Epistemic economics and organization forms of rationality and governance for a wiser economy

ROUTLEDGE STUDIES IN GLOBAL COMPETITION

Epistemic Economics and
Organization
Forms of rationality and governance for
a wiser economy
Anna Grandori


Epistemic Economics and
Organization

This book proposes a new approach to economics, management and organization
that should help in making economic organization ‘wise’, ‘innovative’ and
‘robust’ in an uncertain and risky world. Although the modern economy and
society is ‘knowledge intensive’, Anna Grandori argues that the dominant economic, organizational and behavioural models neglect to a large extent the
problem of valid knowledge construction and effective knowledge governance.
The book integrates inputs from economics and behavioural science with
insights from the philosophy of knowledge to define new micro-foundations:
neither a calculative, deductive and omniscient ‘rational actor’; nor an experiential, adaptive and biased ‘behavioural actor’; but a knowledgeable and imaginative ‘epistemic actor’.
The implications for contracts and organizations, sustained also by insights
from law, are shown to be far reaching, including a new view of the nature of the
firm as an entity-establishing agreement under which to discover uses of
resources under uncertainty, and as a democratic institution.
Anna Grandori is Professor of Business Organization at Bocconi University,
Milan, Italy.


Routledge studies in global competition
Edited by
John Cantwell

Rutgers, State University of New Jersey, USA

and
David Mowery

University of California, Berkeley, USA

  1 Japanese Firms in Europe
Edited by Frédérique Sachwald
  2 Technological Innovation,
Multinational Corporations and
New International
Competitiveness
The case of intermediate countries
Edited by José Molero

  9 Going Multinational
The Korean experience of direct
investment
Edited by Frédérique Sachwald

  3 Global Competition and the
Labour Market
Nigel Driffield

10 Multinational Firms and
Impacts on Employment, Trade
and Technology
New perspectives for a new
century

Edited by Robert E. Lipsey and
Jean-Louis Mucchielli

  4 The Source of Capital Goods
Innovation
The role of user firms in Japan and
Korea
Kong-Rae Lee

11 Multinational Firms
The global–local dilemma
Edited by John H. Dunning and
Jean-Louis Mucchielli

  5 Climates of Global Competition
Maria Bengtsson
  6 Multinational Enterprises and
Technological Spillovers
Tommaso Perez
  7 Governance of International
Strategic Alliances
Technology and transaction costs
Joanne E. Oxley
  8 Strategy in Emerging Markets
Telecommunications
establishments in Europe
Anders Pehrsson

12 MIT and the Rise of
Entrepreneurial Science

Henry Etzkowitz
13 Technological Resources and the
Logic of Corporate
Diversification
Brian Silverman
14 The Economics of Innovation,
New Technologies and
Structural Change
Cristiano Antonelli


15 European Union Direct
Investment in China
Characteristics, challenges and
perspectives
Daniel Van Den Bulcke,
Haiyan Zhang and
Maria do Céu Esteves
16 Biotechnology in Comparative
Perspective
Edited by Gerhard Fuchs
17 Technological Change and
Economic Performance
Albert L. Link and
Donald S. Siegel
18 Multinational Corporations and
European Regional Systems of
Innovation
John Cantwell and
Simona Iammarino

19 Knowledge and Innovation in
Regional Industry
An entrepreneurial coalition
Roel Rutten
20 Local Industrial Clusters
Existence, emergence and evolution
Thomas Brenner
21 The Emerging Industrial
Structure of the Wider Europe
Edited by Francis McGowen,
Slavo Radosevic and
Nick Von Tunzelmann
22 Entrepreneurship
A new perspective
Thomas Grebel
23 Evaluating Public Research
Institutions
The US Advanced Technology
Program’s Intramural Research
Initiative
Albert N. Link and John T. Scott

24 Location and Competition
Edited by Steven Brakman and
Harry Garretsen
25 Entrepreneurship and Dynamics
in the Knowledge Economy
Edited by Charlie Karlsson,
Börje Johansson and
Roger R. Stough

26 Evolution and Design of
Institutions
Edited by Christian Schubert and
Georg von Wangenheim
27 The Changing Economic
Geography of Globalization
Reinventing space
Edited by Giovanna Vertova
28 Economics of the Firm
Analysis, evolution and history
Edited by Michael Dietrich
29 Innovation, Technology and
Hypercompetition
Hans Gottinger
30 Mergers and Acquisitions in
Asia
A global perspective
Roger Y.W. Tang and
Ali M. Metwalli
31 Competitiveness of New
Industries
Institutional framework and
learning in information technology
in Japan, the US and Germany
Edited Cornelia Storz and
Andreas Moerke
32 Entry and Post-entry
Performance of Newborn Firms
Marco Vivarelli

