To Navigate Safely in the Vast Sea of Empirical Facts : A Weberian Analysis of Behavioral and Neoclassical Economics. Erik Angner * Date: 1 April 2013

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1 To Navigate Safely in the Vast Sea of Empirical Facts : A Weberian Analysis of Behavioral and Neoclassical Economics Erik Angner * Date: 1 April 2013 Word Count: 8235 * Dept. of Philosophy, Dept. of Economics, and School of Public Policy, George Mason University, 4400 University Drive 3F1, Fairfax, VA 22030, USA. Phone: Fax: eangner@gmu.edu. Unless otherwise noted, all italics as in original. I am grateful to George Loewenstein for constructive comments on an earlier draft. Errors remain my own.

2 BEHAVIORAL VS. NEOCLASSICAL ECONOMICS: A WEBERIAN ANALYSIS Abstract. This paper examines the epistemological status of neoclassical economic theory within behavioral economics: the attempt to increase the explanatory and predictive power of economic theory by providing it with more psychologically plausible foundations. Behavioral economics, the runaway success story of contemporary economics, is often described as rejecting assumptions underlying orthodox, neoclassical economic theory of rational decision making. Yet, behavioral economists have gone out of their way to praise those very assumption. Consider Matthew Rabin, who writes that behavioral economics is not only built on the premise that [orthodox] economic methods are great, but also that most mainstream economic assumptions are great. These apparently contradictory attitudes toward neoclassical theory raises the question of what, exactly, the epistemological status of neoclassical theory within behavioral economics is. This paper argues the paradox can be resolved, and the question answered, by thinking of the epistemological status of neoclassical economics within behavioral economics in terms of Max Weber s ideal types: analytical constructs which are not intended to be empirically adequate but which nevertheless can be used for a variety of theoretical purposes. The analysis has important implications for the practice of not just behavioral economics but for neoclassical economics too. 1

3 1 Introduction Behavioral economics is the attempt to increase the explanatory and predictive power of economic theory by providing it with more psychologically plausible foundations, where psychologically plausible means consistent with the best available psychological theory (Angner & Loewenstein, 2012, p. 642). 1 In the decades since its founding, behavioral economics has been a smashing success. In the words of Robert H. Frank: Behavioral economics has been the economics profession s runaway growth area of recent decades (Frank, 2011, p. ix). Behavioral economics is best seen as representing a cognitive revolution in economics. Like cognitive science, behavioral economics emerged in reaction to certain positivist methodological strictures that were in place at its founding; is based on a belief in the legitimacy of making reference to unobservable entities such as emotions and heuristics; and adopts an interdisciplinary approach, using a variety of methods to generate diverse forms of evidence. Like cognitive scientists, behavioral economists recognize that the mental mechanisms underpinning human judgment and decision making are fundamentally functional but sometimes fail, and aspire to develop models of judgment and decision making that account for the successes as well as the failures. In spite of the break with orthodoxy, behavioral economics is still economics: it remains, as Frank and Ben S. Bernanke express the canonical view, the study of how people make choices under conditions of scarcity and of the results of those choices for society (Frank & Bernanke, 2004, p. 4). As the definition suggests, behavioral economics is motivated by the realization that actual human beings deviate in significant, systematic, and therefore predictable ways from the assumptions of orthodox (neoclassical) economics including the assumptions of stable, consistent, and transitive preferences; Bayesian updating; expected utility maximization; exponential time 1 A Course in Behavioral Economics (Angner, 2012) offers an accessible introduction to behavioral economics. 2

4 discounting; and so on and it aims to replace those assumptions with more empirically adequate ones, typically borrowed from psychology. One of the first self-described behavioral economists was Herbert A. Simon, winner of the 1978 Nobel Memorial Prize. In the 1987 New Palgrave Dictionary of Economics, Simon writes that behavioural economics is best characterized not as a single specific theory but as a commitment to empirical testing of the neoclassical assumptions of human behavior and to modifying economic theory on the basis of what is found in the testing process (Simon, 1987, p. 221). Variations of this idea reappear repeatedly in behavioral literature. According to Sendhil Mullainathan and Richard H. Thaler, writing in the International encyclopedia of the social & behavioral sciences: The behavioral economics research program has consisted of two components: (a) identifying the ways in which behavior differs from the standard model and (b) showing how this behavior matters in economic contexts (Mullainathan & Thaler, 2001, p. 1094). Roberto A. Weber and Robyn M. Dawes write: The main goal of behavioral economists is to change the way that economics is done by replacing behaviorally unrealistic assumptions of economic theory and analysis (R. A. Weber & Dawes, 2005, p. 91). Daniel Kahneman describes behavioral economics as an approach in which the assumptions [of orthodox economics] are not held sacrosanct (Kahneman, 2003a, p. 162). Matthew Rabin characterizes behavioral economics in terms of efforts to incorporate more realistic notions of human nature into economics (Rabin, 2002, p. 657). Colin Camerer writes that behavioral economics improves the realism of the psychological assumptions underlying economic theory by suggesting mathematical alternatives with firm psychological foundations to [neoclassical] rationality assumptions (Camerer, 1999, p ). Camerer and coauthors review standard economic assumptions and state: Behavioral economics challenges all of these assumptions and attempts to replace them with more realistic approaches based on scientific findings from other social sciences (Camerer, Issacharoff, Loewenstein, O Donoghue, & Rabin, 2003, p. 1215). It seems fair to conclude that the consensus opinion among behavioral economists is 3

