CHAPTER -10 1 . Current Definition of Bounded Rationality: Simon (1957, p 198) defines, ‘The capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required for objectively rational behavior in the real world.’
Magill and Quinzii (1996, p 13) define bounded rationality in the broadest way. They specify the following three limitations to indicate bounded rationality: ‘(i) Limitations on the knowledge that an agent has of his environment--which includes the characteristics and actions of other agents; (ii) limitations on the ability of an agent to envision (imagine) what the future may have in store; (iii) limitations on the ability of an agent to calculate optimal strategies in a complex decision problem.’ They note, ‘Some economists do not include (i) and (ii) in their definition of bounded rationality.’
Conceptually, it is essential to distinguish imperfect rationality from imperfect information. For example, one may not see clearly either because of an impaired vision (which may be because of cataract) or because of a dense fog. This distinction is important if we want to develop some technology to eliminate this impairment, that is, to have an eye operation or to have fog lights or both. Conlisk (1996) describes this choice as a trade-off between costly information gathering and costly deliberation.
2. Gene Bellinger (2004) defines information, knowledge and wisdom as follows: Information relates to description, definition, or perspective (what, who, when, where).
Knowledge comprises strategy, practice, method, or approach (how).
Wisdom embodies principle, insight, moral, or archetype (why).
Vlatka Hlupic, Athanasia Pouloudi and George Rzevsky (2002) compile a list of eighteen definitions of knowledge management and provide valuable suggestions to integrate the various approaches and that might ultimately shorten the list.
3. According to Confucius (551-479 BCE), ‘By three methods we may learn wisdom: First, by reflection, which is noblest; second, by imitation, which is easiest; third by experience, which is the bitterest.’ http://www.brainyquote.com/quotes/authors/confucius.html 4. Liebeskind (1996) labels this as a trade-off between protection and innovation. Similarly, Volker Mahnke (1998, p 3) writes, ‘This paper suggests that knowledge-sharing might be a double edged sword in attempts to foster competitive advantage. For example, when competitive advantage partially depends on non-imitability of knowledge used in product strategies, and knowledge-sharing comes at the costs of increased leakage of knowledge to competitors, thus easing imitation, the company’s competitive position might be eroded rather than improved.’ 5. Marcello Basili and Carlo Zappia (2005, p 4): ‘Keynes (1921, p 12) distinguished between direct and indirect knowledge. The former is “that part of our rational belief which we know directly”, the latter is “the part which we know by argument”. Keynes explained: “our knowledge of propositions seems to be obtained in two ways: directly by contemplating the objects of acquaintance and indirectly, by argument, through perceiving the probability-relation of the proposition, about
which we seek knowledge, to other propositions.”’
6. See Maddock and Carter (1982, fn. 15) for a distinction between rational
expectations and Muth expectations (all-information approach).
CHAPTER -11 1. Similarly, Roger B Myerson (1999) remarks, ‘A generation before Nash could have accepted a narrower definition of economics, as a specialized social science concerned with the production and allocation of material goods.’ He adds, ‘But today economists can define their field more broadly, as being about the analysis of incentives in all social institutions.’
Ruth W Grant (2002) remarks, ‘The ubiquity of the use of incentives in managing many different spheres of life is a sign of the increasing influence of the economic paradigm on the way in which we conceive of our public relationships and of our individual psychology.’
S Todd Lowry (1987, 247) defines economics from the Greek perspective as: ‘Thus their oikonomia or political economy was the study of the efficient management of personal and political affairs, with emphasis upon the human factor. Modern political economy, on the other hand, concentrates primarily upon the material factors of economic life and only secondarily upon human responses to them.’
See Peter Groenewegen (2002, 68) for the definitions by Adam Smith, Marshall, Robbins and other prominent economists. 2. Moral Hazard: This term has two meanings. Webster’s Dictionary defines it as, ‘An insurance company’s risk as to the insured’s trustworthiness and honesty.’ On the other hand, according to Wikipedia (2005), ‘In law and economics, moral hazard is the name given to the risk that one party to a contract can change their behavior to the detriment of the other party once the contract has been concluded.’
