San José State University
Department of Economics

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Thayer Watkins
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The Irrelevance of Empirical Studies
of Human Decision-making to Microeconomic
Theory and Analysis

In 1978 Herbert Simon was awarded the Nobel Prize in the Economic Sciences for his work on the study of decision making in organizations. In 2002 Daniel Kahneman and Vernon Smith shared that same prize for their empirical studies of decision making. The gist of such empirical studies is that the way people actually make decisions is definitely not that which is assumed by microeconomic theory. The seeming implication is that microeconomic theory is defective and needs to be replaced. That implication is not valid. Microeconomic theory is concerned with the behavior of markets not the behavior of individual participants in those markets.

The understanding that non-intervened markets can be rational even if the agents in those markets are not rational in an economic sense of the term goes back to an article by Armen Alchian,
"Uncertainty, Evolution and Economic Theory,"published in The Journal of Political Economy,Volume 58 (1950), pages 211-221.

Armen Alchian's article was very influential. It first introduced the notion that the power of the market does not depend upon the brilliance and the motivation of the entrepreneurs in the market. The power of the market instead lies in its evolutionary character. The entrepreneurs in a market may not have the information and savvy necessary to maximize profits. They may not even want to maximize profits. Nevertheless the market system ensures that the decisions get made which result in the market evolving in the same direction as it would have if the entrepreneurs had the information and motivation to maximize profits.

When a decision has to be made there may be no one of the market participants who knows which decision will be in his or her best interest. The decisions that are made will generally be varied. They may be made randomly; they may be made by incorrect analysis and/or for the wrong reasons. Nevertheless the operation of the market will dictate that some of the decisions will perform better than others. There may be one entity which for whatever reason makes the decision that results in the best market performance. That entity will prosper and will likely grow. Other entities seeing the prospering of that entity will imitate its decisions. In Alchian's words, the other entities will adopt the decisions of the most prosperous. And thus the market moves in the direction dictated by the best-performing entity. The end result is that by evolution the market moves in the direction dictated by the highest prospering market participant. That market participant may have the right choice by chance or wrong analysis, nevertheless the end result for the market is as though the entities maximized their self interest. The market participants do not need to know how to maximize profit, they only need to know how to recognize what they like.
 
In contrast, in a centrally administered economy the planners, when faced with decisions to be made make a single decision. There is no variation; there is no range of choices to evaluate. There is no most prosperous choice to imitate. The decision made by the planners may be wrong but no one can admit that. No one but the planners get to make the decisions so there can be no imitation, no adoption in Alchian's terminology.

A functioning evolutionary system needs three elements:

In a market the entrepreneurs acting independently generate the alternatives. The criterion for evaluation of the alternatives is usually called profit, but that is an abbreviation for the present value of net gains. (For more on this issue see profit maximization.) The profit criterion results in those who do not gain profit get eliminated and are replaced by those who do.

In a centrally administered economy:

Here is an illustration of how an optimal choice was made by pure chance. A student-friend of mine named John told me of his experience in the U.S. Army during the era of the Vietnam War. John was assigned to the army language school. The time was the middle 1960's when the Vietnam War was still operational. The Army needed Vietnamese interpreters. The administrators gave the students in the language program a list of 25 languages and asked them to compile a list of their preferences of languages to learn. All of the students put languages like French and German at the tops of their lists and Vietnamese at the very bottom. John did likewise but found when he finished that he had only 24 languages in his list. After careful searching John found that he had left out Polish. He did not want to rewrite the list so he put Polish at the bottom of his list just below Vietnamese. The administrators' ploy of giving students of their choice of languages to learn was in the nature of a joke. They gave them the language that was on the bottom of their lists. John to his surprise was assigned to learn Polish. When he completed the program he was stationed at an Army base near the Baltic Sea coast of West Germany. His duty was to monitor the radio broadcasts from Poland and sometimes he could do that at the beach. It was a remarkably easy assignment. Completely by chance John found that he had made the optimum choice for himself.

For Alchian's article see Alchian.


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