Robert F. Nau, Fuqua School of Business, Duke University

Full text of paper (379K Word 97 file, December 1998)

ABSTRACT: Rational choice theory rests on the assumption that decision makers have complete mental models of the events, consequences and acts that constitute their environment. They are considered to be individually rational if they hold preferences among acts that satisfy axioms such as ordering and independence, and they are collectively rational if they satisfy additional postulates of inter-agent consistency such as common knowledge and common prior beliefs. It follows that rational decision makers are expected-utility maximizers who dwell in conditions of equilibrium. But real decision makers are only boundedly rational, they must cope with disequilibrium and environmental change, and their decision models are incomplete. As such, they are often unable or unwilling to behave in accordance with the rationality axioms, they find the theory hard to apply to most personal and organizational decisions, and they regard the theory’s explanations of many economic and social phenomena to be unsatisfying. Models and experimental studies of bounded rationality, meanwhile, often focus on the behavior of unaided decision makers who employ strategies such as satisficing or adaptive learning that can be implemented with finite attention, memory, and computational ability.

This essay proposes a new foundation for rational choice theory, which does not rely on consequences, acts, and preferences as primitive concepts. Rather, agents articulate their beliefs and values through the acceptance of small gambles or trades in a stylized market. These primitive measurements are intersubjective in nature, eliminating the need for separate common knowledge assumptions, and they partly endogenize the writing of the "rules of the game." In place of the assorted preference axioms and inter-agent consistency conditions of the standard theory, only a single axiom of substantive rationality is needed, namely the principle of no arbitrage. No-arbitrage is shown to be the primal characterization of rationality with respect to which solution concepts such as expected-utility maximization and strategic and competitive equilibria are merely dual characterizations. The traditional distinctions among individual, strategic, and competitive rationality are thereby dissolved.

The no-arbitrage definition of rationality does not assume that the decision models of individuals are complete, so it is compatible with the notion that individual rationality is bounded. It is also inherently a standard of group rationality rather than individual rationality, so it can be applied at any level of activity from personal decisions to games of strategy to competive markets. This group-centered view of rationality suggests that individuals do not merely satisfice when making decisions in complex environments for which they lack complete models. Rather they use "other people’s brains": they seek advice from colleagues and experts, they form teams or management hierarchies, they consult the relevant literature, they rely on market prices, they invoke social norms, and so on. The most important result of such interactive decision processes usually is not the identification of an existing alternative that optimizes the latent beliefs and values of the putative decision maker, but rather the synthesis of a more complete model of the problem than she (or perhaps anyone) intially possesses, the construction of sharper beliefs and values, and the discovery or creation of new (and perhaps dominant) alternatives. On this view, traditional models of rational choice that attempt to explain the behavior of individuals, firms, organizations, markets, polities, etc., purely in terms of the satisfaction of existing preferences are perhaps overlooking the most important effect of socioeconomic interactions, namely the effect of completing the model.