5 that (a) the fundamental assumptions of neoclassical economics fail to capture the behavior of actual human beings, and (b) substituting more psychologically realistic assumptions would on the margin improve the explanatory and predictive power of economic theory. Even so, there remains considerable confusion regarding the epistemological status of neoclassical economic theory within behavioral economics. (For simplicity, I will treat neoclassical economic theory as the conjunction of all neoclassical economic assumptions.) The confusion is in no small part due to apparently contradictory statements by behavioral economists themselves. Without denying anything that was said above, bona fide behavioral economists also write things like these: [Behavioral economics] is not only built on the premise that economic methods are great, but also that most mainstream economic assumptions are great. It does not abandon the correct insights of neoclassical economics, but supplements these insights with the insights to be had from realistic new assumptions (Rabin, 2002, p. 659). In the first part of the quote, Rabin endorses the experimental methods developed by neoclassical economists, which remain widely used by behavioral economists. But he is also praising the theoretical assumptions that constitute the foundations of neoclassical theory. Similarly, Camerer and George Loewenstein write: At the core of behavioral economics is the conviction that increasing the realism of the psychological underpinnings of economic analysis will improve the field of economics on its own terms generating theoretical insights, making better predictions of field phenomena, and suggesting better policy (Camerer & Loewenstein, 2004, p. 3) Yet, the two immediately go on to say: This conviction does not imply a wholesale rejection of the neoclassical approach to economics based on utility maximization, equilibrium, and efficiency (Camerer & Loewenstein, 2004, p. 3). The apparently contradictory attitudes toward neoclassical theory raises the question of what, exactly, the epistemological status of neoclassical theory within behavioral economics is. 4

6 The aim of this paper is to reconcile the apparently contradictory attitudes to the orthodox economic assumptions, viz., that they are simultaneously unrealistic, in need to be replaced, and great. The main thesis is that the paradox can be resolved, and the question answered, by thinking of the epistemological status of neoclassical economic theory within behavioral economics in terms of Max Weber s ideal types: analytical constructs that are not intended to be empirically adequate but which nevertheless can be used for a variety of theoretical purposes. Although behavioral economists have marshaled a great deal of evidence undermining the empirical adequacy of the assumptions of orthodox economics, they in fact make extensive use of them: not as a true description of choices, but as an analytical tool, as a basis for theoretical developments, and as a normative standard. The analysis has important implications for the practice of not just behavioral economics but for neoclassical economics too. 2 Weber on ideal types The concept of an ideal type was made famous by the great German sociologist and economist Max Weber. He described it at some length in a 1904 paper titled Objectivity in Social Science and Social Policy (M. Weber, 1949 [1904]). It also played a central role in the magisterial Economy and Society, which appeared posthumously in 1922 (M. Weber, 1978 [1922]). As Weber describes it, an ideal type is a mental construct (M. Weber, 1949, p. 90) or a conceptual construct (M. Weber, 1949, p. 93), that is, an abstract entity of some sort. Ideal types are constructions, which the scientist has produced by exaggerating or idealizing features of the world that, for whatever reason, are of interest to him or her. As Weber puts it: An ideal type is formed by the one-sided accentuation of one or more points of view and by the synthesis of a great many diffuse, discrete, more or less present and occasionally absent concrete individual phenomena... into a unified analytical construct (M. Weber, 1949, p. 90). 5

