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.

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.