In the opening words of his Principles, Alfred Marshall proclaimed economics to be a psychological science. Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing. Thus it is on the one side a study of wealth; and on the other, and more important side, a part of the study of man. For man's character has been moulded by his every-day work, and the material resources which he thereby procures, more than by any other influence unless it be that of his religious ideals. In its actual development, however, economic science has focused on just one aspect of Man's character, his reason, and particularly on the application of that reason to problems of allocation in the face of scarcity. Still, modern definitions of the economic sciences, whether phrased in terms of allocating scarce resources or in terms of rational decision making, mark out a vast domain for conquest and settlement. In recent years there has been considerable exploration by economists even of parts of this domain that were thought traditionally to belong to the disciplines of political science, sociology, and psychology.

DECISION THEORY AS ECONOMIC SCIENCE

The density of settlement of economists over the whole empire of economic science is very uneven, with a few areas of modest size holding the bulk of the population. The economic Heartland is the normative study of the international and national economies and their markets, with its triple main concerns of full employment of resources, the efficient allocation of resources, and equity in distribution of the economic product. Instead of the ambiguous and over-general term "economics," I will use "political economy" to designate this Heartland, and "economic sciences" to denote the whole empire, including its most remote colonies. Our principal concern in this paper will be with the important colonial territory known as decision theory. I will have something to say about both its normative and descriptive aspects, and particularly about its applications to the theory of the firm. It is through the latter topic that the discussion will be linked back to the Heartland of political economy. Underpinning the corpus of policy-oriented normative economics, there is, of course, an impressive body of descriptive or "positive" theory which rivals in its mathematical beauty and elegance some of the finest theories in the physical sciences. As examples I need only remind you of Walrasian general equilibrium theories and their modern descendants in the works of Henry Schultz, Samuelson, Hicks, and others; or the subtle and impressive body of theory created by Arrow, Hurwicz, Debreu, Malinvaud, and their colleagues showing the equivalence, under certain conditions, of competitive equilibrium with Pareto optimality. The relevance of some of the more refined parts of this work to the real world can be, and has been, questioned. Perhaps some of these intellectual mountains have been climbed simply because they were there - because of the sheer challenge and joy of scaling them. That is as it should be in any human scientific or artistic effort. But regardless of the motives of the climbers, regardless of real-world veridicality, there is no question but that positive political economy has been strongly shaped by the demands of economic policy for advice on basic public issues. This too is as it should be. It is a vulgar fallacy to suppose that scientific inquiry cannot be fundamental if it threatens to become useful, or if it arises in response to problems posed by the everyday world. The real world, in fact, is perhaps the most fertile of all sources of good research questions calling for basic scientific inquiry.

Decision Theory in the Service of Political Economy

There is, however, a converse fallacy that deserves equal condemnation: the fallacy of supposing that fundamental inquiry is worth pursuing only if its relevance to questions of policy is immediate and obvious. In the contemporary world, this fallacy is perhaps not widely accepted, at least as far as the natural sciences are concerned. We have now lived through three centuries or more of vigorous and highly successful inquiry into the laws of nature. Much of that inquiry has been driven by the simple urge to understand, to find the beauty of order hidden in complexity. Time and again, we have found the "idle" truths arrived at through the process of inquiry to be of the greatest moment for practical human affairs. I need not take time here to argue the point. Scientists know it, engineers and physicians know it, congressmen and members of parliaments know it, the man on the street knows it. But I am not sure that this truth is as widely known in economics as it ought to be. I cannot otherwise explain the rather weak and backward development of the descriptive theory of decision making including the theory of the firm, the sparse and scattered settlement of its terrain, and the fact that many if not most of its investigators are drawn from outside economics - from sociology, from psychology, and from political science. Respected and distinguished figures in economics - Edward Mason, Fritz Machlup, and Milton Friedman, for example - have placed it outside the Pale (more accurately, have placed economics outside its Pale), and have offered it full autonomy provided that it did not claim close kinship with genuine economic inquiry.

Decision Theory Pursued for its Intrinsic Interest

Of course the definition of the word "economics" is not important. Like Humpty Dumpty, we can make words mean anything we want them to mean. But the professional training and range of concern of economists does have importance. Acceptance of the narrow view that economics is concerned only with the aggregative phenomena of political economy defines away a whole rich domain of rational human behavior as inappropriate for economic research. I do not wish to appear to be admitting that the behavioral theory of the firm has been irrelevant to the construction of political economy. I will have more to say about its relevance in a moment. My present argument is counterfactual in form: even if there were no present evidence of such relevance, human behavior in business firms constitutes a highly interesting body of empirical phenomena that calls out for explanation as all bodies of phenomena. And if we may extrapolate from the history of the other sciences, there is every reason to expect that as explanations emerge, relevance for important areas of practical application will not be long delayed.