33 Changes in Regional Firm
Founding Activities
A theoretical explanation and
empirical evidence
Dirk Fornahl

42 Evolutionary Economic
Geography
Location of production and the
European Union
Miroslav Jovanovic

34 Risk Appraisal and Venture
Capital in High Technology New
Ventures
Gavin C. Reid and Julia A. Smith

43 Broadband Economics
Lessons from Japan
Takanori Ida

35 Competing for Knowledge
Creating, connecting and growing
Robert Huggins and Hiro Izushi

44 Targeting Regional Economic
Development
Edited by Stephan J. Goetz,
Steven C. Deller and

Thomas R. Harris

36 Corporate Governance, Finance
and the Technological
Advantage of Nations
Andrew Tylecote and
Francesca Visintin
37 Dynamic Capabilities between
Firm Organisation and Local
Systems of Production
Edited by Riccardo Leoncini and
Sandro Montresor
38 Localised Technological Change
Towards the economics of
complexity
Cristiano Antonelli
39 Knowledge Economies
Innovation, organization and
location
Wilfred Dolfsma
40 Governance and Innovation
Maria Brouwer
41 Public Policy for Regional
Development
Edited by Jorge Martinez-Vazquez
and François Vaillancourt

45 Innovation, Knowledge and
Power in Organizations
Theodora Asimakou

46 Creativity, Innovation and the
Cultural Economy
Edited by Andy C. Pratt and
Paul Jeffcutt
47 Coopetition Strategy
Giovanni Battista Dagnino and
Elena Rocco
48 Knowledge Intensive
Entrepreneurship and
Innovation Systems
Evidence from Europe
Edited by Franco Malerba
49 Innovation in Complex Social
Systems
Edited by Petra Ahrweiler
50 Internationalization,
Technological Change and the
Theory of the Firm
Edited by Nicola De Liso and
Riccardo Leoncini


51 Territory, Specialization and
Globalization in European
Manufacturing
Helena Marques and
Francisco Puig
52 Institutional Diversity and
Innovation
Continuing and emerging patterns

in Japan and China
Cornelia Storz and
Sebastian Schäfer
53 Innovation and Economic Crisis
Daniele Archibugi and
Andrea Filippetti
54 The Communications Industries
in the Era of Convergence
Catherine Mulligan
55 Innovation, Technology and
Knowledge
Charlie Karlsson,
Börje Johansson and
Roger R. Stough

56 Evolution of Competition Laws
and their Enforcement
Pradeep S. Mehta
57 The Economics of Structural
Change in Knowledge
Francesco Quatraro
58 Economic Geography and the
Unequal Development of Regions
Jean-Claude Prager and
Jacques-François Thisse
59 Social Networks, Innovation and
the Knowledge Economy
Edited by Isabel Salavisa and
Margarida Fontes
60 The Economics of Creativity

Ideas, firms and markets
Edited by
Thierry Burger-Helmchen
61 Epistemic Economics and
Organization
Forms of rationality and
governance for a wiser economy
Anna Grandori



Epistemic Economics and
Organization

Forms of rationality and governance for a
wiser economy
Anna Grandori


First published 2013
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
Simultaneously published in the USA and Canada
by Routledge
711 Third Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2013 Anna Grandori
The right of Anna Grandori to be identified as author of this work has been
asserted by her in accordance with the Copyright, Designs and Patent Act
1988.

All rights reserved. No part of this book may be reprinted or reproduced or
utilized in any form or by any electronic, mechanical, or other means, now
known or hereafter invented, including photocopying and recording, or in
any information storage or retrieval system, without permission in writing
from the publishers.
Trademark notice: Product or corporate names may be trademarks or
registered trademarks, and are used only for identification and explanation
without intent to infringe.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
Grandori, Anna.
Epistemic economics and organization: forms of rationality and
governance for a wiser economy/Anna Grandori.
p. cm.
1. Knowledge management–Economic aspects. 2. Epistemics.
3. Organizational learning–Economic aspects. I. Title.
HD30.2.G723 2013
302.3′5–dc23
012035526
ISBN: 978-0-415-57565-2 (hbk)
ISBN: 978-0-203-78677-2 (ebk)
Typeset in Times New Roman
by Wearset Ltd, Boldon, Tyne and Wear


Contents

List of tables
List of abbreviations



Introduction

Part I

Micro foundations: from bounded to epistemic rationality

xi
xii
1

7

1╇ ‘Models of man’ and the ‘rationality divide’╇ 9
2╇ Savage and Simon revisited: how both ‘maximizing’ and
‘satisficing’ simplify problems╇ 13
3╇ Endogenizing assumptions: contingent rationality╇ 19
4╇ The ‘psychology’ versus the ‘logic’ of judgement and
discovery╇ 22
5╇ The logic of economic discovery: an epistemic decision
model╇ 25
6╇ Conclusions╇ 40
7╇ Summary╇ 40
Part II

Contracts and the firm beyond transactions: the
governance of knowledge and association
1╇ Contract incompleteness and the rationality divide╇ 44
2╇ How both relational contracting and authority relations have
limited capacity of governing uncertainty╇ 47
3╇ Contracting without knowing╇ 52
4╇ Ten theses on the nature of the firm╇ 63
5╇ Relations with extant views of the firm╇ 73
6╇ Summary╇ 77

