Palgrave Advances in Behavioral Economics. Series Editor John F. Tomer Co-Editor, Jl of Socio-Economics Manhattan College Riverdale, USA

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1 Palgrave Advances in Behavioral Economics Series Editor John F. Tomer Co-Editor, Jl of Socio-Economics Manhattan College Riverdale, USA

2 This ground breaking series is designed to make available in book form unique behavioral economic contributions. It provides a publishing opportunity for behavioral economist authors who have a novel perspective and have developed a special ability to integrate economics with other disciplines. It will allow these authors to fully develop their ideas. In general, it is not a place for narrow technical contributions. Theoretical/conceptual, empirical, and policy contributions are all welcome. More information about this series at

3 Shinji Teraji Evolving Norms Cognitive Perspectives in Economics

4 Shinji Teraji Yamaguchi University, Yamaguchi Japan Palgrave Advances in Behavioral Economics ISBN ISBN (ebook) DOI / Library of Congress Control Number: The Editor(s) (if applicable) and The Author(s) 2016 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. Cover illustration: m-images / Alamy Stock Photo Printed on acid-free paper This Palgrave Macmillan imprint is published by Springer Nature The registered company is Nature America Inc. New York

5 To the memory of my late mother

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7 PREFACE AND AC KNOWLEDGEMENTS This book is about social norms in a variety of cognitive and institutional processes. Social norms are shared guidelines to socially accepted and expected behavior. Social norms provide order to what may otherwise be seen as ambiguous, uncertain, or threatening situations. Norms may be seen as regular behavioral patterns that develop as individuals interact with one another socially. The main purpose of this book is to develop a general framework within which it is possible to analyze a relationship between the sensory order and the social order. A choice is a selection among numerous possible behavioral alternatives. A decision is a process through which this selection is performed. Conventional economic models include only variables that condition what an agent chooses and none that condition how an agent chooses. This entails a black box view on the individual, meaning that it does not matter analytically how that behavior is actually generated. F.A. Hayek s theory of mind sheds light upon the process of choice. The sensory order is fundamental in the sense that the explanation of social order begins with the human mind. The central element in the cognitive process is the feedback between individual and environment. The book explains institutional evolution as an endogenous phenomenon from a cognitive viewpoint. In The Sensory Order (1952), Hayek provided a theory of the process by which the mind perceives the world around it. According to Hayek, knowing the world is a classification of sensory qualities by the mind. What we know at any moment about the external world is determined by the order of the apparatus of classification which has been built up by previous vii

8 viii PREFACE AND ACKNOWLEDGEMENTS sensory linkages. The qualitative differences in perceptions that people experience depend upon the specific pattern of neuron firings that a given stimulus produces within various neural networks. The experience of each individual will differ according to the pattern of neuron firings that each one develops. The subjectivity of individual knowledge finds its foundation in the construction of the mind. Through learning and updating, the sensory order evolves into a gradual approximation of the physical order. The mind operates by assembling new sensory data into associations with our accumulated inventory of knowledge. An understanding of social norms is critical to predict and explain human behavior. Hayek s concept of perception as classification has a counterpart in his concepts of rules and rule-following behavior. People follow rules of conduct in society. These rules indicate what people should or should not do under some circumstances. Relying upon rules is a device we have learned to use because our reason is insufficient to master the detail of complex reality. For Hayek, rules make it possible for individuals to classify stimuli. The order of a group can be generated by the rules of conduct adhered to by its members. How the mind classifies stimuli determines how individuals act in the external world. Much of our knowledge is embedded in institutions. The mind is shaped not only by experience but also by custom. Rules of conduct are shared by individuals having a common cultural tradition. If people have widely divergent expectations, some of their actions will invariably fail and need to be revised. Culture limits the range of actions that people are likely to take in a particular situation, making their conduct more predictable and thereby facilitating the formation of reliable expectations. Shared mental models can give rise to behavioral regularities to the extent that they can be observed in the population. As a consequence, following rules of conduct mutually reinforce sets of expectations to maintain a degree of social order. Patterns emerge endogenously, reflecting a socially constructed reality. Given the human need for rules, there is a tendency to repeat those patterns as a guideline for action in future instances of similar behavior. The structure of this book follows the development of these arguments. Chapter 1 explains some fundamental concepts that are used in the book. The concepts are as follows: social norms, economic behavior, rationality, cognition, institutions, path dependence, and institutional change. An understanding of social norms is critical to predict and explain human behavior. People incorporate in themselves a set of social norms from their surroundings. Norms govern behavior, and are self-sustaining in an

