RATIONAL ACTORS, TCA, P

1
RATIONAL ACTORS, TCA, PA
Most economists rigorously defend the rational
actor model of decision making, but others seek
to modify assumptions to induce greater realism.
Expected utility is simply a utility function
applied to uncertain events. Its key property
can be exemplified An actor faces two uncertain
outcomes, X and Y, occurring with subjective
expected probabilities of p and 1-p. An SEU
actor compares each options utility, weighting
by their probabilities. Hence, the actors
expected utility will be U (p)U(X)
(1-p)U(Y) Play RC Games to get a feel for this
process.
After examining bounded-rationality alternatives
that attempt to rescue rational choice from its
utility-maximizing assumption, well look at
transaction cost and principal-agent theories
that replace the atomized homoeconomus with
calculators who must take others into account.
2
Rational Choice Games
Makes a rational choice for each pair of bets
i.e., choose that bet which will maximize your
subjective expected utility U (p)U(X)
(1-p)U(Y)
Problem 2 Choose between (C) Certainty of
receiving 100 (D) 10 chance of winning 500
and 90 chance of winning 100

• Problem 1 Choose between
• 10 chance of winning 100 and
• 90 chance of nothing
• (B) 10 chance of winning 500 and
• 90 chance of nothing

Problem 3 Choose between (E) Certainty of
receiving 100 (F) 50 chance of winning 200 and
50 chance of winning nothing
Problem 4 Choose between (G) Sure loss of
100 (H) 50 chance of losing 200 and 50
chance of losing nothing
3
Milton Friedman, As If
In The Methodology of Positive Economics
(1953), Milton Friedman defended the allegedly
unrealistic assumptions of rational choice
model.
He argued that people and firms make decisions
as if they apply SEU maximization under perfect
information. Economic theory has great
predictive value despite its obvious
unrealistic assumptions. Whether firms really
seek to maximize profits is irrelevant the only
important theoretical criterion is that it
generates correct and significant predictions.
It is frequently convenient to present such a
hypothesis by stating that the phenomena it is
desired to predict behave in the world of
observation as if they occurred in a hypothetical
and highly simplified world containing only the
forces that the hypothesis asserts to be
important. In general, there is more than one way
to formulate such a description more than one
set of assumptions in terms of which the theory
can be presented. The choice among such
alternative assumptions is made on the grounds of
the resulting economy, clarity, and precision in
presenting the hypothesis their capacity to
bring indirect evidence to bear on the validity
of the hypothesis by suggesting some of its
implications that can be readily checked with
observation or by bringing out its connection
with other hypotheses dealing with related
phenomena and similar considerations.
4
Simon Says, Bounded Rationality
The polymath Herbert Simon proposed that
rationality is bounded. Because getting
information is costly and decision outcomes
typically unknown, instead of maximizing
utilities, people only try to satisfice.
Satisficing behavior seeks only a minimum, not a
maximum value of a variable people choose as
well as they think is possible. The behavioral
theory of the firm sees producers treating
profits as constraints, not goals to be
maximized. Although some critical level of
profit must be achieved, thereafter, a firms
priority turns to its other goals.
Most producers are employees, not owners of the
firms..... Viewed from the vantage point of
classical economic theory, they have no reason
to maximize the profits of the firms, except to
the extent that they can be controlled by
owners.... there is no difference, in this
respect, among profit-making firms, nonprofit,
and bureaucratic organizations. All have exactly
the same problem of inducing their employees to
work toward the orgl goals. There is no reason,
a priori, why it should be easier (or harder) to
produce this motivation in organizations aimed at
maximizing profits than in organizations with
different goals. The conclusion that
organization motivated by profits will be more
efficient than other organizations does not
follow the organizational economy from
neoclassical assumptions. If it is empirically
true, other axioms will have to be introduced to
account for it.
5
Prospecting for Gains Losses
Daniel Kahneman Amos Tverskys prospect theory
posited a gain-loss cognitive process that guide
behaviors under conditions of uncertainty.
Using lottery choices as a paradigm, they divided
behavioral decision making into two phases (1)
Editing events into a mental model, which orders
alternatives by a simple heuristic, to
enable (2) Evaluation, which is asymmetric
losses have bigger impact than gains on choices
(risk-aversion)