43


x╇╇ Contents
PART III

Organization design beyond comparative assessment: the
discovery of forms, and forms for discovery

79

1╇ Organization forms and forms of rationality╇ 81
2╇ How both markets and hierarchies decompose problems╇ 83
3╇ Missing alternatives: non decomposable systems and panarchic
governance╇ 87
4╇ From ‘discrete institutional alternatives’ to discrete
coordination mechanisms╇ 96
5╇ Instrumentally and epistemically rational coordination
mechanisms╇ 99
6╇ Combining mechanisms: complementarity and the design of

structural heterogeneity╇ 107
7╇ The negotiated discovery of organizational arrangements╇ 112
8╇ Properties of robust economic organization in uncertain
worlds╇ 118
9╇ Summary╇ 122


Conclusion

124



Appendix

127






Notes
References
Name index
Subject index

132
136
150

154


Tables

II.1 Contractual specification of property rights and action rights
and obligations in multi-party projects
II.2 Incidence of capital invested by type, and property rights
assignments in inter-organizational projects
A.1 Organizational elements and practices
A.2 Sectoral proxies of uncertainty
A.3 Size proxies of complexity
A.4 Formulas for high efficiency (complexity as contingency) 
A.5 Formulas for high efficiency (uncertainty as contingency) 
A.6 Formulas for innovation (complexity as contingency) 
A.7 Formulas for innovation (uncertainty as contingency) 
A.8 Formulas for both high efficiency and innovation (complexity
as contingency) 
A.9 Formulas for both high efficiency and innovation (uncertainty
as contingency) 

56–57
69
127
128
128
128
129
129
130

130
131


Abbreviations

BATNA
CM
CQA
DSA
ER
GDP
HC
IPO
KGP
L&E
OD
OE
OT
PR
PRT
TCE
VC

Best alternative to a negotiated agreement
Coordination mechanism
Comparative qualitative analysis
Discrete structural alternatives
Epistemic rationality
Gross domestic product

Human capital
Initial public offering
Knowledge, governance and projects
Law and economics
Organization design
Organizational economics
Organization theory
Property rights
Property rights theory
Transaction cost economics
Venture capitalist


Introduction

The book sets out the main tenets of a research program in economics and organization capable of explaining and designing actions and structures in a discovery
oriented, knowledge intensive and risky economy.
It is commonly recognized that the modern economy and society are increasingly characterized by those traits. The recent and increasingly frequent economic ‘crises’ are also widely recognized as signals that there is something
wrong in the way decisions are taken and economic organization designed. It is
also increasingly recognized that the traditional economic models fall short of
providing a good guide for action. What is less clear or convincingly developed
is what the alternative models might be.
In fact, economics has so far been ‘reformed’ mainly by having been made
more ‘psychological’, ‘behavioural’ and ‘experimental’. That route is guided by
the good intention of making economics more ‘realistic’ and better able to
‘predict’ the most common behaviours. This approach is certainly useful for the
prediction of normal behaviours, and therefore also for designing some aspects
of economic organization that should take real average behaviour into account
(such as laws and rules, or incentives). By contrast, the approach entails a risk of
anchoring institutions to ‘wrong’ or biased behaviours that could be improved to

start with; the risk of being founded on ‘reduced’ standards of rationality. Organizational and behavioural models have neglected to a large extent the problem of
valid knowledge construction and effective knowledge governance; and have
focussed on ‘experiential learning’ as an alternative to thinking ahead and to
foresight. However, in a strongly uncertain and variable world, experience, at
least used in the inductive way often implied by the ‘common patterns of behaviours’ incorporated in behavioural models, is anything but a logically sound
basis; actually it is a most unreliable and dangerous way of proceeding (as it has
been pointed out in major classic works – e.g. Bandura 1986).
This book – and indeed all my work, on which it builds – takes another route.
The aim is to contribute to making economic organization ‘wiser’ and ‘more
robust’, and in that sense ‘more rational’ rather than less rational, in the face of
uncertainty. A main shift, or reform of assumptions, on which the attempt rests
is a disentanglement between what the state of knowledge (risk and uncertainty,
unpredictability) is, from what rationality is. Not knowing is one thing, not being


