Adam Smith and the rationality assumption

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The evolution of the ideas regarding the human decision maker is important to understand because it reveals why researchers developed behavioral economics. Moreover it helps to understand the rise of the importance of cognitive biases. The ideas of the 17th century are far-gone but they are essential to understand the evolution of the field of decision-making.

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Descartes in the 17th century developed the Cartesian model of rationality wherein he described that the human reasoning is and should be logical, he assumed our reasoning is conscious and deliberate. Influenced by Descartes, Leibniz, in 1677, imagined a mathematical model for decision-making capable of leading all reasonable persons using it to a same conclusion. His idea was to create characteristic numbers for all ideas. Disputes would be reduced to computations involving those numbers. Withdrawing all subjectivity in decision-making his model would eradicate all never-ending disputes.

“Its authority will not be open any longer to doubt when it becomes possible to reveal the reason in all things with the clarity and certainty which was hitherto possible only in arithmetic. It will put an end to that sort of tedious objecting with which people plague each other, and which takes away the pleasure of reasoning and arguing in general.” (Leibniz, 1679)

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In the late 18th century Adam Smith put a milestone for what will become our neoclassical economic models. In his book ‘The Wealth of the Nations’ (A. Smith, 1776) he outlines his theory on Economics. Economics in his opinion, is the science of the wealth. A. Smith wanted to develop a theory using a scientific approach similarly to Newton and his mathematical laws for explaining physics. To be able to validate his theory, he made assumptions. One of the most important assumptions he made was the rationality of the human economic agent. Later, most economists would develop the economics as a systematic science.

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However, in their study, G. Loewenstein et al. (2005) argue Adam Smith was aware of the “multi- dimensional and realistic human being” in opposition to what he is pictured in many studies. The study shows that 18 years before writing his masterpiece, A. Smith wrote The Theory of Moral Sentiments (1759) in which he develops psychological factors affecting decision-making with outcomes as overconfidence or “loss aversion”.

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According to above-mentioned article A. Smith was aware of psychological factors affecting decision-making. If so, what happened and why were we using the neo-classical models based on an incomplete rationality assumption to explain economical behavior?

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This is due to economists neglecting the psychological findings of A. Smith on decision-making. Indeed, at the same period, in philosophy of science, positivism made his appearance and became the mainstream way of thoughts. (Arzlan, 2003) Positivists believe that knowledge can be deduced only by science, they categorically reject any form of subjectivism or intangible factors. Most economists of that period shared the “modernistic thinking” which consists on relying purely on rationality to achieve progress.

In this context the economics as emerging field wanted to eradicate any form of psychological aspect in their field wanting to achieve a pure natural science.

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The economists developed mathematical economic models that rely on one of A. Smith major assumptions namely the rationality of the economical agent. The Homo Economicus was born. This term, refers to the entirely rational nature of the human being.

Edgeworth, Walras, Paretto: all are examples of economists who build theories based on the rationality of the economical agent and thus build the foundations of our neo-classical economics. These models and their correlated assumptions accordingly affected the field of decision-making. Among them Von Neuman and Morgenstern (1947) developed the model of expected utility based on the assumption that the decision-maker is fully rational. This model became the paradigm in our economic reasoning. The decision-maker was considered as a 100% rational agent that follows strict patterns in order to optimize a solution to a given problem under fixed constraints.

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In her paper on Decision Making and Judgment Analysis, Davies (2011) writes on the expected utility theory:

 

“The application of expected utility theory for understanding decision making comes from the assumption that individuals will always act to maximise expected utility (Edwards, 1954). This means that if we can identify the value of different outcomes for an individual and the associated probabilities, we can anticipate likely decisions”

 

All in one, the prescriptive models were born. The aim was to consider the human agent as capable of making optimal decisions following rational patterns.

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To summarize, to assure the consistency of their models based on a scientific method, the neo- classical economists had to embrace the rationality assumption of the decision-maker.

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Herbert Simon and bounded rationality

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However, in the mid 20th century, researchers noticed the neo-classical models had their limitations. The idea grew that multiple other factors interfered in practice and that the rationality assumption on which economists based their models was incomplete.

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Herbert Simon introduced one of the first concepts contradicting the neo-classical models in 1955. He argued the power and the scope of rational decision making in causing and explaining human action (J.Kaplan, 2008).

H. Simon noticed decision-makers couldn’t process all the relevant information (Simon, 1955) to a particular problem before the actual decision had to be made. He developed the concept of “ Bounded rationality”. He argued the decision-makers were not 100% rational as developed in the neo-classical models. The decision-makers had limits to information processing; there are bounds on our rationality.

 

Besides, a researcher who contributed to the emerging of the concept of bounded rationality is Frederick Hayek. Roger Frantz in his book (Hayek and Behavioral Economics, 2012) argues F. Hayek’s principal argument against the rationality assumption was the limits of the human inner environment, the “computational limits of human beings”.

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Moreover, as noted by H. Schwartz (2002), H. Simon assumed, in contradiction with the neo- classical theories that an important task of the decision-maker is to develop means of searching to design alternatives to a specific problem set. Thus he introduced a new scope into the field decision- making. The decision-maker is not anymore only responsible to optimize a problem set according to rationality assumption. Besides, his responsibility is to create means to design alternatives to the problem set.

Simon (1997) wrote bounded rationality is rationality: “that is consistent with our knowledge of actual human choice behaviour, assumed that the decision maker must search for alternatives, has egregiously incomplete and inaccurate knowledge about the consequences of actions, and chooses

actions that are expected to . . . attain targets while satisfying constraints”.

 

H. Simon disagreed with the neo-classical assumption and models of Paretto that decision-makers would always adopt the optimal solution for a given problem set. Simon wrote (1997):  “Many expert systems are designed to seek satisfactory (satisficing) solutions instead of optimizing solutions, thereby making it feasible to handle many kinds of decisions whose optimal solutions are computationally unobtainable”. Decision-makers in a business context where time constraints are coupled with uncertainty and ambiguity are forced to “satisfice”.

 

This concept, a porte-manteau of “satisfy” and “suffice”, underlines H. Simon disagreement with the neo-classical models. H. Simon wanted to stress the impossibility of decision-makers to “optimize” under all circumstances due to limited brain and/or time capacity.

 

In further research Herbert Simon noticed they were psychological aspects to rationality. He worked with Newell and al. (1962) with whom he described a heuristic: “Any principle or device that contributes to the reduction in the average search to a solution” he developed the idea that decision-making was often influenced by the heuristics. 

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To summarize, Herbert Simon disagrees with the concept of pure rationality used in the neo-classical models.

According to him the decision-maker is not 100% rational as described by the assumption of Adam Smith. With his concept of “bounded rationality” he shed the light of the computational limits of the decision-maker.

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