Evolving norms cognitive perspectives in economics

PALGRAVE ADVANCES IN BEHAVIORAL ECONOMICS

EVOLVING NORMS
Cognitive Perspectives
in Economics
Shinji Teraji


Palgrave Advances in Behavioral Economics
Series Editor
John F. Tomer
Co-Editor, Jl of Socio-Economics
Manhattan College
Riverdale, USA


This ground breaking series is designed to make available in book form
unique behavioral economic contributions. It provides a publishing opportunity for behavioral economist authors who have a novel perspective and
have developed a special ability to integrate economics with other disciplines. It will allow these authors to fully develop their ideas. In general, it
is not a place for narrow technical contributions. Theoretical/conceptual,
empirical, and policy contributions are all welcome.

More information about this series at
/>

Shinji Teraji

Evolving Norms
Cognitive Perspectives in Economics

Shinji Teraji
Yamaguchi University, Yamaguchi
Japan

Palgrave Advances in Behavioral Economics
ISBN 978-1-137-50246-9
ISBN 978-1-137-50247-6
DOI 10.1057/978-1-137-50247-6

(eBook)

Library of Congress Control Number: 2016942806
© The Editor(s) (if applicable) and The Author(s) 2016
This work is subject to copyright. All rights are solely and exclusively licensed by the
Publisher, whether the whole or part of the material is concerned, specifically the rights of
translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on
microfilms or in any other physical way, and transmission or information storage and retrieval,
electronic adaptation, computer software, or by similar or dissimilar methodology now
known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this
publication does not imply, even in the absence of a specific statement, that such names are
exempt from the relevant protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and information
in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the
material contained herein or for any errors or omissions that may have been made.
Cover illustration: © m-images / Alamy Stock Photo
Printed on acid-free paper
This Palgrave Macmillan imprint is published by Springer Nature
The registered company is Nature America Inc. New York

To the memory of my late mother



PREFACE

AND

ACKNOWLEDGEMENTS

This book is about social norms in a variety of cognitive and institutional
processes. Social norms are shared guidelines to socially accepted and
expected behavior. Social norms provide order to what may otherwise be
seen as ambiguous, uncertain, or threatening situations. Norms may be
seen as regular behavioral patterns that develop as individuals interact with
one another socially.
The main purpose of this book is to develop a general framework within
which it is possible to analyze a relationship between the sensory order
and the social order. A choice is a selection among numerous possible
behavioral alternatives. A decision is a process through which this selection is performed. Conventional economic models include only variables
that condition ‘what an agent chooses’ and none that condition ‘how an
agent chooses.’ This entails a ‘black box’ view on the individual, meaning
that it does not matter analytically how that behavior is actually generated.
F.A. Hayek’s theory of mind sheds light upon the process of choice. The
sensory order is fundamental in the sense that the explanation of social
order begins with the human mind. The central element in the cognitive
process is the feedback between individual and environment. The book
explains institutional evolution as an endogenous phenomenon from a
cognitive viewpoint.

In The Sensory Order (1952), Hayek provided a theory of the process by
which the mind perceives the world around it. According to Hayek, knowing the world is a classification of sensory qualities by the mind. What
we know at any moment about the external world is determined by the
order of the apparatus of classification which has been built up by previous
vii


viii

PREFACE AND ACKNOWLEDGEMENTS

sensory linkages. The qualitative differences in perceptions that people
experience depend upon the specific pattern of neuron firings that a given
stimulus produces within various neural networks. The experience of each
individual will differ according to the pattern of neuron firings that each
one develops. The subjectivity of individual knowledge finds its foundation in the construction of the mind. Through learning and updating, the
sensory order evolves into a gradual approximation of the physical order.
The mind operates by assembling new sensory data into associations with
our accumulated inventory of knowledge. An understanding of social
norms is critical to predict and explain human behavior.
Hayek’s concept of perception as classification has a counterpart in his
concepts of rules and rule-following behavior. People follow rules of conduct in society. These rules indicate what people should or should not do
under some circumstances. Relying upon rules is a device we have learned
to use because our reason is insufficient to master the detail of complex
reality. For Hayek, rules make it possible for individuals to classify stimuli.
The order of a group can be generated by the rules of conduct adhered
to by its members. How the mind classifies stimuli determines how individuals act in the external world. Much of our knowledge is embedded
in institutions. The mind is shaped not only by experience but also by
custom. Rules of conduct are shared by individuals having a common cultural tradition. If people have widely divergent expectations, some of their
actions will invariably fail and need to be revised. Culture limits the range