7 Because there are many points of view, many different ideal types can be inspired by one and the same empirical reality; consequently many ideal types can simultaneously claim to correspond to it (M. Weber, 1949, p. 91). Ideal types are not intended to be descriptively true. Ideal types are not constructed as a representation of real empirical phenomena, or even as the average of such phenomena (M. Weber, 1949, p. 90). As a result, the ideal type is no hypothesis... It is not a description of reality (M. Weber, 1949, p. 90). In his Objectivity paper, in fact, Weber goes so far as to suggest that an ideal type is never true of anything: In its conceptual purity, this mental construct cannot be found empirically anywhere in reality (M. Weber, 1949, p. 90). In his later and more mature work, he appears to have loosened his position somewhat. Here, he admits at least implicitly that the ideal type may be true of some things. He writes: [It] is probably seldom if ever that a real phenomenon can be found which corresponds exactly to one of these ideally constructed pure types (M. Weber, 1978, p. 20). Even if an ideal type can be true of something that actually exists, though, this is not its main function. Rather than being true, an ideal type serves as a heuristic device, or an analytical tool, in studying empirical reality. The purpose of using ideal types is to make features and relationships in the real world pragmatically clear and understandable (M. Weber, 1949, p. 90). The purpose, according to Weber, is accomplished in several ways. Ideal types permit scientists to describe phenomena as approximations to, or deviations, from the norm defined by the ideal type. In Weber s words: It has the significance of a purely ideal limiting concept with which the real situation or action is compared and surveyed for the explication of certain of its significant components (M. Weber, 1949, p. 93). Similarly, sociological analysis [using ideal types] both abstracts from reality and at the same time helps scientists understand it, in that it shows with what degree of approximation a concrete historical phenomenon can be subsumed under one or more of these 6

8 concepts (M. Weber, 1978, p. 20). The fact that ideal types allow scientists to describe phenomena as approximations to or deviations from some norm allows the scientist to identify the conditions under which, as well as the degree to which, actual phenomena deviate from that norm. Weber says the ideal type allows the scientist to explore the extent to which this ideal-construct approximates to or diverges from reality (M. Weber, 1949, p. 90). Consequently, the ideal type can be used for the measurement of reality (M. Weber, 1949, p. 97). Ideal types are assessed not by reference to how realistic they are, but by reference to how successful they are at attaining the goals for which they were constructed. In Weber s view, there is only one criterion, namely, that of success in revealing concrete cultural phenomena in their interdependence, their causal conditions and their significance (M. Weber, 1949, p. 92). Consequently: The construction of abstract ideal-types recommends itself not as an end but as a means (M. Weber, 1949, p. 92). The exact relationship between ideal type and empirical reality varies considerably from case to case (M. Weber, 1949, p. 96). But whatever this relationship is, and no matter how useful an ideal type is for a given purpose, one must not confuse the means with the end, whatever it is (M. Weber, 1949, pp ). In Weber s words, the ideal-type and historical reality should not be confused with each other (M. Weber, 1949, p. 107). An ideal type can also serve as a guide for theoretical development. Weber writes: The ideal typical concept offers guidance to the construction of hypotheses (M. Weber, 1949, p. 90). In particular, an ideal type can serve as an aim in formulating causal hypotheses. As an ideal type allows scientists to explore the conditions under which empirical phenomena fail to conform to it, it helps reveal the factors involved in their production. In Weber s words, by throwing the discrepancy between the actual course of events and the ideal type into relief, the analysis of the [factors] actually involved is facilitated (M. Weber, 1978, p. 21). In this way, the ideal type permits the researcher to 7

9 examine not only when, but why, empirical reality differs from the ideal. (Below, we will see how Weber thinks this works in the context of an actual example.) The reason is that ideal types are not just useful, in Weber s opinion, but frequently indispensable for heuristic as well as expository purposes (M. Weber, 1949, p. 90). Ideal types cannot be avoided altogether because of the complexity of empirical reality, which prevents a complete description of those parts of reality that attract our attention: None of those systems of ideas, which are absolutely indispensable in the understanding of those segments of reality which are meaningful at a particular moment, can exhaust its infinite richness. They are all attempts, on the basis of the present state of our knowledge and the available conceptual patterns, to bring order into the chaos of those facts which we have drawn into the field circumscribed by our interest (M. Weber, 1949, p. 105). Thus, the use of ideal types is not a stage that immature sciences need to get over: ideal types are part and parcel of any scientific attempt to grapple with empirical reality. It is the very fact that an ideal type is abstract that makes it so useful for scientific purposes. As Weber puts it: As in the case of every generalizing science the abstract character of the concepts of sociology is responsible for he fact that, compared with actual historical reality, they are relatively lacking in fullness of concrete content. To compensate for this disadvantage, sociological analysis can offer a greater precision of concepts (M. Weber, 1978, p. 20). Thus, in Weber s view, the precision of concepts required for serious scientific work can only be had at the cost of sacrificing some fullness of concrete content. Again: The more sharply and precisely the ideal type has been constructed, thus the more abstract and unrealistic in this sense it is, the better it is able to perform its functions in formulating terminology, classifications, and hypotheses (M. Weber, 1978, p. 21). This last passage is fascinating because it is so strongly reminiscent of a much better known (and frequently ridiculed) passage from Milton Friedman s 8

