beh-Eco:Cognitive Limitations and Rational Consumer Choice.

Cognitive Limitations and Rational Consumer Choice.

A.)Bounded Rationality

Humans don’t behave like rational beings potrayed in standard rational choice models. This comment on human behavior was potrayed by Herbert Simon, a pioneer in artificial intelligence, ie, instructing a computer to reason.

When we ourselves confront a puzzle we don’t reach a solution in a neat linear fashion. We search in a haphazard way for potentially relevant facts and information and usually quit once our understanding reaches a particular threshold. Our conclusions are often inconsistent even incorrect. Yet we come up with serviceable even imperfect solutions. We are satisficers not maximisers.

B.)Decision-making under incomplete information

It is not even rational to make fully informed choices. It is irrational to be completely informed. This literature has infact bolstered our confidence in The Rational Choice Model.

However another offshoot of Simon’s work less friendly to the rational choice model is that even with transparently simple problems people often violate the most fundamental axioms of rational choice. (Frank, RH, 2003)

C.)Framing

How a choice is presented decides the preferences that are revealed

Asian disease problem-Disease threatens 600 people, there is a positive way of framing the problem

A-200 people are saved

B-1/3^rd probability 600 are saved, 2/3’rd probability zero are saved with an expected value of 200 being saved. The preference pattern seen is that 72% choose A-certainly

saving 200 is better.Majority choice is risk-averse.

Whereas another way of framing the problem is-

C-400 people will die D-1/3^rd probability zero will die, 2/3^rd probability 600 will die with an expected value of 400 dying.The preference pattern is that 78% choose D.Majority choice is risk-taking, certain death of 400 is less acceptable.

This is an example of Framing of Choice with risk aversion leading to inconsistent preferences.

·        Outcomes in Problem1 are described in terms of lives saved, problem 2 in terms of lives lost.

·        Choices involving gains are risk averse, losses are risk-taking.

This leads to inconsistent preferences. Despite the fact that A and C and B and D are equivalent in terms of lives lost or at  risk, most people choose A over B but D over C.”(Tversky and Kahneman, 1981)

D.) Assymetric Value Function

In Rational Consumer Choice we evaluate events on basis of overall effect on total wealth. Consider A-Unexpected gift of $100. B-Repair of broken water line on your property, invoice of $80. Net effect of $20-increase in wealth

But, Kahneman and Tversky say that people weigh each event separately giving less importance to gain then loss. A larger value in absolute terms to loss of $80 than to a gain of $100.(Tversky and Kahneman, 1981)

E.) Sunk Costs

According to Rational consumer choice Sunk costs should be ignored but according to Thaler(Thaler,1980), people ignore this principle rather than sunk costs.A pair of $200 shoes causes discomfort would you wear it or give it away, would your choice change if it was a gift. Either way you own them now and the only question is whether the discomfort they cause is serious enough to discontinue wearing them.People however are much more likely to abandon wearing them if they received them as a gift.

V. Judgemental Heuristics and Biases:

A.)Examples considered so far make it clear that even when people have facts on their fingertips they make mistakes, another difficulty of the rational choice model is we often draw erroneous inferences about what the relevant facts are. More important, many of the errors we make are systematic not random.

Three simple heuristics or rules of thumb we use to make inferences about the environment, which lead to large predictable errors even if they help us economise on cognitive effort.(Kahneman and Tversky, 1974)

Representativeness heuristic: What is the probability that person A (Steve, a very shy and withdrawn man) belongs to group B ( librarians) or C (salesmen)? In answering such questions, people typically evaluate the probabilities by the degree to which A is representative of B or C (Steve´s shyness seems to be more representative for librarians than for salesmen) and sometimes neglect base rates (there are far more salesmen than librarians in a certain sample).

Availability Heuristic: This heuristic is used to evaluate the frequency or likelihood of an event on the basis of how quickly instances or associations come to mind. When examples or associations are easily brought to mind, this fact leads to an overestimation of the frequency or likelihood of this event. Example: People are overestimating the murder rate in New York as compared to that of suicide if they can quickly remember reading on instances of murder. People tend to be biased by information that is easier to recall. They are swayed by information that is vivid, well-publicized, or recent. People also tend to be biased by examples that they can easily retrieve.

Anchoring and adjustment: People who have to make judgements under uncertainty use this heuristic by starting with a certain reference point (anchor) and then adjust it insufficiently to reach a final conclusion. Example: If you have to judge another person''s productivity, the anchor for your final (adjusted) judgement may be your own level of productivity. Depending on your own level of productivity you might therefore underestimate or overestimate the productivity of this person.