Cognition and Economics: Volume 9

The cognitive sciences, having emerged in the second half of the twentieth century, are recently experiencing a spectacular renewal, which cannot leave unaffected any discipline that deals with human behavior. The primary motivation for our project has been to weigh up the impact that this ongoing revolution of the sciences of the mind is likely to have on social sciences – in particular, on economics. The idea was to gather together a diverse group of social scientists to think about the following questions. Have the various new approaches to cognition provoked a crisis in economic science?¹ Should we speak of a scientific revolution (in the sense of Kuhn) also in contemporary social sciences, occurring under the growing influence of the cognitive paradigm? Above all, can a more precise knowledge of the complex functioning of the human mind and brain advance in any way the understanding of economic decision-making?

Cognition and psychology have become central issues in economics. While this interest represents a radical change in economic theory, it does have a useful history that we believe is only partially recognized by contemporary economists. Although it is customary to cite Herbert Simon's important work in this regard,¹ we suggest Hayek's earlier work The Sensory Order (1952) should enjoy similar billing.

As the cognitive sciences – particularly neuroscience, cognitive psychology, and a rejuvenated artificial intelligence movement that has largely abandoned the model of the mind as a formal machine – have seen major development over the past quarter-century, it is inevitable that the findings thrown up by this ‘cognitive revolution’ should be examined for their relevance to the understanding of economic behavior. This ongoing examination has tended to emphasize those characteristics of human cognitive capabilities that call into question the descriptive adequacy of the rational-choice model, focusing on departures from individual rationality that may have economic consequences at the market level.¹ Such a move may be the obvious one for an economist confronted with this interdisciplinary challenge, but it is not the only one. The new insights into the functioning of the brain can also be deployed in the understanding of complex systems in general – and of specific social arrangements in particular – and that is the direction taken here. By critically examining the systemic similarities and differences between the social arrangements of science and market, the aim is to show how a complex systems approach, inspired by developments in cognitive psychology but applying these at the level of the system rather than of the individual, can provide a new and useful way of understanding social systems.

All through last century, the Austrian School of Economics introduced a series of original and interesting ideas into social sciences, which are still fruitful for contemporary research. We are not referring only to the ideas that are particularly relevant in economics, such as marginal utility, competition, market, entrepreneur, time irreversibility, information, risk, uncertainty, economic cycle, money, theory of capital, public choice, to mention only the most relevant ones. What we have in mind is ideas relevant for all social sciences: methodological subjectivism, apriorism, human knowledge, human action, decision making, praxeology, human freedom, evolution, nature and role of institutions. The ideas expressed by the authors belonging to this school are often so heterogeneous, that they are rather a composite collection of ideas than a single consistent corpus. Nevertheless, a few common aspects characterize the school as a whole.

In much of philosophy and social theory since classical antiquity, human belief and reason have been placed in the driving seat of individual action. In particular, social theory has often taken it for granted, or even by definition, that action is motivated by reasons based on beliefs. In contrast, a minority has criticized the adoption of this ‘folk psychology’ that explains human action wholly in such ‘mind first’ terms. Critics point out that such explanations are a mere gloss on a much more complex neurophysiological reality. These dualistic and ‘mind-first’ explanations of human behavior are unable to explain adequately such phenomena as sleep, memory, learning, mental illness, or the effects of chemicals or drugs on our perceptions or actions (Bunge, 1980; Churchland, 1984, 1989; Churchland, 1986; Rosenberg, 1995, 1998; Kilpinen, 2000).

In this paper I employ the perspective of embodied cognition to develop a ‘cognitive’ theory of the firm and organisations more in general. An organisation is any form of coordinated behavior, while a firm is a special form of organisation, with a legal identity concerning property rights, liability and employment. A possible misunderstanding of terminology should be eliminated from the start. In this paper, the terms ‘knowledge’ and ‘cognition’ have a wide meaning, going beyond rational calculation. They denote a broad range of mental activity, including proprioception, perception, sense making, categorisation, inference, value judgments, and emotions. Following others, and in line with the perspective of embodied cognition, I see cognition and emotion (such as fear, suspicion), and body and mind, as closely linked (Merleau-Ponty, 1942, 1964; Simon, 1983; Damasio, 1995, 2003; Nussbaum, 2001).