10 essay The methodology of positive economics (Friedman, 1953, pp. 3 43). Friedman writes: Truly important and significant hypotheses will be found to have assumptions that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions (in this sense) (Friedman, 1953, p. 14). Eric Schliesser notes that there may in fact have been a historical connection, since Friedman s teacher Frank Knight was not merely the first American translator of Weber, but remained keenly and, perhaps, increasingly interested in Weber throughout his life (Schliesser, 2010, p. 1). Because an ideal type serves as aid in theoretical development, it can be said to carry the seeds of its own destruction: insofar as it is successful, it will be replaced by others. As Weber puts it: It serves as a harbor until one has learned to navigate safely in the vast sea of empirical facts. The coming of age of science in fact always implies the transcendence of the ideal-type (M. Weber, 1949, p. 104). Indeed, one function of ideal types is to draw attention to the areas in which they fail. In Weber s words: The great attempts at theory-construction in our science were always useful for revealing the limits of the significance of those points of view which provided their foundations (M. Weber, 1949, p. 106). Yet, the transcendence of an ideal type does not mean that ideal types can be dispensed with: At the very heart of their task lies not only the transciency of all ideal types but also at the same time the inevitability of new ones (M. Weber, 1949, p. 104). Finally, an ideal type can serve as a normative ideal and standard of evaluation. Weber writes that ideal types can be used as model types which contain what, from the point of view of the expositor, should be and what to him is essential because it is enduringly valuable (M. Weber, 1949, p. 97). This is, of course, a very different use of an ideal type. As Weber points out: In this sense, however, the ideas are naturally no longer purely logical auxiliary devices, no longer concepts with which reality is compared, but ideals by which it is evaluatively judged. Here it is no longer a matter of the purely 9

11 theoretical procedure of treating empirical reality with respect to values but of value-judgments (M. Weber, 1949, p. 98). While Weber points out that ideal types are often invoked as a normative ideal and standard of evaluation, an ideal type need not be used in this way. As he says: There are ideal types of brothels as well as of religions (M. Weber, 1949, p. 99), assuming, presumably, that religions are good but brothels not so much. Though the two roles that can be played by ideal types descriptive and normative are often confused, they must be kept conceptually distinct (M. Weber, 1949, pp ). A remarkable number of Weber s examples of ideal types are drawn from contemporary economics. It has been argued that Weber s source of inspiration was the great Austrian economist Carl Menger. In the words of Fritz K. Ringer: We know that [the concept of the ideal type ] was at last partly inspired by Carl Menger, and that Weber persistently cited neoclassical economic theory to illustrate the uses of ideal-typical construction (Ringer, 1997, p. 110). In Weber s view, the highest degree of precision has been attained in the case of concepts and generalizations which formulate rational processes (M. Weber, 1978, p. 20). In fact, the concept of an ideal type is introduced in the context of a discussion of abstract economic theory, which according to Weber offers an ideal picture of events on the commodity-market under conditions of a society organized on the principles of an exchange economy, free competition and rigorously rational conduct (M. Weber, 1949, pp ). If what Weber has in mind is the two-person, two-good exchange economy, it may well be right that there never was such a thing, which is why it is often illustrated using the fictional characters Robinson Crusoe and Friday. Nevertheless, in Weber s view, this model serves to make the characteristic features of market-conditioned relationships clear and understandable (M. Weber, 1949, p. 90). Weber also goes out of his way to defend the use of this particular ideal type against the charge that empirical reality can be studied in the absence of ideal 10

12 types: Those who are so contemptuous of the Robinsonades of classical theory should restrain themselves if they are unable to replace them with better concepts, which in this context means clearer concepts (M. Weber, 1949, p. 95). As we know, Weber takes ideal types to be not just useful but indispensable: consequently, it is pointless to criticize an ideal type if the critic is not prepared to propose a superior one. As ideal types, economic models are obviously unrealistic: The ideal types of social action which for instance are used in economic theory are thus unrealistic or abstract in that they always ask what course of action would take place if they were purely rational and oriented to economic ends alone (M. Weber, 1978, p. 21). In spite or because of being unrealistic, these models can be used to understand all sorts of behavior, whether it is economically determined by which Weber means, presumably, rational and self-interested or not. As he puts it: This construction can be used to aid in the understanding of action not purely economically determined but which involves deviations arising from traditional restraints, affects, errors, and the intrusion of other than economic purposes or considerations (M. Weber, 1978, p. 21). By comparing observed behavior to the ideal type, we are in a position to analyze both the extent to which those actions are economically determined, and other factors that play a role in determining behavior, which allows economists to develop causal hypotheses about all sorts of behavior. They may, for instance, propose that observed deviations from the norm results from misinformation, strategical errors, logical fallacies, personal temperament, and similar (M. Weber, 1978, p. 21). This shows that an ideal type that describes rational action can be used to understand not just rational behavior, but a wide variety of irrational behaviors as well. 11

