RATIONALITY

Lecture: PEB
Week 2-3
What the lecture will cover?

Two Systems Behavioural

Rationality
of Thinking Economics
 What is Rationality?
Example of rational behaviour?
similarly …

What is Irrationality?
Example of irrational behaviour?
Take a look at below figure.

Which one has longer line?

 Two-Systems Thinking …

Kahneman, D. (2011). Thinking Fast and Slow. Great Britain: Penguin Books.
 Kahneman (2011)
• System 1 operates
automatically and
quickly, with little or no
effort and no sense of
voluntary control.

• System 2 allocates
intention to the effortful
mental activities that
demand it, including
complex computations.

Kahneman, D. (2011). Thinking Fast and Slow. Great Britain: Penguin Books.
 Two-systems thinking – at glance
• When we think of ourselves, we
identify with System 2, the
conscious, reasoning self that has
beliefs, makes choices, and decides
what to think about and what to do.
• System 1 – effortlessly originating
impressions and feelings that are
the main sources of the explicit
beliefs and deliberated choices of
System 2.
• The automatic operations of System
1 generate surprisingly complex
patterns of ideas, but only the
slower System 2 can construct
thoughts in an orderly series of
steps.
• System 2 takes over, overruling the
freewheeling impulses and
associations of System 1.

Kahneman, D. (2011). Thinking Fast and Slow. Great Britain: Penguin Books.
SYSTEM 1
 Take a look at this example

o … occurs automatically and require little or no effort.

o The capabilities of System 1 include innate skills that we share with other animals.
o Several of the mental actions in the list are completely involuntary.
Kahneman, D. (2011). Thinking Fast and Slow. Great Britain: Penguin Books.
 System 1 – shares a common
animal characteristic.
• System 1 is rapid and is or feels
instinctive, and it does not
involve what we usually associate
with the word thinking.
• System 1 is our gut reaction and
the System 2 is conscious
thought. Gut feelings can be quite
accurate, but we often make
mistakes because we rely too
much on our System 1 – System 1
says “The airplane is shaking, I’m
going to die” while System 2
responds “ Planes are very safe!”.
• Activities of the System 1 are
associated with the oldest parts
of the brain, the parts we share
with lizards.
Thaler, R. H., & Sunstein, C. R. (2009). Nudge: Improving decisions about health, wealth, and happiness. Penguin.
 System 1 can be SHAPED!
• Countless hours of practice
enable an accomplished
golfer to avoid reflection
and to rely on her System 1
… they know the hazards of
‘thinking too much’ and
might well do better to
‘trust the gut’, or ‘just do it’.
• System 1 can be trained
with lots of repetition – but
such training takes a lot of
time and effort.
• Likewise, being truly
bilingual means that you
speak two languages using
the System 1.
Thaler, R. H., & Sunstein, C. R. (2009). Nudge: Improving decisions about health, wealth, and happiness. Penguin.
 System 1 – Cognitively Easy!
• System 1 is indeed the origin
of much that we do wrong,
but it is also the origin of most
of what we do right – which is
most of what we do. Our
thoughts and actions are
routinely guided by System 1
and generally are on the mark.
• System 1 registers the
cognitive ease with which it
processes information, but it
does not generate a warning
signal when it becomes
unreliable.
• Intuitive answers come to
mind quickly and confidently,
whether they originate from
skills or from heuristics.
Kahneman, D. (2011). Thinking Fast and Slow. Great Britain: Penguin Books.
PITSTOP 1
• In sum: explain about System 1!
SYSTEM 2
 Look at below situations.

In all these situations you must pay attention – and you will perform less well, or not
at all, if you are not ready or if your attention is directed inappropriately.