9 PREFACE AND ACKNOWLEDGEMENTS ix interdependent system. Norms specify a limited range of behavior that is acceptable in a situation, and facilitate confidence in the choice of action. Norms enable individuals to deal with the complexity and incompleteness of information, and make them stick to prescribed behavior. Norms thus describe the uniform behaviors that characterize groups. Chapter 2 presents some reasons why people comply with social norms. First, in large measure, people do what they do because they have learned from those who surround them. Society is sustained by processes favorable to individuals endowed with an element of docility in following rules. Second, social norms can be sustained if the pecuniary advantage from breaking norms is not sufficient to offset the forgone reputation effect. Third, people comply with norms because the threat of punishment makes being compliant within their interest. Fourth, norms are represented as Nash equilibria of games played by rational agents, and as such they are self-enforcing. Finally, correlated equilibrium allows players actions to be statistically dependent upon some random signals external to the model. Chapter 3 focuses on The Sensory Order (1952). Hayek provides a theory of the process by which the mind perceives the world around it. The sensory order is a classification that takes place via a network of impulse connections. The essence of Hayek s attempt in theoretical psychology is to show how a structure can be formed which discriminates between different physical stimuli and generates the sensory order that we actually experience. The sensory order is an incomplete and imperfect representation of the physical world. The subjectivity of individual knowledge finds its foundation in the construction of the mind. The brain is an adaptive system interacting with and adapting to its environment by performing a multi-level classification on the stimuli it receives from the environment. Chapter 4 deals with the social order. The dissemination of knowledge is crucial in society. People live in a world of expectations about interactions with others actions. It is meaningful to discuss the social order only when all agents share the same perception of existing reality which includes others actions. People follow rules of behavior in society. Relying on rules is a device we have learned to use because our reason is insufficient to master the detail of complex reality. If rules are recognized as recurrent patterns of behavior, individuals act according to rules of conduct. The diffusion of shared behavioral patterns is necessary to obtain social order. Shared rules facilitate decision-making in complex situations by limiting the range of circumstances to which individuals have to pay attention.

10 x PREFACE AND ACKNOWLEDGEMENTS Chapter 5 covers culture and cultural evolution. Culture, as a system of shared beliefs, provides collective understandings in forming peoples choices. The existence of culture presupposes a population capable of mental representations. Culture coordinates the expectations of many agents with regard to actions, and it shapes and structures our daily patterns of behavior, guiding much of what we should do by prescribing what behavior is acceptable. Agents who belong to the same cultural group are exposed to the same external representation of knowledge. In Hayek s theory of cultural evolution, societies are not only subject to group selection but have developed through a process in which individuals choose the rules that form the social order. New rules undergo some kind of de-centralized selection process, as a consequence of which some spread through the population. Chapter 6 deals with coevolution of mind and society. Theories of institutions can be classified into two broad approaches: institutions-asrules and institutions-as-equilibria. Institutional structures and individual actions coevolve. In order to have a complete picture of institutions in interactions between structure and agency, we need to take both approaches into consideration. In the mental dimension, institutions guide individual behavior and thought. In the emergence dimension, the equilibrium state is generated as the result of actions chosen by individual agents. The mind is endogenous to the individual s environment, which implies that expectations are also endogenous to the individual s environment. Shifts in mental models change individuals plans and actions, which in turn lead to institutional evolution. A key to understanding institutional evolution is an understanding of how individuals modify their mental models. Most of the material of this book was written at the Department of Economics, Yamaguchi University. I would like to thank some of my colleagues for valuable discussions. At the University of Canterbury, which I visited, I am grateful to Jeremy Clark for his useful remarks on my research. Some articles in the book were presented at international conferences sponsored by the Society for the Advancement of Behavioral Economics (SABE) and the International Association for Research in Economic Psychology (IAREP). Many thanks to Morris Altman (Professor, University of Newcastle) for his thoughtful comments and suggestions. As a series editor of Palgrave Advances in Behavioral Economics, John Tomer (Emeritus Professor, Manhattan College) encouragingly accepted my idea to publish a book on behavioral and institutional economics. It

11 PREFACE AND ACKNOWLEDGEMENTS xi has been a pleasure to work with Sarah Lawrence at Palgrave Macmillan. I would also like to thank Leila Campoli for bringing this project to fruition. This book is based upon previously published journal articles, with permission from Elsevier. This book s chapters and relevant journal articles are as follows: Appendix 2 in Chap. 1, Shinji Teraji (2003) Herd behavior and the quality of opinions, Journal of Socio- Economics, vol. 32 (6), pp Appendix 1 in Chap. 2, Shinji Teraji (2007) Morale and the evolution of norms, Journal of Socio- Economics, vol. 36 (1), pp Appendix 2 in Chap. 2, Shinji Teraji (2013) A theory of norm compliance: Punishment and reputation, Journal of Socio- Economics, vol. 44 (C), pp Appendix 3 in Chap. 2, Shinji Teraji (2009b) A model of corporate social performance: Social satisfaction and moral conduct, Journal of Socio-Economics, vol. 38 (6), pp Appendix 2 in Chap. 5, Shinji Teraji (2008a) Culture, effort variability, and hierarchy, Journal of Socio-Economics, vol. 37 (1), pp Appendix 3 in Chap. 5, Shinji Teraji (2008b) Property rights, trust, and economic performance, Journal of Socio- Economics, vol. 37 (4), pp Appendix 4 in Chap. 5, Shinji Teraji (2009a) The economics of possible selves, Journal of Socio- Economics, vol. 38 (1), pp Appendix 5 in Chap. 5, Shinji Teraji (2011) An economic analysis of social exclusion and inequality, Journal of Socio-Economics, vol. 40 (3), pp Shinji Teraji Yamaguchi, Japan

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13 CONTENTS 1 Foundations 1 2 Why Do People Obey Norms? 65 3 The Sensory Order Revisited Norms, Coordination, and Order Culture and Cultural Evolution Coevolution of Mind and Society 311 Epilogue 345 Index 351 xiii

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15 LIST OF FIGURES Fig. 2.1 Population dynamics through socialization 97 Fig. 2.2 The relationship between b and p 110 Fig. 2.3 The increase in p 111 Fig. 2.4 The decrease in p 112 Fig. 3.1 Macro-micro relations 165 Fig. 5.1 The state space separated into two sets 295 Fig. 6.1 Macro micro relations and two dimensions 327 xv