The phenomenon of the ethnically homogeneous middleman group (EHMG) or ethnic trade network – the Chinese merchants in Southeast Asia, the Gujarati-Indians merchants in East Africa, the Jewish merchants in medieval Europe, etc. – is ubiquitous in stateless societies, pre-industrial and in less-developed economies (Curtin, 1984). Neoclassical (Walrasian) theory of exchange cannot explain the existence of merchants let alone the phenomenon of the EHMG. This is because Neoclassical theory of exchange is a static theory of frictionless, perfectly competitive markets with the Walrasian auctioneer costlessly coordinating the plans of anonymous producers (sellers) and consumers (buyers) so as to achieve equilibrium. There is no role for merchants in the Neoclassical theory of exchange.

In recent years, traditional legal systems have been increasingly challenged by the rapid and wide-ranging changes induced by modern technology and science which constantly transform our economies and societies. The rise of a new type of scholarship in contemporary legal thought can be understood in the light of the growing disjunction between the traditional methods of law dealing with social problems and the overall pragmatic spirit of the globalized economies. The intrinsic conservatism of traditional law is sometimes (more or less explicitly) accused of being inadequate to cope with the problems raised by the application of new technologies and sciences, or worse, of being an impediment to the development of the full potential of the modern economies.

The first issue that requires examination is the question of how we got to this point to begin with. The answer to this question, of course, is a function of who “we” happens to be. The lawyers can blame Oliver Wendell Holmes (1897, p. 469), who made “the man of the future … the man of statistics and the master of economics.” The future, it would seem, is now. Legal Realist/Institutionalist lawyer-economists such as Walton Hamilton and Robert Lee Hale, who were economists on law school faculties before that tradition got started at Chicago, had something to do with this too, although neither they nor law-minded economists such as John R. Commons can be given credit or blame for the economic analysis of law – at least not directly.³ The birth of the economic analysis of law is very much a Chicago story – Coase, Becker, and Posner – although we must allow that Guido Calabresi also had more than a bit to do with these things.⁴

This project of derivation that I have just described may seem strange, but is not. In this as in many respects Plato set the fashion for the millennia to come. The ideal state sketched in the Republic is not only an analogy to the soul (though it is that too); it is an implication of Plato's conception of human mental capacity, a conception that is ontological as well as epistemological. It was Plato who, according to Aristotle, first separated a universal (i.e., a concept) from particulars (i.e., a concept's physical embodiments or expressions). There are a multitude of chairs, very different in size, shape, color, and design, yet there is also a concept of the “chair,” in which all the physical chairs participate. The concept has no physical body and therefore in a sense exists outside time and space – it is immaterial and eternal. But Plato believed, reasonably as it seems to me, that it is real. It is real in the same way that a line or circle in Euclidean geometry is real even though it is not identical to any physical line or circle and cannot be – the Euclidean line has only one dimension, and the Euclidean circle only two, and there are no one-or two-dimensional objects in the physical world (although electrons are dimensionless), as far as we know.

The “winner's curse” (or, more precisely, failure to account for the winner's curse) was one of the first behavioral “anomalies” to be discussed in the literature. The idea dates back to 1971, and was first applied to the bidding for oil drilling rights (See Capen, Clapp, & Campbell, 1971). The winner's curse is the phenomenon of systematically upward-biased winning bids in an auction market. That is, the winning bid in an auction tends to be much higher than some objectively defined value of the good.² The basis of the anomaly is relatively simple. In an auction with a large number of buyers, each possessing imperfect information concerning the value of the auctioned good, there will be a spread of estimated values. If buyers possess rational expectations, we will expect roughly half (assuming a symmetric distribution of estimates) of the bidders to overestimate the value of the good, and roughly half to underestimate its true value. If buyers naively bid their estimated value of the good, the winning bid will equal the most extremely over-valued estimate. Thus, the winning bid will not only be an overestimate of the good's true value, but it will be the most extreme overestimate made by any bidder. Hence, while on average an individual's bid may equal the actual value of the auctioned good, the winning bid will most likely be a severe overestimate of the good's value. For this reason, bidders who naively bid their estimated value at an auction will tend to regret winning.