13 3 Neoclassical economics as an ideal type In this section, I argue that Weber s concept of an ideal type helps elucidate the epistemological status of neoclassical economic theory within behavioral economists. My thesis is that behavioral economists use neoclassical economic theory very much in the manner that Weber described. As a preliminary, it is hardly necessary to point out that neoclassical economic theory is an abstract construction, which scientists have produced by exaggerating or idealizing features of the world that are of interest to them. The use of neoclassical economic theory is perhaps best captured by the following quote, in which Camerer and Loewenstein describe to modus operandi of the behavioral economist: Early papers established a recipe that many lines of research in behavioral economics have followed. First, identify normative assumptions or models that are ubiquitously used by economists, such as Bayesian updating, expected utility, and discounted utility. Second, identify anomalies i.e., demonstrate clear violations of the assumptions or model, and painstakingly rule out alternative explanations, such as subjects confusion or transaction costs. And third, use the anomalies as inspiration to create alternative theories that generalize existing models. A fourth step is to construct economic models of behavior using the behavioral assumptions from the third step, derive fresh implications, and test them (Camerer & Loewenstein, 2004, p. 7). In what follows, I will expand on the ways in which behavioral economists use neoclassical theory, and shed light on how it is possible for them to say that neoclassical theory, in spite of its flaws, is great. It is quite obvious that behavioral economists do not take neoclassical choice theory to be descriptively true. As the quote from Camerer and Loewenstein indicates, behavioral economists fully expect that the standard economic assumptions they are testing will be violated by the participants in their studies. The contention that orthodox choice theory is descriptively inadequate has been part and parcel of in fact, has served to motivate the behavioral approach from the very 12

14 beginning. Summarizing behavioral work up to the mid-1980 s, Benjamin Gilad and Stanley Kaish conclude: The emerging picture of economic man is definitely that of a less than fully rational, organizationally rooted creature who is systematically biased, often misinformed, always a role player, and who frequently violates the rationality postulates of consistent ordering and transitivity. When aggregated into groups he carries his psychology with him, making organizational behavior no more rational than that seen among individuals (Gilad & Kaish, 1986, p. xx). The contention has not changed since the 1980 s. In the words of Peter Diamond and Hannu Vartiainen: Interest in behavioral economics has been stimulated by accumulating evidence that the standard model of consumer decision-making provides an inadequate positive description of human behavior for some questions (Diamond & Vartiainen, 2007, p. 2). Though behavioral economists do not consider neoclassical theory to be empirically adequate, they gladly use it as a heuristic device or analytical tool in studying empirical reality. It is no coincidence that Camerer and Loewenstein (2004, p. 7) suggest the very first step of a behavioral study is to identify normative assumptions or models that are ubiquitously used by economists. Most obviously, standard economic theory is used to describe and classify behavior. Thus, behavioral patterns are labeled rational insofar as they conform to the theory and irrational insofar as they do not (more about this later in the section). As Esther-Mirjam Sent notes, behavioral economists rely on the insights from Kahneman and Tversky that use the rationality assumption of mainstream economics as a benchmark from which to consider deviations (Sent, 2004, p. 750). In addition, orthodox theory is often used to establish the conditions under which people s observed behavior deviates from the predictions of the traditional theory and consequently can be described as irrational. The second step of Camerer and Loewenstein s recipe emphasize the focus on violations of the orthodox assumptions. Weber and Dawes agree that behavioral researchers typically look for reliable patterns of deviations from the predictions of traditional economic 13

15 models (R. A. Weber & Dawes, 2005, p. 92). Behavioral economists sometimes try to estimate the degree to which people s actual behavior deviates from the predictions of orthodox theory; in this sense, the theory is used for what Weber called the measurement of reality. Behavioral economists also use orthodox theory to identify conditions under which people s choices conform to the theory and consequently can be described as rational. While all behavioral economists agree that neoclassical choice theory is not in general empirically adequate, most of them also believe that people to some extent, under certain conditions, do succeed in conforming to it. Amos Tversky and Kahneman argued that the heuristics that people follow are quite useful, and only sometimes lead to severe and systematic error, as assessed by the standard of expected utility theory (Tversky & Kahneman, 1974, p. 1124). Thus, Tversky and Kahneman s work on heuristics and biases can be understood, in part, as an effort to understand the conditions under which people s behavior does not deviate from the predictions of orthodox theory. Behavioral economists belief that people at least some of the time manage to act in accordance with the theory is reflected in their models; as we will see below, neoclassical theory is often preserved as a special case of behavioral theories. Standard economic theory is frequently used as a basis for theoretical developments in behavioral economics. Camerer and Lowenstein s third step involves using confirmed violations of standard theory as inspiration to create alternative theories As Weber and Dawes write: [The] goal of most behavioral economists is not to tear down economics and replace it with something else, but rather to improve the existing economic approach to increase its value as a descriptive and positive science (R. A. Weber & Dawes, 2005, p. 91). They continue: This work has proceeded mainly by researchers asking two questions: What part of the traditional theory is inconsistent with the behavior? and How can this part be modified to produce predictions consistent with the behavioral phenomenon? (R. A. Weber & Dawes, 2005, p. 93). In particular, behavioral economists use the mainstream theory to produce causal hypotheses. That is, behavioral economists 14

