a) Explain and contrast the concept of full rationality in economics with the concept of bounded rationality in human decision making.

b) What is the availability heuristic and what biases emanate from this heuristic?

Answer:

There is a major difference between the concept of full rationality in economics (homooeconomicus) and the concept of bounded rationality in human decision making (homo-sapiens).

Rationality is a decision making process that is logically expected to lead to optimal results given an accurate assessment of the decision maker’s values and risk preferences. The rational decision procedure consists of six stages. The first stage is to define the problem using an accurate judgment. Secondly, a rational decision maker identifies all the relevant criteria in the decision making process. In the third stage, a rational decision maker has to weigh all the criteria regarding his decision. The weight of these criteria varies in importance and the decision maker knows the values they place on each one of them. The decision maker, in the fourth stage, can search and generate for alternatives until the time that the cost of the search outweighs the value of the added information. The most difficult stage of the decision maker is the fifth stage, where the decision maker has to carefully assess potential consequences of each identified criteria of selecting each of the alternatives. Rating each alternative on each criterion requires forecast of future events. The last and sixth stage is to compute the optimal decision. In this stage, the decision maker multiplies the ratings in the previous stage by weighing each criterion. Then, he adds up all the weighted ratings and in the end, he chooses the solution with the highest sum of weighted ratings. This model of decision making assumes that people follow these six steps in a fully rational manner.

On the other hand, Herbert Simon talks about a more realistic and bounded rationality framework. When individuals attempt to make rational decisions, they often lack important information, that they would help them define the problem, the relevant criteria and so on. Time and cost constraints limit the quantity and quality of the available information. Decision makers retain only a relatively small amount of information in their usable memory. Moreover, intelligence limitations and perceptual errors constrain the ability of decision makers to calculate accurately the optimal choice from all the available alternatives together. Moreover, Richard Thales (2000) suggested that decision making is bounded in two ways. Firstly, willpower is bounded, such that greater weight is given to present concerns rather than future ones. As a result, temporary motivations are often inconsistent with our long-term interest. Secondly, self-interest is bounded, in the sense that, people are not selfish and they care about other people’s well being.

All these limitations presented above, prevent decision makers from making the optimal decisions assumed by the fully rational model. Furthermore, in the real world, decision makers are also willing to sacrifice the best solution in favor of one that is the most satisfactory or reasonable. The concept of bounded rationality and sacrificing shows that human judgment deviate from rationality, without however, implying that homo-sapiens are irrational. Specifically, that helps us identify situations when individuals may act upon limited information, but it doesn’t suggest how these judgments are biased.

Homo sapiens tend to use heuristics or other simplifying strategies when they make decisions. Heuristics are cognitive tools that are used to simplify decision making. They are used, because they speed up the process and also because it is not always possible to go through the detailed process and so sometimes we just follow an intuition.

One type of the judgmental heuristics is the availability heuristic. In availability heuristic, people assess the probability of an event depending on knowledge that is readily available in memory. An event that is vivid, easily imagined and evokes emotions, will be more available in memory than an event that is unemotional in nature, vague or difficult to imagine. Availability heuristic could often lead to accurate judgment, since people’s minds usually recall instances of events of greater frequency more easily than rare events. However, this heuristic can also be fallible, as the availability of information is also affected by factors unrelated to objective frequency of the judged event.

There are two biases emerging from this heuristic. The first one is the ease of recall, which is based on vividness and recency. This bias describes the inferences that people make about event commonness, based on the ease with which people can remember instances of that event. Studies show, consistently with this bias, that people are more likely to buy insurance after having experienced a natural disaster than they are to purchase such insurance before such experience. Another example is that the risk of experiencing an earthquake becomes more vivid and salient after one has experienced an earthquake, even if the risk of another earthquake in the same area diminishes. This explains why recent memories and experiences have such a strong impact on people’s decisions.

The other bias is the retrievability. Trevsky and Kahneman (1983) demonstrated this bias when they asked participants in their study to estimate the frequency of seven letter words that had the letter ‘n’ in the sixth position. The participants estimate such words to be less common than seven-letter words ending in ‘ing’, even though all words ending in ‘ing’ also have an ‘n’ as the sixth letter. Trevsky and Kahneman argue that ‘ing’ words are more retrievable to memory due to commonality of the ‘ing’ suffix in contrast to words that have an ‘n’ in the sixth position. Moreover, the natural search strategy may not prove to be helpful. For example, without intending to discriminate an organization led by white, college-educated males, people end up hiring more of the same. Or another example is that, multiple gas stations are at the same intersection or upscale retailers are all in the same location, since people learn the location of a particular type of product or store and they organize their minds accordingly.

In conclusion, it appears that, although there is an economically fully rational decision making process, in real world, people tend to choose less optimal decisions by choosing the most satisfactory one and by following their intuition. There are many constraints and limitations that prevent people to choose the most rational choice. Homo sapiens often follow some cognitive tools or rules of thumb, called heuristics, to help them make their decisions. The availability heuristic, which depends on how much available are instances of events in people’s memories, appears to have two biases, which are the ease of recall and the retrievability. Finally, although the availability heuristic can yield appropriate and adequate decisions, its overuse may lead to systematic errors in managerial judgment.