Rational Economic Agents Research Articles

Rationality of Expectations: Comparison of Neoclassical and Evolutionary Approaches

Paper compares two major schools of economic thought - neoclassical and evolutionary - from the perspective of keystone assumption: rationality of economic agents. It discusses role of rationality assumption in neoclassical and evolutionary theories; importance of expectations; and perspectives for analyzing them within the framework of evolutionary game theory - namely, through replicator dynamics.

L'agent économique : rationalité maximale ou minimale

Résumé On admet généralement qu’un agent économique idéalement rationnel devrait être doué d’une parfaite capacité de déduction à partir de croyances et de préférences correctes et cohérentes. De telles exigences devant exclure tout changement de goût et tout apprentissage, l’omniscience et la connaissance du futur seraient logiquement requises. Toutes ces exigences transformeraient cet agent idéal en un "agent" intemporel inapte à agir. Une fois rejetée cette notion auto-contradictoire, la différence entre divers modèles d’agent économique devient une pure affaire de degrés de rationalité sur une échelle allant de la présumée maximisation des modèles néoclassiques à la rationalité limitée ou même minimale.

The economics of ethics revisited and importance of economics: A response to the critics

I would like to thank David Colander, John Cullis, Aaron Levine, for their thoughtful and thought provoking comments on my paper, “The ethical economy and competitive markets: reconciling, altruistic, moralistic and ethical behaviour with the rational economic agent and competitive markets”. I will respond to the critics in alphabetical order thereby betraying no preference, apart from a lexicographic one, to clarify and elaborate upon some key points made in my contribution.

The ethical economy and competitive markets: Reconciling altruistic, moralistic, and ethical behavior with the rational economic agent and competitive markets

Contrary to some of the leading critiques of neoclassical theory, I argue that this theoretical framework can incorporate the moral dimension into the modeling of economic agents when the consequences of their choices are not answerable to market forces. Neoclassical theory, broadly defined, simply stresses the potential trade-off that exists between altruistic or ethical behavior and the material well-being of the individual. Nevertheless, the behavioral assumptions of neoclassical theory are too narrow to deal with the potential ramifications of introducing the moral dimension into the objective function of workers, managers and owners. The conventional wisdom predicts that moral or ethical firms cannot survive in a competitive market since it is assumed that such firms must produce at relatively higher unit costs. However, higher cost firms can survive as demand is restructured towards the output of the relatively ethical firms. Moreover, modifying mainstream economic theory by introducing more realistic behavioral assumptions into the modeling of the economic agent allows for the simultaneous survival over time of both unethical and ethical firms that are cost competitive and profitable. These revisions of the conventional wisdom have important implications for public policy as well as for an understanding of the actual scope that is afforded to firm decision makers with regards to altruistic or ethical behavior.

The ethical economy and competitive markets: Reconciling, altruistic, moralistic and ethical behaviour with the rational economic agent and competitive markets: A commentary

The ethical economy and competitive markets: Reconciling, altruistic, moralistic and ethical behaviour with the rational economic agent and competitive markets: A commentary

Financial Decision-making and Portfolio Choice under Behavioral Preferences: Implications for the Equity Home Bias Puzzle

The aim of this paper is to provide a plausible explanation of aggregate portfolio behavior, in a framework where economic agents have behavioral (narrow framing) preferences. Basically, we develop our analysis assuming the existence of boundedly rational economic agents. In that sense, we explicitly recall some Keynesian propositions. In fact, under different aspects, the analysis of Keynes’ work reveals that his approach was quite consistent with and actually anticipated both Simon's conception of bounded rationality and recent work on cognitive psychology. The idea is that representative agent derives utility not only from consumption (as in “standard” models) but also from financial (stock) wealth fluctuations (Barberis, Huang and Santos, 2001). Moreover, the investor frames the stock market risk narrowly and has loss averse preferences. With these premises, we numerically solve a simple model of international portfolio choice, providing a possible explanation for the equity home bias puzzle. Only economic agents able to process correctly information deriving from stock markets exploit the diversification opportunities provided by international financial markets. The mechanism in action is based on the individual’s limited capabilities of processing information: foreign asset is perceived as less attractive than it would be if the investor had the optimal information skills and hence would be able to evaluate the two risky assets in conjunction. What follows is a low foreign equity share. For the Italian case, this outcome is also confirmed by empirical evidence available at the household level. At the best of our knowledge, the present paper is the first one to obtain the outcome described above under narrow framing preferences.

Long-run dynamics of official and black-market exchange rates in Latin America

This paper attempts to investigate the long-run dynamic relationship between official and black-market exchange rates for four Latin America markets namely, Argentina, Brazil, Chile, and Mexico. We follow (Moore, M. J., & Phylaktis, K. (2000). Black and official exchange rates in the Pacific Basin: Some tests of dynamic behaviour. Applied Financial Economics, 10, 361–369.) and we distinguish between long-run informational efficiency and short-run predictability in a sense that these notions are compatible with cointegration and error-correction mechanisms (ECM). Our findings indicate a constant black-market premium for each country, which is taken as strong support for long-run informational efficiency between the official and black markets for foreign currency. In addition, the evidence of short-run predictability is not considered as a violation of market efficiency, but it is the outcome of optimal arbitrage by rational economic agents.

