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1 Rational Markets, Irrational Actors Neoclassical decision theory has explained various economic phenomena by employing a psychologically implausible decision theory. How is this possible? Several theorists have argued that the structure of social and economic institutions pushes real-world agents to approximate the traditional homo economicus model of rational choice. Some institutions produce effective economic decisions by limiting choices, a success-through-elimination model. Yet the mechanism remains obscure. I argue that effective social and economic institutions produce rational economic behavior when they reduce the cognitive costs required to make rational decisions by providing agents relevant information. The effects of even meager information can lead markets converge on economically rational outcomes. Institutions that effectively reduce cognition costs allow economic actors to coordinate effectively, which then through imitation and adaptation enables markets to clear as they would were they populated with rational actors. This essays proceeds in four parts. In Section I, I review neoclassical decision theory and psychological challenges to it. In Section II, I discuss some proposed resolutions to the conflict and criticize them. In Section III, I defend advance a ―costs of cognition‖ approach and show how it can accommodate the benefits of the models discussed in Section II. In Section IV, I conclude. Section I: Neoclassical Decision Theory and Its Critics (I.i) Most economists employ standard decision theory to produce economic models. i Standard decision theory is ordinalist, conceiving of rational choice as choice based on consistent preference orderings. Second, standard decision theory is instrumentalist. It only specifies the implications of an agent‘s beliefs and preferences. An individual is rational when his choices are based on an ordinal utility function with weakly ordered preferences,

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Page 1: Rational Markets, Irrational Actors

1

Rational Markets, Irrational Actors

Neoclassical decision theory has explained various economic phenomena by employing a

psychologically implausible decision theory. How is this possible? Several theorists have

argued that the structure of social and economic institutions pushes real-world agents to

approximate the traditional homo economicus model of rational choice. Some institutions

produce effective economic decisions by limiting choices, a success-through-elimination

model. Yet the mechanism remains obscure. I argue that effective social and economic

institutions produce rational economic behavior when they reduce the cognitive costs

required to make rational decisions by providing agents relevant information. The effects of

even meager information can lead markets converge on economically rational outcomes.

Institutions that effectively reduce cognition costs allow economic actors to coordinate

effectively, which then through imitation and adaptation enables markets to clear as they

would were they populated with rational actors.

This essays proceeds in four parts. In Section I, I review neoclassical decision theory

and psychological challenges to it. In Section II, I discuss some proposed resolutions to the

conflict and criticize them. In Section III, I defend advance a ―costs of cognition‖ approach

and show how it can accommodate the benefits of the models discussed in Section II. In

Section IV, I conclude.

Section I: Neoclassical Decision Theory and Its Critics

(I.i) Most economists employ standard decision theory to produce economic models.i

Standard decision theory is ordinalist, conceiving of rational choice as choice based on

consistent preference orderings. Second, standard decision theory is instrumentalist. It only

specifies the implications of an agent‘s beliefs and preferences. An individual is rational

when his choices are based on an ordinal utility function with weakly ordered preferences,

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which must meet four conditions.ii First, an ordering must be complete. If John has a

complete ordering, he can rank any two preferences vis-à-vis one another; either preference

A > B, B > A or B is indifferent to A. Second, preferences must be asymmetric: if John prefers

A to B, he cannot prefer B to A. The indifference relation is symmetric. If John is indifferent

between A and B, he must be indifferent between B and A. Finally, preferences must be

transitive. If John prefers A to B and B to C, he must prefer A to C.

(I.ii) Economists add conditions to agents with ordinary utility functions to generate the

homo economicus model of economic behavior.iii First, homo economics prefers more to less.

This is a ceteris paribus condition. If John wants a pizza, he prefers more pizza to less all

things equal. Suppose that for $10 John can have two pizzas or one pizza. If he chooses one

pizza we would call him irrational. Even if he does not want to eat the second pizza, he may

be able to find a use for it, perhaps to be eaten later, given to a friend or the homeless, or so

on. One way of putting it formally is to say, following Russell Hardin, that ―the simplest

definition of rationality … is that one should choose more rather than less value.‖iv Second,

homo economicus makes choices at the margin. Thus, if she is consuming units of pizza, she

will prefer the first piece to the second piece, the second to the third, and so on. Economists

call this the law of diminishing marginal utility. The value rational individuals place on

goods diminishes for each additional good acquired. To illustrate, suppose that John is a

farmer and needs grain to meet his ends. He will use his first bag of grain to satisfy his

highest ranked preference, perhaps eating. The second bag will be used to satisfy John‘s

second highest ranked preference, such as sustaining his livestock. From there John meets

further goals, saving grain for future eating, for feeding future livestock and for sale at

market.v John‘s behavior is irrational otherwise; his action would violate his preference

ordering. Homo economicus follows also has downward sloping demand curves. In other

words, when prices rise, demand falls. The law of demand holds due to opportunity costs.

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The cost of satisfying preference A is not satisfying the next ranked preference B; B is the

opportunity cost of A. Homo economicus is also assumed to have wealth-maximization

preferences.vi Some economists however, assume that many agents do not have wealth-

maximizing preferences. Herbert Simon, in his work on bounded rationality, argued that

rational agents often ‗satisfice‘ rather than maximize.vii Satisficing is choosing a solution that

is ‗good enough‘ rather than perfect in order to economize on costs of cognition. Gerald Gaus

notes that ‗it is not always clear whether satisficing is really an alternative to maximizing‘.viii

Sometimes those who maximize do best to satisfice as they will waste time calculating.

Expected utility theory applies the homo economicus model to decision-making

under risk. Expected utility theories combine the utility of an outcome with the outcome‘s

probability, holding that rational individuals will select the greater product of utility and

probability than the lesser.ix All of the choice axioms that apply above apply to standard

expected utility theory.

(I.iii) The homo economicus model has been widely criticized.x Prominent examples come

from cognitive psychologists, such as Daniel Kahneman, Richard Thaler and Amos Tversky.xi

They have documented voluminous cases of poor human decision-making. One well-known

example is the conjunction fallacy. Kahneman and Tversky performed a famous experiment

demonstrating the fallacy by giving subjects the following questionxii:

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy.

As a student, she was deeply concerned with issues of discrimination and social

justice, and also participated in anti-nuclear demonstrations.

Please rank the following statements by their probability, using 1 for the most

probable and 8 for the least probable.

