What Are Rational Preferences

Scott Sumner has an interesting post on Econlog about the economists’ use of what can be called the “Max U” framework, i.e. the approach consisting in describing and/or explaining people’s behavior as a utility maximization. As he points out, there are many behaviors (offering gifts at Christmas, voting, buying lottery tickets, smoking) that most economists are ready to deem “irrational” while actually they seem amenable to some kind of rationalization. Sumner then argues that the problem is not with the Max U framework but rather lies in the economists’ “lack of imagination” regarding the ways people can derive utility.

Sumner’s post singles out an issue that lies at the heart of economic theory since the “Marginalist revolution”: what is the nature of utility and of the related concept of preferences? I will not return here on the fascinating history of this issue that passes through Pareto’s ordinalist reinterpretation of the utility concept to Samuelson’s revealed preference account whose purpose was to frame the ordinalist framework in purely behaviorist terms. These debates had also much influence on normative economics as they underlie Robbins’ argument for the rejection of interpersonal comparisons of utility that ultimately led to Arrow’s impossibility theorem and the somewhat premature announcement of the “death” of welfare economics. From a more contemporary point of view, this issue is directly relevant for modern economics and in particular for the fashionable behavioral economics research program, especially as it has now taken a normative direction. Richard Thaler’s reaction to Sumner’s post on Twitter is thus no surprise:

<blockquote class=”twitter-tweet” lang=”fr”><p lang=”en” dir=”ltr”>Yes. This version of economics is unfalsifiable. If people can &quot;prefer&quot; $5 to $10 then what are preferences? <a href=”https://t.co/Cn1XQoIzsh”>https://t.co/Cn1XQoIzsh</a></p>&mdash; Richard H Thaler (@R_Thaler) <a href=”https://twitter.com/R_Thaler/status/680831304175202305″>26 Décembre 2015</a></blockquote>

Thaler’s point is clear: if we are to accept that all the examples given by Sumner are actual cases of utility maximization, then virtually all kinds of behaviors can be seen as utility maximization. Equivalently, any behavior can be explained by an appropriate set of “rational” preferences with the required properties of consistency and continuity. This point if of course far from being new: many scholars have already argued that rational choice theory (either formulated in terms of utility functions [decision theory for certain and uncertain decision problems] or of choice functions [revealed preference theory]) is unfalsifiable: it is virtually always possible to change the description of a decision problem such as to make the observed behavior consistent with some set of axioms. In the context of revealed preference theory, this point is wonderfully made by Bhattacharyya et al. on the basis on Amartya Sen’s long-standing critique of the rationality-as-consistency approach. As they point out, revealed preference theory suffers from an underdetermination problem: for any set of inconsistent choices (according to some consistency axiom), it is in practice impossible to know whether the inconsistency is due to “true” and intrinsic irrationality or is just the result of an improper specification of the decision problem. In the context of expected utility theory, John Broome’s discussion of the Allais paradox clearly shows that reconciliation is in principle possible on the basis of a redefinition of the outcome space.

Therefore, the fact that rational choice theory may be unfalsifiable is widely acknowledged. Is this a problem? Not so much if we recognize that falsification is no longer recognized as the undisputed demarcation criterion for defining science (as physicists are currently discovering). But even if we ignore this philosophy of science feature, the answer to the above question also depends on what we consider to be the relevant purpose of rational choice theory (and more generally of economics) and relatedly, what should the scientific meaning of the utility and preference concepts. In particular, a key issue is whether or not a theory of individual rationality should be part of economics. Three positions seem to be possible: The “Not at all” thesis, the “weakly positive” thesis and the “strongly positive” thesis:

A) Not at all thesis: Economics is not concerned with individual rationality and therefore does not need a theory of individual rationality. Preferences and utility are concepts used to describe choices (actually or counterfactually) made by economic agents through formal (mathematical) statements useful to deal with authentic economic issues (e.g. under what conditions an equilibrium with such and such properties exists?).

B) Weakly positive thesis: Economics builds on a theory of individual rationality but this theory is purely formal. It equates rationality with consistency of choices and/or preferences. Therefore, it does not specify the content of rational preferences but it sets minimal formal conditions that the preference relation or the choice function should satisfy. Preferences and utility are more likely (but not necessarily) to be defined in terms of choices.

C) Strongly positive thesis: Economics builds on a theory of individual rationality and actually parts of economics consist in developing such a theory. The theory is substantive: it should state what are rational preferences, not only define consistency properties for the preference relation. Preferences and in particular utility cannot be defined exclusively in terms of choices, they should refer to inner states of mind (e.g. “experienced utility”) which are accessible in principle through psychological and neurological techniques and methods.

Intuitively, I would say that if asked most economists would entertain something like the (B) view. Interestingly however, this is probably the only view that is completely unsustainable after careful inspection! The problem is the one emphasized by Thaler and others: if rational choice theory is a theory of individual rationality, then it is empirically empty. The only way to circumvent the problem is the following: consider any decision problem Di faced by some agent i. Denote T the theory or model used by the economist to describe this decision problem (T can be either formulated in an expected utility framework or in a revealed preference framework). A theory T specifies, for any Di, what are the permissible implications in terms of behavior (i.e. what i can do given the minimal conditions and constraints defined in T). Denote I the set of such implications and S any subset of these implications. Then, a theory T corresponds to a mapping T: D –> I with D the set of all decision problems or, equivalently, T(Di) = S. Suppose that for a theory T and a decision problem Di we observe a behavior b such that b is not in S. This is not exceptional as any behavioral economist will tell you. What can we do? The first solution is the (naïve) Popperian one: discard T and adopt an alternative theory T’. This is the behavioral economists’ solution when they defend cumulative prospect theory against expected utility theory. The other solution is to stipulate that actually i is not facing decision problem Di but rather decision problem Di’, where T(Di’) = S’ and b ∈ S’. If we adopt this solution, then the only way to make T falsifiable is to limit the range of admissible redefinitions of any decision problem. If theory T is not able to account to some implication b under all the range of admissible descriptions, then it will be falsified. However, it is clear that to define such a range of admissible descriptions necessitates making substantive assumptions over what are rationalizable preferences. Hence, this leads one toward view (C)!

Views (A) and (C) are clearly incompatible. The former has been defended by contemporary proponents of variants of revealed preference theory such as Ken Binmore or Gul and Pesendorfer. Don Ross provides the most sophisticated philosophical defense of this view. View (C) is more likely to be endorsed by behavioral economists and also by some heterodox economists. Both have however a major (and problematic for some scholars) implication once the rationality concept is no longer understood positively (are people rational?) but from an evaluative and normative perspective (what is it to be rational?). Indeed, one virtue of view (B) is that it nicely ties together positive and normative economics. In particular, if it appears that people are sufficiently rational, then the consumer’s sovereignty principle will permit to make welfare judgments on the basis of people’s choices. But this is no longer true under views (A) and (C). Under the former, it is not clear why we should grant any normative significance to the fact that economic agent make consistent choices, in particular because these agents have not to be necessarily flesh-and-bones persons (they can be temporal selves). Welfare judgments can still be formally made but they are not grounded on any theory of rationality. A normative account of agency and personality is likely to be required to make any convincing normative claim. View (C) cannot obviously build on the consumer’s sovereignty principle once it is recognized that people do not always choices in their personal interests. Indeed, this is the very point of the so-called “libertarian paternalism” and more broadly of the normative turn of behavioral economics. It has to face however the difficulty that today positive economics does not offer any theory of “substantively rational preferences”. The latter is rather to be found in moral philosophy and possibly in natural sciences. In any case, economics cannot do the job alone.

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