2   Introduction
rational is quite another. The challenge is precisely how to address rationally a
situation of high uncertainty and risk. The ‘original sin’, in a way shared both by
economics and behavioural approaches, is to equate the two things, and assume
that if knowledge is imperfect, than decision makers are forced to be ‘less
rational’. This widespread assumption has blocked the development of rational
approaches for a high risk, high uncertainty world – the core theme of this book
and the approach that has always inspired my work. The approach is based on a
broadening of the sense in which decisions can be said to be rational, connecting
that sense to the meaning that rationality has in philosophy and science – where
it emphatically does not mean ‘knowing everything’. The foundations of economic reasoning have been divorcing from this wider and wiser form of rationality and thought, in which the core problem is one of generating and testing valid
knowledge about what we are doing, before calculating the costs and benefits of
action. This book is about how to reconnect economics and organization to the
problem of discovery and of knowledge validity and growth. Therefore, the
approach is both empirically grounded and prescriptive, as it is in all those contributions to the theory of knowledge interested in detecting, in science and other

discovery activities, ‘the best patterns of thought and judgement’ (Lakatos
1970a; Kiss 2006) that humans are capable of, not the most frequent patterns.
Once modelled, the superior patterns can become more diffuse and common.
The three parts of the book critically revisit the main working hypotheses that
are currently dominating, respectively, at the micro-level of assumptions about
economic rationality, at the level of coordination and contracting among actors,
and at the level of governance and organization structures. In each part then, the
missing and new epistemic perspective, on economic activity and its organization as a problem of knowledge, is outlined: decision making as a process of
imagination and discovery, contractual structures able to govern processes of
collective discovery, and organization structures as a set of mechanisms for governing the growth of knowledge.
The first part of the book integrates inputs from economic and behavioural
science with insights and models from the philosophy of knowledge and of economic philosophy, to define new micro-foundations: neither a calculative, deductive and omniscient ‘rational actor’; nor an experiential, adaptive and biased
‘behavioural actor’; but a theory building, knowledgeable, imaginative ‘epi­
stemic actor’. A model of behaviour that in the course of being heuristic (in the
sense of based on a logic of discovery) is also rational (in the sense of logically
sound according to the canons of reason) has been called for by only a couple of
outstanding thinkers in economic sciences (Shackle 1972; Loasby 2004), and
little attention and effort has been invested in this direction. The time is more
than ripe now though, as testified by the increasing attention paid to knowledge
processes in economic, organizational and management fields. Hence, I thought
it sensible to bring together all my work inspired by an ‘epistemic’ approach to
economic behaviour and organization in this book. In fact, I embarked on my
scientific enquiry with the thesis that economic decision making and coordination is first and foremost an epistemic and discovery problem, before being a


Introduction   3
problem of allocating given scarce resources and of conciling given interests and
proposing an ‘extension’ of the available Simonian heuristic decision model to
incorporate more innovation oriented discovery heuristics (Grandori 1984). Later
on, I mobilized some scholars, sharing the idea of developing the neglected sides

of Simon’s legacy, to contribute in this direction (Grandori 2001a) and started
work on a repertory of ‘rational heuristics’ for innovation (Grandori 2010a).
On the basis of those micro-foundations, the book then presents the ‘new
facts’ that a research program in epistemic economics and organization can
explain and predict as to the nature and shape of contracts, firms and economic
organization structures, using available evidence in organizational economics
(OE) and organization theory (OT) research, as well as the empirical ad hoc
research conducted by myself and associates over the years, as follows.
Part II focuses on contracts and the firm. It reviews the limits of the classic
solutions of ‘relational contracting’ and of authority or power relations in managing uncertainty. The notions of ‘constitutional governance’ and ‘contracts of
society’ are then introduced to overcome those limits. They turn out to provide
a foundation to the firm that is linked to uncertainty and knowledge but independent from power or authority – so commonly linked to the ‘nature’ of the
firm. The implications for the nature of the firm are drawn and exposed in ten
theses that overall should free our view of the enterprise from the nineteenthcentury dichotomies between central planning and ‘spontaneous’ market order,
and more recent dichotomies between contracts and organizations. These propositions on the nature of the firm are based on a ‘rational reconstruction’ of the
need for firm-like associations, rather than starting from the average large capitalistic firm as it has become diffused in the last century. The result is to rescue
the firm from being a special world based on power rather than on right, violating not only the constitutional principles applied to any other association, but
even the Hayekian law that no complex system can be governed by planning
and command.
Part III develops the implications of the two former parts in terms of organization forms and their design. This analysis ‘closes the circle’ in that it substitutes the classic nexus between bounded rationality as a micro-foundation and
‘discrete structural alternatives’(DSAs) as a macro-structural consequence, with
the nexus between the more rational but still heuristic notion of epistemic rationality (ER) as a micro-foundation and a more continuous space of qualitatively
different structural configurations as a macro-structural consequence. Consistent
with the generative and discovery-based approach outlined in the book, some
guidelines for design-as-discovery of new configurations are specified. The substantive features of the configurations more suitable for sustaining discovery and
managing uncertainty are also illustrated. They include ‘nearly-indecomposable’
rather than nearly-decomposable forms; ‘panarchic’ rather than hierarchic and
polyarchic governance regimes; ‘robust’ rather than adaptive structures; and
‘multimodal’ rather than ‘coherent’ forms.
In disciplinary terms, the analysis builds on, and contributes in integrating,

