Psychologists distinguish between two kinds of theories: normative and descriptive. To them, normative theories characterize rational choice: examples would include the axioms of expected utility theory and Bayes’ rule. Descriptive theories try to characterize actual choices. Prospect theory is an example of a descriptive theory. Agents who choose according to prospect theory violate fundamental axioms of rational choice; for example, under certain circumstances they will choose option A over B even when B dominates A, as long as the dominance is not too obvious.
I would not want to call such choices rational, but since people do choose them in real life, high stakes situations, it is important that economists develop models that predict such behavior. Economists have traditionally used one theory to serve both the normative and descriptive purposes. Expected utility theory and the life-cycle theory of saving are rational (normative) models that economists have used also as descriptive models. Occasionally economists have proposed explicitly descriptive theories, such as William Baumol’s (1967) theory of the firm in which managers maximize sales subject to a profit constraint.
However, such descriptive theories have not won great acceptance. Part of the resistance to such theories, I think, has been based on a misunderstanding of the issues raised above regarding how competition will force changes in quasi-rational behavior. For example, Baumol often heard the critique that firms that maximized sales would inevitably lose market share to competing firms that were trying to maximize profits. The selfcontradictory nature of this critique—that maximizing sales would cause lower market share—did not seem to bother (or occur to) its adherents. There is, of course, a perfectly good equilibrium in which some firms are willing to accept lower profits in order to be bigger, and such firms take market share away from profitmaximizing competitors, not vice versa.
Similarly, if a baseball team owner chooses to buy a World Series victory at the expense of profits, the profit-maximizing owners of other teams can do little except become even richer losers. One additional point about descriptive theories: they are, of necessity, driven by data. Baumol’s sales maximization hypothesis was suggested to him by conversations with managers. Kahneman and Tversky’s prospect theory was derived by examining hundreds of choices between pairs of gambles. Some economists seem to feel that data-driven theory is, somehow, unscientific. Of course, just the opposite is true. Copernicus watched the movements of the planets before devising his theory that the planets orbit the sun. What makes for a good descriptive theory is out-of-sample tests; for example, the prediction that Pluto would be discovered before telescopes were good enough to see it. So, this prediction leads to an auxiliary prediction that more theorists will pay attention to data.
Prof. Richard H. Thaler