What are the basic assumptions about human beings in economics?   Are these assumptions based on healthy human beings?  If not, can they be fine-tuned?

Nathalie Ishizuka applies the assumption about human fear and how it affects optimal decision making to the 2009 Nobel laureate Olivier Williamson’s, Transaction Cost Economics.

Economics is Based on Simple Assumptions about Human Beings
Economic models are based on simple assumptions about human beings.

Whereas traditional economic man is considered as omniscient and able to take into account the consequences of all alternatives, transaction cost economics (TCE) incorporates an understanding about human beings or human costs that include Herbert Simon’s (Nobel Prize, 1978) cognitive assumption of “bounded rationality” (from the little we do know, we make the best decision), and Oliver Williamson’s (Nobel Prize, 2009) behavioral assumption of “opportunism” (suggesting that transactions and organizations benefit from safeguards and the aligning of incentives).

Adding an Assumption about Healthy Human Beings to Economics
The assumption by Simon and Williamson are useful to understanding economic costs.  However, human beings do not only think (cognitive assumption of TCE economics) and act (behavioral assumption of TCE economics), but also feel. The question then becomes what emotion influences the make or buy decision?

Adding Affect: Fear
Based on her understanding of healthy human beings from Dr. Yukio Ishizuka‘s model of human personality,  Nathalie Ishizuka adds a healthy assumption about human affect (fear) to the make or buy decision.  According to Nathalie Ishizuka, the human affect fear implies we are not only “limited cognitively,” but even when we do know the best decision–due to fear–we may not always chose it.

Fear and other Economic Theories
Nathalie Ishizuka hopes that the assumption fear will be included in transaction cost economics (in Ishizuka’s viewpoint one of the most formidable paradigms in economics and organization).  She also follows with interest the work of Agency Theory by Michael Jensen.  While important work on fear in small decisions (gambling) in economics is notable, Ishizuka is not talking about risk aversion, but about how fear can lead us not to act optimally even when we know what is best for us. It is this type of fear that can place the economic system at risk.  In the future Nathalie Ishizuka wishes to work on how fear varies, and identifying the factors that are responsible for this variation.

The ‘Psychological’ Make or Buy Decision,
Ishizuka, Nathalie, “The Psychological Make or Buy Decision: Psychology and Transaction Cost Economics,” paper presented at the Academy of Management, Boston, August 1997.

ABSTRACT
Transaction cost economics is integrated with cognitive and affective aspects of ownership and contract.  Integrating these distinct streams of literature leads to a more comprehensive view of the “make or buy” decision, describing not only how individuals behave, but also how they think and feel within alternative exchange relationships.

EXCERPT

TRANSACTION COSTS ANALYTICAL ASSUMPTIONS
Transaction costs or the “costs of running the economic system” (Arrow, 1969: 48) are ultimately about human costs.  Once one recognizes that firms are “legal fictions” that serve as a nexus of “contracting relationships among individuals,” (Jensen & Meckling, 1976: 311) then one must admit that transaction costs or agency costs are neither experienced by the market nor the firm in the abstract, but by individuals. The “friction in physical systems“  (Williamson, 1985: 19) that economists have baptized transaction costs are the equivalent of friction or stress created in the interaction of human beings with each other, with their environment and within themselves.  In this sense, agency costs and transaction costs are very much the same.   In a like manner, agency costs can be thought of as the equivalent of friction in “any situation involving cooperative effort by two or more people,” (Jensen and Meckling, 1976: 309) and can exist in the form of conflicts with oneself (Thaler and Shefrin, 1981).

Coase’s insights on individuals are consistent with this point.  Coase tells us that the choice of markets versus firms to organize transactions is the result of, “man as he is, acting within the constraints imposed by real institutions” (Coase, 1984: 231).  Williamson also concurs attributing transaction costs to “behavioral assumptions” of “bounded rationality” and “opportunism.” Although Williamson lumps these assumptions of “bounded rationality” and “opportunism” together as “behavioral assumptions,” or assumptions about how individuals act, bounded rationality is really a cognitive assumption or theory about the limits of the thought process.  Opportunism, on the other hand, is a behavioral assumption about the way individuals behave.

Bounded Rationally: The Cognitive Assumption of Transaction Cost Analysis
The idea of bounded rationality comes from Simon, who argued that human beings are “intendedly rational, but only limitedly so” (Simon, 1976: xxviii).   Whereas traditional economic man is considered as omniscient and able to take into account the consequences, probabilities and utilities of all alternatives, Simon argued that individuals are “limited in knowledge, foresight, skill and time” (Simon, 1957: 199).  The cognitive abilities of individuals are “bounded” in that they can only take in and make sense of a limited amount of information.  In terms of transaction cost analysis, cognitive limits have important implications for planning, adopting and monitoring exchange relationships.  To the extent that internalization can serve to reduce uncertainty and complexity (Williamson, 1975), one can successfully reduce transaction costs and economize on bounded rationality (Chiles and McMackin, 1996) .

