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New paper on Armen Alchian, behavioral economics, and the firm

I have just posted a new paper, “Uncertainty, Evolution, and Behavioral Economic Theory” on SSRN (co-authored with Geoffrey Manne). The upshot of the paper is that even if the findings of behavioral economics are sound and robust, those findings have little relevance for understanding or predicting the behavior of firms. Drawing on a classic article by Armen Alchian, we argue that even if individual actors within firms are irrational or biased, it is still possible and accurate to predict firm behavior as if those firms are rational actors. We also suggest that it is possible that what looks like inefficient behavior of firms, especially with respect to their internal organization, may in fact be a response to certain biases by individuals within the firm. And we throw in a swipe at the “shrouded fees” literature to boot.

The article was written as a contribution to a symposium held at George Mason in the fall on “The Unique Contributions of Armen Alchian, Robert Bork, and James Buchanan to George Mason University School of Law” and will be published in George Mason’s Journal of Law, Economics and Policy. Thus, while some of the points made in the article echo observations made by previous scholars, those lessons have not been fully digested, thus Geoff and I were happy to take up the invitation to write this piece.

Here’s the abstract:

Armen Alchian was one of the great economists of the twentieth century, and his 1950 paper, Uncertainty, Evolution, and Economic Theory, one of the most important contributions to the economic literature. Anticipating modern behavioral economics, Alchian explains that firms most decidedly do not – cannot – actually operate as rational profit maximizers. Nevertheless, economists can make useful predictions even in a world of uncertainty and incomplete information because market environments “adopt” those firms that best fit their environments, permitting them to be modeled as if they behave rationally. This insight has important and under-appreciated implications for the debate today over the usefulness of behavioral economics.

Alchian’s explanation of the role of market forces in shaping outcomes poses a serious challenge to behavioralists’ claims. While Alchian’s (and our) conclusions are borne out of the same realization that uncertainty pervades economic decision making that preoccupies the behavioralists, his work suggests a very different conclusion: The evolutionary pressures identified by Alchian may have led to seemingly inefficient firms and other institutions that, in actuality, constrain the effects of bias by market participants. In other words, the very “defects” of profitable firms – from conservatism to excessive bureaucracy to agency costs – may actually support their relative efficiency and effectiveness, even if they appear problematic, costly or inefficient. In fact, their very persistence argues strongly for that conclusion.

In Part I, we offer a short summary of Uncertainty, Evolution, and Economic Theory. In Part II, we explain the implications of Alchian’s paper for behavioral economics. Part III looks at some findings from experimental economics, and the banking industry in particular, to demonstrate how biases are constrained by firms and other institutions – in ways often misunderstood by behavioral economists. In Part IV, we consider what Alchian’s model means for government regulation (with special emphasis on antitrust and consumer protection regulation).

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