Meanings of Rationality in Economics

Q1. Outline what is meant by rationality in Economics. Describe a number of ways in which individuals might deviate from rationality (1000 words).

The field of economics can be defined as the study of how individuals “coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society” (Colander, 2006, p. 4). In other words, economics looks at how human beings navigate through their decisions to attain preferred items. This process is carried out through the utilisation of resources available to them; these could be intangible (information) or tangible (financial incentives). Rational economic theory postulates that individuals make decisions in their highest self-interest (Smith, 1776). They do this through logical and calculated decisions that maximize their gains and minimize their losses (Blume & Easley, 2008) by weighing the costs and benefits of each. With this assumption, individuals should be making the right decisions by analysing their options and picking the best one, because everyone wants what is best for them. However, we know that as humans, we do not always make the best choices. We sign up for a monthly gym membership but only go once, or buy chocolate while on a sugar-free diet. Backhouse et al. (2009) states rationality also “extends to the analysis of situations facing principals and agents”. This implies that it is important to understand the environmental influences and context, and the states that drive decisions; for example, the manner in which the choices are arranged and the emotional state of the chooser.

Individuals do not engage their highest analytical skills with every decision they partake in. This may result in choosing an option that benefits them partially over an option that could have been better. Behavioural economics explains this irrational behaviour by categorizing the decision-making process into two classifications: System 1 and System 2; also known as the experiential system and rational system respectively (Epstein, 1994). These systems explain why individuals behave irrationally, i.e. against their own self- interest. Rationality involves evaluating the pros and cons of each choice; this involves time and deliberation (System 2). When making a quick decision, we may rely on our intuition (System 1), which accesses associative information faster. System 1 uses emotional and immediate impressions, and is thus not monitored as thoroughly, which can lead to errors in judgments (Kahneman and Frederick, 2002). System 1 frequently uses “heuristics” to simplify intricate tasks (Kahneman, 2003) in order to engage in swift decision-making under uncertainty, such as availability, anchoring, and representativeness (Tversky and Kahneman, 1974). These heuristics reveal biases that may result in irrational behaviour. In this paper I will illustrate ways in which individuals deviate from rationality using the framing effect, affective heuristic, and prospect theory.

The framing effect refers to the manner in which choices are presented with regard to the salience of specific information (insert ref/ Kahneman, 2003). Accordingly, two options that have similar implications could be perceived as two independent scenarios when specific information is made more or less salient. For example, “Would you like to go out dancing or stay in for a quiet dinner?” or “Would you like to go out to a noisy disco or stay in and eat your favourite dinner?” While both these activities could be considered enjoyable, in the first option the saliency of dancing is perceived as more desirable as it evokes an emotion of fun; in the second option the saliency of noise evokes an emotion of unease versus the comfort of a meal. The mere manner in which the question is framed would result in two different behaviours, in spite of them having the exact same implications. The framing effect can have large-scale business and policy implications as it could result in pushing individuals in one direction over the other. If a promotion is described as an increase in responsibility and longer hours versus an increase in salary and status individuals may be more likely to turn it down, as they may not be assessing the trade-offs rationally.

With the framing effect we can see the power that evoking emotions play in decision-making. Associating positive emotions could result in increased engagement with a choice, versus an alternative that is associated with negative emotions. This leads to the affect heuristic that explains why individuals do not conform to logical decision-making when their emotions are induced. For example, you may set a fixed Christmas shopping budget of £200 because last year you went overboard and barely made it through January. However, as the holiday draws nearer and you watch Christmas advertisements emphasizing the joy of giving, you indulge and go over your budget again. These are part of self-control failures, and are caused by impulsivity (insert ref/ Kahneman, 2003). Rationally, you understand how important it is to stay within the feasibility of your budget; affectively, you feel better when you are giving out more presents in the moment. The regret only comes later. This is also part of a phenomenon known as hyperbolic discounting, where we make inconsistent inter-temporal choice decisions. We tend to value the smaller yet closer reward, over waiting for a larger reward (Rachel & Green, 1972). Our emotions also come into play when assessing risk aversion (Finucane et al. 2000), we would rather stay happy with what we have than risk opting for a larger amount, due to the fear of losing our current status, even over the possibility of a gain. The affect heuristic can concurrently bias our preferences and beliefs over certain products or policies (Kahneman et al. 1997).

The economics discourse focuses on how individuals make choices. Prospect theory is a model that describes how choices are made in the presence or absence of a risk, and loss aversion. The theory states that reference points can influence our decision-making (Kahneman, 2003). So, if your friend has lost £20 in a bet while you lost £5, it could possibly influence you to risk placing another bet in spite of thinking rationally and quitting while you’re ahead. This is because your friend’s loss becomes the parameter for the reference point to assess your own loss, i.e. the status quo. In this way, prospect theory focuses on short-term outcomes (Kahneman, 2003). Consequently, the value of a good is influenced by loss aversion. A good is perceived as higher when it could be lost versus when that same good could be gained (Kahneman et al., 1990).

While classic economic theory expects individuals to behave rationally at all times, we can see that there are times when our opinions are biases, which may cause us to behave irrationally. This can be influence by the manner in which information is presented, our emotional state, or even what the bad decisions our friends make.

References:

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• Colander, David C.2006. Economics. 6th ed. Boston: McGraw-Hill Irwin.
• Epstein, (S., 1994). Integration of the cognitive and psychodynamic unconscious. American Psychologist 49, 709– 724.

• Finucane, M.L., Alhakami, A., Slovic, P., Johnson, S.M., 2000. The affect heuristic in judgments of risks and benefits. Journal of Behavioral Decision Making 13, 1–17.

• Kahneman, Daniel; Knetsch, Jack and Thaler, Richard. (1990) "The Endowment Effect, Loss Aversion, and Status Quo Bias: Anomalies." Journal of Economic Perspectives, 5(1), pp. 193-206.
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