Complexity and Bounded Rationality in Individual Decision Problems
I develop a model of endogenous bounded rationality due to search costs, arising implicitly from the decision problem's complexity. The decision maker is not required to know the entire structure of the problem when making choices. She can think ahead, through costly search, to reveal more of its details. However, the costs of search are not assumed exogenously; they are inferred from revealed preferences through choices. Thus, bounded rationality and its extent emerge endogenously: as problems become simpler or as the benefits of deeper search become larger relative to its costs, the choices more closely resemble those of a rational agent. For a fixed decision problem, the costs of search will vary across agents. For a given decision maker, they will vary across problems. The model explains, therefore, why the disparity, between observed choices and those prescribed under rationality, varies across agents and problems. It also suggests, under reasonable assumptions, an identifying prediction: a relation between the benefits of deeper search and the depth of the search. In decision problems with structure that allows the optimal foresight of search to be revealed from choices of plans of action, the relation can be tested on any agent-problem pair, rendering the model falsifiable. Moreover, the relation can be estimated allowing the model to make predictions with respect to how, in a given problem, changes in the terminal payoffs affect the depth of search and, consequently, choices. My approach provides a common framework for depicting the underlying limitations that force departures from rationality in different and unrelated decision-making situations. I show that it is consistent with violations of timing-independence in temporal framing problems, dynamic inconsistency and diversification bias in sequential versus simultaneous choice problems, and with plausible but contrasting risk attitudes across small- and large-stakes gambles.
|Date of creation:||2008|
|Date of revision:|
|Contact details of provider:|| Postal: Via Real Collegio, 30, 10024 Moncalieri (To)|
Web page: http://www.carloalberto.org/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Amos Tversky & Daniel Kahneman, 1979.
"Prospect Theory: An Analysis of Decision under Risk,"
Levine's Working Paper Archive
7656, David K. Levine.
- Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
- Ehud Kalai & William Stanford, 1986.
"Finite Rationality and Interpersonal Complexity in Repeated Games,"
679, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- Kalai, