Masood Mortazavi's Weblog

Tuesday March 08, 2005

[ Economics ] Bounded Rationality and Contracts

Munich: Live webcam view of Marienplatz.
The contractual view of economics, as developed by the transaction cost economists, can be quite revealing. This view depends on two core behavioral assumptions used in transaction cost economics: bounded rationality and opportunism. The first has to do with cognitive limits of actors and the second with their self-interest-seeking tendencies.
This is what Professor Avinash K. Dixit says about bounded rationality in his book The Making of Economic Policy -- A Transaction-Cost Politics Perspective (Munich Lectures in Economics):

Orthodox economic analysis assumes that all individuals know the true model of the world and costlessly calculate their optimal actions, although the more recent versions recognize various informational limitations under which they do this calculation. TCE [Transaction Cost Economics] recognizes that the possible states of the world are very complex, and individuals' knowledge of the workings of the world is very imperfect. This affects the actions of individuals as well as the transactions among them. Most importantly, individuals cannot condition these transactions on extremely complex and even unknown future contingencies. In other words, all feasible contracts are necessarily incomplete. Therefore, ex post^[1] institutions (dispute-settlement mechanisms) are very important. But the very complexity of nature makes these mechanisms less than perfect--the state of the world may not be observable ex post, or even if observed by the parties to the contract, may not be verifiable to an outsider whose job is to enforce it.

To state that contracts cannot be complete because of "extremely complex and even unknown future contingencies" seems like a very obvious claim but we live in a world where scientism has taken a strong hold on people's thinking such that the general expectation takes future to be inherently predictable in all its facets (or at least in all its most important facets, according to some). In such a world, what was obvious in the past becomes less so and demands its due visit.

For a few other weblogs I've written about transaction cost economics, see here.

[1] ex post to the contract.

Economics, Transaction Cost Economics, Bounded Rationality, Cognition, Contracts, Munich, Institutions