OE, L&E (law and economics), OT, and behavioural science as applied to


4╇╇ Introduction
understanding and designing economic organization. I have tried to implement
(who else if not me?) the ‘methodological options for an integrated view of economic organization’ that I myself proposed in the Millennium Special issue of
Human Relations (Grandori 2001): the ‘endogenization of assumptions’; the
‘disentanglement of concepts’; and the ‘rejuvenation of design’.
In my writing, I have also tried to keep faith to, and hopefully fulfil, the
judgements and expectations on the positioning and potential of my contribution provided by some of the anonymous reviewers of this book. Thanking
them heartily for their confidence in the project and their ameliorating suggestions, I will let their words define the positioning and potential interested
readership:
This book is positioned at the interfaces of economics, strategic management, entrepreneurship, and innovation. It thus addresses a wide range of
audiences. The book will also raise interest in the growing behavioural economics community and in constitutional economics, as well as neighbouring
social sciences such as psychology, sociology, and philosophy of
knowledge.
It tackles questions largely debated by articles published in highly ranking
international Reviews, in the fields of Organization Theory, Economics, and
Management.
The material is highly innovative since it envisages a new perspective on
the creation and the evolution of firms on the basis of three fundamental
ingredients: (1) recent advances in the theory of rationality. (2) A peculiar
expanding of the vision of firms according to a ‘generative’ and ‘combinatorial’ mental frame, which models decision making under structural uncertainty, viewed as discovery process, with multifaceted organizations forms
(called multimodal and multifunctional). (3) A sound endeavour to overcome the prevailing theoretical approach, based on “discrete structural
alternatives”.

Dedication
This book is dedicated not to the ‘memory’ but to the ‘living legacy’ of two
fathers, both recently disappeared. I cannot even trace all the debts I have toward
them, but I can perceive with clarity that the debts are large and that my gratitude is immense.

One is my real father, Giuseppe Grandori. Perhaps nothing more than the
intense relation and endless discussions with him, one of the pioneers of modern
seismic engineering, on how to frame and solve complex problems marked my
development and thought. Certainly, the ‘generative and combinatorial mental
frame’ that has been noticed in my work has a root in the kind of engineering as
‘ingeniousness’ in which my father was a master.


Introduction   5
Perhaps, among the reasons for studying decision making and ‘adopting’
Herbert Simon as a scientific father there has been the similar interest he cultivated
for ‘the world as it might be’. This election or adoption was somehow recognized by Simon, who wrote to me on the occasion of the publication of my 1984
ASQ paper on contingent decision making that it was ‘a step forward in our
understanding of decision making’. One can imagine what a motivational and
reassuring effect those simple words had on a young Italian female researcher at
the beginning of her scientific enquiry more than 30 years ago; on top of that
daring to criticize, since that very first article, the ‘satisficing’ model for being a
particular and ‘too behaviourist’ version of a more important ‘heuristic-asepistemic’ approach to decision making. But, as in any healthy inheritance
relationship, the acknowledgment of the importance of the heritage should never
become the acceptance of everything received. Actually this book, and most of
my work of which it expresses the ‘fil rouge’, builds on an active interpretation,
a ­revitalization through reinterpretation, of Simon’s work and of the perspectives
it originated in economics, organization and management.

Acknowledgements
For this kind of book, I should actually acknowledge all colleagues in my research
network who continue to nurture my thought and work. Some research and edit­
orial projects have been prominent in the formation and evolution of the core ideas,
especially of the second and third parts of the book. Early salient networked experiences in the 1990s included the series of workshops that led to my becoming one
of the co-founders of the EGOS Standing Group on Network Research; and having

been one of the scientific directors of the ESF Research Program on European
Management and Organization in Transition’ – the conjecture that ‘breaking’
DSAs and resorting to a combinatorial approach was ‘necessary’ for understanding
and designing economic organization, matured there.
In the last decade, three projects have had a particularly important impact, and
are in fact widely cited in the book. One has been the ‘Knowledge, Governance
and Projects’ research programme, promoted by, and conducted in collaboration
with the research centre (CRORA) I was directing at the time.
The other two projects have been editorial projects mobilizing researchers to
whom I felt akin in both concern and approach (at least in the effort of integrating
rather than dividing ‘schools’ and ‘disciplines’) around a joint output. They were
the edited volumes Corporate Governance and Firm Organization in 2004, and
the Handbook of Economic Organization currently in press. I warmly thank all the
colleagues who accepted the invitation to join those projects; their contributions
and discussions form a very direct pillar on which this book rests.
A particular and personal thanks goes to the younger scholars who have been
working and co-publishing with me over the years – Giuseppe Soda, Massimo
Neri, Santi Furnari, Marco Furlotti, Magdalena Cholakova (more or less in a generational order) –: their contribution is quite intermingled within the research on
which this book is based.