of actions that people are likely to take in a particular situation, making
their conduct more predictable and thereby facilitating the formation of
reliable expectations. Shared mental models can give rise to behavioral
regularities to the extent that they can be observed in the population.
As a consequence, following rules of conduct mutually reinforce sets of
expectations to maintain a degree of social order. Patterns emerge endogenously, reflecting a socially constructed reality. Given the human need for
rules, there is a tendency to repeat those patterns as a guideline for action
in future instances of similar behavior.
The structure of this book follows the development of these arguments.
Chapter 1 explains some fundamental concepts that are used in the
book. The concepts are as follows: social norms, economic behavior, rationality, cognition, institutions, path dependence, and institutional change.
An understanding of social norms is critical to predict and explain human
behavior. People incorporate in themselves a set of social norms from
their surroundings. Norms govern behavior, and are self-sustaining in an


PREFACE AND ACKNOWLEDGEMENTS

ix

interdependent system. Norms specify a limited range of behavior that is
acceptable in a situation, and facilitate confidence in the choice of action.
Norms enable individuals to deal with the complexity and incompleteness
of information, and make them stick to prescribed behavior. Norms thus
describe the uniform behaviors that characterize groups.
Chapter 2 presents some reasons why people comply with social norms.
First, in large measure, people do what they do because they have learned
from those who surround them. Society is sustained by processes favorable to individuals endowed with an element of docility in following rules.
Second, social norms can be sustained if the pecuniary advantage from
breaking norms is not sufficient to offset the forgone reputation effect.

Third, people comply with norms because the threat of punishment makes
being compliant within their interest. Fourth, norms are represented as
Nash equilibria of games played by rational agents, and as such they are
self-enforcing. Finally, correlated equilibrium allows players’ actions to be
statistically dependent upon some random signals external to the model.
Chapter 3 focuses on The Sensory Order (1952). Hayek provides a
theory of the process by which the mind perceives the world around
it. The sensory order is a classification that takes place via a network of
impulse connections. The essence of Hayek’s attempt in theoretical psychology is to show how a structure can be formed which discriminates
between different physical stimuli and generates the sensory order that
we actually experience. The sensory order is an incomplete and imperfect representation of the physical world. The subjectivity of individual
knowledge finds its foundation in the construction of the mind. The
brain is an adaptive system interacting with and adapting to its environment by performing a multi-level classification on the stimuli it receives
from the environment.
Chapter 4 deals with the social order. The dissemination of knowledge is
crucial in society. People live in a world of expectations about interactions
with others’ actions. It is meaningful to discuss the social order only when
all agents share the same perception of existing reality which includes others’ actions. People follow rules of behavior in society. Relying on rules is
a device we have learned to use because our reason is insufficient to master
the detail of complex reality. If rules are recognized as recurrent patterns
of behavior, individuals act according to rules of conduct. The diffusion of
shared behavioral patterns is necessary to obtain social order. Shared rules
facilitate decision-making in complex situations by limiting the range of
circumstances to which individuals have to pay attention.