Kahneman, D. (2011). Thinking Fast and Slow. Great Britain: Penguin Books.
Take a look at these examples.
• A bat and ball cost $1.10 in total. The bat costs
$1.00 more than the ball. How much does the ball
cost? ____ cents.
• If it takes 5 machines 5 minutes to make 5 widgets,
how long would it take 100 machines to make 100
widgets? ____ minutes.
• In a lake, there is a patch of lily pads. Every day,
the patch doubles in size. If it takes 48 days for the
patch to cover the entire lake, how long would it
take for the patch to cover half of the lake? ____
days.
Answers?
• 5 cents.
• 5 minutes.
• 47 days.
 System 2 – Reasoning
• System 2 articulates judgments
and makes choices, but it often
endorses or rationalizes ideas
and feelings that were generated
by System 1. Voters by the way,
seem to rely primarily on System
1.
• System 2: the investment of
attention improves performance
in numerous activities – however,
its abilities are limited.
• We do not always think straight
when we reason, and the errors
are not always due to intrusive
and incorrect intuitions. Often
we make mistakes because we do
not know any better.
Kahneman, D. (2011). Thinking Fast and Slow. Great Britain: Penguin Books.
THE INTERPLAY OF
BOTH SYSTEMS
 The Invisible Gorilla
• Seeing and orienting
are automatic functions
of System 1, but they
depend on the
allocation of some
attention to the
relevant stimulus.
• Insight: we can blind to
the obvious, and we are
also blind to our
blindness.

Simons, D. J., & Chabris, C. F. (1999). Gorillas in our midst: Sustained inattentional blindness for dynamic events. perception, 28(9), 1059-1074.
 Incapability while focusing on one
System 2 activity.
It is easy to let System 1 multitasks, but
not for System 2 – it is not that easy to
allocate such high attention to multiple
operation. Imagine this situation:
• Compute the product of 17 x 24 while
making a left turn into dense traffic –
and you certainly should not try!
• Drive a car and overtake a truck on a
narrow road – adult passengers quite
sensibly stop talking. They know that
distracting the driver is not a good idea,
and they also suspect that you are
temporarily deaf and will not hear what
they say.
Intense focusing on a task can make
people effectively blind, even to stimuli
that normally attract attention - you can
do several things at once, but only if they
are easy and undemanding.

Kahneman, D. (2011). Thinking Fast and Slow. Great Britain: Penguin Books.
 Collective Work of both Systems
• System 1 runs automatically, and
System 2 is normally in a
comfortable low-effort mode, in
which only a fraction of its capacity is
engaged.
• When System 1 runs into difficulty, it
calls on System 2 to support more
detailed and specific processing that
may solve the problem of the
moment.
• System 2 is activated when an event
is detected that violates the model of
the world that System 1 maintains.
• In sum: most of what you (your
System 2) think and do originates in
your System 1, but System 2 takes
over when things get difficult, and it
normally has the last world.

Kahneman, D. (2011). Thinking Fast and Slow. Great Britain: Penguin Books.
PITSTOP 2
• In sum: explain about System 2!
 SYSTEMATIC ERROR
or
PREDICTABLE ERROR??
 How the Error started to err?
• Little can be achieved without
a considerable investment of
effort.
• System 1 is generally very
good at what it does: its
models of familiar situations
are accurate, its short-term
predictions are usually
accurate as well, and its initial
reactions to challenges are
swift and generally
appropriate.
• The way to block errors that
originate System 1 is simple in
principle: recognize the signs
that you are in a cognitive
minefield, slow down, and ask
for reinforcement from
System 2.
HOWEVER …
• System 1 has biases, a systematic
errors that it is prone to make in
specified circumstances –
‘EQUILIBRIUM’ sometimes answers easier
questions and has little
ACHIEVED! understanding of logic and
• Easy task, low attention statistics.
needed, careful reflection,•
To get things even worst: System 1
load is properly distributed. cannot be turned off at will, errors
of intuitive thought are often
• Effort is minimised and difficult to prevent.
performance is optimized.
• System 2 is much too slow and
inefficient to serve as a substitute
for System 1 in making routine
decision.
• The best we can do is compromise:
learn to recognize situations in
which mistakes are likely and try
harder to avoid significant mistakes
when the stakes are high.
Rational vs Irrational
• Rational: conveys an image of greater deliberation,
more calculation, and less warmth, but in common
language a rational person is certainly reasonable.