Part I

Micro foundations
From bounded to epistemic rationality

1
2
3

4
5
6
7

‘Models of man’ and the ‘rationality divide’
Savage and Simon revisited: how both ‘maximizing’ and ‘satisficing’ simplify
problems
Endogenizing assumptions: contingent rationality
The ‘psychology’ versus the ‘logic’ of judgement and discovery
The logic of economic discovery: an epistemic decision model
Conclusions
Summary

The term rationality, (from the Latin ‘ratio, rationis’) according to its encyclopaedic, etymological and philosophical definitions, means ‘the principle governing the activity of knowing’: something is rational if ‘it proceeds from reason’, if
it ‘is founded on logically sound procedures, on scientific method’. The meaning
of rationality has been reduced to a much narrower meaning in both economic
and behavioural sciences, albeit in different ways. In this chapter it is argued that
a reduction in the wisdom and validity of possible behaviours is the result of following either of the two prevailing economic and behavioural paradigms on
rationality. Furthermore, it is argued and shown that those wiser behaviours are
not only logically possible, but indeed are followed by a variety of innovative
and discovery-based decision processes. Therefore, the proposed enrichment of
extant decision models with models of the logic of economic discovery is also
bringing superior predictive power to the decision making theory employed in
economic sciences; in particular the capacity of predicting and guiding the innovative yet rational behaviours that are so important in modern knowledge intensive economies, but very poorly acknowledged and modelled in economic
sciences. The questions rarely posed in the analysis of the micro-foundations of
our disciplines, and central stage here, are of the type: if a problem is not ‘given’,
are there any (logically sound) ways of formulating it? If so, knowing them may
help in escaping from addressing ‘wrong’ or badly defined problems. Are there
any (logically sound) methods for ‘having good ideas’, i.e. for generating and

testing novel action alternatives? If so, knowing them may prevent remaining
trapped in conventional and past-based courses of action. These questions are


8   Micro foundations
logically prior to the questions that are typically addressed in extant decision
making models, where problems are defined to start with, and alternatives are at
best ‘searched’, not ‘researched’.
‘Logically sound procedures’ can be defined with respect to various logical
operations relevant in the activity of knowing and deciding. In particular, two
distinctions are particularly relevant for discussing and renewing how the notion
of rationality is employed in economic and behavioural sciences, and will be
widely used in this book. First, knowing activity involves both a ‘logic of justification’ and a ‘logic of discovery’ of any proposition (a central distinction in philosophy of science, as is well known) (e.g. Lakatos and Musgrave 1970; Simon
1977). Second, decision making involves two differing broad categories of
judgements, both calling for logically sound procedures: rationality in ‘instrumental’ judgements (what are the best means to ends) and rationality in ‘epistemic’ judgements (is it true that those means have those effects? Is it true that
those ends are desired?) (Foley 1987).
In economics, the meaning of rationality has been restricted to refer only to the
logically sound procedures for ordering alternatives according to preference and to
the logic of justification of choice among them (Shackle 1972). Hence, it can be
said that economics has been concerned with instrumental rationality – a set of logically sound procedures for consistency in utility judgements and means to end
choices – not with epistemic rationality – a set of logically sound procedures for
knowing what the preferences, alternatives and consequences are in the first place.
Second, a judgement expressed by Lakatos (1976) about mathematics could be
applied equally well to economics: it has been concerned only with the ‘deductive’
rather than with the ‘heuristic’ component of rationality, that is only with the ‘logic
of justification’, not also with the ‘logic of discovery’.
This use of the term ‘heuristics’ also throws light on another, related, mismatch of meaning between the philosophy of science and knowledge on one
side, and economic and social sciences on the other. ‘Heuristics’ in the philo­
sophy of science is a branch or sub-discipline concerned with ‘the logic of discovery’: the set of ‘logically sound procedures for researching and finding’, for
generating conjectures and controlling them, the very method of empirical

science. ‘Heuristics is neither psychology nor logics, but an independent discip­
line, the logic of discovery’ (Lakatos 1976, appendix II, note 4). As such (some)
‘heuristics’ can be qualified as ‘rational’, in the same sense as the methods of
scientific empirical research can be defined to be rational: they are logically
correct methods for discovery (Grandori 2010a). Hence, the concept of ‘heuristics’ has also been restricted, and ‘downgraded’, in behavioural and economic
sciences usage: it is used to refer to psychological devices, substituting cognitive
‘shortcuts’ and ‘fast and frugal’ thinking to deductive rationality and statistical
decision theory. As such, ‘heuristics’ have been associated with quick and low
effort choice (Gigerenzer et al. 1999) or with ‘biases’ (Kahneman et al. 1982)
rather than with rational discovery.
Building on those observations, and on a long lasting research program
oriented by them (Grandori 1984, 2001a, 2010a), Part I of this book aims at