x

PREFACE AND ACKNOWLEDGEMENTS

Chapter 5 covers culture and cultural evolution. Culture, as a system
of shared beliefs, provides collective understandings in forming peoples’
choices. The existence of culture presupposes a population capable of
mental representations. Culture coordinates the expectations of many
agents with regard to actions, and it shapes and structures our daily patterns of behavior, guiding much of what we should do by prescribing what
behavior is acceptable. Agents who belong to the same cultural group are
exposed to the same external representation of knowledge. In Hayek’s
theory of cultural evolution, societies are not only subject to group selection but have developed through a process in which individuals choose
the rules that form the social order. New rules undergo some kind of
de-centralized selection process, as a consequence of which some spread
through the population.
Chapter 6 deals with coevolution of mind and society. Theories of
institutions can be classified into two broad approaches: institutions-asrules and institutions-as-equilibria. Institutional structures and individual
actions coevolve. In order to have a complete picture of institutions in interactions between structure and agency, we need to take both approaches
into consideration. In the mental dimension, institutions guide individual behavior and thought. In the emergence dimension, the equilibrium
state is generated as the result of actions chosen by individual agents. The
mind is endogenous to the individual’s environment, which implies that
expectations are also endogenous to the individual’s environment. Shifts
in mental models change individuals’ plans and actions, which in turn lead
to institutional evolution. A key to understanding institutional evolution is
an understanding of how individuals modify their mental models.
Most of the material of this book was written at the Department of
Economics, Yamaguchi University. I would like to thank some of my
colleagues for valuable discussions. At the University of Canterbury,
which I visited, I am grateful to Jeremy Clark for his useful remarks on
my research. Some articles in the book were presented at international
conferences sponsored by the Society for the Advancement of Behavioral
Economics (SABE) and the International Association for Research in
Economic Psychology (IAREP). Many thanks to Morris Altman (Professor,
University of Newcastle) for his thoughtful comments and suggestions.

As a series editor of Palgrave Advances in Behavioral Economics, John
Tomer (Emeritus Professor, Manhattan College) encouragingly accepted
my idea to publish a book on behavioral and institutional economics. It


PREFACE AND ACKNOWLEDGEMENTS

xi

has been a pleasure to work with Sarah Lawrence at Palgrave Macmillan. I
would also like to thank Leila Campoli for bringing this project to fruition.
This book is based upon previously published journal articles, with
permission from Elsevier. This book’s chapters and relevant journal articles are as follows: Appendix 2 in Chap. 1, Shinji Teraji (2003) “Herd
behavior and the quality of opinions,” Journal of Socio-Economics,
vol. 32 (6), pp. 661–673. Appendix 1 in Chap. 2, Shinji Teraji (2007)
“Morale and the evolution of norms,” Journal of Socio-Economics, vol.
36 (1), pp. 48–57. Appendix 2 in Chap. 2, Shinji Teraji (2013) “A theory of norm compliance: Punishment and reputation,” Journal of SocioEconomics, vol. 44 (C), pp. 1–6. Appendix 3 in Chap. 2, Shinji Teraji
(2009b) “A model of corporate social performance: Social satisfaction and
moral conduct,” Journal of Socio-Economics, vol. 38 (6), pp. 926–934.
Appendix 2 in Chap. 5, Shinji Teraji (2008a) “Culture, effort variability,
and hierarchy,” Journal of Socio-Economics, vol. 37 (1), pp. 157–166.
Appendix 3 in Chap. 5, Shinji Teraji (2008b) “Property rights, trust,
and economic performance,” Journal of Socio-Economics, vol. 37 (4),
pp.  1584–1596. Appendix 4 in Chap. 5, Shinji Teraji (2009a) “The
economics of possible selves,” Journal of Socio-Economics, vol. 38 (1),
pp. 45–51. Appendix 5 in Chap. 5, Shinji Teraji (2011) “An economic
analysis of social exclusion and inequality,” Journal of Socio-Economics,
vol. 40 (3), pp. 217–223.
Shinji Teraji
Yamaguchi, Japan

CONTENTS

1

1

Foundations

2

Why Do People Obey Norms?

3

The Sensory Order Revisited

143

4

Norms, Coordination, and Order

175

5

Culture and Cultural Evolution

207

6

Coevolution of Mind and Society

311

65

Epilogue

345

Index

351

xiii



LIST

Fig. 2.1
Fig. 2.2
Fig. 2.3
Fig. 2.4
Fig. 3.1

Fig. 5.1
Fig. 6.1

OF

FIGURES

Population dynamics through socialization
The relationship between b and p
The increase in p
The decrease in p
Macro-micro relations
The state space separated into two sets
Macro–micro relations and two dimensions

