Should we Get Rid of the Preference Concept in Normative Economics?

Douglas Bernheim (with his co-author Antonio Rangel) is a major contributor of the recent developments within the so-called ‘behavioral welfare economics’ (BWE) research program. BWE can be viewed as an attempt to lay the theoretical foundations for the normative turn of behavioral economics that has been engaged in the late 1990s. Contrary to (too) many contributions within behavioral economics that merely take a casual approach to normative issues, the BWE pioneered by Bernheim and others builds on and extends the formal apparatus of welfare economics to cases of various behavioral inconsistencies. In this light, Bernheim’s recent paper “The Good, the Bad, and the Ugly: A Unified Approach to Behavioral Welfare Economics” published in the Journal of Benefit and Cost Analysis in which he attempts to develop a unified approach to BWE is worth reading for anyone interested in behavioral and normative economics.

Bernheim’s paper covers a lot of ground and makes many important points that I cannot discuss in detail here. I would retain however a very general idea that Bernheim never explicitly develops but which is nonetheless at the core of a key difficulty the normative turn of behavioral economics has given rise to, i.e. the problem related to the use of the preference concept in the normative analysis. Welfare economics has indeed historically made used of an account of welfare in terms of preference satisfaction. The pervasiveness of this account is due to several factors, at least two of them being especially prominent. First, the preference-satisfaction view of welfare is tightly related to a form of consumer sovereignty principle according to which economists should defer to individuals’ judgments regarding what is good or best for them. This principle may itself be justified on different grounds, for instance epistemic (individuals have a privileged access to the knowledge of what is good for them) or ethical (we must defer to individuals’ judgments because individuals are autonomous agents). Whatever the specific justification, the consumer sovereignty principle indicates that there are presumably strong reasons to view the satisfaction of preferences as being constitutive (or at least a good proxy) of welfare. Second, these reasons are strengthened by the formal isomorphism between the binary preference relation that is at the core of the notion of rationality in economics and the ‘better than’ relation that underlies any welfare judgment. As all microeconomic textbooks explain, rationality in economics correspond to the existence of well-ordered preferences over some domain of objects. In particular, this presupposes that the binary preference relation is transitive. On the other hand, there are good reasons to take the ‘better than’ relation as being intrinsically transitive – in the same way as the ‘taller than’ relation for instance. The fact that preferences and welfare judgments are well-ordered obviously makes easier (though obviously does not require) to assume that one can be directly mapped into the other. Problems however arise once it appears that individuals do not have well-ordered preferences. This is precisely the motivation behind the whole BWE approach.

As it is well-known, standard welfare economics essentially adopt a revealed preference stance and therefore associates welfare and choice. According to Bernheim, such an association is done on the basis of three premises:

Premise 1: Each agent is the best judge of our own well-being.

Premise 2: Our judgments are governed by coherent, stable preferences.

Premise 3: Our preferences guide our choices: when we seek to benefit ourselves.

Bernheim’s unified approach accepts (with several qualifications) premises 1 and 3 but rejects premise 2. This is important because, as I indicate just above, premise 2 has been essential in the economists’ endorsement of the preference-satisfaction view of welfare. In the normative writings of behavioral economists, premise 2 tends to be kept even in the face of experimental results by postulating that individuals have ‘true’ (or ‘latent or ‘inner’) preferences that failed to be revealed by choices. Crucially, these are these preferences rather than the actually revealed ones that are assumed to be well-ordered. Alternatively, it is sometimes assumed that individuals are endowed with several and mutually inconsistent preference orderings which, depending on the choice context, may determine one’s choice. Bernheim rejects, rightfully I believe, these views. He rather endorses the ‘constructed preference’ view according to which “I aggregate the many diverse aspects of my experience only when called upon to do so for a given purpose, such as making a choice or answering a question about my well-being”.