(a) Linda is a teacher in elementary school.

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(b) Linda works in a bookstore and takes Yoga classes.

(c) Linda is active in the feminist movement.

(d) Linda is a psychiatric social worker.

(e) Linda is a member of the League of Women Voters.

(f) Linda is a bank teller.

(g) Linda is an insurance sales person.

(h) Linda is a bank teller and is active in the feminist movement.

For ordinary undergraduate students with no statistics coursework, 89% ranked (h) as more

likely than (f). But the probability of being an F cannot be lower than the probability of

being an F and an H. The probability of F and H can only be as large as the probability of F

and could be a great deal lower. Thus individuals make poor decisions when conjuncting

identical probabilities and utilities with distinct descriptions. The phenomenon of preference

reversal is similar. When the same decision is presented under different descriptions,

preferences often reverse. In the cognitive psychology literature, these are known as ‗framing

effects‘.xiii Framing effects challenge the homo economicus model because decision theory

requires complete and intransitive preferences; these experiments appear to show otherwise

because they at least seem to show that preferences are often inconsistent. Another

important challenge is based on the status-quo bias, where subjects prefer what they

currently have to clearly superior alternatives.xiv Experiments like these have generated the

‗heuristics and biases‘ tradition in cognitive science. According to this view, humans have

evolved to process information according to crude cognitive heuristics with low cognitive

costs and that produce systematically biased behavior. Despite promoting survival, these

heuristics often get the answer rightxv, despite often erring.xvi

Section II: Attempts at Reconciliation

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(II.i) How might the psychological challenges be reconciled with the homo economicus

model? One common view among economists is that the irrationality of individual actors

doesn‘t matter so long as models have predictive power, a sort of positivist position. This

methodological disposition derives from Milton Friedman‘s early 1953 article ‗The

Methodology of Positive Economics,‘ where Friedman argues that a hypothesis matters ‗if it

abstract the common and crucial elements‘ from a range of phenomena and generate

predictions. Thus ‗a hypothesis must be [emphasis mine] false in its assumptions‘; in fact the

most significant hypotheses will make assumptions that are ―wildly inaccurate descriptive

representations of reality‘.xvii To give an example, Milton Friedman‘s permanent income

hypothesis holds, to oversimplify, that patterns of consumer choices are not fixed by their

current income. Instead, consumers consume according to income expectations over their

lifetime. The theory predicts that short-term changes in income will not significantly affect

consumer behavior and is consistent with the empirical fact that consumption is relatively

smooth over short periods.xviii While other views have superseded the permanent income

hypothesis, it has explanatory power despite the implausible assumption that economic

agents make consumption decisions bearing in mind a coherent and determinate expectation

of their incomes over their lifetimes.xix For Friedman, the psychological implausibility of the

view did not matter.

The positivist strategy is inadequate. Rather than solving the conflict, it tries to

dissolve it. Three replies are in order. First, even if Friedman is right, we might still wonder

how individual psychology and economic reality mesh. Second, we often want science to

illuminate the truth about its subject matter. The permanent income hypothesis is probably

false. But what true theory explains how it fits with data on consumer choices? Third,

philosophers of science and many scientists knew long before Quine made it commonplace

that a vast number of theories are compatible with most data.xx And this is true across the

scientists. Economics deals with more variables than many models in natural sciences;

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accordingly, indeterminacy is worse.xxi One advantage of developing a psychologically

plausible model is limiting the range of theories used to explain empirical phenomena,

increasing the effectiveness of the scientific process.

(II.ii) The conflict between individual irrationality and market efficiency might be resolved

by asserting that psychological evidence demonstrates extensive market failure. Some

behavioral economists and cognitive scientists pursue this line, arguing that economic

evidence for market successes is ambiguous and market efficiency illusory. Behavioral

economists do not believe that markets always fail, but that they appear to work much more

often than close psychological examination of individual economic choices significant

irrationalities.

In Predictably Irrational, Dan Ariely argues that humans are often fooled into

thinking that they make rational decisions when they do not. Ariely asks:

If I asked you for the last two digits of your social security number (mine are 79), then

asked you whether you would pay this number in dollars (for me this would be $79)

for a particular bottle of [wine], would the mere suggestion of that number influence

how much you would be willing to spend online?xxii

The answer is yes, even for a group of MIT MBA students. Humans irrationally anchor

themselves to initially suggested prices and resist moving off of them. Ariely claims that

economists assume that prices are determined by supply and demand, but this depends on

‗the assumption that the two forces are independent and that together they produce the

market price‘.xxiii Ariely, et al.‘s experiments are evidence to the contrary: ‗what consumers

are willing to pay can easily be manipulated‘.xxiv Ariely goes onto suggest that, for instance,

increasing gasoline prices won‘t permanently reduce demand because people will adjust their

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anchors over time; as a result, free market exchanges may not always be mutually beneficial.

Ariely‘s argument is radical. Since we can be mistaken about what brings us utility, why

should economists and policy makers assume that individuals tend to act in their best

interests? While policy makers should ‗take this into account‘, if Ariely is right the case for

the free-market is destroyed. The classic defense of markets is that they utilize the expertise

of individuals concerning their own preferences and local information.xxv If individuals

routinely err when making economic decisions then this classic defense is threatened.

Ariely oddly neglects to mention a fifty-year old field of economics that has already

addressed these questions: experimental economics, a branch of economics that attempts to

verify the details of economic models by running economic experiments with test subjects.

This contrasts with the work of behavioral economists like Ariely, which primarily focus on

individual economic behavior. Smith and his colleagues have conducted hundreds of

experiments that replicate market efficiency. While Smith notes that his experiments do not

always confirm standard expected utility theory, ‗experimental tests of market theories,

which explicitly assume expected utility (or value) maximization, have not falsified many of

these theories‘.xxvi And while many initial tests show marked irrationalities, over time

behavior approximates economic models. Smith has long thought ‗that markets may induce

greater ―rationality‖ in behavior because they force or promote a response to, or discovery of,

opportunity cost conditions, that need not be readily forthcoming when agents merely think

about the choices they make‘.xxvii Framing effects ‗do relatively low level damage to [the

expected utility hypothesis]‘; economic actors can learn to avoid these effects.xxviii Economic

actors become expert statistical reasoners; rather, they learn to avoid options that lead to net

cost. For instance, experimental economists freely admit that individuals exhibit anchoring

effects and that, initially, groups do as well; the question is whether these effects will persist

over time as individuals become more familiar with how to avoid net costs. Experimental

economists would reject Ariely‘s conclusions because his work (i) does not include a choice

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class of objects that are subject to a budget constraint, and (ii) ignores whether in repeat

conditions learned rationality will reduce anchoring effects.

