The assumption of hounded rational economic man

Simon w'as a leading critic of the concept of complete rationality of economic man. In 1949, Simon and other political scientists, economists, engineers, and psychologists conducted joint research on organizations and management. Simon (1997) argued that the premises of the rational model w'ere to postulate that the decision maker knew' all the possible plans and outcomes. However, this is impossible in reality. He proposed five limiting factors of the rational choice model: (1) incomplete and imperfect information; (2) the complexity of the decision problem itself; (3) the limitations on the human ability to solve problems; (4) decisions being made w'ithin a period of time;

and (5) an individual’s understanding of the objectives of the organization being always inconsistent and controversial. Simon called these factors the limits of rationality and stated that decisions in reality were made with bounded rationality. Simon’s theory of bounded rationality implies that a person with bounded rationality will always try to maximize the utility function but with limited ability to gather and process information. This limited ability leads to the inevitable presence of private information. When one subject attempts to acquire information another already has, it is highly possible that the costs will come to outweigh the benefits. Even if an individual tries to disclose such information to another, the information may not be confirmed by the recipient. The introduction of information asymmetry has created new branches of microeconomics. The theoretic achievements of these branches are known as the incentive theory, contract theory, and agent theory. We can now modify Smith’s economic man to economic man with bounded rationality.

From transaction economic man to the contract economic man

As the father of institutional economics, Veblen initially incorporated institutions into the analytical framework of the relationship between the struggle for existence and human behavior. Veblen (1934) holds that the nature of institution was individual’s or society’s habit of considering relations and effects that were closely related to them. He believes that basic instincts establish the ultimate goals of human behavior and push human beings to achieve these goals through their efforts. Both personal and social actions are guided and dominated by instincts. These actions gradually form thoughts and habits and eventually form institutions. After the emergence of institutions, human behavior was restricted by those institutions. Institutions varied with environmental changes. The changing environment required people to change their thinking habits in response to environmental changes. The change in human behavior was an elimination process, the purpose of which was to adapt to the environment. Commons (1936) was the first to introduce economic activities of economic man from production to exchanges. In Commons’s work on institutional economics, transaction corresponds to production, a generalized concept in orthodox economics. According to Commons’s classification, the activity of production is a human activity of nature while the activity of transaction is a relation pattern between human beings. The production activity together with the transaction activity is composed of all human economic activities and ways of production. Commons holds that the basic unit of institutional economics is transaction, and the operation of institution is completed by numerous transactions. Commons classified transactions into three basic types: (1) bargaining transactions—the major form of activities of institutions in the market economy; (2) managing transactions—the relationship between orders and obedience; and (3) rationing transactions—the relationship between individuals and government. Commons argues that the three types of transactions covered all interpersonal activities, and different economic institutions could be viewed as different combinations of these basic types of transactions. Commons used transaction as the basic unit of institution to establish his framework of institutional economics. From the relationship of transactions among economic men, the institutional structure is at the heart of the activities of economic man. The behavior of any economic man is founded on voluntary exchanges and reciprocity, and transactions naturally become the object of institutional design and institutional change. At this time, the economic man described by Commons became the “transaction economic man.”

The difference between institutional economics and new institutional economics lies in the existence of transaction costs. Commons (1936) conducted a thorough analysis on transactions, but transactions occurred almost instantaneously and did not require any costs. The term “transaction costs,” coined by Coase (1995), is a central concept in new institutional economics. Transaction costs are an effective theoretical tool when analyzing all types of organizations and social activities. Transaction costs include the costs of collecting market information and implementing the contract and the costs of measuring, defining, and certifying property rights, the costs of finding both the objects of transactions and the transaction prices, the bargaining costs, the costs of signing contracts, the costs of enforcing and monitoring contracts, and the costs of maintaining transaction order. Transaction cost economics, represented by Williamson (1975), categorized transaction costs in both the broad and the narrow sense. Transaction costs in the narrow sense refer to the relative expenses incurred in the transfer and exchange process of property rights, which are outside the narrowly defined production process, whereas transaction costs in the broad sense refer to the operating costs associated with institutional changes. Hence, transaction costs have a general definition and become the costs of running an economic system. We can say that transaction costs are the source of institutions.

