Behavioral Economics, Power, Rational Inefficiencies, Fuzzy Sets, and Public Policy

By Altman, Morris | Journal of Economic Issues, September 2005 | Go to article overview

Behavioral Economics, Power, Rational Inefficiencies, Fuzzy Sets, and Public Policy


Altman, Morris, Journal of Economic Issues


A fundamental difference between mainstream or traditional neoclassical theory and the various variants of behavioral economics is that to behavioral economics assumptions matter substantively to the construction of economic models (Altman 1999, 2001d, 2003; Simon 1987a, 1987b). In addition, behavioral economics explicitly recognizes the importance of institutional parameters in model building since institutions affect the decision-making process. Moreover, the Herbert Simon tradition in behavioral economics maintains that intelligent behavior need not yield the type of optimal or efficient behaviors predicted by traditional neoclassical theory (March 1978; Simon 1987b, 1991).

Although the focus of much of the recent research and discourse on behavioral economics has been in the realm of consumption and demand, this paper focuses upon the critically important domain of production in the tradition of Richard Cyert and James March (1963) and Harvey Leibenstein (1966, 1973, 1987). Moreover, unlike some in the recent literature in behavioral economics, following upon the work of Daniel Kahneman and Amos Tversky, we do not assume that the behavior of economic agents is inherently error prone, lacking in intelligence, or irrational. (1) Rather, following in the Simon and James March tradition, we assume that economic behavior is boundedly rational and therefore intelligent and purposeful. Rational behavior is not defined as "neoclassical" behavior, and behavior that deviates from neoclassical norms is not assumed to be irrational (Altman 2003).

This paper builds upon the empirically based premise that neoclassical assumptions about the optimality and efficiency of economic agents in the sphere of production are wrong. Such assumptions are in part situated in the worldview that market forces induce optimal and efficient behavior in the firm and, also, in the worldview that such behavior is part and parcel of human nature--that it is "bred in the bone." An important component of this worldview is that the quantity and quality effort inputs into the production process are maximized at all points in time. Thus firms are assumed to be, in Leibenstein's narrative on the firm, x-efficient in production. Building upon and extending the x-efficiency and efficiency wage theories pioneered by Leibenstein (1957, 1966, 1979, 1987; Frantz 1997) wherein the assumption of effort discretion is introduced into the production function of the firm, a model is presented here where both efficient (x-efficient) and inefficient (x-inefficient) firms can survive in equilibrium even in a regime of competitive product markets. (2)

In mainstream theory, effort discretion does not exist as economic agents are all maximizing their effort inputs, in both their quantity and quality dimension, into the production process. In the model presented here, both relatively efficient and inefficient firms and the choices of individuals underlying the relatively efficiency of the firms are both consistent with rational or intelligent behavior. Thus, assuming either competitive product markets or rational behavior need not result in efficiency in production. Whether or not efficiency obtains critically depends upon the preferences of the firms' economic agents and institutional parameters, including bargaining power, which constrain or affect the choices made by these economic agents. Rational individuals have no incentive to choose neoclassical efficiency unless such choice is in their self-interest or in the self-interest of the group or network of which they are part. This need not be the case for workers, managers, or firm owners wherein these economic agents possess differing and even conflicting objective functions.

As Kurt Rothschild (2002) has pointed out, the incentive structure within the firm as affected by the power relationship between firm members has been long neglected in contemporary economics inclusive of behavioral economics with the exception of Leibenstein (1982, 1984, 1987) and Simon (1991). …

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Behavioral Economics, Power, Rational Inefficiencies, Fuzzy Sets, and Public Policy
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