Smith argues that economic experiments show that institutions matter. The formal

and informal rules that govern institutional environments are required to enable economic

learning. On Smith‘s view, economic rationality is an achievement that occurs only under

the right sets of rules.xxix In many cases, market optimization is an unconscious process: Smith

reports that ‗hundreds of double auction experiments … would spotlight the crucial

importance of not ruling out the rationality of unconscious decision in rule-governed repeat

interaction settings‘.xxx Smith also found that market actors often become less rational when

given more information. A bargainer with better information, ‗… knowing that the other

player knew only his own payoff, is more forgiving when his opponent makes large

demands‘. xxxi Surprisingly, ‗[t]his concessionary posture works to the disadvantage of the

completely informed player‘.xxxii Finally, efficiency requires that actors often play dominated

strategies.xxxiii Players should cooperate even when it leads to short-term losses because

cooperation helps form common expectations. Common expectations allow players to

reliably predict what others players will do, and so reduces worries about defection in

economic exchanges. A willingness to sacrifice some benefit for the sake of cooperation helps

to grease the cooperative wheel which in the long-term produces a more efficient

environment. Common knowledge, Smith has found, is not sufficient to produce efficient

outcomes. Common expectations must be established before efficiency can be fully achieved.

These common expectations are formed through repeated cooperation. Thus Smith says,

‗dominated strategies are for playing, not eliminating‘.xxxiv

Ariely‘s experiments no doubt show that individuals can be irrational. And other

behavioral economists have challenged experimental economists‘ account of market learning,

arguing that some irrationality is not reduced through learning.xxxv Some recent work even

purports to show that some irrationality even increases through repetition.xxxvi But it is

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widely established that repetition reduces irrational economic behavior; in many cases

markets can regularly achieve efficient outcomes despite individual irrationality. Market

efficiency is possible if individuals are irrational by themselves, so long as individuals are

rational in groups under the appropriate rules and interact over time.xxxvii

Unlike Ariely, most behavioral economists admit that market repetition sometimes

reduces market irrationalities. Thus widespread market success need not be denied. The

problem with the ‗extensive market failure‘ solution is similar to the problem with

positivism. Instead of struggling to understand an important tension, it simply discounts one

side. The apparent tension between individual irrationalities and widespread market success

cannot be denied; it must be resolved.

(II.iii) Perhaps the most sophisticated attempts to reconcile irrational psychologies with

market rationality lies in the field of alternative expected utility theories. These theories

depart, in one way or another, from the standard assumptions of expected utility theory

outlined in Section I. The theories vary substantially, so I will describe two general

alternative expected utility theories, and show that, while accounting for the psychological

evidence within a decision theoretic framework, they fail to generate a satisfying

reconciliation.

The two types of alternative expected utility theories [henceforth, EUT/AEUT] are

―conventional‖ EUTs and ―nonconventional‖ EUTs.xxxviii Conventional EUTs try to preserve

the expected utility theory generally while relaxing some of its standard assumptions. They

still assume that agents optimize a preference function. Nonconventional EUTs or

‗procedural‘ theory only assume that economic actors use decision heuristics.xxxix One

conventional EUT is weighted expected utility theory, which treats standard EUT as a

specific case of a broader theory.xl Standard EUT holds when all consequences are equally

weighted. Outcomes of actions are ‗weighted‘ when they are given more value in an

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expected utility calculation vis-à-vis other outcomes that exceeds the value warranted by the

product of the utility and probability of the outcome. Advocates of weighted EUT maintain

that divergence from behavior predicted by standard EUTs can be explained by

distinguishing between differently weighted consequences. For instance, in preference

reversal cases sometimes two bets are presented, one with a low probability of a high payout

and the other with a moderate probability or a moderate payout. The expected utility of both

bets is identical, yet betting agents consistently prefer the higher probability outcome.

Weighted expected utility theorists argue that innate decision-making heuristics produce a

tendency to assign more weight to the less risky bet. For instance, if humans use heuristics

that generate framing effects, they may be more likely to weight an outcome more heavily

than under one description than another.

The most prominent nonconventional expected utility theory is prospect theory.xli

Prospect theory argues that normal human decision-makers do not maximize a utility

function and so standard decision theory employs an implausible model of human cognition.

Instead, prospect theorists claim that decision-making under risk has two separate stages, an

‗editing‘ phase and an ‗evaluation‘ phase. In the editing phase, the realized options are

structured and formed to make choice easy. During this cognitive process, heuristics are used

to assign perceived outcomes positive or negative values judged against some baseline.

Common factors are omitted, probabilities of similar outcomes are combined, and dominated

options are removed when detected. However, many mistakes occur. The evaluation phase

contains both a value function and a weighting function, as weighted expected utility theory

suggests. The decision weighting function usually involves assigning what many

psychologists judge as unreasonably high expected costs to low probability events. For our

purposes, take prospect theory as a description of how normal humans make decisions. There

have been some speculations about how to use prospect theory prescriptively.xlii Some

economists have worried about the relevance of the editing phase, so Kahneman and Tversky

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developed cumulative prospect theory, which avoids relying too heavily on the editing

phase.xliii In cumulative prospect theory, only cumulative probabilities are transformed rather

than individual probabilities. Consequently, real agents make choices in accord with the

probability of a class of actions of which the relevant choice is member. Prospect theorists

then argue that the irrationality high weights we assign to low probability events result from

the editing phase. Heuristics are used to edit which events are risky and which are not and

these heuristics, while cognitively cheap and evolutionarily successful, generate irrational

behavior in many cases. Consequently, such heuristic may generate irrational risk-aversion

and make probability assignment overly sensitive to the presentation of scenarios.