Micro foundations╇╇ 9
providing renewed and enlarged micro-foundations to economic behaviour. Theoretically, then, the view proposed in this first part of the book originates from
the observation of the mismatches between the broader philosophical meaning of
rationality and the narrower meanings attributed to the term in economic and
behavioural sciences; and will show how the latter reduced meanings are at the
origin of many puzzles and problems in important areas such as contract theory
and innovation management. Empirically, it originates from the observation that
actual behaviours inspired by instrumental rationality only, on calculating costs
and benefits, all too often lead to proceeding in quite a distorted manner, disregarding all the important considerations about the validity of action hypotheses
that are considered, and on ‘simplifying’ problems too much for making those
calculations possible (rather than implying ‘wide’ or even ‘complete’ knowledge
of the world, as they are commonly said to imply). On the other side, actual
behaviours saving on effort and based on limited search and limited understanding of the problem at hand, all too often ‘leave resources on the table’. This
expression, commonly employed in negotiation analysis is evocative of the real
problems I am pointing at: suppose that a negotiator or a designer of a new
product adopts the rule of stopping at the first satisfactory alternative found, or

lowers their aspirations in the face of difficulty .â•›.â•›. Even in problems with no
closed boundaries, with infinite possible solutions, much better can be done, and
is often done.
The analysis will feature the following aspects and be developed through the
following analytical steps:
•

•

revisiting and criticizing the standard ‘rationality divide’ between the
‘rational actor paradigm’ and the ‘bounded rationality paradigm’, offering a
different account or interpretation of the two models, allowing to interpret
them not as incomparable or rival ‘paradigms’ but as comparable and contingently rational decision strategies;
specifying a further, missing, ‘epistemic’ model of decision behaviour that,
in the course of being heuristic (aimed at discovery) is also ‘rational’ (logically correct); capable of explaining and guiding behaviour in the rather
uncharted and neglected territory of the rational discovery of economic
action.

1╇ ‘Models of man’ and the ‘rationality divide’
The model of rational decision making employed in economic sciences typically
includes the statement that the set of possible actions A and the set of possible
‘states of the world’ S (or the ‘contingencies’ under which actions generate their
consequences) are ‘known’ (the elements in the set are enumerable or a criterion
of belongingness to the set is given). An expected utility can be defined ‘over’
the combinations of a and s belonging to A and S respectively: by ordering the
values of outcomes according to preference and by assigning probabilities when
their value is not known for certain. The only rational learning method


10   Micro foundations

considered is the Bayesian updating of probabilities, if they can be assigned,
upon the observation of new information on a and s.
If analysed from an epistemological standpoint, those standard assumptions
on rationality in economics should be characterized as a set of ‘logically sound
procedures’ for the calculative component of decision only (Shackle 1972).
If analysed from an epistemological standpoint, it may also be noticed,
however, that these assumptions allow two different interpretations – a conventionalist and a realist version.
In a conventionalist interpretation, they can be read as follows: let’s assume
that actors behave ‘as if ’ they have knowledge of the inputs and are calculating
and choosing the option with the maximum expected value in a given set of
options, and explore and test the predictions (Friedman 1953). The prediction, as
known, is that, under those restrictive conditions approximating perfect competition, if actors behave ‘as if ’ they were value maximizers, then equilibrium prices
will be reached and resources allocated efficiently at their best use.
In the most common interpretation, though, the conventionalist assumption
that inputs are known and calculations are performed according to value maximizing calculation procedures, has been transformed into the descriptive and
realist assumption that actors do in fact possess a complete and infallible know­
ledge of the possible states of the world and their possible actions. Economists
have apparently started to believe that the admission that knowledge is fallible
and that actors do not have perfect foresight, would amount to abandoning the
rational actor paradigm for accepting a ‘bounded rationality’ assumption: e.g.
‘with rational agents contingencies are never unforeseen, they are at worst indescribable’ (Tirole 1999); ‘If parties do not foresee even relatively obvious events,
it would seem necessary to assume that they are boundedly rational’ (Hart and
Moore 1999).
This realist version of the rational actor paradigm entails some epistemological problems that a conventionalist version does not.
Ernst Nagel offers an interesting starting point. He observed (Nagel 1963:
214) that a ‘trivial way in which any statement can be said to be unrealistic is
that it can never give a complete description of all the infinite aspects of any real
objects or situation’. This criticism applies to the realist version of economic
rationality, according to which the rational actor actually has a complete know­
ledge of the world, and actually foresees all possible contingencies. The criticism

is consistent with and rooted in the tradition of the philosophy of knowledge and
science, to which Nagel himself contributed. According to that tradition (after
Russell and Popper), in fact, any assertion or assumption about knowledge being
‘objective’, ‘complete’, ‘perfect’, or assertions like ‘there are no unforeseen contingencies’, would be considered naïve and even illogical statements. A core
argument, due to Popper, is that one can never prove, according to logically
sound procedures, that a statement about reality is true or to have considered ‘all
the possible contingencies’ because they are infinite not only in number but also
in kind. Hence, one can provocatively say that the assumptions of classic
economic rationality in their realist version . . . are not rational, in the sense of