Opportunism: The Behavioral Assumption of Transaction Cost Analysis
Opportunism is the behavioral attribute that underlies transaction cost analysis.  According to Williamson, opportunism is not just self-interested behavior, but  “self-interest seeking with guile“  (Williamson, 1985: 47).   Opportunism includes not only “subtle forms of deceit,” such as “incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, disguise, obfuscate, or otherwise confuse,” but also overt “lying, stealing, and cheating” (Williamson, 1985: 47).   This assumption about human beings is important because it suggests that transactions and organizations would benefit from safeguards and the aligning of incentives(Williamson, 1985: 48).   Ghoshal and Moran (1996) have argued that this behavioral assumption of opportunism is an overly pessimistic view of human nature.  They seem to have interpreted Williamson’s statement to mean that organizations exist solely because of their ability to attenuate opportunism through hierarchical control.   This is not Williamson’s central point.  Williamson is not assuming that all individuals act opportunistically, rather that without evidence to the contrary, the assumption of opportunism is reasonable.  Naturally, “rules” or hierarchical organization can at times serve to limit opportunism, however, if humans have the capacity to be opportunistic then opportunism will continue to exist both in the market and within the firm.  Williamson’s point then is not to remedy market failure with “benign forms of organization,” but rather to stress the importance of a comparative approach (Williamson, 1993a: 102). Ultimately, the existence and extent of opportunistic behavior by individuals and the degree to which it impacts internalization (Hill, 1990) is an empirical issue.

Affect:  The Missing Assumption in Transaction Cost Analysis
Adherents to the transaction cost view accept the assumptions of bounded rationality and opportunism as descriptions of the way human beings think and act in make or buy decisions.  These simple assumptions distinguish transaction cost economics from classical economics, which does not recognize the “psychological make-up” of individuals. Classical economics limits itself to the constraints that are external to the individual and to the organization, such as technology and the interests of individuals who depart from one’s own (Simon, 1957: 199).  By embracing more realistic cognitive and behavioral assumptions about individuals, transaction cost economics provides strategic management with a perspective that connects the individual actor with its larger institutional structure.

What remains surprising, however, is that transaction cost economics has yet to make explicit affective assumptions about human actors that may influence the make or buy decision.  Just as Simon and Williamson made assumptions about the cognitive and behavioral attributes of humans, a similar assumption should be made explicit regarding the affective capacities of individuals. While Williamson’s view on this issue has yet to be determined, Simon, himself, suggests that any mature social science “will have to come to accommodate both intellect and affect” (1957: 200).

End Note by Ishizuka:
“As they say in academia, all errors are mine.  I do believe Oliver Williamson, given his openness and interdisciplinary scope will one day incorporate fear into TCE and that this will have fundamental implications on understanding the current financial crisis and lessening the impact of future ones.  His framework is important because it is an integrated paradigm in economic organization.  For fear to be included in such a paradigm, however, it is my turn to work, to get Dr. Yukio Ishizuka’s theory and understanding of fear known and accepted.  In the future, I would like to work on how fear varies, and identify the factors that are responsible for this variation.”

— Nathalie Ishizuka

The paper was accepted for presentation at the Academy of Management, Boston, August 1997.  To ask that the full article or parts be included in a journal or book, please contact the author through the Lifetrack Contact Form on this site.

If you have a syllabus with assumptions about healthy human beings applied to organizations, economics, negotiation, political science or other fields please contact Nathalie Ishizuka through the Positive Mental Health Foundation contact form.  She is interested in collecting these for future use and sharing.

Copyright © 1997 Nathalie Ishizuka

For More on Healthy Individuals and applications to Organizations, Nations, and International Behavior See:

A Need for Models of Healthy Human Beings

Organizational and International behavior should be based on assumptions about healthy human beings.  Read section a Science of Health (life way), Criteria for Health Models (science of happiness), Happiness Defined? Quantified?  (cycle of life),  Happier? (fear of the unknown),  Why Positive Mental Health Works (objective subjective), and Insights (life purpose).

Visit http://www.PositiveMentalHealthFoundation.com to understand individuals at their best, happiest, and most creative form.  Link to us to promote health and happiness.

Ready Made Descriptions to Link to Organizational and International Behavior:

Individual Health, Organizational Health, National Health
Applications about healthy human beings to economics, international affairs, nations, organizational behavior.  A new organizational behavior concept or simply a new field of international behavior based on healthy human beings?