97
110
111
112
165
295
327

xv


Chapter 1

Foundations

1.1   Social Norms
Individual attitudes and behaviors are influenced by the presence of others
in social life. Individuals join together to achieve a goal, and try to satisfy
a need through their joint association. They influence each other in group
interactions that are structured by a set of social norms. People incorporate in themselves a set of social norms from their surroundings. They conform to, or are regulated by, social norms. Sometimes people deviate from
conventional economic predictions. Many anomalies in human behavior
can be explained by reference to social norms.
An understanding of social norms is critical to predict and explain
human behavior. Social norms can impact our judgments. For example,
according to Cialdini et al. (1990), people are more likely to litter when
the floor is already littered. That is, when the apparent social norm is to
litter (i.e., the floor is covered with trash in public places), people are more
likely to conform to that apparent social norm by throwing their trash on
the floor. When the apparent social norm is not to litter (i.e., the floor is
nearly spotless in public places), people are more likely to conform to that
norm by refraining from littering. This difference is magnified when the
norm is made more salient.
What is a social norm? First, social norms can be thought of as a shared
belief system of rules and standards in a given group. There are widespread expectations of proper and acceptable behavior within the group.

© The Editor(s) (if applicable) and The Author(s) 2016
S. Teraji, Evolving Norms,
DOI 10.1057/978-1-137-50247-6_1

1


2 

S. Teraji

A social norm is a behavior characterized by its being prevalent among
group members. Second, social norms emerge out of interpersonal interaction with others. People conform if they choose to follow the norms of
the society to which they belong. The norms are social rules which reflect
a historical trial-and-error process. Through this bottom-up process, the
norm-produced social rules tend to reflect peoples’ diverse and specialized situations. As the number of people complying with a norm increases
over time, the expectation leads the norm to continue into the future.
Third, social norms guide peoples’ behavior without the force of laws.
Laws are promulgated by public institutions, such as legislatures, regulatory agencies, and courts, after deliberate procedures, and are enforced by
the power of the state. Social norms are, on the other hand, enforced privately in a decentralized way. Norm violators are punished through nonlegal sanctions from social networks.
The importance of norms is highlighted, for example, in Posner (2000):
Why tax compliance? A widespread view among tax scholars holds that law
enforcement does not explain why people pay taxes. The penalty for ordinary tax convictions is small; the probability of detection is trivial; so the
expected sanction is small. Yet large numbers of Americans pay their taxes.
This pattern contradicts the standard economic model of law enforcement,
which holds that people violate a law if the benefit exceeds the expected
sanction. Some scholars therefore conclude that the explanation for the tendency to pay taxes must be that people are obeying a norm—presumably
a norm of tax payment or a more general norm of law-abiding behavior.
(Posner 2000, p. 1782)

Law is conceptualized as a top-down mechanism to bring order and
control violence through coercive enforcement. In the case of legal compliance, individual incentives most often refer to deterrence (Becker 1968).
Individuals are deterred from criminal activities by a higher fine and by a
higher probability of conviction. This asserts that people respond significantly to the deterring incentives created by the criminal justice system.
If so, punishment of criminals may be the best way to reduce the amount
of crime. In general, the choice of crime is more appealing when crime is
less punishing. People obey the law only when their expected compliance
utility (i.e., the payoffs expected to be obtained when they obey the law)
is greater than their expected violation utility (i.e., the expected payoffs
when they violate the law).

Foundations 

3

The literature of law has devoted considerable research effort to two
main issues: the modeling of criminal behavior using the utility function framework and the policy design of optimal law enforcement. In the
rational choice approach, legal compliance is accounted for by standard
economic incentives of self-utility maximization; compliance is in one’s
self-interest. Thus, the rational choice approach predicts that the frequency of crimes will decrease if the perceived benefits associated with
offending decisions are reduced, and the perceived costs associated with
offending decisions are increased. Unlike legal rules, social norms are
not supported by formal sanctions. Individuals may care about how their
decision to comply with norms is perceived by others, creating a role for
social interaction. Norms are then understood as sets of expectations from
others. Norms make people stick to prescribed behavior even if new and
apparently better options become available (Elster 1989).
Norms must inform any methodology that studies behavior and incentives and takes account of how people follow norms in choosing actions.
Kreps (1997) distinguishes intrinsic motivations from extrinsic incentives
as potential factors giving rise to social norms. McAdams and Rasmusen
(2007) define norms as behavioral regularities supported at least in part by
normative attitudes. The norm of legal obedience provides intrinsic motivations to obey the law that is independent of extrinsic incentives (material
sanctions). People suffer from guilt, disapproval, or shame from breaking
the law. There are possibilities that an individual sanctions oneself. Guilt
is disutility that violators feel, at least to some extent, about stealing, even
though they believe they are certain not to be caught. Someone might
lose utility from believing that other people disapprove of one, regardless
of whether they take action that may materially affect one. Unlike utility
from guilt, utility from disapproval arises only when one believes other

