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Incorporating Limited Rationality into Economics

  • Matthew Rabin
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    Harstad and Selten (this forum) raise interesting questions about the relative promise of optimization models and bounded-rationality models in making progress in economics. This article builds from their analysis by indicating the potential for using neoclassical (broadly defined) optimization models to integrate insights from psychology on the limits to rationality into economics. I lay out an approach to making (imperfect and incremental) improvements over previous economic theory by incorporating greater realism while attempting to maintain the breadth of application, the precision of predictions, and the insights of neoclassical theory. I then discuss how many human limits to full rationality are, in fact, well understood in terms of optimization.

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    File URL: http://www.aeaweb.org/articles.php?doi=10.1257/jel.51.2.528
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    File URL: http://www.aeaweb.org/jel/ds/5102/JEL.51.2.528_ds.zip
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    Article provided by American Economic Association in its journal Journal of Economic Literature.

    Volume (Year): 51 (2013)
    Issue (Month): 2 (June)
    Pages: 528-43

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    Handle: RePEc:aea:jeclit:v:51:y:2013:i:2:p:528-43
    Note: DOI: 10.1257/jel.51.2.528
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    1. Rabin, Matthew & Vayanos, Dimitri, 2007. "The Gambler's and Hot-Hand Fallacies: Theory and Applications," CEPR Discussion Papers 6081, C.E.P.R. Discussion Papers.
    2. Laibson, David, 1997. "Golden Eggs and Hyperbolic Discounting," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 443-77, May.
    3. Rabin, Matthew, 1993. "Incorporating Fairness into Game Theory and Economics," American Economic Review, American Economic Association, vol. 83(5), pages 1281-1302, December.
    4. Matthew Rabin, 2001. "Inference by Believers in the Law of Small Numbers," Method and Hist of Econ Thought 0012002, EconWPA.
    5. Spiegler, Ran, 2014. "Bounded Rationality and Industrial Organization," OUP Catalogue, Oxford University Press, number 9780199334261, March.
    6. Sendhil Mullainathan, 2002. "A Memory-Based Model Of Bounded Rationality," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 735-774, August.
    7. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    8. Matthew Rabin, 2013. "An Approach to Incorporating Psychology into Economics," American Economic Review, American Economic Association, vol. 103(3), pages 617-22, May.
    9. Stahl, Dale II & Wilson, Paul W., 1994. "Experimental evidence on players' models of other players," Journal of Economic Behavior & Organization, Elsevier, vol. 25(3), pages 309-327, December.
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