Allard E Dembe and Leslie I Boden (2000) explore the history of its two origins and two meanings. They assert, ‘Moral hazard is a concept that has been employed in various ways by different disciplines for more than 200 years. There are two distinct historical pathways that have recently blended to create the contemporary environment in which moral hazard is discussed. One path originates in the literature concerning insurance and the other stems from statistical and economic analysis of probability and economic decision-making.’ They give credit to Kenneth J Arrow’s (1963) seminal work for the current interest in this area. According to them, ‘Arrow’s work thus represents an important historical turning point in which the value-neutral approaches traditionally used in the mathematical treatment of risk-bearing merged with the highly moralistic rhetoric that had previously existed in the insurance literature.’ Kautilya did not make a distinction between its two meanings and tried to alleviate the problem both, due to dishonesty, and laziness.
3. See Lowry (1987, Chap III) for an in-depth analysis of Xenophon’s ideas.
4. Reemergence of the Principal-Agent Problem: Adolf A Berle and Gardiner C Means (1932) observed that there was a separation of ownership and control in public corporations and suggested that incentives were required to induce the CEO, the agent, to adhere to the objective of the shareholders, the principal. Since then a considerable amount of effort has been devoted to explore a whole set of mechanisms to resolve the principal-agent problem. However, Joseph E Stiglitz (1987, p 966) credits Ross for coining the term principal-agent in 1973. Eric Rasmusen (1994, p209) discusses various mechanisms such as: piece rates, profit sharing, efficiency wages, bonuses, merit pay, tournaments, deferred compensation, promotions and even boiling-in-oil (ie. heavy punishments) to induce workers to supply optimum level of effort. Recently, Prendergast (1999) provides a comprehensive survey of the various incentives provided by the firms to elicit effort from workers. The survey concentrates primarily on two issues: (i) ‘do incentives matter?’ and (ii) are contracts designed to incorporate the trade-off between insurance against risk and incentives for effort? This is an extremely active field of investigation.
5. Definitions (Encyclopedia): Remunerative incentives (or financial incentives) are said to exist where an agent can expect some form of material reward — especially money in exchange for acting in a particular way. Moral incentives are said to exist where a particular choice is widely regarded as the right thing to do, or as particularly admirable, or where the failure to act in a certain way is condemned as indecent. A person acting on a moral incentive can expect a sense of self-esteem, and approval or even admiration from her community; a person acting against a moral incentive can expect a sense of guilt, and condemnation or even ostracism from the community.
Coercive incentives are said to exist where a person can expect that the failure to act in a particular way will result in physical force being used against her (or her loved ones) by others in the community—for example, by inflicting pain in punishment, or by imprisoning her, or by confiscating or destroying her possessions.
Kautilya’s Definition of Coercion: According to Kautilya (1992, p133), ‘A decadent king, on the other hand, oppresses the people by demanding gifts, seizin
g what he wants and grabbing for himself and his favourites the produce of the country [ie. the king and his coterie consume more than their due share thus considerably impoverishing the treasury and the people.] (8.4).’ He added that such a king ‘fails to give what ought to be given and exacts what he cannot rightly take.’ Thus, according to Kautilya, coercion was implied only when the rule of law was not followed.
6. Implicit contracts: Horne H Carmichael (1989) defines them as: ‘Self-enforcing contracts are collections of promises that, while they might not be legally binding, are nonetheless credible. Everyone can be confident that the promises will be kept.’ He adds, ‘They are based on understandings between workers and their firms, not on legal rights.’ Implicit contracts are self-enforcing.
Jeffrey Church and Roger Ware (2000, p73) define a complete contract as: ‘A complete contract is one that will never need to be revised or changed and is enforceable.’ They point out the possibility of opportunism and the costs of hold-up, if contracts are incomplete while there are prohibitive transaction costs to a complete contract.
7. Joseph J Spengler (1971, p74) observes, ‘His analysis, of course, was implicit, not explicit; it rested upon the assumption that individual behavior could be controlled in large measure through economic rewards and penalties, particularly when these were commensurate with the action to be encouraged or discouraged. Accordingly, while Kautilya looked at economic issues through the eyes of an economic administrator, he was aware that rules must fit man’s economic propensities and foster rather than repress useful economic activity.’
8. Recently, Andreoni et al (2003) explore the complementary role of rewards and punishments. They conclude, ‘This indicates that rewards and punishments act to complement one another.’ They continue,‘The process suggested by our data is that the stick can help by getting people to move away from perfect selfishness and to test the waters of cooperation. The carrot can then take over by encouraging further cooperation, rendering the stick a rarely used but necessary tool.’
9. Kautilya did not recommend but accepted the existence of prostitution. However, he recommended the strictest possible controls over its operation. Moreover, the definition itself of what is ethical has been changing over the years and thus, making comparisons across time very difficult. Calvin G Mackenzie and Michael Hafken (2002, p 7) observe, ‘An added problem is that of changing standards and then of changing laws. Some practices, once very common, would now get the practitioners indicted in federal courts.’ It may also be noted that there is no such thing as national values, ie. no country is homogeneous in terms of values. Charles Kindleberger (1964, p 92) observes, ‘National characteristics and values differ, but these also differ from class to class. At one time the values of one class dominate; at another, those of another. This may account for some of the contradictions in national character and the changes that supervene. We can distinguish the aristocrat, the bourgeois, the town worker and the countrymen, each with separate attitudes and beliefs.’
10. Recently, Daron Acemoglu and Thierry Verdier (2000) provide such a formal model. Joseph E Stiglitz (1998) also discusses government failures.
11. Paul Osterman (1994) finds, ‘The models provide strong support for the view that efficiency wages are an alternative to supervision and that the payment of efficiency wages enables employers to provide workers with more discretion.’
12. Incidentally, see Archie B Carroll and Ann K Buchholtz (2003, p 186) for the rediscovery of the classification of individuals among moral, amoral and immoral ones.
13. Kenneth Arrow (1968) notes, ‘Because of the moral hazard, complete reliance on economic incentives does not lead to an optimal allocation of resources in general. In most societies, alternative relationships are built up which to some extent serve to permit cooperation and risk sharing. The principal-agent relation is very pervasive in all economies and especially in modern ones; by definition the agent has been selected for his specialized knowledge and therefore the principal can never hope completely to check the agent’s performance. You cannot therefore easily take out insurance against the failure of the agent to perform well. One of the characteristics of a successful economic system is that the relations of trust and confidence between principal and agent are sufficiently strong so that the agent will not cheat even though it may be “rational economic behavior” to do so.’
14. Charles F Manski (1995,p 8) remarks, ‘The economist presented his forecast as a likely range of values for the quantity under consideration. Johnson is said to have replied, “Ranges are for cattle. Give me a number”. Similarly, President Truman preferred an economist only with one hand.’
Gerald R Faulhaber and William Baumol (1988) remark, ‘Let us next examine the case of marginal analysis, remarkable because this analysis is so fundamental for neoclassical economics, while its explicit use by business and government has apparently been very limited, at least until recently.’
15. In fact, a much richer principal-agent model is implicit in the Arthashastra. The utility functions of the principal and agent may be specified as follows:
UP (w, E (w), F (w), M, EE)
UA (w, E)
Where E denotes the agent’s effort, which depends on the wage package but also on its fairness, moral incentives (M) and employer’s ethics (EE). The principal offers a package (w) (of wage, and supervision etc.) and ensures fairness and participation in the designing of the package and consults frequently during the execution of the task. For example, differentiating with respect to w gives
əUP/əw + (ə UP/əE) (əE/əw) + (ə UP/əE) (əE/əF) (əF/əw) The first term is the cost of the package to the principal and the second term captures its effect on the agent’s effort, if all other things are held constant. But the third term captures the effect of other attributes of the package. If the agent considers the package to be fair, and the principal to be ethical, it is positive, that is he works harder.
