The nature of rationality

Question 1

What is the basic aim of studying the nature of rationality?

Answer 1

To examine the broad question of whether humans are rational.

Question 2

What are the three kinds of models of rationality?

Answer 2

Descriptive, prescriptive and normative models.

Question 3

Define descriptive models of rationality.

Answer 3

Models of how thought processes operate irrespective of whether the decision is good or bad.

Question 4

Define prescriptive models of rationality.

Answer 4

Models that state how we ought to think in order to make the best decisions.

Question 5

Define normative models of rationality.

Answer 5

Models that evaluate a decision in terms of the goals of the decision maker; a decision is good to the extent it reaches these goals.

Question 6

What is a good (/rational) decision?

Answer 6

It’s normative, it maximises utility, and rationality is subjective.

Question 7

What is meant by the statement that ‘rational thinking is normative’?

Answer 7

That a decision is good to the extent that it allows the decision maker to reach their goals.

Question 8

What is meant by the statement that ‘a rational decision maximises utility’?

Answer 8

It maximises utility to the decision-maker, where utility is the extent of goal achievement.

Question 9

What is meant by the statement that ‘rationality is subjective’?

Answer 9

We have different goals, thus making what is rational to one person, irrational to another

Question 10

What did Todd and Gigerenzer (2000) state about model types (i.e. visions of rationality)?

Answer 10

There are four different types of model, which can be divided by whether they’re ‘demons’ or ‘bounded rationality’ models.

Question 11

What’s the difference between a ‘demons’ and ‘bounded rationality’ model of rationality?

Answer 11

Whether our evolved cognitive processes (architecture) are capable of making a rational decision - ‘demons’ models believe we can, ‘bounded rationality’ that we can’t.

Question 12

What are the four types of rationality models outlined by Todd and Gigerenzer (2000) and which category do they belong to?

Answer 12

Demons: unbounded rationality + optimisation under constraints
Bounded rationality: satisficing + fast and frugal heuristics.

Question 13

What type of rationality model refers to the normative benchmark?

Answer 13

Unbounded rationality. Believed by a subset of economists.

Question 14

What is the main premise behind optimisation under constraints models of rationality?

Answer 14

That we are (i.e. our cognitive architecture is) capable of making rational decisions, but that we are lazy/uninformed.

Question 15

What are the main ideas behind fast and frugal heuristics models of rationality?

Answer 15

That we have evolved specific decision-making apparatus that are domain-specific, forming rules of thumb.

Question 16

What are the advantages and disadvantages of using rules of thumb to make decisions?

Answer 16

They’re fast and involve little computational power, but they don’t always result in perfectly rational decisions.

Question 17

What kind of model is Rational Choice Theory an example of?

Answer 17

Unbounded rationality.

Question 18

What is meant by the statement that RCT is social physics?

Answer 18

It’s a search for universal mathematical laws to explain social and economic phenomena in terms of the behaviour of their “fundamental particles” (human decision makers).

Question 19

What do individuals do in a conventional rational choice model?

Answer 19

They strive to satisfy their preferences for the consequences of their actions given their beliefs about events which are represented by utility functions and probability distributions and interactions among individuals are governed by equilibrium conditions. Normative benchmark!

Question 20

What models does the conventional rational choice paradigm include?

Answer 20

Most standard models of mathematical economics, finance theory, business research (e.g. marketing) and statistical decision theory. Also rational-actor models that have become prominent and controversial in other fields such as political science, sociology, philosophy and law.

Question 21

What is the normative benchmark?

Answer 21

The most rational decision possible against which decisions are compared - involves a perfect decision maker with perfect apparatus.

Question 22

How far back does the modern RCT date?

Answer 22

50 years - three publications:

• von Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944/47)
• Kenneth Arrow’s Social Choice and Individual Values (1951)
• Savage’s Foundations of Statistics (1954)

Question 23

What were von Neumann, Arrow and Savage’s publications a part of?

Answer 23

A general ferment of cross-disciplinary operational research during the early post-war era which
laid the foundation for a dramatic escalation in the use of mathematical methods in the social sciences.

Question 24

What mathematical methods exactly did cross-disciplinary operational research during the early post-war era encourage?

Answer 24

Axiomatic methods, concepts of measurable utility and personal probability, and tools of general equilibrium theory and game theory.

Question 25

Where can the roots of RCT be found?

Answer 25

In the first formal use of equilibrium models by marginalist economists in the 1800s, Bernoulli’s proposal of expected-utility-maximisation in the 1700s, probability theory in the 16th and 17th centuries, and even Euclid’s development of the axiomatic method.

Question 26

In what situations is choice under uncertainty used?

Answer 26

In judgement and decision making experiments.

Question 27

What is the concept behind choice under uncertainty?

Answer 27

That given a choice between two or more alternatives the rational choice is the option with the highest value or utility.

Question 28

What is the difference between value and utility?

Answer 28

Value is numeric and often monetary, whereas utility is abstract.

Question 29

How do we measure expected value (EV)

Answer 29

We multiply the utility by the probability of receiving that outcome.

Question 30

What is the EV of £100 with 50% probability?

Answer 30

£50.

Question 31

According to RCT, what do all decisions boil down to?