Both conventional and nonconventional expected utility theories purport to explain

why markets work in some cases and not others. In some cases, their explanations are

illuminating. Both theories can account for assigning irrational risk-aversion and both can

accommodate framing effects, among others. To this extent, alternative expected utility

theories help to reconcile how markets work with the fact that humans are sometimes

irrational economic actors. In cases where preference reversal, framing, etc. are significant,

markets will not work as well as they could; but in cases where irrationalities do not arise,

markets may be efficient. However, these theories do not directly explain anomaly reduction

through repetition. We saw in II.ii that repetition allows actors to approximate the behavior

that standard expected utility theory prescribes. The feedback from repeated social

interactions helps isolated actors or actors in single-shot bets to act rationally according to

their self-interest.xliv So while alternative expected utility theories may help resolve the

conflict, social interaction, adaptation and common expectations must also play an

explanatory role.

(II.iv) Behavioral and experimental economists agree that limiting options is one way to

generate rational behavior.xlv Option restriction is related is called ‗situated‘ or ‗embedded‘

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cognition.xlvi The view, in short, is that human cognition is not merely ‗in the head‘ or

entirely contained within the brain. Instead, cognition arises from the interplay between

brain, body and environment. Philosopher Andy Clark argues that human cognition is

unique not because humans are good individual reasoners but because they possess ‗amazing

capacities to create and maintain a variety of special external structures‘.xlvii He continues:

‗these external structures function so as to complement our individual cognition profiles and

to diffuse human reason across wider and wider social and physical networks whose

collective computations exhibit their own special dynamics and properties‘.xlviii Cognition

extends into the environment, making complex forms of cognition easier. Clark argues that

advanced cognition requires the ability to ‗dissipate‘ some forms of reasoning and thereby

reduce the cognitive demands on our brains. Ultimately what distinguishes us from animals

and robots is our ability to structure our environment to amplify our cognition.

‗Situated‘ cognition and option limitations have analogues in philosophical

interpretations of decision theory. Debra Satz and John Ferejohn defend ‗moderate

externalism‘ about social scientific explanations (including economics).xlix The internalist

holds that social scientific events can only be explained by intentional states interior to the

individual human. Moderate externalism argues that while individual intentional states are

relevant to social scientific explanations, their connection is ‗remote‘. Moderate externalism

‗does not explain behavior in terms of these mental entities; it merely shows that behavior

can be interpreted as consistent with them‘.l It explains social scientific events in terms of the

‗structure in which [individual action] is embedded‘.li The basic unit of analysis for the

moderate externalist is not the individual but a set of individuals and institutional conditions.

The New Institutional Economics shares much with the embedded cognition

paradigm. Neoclassical economics relies on what new institutional economists Arthur

Denzau and Douglass North call ‗substantive rationality‘ or rationality that is contained

entirely ‗in the head‘.lii But Denzau and North argue that economic and political history

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cannot be effectively understood if individuals always act in accord with standard decision

theory. Instead, institutions are required to reduce transactions costs, thereby making market

efficiency possible. Ronald Coase was one of the first economists to focus on the role

transactions costs in economic behavior. Transactions costs are ‗the costs other than the

money price that are incurred in trading goods or services‘.liii Standard neoclassical

economics assumes zero transactions costs, but this assumption is unrealistic; sometimes

transactions costs have substantial impact on market functioning. For instance, Coase saw

that if transactions costs are ignored, firms cannot arise on the free-market. Firms are

centrally directed exchanges—command economics in microcosm. Yet why should centrally

directed exchanges arise in the free market if markets are efficient? Coase‘s answer: to reduce

transactions costs.liv Discovering the information necessary to coordinate exchanges and

produce assurance are costly; firms arise to reduce these costs. However, firm expansion is

limited because the inefficiencies of central direction eventually outweigh the reduction in

transactions costs. Denzau and North apply this Coasean framework to economic history,

arguing that ideologies and cultural institutions arise to reduce transactions costs as well.

Economic and social institutions are also mechanisms that ‗offload‘ cognition onto the

environment, or in their terms, reduce transactions costs.lv

How do these two traditions solve the conflict between psychology and economics?

They argue that individual psychology isn‘t the main explanatory factor for why markets

work. Rather, most market efficiency is caused by the institutional structure in which

economic actors are embedded. Humans create these institutions, to be sure. But once

transactions costs are sufficiently reduced and economic cognition is sufficiently embedded,

choice options are limited. Cognition is easy enough for reliably rational decision-making.

These accounts can explain why markets work in some environments and not others. North

work was influenced by observing how poorly markets performed when implemented in the

Soviet Union. He argues that markets failed there because the Soviet republics lacked the

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cultural and moral institutions required to sufficiently reduce transactions costs. Individuals

could not trust one another and did not know how to run businesses.lvi

North and Clark cite experimental evidence that individual rationality is less central

than is often thought for market efficiency. Their primary evidence comes from economic

experiments where human traders are replaced with ‗zero-intelligence‘ programs. These

programs submit random bids and offers subject only a budget constraint; they engage in no

strategic reasoning whatsoever. Dhananjay K. Gode and Shyam Sunder find that ‗imposing a

budget constraint (i.e., not permitting traders to sell below their costs or buy above their

values) is sufficient to raise the … efficiency of these auctions close to 100 percent‘.lvii They

go on to claim that the efficiency of markets appears to be due to ‗its structure independent

of traders‘ motivation, intelligence, or learning‘.lviii Again, the shape of institutions produces

rational action. Like Satz and Ferejohn, Gode and Sunder explain the rationality of markets

in institutional terms. Like North and Denzau, they find that institutions are required to

make markets work. And like Clark, they argue that rational cognition occurs when

cognition is embedded in the world. Vernon Smith has argued in favor of what he calls the

Hayek Hypothesis, that limited information and reliable trading rules ‗are sufficient to

produce competitive market outcomes at or near 100% efficiency‘.lix But Gode and Sunder go

farther: Economic actors do not need much information or rationality in order to produce

efficient outcomes under the right rules. As they say, ‗Adam Smith‘s invisible hand may be

more powerful than some have thought; it can generate aggregate rationality not only from

individual rationality but also from individual irrationality‘.lx

The embedded cognition/transactions cost approach explains how individuals can be

irrational and ignorant and yet produce efficient outcomes under certain economic

conditions. But it has two drawbacks. First, it implies that individual rationality is largely

causally irrelevant. That said, these experimenters argue that economic rationality is so

embedded in the world and subject to external constraints that the common sense

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conception of individual rationality is threatened. Some will welcome this counterintuitive

consequence, but it has theoretical costs. The causal inefficacy of our rational faculties seems

to undermine our common sense understanding of the world. For instance, we experience

our own rational choices in many economic environments. Some engage in economic

activities such as buying groceries or a house, with a high degree of thought. Surely these

calculations make a substantive causal contribution to our decisions.