16. B Frey and R Jegan (2001) provide a very illuminating survey on the possibilities of crowding out and crowding in, resulting from material incentives. R Benabou, and J Tirole (2003) offer a very rigorous and in-depth analysis of extrinsic incentives and their impact on intrinsic motivation.
Benabou, and Tirole use ‘The Looking-glass self ’ concept in capturing the psychological effect of the material incentives on an agent’s self-esteem or self-confidence. Incidentally, Kautilya was aware of the concept but not the phrase ‘The Looking-glass self ’: For example, he (1992, p 205-6) advised a courtier, ‘He shall watch carefully the king’s gestures and expressions; a wise man will know the mind of another who is trying to reach a decision by looking out for the following: liking and hatred, joy and distress, resoluteness and fear. That the king is satisfied with a courtier is shown by the following: looking pleased at the sight of the courtier, returning his greeting, giving him a seat,… giving orders with a smile. That the king is dissatisfied with a courtier is shown by the following opposite indications: looking angry at the sight of the courtier, ignoring or not returning his greeting, neither giving a seat nor looking at him.’
However, A J Marr (2005) challenges the distinction between intrinsic and extrinsic distinction. He asserts, ‘The intrinsic vs. extrinsic motivation controversy is a sham because distinctive intrinsic and extrinsic motivational processes simply do not exist.’ He adds, ‘The unified principle of reinforcement that is emerging from neuroscience casts doubt on many widely accepted categories of motivation due to the simple fact that they have no distinctive neural correlates, and can be more parsimoniously explained as the emergent properties of very simple neural processes that underlie all behavior.’
17. David B Montgomery and Catherine A Ramus (2003) explored whether businesses’ ethical standards, environment friendliness and caring about employees attracted MBAs. They report, ‘Overall they were willing to forego 11.9% of their mean expected income to work for an organization exhibiting all three characteristics.’
18. George Akerlof (19
83) believes that it may be possible to move a child from being immoral to moral. He remarks, Values are not fixed, as in standard economics, but are a matter of choice. Economic theory, which is largely a theory of choice, then becomes a useful tool in analyzing how these values are chosen. Most parents attempt to choose values for their children (and perhaps for themselves) according to their economic opportunities that allow them to get along economically.’ He adds, ‘It pays parents to teach honesty and class loyalty because the appearance of honesty and class loyalty are beneficial; the easiest way to achieve these appearances is to be honest and loyal, even though honesty and loyalty themselves involve sacrifices.’
19. Carl Shapiro and Joseph Stiglitz (1984) analyze possibility (i), the tradeoff between monitoring (supervision) and paying an efficiency wage to reduce shirking. They find, ‘The critical wage, w, is higher the lower the probability of being caught shirking.’ Dilip Mookherjee and Ivan P L Png (1992) explore possibility (ii), the trade-off between monitoring and investigation. They assert, ‘To regulate employees’ effort, an employer could hire supervisors to monitor the workers or, instead, rely on reports from dissatisfied customers.’
20. Kautilya was a very sophisticated thinker. According to him, a king should anticipate his advisers’ apprehensions in case of undesirable outcomes resulting from their advice and take appropriate measures to retain them. He (1992, p 636) asserted, ‘The king becomes angry and the counselors afraid when a campaign, undertaken on the advice of the counselors, fails to produce the gain predicted by them, but leads to losses and expenses. Counselors frightened of punishment may rebel. When the king gains from a campaign, disregarding the advice of traitorous counselors, then too the king becomes angry and the counselors afraid that the successful king will kill them for giving wrong advice. This too may make them rebel. When a campaign undertaken on the advice of trustworthy counselors achieves the objective or when a campaign undertaken disregarding the advice of untrustworthy counselors fails--in both cases the net result pleases all.’ Kautilya’s ideas on the relationship between accepting advice from trusted or nontrusted advisers and success or failure of a campaign may be expressed by Matrix 11.2:
Kautilya- the True Founder of Economics Page 39