142, 235, 562–3, 564 modes of 550
self-sacrifice 559 reciprocity 480–81
Selten, Reinhardt 62, 65, 130 reputation 480–82
Sen, A. 31, 34, 559, 561, 564 seeing others 482–5
Sensory Order (Hayek) 526–7, 531, 537 speech 485–6
Sent, E.-M. 121 trustworthiness 482–4
Shafir, E. 198 social learning 533–4
shares 385 social norms 526, 528–30
Sheehy, G. 147 and community crime prevention (CCP)
Shefrin, H.M. 460 516–17, 520–23
Shiller, R.J. 28, 111 and economic man 561
Shin, D. 286 and identity 519
shirking (weakness of will) 498–504 and obesity 443–4
shocks (weakness of will) 505–6, 507, 509, tax compliance 326–7, 338–40
510–11 traditional societies 243–4
similarity, reasoning by 128 social order 71–2, 77
Simon, H.A. social preferences 551–2
behavioral strategy 161–2 sociological variables, and choice behavior
bounded rationality 19, 21 15
economic man 142 Soss, N.M. 465–6
habits and routines 493–4 South Korea, x-efficiency of banks 286
institutions 16 Specter, S.E. 440
psychology 101, 115 speech 485–6
rationality 3, 20–21, 277, 278 spending decisions, individuals and households
smart person 145 350–52, 354–6, 359
social norms 528 Spinoza, B. 188
Simpson’s paradox 90–91, 93 stag hunt game 566–8
slackening (weakness of will) 505–6 Stahl, D.O. 126
smart decision-making, summary 1–7 Stalker, J. 559
Smith, Adam statistical discrimination 482
duty 564 stiffness of will, see will, weakness and stiffness
Hayek on 82 of
injustice 563 Stigler, G. 559
morality 560–61 Stöckl, T. 386–7
praise 562, 563 Strassels, P.N. 325
rationality 277, 497 strategy, behavioral, see behavioral strategy
self-interest 562–3, 564 Strathman, A. 416
value 242–3 Strotz, R.H. 458
‘view of man’ 83 Strümpel, B. 325
virtue 558, 559, 560, 561, 563–4 subjective expected utility (SEU) theory 142,
Smith, P.K. 437 277

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Index 583
success, desire for 502 true preferences 29–30, 31, 32

Sugden, R. 197 trust
Suhonen, N. 195 as social capital 518
suicide, and intelligence 464–5 and social interactions 482–4
cost–benefit analysis 466–9 universalist principle of honesty 547–8
creativity 472–3 Tullock, G. 306, 307
delay discounting 470–72 Tversky, A. 3, 21–2, 112, 121, 122, 198
executive functioning 472
income 473 Uberoi, J.S. 241
microeconomic theory of 465–6 uncertainty
Sunder, S. 127 and behavioral strategy 168
Sunstein, C. 31, 32, 323, 326 and decision-making 105–7
survival 14, 20 and nudging 109–11
Sussman, A.B. 331–2 unemployment 35–8
and birth rates 86–7, 88–9
Taiwan, x-efficiency of banks 285–6 US Marine Corps, behavioral strategy 163–9
Tajfel, H. 487 utilitarianism 566
taxation utility
fairness 321–2, 339 altruistic 507
and nudging 317–18, 322–8 early representation theorems 63
and obesity 435 gift-giving 214
size and extent of 318–20 identity 519
see also endogenous quality jurisdictions reflexive 508–9
model; income tax, compliance and regret theory 195–7
technological change, and obesity 438–40 subjective expected utility (SEU) 142, 277
tee (ceremonial practice) 244 types of 496–7
Thailand, x-efficiency of banks 285 utility maximization
Thaler, R.H. 31, 32, 121–2, 323, 325, 353–4, and core assumptions, conventional
458, 460 economics 19
Tideman, T.N. 201 discounting 458
time and freedom of choice 30–31
hyperbolic discounting, obesity 437–8 heuristics 125
and investment diversification 353 intertemporal 394, 395–6, 397–8
preference, obesity 436–7 loyalty, models of 207–25
rational lifetime planning, obesity 433–4, and obesity 433–9
437 and social inefficiency 18
treatment of 211 and suicide 465–6
utility maximization, intertemporal 394,
395–6, 397–8 value conflicts 355
see also love, models of Veblen, T. 69, 72, 74
time inconsistent preferences, physical activity Vesterland, L. 182
and weight loss 450, 457–61 virtues 149–51, 558–60, 561, 563–4
time orientation 413–17, 424–5 Vogel, T. 89, 92
consideration of future consequences vote-buying 483
416–17, 421, 422–4 voting
discounting 414–15, 417, 419–21, 422–3 classical rational actor model 543–6
domain differences in 419–21 motives 550, 553–4
and health behavior 413, 422–4 and regret 200–202
relationship between measures 417 rule-consequentialism 549
time perspective 415–16, 421
Todd, P.M. 20 wages, and unemployment 35–8
Torgler, B. 322 Wansink, B. 442, 443–4
trading, asset markets, see experimental asset Wason selection task 103
markets weakness of will, see will, weakness and
Treatise on Human Nature (Hume) 12–13 stiffness of

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wealth, consumption-savings model 396–405 definition 279

Weatherly, J.N. 419, 420–21 reason for existence 278–9
Whitehead, A.N. 62, 63 studies on 280–87
Wilber, K. 138, 140–41, 143, 151 x-inefficiency 23–6, 275, 276
will, weakness and stiffness of 492–6 choice 30
favoritism 506–8 extent of 279
literature review 496–8 reason for existence 278–9
pornography 510–11
shirking 498–504 Yang, B. 466
slackening 505–6 Yaniv, G. 434–5
spoiling of children 508–10 Yao, S. 281–2, 283
wishful thinking 502–3 Yoeli, E. 482
Wood, W.J. 149, 150 Young, H.P. 190
Wu, H. 282–3
Zhang, L. 437
x-efficiency 37, 275–6 Zimbardo Time Perspective Inventory (ZTPI)
choice 29–31 416, 417, 422–3

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HANDBOOK OF BEHAVIOURAL ECONOMICS AND

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Cheltenham, UK • Northampton, MA, USA

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1 Introduction to smart decision-making 1

PART I SMART DECISION-MAKERS, DIFFERENT TYPES OF

2 Rational inefficiency: smart thinking, bounded rationality and the scientific

PART II ASPECTS OF SMART DECISION-MAKING

9 Behavioral strategy at the frontline: insights and inspirations from the US

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PART III DEVELOPMENT AND GOVERNANCE

PART IV TAX BEHAVIOUR

17 Taxation and nudging 317

PART V SMART MACROECONOMICS AND FINANCE

19 Financial decisions in the household 349

PART VI DIMENSIONS OF HEALTH

23 Time orientation effects on health behavior 413

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25 Time inconsistent preferences in intertemporal choices for physical activity

PART VII SOCIOLOGICAL DIMENSIONS OF SMART DECISION-

27 Seeing and knowing others: the impact of social ties on economic

PART VIII MORALS AND ETHICS

31 Rational choice in public and private spheres 543

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such as Organization Science, Industrial and Corporate Change, Journal of Management

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published in the areas of behavioural economics, experimental economics and macro-

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Vernon L. Smith, Professor of Economics and Law

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