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Kahneman, Tversky, and Institutional Economics

By Pressman, Steven | Journal of Economic Issues, June 2006 | Go to article overview

Kahneman, Tversky, and Institutional Economics


Pressman, Steven, Journal of Economic Issues


For institutionalists, behavior depends on the habits, routines, and customs of economic actors. Habits, routines, and customs are how actors make decisions. They are matters of law and tradition, and they get passed along by examples, by the expectations of society, by social sanctions, and by the power of the state. People tend to follow these rules because they see everyone else doing so and because there are social rewards for doing so. When most people follow institutional rules, behavior becomes more certain and individuals are less likely to feel foolish by being wrong about important choices.

Most institutionalists adopt this social view of human behavior. But there is an alternative to the social transmission of routines and habits. It is possible that behaviors have evolved over the course of human history and have survival value. With time, decision-making algorithms have become part of the human makeup and the architecture of the human mind. This approach to human behavior moves institutional economics toward evolutionary economics, a necessary step if economics is to progress (Hodgson 1998, 2004).

The purpose of this paper is two-fold. First, it seeks to make institutionalists more aware of the work of Daniel Kahneman and Amos Tversky. Supporting institutional economics, their work shows that people do not behave as neoclassical economists predict. Second, their experiments are not social in nature. They study isolated individuals in unique situations with minimal social influences. Consequently, their results are more consistent with an evolutionary approach to economics.

Starting with Lionel Robbins (1932), neoclassical economics has studied the alternative uses of scarce resources to satisfy unlimited wants. Rationality is the force compelling people to efficiently use resources and satisfy their wants to the greatest extent possible.

The rationality assumption has been criticized many times and for many reasons (Walsh 1996; Hodgson 2004, 408-10). One problem is the pervasive phenomenon of voting behavior (Pressman 2004). Another problem is that in games such as the prisoner's dilemma the rational thing to do is not clear. Using logic and maximization yields less optimal results than cooperation among individuals (Rizvi 1994).

Institutionalist economists have also rejected the rationality assumption. Thorstein Veblen and John Kenneth Galbraith emphasized how conspicuous consumption and advertising, rather than utility maximization, impact spending. For Veblen ([1899] 1908), we decide what to consume and what gives us utility by looking at what other people are doing. Veblen (1919) also criticized the view that people could quickly calculate the pleasures and pains that would result from every possible action. For Galbraith (1969), people take their cues from the heavy advertising done by large companies.

Kahneman and Tversky have supported this view via experiments showing that people do not behave according to the precepts of rational economic man. But before we get to this, a few words are needed regarding their framework.

Kahneman (and Fredrick 2002) and Tversky see human judgments as having two different components. First, people directly perceive things; we take in information from the environment around us. However, our perceptual systems are not perfect. Optical illusions are one well-known class of perceptual error.

Second, we have a deliberative or evaluative system which knows that our perceptions can be mistaken and may try to correct them. Unfortunately, we cannot always succeed. Kahneman and Tversky identified several types of decision-making mistakes-when our perceptual system generates errors and our deliberative system fails to correct them. Moreover, Kahneman and Tversky (1973) have shown that these errors are not mitigated through either education or experience. People do not seem to learn from their past mistakes; instead, they tend to repeat them.

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