Bernheim’s endorsement of the ‘constructed preference’ view is important to understand why he continues to accept premises 1 and 3, even with qualifications. Regarding premise 1, he basically grounds it on the consumer sovereignty principle I discuss above. The qualification of premise 1 rests on the fact however that not all individuals’ judgments provide a correct assessment of their welfare. Berhneim argues for the distinction between ‘direct’ judgments, referring to ‘ultimate objectives’, and ‘indirect’ judgments, referring to the determination of means to achieve ultimate objectives. Only the latter but not the former are susceptible of mistakes that should be accounted for in the welfare analysis. Another way to state Bernheim’s claim is that behavioral economics cannot provide evidence for the fact that individuals are eating too much or insufficiently saving. But it can demonstrate that given their aims, individuals fail to make the best choices. Premise 3 then indicates that individuals’ aims, under appropriate conditions, indeed guide their choices. This makes choices often – but not always – a good indication of individuals’ welfare judgments. On this basis, Bernheim claims that choice-based welfare analysis should be regarded as preferable to approaches relying on self-reported well-being, including hedonistic measures favored by some behavioral economics. The unified approach to BWE Bernheim is suggesting proceeds through two steps: first, the behavioral welfare economists should determine the ‘welfare-relevant domain’ by identifying which choices merit deference (i.e. which choices are actually guided by welfare judgments); second he should construct a welfare criterion based on the properties of choices within that domain. Since there is no presumption that individuals’ preferences and judgments are well-ordered (rejection of premise 2), the resulting welfare-ordering will most of the time happened to be incomplete.

As I say above, the main lesson I retain from Bernheim’s paper is that we should probably completely abandon the preference concept in normative economics. To understand how I arrive at this conclusion, two points should be noted. First, Bernheim’s unified BWE approach does not rely on any assumption of the existence of true or inner preferences. There are choices on which the welfare analysis can build (the welfare-relevant domain) but this is completely unrelated to the existence of true preferences. The determination of the welfare-relevant domain will rather depend on the identification of mistakes or cases of lack of information and even once this is done, there is no guarantee that the choices will be coherent. Second, rather than preferences, Berhneim rather uses the term ‘judgments’ to refer to what is reflected by choices. Bernheim shows that ultimately the individual’s welfare judgments are reflected by a welfare relation that is isomorphic with a choice-based binary relation that has minimal formal properties (especially acyclicity). Interestingly, even if one rejects Bernheim’s choice-based approach, the alternative SRWB approach can also completely dispense with the preference concept since it does not need to stipulate that individual have well-ordered inner preferences.

As a conclusion, it may be worth remarking that Bernheim’s unified approach is somewhat ambiguous regarding the relationship between welfare judgments and choices. In a revealed-preference perspective, we may suppose that (possibly incoherent) choices reveal (possibly incoherent) welfare judgments. But at the same time, there is a sense in which Bernheim’s whole argument builds on the idea that choice-based welfare analysis is preferable because our choices are guided by our welfare judgments. In particular, the identification of mistakes is possible only because we can – at least in principle – identified either a gap between ultimate judgments of welfare and actual choices (what Bernheim calls ‘characterization mistakes’) or inconsistencies in judgments.  In either case, the relevant criterion for the welfare analysis is not that individuals are making inconsistent choices per se but rather how judgments and choices are articulated. Added to the fact that the unified approach naturally calls for the use of non-choice data, this indicates a real departure from the revealed-preference view that is still pervasive in welfare economics. All of this as interesting implications for another topic related to the normative turn of behavioral economics, i.e. libertarian paternalism, but I leave that for another post.

Is the Choice of a Welfare Criterion a Matter of Opinion?

Noah Smith has a post on Gul and Pesendorfer’s 2005 much-discussed manifesto on the methodology of economics, especially regarding the rise of neuroeconomics. Philosophers of economics tend to compare Gul and Pesendorfer’s essay to Friedman’s 1953 article which provides an instrumentalist defense of the rationality assumption. Their article has generated a significant literature, notably a book edited by Schotter and Caplin. A recent discussion of the significance of Gul and Pesendorfer’s essay regarding the relationship between economics and psychology is provided by Don Ross in book Philosophy of Economics.

Noah Smith highlights two points. First, Gul and Psendorfer’ claim that only choice data are relevant in economics. Second, they argue against the idea that neuroeconomics and behavioral economics are relevant for welfare economics. Regarding the second point, he writes (my emphasis):

To be blunt, all welfare criteria seem fairly arbitrary and made-up to me. Data on choices do not automatically give you a welfare measure – you have to decide how to aggregate those choices. Why simply add up people’s utilities with equal weights to get welfare? Why not use the utility of the minimum-utility individual (a Rawlsian welfare function)? Or why not use a Nash welfare function? There seems no objective principle to select from the vast menu of welfare criteria already available. The selection of a welfare criterion thus seems like a matter of opinion – i.e., a normative question, or what GP call “social activism”. So why not include happiness among the possible welfare criteria? Why restrict our set of possible welfare criteria to choice-based criteria? I don’t see any reason, other than pure tradition and habit.