The extended cognition model also leaves unclear how economic actors in the lab

improve efficiency in repeat interactions. Experimental economists have shown that

economic actors learn to interact more effectively under the same set of rules. That is to say,

the institutional structure of a market remains the same, but efficiency increases. Zero-

intelligence traders do not update their behaviors which may be crucial for market

efficiency. A better theory explains how irrational humans produce efficient markets and

how they can improve. Clark and North tell stories about how humans alter their institutions

but the stories remain vague; the local-level at work are poorly understood.

Section III: Subjective Costs of Transacting as a Solution

(III.i) In this section, I defend the subjective cost of transacting (SCT) theory.lxi The theory is

not meant primarily as a prescriptive theory or a theory about what humans should do;

rather I advance the SCT theory as an explanation of the compatibility of irrational actors

and rational markets. Subjective costs of transacting are the costs of ‗thinking, calculating,

deciding and acting‘.lxii These costs are subjective because they are cognitive, or internal to an

agent‘s cognitive systems. Further, these are costs that are, to some extent, under the agent‘s

control. That is, they can be paid. To illustrate, imagine that John wants to buy Wheat

Things at the grocery store. When he arrives, he finds two differently sized boxes. The

smaller box is cheaper but contains fewer Wheat Thins. Typically the large box has a lower

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unit price, but today the small box is on sale. John must now calculate the relative unit prices

of the two boxes himself.lxiii For John, division with decimals and multiple digits is a chore.

Even with a mobile phone calculator, John must still slow down and delay moving on to

other tasks. The unit price calculation is a subjective transaction cost. Such costs are (a) and

(b) volitional.

External structure in the economic environment can reduce the subjective costs of

transacting. For instance, common behavioral expectations can be implicitly learned at early

ages. Such expectations may reduce stress when trusting others. If John does not trust that

his box of Wheat Thins does not contain a small piece of metal from a faulty manufacturing

plant, he will have to take the risk of buying the box and checking for himself. If John lives

in a developed country with good institutions, rules like contract laws, regulations and

informal moral norms can effectively eliminate this problem, along with many others. It will

also reduce the costs of decision-making generally. Many economic decisions become

unconscious habit over time, especially when formal and informal rules remain stable. If

humans are rational when subjective transactions costs are low but irrational when they are

high, then rational market behavior should increase within institutions that reduce

transactions costs. Thus, the SCT theory is consistent with the insights of the embedded

cognition/new institutional approach which emphasizes that cognition is eased under good

institutions. For North and Clark, John‘s cognition can be offloaded onto the environment

when he needn‘t calculate the risk that he will find metal in his Wheat Thins or when unit

prices are displayed in the grocery store, even during sales.

Repetition can also reduce subjective transactions costs when rules remain stable.

Learning reduces the subjective transactions costs of acquiring, storing and accessing

information. Human agents learn to make good decisions through repetition, observing

outcome and adjusting behavior accordingly. Consider the insights of experimental

economics: as trials are repeated, individuals approach efficient market outcomes. If

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repetition lowers subjective transactions costs, then it is no surprise that repetition increases

rational market behavior. In fact, Vernon Smith defends the subjective transactions costs

theory to explain how repetition produces market efficiency.lxiv

The SCT approach renders market rationality consistent with the extensive use of

heuristics observed by cognitive psychologists. Explicit and calculative thinking is costly

even with the relevant information collected; gather information is costly as well. In many

cases, it saves cognitive exertion to employ a cognitively cheaper but less reliable decision-

making heuristic. On this view, purported irrationalities documented by behavioral

economists are rational responses to high subjective transaction costs. Heuristic use is a

rational response to expensive cognition. expensive. Some neurological evidence suggest

thats calculation in more explicitly cognitive, less emotional parts of the brain are slower and

more cognitively expensive than other processes.lxv Richard Samuels and Stephen Stich

defend a dual processing theory of reasoning that has gained prominence over the last

decade.lxvi The dual processing theory holds that agents make decisions via two distinct

neurological systems. One system is ‗fast, holistic, automatic, largely unconscious, and

requires relatively little cognitive capacity‘.lxvii But the other system is ‗relatively slow, rule

based, more readily controlled and requires significantly more cognitive capacity‘.lxviii

Psychologists who adhere to this theory argue that the former system is evolutionarily older

than the latter system and that the latter system can be deeply affected by cultural and

institutional factors. Differences in aptitude will affect the degree to which the latter, newer

system functions adequately, while the older system is hard to improve and is equally error-

laden across different agents. Recent work in moral decision-making has built on dual

processing models of decision-making. Joshua Greene has argued that deontological

judgments are associated with the older, more instinctive system while utilitarian judgments

are associated with the latter, more ‗rational‘ system by showing that different parts of the

brain simultaneously react to the same moral problems.lxix In standard moral dilemmas, parts

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of the brain that generate deontological judgments exhibit some of the same putatively

erroneous behavior as those tasks discussed above. Agents may often have a choice as to

which system to rely on. They can can use their ‗fast, holistic, automatic‘ system that

requires ‗little cognitive capacity‘ or spend the resources to employ our ‗relatively slow, rule-

based, more readily controlled‘ system of reasoning. When the information required to make

an explicit calculation is costly to collect or the required calculation is cognitively expensive,

it is rational to select systems of reasoning that are less reliable given the relative costs and

benefits of getting the right answer. The SCT theory does not require that agents always

choose which system to rely on. Most decisions are governed by the faster, less conscious

system. But in economic decisions agents can often choose which system determines action.

Agents can employ their slower, system reasoning to override the outputs of the faster,

system. In many cases, agents cannot prevent the older system from operating, but they can

prevent its outputs from determining action.

In the same way, when a decision is cognitively inexpensive, i.e., when the subjective

transactions costs of calculating are low, rational agents will reduce their heuristic use,

replacing them with more accurate processes. In this way, decision-making can approach

market efficiency by reducing irrationality. As seen above, experimental economists have

recorded this phenomenon. For instance, repetition reduces the endowment effect. Many

experiments that uncover irrationalities rely on probability calculations that require more

difficult reasoning cognition, such as framing effects. Individuals may not realize that they

would do better to calculate rather than let their natural heuristics dictate their decisions.