• Prospect theory may offer better explanations
  than the standard rational choice model of
• Gambling betting puzzles we suffer more from
  a loss than we enjoy a win
• Endowment effect over-valuing something once
  you own it (house, painting)
• Status quo bias people prefer that things stay
  relatively unchanged
• Equity premium puzzle why are stock returns 6
  gt govment bonds?
• Intertemporal consumption personal savings are
  highest in middle-age because people divide their
  assets into mental accounts with different
  consumption rates

Unlike additive utility functions of neoclassical
economics, prospect theory implies that personal
utilities can derive from social reference
groups. Happiness research finds that subjective
measures of well-being remain relatively stable
over time, despite large absolute increases in
living standards within a population (Easterlin
1974 Frank 1997).
6
Uncertainty as a Scope Condition?
Jens Beckerts (1996) criticized rational choice,
not for its unrealistic informational
requirements, but inability to explain how people
actually choose under conditions of uncertainty
(no info to assign probabilities).
The assumption of uncertainty threatening
the notion of rational choice as the core
behavioral assumption of economic theory.
Important to look at those cognitive,
structural, cultural mechanisms that agents
rely upon when determining their actions without
knowing what to do in order to maximize their
outcome.

• Should the scope condition of RCT be restricted
  only to near-certain economic situations (i.e.,
  perfect markets complete information)?
• Give examples of social devices that actors can
  use in uncertain conditions that limit the
  choice set and make actions at the same time
  predictable
• Rules regulations (institutions)
• Social norms conventions
• Social structures
• Power relations

7
Transaction Cost Analysis
While still a grad student, Ronald Coase (The
Nature of the Firm 1937) posed two questions
that won him the 1991 Nobel Prize for economics

• Why do any firms emerge in a market economy,
  instead of just individuals contracting each
  other?
• Why not just One Big Firm for the entire
  economy, with all employees hired by a single
  entrepreneur to produce everything?

Coase argued that markets arent cost-free, but
involve transaction costs time money to search
for sellers buyers, negotiate exchange terms,
write contracts, keep trade secrets, inspect
results, enforce deals.
Firms will emerge whenever an economizing
organization can reduce its production
transaction costs lt market prices Firm expansion
halts when intra-orgl TC gt market prices
8
The Costs of Transacting
Transactions are embedded within social,
political, legal institutional environments that
affect transaction costs. These rules of the
game affect property, production, distribution,
and exchange relations among economic actors.
EPA regulations about lead
pollution emissions
Opportunism Self-interest with guile could
induce strategic behavior by transactors to lie
to, cheat, confuse, mislead their exchange
partners Used car salesmen political
candidates your prelim study group?
Even if opportunism risks are low, actors must
still safeguard against possibly severe damages
from opportunistic partners (the worst-case
scenario). But, contracts cannot be iron-clad
against all possible contingencies that may
arise! What to do?
9
Transaction Economizing ? Governance
Oliver Williamson identified three forms for
governing transactions conditions where each
governance form more likely to be used.
Market Transactions governed by prices in
supply-demand equilibrium Hierarchy (Formal org)
Transactions among parties occur under one owner,
who settles disputes by administrative
fiat Hybrid Long-term contractual relations
that preserve parties autonomy, but provide
added transaction-specific safeguards as compared
with the market.

