Behavioral economics, power, rational inefficiencies, fuzzy sets, and public policy.

Author:Altman, Morris

A fundamental difference between mainstream or traditional neoclassical theory and the various variants of behavioral economics is that to behavioral economics assumptions matter substantively to the construction of economic models (Altman 1999, 2001d, 2003; Simon 1987a, 1987b). In addition, behavioral economics explicitly recognizes the importance of institutional parameters in model building since institutions affect the decision-making process. Moreover, the Herbert Simon tradition in behavioral economics maintains that intelligent behavior need not yield the type of optimal or efficient behaviors predicted by traditional neoclassical theory (March 1978; Simon 1987b, 1991).

Although the focus of much of the recent research and discourse on behavioral economics has been in the realm of consumption and demand, this paper focuses upon the critically important domain of production in the tradition of Richard Cyert and James March (1963) and Harvey Leibenstein (1966, 1973, 1987). Moreover, unlike some in the recent literature in behavioral economics, following upon the work of Daniel Kahneman and Amos Tversky, we do not assume that the behavior of economic agents is inherently error prone, lacking in intelligence, or irrational. (1) Rather, following in the Simon and James March tradition, we assume that economic behavior is boundedly rational and therefore intelligent and purposeful. Rational behavior is not defined as "neoclassical" behavior, and behavior that deviates from neoclassical norms is not assumed to be irrational (Altman 2003).

This paper builds upon the empirically based premise that neoclassical assumptions about the optimality and efficiency of economic agents in the sphere of production are wrong. Such assumptions are in part situated in the worldview that market forces induce optimal and efficient behavior in the firm and, also, in the worldview that such behavior is part and parcel of human nature--that it is "bred in the bone." An important component of this worldview is that the quantity and quality effort inputs into the production process are maximized at all points in time. Thus firms are assumed to be, in Leibenstein's narrative on the firm, x-efficient in production. Building upon and extending the x-efficiency and efficiency wage theories pioneered by Leibenstein (1957, 1966, 1979, 1987; Frantz 1997) wherein the assumption of effort discretion is introduced into the production function of the firm, a model is presented here where both efficient (x-efficient) and inefficient (x-inefficient) firms can survive in equilibrium even in a regime of competitive product markets. (2)

In mainstream theory, effort discretion does not exist as economic agents are all maximizing their effort inputs, in both their quantity and quality dimension, into the production process. In the model presented here, both relatively efficient and inefficient firms and the choices of individuals underlying the relatively efficiency of the firms are both consistent with rational or intelligent behavior. Thus, assuming either competitive product markets or rational behavior need not result in efficiency in production. Whether or not efficiency obtains critically depends upon the preferences of the firms' economic agents and institutional parameters, including bargaining power, which constrain or affect the choices made by these economic agents. Rational individuals have no incentive to choose neoclassical efficiency unless such choice is in their self-interest or in the self-interest of the group or network of which they are part. This need not be the case for workers, managers, or firm owners wherein these economic agents possess differing and even conflicting objective functions.

As Kurt Rothschild (2002) has pointed out, the incentive structure within the firm as affected by the power relationship between firm members has been long neglected in contemporary economics inclusive of behavioral economics with the exception of Leibenstein (1982, 1984, 1987) and Simon (1991). Needless to say, the power relationship and the wider institutional context within which it is embedded and which in turn affects and is affected by it was central to the oeuvres of key institutional economist John R. Commons (1911, 1923; see also McIntyre and Ramstad 2002). It also played an important role in the central narrative of contemporary economics: Adam Smith's Wealth of Nations ([1776] 1937; see also Altman 2000a, 2000b). (3) In this paper, the power relationship in the firm and its institutional context play a pivotal role. Market forces do not neutralize power as a long-run causal factor in the analysis of firm behavior. Rather, the power relationship among workers, managers, and owners can have a long-run effect on efficiency and on the level and distribution of socio-economic well-being.

This modeling of agency and the firm better allows us to explain why and how relatively high-wage firms and environments conducive to high-wage regimes can persist and prosper over historical time side by side with low-wage firms and environments, why and how inefficient firms can survive and prosper over historical time, and why there need not be, as there has not been, a convergence between low-wage and high-wage economies and institutional and related cultural variables within which such differing economies are embodied. We can also better explain why labor market discrimination can persist even in the face of competitive markets and why greener economies can be both cost competitive and more efficient and productive than less environmentally friendly ones.

Last but not least, using such behavioral modeling we can better explain how ethical and moral behavior is realizable in the process of production even in the face of competitive product markets. Moreover, ethical behavior, in this narrative, yields higher levels of efficiency as do higher-wage economies and economies with lesser amounts of discrimination, and with cultural sets which encourage a work ethic and human capital formation. Which path to competitiveness is chosen is a product of the preferences of the firms' decision makers with regard to ethical or moral behavior, albeit constrained by the preferences of consumers with regard to the ethical or moral dimension of the production process and their capacity to realize their preferences on the marketplace. These analytical predictions are quite contrary to what is found in the conventional economic models, which are built on less realistic and less dynamic behavioral assumptions. They are also contrary to the analytical predictions of much of the unconventional economic literature, which suggests that low-wage and unethical firms should dominate their higher wage and ethical counterparts. This discourse builds on and is derived from Altman 1992, 1996, 1998, 1999, 2000, 2001a, 2001b, 2001c, 2002, and 2004.

Mainstream economic theory yields unambiguous predictions with regard to how rational agents can be expected to behave and suggests a one-to-one causal linkage between rationality and efficiency. Thus efficiency is a natural product of rational choice, albeit sometimes egged on by market forces. This prediction yields unambiguous public policy recommendations with regard to the degree of freedom afforded to economic agents to increase wages, improve working conditions, and behave morally or ethically without negatively impacting on employment or costs. In a word, there is none since any such public policy generates negative economic affects apart from those directly benefiting from such improvements. And even here, in the long run, these individuals might suffer if average costs increase and their firms become less competitive.

The behavioral model presented here yields a wider set of viable and rational behavioral patterns with regard to the place of work. Higher-wage economies and moral and ethical behavior become a choice option within the place of work as do low-wage economies and amoral and unethical behavior. Unlike in the conventional model, in the behavioral model presented here both high- and low-wage firms and relatively ethical and unethical firms, for example, can produce at the same unit costs of production. This is for reasons related to differences in the levels of x-inefficiency which are induced by differences in production costs and institutional parameters which include the power relationships between economic agents. However, converging toward either a high- or low-wage or an ethical or unethical economy, for example, is not inevitable. There exists no unique equilibrium given by economic variables. Economic agents are not forced to converge to any particular action or outcome by market forces or by some biologically determined imperative. The behavioral model allows for a multiple equilibria or a fuzzy set solution to the choice set afforded to economic agents in the fundamentally important domain of production. For this reason, the behavioral model helps explain important stylized economic facts--persistent regularities--which appear to be inconsistent with the analytical predictions of mainstream economic theory which does allow for the complexity and variety of outcomes in competitive equilibrium, which is the substance of economic life. (4)

It is important to note, as will be discussed in some detail below, that the behavioral model generates analytical predictions and causal analyses which are quite distinct from what flows from contemporary efficiency wage theory. Although in this modeling effort input is also a variable, rational maximizing agents hover toward a unique equilibrium with regard to wages and productivity, yielding negative consequences for employment and macroeconomic efficiency not unlike those predicted by the conventional wisdom where effort discretion does not exist.

The Conventional Model

A fundamental assumption of the conventional model of the firm is that economic agents...

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