Valuing International Safety Externalities: Does the “Golden Rule” Apply?

How should a developed country quantify the costs and benefits of the safety externalities that its energy and environmental policies generate for a developing country and vice versa? This paper addresses this question within a conventional utilitarian welfare-economics framework on the assumption that citizens of the countries concerned are rational economic agents. Counter to moral intuition, the paper shows that a developed country that displays purely altruistic concern for the wellbeing of citizens of a developing country will not value the safety externalities that it generates for the developing country at the developed country's “high” value of safety, but will instead apply the developing country's own “low” value. In turn, it is shown that even if the developing country displays a corresponding degree of purely altruistic concern for the wellbeing of citizens of the developed country it will nonetheless value the safety externalities that it generates for the developed country at a substantial discount relative to its own “low” value of safety. The paper also explores the implications of other forms of altruistic concern.

Expectation Formation and Endogenous Fluctuations in Aggregate Demand

The paper recognizes that expectations and the process of their formation are subject to standard decision making and are determined as a part of equilibrium. Accordingly, the paper presents a basic framework in which the form of expectation formation is a choice variable. At any point in time rational economic agents decide on the basis of the level of utility what expectation formation technology to use and as a consequence what expectations to hold. As economic decisions are conditioned on expectations holding proper or rational expectations eliminates the possibility of ex ante inefficiencies. The choice of expectation formation technology is not trivial as the paper assumes that information gathering and processing are costly. Consequently, economic agents must make informed decisions with the regard to the quality of expectation formation technologies they wish to use. The paper shows that agents' optimization over expectations not only adds on to realism, but also can carry non trivial implications for the behavior of macroeconomic variables. Specifically, the paper illustrates that endogenous expectation revisions can be a source of permanent oscillations in aggregate demand and can prevent an economy from settling into a steady state. In addition, the paper quantifies intangible notions such as overheating, overborrowing, and output gap. Finally, the paper shows that active policy measures can limit inefficiencies resulting from output fluctuations.

Agents' Rationality and the CHF/USD Exchange Rate Part 1

The analysis of monthly exchange rates is carried out using a model of McCallum, which is based on the concept of Rational Expectations. Applying the model to the CHF/USD exchange rate starting a misspecification analysis, the RE component appears to be a weak point of the model. The theory of rational beliefs of M. Kurz generalizes the RE concept introducing special consideration of Data Generating Processes (DGP). We find, however, some evidence speaking against the rational belief approach (with respect to the CHF/USD exchange rate) which is related to regime switchings and the presence of unobserved variables in the data-generating process. It appears that the rationality of economic agents depends on complex cognitive processes not discussed by Kurz, but taken into account in a ''story'' by Paul De Grauwe. This story will be supplemented in Part II of the paper in order to eliminate the RE component and to proceed with the misspecification analysis of McCallum's model.

When will payoff maximization survive?

Survival of payoff maximization is the usual as if-justification for assuming rational economic agents. An indirect evolutionary analysis allows for stimuli which are not directly related to reproductive success although they affect behavior. One first determines the solution for all possible constellations of stimuli, and then the evolutionarily stable stimuli. Our general analysis confirms the special results of former studies that payoff maximization in case of commonly known stimuli requires either that own success does not depend on other's behavior or that other's behavior is not influenced by own stimuli. When stimuli are private information, one can derive similar necessary conditions.

Partisan business cycles under variable election dates

This paper develops a model where rational economic agents face uncertainty regarding the timing of elections and which party will emerge victorious should an election occur. This electoral uncertainty affects the macroeconomy, where the size and direction of the impacts are dependent on the party in power in the current and previous period, time elapsed since the last election, and party popularity. Leftist governments are expected to sustain higher output levels throughout their electoral term compared to right-wing governments, and the partisan differences will continue to increase until the next election.

When green isn't mean: economic theory and the heuristics of the impact of environmental regulations on competitiveness and opportunity cost

The conventional neoclassical economic wisdom argues that the opportunity costs of environmental regulations are high, with negative implications for costs and profits and, by implication, for growth and per capita gross domestic product (GDP). The minority view that environmental controls induce cost offsets that minimise such opportunity costs is marginalised by the conventional wisdom, which assumes that economic agents are x-efficient in production. A behavioral model of the firm is presented in this paper, whereby x-inefficiency in production prevails even in a world of perfect product market competition that is dominated by rational economic agents. In this model, environmental regulations affect both the level of x-efficiency and the extent of technological change and greener firms can be cost competitive and profitable. However, private economic agents cannot be expected to adopt ‘Green’ economic policy independent of regulations since, in this model, there need not be any economic advantage accruing to the affected firms in becoming greener.

