The view that human behaviour can and ought to be explained by citing beliefs and desires is called folk psychology. Sometimes folk psychology is understood as ‘the body of information people have about the mind', which in return is regarded as the ‘basis for our capacity ti attribute mental states and to predict and explain actions'.
Behaviour is the more general notion that describes physical movements of the body that originate within the individual.
Not every reason an individual might have to perform an action also constitutes the reason that explains his or her actions. Rather, it is the reason the individual acted on that explains the action. When one acts on a reason such that the action is an effective means to one's end, one is said to act in accordance with instrumental rationality.
Ordinal choice theory: a model of decision making under certainty
Cardinal choice theory: a model of decision making under risk
Preferences: economists explain action by preferences which represent beliefs and desires. Preferences differ from desires. Most fundamentally, preferences are comparative, desires are absolute.
Standard economics focuses on revealed preference because economic data come in this form. Economic data can reveal what the agent wants (or has chosen) in a particular situation. Such data do not enable the economist to distinguish between what the agent intended to choose and what he ended up choosing; what he chose and what he ought to have chosen. If economists want to explain economic phenomena using preferences they must be able to estimate preferences from data accessible to them, and individuals' mental states are not normally accessible.
In sum, the two major axioms of ordinal decision theory are not incontrovertible from the point of view of rationality. Meeting a money pumper and accepting his offers, one better had transitive preferences over time. But this tells us little about other situations. Likewise, when one is forced to make a choice, one will, but that does not necessarily reveal a preference.
In decision making under risk, it is not known what outcome will obtain, but it is known what outcome might obtain and with what probability.
In decision making under uncertainty it is neither known which outcome will obtain nor the probability with which it will occur. In fact, such a probability might not even exist.
There are three main differences between decision making under certainty and under risk. First, the alternatives are interpreted as prospects, which are defined as the pairing of the consequences of an action with the probabilities of these consequences occurring when the action is taken. Second, in order to construct a representation of the agent's preferences by an (expected) utility function, a variety of additional assumptions are required.
Third, if an agent's preferences satisfy all axioms, these can be represented by an expected utility function that is unique up to a positive affine transformation.
Risk-neutrality means that an agent is indifferent between a playing lottery and receiving the expected value of the prospect for certain; that is, his expected utility of the prospect is identical to the utility if its expected value.
Risk-aversion means that an agent prefers receiving the expected value if the prospect for sure to playing the lottery.
Risk-loving means that an agent prefers playing the lottery to receiving its expected value for sure.
Experimental evidence suggests people seem to prefer an amount for sure to a gamble in which they have some chance of winning a higher amount but also some chance of winning nothing. By contrast, if they are in a betting situation anyway, they prefer the lottery with the higher expected payoff.
Any apparent violation of an axiom of the theory can always be interpreted as either of three things:
- The subjects' preferences genuinely violate the axioms of the theory
- The subjects' preferences have changed during the course of the experiment
- The experimenter has overlooked a relevant feature of the context that affects the subjects' preferences
Stability: individuals' preferences are stable over the period of the investigation
Invariance: individuals' preferences are invariant to irrelevant changes in the context of making the decision.
Principle of individuation by justifiers: outcomes should be distinguished as different if and only if they differ in a way that makes it rational to have a preference between them.The dilemma the economist faces, then, is this. He can either stick with the ‘formal axioms' of completeness, transitivity, strong independence and so on and refuse to assume the principles of stability and invariance. But then Rational Choice Theory will be useless for all explanatory and predictive purposes because people could have fully rational preferences that constantly change or are immensely context dependent. Alternatively he can assume stability and invariance but only at the expense of making Rational Choice Theory a substantive theory, a theory laden not just with values but with the economist's values. The economist then has to decide whether, say, presenting an analogous problem as a choice task and as a valuation task is the same thing; more generally whether framing a problem one way or another may reasonably affect someone's preferences; what relevant alternatives are; whether, to what extent and what social norms may matter; whether to conceive of a series of choices as a single choice problem or indeed a series of independent choices; and so on.