However, the SCT is threatened by studies that show statistics courses often do not

reduce probability miscalculations. In some cases, they even seem to increase some biases.lxx

The SCT predicts that knowledge of statistics should reduce subjective transactions costs, and

thereby increase the level of rational decision-making. An experimental economist could

counter that even statistics coursework fails to provide enough reduction in subjective

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transactions costs to engage in explicit calculation accurately; further, calculation may be

regarded as too costly for a psychological experiment, when the outcome is inconsequential

to an individual‘s aims. Some experiments suggest that financial payoffs substantially

improve rational risk-taking, although errors are not eliminated.lxxi Smith and Walker argue

that ‗increased financial rewards [may] shift the central tendency of the data toward the

predictions of rational models … [and] in virtually all cases rewards reduce the variance of

the data around the predicted outcome‘.lxxii Some have argued that the ‗labor cost‘ of

cognition—not the only relevant cognitive cost that matters. Camerer and Hogarth

emphasize the ‗capital‘ aspect, which include cognitive abilities that, while largely invariant

in the short run, can be improved through repetition.lxxiii The SCT theory does not specify

which costs are relevant, only that cognition costs, when reduced, generate rational

behavior.

The SCT theory retains a causal role for individual rationality. Subjective transactions

costs increase the cost of good reasoning; consequently, individuals are less rational when

these costs are high. Thus subjective transactions costs are barriers to the causal efficacy of

rationality; when subjective transactions costs are reduced, individual rationality can more

readily exercise its causal power. The SCT theory suggests that institutions function as

enablers for rationality‘s causal power by reducing subjective transactions costs instead of

displacing rational decision-making or showing that the causal power of reasoning was

illusory. But what about the zero-intelligence traders? One might argue that their success

shows that rationality either lacks causal power or that the results of economic decision-

making are overdetermined by institutions and individual reasoning. The advocate of the

SCT theory could reply that the zero-intelligence traders do so well because the rules of the

economic game in question are clearly defined and all relevant learning has taken place;

accordingly, traders mimic human rational decision-making. The zero-intelligence traders

only show that rational behavior is extremely easy when all the relevant learning has taken

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place and rules are very stable and unambiguous. They do not show that we must adopt the

counterintuitive position that individual rationality lacks causal power; it shows that

individual rationality‘s causal power is consistent with the data.

(III.ii) The SCT theory has advantages over the four previously discussed proposals. First, it

avoids the error of positivism by accounting for psychological errors in reasoning. But it also

avoids claiming that market failure is extensive because agents are sometimes irrational. The

SCT theory accommodates the findings of cognitive psychologists, explaining why agents

rationally rely on prospects and heuristics when they could spend the resources to engage in

more expensive calculations. Further, it fits comfortably with views that rely heavily on the

causal impact of the environment and explains how learning and repetition and learning

reduces subjective transactions costs. The SCT theory does not ascribe most of the effects of

economic decisions to features of the external environment, an advantage it has over more

externalist theories. The SCT theory thereby ratifies the common sense intuition that

rational deliberation has causal efficacy while acknowledging a vital role for the

environment. But the SCT theory has another implication. Note that the SCT theory suggests

that efficient market outcomes can be generated by reducing subjective transactions costs.

Social institutions with stable formal and informal rules enable feedback which promotes

learning. In turn, learning can lead to effective cognition and thus market efficiency. While

these recommendations are abstract, they may be made more concrete through further

scientific inquiry.

(III.iii) The SCT theory has a significant drawback, however. Smith comments that subjective

transactions costs are hard to operationalize within a clear theoretical framework ‗as that

attempted in [expected utility theory] and [weighted expected utility theory], that allow the

latter to be deduced as limiting cases when SCT goes to zero, or when outcome values get

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large relative to a fixed SCT‘.lxxiv Responding to formalization concerns requires quantifying

subjective transactions costs in the lab and real-world data collection. Yet formalization

proves difficult and so the SCT theory is hard to apply and test. I cannot speculate on

methods of quantification and so must leave it to future work. Nonetheless, the SCT theory

has clear advantages over the four alternatives covered in Section II and thus merits an

attempt to mitigate its deficiencies.

Section IV: Conclusion

This essay began with a simple problem: economists think markets are efficient but their

models assume that humans are rational economic actors, while psychologists think that

humans are not rational economic actors. This apparent tension must be resolved. Four

strategies for resolving the conflict were considered: (a) accepting methodological positivism

in economics, (b) rejecting the effectiveness of markets, (c) building an alternative utility

theory to accommodate the problem, or (d) resorting to an embedded cognition model of

economic behavior. Strategies (a) and (b) were rejected as inadequate and while strategies (c)

and (d) have merits, they needed supplementation. In response, I advanced the subjective

transactions costs (SCT) theory, which embraces and explains the economic and

psychological data, resolves the tension, and integrates the advantages of (c) and (d). The SCT

theory assigns individual rationality a causal role, while explaining the importance of

heuristics and the environment in facilitating rational choice; the theory predicts that

economic actors will behave rationally when the subjective costs of transaction are low. The

SCT theory may be the key to showing how human irrationality can result in efficient

market outcomes.

i This said, decision theory is employed differently by different subfields in economics. For more on the plural

understanding of rationality used by economists, see Tyler Cowen, ―How Do Economists Think About

Rationality?,‖ Satisficing and Maximizing, 213-236. Our scope is restricted to those areas of economics which

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employ the theory in relatively unmodified forms; to the extent a sub-field of economics employs traditional

decision theory, to that extent it applies to what I say here. ii I draw on the list provided by Gerald Gaus, On Politics, Philosophy and Economics, Wadsworth Publishing,

2007, 36-37. iii The following list of features of homo economicus is given by Gerald Gaus, ibid, 1.3, 19-27. iv Russell Hardin, Indeterminacy and Society, Princeton University Press, 2005, 16. v The grain example is well-known. See Eugen von Bohm-Bawerk, The Positive Theory of Capital, Bk III, Ch.