people have formed beliefs about one’s behavior. Shame might arise when
other people discover the violation and think badly of the violator. The
violator can imagine what others would think if they discover the violation. The violator may also feel ashamed even though others do not discover it. The shamed person fails to meet standards set by the normative
beliefs of others even though one lives up to one’s own principles. Unlike
disapproval, the person feeling shame suffers disutility regardless of what
others think.
In McAdams and Rasmusen (2007), behavioral regularities that lack
normative attitudes are referred to as conventions. Furthermore, according to Voss (2001), norms can be distinguished from conventions in


4 

S. Teraji

­ eneral by the necessity of sanctioning. In social psychology, norms cong
sist of two major categories: they are both descriptive (‘is’ statements) and
injunctive (‘should’ statements) (Cialdini and Trost 1998). Descriptive
norms describe what people generally do in a situation, while inductive
norms describe what people ought to do there. Conventions are thought
of as descriptive norms that are simply what people do. Norms broadly
encompass conventions. A specific convention is an actual behavioral regularity in a given group; it implies the behavioral pattern, or customary
practice, actually followed by the group members in a recurrent situation
of social interaction. In the theory of conventions, norms are considered
as coordinating devices and one of several alternatives that enable people
to achieve their goals (Young 1998). A convention is a stable solution to
a recurrent coordination problem; it is arbitrary in the sense of being the
realization of only one of multiple equilibria that a coordination game displays. An injunctive norm is, on the other hand, referred to as any norm
that one is obliged to follow due to the threat of sanctioning its violation.
It is considered a belief system about what constitutes morally approved
and disapproved conduct.

There is now growing recognition that norms play a significant role in
behavioral prediction and explanation. Norms govern behavior, and are
self-sustaining in an interdependent system. Norms specify a limited range
of behavior that is acceptable in a situation, and facilitate confidence in the
course of action. Norms enable individuals to deal with the complexity and
incompleteness of information, and make them stick to prescribed behavior (even if new and apparently better options become available). Norms,
thus, describe the uniformities of behavior that characterize groups. While
the independent decisions of individuals are shaped by narrow intentions,
their consequences are unlimited; there exists a dimension of spontaneous
social order. Norms come into existence as a product of group interactions. A norm is the behavior performed by the majority of the relevant
group. It is construed as the central tendency of the distribution of a certain attribute within a group.1 People learn information about a social
category that represents the collective, and this information is used to
infer the distribution of the members’ attitudes within the collective. How
these interactions, and the outcomes they give rise to, take shape depends
upon the specific institutions of the society. Habits and traditions become
‘institutionalized’ behavior more or less in accordance with the norms of
prior generations, which are again passed over to the next generations.
Different norms provide the contours of different groups.


Foundations 

5

1.2   Economic Behavior
Economics is divided into some competing schools based upon views of
human nature. In particular, behavioral economics, which has made significant advances in recent decades, demonstrates how neoclassical (or
conventional) economics fails to represent the reality of human behavior.
The concept of preference is fundamental in two schools, neoclassical and
behavioral. A preference is a relation. Neoclassical economic theory identifies individuals as a set of ‘well-defined’ preferences. That is, in neoclassical economics, preferences are axiomatically required to be ‘rational’ so

that choices are rational. Its core has been axiomatized in expected utility
theory. More specifically, it treats individuals as choosing under risk, where
outcomes of actions have a determined probability. Expected utility theory
measures an individual’s valuation of things called ‘prospects.’ Generally,
any prospect is represented by a probability distribution over a fixed set of
pure consequences. The ordering axiom requires both completeness and
transitivity. First, individuals are assumed to have their own preferences,
and rank order in a consistent way the preferences for all conceivable prospects. Individuals always know and can express that they prefer one prospect to another or are indifferent to either of them. A preference relation is
then complete. Second, if individuals choose one prospect, q, over another
prospect, r, and r over s, then they will choose q over r. A preference relation is then transitive. Completeness and transitivity together ensure that
the individual has a preference ordering over all prospects. Furthermore,
the axiom of continuity is required for all prospects; for any prospect, r,
there is always a prospect, q, preferred to r, and another prospect, s, over
which r is preferred, such that a probability mixture of q and s is equal to
r in value. The axioms of ordering and continuity imply that preferences
over prospects can be represented by a function which assigns a real-valued
index to each prospect. The function is a representation of preferences; an
individual prefers the prospect q to the prospect r if and only if the function assigns a higher value to q than to r.
Neoclassical economic theory postulates a predetermined set of axioms leading to choices that are independent of social context. In neoclassical economics, rational agents are assumed to make their choices in
a ­consistent manner. However, an underlying theme of much decision
research is that preferences for objects are often constructed in the generation of a response to a judgment to choice task. March (1978) attributes


