How do people choose? The myth of rationality

We like to believe that we are rational, and what is called as the neoclassical theory of economics is based on the assumptions, that humans have fixed preferences, and these preferences are called transitive. Fixed preferences mean if you prefer key lime pie to caramel fudge cheesecake on Monday, you will do it on Tuesday too. (This book is not about healthy diet desserts). Transitivity means, for example, if you decide about the dessert to complete your dinner in a fine-dining restaurant, if you prefer key lime pie to caramel fudge cheesecake, and these cheesecake to chocolate mousse, than you will prefer this pie to the chocolate mousse, too. So, the choice of a dessert is a rational activity, but in a restricted sense of the world. We would not tell somebody that she is crazy by still choosing chocolate mousse to key lime pie.

Neoclassical economic theories are based on the concept that we are rational in a sense
that during decision making humans are maximizing our expected gain (say, pleasure or profit) expressed by the utility function. However, if we want to make a quantitative analysis, say to maximize the utility function for the dessert selection, we should be able to assign numerical values to our desire to consume pie, cheesecake or mousse. The rational choice theory47 madepossible to represent and solve problems of choice in a formal manner, and was the basis of many results in decision theory, game theory, and microeconomics. Rational choice theory is based on absurdly simple assumptions, as that more is always better, and people have full information, an use this information rationally. In addition people are not affected by their emotion, as fear or envy. So, more or less the model assumes that people are emotionless robots, who don’t make computational errors. In a famous publication (6325 citations in the Google Scholar today (June 7h, 2018)) the celebrated economist Milton Freedman48 argues that it is possible to offer useful prediction tools for economists even based on oversimplified assumptions.

How social decision emerge in the society of homo economicus? Before starting to give any answer, let’s clarify the differences between two types of theories. They are called descriptive and normative, respectively. The first attempts to answer the question ”How does the world work?”, while the second is interested in the problem of ”How the world should work?”. Responses for the second question arrived both from mathematics and moral philosophy, and I would like to believe that the best ones come from the combination of the two. In the world of the society of self-rational people Pareto optimality state corresponds to the allocation of resources from which it is impossible to improve any individual’s utility without making at least one individual worse
off. Welfare economics promised to find the state that creates the highest overall level of social satisfaction among its members. Technically, the problem is to give a complete and transitive ranking of all social alternatives.
As always in with ranking and rating problems, there are two possibilities. First, it is possible to give a an ordered list of preferences. Economists use the terminology of ordinal utility function for an individual to rank all possible ”states”. It tells that an individual prefers possible state X to possible state Y , but it is meaningless to ask how much better she prefers the first option. Second, a cardinal utility function assigns a number to characterize the attractivity of any state, so it it is possible to express the magnitudes of how much an individual prefers X to Y . Here is a recurring problem, how to assign numbers to qualities? In a very very reduced sense the state of the world is nothing else, but a set of products to buy. One way to put numbers on goods
utility is to ask what price people are willing to pay for a good. If you are ready to pay $27,000 for a Toyota Camry Hybrid, you can say that this product has a 27; 000 utils (the abstract unit of utility). But it is a very naive picture.

How to construct a cardinal social welfare function (SWF) from the utility functions of individuals? Identifying the utilities of individuals one might define SWF as their sum of the individual utilities. In this case the goal of maximizing the SFW means maximizing the individual incomes. Any thoughts about income distribution were totally neglected. A very skew distribution, where a small portion of people (”1%”) owns the majority of wealth may maximize the SWF defined this way. Others may prefer a ”social state” with more total income even if itis unevenly distributed. As a third, and influential option, one may define SWF based on the average of individual utilities.
John Rawls (1921—2002), a leading political and moral philosopher of the last century identified classical and average utilitarianism ”as the Principal Opponent: and suggested to define SWF based on the utility of worst-off individual. So, maximizing SWF would mean maximizing the income of the poorest person in society without taking into account the income of other individual.49
Amartya Sen, the legendary Indin economist, proposed a form of SWF, which penalizes
economic inequality50. Sen adopted the concept of Gini coefficient (G). G is zero in case of perfect equality, (assuming everyone has the same income), and coefficient of 1, in there is a maximal inequality (e.g., ideally where only one person has all the income and all others have none, the Gini coefficient will be one.) His SWF is defined as the average per capita income of a country, is multiplied with a number(1-G). A good normative theory could be applied to the real world, and we will return to an application to show the ranked lists of countries based on Sen’s SWF will in 6.3.1.