16 try to improve their understanding of why people fail to act in accordance with the theory by identifying the causal factors responsible for producing the phenomenon. In throwing deviations from the ideal into relief, ideal types help scientists understand when, and why, deviations occur, and what causal factors might have produced the result. For example, many studies of emotions and their impact on decision making aim to determine under what conditions people act rationally and under what conditions they do not, and what factors that are responsible for these deviations. As a result of this procedure, behavioral theories frequently turn out to be generalizations or extensions of orthodox theory. Camerer and Loewenstein (2004, p. 7) assert that the alternative theories generalize existing models ; Diamond and Vartiainen write that behavioral economists seek to extend the standard economics framework (Diamond & Vartiainen, 2007, p. 1). This typically means that neoclassical theory is preserved as a special case of behavioral theories. Consider, for instance, models of quasi-hyperbolic discounting, which retain models of exponential discounting as a special case (when ß=1). The fact that the standard theory is preserved as a special case is welcomed by behavioral economists. As Camerer puts it: Behavioral economists hope to look back soon and regard rational assumptions like exponential discounting, self-interest, or even equilibrium as special examples of much more general theories (Camerer, 1999, p ). Keeping the neoclassical theory as a special case of behavioral theories has multiple advantages. One advantage is that the new theories permit rational behavior, under certain circumstances, as assessed by the standard of orthodox theory. Another advantage is that it allows behavioral economists to give clear, principled answers to the question about the conditions under which people s choices are rational and the neoclassical model is empirically adequate. In the case of discounting, for example, the behavioral economist can say that a person will be time consistent just in case ß=1 and that the degree of time inconsistency can be assessed, or measured, by the value of ß. 15

17 Indeed, orthodox economic theory has proven not just useful but indispensable to the behavioral enterprise in multiple ways. First, one of the central virtues of standard theory is that it (in conjunction with widely used auxiliary hypotheses) makes clear and crisp predictions that can be explored in laboratory and other settings. Thus, it defines what Camerer and Loewenstein call a hard target for critics of the orthodoxy: Whereas the assumptions and implications of generic utility analysis are rather flexible, and hence tricky to refute, the expected utility and discounted utility models have numerous precise and testable implications. As a result, they provided some of the first hard targets for critics of the standard theory (Camerer & Loewenstein, 2004, p. 6). A case can be made that behavioral economics would not exist if it were not for the existence of such a hard target. If behavioral economists had been unable to establish that orthodox theory was empirically deficient, they would have had a much harder time justifying their more general and more complex alternative theories. Second, and relatedly, neoclassical economics as a general rule serves as a source of null hypotheses when analyzing empirical data. In describing his joint work with Tversky, Kahneman is explicit: The rational-agent model was our starting point and the main source of our null hypotheses (Kahneman, 2003b, p. 1449). In the case of studies into the endowment effect, for example, behavioral economists take the null hypothesis to be that endowments make no difference with respect to valuations. Then, they establish the existence of an endowment effect by showing that the null can be rejected with some confidence. Null hypotheses are, of course, required for the application of classical statistics methods, which are used to establish deviations from the predictions of neoclassical theory. Because neoclassical choice theory plays a critical role in generating null hypotheses, and because null hypotheses are necessary for classical statistical testing, there is a sense in which all behavioral economists results depend on that theory. 16