6 

S. Teraji

the construction of preferences to the limits on information processing
capacity:
Human beings have unstable, inconsistent, incompletely evoked, and imprecise goals at least in part because human abilities limit preference orderliness. (March 1978, p. 598)

Preferences are not necessarily generated by some consistent and invariant algorithm. The information used to construct preferences appears to
be highly contingent on a variety of context factors. People often adopt
different options in different situations, potentially leading to variance
in preferences. Instability or ambiguity of preferences is not necessarily a
fault in human choice to be corrected but often a form of intelligence to
be refined.
Over the last several decades, the neoclassical prediction of human
behavior has been subject to challenges from empirical results qualified as
anomalies (Thaler 1988). Anomalies are often labeled as decision-making
failures or mistakes. Behavioral economics is the study of how individuals
behave and how thinking and emotions affect individual economic decisions. Behavioral economics encourages economists to be more receptive
to the results of experimental research. By adding insights from psychology, behavioral economics tries to modify the conventional economic
approach, and to analyze how ‘flesh-and-blood’ people act in social contexts. Psychological research teaches conventional economists about ways
to describe preferences more realistically, about biases in belief formation,
and about ways it is misleading to conceptualize people as attempting to
maximize stable, coherent, and accurately perceived preferences. The idea
of behavioral and cognitive modularity helps explicate a variety of otherwise anomalous observations (see Appendix 1 for hyperbolic discounting).
How closely we wish to interweave economics with psychology depends
both on the range of questions we wish to answer and on our assessment
of how far we may trust the assumptions of conventional economic theory
as approximations. Simon (1957) coins the term ‘bounded rationality’
to refer to choices, given the psychological cognitive limitations on the
individual decision-makers in terms of acquiring and processing of information. He takes it as an axiom; human beings are capable only of very
approximate and bounded rationality. Human beings do not know all of
the alternatives that are available for action, and are unable to make the


Foundations 

7

calculations that would support optimization. Decision-making that deviates from neoclassical rationality does not imply irrationality.
Since the early 1970s, two psychologists, Daniel Kahneman and Amos
Tversky, published a series of articles testing the conventional economic
model of choice under uncertainty.2 Consistent with Simon (1957), people
rely on simplifying strategies or heuristics. While heuristics are frequently
useful shortcuts, they also lead to biases. The presence of an error of judgment is demonstrated by comparing intuitive inferences and probability
judgments to the rules of statistics and the laws of probability:
In making predictions and judgements under uncertainty, people do not
appear to follow the calculus of chance or the statistical theory of prediction.
Instead, they rely on a limited number of heuristics which sometimes yield
reasonable judgements and sometimes lead to severe and systematic errors.
(Kahneman and Tversky 1973, p. 237)

Heuristics describe how people make judgments and decisions based
on approximate rules of thumb. Heuristics require less effort compared to
a rational, calculated choice.
People are often insensitive to sample size. In Tversky and Kahneman’s
(1971) ‘Belief in the law of small numbers’ and further developed in
Kahneman and Tversky’s (1972) ‘Subjective probability: A judgment of representativeness,’ people ignore sample size and apply a ‘law of small numbers’ to make predictions in situations in which the ‘law of large numbers’
is appropriate. People have much more faith in small samples than they
should. An individual’s erroneous behavior is the result of false beliefs for
which the individual cannot really be blamed. The “deviations of subjective from objective probability seem reliable, systematic, and difficult to
eliminate” (Kahneman and Tversky 1972, p. 431).
Anomalies arise from the way humans process information to form beliefs.
Tversky and Kahneman (1974) describe three heuristics that are employed
to assess probabilities and to predict values. First, ­representativeness is the
tendency for people to assess the likelihood of an event based upon the
similarity of that occurrence to their stereotypes of similar occurrences.

