L2 Bounded Reality

Question 1

What are the two kinds of theories for bounded reality?

Answer 1

Descriptive - models of how decision processes operate, irrespective of whether the outcome of the decision is good or bad
Normative - evaluate a decision in terms of the goals of the decision maker. Decisions can be good or bad and a decision is good if it reaches these goals

Question 2

What is a good decision?

Answer 2

Rational thinking is normative
Enables the decision maker to reach their goals
Rational decision maximises expected value
- assumes agent knows the probability of outcome, alternatives and the value of it

Question 3

What is the rational choice theory?

Answer 3

Assumes agent has full access to all alternatives
Knows the probability of their outcomes
Knows the value of their outcomes
Can integrate all information and chose the behaviour with the highest utility

Question 4

What is bounded rationality?

Answer 4

Limited cognitive capacity, limited information on outcomes
Human behaviour can be impulsive, habitual, imitating others and random
Herbert Simon

Question 5

What is the St Petersburg Paradox?

Answer 5

Peter tosses a coin and continues to until it should land heads
He agrees to give one ducat if he gets heads on the very first throw, two on the second and so on
The expected value of this gamble is infinite but the chance to win a high value is low
This is where rational choice theory fails to make predictions about rational choice

Question 6

What is expected utility theory?

Answer 6

A normative theory, clearly defines what rational choices are
Expected utility may deviate from expected value
It allows the expected utility of a particular choice outcome to be situationally dependant

Question 7

What is risk seeking vs risk averse behaviour?

Answer 7

Would you prefer - 80% winning £4000 or a certain win of £3000
Most people prefer a sure gain although the expected value of the risky one is higher
Preferences are reversed when it is losses instead of gain
People chose the most mathematically logical option

Question 8

What is prospect theory?

Answer 8

Kahneman and Tversky developed a descriptive model
Intended to account for deviations from rational choice theory
Prospect theory has two main components - utility and probability

Question 9

What is the value function?

Answer 9

X axis represents gains and loss and the midpoint is current reference
Y axis is utility
Function for gains and losses are asymmetric
Utility function is nonlinear

Question 10

What is the pi function>

Answer 10

The certainty effect
For losses people prefer to gamble
Probabilities near 0 are overweighted relative to objective probabilities, probabilities near to 1 are underweighted

Question 11

What are the consequences of the pi function?

Answer 11

Very low probabilities tend to be overweighted e.g. lottery
These are different for losses and gains

Question 12

What is regret theory?

Answer 12

We compare outcomes, particularly after the decision has been made
We will regret a decision if an alternative outcome led to a higher payoff

Question 13

What is an inter-temporal choice?

Answer 13

Choices between immediate investment and long term reward or immediate gain and no long term reward
Most people prefer the first
Discount function is an exponential constant rate

Question 14

What is exponential discounting?

Answer 14

v = Ve ^-kd