The notion that the choice of a welfare criterion is a matter of “opinion” seems to me somewhat odd. This is even more the case when “opinion” seems to be synonym with “normative question”. Are all normative issues matter of opinion? Is normative economics devoid of any objective or scientific basis? Or is science as a whole nothing but a matter of opinion?

This issue is even more difficult to discuss in the context of Gul and Pesendorfer’s essay because the latter are somehow heterodox in their view of welfare economics. Contrary to the received view, Gul and Pesendorfer claim that standard welfare economics is not normative economics. Rather, welfare analysis is “a tool for analyzing economic institutions and models” (p. 25 in Caplin and Schotter’s book). They actually reduce the welfare analysis to revealed preference and the Pareto criterion because “it is the only criterion that can be integrated with positive economic analysis” (p. 25). According to them, economists “use welfare analysis to identify the interest of economic agents and to ask whether the understanding of the institutional constraints on policies remains incomplete. This use of welfare analysis requires the standard definition of welfare” (p. 25, my emphasis).

In other words, what Gul and Pesendorfer are doing is to completely ground welfare economics in positive, revealed preference analysis. Welfare economics has no justification outside positive economics. I said above that this is somewhat heterodox because the choice of a welfare criterion is generally regarded as outside the domain of positive economics, or at least this was the view of the pioneers of the “new” welfare economics like Samuelson. However, the suggestion that positive economics imposes constraints on the choice of a welfare criterion is not new: in the 1930’s, the rejection of the then standard Utilitarian view of welfare was made on the basis of a “positive” claim that interpersonal comparisons of utility were outside the realm of science but instead depend on “value judgments”.

As I understand it, Noah Smith’s claim that the selection of a welfare criterion is “a matter of opinion” is that we cannot tie the latter to scientific theories and facts. We can study facts on the basis of the scientific method and reject scientific theories on the basis of evidence but normative issues cannot be settled in this way. This sounds reasonable and indeed that has been the received view in the philosophy of science for decades. The problem is that this view relies on a distinction between the positive and the normative (or between facts and values) which is too strong. Consider Gul and Psendorfer’s argument that links welfare analysis to the revealed preference approach of positive economics. What is problematic or at least debatable is not the idea that welfare analysis should be coherent with or informed by positive analysis. The problem is the tacit presupposition that revealed preference and choice data are the only acceptable scientific input in the analysis (Noah Smith’s first point). What is the status of this presupposition? Well, at the most basic level, it is purely conventional in the sense that it reflects some consensus among economists. In itself however, it is not empirically testable and seems to be nothing more than “a matter of opinion”.

Now, consider the other way around: can (and should) normative economics inform and constrain positive economics as Amartya Sen (among others) contends? Given the fact that positive economics is also grounded on conventional choices, there is absolutely no reason to reject this possibility. But wait: if everything is a matter of opinion (i.e. is conventional), what remains of science? The answer is simply that we must recognize that the scientific endeavor is constituted by values and conventional choices. The point is that these choices are not totally arbitrary though and that we are constantly arguing about them (philosophers of economics more explicitly than others). From this point of view, the choice of a welfare criterion is no more a matter of opinion than the choice of the relevant data for positive analysis. But this is or should be  a “justified” or “reasonably argued” opinion based on facts and theories, but also on ethical considerations. This is no more “social activism” (Gul and Pesendorfer’s term) than a methodological manifesto like Gul and Pesendorfer’s one.

Irrational Consumers, Market Demand and the Link Between Positive and Normative Economics

Note : This post has been originally published at the blog “Rationalité Limitée“

As a follow-up to my last post, I would like to briefly return on the claim that the representative agent assumption is also well alive in microeconomics, not only in macroeconomics. As Wade Hands explain in several papers I linked to in the previous post, the representative agent assumption in microeconomics finds its roots in the study of consumer’s choice and more generally in demand theory. This may seem surprising (at least for non professional economists) since in virtually all microeconomic textbooks the study of demand theory starts from the analysis of the individual consumer’s choice. This reflects the fact that initially ordinal utility theory was conceived as a theory of the rational individual consumer with market demand simply derived through the horizontal summation of the individual demand curves. Similarly, in his seminal article on revealed preference theory, Samuelson started with well-behaved individual demand functions on the basis of which he derived a consistency axiom nowadays known as the weak axiom of revealed preference theory.

