Arbitrage, Incomplete Models, and Other People's Brains

1. Introduction Over the last 50 years, the theory of rational choice has emerged as the dominant paradigm of quantitative research in the social and economic sciences. The idea that individuals make choices by rationally weighing values and uncertainties (or that they ought to, or at least act as if they do) is central to Bayesian methods of statistical inference and decision analysis; the theory of games of strategy; theories of competitive markets, industrial organization, and asset pricing; the theory of social choice; and a host of rational actor models in political science, sociology, law, philosophy, and management science. Rational choice theory is founded on the principles of methodological individualism and purposive action. Methodological individualism means that social and economic phenomena are explained in terms of " a particular configuration of individuals, their dispositions, situations, beliefs, and physical resources and environment " rather than in terms of holistic or emergent properties of groups. Purposive action means that those individuals have clear and consistent objectives and they employ reason to find the best means of achieving those objectives. They intend their behavior to cause effects that they desire, and their behavior does cause those effects for the reasons they intend. (Ordeshook 1986, Elster 1986) In most versions of the theory, the objectives of the individuals are expressed in terms of preferences: they choose what they most prefer from among the alternatives available, and the (only) role of social and economic institutions is to enable them to satisfy their preferences through exchange or strategic contests with other individuals This paper sketches the outline of arbitrage choice theory (ACT), a new synthesis of rational choice that weakens the emphasis on methodological individualism and purposive action and departs from the traditional use of preference as a behavioral primitive, building on earlier work by Nau and McCardle