legal theory: law and economics

Critiques of Law and Economics


Critique #2: People are not the rational maximizers of individual preferences that economic analysts assume them to be.

Most economic analyses of law rest on the assumptions that people have stable preferences and strive to maximize their utility based upon those preferences. But psychology, sociology, history, and commont science teach us that those assumptions are often unfounded. In a recent essay, Christine Jolls, Cass R. Sunstein, and Richard Thaler summarize three important respects in which the behavior of "real people" deviates from the behavior one would expect from "homo economicus":

1. Bounded rationality.

Bounded rationality, an idea first introduced by Herbert Simon, refers to the obvious fact that human cognitive abilities are not infinite. We have limited computational skills and seriously flawed memories. People can respond sensibly to these failings; thus it might be said that people sometimes respond rationally to their own cognitive limitations, minimizing the sum of decision costs and error costs. To deal with limited memories we make lists. To deal with limited brain power and time we use mental shortcuts and rules of thumb. But even with these remedies, and in some cases because of these remedies, human behavior differs in systematic ways from that predicted by the standard economic model of unbounded rationality. Even when the use of mental shortcuts is rational, it can produce predictable mistakes. The departures from the standard model can be divided into two categories: judgment and decisionmaking. Actual judgments show systematic departures from models of unbiased forecasts, and actual decisions often violate the axioms of expected utility theory.

A major source of differences between actual judgments and unbiased forecasts is the use of rules of thumb. As stressed in the pathbreaking work of Daniel Kahneman and Amos Tversky, rules of thumb such as the availability heuristic - in which the frequency of some event is estimated by judging how easy it is to recall other instances of this type (how "available" such instances are) - lead us to erroneous conclusions. People tend to conclude, for example, that the probability of an event (such as a car accident) is greater if they have recently witnessed an occurrence of that event than if they have not. What is especially important in the work of Kahneman and Tversky is that it shows that shortcuts and rules of thumb are predictable. While the heuristics are useful on average (which explains how they become adopted), they lead to errors in particular circumstances. This means that someone using such a rule of thumb may be behaving rationally in the sense of economizing on thinking time, but such a person will nonetheless make forecasts that are different from those that emerge from the standard rational-choice model.

Just as unbiased forecasting is not a good description of actual human behavior, expected utility theory is not a good description of actual decisionmaking. While the axioms of expected utility theory characterize rational choice, actual choices diverge in important ways from this model, as has been known since the early experiments by Allais and Ellsberg. There has been an explosion of research in recent years trying to develop better formal models of actual decisionmaking. The model offered by Kahneman and Tversky, called prospect theory, seems to do a good job of explaining many features of observed behavior . . ..

2. Bounded willpower.

In addition to bounded rationality, people often display bounded willpower. This term refers to the fact that human beings often take actions that they know to be in conflict with their own long-term interests. Most smokers say they would prefer not to smoke, and many pay money to join a program or obtain a drug that will help them quit. As with bounded rationality, many people recognize that they have bounded willpower and take steps to mitigate its effects. They join a pension plan or "Christmas Club" (a special savings arrangement under which funds can be withdrawn only around the holidays) to prevent undersaving, and they don't keep tempting desserts around the house when trying to diet. In some cases they may vote for or support governmental policies, such as social security, to eliminate any temptation to succumb to the desire for immediate rewards. Thus, the demand for and supply of law may reflect people's understanding of their own (or others') bounded willpower; consider "cooling off" periods for certain sales and programs that facilitate or even require saving.

3. Bounded self-interest.

Finally, we use the term bounded self-interest to refer to an important fact about the utility function of most people: They care, or act as if they care, about others, even strangers, in some circumstances. (Thus, we are not questioning here the idea of utility maximization, but rather the common assumptions about what that entails.) Our notion is distinct from simple altruism, which conventional economics has emphasized in areas such as bequest decisions. Self-interest is bounded in a much broader range of settings than conventional economics assumes, and the bound operates in ways different from what the conventional understanding suggests. In many market and bargaining settings (as opposed to nonmarket settings such as bequest decisions), people care about being treated fairly and want to treat others fairly if those others are themselves behaving fairly. As a result of these concerns, the agents in a behavioral economic model are both nicer and (when they are not treated fairly) more spiteful than the agents postulated by neoclassical theory.

An essay by Martha Nussbaum is even more sweeping and scathing in its identification of the blindnesses of the field. Among the assumptions that have crippled economic analysis, she argues, are:

Well-known literature from history and philosophy, she claims, discredits each of these assumptions. For example, Amartya Sen (building on John Stuart Mill's work) has shown that utility should be understood as a vector rather than a scalar. Partha Dasgupta has demonstrated any defensible measure of utility must include some reference to agency. Henry Richardson has developed a decision-making model that allows for rational deliberation about ends. Finally, she argues (relying on Plato, Aristotle, Kant, and Spinoza) that "preference" oversimplifies the basis of utility by failing to distinguish between, for example, desire, emotion, intention, and action.

The failure to take into account such features of human cognition and behavior distorts all varieties of economic analysis of law. For example, "positive accounts" of the ways in which people do or might respond to legal rules commonly exaggerate people's far-sightedness and selfishness. Wealth-maximization studies frequently go awry by failing to consider, for example, the heuristics that people commonly employ to assess their exposure to risk or their inability, without assistance, to act in their own long-term best interest. And efforts to apply the methodologies of economics to the behavior of public officials typically underestimate the importance of public-spiritedness.