Gary Becker, Nobel Laureate

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This post acknowledges another patron saint of the GEM Project. In 1992, Gary Becker of the University of Chicago was awarded the 1992 Nobel Prize “for having extended the domain of microeconomic analysis to a wide range of human behaviour and interaction.” Becker argued that the “combined assumptions of maximizing behavior, market equilibrium, and stable preferences, used relentlessly and unflinchingly, form the heart of the economic approach as I see it.”  To him, rationality is not a controversial concept: “Everyone more or less agrees that rational behavior simply implies consistent maximization of a well-ordered function, such as a utility or profit function.” His insightful, broadly admired body of work has made it easier for the GEM Project to construct its generalized-exchange theory on rational-behavior foundations.

Becker pulled his wide-ranging research together in one of my favorite books, The Economic Approach to Human Behavior. (The quotes are from that book.) This post looks at a puzzling curiosity in Becker’s important text. Chapter 8, entitled “Irrational Behavior and Economic Theory”, is an abrupt diversion into examples of irrationality that are supported by the evidence. I have always thought that the chapter needlessly weakens his signature message, i.e., the generality of rationality in economic analysis. From the perspective of the GEM Project, limitations in his mainstream analytic tools caused him either to ignore swaths of crucial economic behavior or unnecessarily accept that some important phenomena are irrational (but still vaguely governed by economic principles). The remainder of this post illustrates each strategy.

Ignored Economic Behavior

The most consequential, ubiquitous economic activity that Becker simply ignores is on-the-job behavior (OJB) in circumstances of costly asymmetric workplace information. Becker’s blind eye to that crucial nonmarket venue of price-mediated exchange results from a flaw in his identification of fundamental tenets of economic theory. As indicated above, he believed (along with almost all mainstream theorists) in the centrality of the marketplace in economic analysis. He had no problem restricting rational exchange to markets, despite the obvious existence of important nonmarket transactions, especially since the Second Industrial Revolution and the global ubiquity of large bureaucratic firms. The ill-considered assumption of market centrality caused Becker to push aside consequential workplace behavior as either irrational or too difficult to economic analysis.

The GEM Project identifies workplace reference standards as central to modeling employee OJB. (Recall last week’s post on routinized jobs.) Employees have discoverable preferences that govern the workplace exchange in which they are engaged. Such preferences are an important feature of highly specialized economies, having long been a focus of practitioner interest, research and experimentation. That literature indicates that workers prefer his or her ratio of outcomes (from the job) to inputs (to the job) to be greater than or equal to each of the following reference standards:

  • The ratio of outcomes to inputs for his or her best alternative employment, Ỏi/ Ỉ i a/ Ỉa;
  • The ratio of outcomes to inputs for his or her interpersonal reference standard, i.e., other workers who perform the same or similar tasks as the individual or who work in close proximity to him or her, Ỏi/ Ỉi b/ Ỉb; and
  • The ratio of outcomes to inputs for his or her intertemporal reference standard, i.e., the trend improvement of his or her outcomes-inputs ratio over time, Ỏi/ Ỉi (1+ ġ) Ỏio/ Ỉio =c/ Ỉc.

In the notation, a represents the worker’s best alternative job, b denotes the interpersonal reference standard, c is the intertemporal preference standard, o stands for the relevant earlier time period, and ġ is the trend growth rate in job outcomes that has already occurred.

The three types of reference standards calibrate the worker’s inherent preference for fair treatment. Formally, there exists a set of pairings of workplace outcomes and inputs Ҝi={a/Ỉa,b/Ỉb,c/Ỉc}, demonstrating completeness and transitivity, for which the three-part preference relation is satisfied by the set’s least upper bound: sup Ҝi. The preference for equity (and the desire for redress of unfair treatment) is today best understood to be axiomatic, an outcome of evolutionary biology that became embedded in neural networks as our distant ancestors adapted to survival advantages available from group cooperation. From a prominent neuroscientist, Reade Montague (2006, p.186): “Our instincts for sensing and responding to fair exchange evolved in a social environment where tit for tat was king. What you did to me today was coming back to you tomorrow in kind.”

The preference for equitable treatment was one of the early ideas investigated in behavioral economics. Güth, Schmittberger, and Schwarze (1982) constructed famous experiments based on the “ultimatum game”. There are two players, and the first is given a sum of money and a choice. He or she has to give some part of the money to the second player, who then also has a choice. If the cash offer is accepted, both players keep the allocated money. If rejected, each gets nothing. Economists know that the subgame-perfect equilibrium of the ultimatum game dictates that the (permissible) minimum be offered and accepted. In market-centric economic theory, utility functions are motivated parsimoniously with the preference of more money to less.

Contrary to the predictions of economic models, Güth et al. found a strong desire for fair treatment as well as a powerful urge to retaliate when denied that outcome. Their experiments and the others that followed established the modal offer to be an even division. Inequitable offers are likely to be rejected, with the chances of rejection increasing as the second player’s share decreases. The results of ultimatum-game experiments are obviously significant and must make economists suspicious of mainstream arbitrarily convenient formulations of preferences and utility.

That suspicio is made acute by the ubiquitous practical application of the ultimatum game. A version of it, enriched by established workplace reference standards, incomplete information, and available gradations of retaliation, is played every day in large work establishments. In the workplace game, worker desire for fair treatment is strengthened by the near-zero expected costs associated with reciprocal reductions in cooperation if management fails to play fair. From Larry Samuelson’s (2005, p.97): “… experimental evidence has mounted that people will incur costs not only to bestow benefits on others, but also to penalize others, with the preference for reward or punishment hinging upon perceptions of whether the recipient has acted appropriately or inimically.”

Irrational Relative-Income Hypothesis

Developed by James Duesenberry (1949), the relative income hypothesis states that an individual’s attitude to consumption and saving is dictated more by his income in relation to others than by current income itself; the percentage of income consumed by an individual depends on his percentile position within the income distribution. It further argues that the present consumption is not influenced merely by present levels of absolute and relative income, but also by levels of consumption attained in a previous period. It is difficult for a household to reduce a level of consumption once attained. The aggregate ratio of consumption to income is assumed to depend on the level of outlays in the immediate past.

Without citing Duesenberry by name, Becker’s Chapter 8 uses the once-famous Early-Keynesian analysis to illustrate “irrational” models that fit the evidence better than mainstream rational-behavior theory. From Becker: “Consider now a model of inertia: wherever possible, households consume what they did in the past…. [This] class of irrational behavior, including inert and impulsive behavior as extreme cases, would be encompassed by a model in which current choices were partly determined by past ones and partly by a probability mechanism.”

Becker’s error is not realizing that inertial consumer behavior is best understood as rational. Indeed, the formal model of employee preferences constructed in the GEM Project and briefly described above is easily adapted to household preferences and consequent behavior. A notable accomplishment of the GEM Project is its demonstration that rational behavior is more general than even Gary Becker thought.

Blog Type: Wonkish Chicago, Illinois

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