Despite these diffi culties, economists generate predictions using rational-choice theory and test them using empirical methods. They have done so by making certain assumptions concerning rational behaviour.
First, rationality implies decision making consistent with a cost–benefi t inquiry. This need not entail an explicit weighting of the pros and cons of available options. It is enough if a person implic- itly considers the relative virtues of alternatives and chooses the one that best satisfi es her preferences. This need not even entail conscious deliberation. From this perspective, a person chooses to engage in negligent conduct, to breach a contract, or to commit a crime if the perceived private benefi ts of doing so exceed the private costs. That is why the law can spur more desirable behaviour, principally by altering the private cost, and hence relative demand for, certain courses of conduct.
Second, a rational actor’s preferences are “complete” and “transitive”. Completeness means that an individual can ordinally rank her consumption options. 3 This assumption allows a person to be
indifferent between two or more alternatives. The quality of transitivity means that preferences are consistent, such that if a person prefers good B to good A, and would rather consume good C than B, it necessarily follows that that individual would prefer good C to good A. This assumption features in the theory of consumer choice, specifi cally with respect to the existence of non- overlapping indifference curves. If his preferences were intransitive, a consumer would be unable to make a utility maximising consumption decision. A simple example of intransitivity would entail a choice between rock, paper, and scissors in the well- known children’s game.
There is reason to believe that the assumptions of completeness and transitivity hold in at least some circumstances. The reason is that people violating these assumptions would suffer losses as a result. For instance, assume that a person prefers an Audi A6 to a Lexus IS250, prefers a BMW 535i to an Audi A6, but yet prefers the IS250 over the BMW. Suppose that he currently owns the Lexus IS250 but willingly parts with it and pays an additional premium to get the Audi. Having done so, however, he would still prefer the BMW. So, he gives up the Audi and pays a further premium for the BMW. Of course, given the intransitive preferences just described, this person would then trade in the BMW for the Lexus, obviously losing money along the way. The result is that he ends up where he started, except that he is poorer.
3 An ordinal ranking is an ordering of preferred outcomes, such as: fi rst, second, third, and so on. Cardinal rankings, in contrast, assign numbers to each outcome that have consistent meanings and that are thus comparable. Examples of the latter include weight, height, age, and income. All cardinal rankings are also ordinal, but not all ordinal rankings can be assigned cardinal rankings.
More generally, if people learn over time, one would expect irrational behaviour to be ephem- eral. The same principle should apply to the selling side of the market, as companies that consistently fail to act rationally and maximise profi t will ultimately fi nd themselves subject to insolvency, takeover, or shareholder challenge. This is particularly likely to be true in competitive markets.
Third, economists generally assume that rational actors’ preferences display “strong monoto- nicity”. This term captures the idea that more is better, and thus assumes a lack of satiation. Companies will always seek to make more profi t than less. If a consumer likes a product, he will necessarily prefer a greater quantity of the good. Under this simplifying assumption, rational consumers will always maximise their consumption set subject only to their budget constraints. This implies that consumers will spend all of their income, such that the rational consumption choice lies on the budget line. This assumption permits economists to create models that they can solve as constrained optimisation problems.
Fourth, a rational person treats “sunk costs” as irrelevant. The fact that she may have spent considerable amounts of money on a project, or have devoted considerable effort to it, does not impede her eschewing that project should an alternative path subsequently promise to be more fruitful. Bygones are bygones. For example, the fact that a person may have invested several years and much capital in pursuing an education in medicine should have no impact on his decision to abandon his course of study if he realises that another professional avenue would yield greater rewards, comprising both pecuniary and non- monetary satisfaction.
Fifth, in choosing between alternatives that offer probabilistic outcomes, a risk- neutral, rational actor will rank those alternatives by the “expected value” of each. 4 Thus, for example, if option A
would provide a 10% chance of receiving £500, while option B would yield a 20% chance of £400, a risk- neutral rational actor would choose option B because its expected value of £80 exceeds that of option A (£50).