18 Third, neoclassical theory defines the language that behavioral economists use when describing their subject matter. Behavioral economists tend articulate what they find and what they are trying to explain in terms of anomalies or effects, which are understood as systematic deviations from the norm established by orthodox theory. Camerer and Loewenstein (2004, p. 7) define anomalies as clear violations of the assumptions or model ; elsewhere, they define anomalies as patterns of judgment and choice that [are] inconsistent with utility maximization and/or Bayesian updating (Camerer et al., 2003, p. 1215). Either way, an anomaly or effect so defined makes no sense in the absence of the norm defined by neoclassical economics. To the extent that anomalies and effects are what behavioral economics is about, its very subject matter is defined in part by orthodox economic theory. Again, in a classical statistical setting, in order to establish the presence of a pattern, the data must be shown to be statistically significant. But the results are statistically significant only by being compared to a null hypothesis, which in this case is generated from neoclassical choice theory. Behavioral economists agree that it is the very fact that neoclassical theory is so abstract and precise that makes it so useful for scientific purposes. It is the fact that orthodox theory is articulated at such a high level of abstraction that gives it such a vast range of implications, which can then serve as Camerer and Loewenstein s hard targets. As Kahneman puts it: [The] standard assumptions about the economic agent are in economic theory for a reason: they allow for tractable analysis. The constraint of tractability can be satisfied with somewhat more complex models, but the number of parameters that can be added is small. One consequence is that the models of behavioral economics cannot stray too far from the original set of assumptions (Kahneman, 2003a, p. 166). Kahneman would presumably agree that the precision of the neoclassical ideal type can only be had at the cost of sacrificing some fullness of concrete content. (Critics of neoclassical economists use of formal models should note that it is was that abstract, formal models used that allowed behavioral 17

19 economists to marshal the evidence require to disconfirm the theory.) And not only that: it is the very fact that neoclassical economic theory is false that makes it suitable for the generation of null hypotheses: a true theory would not generate predictions that could be shown to be false (with some degree of confidence) and therefore would not produce statistically significant results. It can be said that neoclassical economic theory, used as an ideal type, is carrying the seed of its own destruction. The more successful behavioral economists are in identifying anomalies and in developing of alternative models, the greater the likelihood that the new alternatives will be radically different from the neoclassical theory with which they started out and that they will not preserve the neoclassical theory as a special case. It is possible that the radical approaches will gradually displace the more cumulative ones, and that behavioral economists will end up using concepts and categories that are radically different from those of neoclassical economics. Such a development would represent what Weber called the transcendence of the ideal-type. If this scenario gets played out, we would be able to say that neoclassical economic theory served as a harbor until economists learned to navigate safely in the vast sea of empirical facts. If so, this would be perfectly consistent with Weber s position: as we know, Weber believed that all ideal types were transient and destined to be superseded. Of course, such a development would not entail that ideal types can be completely dispensed with. It would mean that new ideal types would assume the role played by the old ones. By and large, behavioral economists recognize that ideal types cannot be avoided because of the sheer complexity of empirical reality. Ideal types are often replaced by other ideal types, and not by descriptively accurate models. Rabin clearly acknowledges that complete realism is unattainable, and that many details of human behavior must be ignored (Rabin, 1998, p. 13). He writes: Because of the high premium economics places on the logic and precision of arguments and the quantification of evidence, attending to all facets of human nature is neither feasible nor desirable (Rabin, 1998, p. 18

20 13). Rabin might agree with Weber that critics of contemporary economic theory should restrain themselves if they are not prepared to propose a superior one. Finally, behavioral economists continue to use orthodox theory as a normative ideal and standard of evaluation. The fact that behavioral economists have criticized neoclassical choice theory as a descriptive model does not imply that they reject it as a normative one. They recognize that the two uses are logically independent (Thaler, 2000, p. 138). And some behavioral economists have gone out of their way to underscore that they criticize rational choice theory as a descriptive, not as a normative, model. Thus, Thaler writes: [A] demonstration that human choices often violate the axioms of rationality does not necessarily imply any criticism of the axioms of rational choice as a normative ideal. Rather, the research is simply intended to show that for descriptive purposes, alternative models are sometimes necessary (Thaler, 1991, p. 138). Notice how Thaler writes that alternative models are only sometimes required, allowing for the fact that people s behavior is frequently captured by orthodox theory. In fact, behavioral economists for the most part have largely accepted the conception of rationality associated with neoclassical economics. Rather than modifying their normative theory in such a way that people s behavior comes across as largely rational, behavioral economists tend to look at, e.g., framing effects as evidence that irrationality is systematic and widespread. According to Paul Slovic, Dale Griffin, and Tversky, for example, things like framing effects represent deep and sweeping violations of classical rationality, which implies that it may not be possible to construct a theory of choice that is both normatively acceptable and descriptively adequate (Slovic, Griffin, & Tversky, 1990, p. 26). This is not to say that behavioral economists accept the additional set of assumptions incorporated into the DU model as a normative standard for intertemporal choice, however; the situation in the case of dynamic choice is considerably more complicated. 19