Therefore, unlike economic man, the postulated person in neoclassical economics, human behavior is not based on perfect information or complete rationality to maximize profit. Instead, the pattern of human behavior is based on motivations and the understanding of the environment. In terms of motivation, individuals pursue the maximization of wealth on the one hand, but, on the other hand, they will sacrifice some short-term benefits to achieve the goals of societal value such as reputation, faith, and altruism. In terms of their understanding of environment, individuals are always subject to imperfect information; therefore, their rationality is bounded, and their optimal decisions are unattainable. Under the condition of imperfect information, it is impossible for a person dominated by different motivations to live without friction as described by neoclassical economics. Transaction costs are similar to friction. New institutionalism introduces economics to a world with friction from a frictionless world. Different organizations and institutional arrangements used for reducing transaction costs only appear in transaction cost economics. Transaction economic man, coined by Commons, has become transaction economic man with transaction costs. Economic man is now called “contractual economic man” or “institutional economic man.” Contractual economic man is, in an economic activity, under the premises of bounded rationality, a person who seeks transaction cost minimization to reduce the risk of opportunism and guarantee the enforcement of contracts.

The assumption of “power economic man”

The Coase theorem holds that the completeness of property rights depends on whether the owner of property rights has the exclusive use rights, the exclusive right to income, and the right of free transfer. After the property right is well defined, persons involved in an economic activity will negotiate with each other spontaneously to internalize an externality and to enhance resource distribution efficiency. In other words, as long as the property right is clearly defined, regardless of who owns it, private costs will not deviate from social costs. Theoretically speaking, private property rights and public ownership are not mutually exclusive. Private property rights require only that public ownership is voluntary rather than coercive. A “voluntarily consulted” contract, signed through market transactions, can lead to the best allocation of resources. The word “voluntary” is significant.

The emergence of contracts originates from labor division and transactions. The division of labor is a process whereby workers are assigned to particular professions. Transaction is the transfer of goods or services through different markets. People in different professions allocate their products by means of mutually beneficial exchanges to ensure labor division through the transaction and to attain the maximization of social welfare. Then, how is a contract formed? New institutional economics holds that the conclusion and arrangement of contracts are completed through two basic ways: one is voluntary, and one is coercive (usually the contract formed and controlled by government is coercive). The voluntary contractual arrangement is a cooperative arrangement made by individuals who have reached an agreement, and any individual can withdraw legally. This situation implies that consensus among decision makers is required. The costs to accept this decision are lower than the transaction cost of giving up the contract. While the coercive contractual arrangement does not provide the option of withdrawal, consensus is not required in an action, but decision rules should be respected and followed. New institutional economics emphasizes that a voluntary trading contract between economic subjects is carried out in accordance with the participant’s will. However, completely voluntary and completely coercive are two extremes. There may be many possible semi-coercive and semi-voluntary structures between these two extremes. What factors might be the basis for the choice between personal voluntary cooperation and governmental arrangement? To realize what choice economic subjects are willing to embrace depends on the domination of scarce resources. Similarly, the imposition of a coercive contract on others should be based on the domination of resources to which others become dependent; otherwise no one would accept coercion.

To illustrate various possibilities of willingness between voluntary trades and coercive trades, we define the term “willingness to trade.” In short, willingness to trade is the willingness of both economic subjects and economic objects to carry out a transaction. To be specific, willingness to trade refers to an economic subject’s spectrum of options concerning whether to trade with an economic object, under what range of conditions the trade will occur, and how to trade with the object based on the advantages of their economic resources. As the willingness to trade between the two parties increases, the likelihood of signing the contract and completing the transaction increases. The willingness to trade is inversely proportional to the transaction costs, which implies that the lower the transaction costs, the higher the willingness to trade. Conversely, the higher the transaction costs, the lower the willingness to trade. The intensity of willingness to trade depends on the influence of the subject on the transaction object; that is, the economic power. The size of the economic power of an economic subject determines the willingness to trade, the willingness to trade of two or more parties determines the amount of transaction costs, and the amount of transaction costs, in turn, determines the conclusion of contracts or institutions; that is, closing the deal.

Now, we propose the “power economic man” assumption. Power economic man refers to an agent who use economic power to affect the fulfillment and implementation of contracts in an economic activity to achieve maximum benefit under the premises of bounded rationality. Economic power refers to the economic subject’s ability to influence economic objects and to reach personal goals using their dominant resources. In this case, the extent of economic power is determined by the quantity and quality of resources controlled by economic subjects. The quality refers to the importance, scarcity, and substitutability of resources. The following chart illustrates the logical relationship of the formation of power economic man.

The economic man assumption is a historical concept, which has different connotations in different stages. Since Adam Smith, economists have made a series of assumptions concerning economic man: from pursuing maximum benefits to pursuing maximum utility; from complete rationality to bounded rationality; from complete self-interest to altruism. The power economic man proposed here is a theoretical discussion. Undoubtedly,

Power and economic power paradigm 39

Logical relationship of the formation of power economic man

Figure 2.1 Logical relationship of the formation of power economic man.

reinterpreting economic man has become a new trend in the development of economic frontiers. As economists deepen their understanding of human behavior, the assumptions concerning human nature will continue to evolve, and the scope of economic research will widen. With such a trend, assumptions concerning economic man will become increasingly realistic.

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