RATIONAL ACTORS, TCA, P&A * 07/16/96 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 option’s utility, weighting by their probabilities. Hence, the actor’s 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, we’ll look at transaction cost and principal-agent theories that replace the atomized homoeconomus with calculators who must take others into account. *

Rational Choice Games U = (p)U(X) + (1-p)U(Y) 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 1 Choose between: 10% chance of winning $100 and 90% chance of nothing (B) 10% chance of winning $500 and Problem 2 Choose between: (C) Certainty of receiving $100 (D) 10% chance of winning $500 and 90% chance of winning $100 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

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.”

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 firm’s 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 org’l 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.”

Prospecting for Gains & Losses Daniel Kahneman & Amos Tversky’s 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% > gov’ment 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).

Uncertainty as a Scope Condition? Jens Beckert’s (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). “[T]he assumption of uncertainty … threatening the notion of rational choice as the core behavioral assumption of economic theory. … [I]mportant 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

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 aren’t 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 < market prices Firm expansion halts when intra-org’l TC > market prices

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?

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 supplier’s 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

Williamson’s discriminating alignment hypothesis Williamson’s 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” (1998:37). Public bureau is the “form of last resort.”

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 P’s interests? (If P had necessary knowledge and skills, then A’s services would be unnecessary) Agency costs: Principal’s 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

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 won’t 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 principal’s interests.

Performance Incentives Monitoring Agent’s skills & activities is difficult, so Principal could use pay-for-performance incentives to encourage A’s risk-taking and make A more accountable in looking out for P’s interests Make A’s compen$ation contingent on actual outcomes CEO bonus, stock options depend on annual share prices Teacher’s salary gains tied to her student’s test scores Problem: Org’s performance affected by many factors beyond agent’s 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 week’s 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 1990:227)

Readings Discussion Quex 1. Does Williamson’s 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: “[T]here 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. Eisenhardt’s 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 Boudon’s propose to salvage RCT for sociology? 7. Why does Boudon characterize Weber’s interpretive sociology of religion as not an RCT? Could it become RCT by embracing additional postulates?