2 - The Rise and Fall of Utility as an Ordering Principle

Summary

In the early years of neoclassical economics, agents were pleasure-seekers and their marginal utility for a good diminished continuously as consumption increased. This psychology ensured that agents could optimize and identify smooth trade-offs. Later generations abandoned this utilitarian inheritance in favor of a theory of rationality, but they had no replacement explanation for why agents can always order their options from best to worst. The same pattern has recurred in the theory of choice under uncertainty. In early theories, agents have preferences over lotteries where outcomes have known or objective probabilities. But once economists recognized the primacy of idiosyncratic risks, they turned to theories where agents form preferences based on their judgments of the likelihood of outcomes. These theories of subjective probability cannot explain why agents are capable of making these judgments. And if agents cannot pin down subjective probabilities they will not able to order their options. More broadly, agents face different classes of decisions, some where they are guided by an ordering principle that shows how to weigh their options and others where agents cannot judge trade-offs and form preferences.