Beyond Rationality

- Dr. Aashita Dawer

Rationality

 Self Interest
 Maximization of Utility
 Transitive and Complete Preferences
 Optimal Choice – Maximization of Utility based on a constraint
 Omniscience - perfect information - know all the utilities and production
possibilities of others in the present domain
 conscious deliberation - individuals are constantly thinking about available
options
 Expected Utility Theory
 Majority Rule
Beyond Rationality – Behavioral
Economics
 Simon(1947) – Bounded Rationality - decision-making that attempts to
make sense of the world by the way a person takes in information and
processes it to create preferences and choices. - human behavior is limited
by cognition to assess the gains and losses and is accompanied with
emotional motivations towards decision making
 Cognitive Psychologists: Internal Mental Processes: Desires, Imagination,
Mind, Knowledge, Motivation
 Behavioral Decision Research: Compute emotions, thinking and judgment,
Cognition constraint
 Heuristics, Biases and Prospect Theory
Heuristics and Biases

 Tversky and Kanheman - people possess various heuristics and biases which
transforms complex probabilities into simple ones and thus guides their
behavior
 Heuristics are cognitive rules of thumb or hardwired mental shortcuts that
everyone uses every day in routine decision-making and judgment
 Cognitive bias is any inclination toward a particular belief or perspective —
most often one that is ill-supported by reason or evidence.
 Decision-makers use satisficers, to obtain a satisfactory solution rather than
an optimal one.
 The term, “satisficing,” a combination of ‘satisfy and suffice,’ was
introduced by Simon in 1956.
Representative bias

 Refers to determining the probability of occurrence of an event by

incorporating how much is the event representative of the sample it is
drawn from.
 This implies that when a person judges the probability of drawing X from Y
by how much similarity X has to Y, she is said to be displaying representative
heuristic.
 Example - with a sample of 30 lawyers and 10 housewives, with given
description that ‘the variable drawn is very hardworking and busy
throughout a day’, people would end up judging the probability of 0.5
instead of 0.75 and 0.25.
 People tend to ignore the size of the sample and determine the probability
based only on similarity.
Availability bias

 The ease of recalling of an event in a person’s mind. This happens due to

the familiarity or the recency of an event.
 People would predict the probability of a heavy rainfall in near future if
there have been heavy rains in the recent past.
 The frequency of occurrence of an event would be considered highly
probable.
 When certain circumstances are easy to imagine than others, those
circumstances receive higher probability by people using mental
computation.
 Example - destruction by an earthquake is more imaginable than a nuclear
bomb and thus occurrence of earthquake would be considered more
probable.
Anchoring and Adjustment

 Series of mental shortcuts where quick decisions are taken by choosing a

reference point and then adjusting to the reference point till we reach a
suitable decision.
 Example - as the salesman knows that there would definitely be bargaining
by the consumer, he would keep the price higher of the product say $100.
 Now, the consumer would automatically anchor to 100$ and would adjust
the bargaining to probably 70$ and ultimately the equilibrium maybe
reached at $80.
 However, if the shopkeeper would have priced the product at $80 initially,
that may have been sold for around $60. Therefore, when we make
decisions, we first determine an anchor and adjust accordingly.
Reference Point

 Status Quo Bias/Endowment Effect – Preference to Current State of Affairs –

Emotional Bias
 Example - You score 23 out of 25 in mid sem – 23 becomes your reference
point and you will not want to gamble it by giving a remedial exam.
 Aspirations – Preference for a better state of affairs
 Example – You score 10 out of 25 – you will want to give a remedial.