• The only test of rationality is not whether a

person’s beliefs and preferences are reasonable,
but whether they are internally consistent.
Are these a form or rationality?
• Inconsistent mental state.
• Unreasoned decision.
• Coherent conclusion.

• Rationality is logical coherence – reasonable or not.

 Rationality & Economics
• Assumptions about our
ability for perfect reasoning
have found their way into
economics – rationality,
which provides the
foundation for economic
theories, predictions, and
recommendations.
• Rationality suggests that we
are all economists … the
simple and compelling idea
that we are capable of
making the right decisions
for ourselves.

Ariely, D. (2009). Predictably Irrational. Great Britain: Harper.

Pitstop 3
• How does Rationality/Irrationality relate to Two-
Systems thinking?
 Bounded Rationality
• Overarching ideas … Simon
(1955,1956) criticized rational
models of decision making for
ignoring situational and personal
constraints such as time pressure
and limited cognitive capacity.
• Bounded Rationality: the mind
had evoked short-cut strategies
that delivered reasonable
solutions to real-world problems
à this shortcuts will later
explained in other lecture
(Heuristics).
• Simon cited: ‘we cannot, of
course, rule out the possibility
that the unconscious is a better
decision-maker than the
conscious’.

Hardman, D. (2009). Judgment and decision making: Psychological perspectives (Vol. 11). John Wiley & Sons.
Djiksterhuis (2004); Djiksterhuis &
Nordgren (2006)
• There is now evidence that the unconscious mind
might well be better suited to making more
complex decisions, with the conscious mind better
at making simpler decisions.
Dijksterhuis et al. (2006)
Dijksterhuis et al. (2006)
Is being not rational means
irrational?
Kahneman (2011)
• Irrational: is a strong word,
which connotes impulsivity,
emotionality, and a stubborn
resistance to reasonable
argument.
Ariely (2009)
• Irrationality: about our distance
from perfection.
• Understanding irrationality is
important for our everyday
actions and decisions, and for
understanding how we design
our environment and the
choices it presents to us.
Thaler and Sunstein (2008) –
econs vs humans

ECONS HUMANS???
Human dominates in most society resulting in a series of misbehaving
in the social context common to occur.
A new discipline is coming to the
stage!
• Behavioural economics, or
judgment and decision
making (JDM).
• … it draws on aspects of both
psychology and economics.
• Econs never make an
important decision without
checking with their System 2.
• But Humans (who prones to
use more of System 1)
sometimes go with the
answer the lizard inside is
giving without pausing to
think.
Ariely (2009)

“Humans are not only

irrational, but
PREDICTABLY IRRATIONAL
– that our irrationality
happens the same way,
again and again.”
Market Forces & Irrationality
• Rationality implies that we
compute the value of all the
options we face and then follow
the best possible path of action.
• What if we made a mistake and
do something irrational? à
MARKET FORCES, will sweep
down on us and swiftly set us
back on the path of righteousness
and rationality.
• We are really far less rational
than standard economic theory
assumes.
• This irrational behaviours of ours
are neither random nor senseless
… they are systematic, and since
we repeat them on and on, it is
predictable!
Nation of HUMANS
• In a nation of Econs, government
should keep out of the way, allowing
the Econs to act as they choose, so
long as they do not harm others.
• But life is more complex for
behavioural economists than for true
believers in human rationality.
• The decision of whether or not to
protect individuals against their
mistakes therefore presents a
dilemma for behavioural economists.
• The economists do not face that
problem, because rational agents
(Econ) do not make mistakes.
• Although Humans are not irrational,
they often need help to make more
accurate judgments and better
decisions, and in some cases policies
and institutions can provide that
help.
Thank you