Tests for bounded rationality with a linear dynamic model distorted by heterogeneous expectations

The purpose of this paper is to develop a methodology which will use economic data to detect the existence of boundedly rational economic agents. The bounded rationality model presented in this paper generalizes a linear dynamic rational expectations model by nesting two types of expectations. In this paper, it is claimed that the bounded rationality model as presented can be transformed into an optimal regulator problem with distortions. As a result, the methodologies developed by the optimal control theory can be used to solve the model. The likelihood function for the model is constructed by the Kalman filtering using the solution of the model. Maximum Likelihood Estimation (MLE) is performed to test for bounded rationality in the U.S. cattle market for the period from 1900 to 1990. The empirical results indicate that some fraction of economic agents in the market are boundedly rational.

The Origins of Money and the Development of the Modern Financial System

The origins of money and banking are explained in nearly every introduction money and banking course, but Wray proposes an alternative approach that emerges from a comparative analysis of economic institutions. Orthodox theory suggests that barter replaced self-sufficiency and increased efficiency by fostering specialization--subsequently, establishing some object as a medium of exchange permits greater efficiency. In essence, the orthodox economist espouses the view that we operate in a free market economy in which neutral money is used primarily to facilitate exchange of real goods, undertaken by self-interested maximizers for personal gain. Institutionalists reject this argument because it emerges from the perspective of a rational economic agent facing scarce resources and unlimited wants--thus, the focus is on choice. Wray states that economic analyses must incorporate interactions between humans and nature, and that the economy is a component of the material life process of society. Hence, the conventionalists' focus on choice should instead be directed at production and distribution. The Wray thesis suggests that money is necessarily endogenously determined: Monetary economies have not, and cannot, operate with exogenous money supply can function with a commodity reserve system, such a system is subject to periodic debt deflations. In sum, the monetarist policy prescription would be counterproductive to systemic stability and would not yield greater control of the money supply.

Self-love, Seif-interest and the Rational Economic Agent

Abstract Hume has a special place in justifications of claims made for rational choice theory to offer a unified language and explanatory framework for the social sciences. He is invoked in support of the assumptions characterising the instrumental rationality of agents and the constancy of their motivations across different institutional settings. This paper explores the problems with the expansionary aims of rational choice theory through criticism of these appeals to Hume. First, Hume does not assume constancy. Moreover, Hume’s sensitivity to the relationships between institutional setting and individual motivation owes something to the relative transparency of the plural language of vices and virtues that he employs. Second, rational choice theory’s minimal modification of Hume’s account of the relation of reason and the passions through the introduction of constraints of consistency on preferences is unstable.

George Eliot and Rational Economic Agents

Conventional economists analyze human behavior by assuming a “rational economic agent” who is motivated solely by material self interest. This assumption has come to permeate our analyses of economic situations and policies, yet it is clearly limited, simplifying, and not capable of explaining the full range of human behavior. In this essay the writings of George Eliot are discussed as commentaries on this assumption and the implicit deductive methodology underlying it, and as explorations toward the possibility of a broader conceptual framework for analyzing economic issues. The paper argues that Eliot was knowledgeable about economic discourse and was consciously wrestling with the rational agent assumption and possible alternatives in her fictional as well as nonfictional work. Her writings suggest ambivalence toward the deductive/maximizing framework and the search for broader conceptualizations of human behavior.

Economic analysis of crime and punishment: an Asian case

In this paper, we have investigated the deterrent effects of sanctions and severity of punishment on crime rates based on the experience of Hong Kong. The effects of socio-economic variables such as unemployment rate, poverty, number of illegal immigrants, and total population on crime rates are also studied. Criminal behaviour is analysed using a utility theoretic framework and criminals are viewed as rational economic agents. Annual data of all categories of crimes committed in Hong Kong from 1972 to 1992 are used to estimate the parameters. In contrast to societies with a European culture, we have found that the crime rates experienced in an Asian city are quite different.

Will social security survive the baby boom?

In this paper we consider the design and implementation of a pay-as-you-go social-insurance system as a problem in political economy. We consider whether a society of forward-looking rational economic agents would implement a system in which the level of benefits depends on the relative shares of different age groups in the population. We calibrate a model economy to match long-run features of the U.S. economy and then look at the nature of the social-security system that results. We show that such a system would collapse given realizations of the population growth rate that the U.S. has experienced since World War II. If the benefits of the current retired generation are viewed as an obligation that must be paid, the system would survive the baby boom.

Speculation, Heterogeneity and Learning: A Simulation Model of Exchange Rates Dynamics

This paper presents a model of a speculative determination of exchange rates. The authors' basic claim is that speculation is intrinsically a disequilibrium phenomenon, mainly because the imperfect rationality of economic agents engenders heterogeneity of their beliefs, representations, and 'models of the world.' They use classifiers systems and genetic algorithms to simulate the behavior of learning agents and study the aggregate results in terms of prices and volume of transaction. Simulated exchange rates exhibit some of the distinctive properties characterizing real series. Copyright 1996 by WWZ and Helbing & Lichtenhahn Verlag AG