Micro foundations   11
applying ‘logically sound procedures’ (Grandori 2010a). In fact, Nagel was actually defending the legitimacy of making ‘unrealistic assumptions’ in economic
modelling, but interestingly concluded that this methodological approach can be
defended precisely because there can be no ‘complete’ description of reality and
no ‘perfect foresight’ of the world!
The alternative notion of ‘bounded rationality’ (Simon 1955), has been
defined in strong reference with the economic model intended in its realist
version, and developed by relaxing some of its core assumptions about the
knowledge of decision inputs. In Simon’s words, in the ‘classical’ (economic)
concept of rationality,
the organism must be able to attach definite payoffs (or at least a definite range
of payoffs) to each possible outcome. This, of course involves also the ability
to specify the exact nature of the outcomes – there is no room in the scheme
for ‘unanticipated consequences’ The payoffs must be completely ordered – it
must always be possible to specify in a consistent way, that one outcome is
better than, or as good as, or worse than any other. And, if the certainty or
probabilitic rules are employed, either the outcomes of particular alternatives
must be known with certainty, or at least it must be possible to attach definite
probabilities to outcomes. My first empirical proposition is that there is a complete lack of evidence that, in actual human choice of any complexity, these

computations can be, or are in fact, performed.
(Simon 1955: 104)
The alternative ‘satisficing’ model was then defined in terms of ‘partial’ and
‘sequential’ exploration of problem spaces, guided by ‘aspiration levels’ (ALs)
or ‘thresholds’ on the expected utility of the sought alternatives, and a choice
rule stated in terms of ‘acceptability’ – an alternative is acceptable if its payoff is
superior to the threshold.
In this way, the main alternative to classic economic rationality was born as a
‘daughter of a minor godness’, a form of rationality ‘trying’ to approximate the
classic economic template, but in almost all situations falling short of accomplishing the task and ending up in a ‘reduced’, more ‘limited’ form of rationality,
a form of ‘weaker thought’.
The two paradigms have been fighting for (more than 50) years, but the type
of objections they raised toward each other remained only on a ground that could
be seen through their respective lenses. What has remained out of sight is a possible epistemological criticism to both.
On one side, as said, the economic notion of rational actor can be used in a
conventionalist interpretation, whereby the use of ‘unrealistic assumptions’ can
be defended, but not in a realist descriptive version. Toward a realist version in
fact, the charge of ‘unrealistic assumptions’ (one of Simon’s main charges)
becomes relevant. In addition, an even stronger objection of logical impossibility
of complete description and knowledge of the world may be raised from an epi­
stemic viewpoint, as argued above.


12   Micro foundations
On the other side, it seems that Simon’s criticism, based on the ‘empirical
proposition’ that humans ‘are not able’ to perform all the calculations involved
in economic models was in a sense too weak and in a sense too strong. It was too
weak because it criticized the classic assumptions interpreted in their realist and
descriptive version, with an empirical and descriptive argument: human behaviour, descriptively and empirically, is commonly ‘less’ knowledgeable and calculative. It did not criticize whether, normatively and logically, the way of being
knowledgeable and calculative of economic classic rationality was actually ‘the’

model toward which to ‘tend’ in our intended rationality. The acceptance of the
equation between ‘complete knowledge’ – or ‘omniscience’ – and value maximizing rationality, present in the realist version of the rational actor model, produced too strong a criticism of value maximizing as an empirically inapplicable
decision process or strategy; a behaviour for which there is ‘no evidence’.
The observation I advance here and develop in the following paragraphs is
that, while there is no evidence (and actually no logical foundation) for complete
knowledge, there is plenty of evidence (and strong logical foundations) for the
applicability of value maximizing strategies to specified classes of structured and
stylized problems (Savage 1954). It can be noticed here that Simon himself provided an outstanding example of the applicability of value maximizing reasoning
with incomplete knowledge, in his analysis of the employment relationship
(1951). The model reconstructs the authority relation as a Pareto-efficient contract among two actors maximizing their respective utility, which is specified as
a function of the benefit or cost of performing the task x, and of the wage w to be
paid or gained: for the employer (e), max Ue = Ue(x) – Ue(w); for the labour provider (l) max Ul = Ul(x) + Ul (w). The attractiveness of a contract giving the
employer the right to choose the task is conditional to the circumstance that there
is uncertainty about which task will be better (contingencies cannot be foreseen),
and the utility of having option rights is high for the employer and low for the
worker.
Hence, a utility maximizing logic does not imply or require perfect knowledge
and complete foresight. Actually, an important contribution by Simon himself has
been to demonstrate that the authority relation (as well as other possible decision
procedures, such as codetermination, or worker self-determination; cf. Simon 1951:
304) can be understood as Pareto-efficient solutions among utility maximizing
actors, precisely under conditions of unforeseeable contingencies.
Both the complete knowledge rationality and the bounded rationality
approaches can be criticized from an epistemological standpoint also in another
respect. Both have neglected, albeit in different ways, the problem of how economic decision makers may construct, in a valid and reliable way, the knowledge (voluminous or not) on which any decision is based. In other words, there
has been little concern, in either tradition, with rational knowledge construction:
in the economic approaches because knowledge is assumed to be there, in the
behavioural tradition because the concern with the ‘common patterns of thinking’ has crowded out the concern with the ‘best patterns of thinking’ humans are
capable of. More practically, questions as simple and important as the following