IV, 151. vi It is not essential that homo economicus be self-interested; she may have altruistic preferences. vii See Herbert Simon, 1959, ―Theories of Decision Making in Economics and Behavioral Science.‖ American Economic Review, 49, 258-283. Some hold that satisficing is rational as an alternative to maximizing not just as

a method of maximizing. See David Schmidtz, Rational Choice and Moral Agency, Princeton University Press, 1996, 31-37. viii Gaus, On Politics, Philosophy and Economics, 26. ix For a clear, concise explanation of expected utility theory, see Michael Resnik, Choices: An Introduction to Decision Theory, University of Minnesota Press, 1987, 45 – 118. x Many anthropologists have argued that in traditional societies, economic decisions are governed by norms of

reciprocity. See Karl Polanyi, 1944, The Great Transformation, Beacon Press, 1991 and Marshall Sahlins, 2004,

Stone Age Economics, Chapter 1, ―The Original Affluent Society,‖ 1-40. Herbert Simon‘s work on bounded

rationality maintains that human rationality is subject to certain cognitive limitations. See Herbert Simon, 1984,

Models of Bounded Rationality, V. I, Economic Analysis and Public Policy, The MIT Press, Cambridge, MA. xi Some classic studies include Amos Tversky and Daniel Kahneman, ―Rational Choice and the Framing of

Decisions,‖ in Hogarth, Robin and Reder, Melvin, eds. Rational Choice: The Contrast Between Economics and Psychology, Chicago: University of Chicago Press, 1987. An original version of the critique appears in

―Judgment under Uncertainty: Heuristics and Biases.‖ Science, September 1974, 185(4157), 1124-31. See also

Richard Thaler, Quasi Rational Economics, New York: Russell Sage Foundation, 1991. xii Kahneman, D. and Tversky, A. 1982, Judgment Under Uncertainty: Heuristics and Biases, New York, NY,

Cambridge University Press, 92. xiii Amos Tversky and Daniel Kahneman, ―Rational Choice and the Framing of Decisions,‖ in Hogarth, Robin

and Reder, Melvin, eds. Rational Choice: The Contrast Between Economics and Psychology, Chicago:

University of Chicago Press, 1987. For the original study of preference reversal, see Maurice, Allais, 1953, ―Le

Comportement de l‘Homme Rationnel devant le Risque: Critique des Postulats et Axiomes de l‘Ecole

Americaine,‖ Econometrica 21, 503-546. xiv See D. Kahneman, J.L. Knetch, and R.H. Thaler, ―The endowment effect, loss aversion, and status quo bias,‖

Journal of Economic Perspectives, 5, 1, 193-206, 1991 for more on the status-quo bias. We will discuss the

endowment effect below. xv Cf. Kahneman, Daniel, and Amos Tversky. "On the Psychology of Prediction." Psychological Review 80

(1973): 237-51. xvi Cf. Bower, B. "Rational Mind Design: Research Into the Ecology of Thought Treads on Contested Terrain."

Science News 150 (1996): 24-25. Also see: Gould, Stephen Jay. Bully for Brontosaurus : Reflections in Natural History. Boston: W. W. Norton & Company, Incorporated, 1992. xvii Milton Friedman, Essays in Positive Economics, Chicago: Chicago University Press, 1953, 3-43, 14-15. xviii For a helpful discussion of the permanent income hypothesis, see:

http://ingrimayne.com/econ/FiscalDead/PermIncome.html. xix A. S. Deaton, ―Life Cycle Models of Consumption: Is the Evidence Consistent with the Theory?‖ In Advances in Econometrics, ed. Amsterdam: North Holland, 1987.

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xx See W.V. Quine, ―On the Reasons for Indeterminacy of Translation,‖ Journal of Philosophy, 67 (6), 178-183. xxi Nobel Laureate economists, F. A. Hayek, discusses his theory of complex phenomena in his Nobel Lecture,

see http://nobelprize.org/nobel_prizes/economics/laureates/1974/hayek-lecture.html. xxii Dan Ariely, Predictably Irrational, HarperCollins, 2008, 26-28. xxiii Ibid, 45. xxiv Ibid. xxv See F.A. Hayek, ―The Use of Knowledge in Society,‖ American Economic Review, XXXV, 4, 519-530. xxvi Vernon Smith, ―Experimental Economics: Reply,‖ 267. xxvii Ibid. xxviii Ibid, 268-269. xxix Vernon Smith, ―Economics in the Laboratory,‖ Journal of Economic Perspectives, 8, 1, Winter 1994, 113-

131, 116. xxx Ibid, 118. xxxi Ibid, 119. This is often called the ―curse of knowledge‖, a term coined in Colin Camerer, George

Loewenstein, and Martin Weber, ―The Curse of Knowledge in Economic Settings: An Experimental Analysis,‖

Journal of Political Economy, October 1989, 97:5, 1232-54. xxxii Ibid. xxxiii A dominated strategy is one that can be systematically beaten by a dominant strategy. See gametheory.net

for further definitions: Shor, Mikhael, "Dominant Strategy," Dictionary of Game Theory Terms, Game

Theory.net, < http://www.gametheory.net/dictionary/DominantStrategy.html> Web accessed: June 15, 2009. xxxiv Smith, ―Economics in the Laboratory,‖ 122. xxxv See George Loewenstein, ―Experimental Economics from the Vantage-Point of Behavioral Economics,‖ The Economic Journal, 109 (February), F25-F34 for criticism. Some irrationalities do not go away after repetition in

social settings or after extensive learning, but irrationalities are often substantially reduced. Other work

suggests that repeated experience significantly reduces the endowment effect, John A. List, ―Does Market

Experience Eliminate Market Anomalies?,‖ The Quarterly Journal of Economics, February 2003, 41-71. xxxvi Cf. Jacinto Braga, Steven J. Humphrey and Chris Starmer, ―Market Experience Eliminates Some anomalies –

And Creates New Ones,‖ CeDex Discussion Paper No. 2006-19, October 2006, forthcoming, European Economic Review. For an opposing view, see Gijs van de Kuilen and Peter P. Wakker, ―Learning in the Allais

Paradox,‖ working paper, August, 2006. xxxvii This point is emphasized in David K. Levine, ―Is Behavioral Economics Doomed? The Ordinary versus the

Extraordinary,‖ Max Weber Lecture, June 8th, 2009. xxxviii These terms derive from Chris Starmer, ―Developments in Non-Expected Utility Theory,‖ Journal of Economic Literature, 38. 332-82. 2000. xxxix This distinction is not well-formed. Heuristic use can be represented as optimizing a preference function.