For example, people ascribe characteristics to groups or subgroups based
upon their experiences with, or perceptions of, members of a group. When
an individual’s experiences with members of a population are not representative of that population, the individual might incorrectly ascribe the
characteristic to the entire population. Second, availability is the tendency


8 

S. Teraji

to assess the frequency or likely causes of an event by the degree to which
instances or occurrences of that event are readily ‘available’ in memory.
That is, if people can readily think of examples of events, they will inflate
their probability estimates of the likelihood of their occurrence. Finally,
anchoring and adjustment refer to the tendency to assess quantities by
starting from an initial value and adjusting to yield a final decision. People
are overly influenced by anchors, even arbitrary ones.
People respond differently to gains versus losses when they make
choices. Peoples’ preferences are affected by whether the decision problems are framed in terms of gains or losses. Tversky and Kahneman (1981)
discuss framing effects involving the different responses to gains and
losses. They illustrate the impact of presentation on framing by showing
that simple wording changes (e.g., from describing outcomes in terms
of lives saved to describing them in terms of lives lost) can lead to different preferences. In the experiment conducted by Tversky and Kahneman
(1981), subjects were given the following choices:
Imagine that the USA is preparing for the outbreak of an unusual Asian
disease, which is expected to kill 600 people. Two alternative programs to
combat the disease have been proposed. Assume that the exact scientific
estimates of the consequences are as follows:
Positive frame
–– If Program A is adopted, 200 people will be saved.

–– If Program B is adopted, there is a one-third probability that 600
people will be saved, and a two-thirds probability that no people will
be saved.
Negative frame
–– If Program C is adopted, 400 people will die.
–– If Program D is adopted, there is a one-third probability that nobody
will die and a two-thirds probability that 600 people will die.
The expected value of Programs A, B, C, and D are the same: 400 lives
saved, 200 lives lost. Despite this, subjects receiving the positive frame
solidly preferred Program A (72 %) and those receiving the negative frame
strongly preferred Program D (78 %). Thus, by restating the consequences
of the alternative programs in terms of potential losses (‘will die’) rather
than the potential gains (‘will be saved’), peoples’ preferences are reversed
even though the choices are identical.


Foundations 

9

People evaluate identical facts differently, depending upon whether
they are presented in a positive or in a negative manner in terms of a
reference point. This implies that values are attached to changes rather
than final states. Prospect theory, developed by Kahneman and Tversky
(1979), accounts for the framing effect through a ‘value function,’ where
values are calculated with regard to a reference point. A reference point
is a base position from which changes are assessed. It determines whether
something is entered as gains or whether it is entered as losses from an
endowment or status quo point of view. Prospect theory suggests that
people choose options as if they were evaluating outcomes with reference

to a zero point rather than in terms of total wealth. Peoples’ assessments of
values are suggested to be based upon an S-shape subjective value function
of gains and losses. Its S-shaped value function represents changes (i.e.,
gains and losses) in the objective value levels on the horizontal axis and
the subjective value resulting from these changes on the vertical axis. The
function for gains is concave and the function for losses is convex. There
is an asymmetry in the value function under prospect theory. A loss would
be felt more strongly than a gain of an equivalent amount.
Dual process models have their origins in the 1970s and 1980s (Evans
1989; Wason and Evans 1975) and have become one of the most important theoretical developments in the understanding of human behavior
(Kahneman 2003). These are labeled System-1 and System-2 to represent
two reasoning processes. System-1 processes are rapid, automatic, and
unconscious, while System-2 processes are slower, deliberate, and conscious. Additionally, System-1 processes are typically thought of as older,
shaped by evolution. System-2 processes, by contrast, are typically thought
to be more recent. Kahneman (2003) applies the terms ‘System-1’ and
‘System-2’ to propose that the human mind consists of both an intuitive
system and an evolutionary newer cognitive system.

1.3   Rationality
Rationality has been given a very specific meaning in neoclassical economic theory. In Simon’s (1978) words:
[T]he rational man of economics is a maximizer, who will settle for nothing
less than the best. (Simon 1978, p. 2)