Answer 31

An estimation of EV.

Question 32

Why can any choice be represented as a gamble?

Answer 32

Because we cannot know the future.

Question 33

What is the main premise of Expected Utility Theory?

Answer 33

All choices can be represented as a gamble, and we can apply EV to Expected Utility (EU).

Question 34

Give an example of the application of Expected Utility Theory.

Answer 34

Pascal’s wager - the comparison between living a holy or a secular life, considering the probability that God exists and the utilities of each outcome (i.e. heaven/hell, fun/less fun).

Question 35

According to Expected Utility Theory, what is a rational choice?

Answer 35

The one with the highest EU.

Question 36

What kind of theory is Expected Utility Theory?

Answer 36

A normative theory - it states what the rational choice is.

Question 37

What arguments does Expected Utility Theory use?

Answer 37

The long-run argument and the argument from principles.

Question 38

What is the long-run argument?

Answer 38

That because EU is based on probabilities and gambles, the rational choice is based on an average of what would happen if you were able to make the same decision on a number of successive occasions, or if a large number of people were to make the same decision.

Question 39

What are the three choice axioms used in theories of rationality?

Answer 39

Weak ordering, transitivity and the sure-thing principle.

Question 40

Define weak ordering.

Answer 40

The idea that for any set of choices we must always be able to say we prefer one over the other or neither. Because we can always express the utility of an option as an integer, we can never say that the two cannot be compared.

Question 41

Define transitivity.

Answer 41

As utility is expressed as an integer our choices must be transitive, i.e. x > y, y > z, therefore x > z.

Question 42

What did the Sure-thing principle arise from?

Answer 42

Multiplications of probability rather than the numerical status of utility.

Question 43

What is the Sure-thing principle?

Answer 43

If there’s some state of the world that leads to a particular outcome irrespective of our choices, then this is cancelled out of the equation and we should not let it affect our choices.

Question 44

What example was given by Bernoulli to show that the idea of EV computation is flawed?

Answer 44

The St. Petersburg Paradox.

Question 45

Describe the St Petersburg Paradox.

Answer 45

Peter agrees to give Paul 1 ducat if Paul gets heads (toss of a coin) on the first go, 2 ducats if he gets it on the second, 4 for the 3rd, 8 for the 4th etc.)
The expected value of this gamble is infinite, but “any fairly reasonable man would sell his chance for 20 ducats”; the subjective utility is low, as indexed by people’s willingness to sell their chance to play for a small sum.

Question 46

How did Bernoulli (1738) explain the utility of wealth?

Answer 46

By suggesting that EV doesn’t equal EU. Instead the utility of wealth is proportional to its logarithm - the utility of each unit decreases as total wealth increases (marginal declining utility).

Question 47

What are three violations of normative theory?

Answer 47

The Allais Paradox, risk seeking vs. risk averse behaviour, and that people don’t integrate prospects with existing assets.

Question 48

What is the Allais Paradox?

Answer 48

Maurice Allais (1953) showed that people don’t maximise expected utility and violate Savage’s choice axiom (sure-thing principle).

Question 49

How do people violate the sure-thing principle and normative thinking on Allais’ tasks?

Answer 49

According to Tversky & Kahneman (1974), most people prefer 1A (£100m for sure, rather than a chance of £100m, £500m and £0) and 2B (10% chance of £500m over 11% of £100m)

Question 50

How do Allais’ tasks show that people violate the sure-thing principle?

Answer 50

We should subtract common outcomes and outcomes with zero utility from the equation, as these shouldn’t affect our choice. In Choice 1, preference for £11m over £50m clearly doesn’t maximise EU, but in Choice 2, this results in a rational preference.

Question 51

What did Kahneman & Tversky (1979; 1992) find about risk seeking vs. risk averse behaviour?

Answer 51

Most people choose a certain gain even if the EV is higher for an 80% chance of more money, but sure thing preferences are reversed when outcomes are losses. People are risk averse for gains and risk seeking for losses.

Question 52

How does risk seeking vs. risk averse behaviour differ when the amounts of money involved are small?

Answer 52

Most people become risk seeking for gains and risk averse for losses - it switches round.

Question 53

What does utility theory suggest about integration of decision outcomes and current assets?

Answer 53

That we should do it - we should choose the riskier option for both gains and losses when they have the same EV

Question 54

What evidence is there that people don’t integrate prospects with existing assets?

Answer 54

Given the choice of two options with the same EV, people tend to pick the certain gain and risky loss options.

Question 55

What did Gigerenzer & colleagues do?

Answer 55

Consider the origin of heuristics and re-defined rationality.

Question 56

What did Gigerenzer & colleagues suggest about heuristics?

Answer 56

That they were evolved in the Environment of Evolutionary Ancestry (the Pleistocene period) on an ad hoc basis to satisfy particular problems.

Question 57

What did Gigerenzer & colleagues re-define as genetic fitness?

Answer 57

Utility.

Question 58

How did Gigerenzer & colleagues explain our performance on cognitive tasks?

Answer 58

We haven’t evolved the architecture for general decision making - our heuristics are specific. Also we differ from the normative model in what utility should be calculated (survival, not money).