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# The contemporary theory of what is standardly referred to as economic

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The contemporary theory of what is standardly referred to as economic  [#permalink]

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Updated on: 17 Oct 2019, 23:02
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This is not a GMAT Like question, topic is archived and locked.

The contemporary theory of what is standardly referred to as economic rationality is descended from Adam Smith’s egoistic model of economic behaviour; it is based on a much more sophisticated and quantitatively precise but still-idealized model of the psychology of individual choice. The modern discipline of decision theory has permitted a great increase in the exactness of what we can say about this type of human motivation, by introducing quantitative measures of subjective degrees of belief and subjective degrees of preference.

If, for example, on a cloudy day you have to decide whether or not to take an umbrella when you go out, you face four possibilities: (1) rain and umbrella; (2) no rain and umbrella; (3) rain and no umbrella; (4) no rain and no umbrella. Obviously, your decision will depend both on your estimate of the likelihood of rain and on how much you mind getting wet, or alternatively how much you mind carrying an umbrella when it isn’t raining, but decision theory makes this more precise. It says your choice is explained by the fact that you assign a probability p between zero and one to the prospect of rain, and (ignoring misty in-between states) a probability of one minus p to the prospect of no rain, and that you assign a desirability, positive or negative, to each of the possibilities (1) to (4). By multiplying the probability and the desirability for each of these outcomes, one can calculate what is called the “expected value” of each of them, and therefore the expected value of taking an umbrella and of not taking an umbrella. The rational choice is to do what has the higher expected value.

Decision theory applies this kind of calculus to choices among alternatives of any complexity, with any possible assignment of subjective probabilities and desirabilities. With the help of game theory, it can be extended to multi-person interactions, as in a market economy. Decision theory assigns these supposed quantifiable psychological states to individuals only on the basis of an idealization. They are not discovered by asking people to report their subjective probabilities and desirabilities: in general, people do not have introspective access to these numbers. Rather, precise psychological states of this type are assigned by the theory itself, on the basis of something to which people do have access, namely their preferences or rankings (better, worse, indifferent) among alternatives.

This by itself does not imply that the states are fictional: real but unobservable underlying causes can often be inferred from observable effects. The fiction comes from the way the inference proceeds in this case. Given a sufficiently extensive set of preferences (rankings of alternatives) by an individual, it is possible, employing relatively simple laws, to assign to that individual a set of subjective probabilities and desirabilities that would account for those preferences,if the individual were rational in the sense of the theory. But since rationality in the sense of the theory involves such superhuman capacities as immunity to logical error, instantaneous calculation of logical consequences, and assigning equal probability and desirability to all possibilities that are logically equivalent, it is clear that no actual humans are rational in this sense. So if we use the theory of economic rationality to think about the behaviour of real human beings, we are treating themas if they were super-rational; we are employing a useful fiction, which allows us to bring human action under quantitative laws.

The fiction is useful only for certain purposes. If it is not to lead us astray, we have to recognise the ways in which it deviates from reality, and to correct for those deviations when they make a difference that matters. This is, in fact, the concern of the recently developed field of behavioural economics, which tries to identify the consequences of systematic deviations of actual human behaviour from the standards of classical economic rationality. For example, people often fail to count logically equivalent possibilities as equally desirable: an outcome described in terms of the probability of death will be evaluated differently from the same outcome described in terms of the probability of survival.

If we try to formulate laws of human psychology, we will inevitably have to ignore a great deal of the messy complexity of actual human life. This is sometimes legitimate, provided that we recognize the idealization and are prepared to restore the complexity when necessary—when, for example, assuming the rationality of every free market would send us off an economic cliff.
1-The main conclusion of the passage is that the theory of economic rationality

A=is a flawed theory that is based on an incorrect view of human nature

B=relies on an unrealistic view of human behaviour that has now influenced decision theory

C=is incompatible with actual human behaviour and knowing its limitations can help economies avoid major pitfalls

D=no longer valid since it ignores the fact that human behaviour often operates outside the boundaries of rationality.

2-The author is most likely to agree with all of the following statements about psychological states as used in decision theory EXCEPT?

A-Not all psychological states are necessarily quantifiable.

B-Psychological states are fictional and hence unobservable.

C-Precise psychological states are not defined by people but by decision theory.

D-People cannot quantify the desirability of a psychological state but can only indicate a preference or lack of it for the same.

3-“If we try to formulate laws of human psychology, we will inevitably have to ignore a great deal of the messy complexity of actual human life”. Which of the following best captures the reason why the author makes this statement?

A-Human behaviour is too vast and varied to be codified into simple laws.

B-Human behaviour is unpredictable and does not conform to laws.

C-Human beings are incapable of consistently making rational choices.

D-Human behaviour cannot always be explained in psychological terms.

Originally posted by AmarRajput on 01 Aug 2018, 07:11.
Last edited by SajjadAhmad on 17 Oct 2019, 23:02, edited 8 times in total.
Updated - Complete topic (1031).
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Re: The contemporary theory of what is standardly referred to as economic  [#permalink]

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01 Aug 2018, 07:13
i was not able to put question close to timer , bcz i dont knw so pardon me
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Re: The contemporary theory of what is standardly referred to as economic  [#permalink]

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01 Aug 2018, 07:45
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AMAR RAJPUT wrote:
i was not able to put question close to timer , bcz i dont knw so pardon me

amar RAJPUT

Here are the rules to be followed while posting the RC questions. Please follow them and you should be able to nicely format the question as per the rules. I will let you do the formatting so you know how to do it.

https://gmatclub.com/forum/rc-forum-rul ... 55874.html
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Re: The contemporary theory of what is standardly referred to as economic   [#permalink] 01 Aug 2018, 07:45
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