However, as it is well-known, the idea that the individual consumer is rational in the specific sense of ordinal utility theory (i.e. the consumer’s preferences over bundle of goods form a complete ordering) or revealed preference theory (i.e. the consumer’s choices are consistent in the sense of some axiom) is a disputed one, inside and outside economics. A foundational issue for economics has been, and still is the relationship between individual rationality and what can be called “market” or “collective” rationality. To ask the question in these terms already marks a theoretical and even an ontological commitment: it presupposes that the rationality criteria we apply to individual agents are also relevant to study collective behavior. Some economists have always resisted this commitment. However, acknowledging the fact that individual consumers may not be rational, the issue is obviously an important one for the validity of many theoretical results in economics, particularly concerning the properties of market competition.

An important paper from this point of view is Gary Becker’s “Irrational Behavior and Economic Theory” published in 1962 in the Journal of Political Economy. Becker established that the so-called law of demand (i.e. demand is a decreasing function of price) is preserved even with irrational consumers who either choose randomly a bundle of goods among the bundles in the budget set or who, because of inertia, always consume the same bundle if it is still available after a change in the price ratio. The simplest, random-choice case, is easy to illustrate. Becker assumes a population of irrational consumers who choose a bundle on their budget hyperplane according to a uniform distribution. In other words, a given consumer has the same chance to choose any bundle which exhausts his monetary income. Consider the figure below:

Consider the budget set OAB first. An irrational consumer will pick any bundle on the budget line AB with the same probability. Since the distribution is uniform, the bundle a (which corresponds to the mid-point between A and B) will be chosen on average in the population. Now, suppose that good x becomes more expensive relatively to good y. CD corresponds to the resulting compensated budget line (i.e. the budget line defined by the new price ratio assuming the same real income than before the price change). For the new budget set OCD, the bundle b is now the one that will be chosen on average. Therefore, the compensated demand for good x has decreased following the increase of its price. This implies that the substitution effect is negative, which is a necessary condition for the law of demand to hold. Note however that this not imply that each consumer is maximizing his utility under budget constraint. Quite the contrary, an individual consumer may perfectly violate the law of demand through a positive substitution effect. For instance, one may choose a bundle near point A with budget set OAB and a bundle near point D with budget set OCD, in which case the consumption of x increases with its price.

Clearly, there is nothing mysterious in this result which simply follows from a probabilistic mechanism. Becker used it as a “as-if” defense of the rationality assumption for consumer choice. Even if consumers are not really rational, one can safely assume the contrary because it leads to the right prediction regarding the shape of the market demand. As Moscati and Tubaro note in an interesting historical and methodological discussion, most of the experimental studies based on Becker’s theoretical argument have focused on the individual rationality issue: are consumers really rational or not? As the authors show, it turns out that Becker’s article and the subsequent experimental studies only offer a weak defense of the rationality assumption because they only show that rational choice is a plausible explanation for demand behavior, not the best explanation.

Surprisingly however, the most significant economic implications of Becker’s argument seem to have been largely ignored: the fact that individual rationality is of secondary importance to study market demand and that only “collective” rationality matters. This idea has been recently developed in several places, for instance in Gul and Pesendorfer’s critique of neuroeconomics and in Don Ross’ writings on the scope of economics. The latter offer a sophisticated account of agency according to which an economic agent is anything that fulfills some consistency requirements. Contrary to Becker, Ross’ approach is not grounded on an instrumentalist philosophy but rather on a realist one and provides a strong defense for the representative agent assumption in microeconomics.

The problem with this approach does not only lie in the fact that it excludes from the scope of economics all issues related to individual rationality. More significantly, as I already noted in the preceding post, it has significant implications for the relationship between positive and normative economics. Welfare analysis has been traditionally grounded on the preference-satisfaction criterion. The latter is justified by the fact that there is an obvious link between the preferences of an (individual) agent and the welfare of a person. The link is lost under the more abstract definition of agency because there is no reason to grant to some abstract market demand function any normative significance, despite its formal properties. Added to the fact that the irrationality of consumers makes the preference-satisfaction criterion meaningless, this makes necessary to rethink the whole link between positive and normative economics.