Aggregative Tests of Decision Theory: Marginalism

If some economists have erroneously supposed that microeconomic theory can only be tested by its predictions of aggregate phenomena we should avoid the converse error of supposing that aggregate phenomena are irrelevant to testing decision theory. In particular, are there important, empirically verified aggregate predictions that follow from the theory of perfect rationality but that do not follow from behavioral theories of rationality? The classical theory of omniscient rationality is strikingly simple and beautiful. Moreover, it allows us to predict (correctly or not) human behavior without stirring out of our armchairs to observe what such behavior is like. All the predictive power comes from characterizing the shape of the environment in which the behavior takes place. The environment, combined with the assumptions of perfect rationality, fully determines the behavior. Behavioral theories of rational choice - theories of bounded rationality - do not have this kind of simplicity. But, by way of compensation, their assumptions about human capabilities are far weaker than those of the classical theory. Thus, they make modest and realistic demands on the knowledge and computational abilities of the human agents, but they also fail to predict that those agents will equate costs and returns at the margin

Have the Marginalist Predictions Been Tested?

A number of empirical phenomena have been cited as providing more or less conclusive support for the classical theory of the firm as against its behavioral competitors (Jorgensen and Siebert, 1968). But there are no direct observations that individuals or firms actually equate marginal costs and revenues. The empirically verified consequences of the classical theory are always weaker than this. Let us look at four of the most important of them: the fact that demand curves generally have negative slopes, the fact that fitted Cobb-Douglas functions are approximately homogeneous of the first degree, the fact of decreasing returns to scale, and the fact that executive salaries vary with the logarithm of company size. Are these indeed facts? And does the evidence support a maximizing theory against a satisficing theory?

Theoretical Inquiries.

On the theoretical side, three questions seemed especially to call for clarification: what are the circumstances under which an employment relation will be preferred to some other form of contract as the arrangement for securing the performance of work; what the relation between the classical theory of the firm and theories of organizational equilibrium is first proposed by C. I. Barnard; and what are the main characteristics of human rational choice in situations where complexity precludes omniscience?

Summary

Thus, by the middle 1950's, a theory of bounded rationality had been proposed as an alternative to classical omniscient rationality, a significant number of empirical studies had been carried out that showed actual business decision making to conform reasonably well with the assumptions of bounded rationality but not with the assumptions of perfect rationality, and key components of the theory - the nature of the authority and employment relations, organizational equilibrium, and the mechanisms of search and satisficing - had been elucidated formally. In the remaining parts of this paper, I should like to trace subsequent developments of decision-making theory,

CONCLUSION

There is a saying in politics that "you can't beat something with nothing." You can't defeat a measure or a candidate simply by pointing to defects and inadequacies. You must offer an alternative. The same principle applies to scientific theory. Once a theory is well entrenched, it will survive many assaults of empirical evidence that purports to refute it unless an alternative theory, consistent with the evidence, stands ready to replace it. Such conservative protectiveness of established beliefs is, indeed, not unreasonable. In the first place, in empirical science we aspire only to approximate truths; we are under no illusion that we can find a single simple formula, or even a moderately complex one, that captures the whole truth and nothing else. We are committed to a strategy of successive approximations, and when we find discrepancies between theory and data, our first impulse is to patch rather than to rebuild from the foundations. In the second place, when discrepancies appear, it is seldom immediately obvious where the trouble lies. It may be located in the fundamental assumptions of the theory, but it may as well be merely a defect in the auxiliary hypotheses and measurement postulates we have had to assume in order to connect theory with observations. Revisions in these latter parts of the structure may be sufficient to save the remainder. What then is the present status of the theory of the firm? There can no longer be any doubt that the microassumptions of the theory - the assumptions of perfect rationality - are contrary to fact. It is not a question of approximation; they do not even remotely describe the processes that human beings use for making decisions in complex situations.

Highlight the main arguments made by the author.

Given Simon's analysis, reflect on business organizations, and their decision making processes.

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Answer Alfred Marshalls Principles of Economics begins by asserting that economics is fundamentally a psychological science emphasizing the study of i... View the full answer