• Orgs hybrids likely to internalize transactions
  (make-not-buy) if
• Frequency of exchanges is high, not a one-off
  occurrence
• Uncertainty about environments/actors is high
  e.g., hurricanes floods often delay
  just-in-time delivery from your suppliers
  factory
• Asset specificity is high, i.e., investments in
  human skills, brand names, sites, machinery
  lacking other uses e.g., a blast furnace that
  produces a type quality of steel demanded by
  just a few customers

10
Williamsons discriminating alignment hypothesis.
Transactions of varying attributes align with
governances structures differing in cost and
competence, so as to effect a (mainly)
transaction cost economizing result (199837).
Public bureau is the form of last resort.
11
Principal-Agent Theory
Principal-agent theory of contracts shares with
TCA core concepts of uncertainty, opportunism,
externalization, cost-efficiency calculations.
Principal pays Agent to perform service in
exchange for fee
? Stars hire Hollywood, sports agents to
negotiate contracts (Jerry McGuire) ? Board of
directors pays white-knight CEO megabuck to
boost share prices ? Trustees search for a
university president to raise its academic
prestige

• Information asymmetry How does Principal know
  if Agent is competent and working on behalf of
  Ps interests? (If P had necessary knowledge and
  skills, then As services would be unnecessary)
• Agency costs Principals costs to search,
  monitor, bond in hiring and supervising the
  Agent (vs P doing the job all by herself)
• Opportunism moral hazard Risk-averse Agent is
  tempted to deceive shirk duties to pocket fee
  but not deliver the best deal

12
Moral Hazards
Moral hazard is the risk that one party to a
contract can change its behavior to the detriment
of the other party after the contract is signed.

• Insurance can encourage riskier behaviors
• Avoid preventive medical, dental check-ups
• Fail to clear brush near California homes
• Incentives to commit arson of failing business
• Bankruptcy laws foster foolish consumption
• Does available abortion promote promiscuity?

To lessen hazards, actuaries wont insure any
property for more than it is worth, or even for
its replacement cost, and almost always require a
deductible (initial up-front sum which the
insured must pay out of his or her own pocket).
They may also impose other conditions, such as
the ownership of fire extinguishers.
A common solution to moral hazard problems
closely related to information asymmetry is to
offer appropriate incentives that will induce
agents act in behalf of the principals
interests.
13
Performance Incentives
Monitoring Agents skills activities is
difficult, so Principal could use
pay-for-performance incentives to encourage As
risk-taking and make A more accountable in
looking out for Ps interests
Make As compenation contingent on actual
outcomes CEO bonus, stock options depend on
annual share prices Teachers salary gains tied
to her students test scores
Problem Orgs performance affected by many
factors beyond agents control (fickle consumers,
govt regs, bad weather) In high uncertainty,
tying compensation to performance may actually
induce a risk-averse CEO to take timid,
less-risky actions in effort to avoid a major
loss to personal fortune
Major corporate CEO pay-performance effect very
weak only 3.25 per 1,000 change in
shareholder wealth 1 weeks pay (9,600 in
1980s) This amount judged small for an
occupation in which incentive pay is expected to
play an important role (Jensen Murphy 1990227)
14
Readings Discussion Quex
1. Does Williamsons TCA theory over-emphasize
the risks from potential opportunism? Why should
actors strive mightily to safeguard against
deceit, when most transacting partners can be
expected to behave honestly? 2. By recognizing
the importance of economic institutions
especially governance structures does TCA plug
weaknesses in neoclassical RCT? 3. Williamson
There is no one, all-purpose, superior form of
organization a place needs to be made for each
generic form, but each form needs to be kept in
its place. Do you agree? What is the place of
public bureaucracies? 4. Eisenhardts P7 Goal
conflict between P A is negatively related to
behavioral contracts positively to
outcome-based contracts. Discuss an example of
P A with little disagreement on goals, leading
to outcome-based contracting. (HINT
Advisor-Grad student relations?) 5. Despite its
focus on cooperative tasks by actors with partial
goal conflicts, is agency theory still too
strongly wedded to economic rational actor
models? 6. How does Boudons propose to salvage
RCT for sociology? 7. Why does Boudon
characterize Webers interpretive sociology of
religion as not an RCT? Could it become RCT by
embracing additional postulates?