The preference function is simply a model for representing choice; utility theory does not require psychological

underpinnings. See Gerald Gaus, Politics, Philosophy and Economics, introduction. xl For generalized expected utility analysis, see Mark Machina, ―‘Expected Utility‘ Analysis Without the

Independence Axiom,‖ Econometrica 50, 277-323. For disappointment Aversion, see G. Loomes and R. Sugden,

―Disappointment and Dynamic Consistency in Choice under Uncertainty,‖ Review of Economic Studies, 53,

271-282, 1986. For rank-dependent EUT, see J. Quiggin, ―A Theory of Anticipated Utility,‖ Journal of Economic Behavior and Organization, 3, 323-343, 1982. For weighted utility theory, see S. H. Chew and K. R.

MacCrimmon, ―Alpha-Nu Choice Theory: A Generalization of Expected Utility Theory,‖ Working Paper No.

669, University of British Columbia, Faculty of Commerce and Business Administration, 1979. xli See Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk",

Econometrica, XLVII (1979), 263-291.

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xlii Bleichrodt, Han; Pinto, Jose Luis; Wakker, Peter P (2001) ―Making Descriptive Use of Prospect Theory to

Improve the Prescriptive Use of Expected Utility‖, Management Science, 47, 11, 1498-1514. xliii Tversky, Amos; Daniel Kahneman (1992). "Advances in prospect theory: Cumulative representation of

uncertainty," Journal of Risk and Uncertainty 5: 297-323. xliv See ft. 26. Also see Graham Loomes, Chris Starmer and Robert Sugden, ―Do Anomalies Disappear in

Repeated Markets?,‖ The Economic Journal, 113 (March), C153-C166, 2003. xlv See ft. 36. xlvi See Andy Clark, Being There, 1997, Cambridge, MIT Press. xlvii Clark, 179. xlviii Ibid. xlix Debra Satz and John Ferejohn, ―Rational Choice and Social Theory,‖ Journal of Philosophy, 91, 2, 71-87,

1994. l Ibid, 77. li Ibid, 78. lii Arthur T. Denzau and Douglass C. North, ―Shared Mental Models: Ideologies and Institutions,‖ working

paper, 1995. liii For a brief explanation of transactions costs, see: http://www.auburn.edu/~johnspm/gloss/transaction_costs liv The classic article here is Ronald Coase, ―The Nature of the Firm,‖ Economica, New Series, 4, 16, 386-405,

Nov., 1937. lv This view may smack of economic determinism, but one need not be an economic determinist to appreciate

this point. lvi For an elaboration of this story, see Douglass C. North, Understanding the Process of Economic Change, Princeton, Princeton University Press, 2005, Chapter 11, The Rise and Fall of the Soviet Union, 146-170. lvii Dhananjay K. Gode and Shyam Sunder, ―Allocative Efficiency of Markets with Zero-Intelligence Traders:

Market as a Partial Substitute for Individual Rationality,‖ The Journal of Political Economy, 101, 1, 119-137,

1993, 119. Also see Dhananjay Gode and Shyam Sunder, ―What Makes Markets Allocationally Efficient?‖ The Quarterly Journal of Economics, May 1997, 603 – 630. lviii Ibid. lix Smith‘s test is positive. See Vernon Smith, ―Markets as Economizers of Information,‖ Economic Inquiry, Vol.

20, April 1982, 165-179. lx Dhananjay K. Gode and Shyam Sunder, ―Allocative Efficiency of Markets with Zero-Intelligence Traders:

Market as a Partial Substitute for Individual Rationality,‖ The Journal of Political Economy, 101, 1, 119-137,

1993, 119. lxi See Jacob Marschak, ―Economics of Inquiring, Communicating, Deciding,‖ American Economic Review Proceedings, May 1968, 58, 1-18. Also Vernon Smith, ―Microeconomic Systems as an Experimental Science,

―American Economic Review, December 1982, 72, 923-55, esp. 934. lxii Smith, 268. lxiii Suppose that your rate of eating Wheat Thins is an exogenous variable (you won‘t eat them faster if you have

more). lxiv See ft. 63. lxv See Richard Samuels and Stephen Stich, ―Rationality and Psychology‖ in Piers Rawling and Alfred R. Mele

(eds.), The Oxford Handbook of Rationality, Oxford University Press, forthcoming . lxvi See Evans, J. and Over. D., ―Dual Processes in Thinking and Reasoning,‖ forthcoming. Also see Sloman, P.

―The empirical case for two systems of reasoning,‖ Psychological Bulletin, 119, 1 (1996), 3-22. lxvii Samuels and Stich, 24. lxviii Ibid.

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lxix Greene, ―The Secret Joke of Kant‘s Soul,‖ in Moral Psychology, Vol. 3: The Neuroscience of Morality: Emotion, Disease, and Development, Walter Sinnott-Armstrong (ed.), MIT Press (2007). lxx See Kahneman, Daniel, and Amos Tversky (eds.) 2000. Choice, Values, and Frames. Also see Kinga Morsanyi,

Caterina Primi, Francesca Chiesi, Simon Handley, ―The effects and side-effects of statistics education:

Psychology students‘ (mis-)conceptions of probability,‖ Contemporary Educational Psychology, 34, 3, 210-220

(2009). lxxi Smith and Walker, ―Monetary Rewards and Decision Cost in Experimental Economics,‖ Economic Inquiry, 31, 245-261. Although, these effects do not increase monotonically, see Gneezy and Rustichini, ―Pay Enough or

Don‘t Pay at All,‖ Quarterly Journal of Economics, 115, 791-811. lxxii Ibid, 245. lxxiii C. Camerer and R. Hogarth, ―The Effects of Financial Incentives in Experiments: A Review and Capita l-

Labor-Production Framework,‖ Journal of Risk and Uncertainty, 19, 7-42. For an attempt to generate a ratio

between these two costs, see Ondrej Rydval and Andreas Ortmann, ―How Financial Incentives and Cognitive

Abilities Affect Task Performance in Laboratory Settings: An Illustration,‖ Economics Letters, 85, 3, 315-320.

The authors find around a 2:1 ratio between ‗capital‘ and ‗labor‘. lxxiv Smith, 268. See Sydney Siegel, ―Decision Making and Learning Under Varying Conditions of

Reinforcement,‖ Annals of the New York Academy of Science, 1961, 89, 766-83.