Economic Rationality under Uncertainty

Though uncertainty pervades all aspects of life and human action, it has a rather short history in economics. Surprisingly, Daniel Bernoulli’s (1738) notion of expected utility, which suggests that (in games of chance) monetary risky ventures ought to be evaluated by the sum of utilities of outcomes weighted by the corresponding probabilities, was not immediately used in economic theory. Indeed, the idea that risk and uncertainty are relevant for economic analysis was clearly suggested by Frank Knight (1921) in his famous book Risk, Uncertainty and Profit. The formal incorporation of the notion of risk (i.e., uncertainty with exogenously given probabilities) through the expected utility model was only accomplished in 1944 by John von Neumann and Oscar Morgenstern in their Theory of Games and Economic Behavior. The main contribution of this work was the explicit formulation of rational foundations for the use of expected utility in individual decision-making under risk. Subsequently, the expected utility rule was derived from elementary postulates of rationality without imposing objective probabilities by Leonard Savage in his classic Foundations of Statistics (1954). In the Savagian theory, utility and subjective probabilities are both inferred from preferences. A theory of choice (under uncertainty) may be seen from two points of view: normative and descriptive. The normative point of view considers some of the formal axioms of choice theory as rules of rational behavior. Such rules, often formulated as logical implications, are justified in terms of consistency. The simplest example of a consistency requirement which has a normative appeal in choice theories is transitivity. If a decision maker prefers A to B and prefers B to C, then (s)he should prefer A to C. In expected utility theory, the independence axiom (von Neumann and Morgenstern) and the sure-thing principle (Savage) are the main consistency rules. The descriptive point of view focuses on the ability of the theory of choice to account for observed behavior. This point of view boils down to see whether the observed behavior is consistent with the rationality rules behind the model under consideration. Consequently, if people persistently choose in a manner that contradicts these rules, then the canons of rationality used should be questioned. In the case of the expected utility model, the confrontation between observed individual behavior and the rationality principles behind the expected utility rule was mainly realized through laboratory experiments. This confrontation considerably deepened the debate on rationality under