Individual experience of bounded rationality/context influence in decision making

ARE HUMANS RATIONAL?

One question that arises in every individual’s mind after getting to know the definition of rationality is, ‘are people actually rational? How do we know that?’. If according to various economic theories which assumes that people are rational, markets should function without any flaws. But, does that happen in reality? “Reality is often disappointing” and this is a great example to prove the quote right. If individuals are not exactly rational, or if they don’t act/react in the best possible way, then what situation are they going through? What is the impact of this imperfection or limited knowledge? The answer can be given by the concept of bounded rationality. To know its definition, Bounded rationality is the idea that rationality is limited, when individuals make decisions, by the tractability of the decision problem, the cognitive limitations of the mind, and the time available to make the decision.  In simple terms, it explains human behaviour and its rationality with limited knowledge and existing circumstances. Information, cognitive boundaries and time are the three key elements which explain bounded rationality. This concept becomes an essential aspect of behavioural economics, as it deals with human behaviour and its sync with economic activities using psychological approaches.

 

“Humans are the most complicated and imperfect animals” said Charles Darwin. This is because of their unique behaviour and dynamic surroundings. Decisions and actions taken by individuals in an economy has a very low probability of being perfect or ‘rational’ because of the circumstances at a given point of time. But the person can act accordingly by utilizing the maximum information available, using his or her cognitive potential at the highest level in the most time efficient way. In other words, this is bounded rationality and not the pre-set, expected rationality. This attributes to a major part of decision-making in this human controlled world. Every single individual is ‘bounded’ by the three key factors and are pushed to act in the most effective way, adjusting to the situation. For example, if an individual takes a lot of time to execute the decision, then he/she commits an irrational act by not being efficient. Thus, human decision-making his highly impacted by individuals following bounded rationality. Human psychology determines all these actions and reactions that happen in the economy and the world! As an economist or any individual who wants to understand human behaviour, it is essential for them to understand the human brain which is the source of events. In the three key elements of bounded rationality, cognitive limitations and the information aspects can be analysed by human psychology. Why does individual A prefers taking up the plan, whereas individual B is completely against it? The subject analyses the cognitive potentials and the information availability/usage in the situation. The information aspect does not deal with the availability alone. It also deals with the perception or understanding of the provided information for effective results. This is how bounded rationality plays a crucial role in decision making and understanding human behaviour.

Consumer Preferences and Microeconomics

Coke over Pepsi? Samsung over Apple? Nike over Adidas?

Why do these questions arise in an individual’s mind when he or she has to buy something to meet their needs and wants? The answer is pretty simple but understanding the concept is a little complicated. It is because of preferences set by consumers. The word ‘preference’ has a strong meaning. Consumers ‘prefer’ one good over the other/others. The options available to choose are ranked in different levels in the consumer’s mind and this varies from every other individual. The analysis and mechanisms of preferences set by consumers is a major part of microeconomics. The consumer is also known as ‘the king of microeconomics’ because these individuals determine every market activity and set the pitch for firms.

 

The ultimate goal for every firm in the market is to place their product in a very good position in every consumer’s mind. This determines the returns to them and their stability in the market. Depending upon the product’s nature, every firm uses various strategies and ideas to satisfy the king – the consumer. The concept of Unique Selling point (USP) as a very famous and essential business move or strategy, arises from the concept of preferences and consumer product positioning. Consumers choose goods or services that give them the highest level of satisfaction over the others, in relative measures. Choices are conditioned to circumstances and a ‘good choice’ makes a consumer arrive to a point where he or she obtains great satisfaction. Talking about consumer preferences in microeconomics, the concept has 2 approaches – utility approach and the indifference approach. Utility approach believes that the satisfaction derived from the consumption of products are measurable and thus choices can be made, whereas the indifference approach believes that consumers are able to rank products in line with their preferences from highest to lowest. Both approaches to consumer behaviour makes the consumer chose bundles of goods that give them the highest level of satisfaction, or the bundle which is ranked higher than the others. Consumers are said to be rational, if they minimize the costs (spending) and maximize the benefits (satisfaction) with complete knowledge about the product and its market. If Nike gives a consumer more satisfaction or is ranked higher than Adidas, then the consumer would prefer Nike over Adidas. The concept becomes easy if all consumers work in one way. But every individual is different and his/her choices vary according to numerous factors and prevailing conditions, which makes the concept a bit complicated.

There’s are a reason why consumers choose Samsung over apple, Coke over Pepsi, Nike over Adidas and many more options in various markets. This is solely because of the mechanism of consumer preferences which explains market activity and leads the branches of microeconomics.