21 4 Discussion In this paper, I have tried to reconcile the apparently contradictory attitudes to the orthodox economic assumptions, viz., that they are simultaneously unrealistic, in need to be replaced, and great. The main thesis is that the paradox can be resolved, and the question answered, by thinking of the epistemological status of neoclassical economic theory within behavioral economics in terms of Max Weber s ideal types: analytical constructs that are not intended to be empirically adequate but which nevertheless can be used for a variety of theoretical purposes. It is quite obvious that neoclassical economic theory is an abstract construction, which scientists have produced by exaggerating or idealizing features of the world that are of interest to them. It is equally obvious that behavioral economists do not take neoclassical choice theory to be descriptively true. Nonetheless, they gladly use it as a heuristic device or analytical tool in studying empirical reality: to describe or behavior, to identify the conditions under which people deviate from the predictions of the orthodox theory and under which they do not, and to estimate the degree to which people s actual behavior deviates from the predictions of orthodox theory. Standard economic theory is frequently used as a basis for theoretical developments in behavioral economics, in such a way that behavioral alternatives are generalizations of extensions of orthodox theory and preserve it as a special case. Indeed, orthodox economic theory has proven not just useful but indispensable to the behavioral enterprise, by providing a hard target for critics of the orthodoxy, by serving as a source for null hypotheses, and by helping define the very language that behavioral economists use to characterize their subject matter. It is the very fact that neoclassical theory is so abstract and precise in conjunction with the fact that it is false that makes it so useful for scientific purposes. Neoclassical economic theory, used as an ideal type, might be said to carry the seed of its own destruction, though the transcendence of this particular ideal type would not entail that ideal types can be completely dispensed with. Finally, behavioral economists continue to use orthodox theory as a 20

22 normative ideal and standard of evaluation. All of this helps explain how behavioral economists can argue that the theory is great in spite of being false, and why all the evidence undermining it nevertheless does not imply that it should be completely abandoned. Perhaps ironically, central neoclassical models were not originally presented as descriptively true even by the economists who developed or defended them. Consider, for example, L. J. Savage, who is sometimes credited with having developed the canonical theory of rational choice under risk. In his book Foundations of statistics (1972), originally published in 1954, Savage emphasizes that his theory is intended as a normative theory only. He recognizes that it could be used for descriptive purposes, but maintains that it would only make for a crude and shallow empirical theory predicting the behavior of people making decisions (Savage, 1972, p. 20). Similarly, in his paper presenting the discounted utility model, Samuelson explicitly disavowed any descriptive implications. He wrote: It is completely arbitrary to assume that the individual [in fact] behaves so as to maximize an integral of the form envisaged (Samuelson, 1937, p. 159). Tversky and Kahneman acknowledge this point: The modern theory of decision making under risk emerged from a logical analysis of games of chance rather than from a psychological analysis of risk and value. The theory was conceived as a normative model of an idealized decision maker, not as a description of the behavior of real people (Tversky & Kahneman, 1986, p. S251) In this sense, behavioral economists are not alone in using rational choice theory as an ideal type. These economists appear clearly to separate what Weber thought of as means and ends, though subsequent generations of neoclassical economists have not. The analysis has implications for behavioral economists. One such implication is that neoclassical theorizing is here to stay. Behavioral economists depend heavily on neoclassical theory and they appear well aware of the fact that theory is necessary in order to attain their goals. As a result of this dependence, behavioral economics makes little sense except against a background of 21

23 neoclassical theory. It follows that behavioral economists, no matter how successful, is unlikely to make neoclassical theory obsolete. At least for the foreseeable future, behavioral economists will continue to need a solid grounding in neoclassical economics. The only way to transcend the ideal type of the rational actor altogether would be to produce another ideal type that is even more useful. So far, that has not happened. The analysis also has implications for neoclassical economists. The possibility of thinking of neoclassical theory as an ideal type gives orthodox economists license to continue to work with it even in the face of overwhelming evidence that it is not empirically adequate. By jettisoning the idea that orthodox theory is a true description of people s actual choices, neoclassical economists would make themselves immune from the charge that their theory is false, which I take it would be a welcome development for them. That said, economists would have to recognize that many different ideal types can simultaneously claim to correspond to one and the same empirical reality and that the orthodox economic theory represents only one of many possible points of view. Moreover, they would have to be prepared to defend, in each case, their use of the ideal type of the rational actor, keeping in mind that ideal types are assessed by reference to how successful they are at attaining the goals for which they were constructed, and whether they succeed in revealing concrete cultural phenomena in their interdependence, their causal conditions and their significance, as Weber put it. Finally, the analysis suggests that the gulf between behavioral and neoclassical economists may be considerably less wide than it has appeared, and that it may be narrowing. While behavioral economists are sometimes accused of wide-eyed empiricism (Ross, 2005, p. 122), they do not in fact try to go about their studies in a theory-free way. The practice of behavioral economists is consistent with the following dictum, sometimes attributed to Immanuel Kant: Although theory without experiment is empty, experiment without theory is blind (cited in Thagard, 2005, p. 8). Consequently, behavioral economics will remain intimately tied to neoclassical theory for the 22

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