Sixth, for simplicity, many neoclassical models assume that rational individuals maximise their fi nancial well- being independent of perceived issues of fairness. On this view, an economically rational decision maximises profi t. A well- known example involves the “ultimatum game” in which two people are given a sum of money (say £100) on the condition that they agree on how to divide it. One party will make an offer dividing the sum in any way she sees fi t (e.g. £50/£50, £20/£80, £0.01/£99.99, etc.), which the other party can either accept or not. There is no negotiation. If the offeree accepts, the parties get the money on the offered terms. If the offeree rejects, neither party gets anything. Neoclassical- economics theory predicts that the offeror would suggest a division of £0.01/£99.99, which the offeree would accept because he would be better off with one penny than with no money at all. Note, however, that this aspect of rationality assumes that fairness and altruism do not form part of the relevant actor’s utility function. One can relax this assumption as part of the neoclassical model of rational choice, though doing so complicates analysis.
Some take issue with characterising human behaviour by reference to the formal calculation of costs and benefi ts. This discomfort emanates in part from the fact that few people explicitly tally quantitative benefi ts and disadvantages in choosing between substitutable forms of conduct. People for whom the rational choice feature of law and economics seems unpalatable may take comfort in the fi eld of behavioural law and economics. This fi eld of economic analysis draws on cognitive psychology to enrich the assumptions underlying economic models, thus generating models giving rise to more- accurate predictions. This book introduces behavioural economics in
Part 9.
4 “Expected value” is the mean or average of a random variable. One can calculate this value by multiplying each possible outcome by the likelihood of its occurrence, and then by adding all of the resulting values. For instance, a bet in which a person rolls a dice and gets £10 for a 6, £8 for a 5, and £0 for any of a 1 to 4 possesses an expected value of £3 (£10*[1/6] + £8[1/6] + £0[4/6]).
DECISION MAKING IN THE PRESENCE OF RISK | 37
Yet, much scepticism of rational-choice theory fl ows from inadequate understanding. Neoclassical economics does not purport to describe the manner in which individuals make deci- sions. Rather, it is a theory of behaviour, designed to predict market- level conduct. Law and economics does not provide a descriptive account of the mental process by which individual people elect to act as they do. The theory does not seek to capture every independent variable that infl uences a person’s choice. Instead, it provides a simplifi ed model of human behaviour, which enables econo- mists to demarcate theoretically implied explanatory variables. Economists can, in turn, run regres- sions using empirical data to determine whether a statistically signifi cant relationship exists between the independent variable being considered and the dependent variable (typically, behav- iour). Having identifi ed such a relationship, law-and-economics theory can then inform the legis- lature and judiciary as to the consequential effects of the law.
Finally, it is worth noting that law and economics, with its focus on rational responses to incentives, is least controversial in the setting of explicit market phenomena. These include the fi elds of competition and regulation, discussed in Part 8. Rationality is more divisive, however, when applied to settings in which regular market transactions involving tangible goods or services do not occur. The idea of a person’s engaging in a cost–benefi t calculus in deciding whether to commit a crime, to marry, or to drive recklessly strikes some observers as implausible.
Yet, it is no requisite of an effective theory that it accurately characterise the manner in which people make decisions. Instead – and this is the crucial point – the relevant question is whether the theory yields useful predictions concerning the manner in which a relevant population reacts to incentives. Law-and-economics theory predicts, and with few exceptions empirical literature confi rms, that people respond to incentives. If society increases the relative price of a crime, neoclassical economics would predict that marginal consumers (in this example, criminals who are on the fence as whether to commit the prohibited act) will substitute the relevant crime for what are now more attractive activities. Empirical research bears out this hypothesis, which is, in turn, a vindication of theory.
Of course, the theory does not provide a perfect account of market- level behaviour. The “R 2 ”,
which is a measure of the correlation between the explanatory variables of a model and observed data, is less than one because the correlation is imperfect. In Part 9, we will consider whether a behavioural account of law and economics can lead to systemically superior predictions. We will see that the answer is a qualifi ed yes, though the behavioural law and economics literature does not yet enjoy a comprehensive theoretical foundation.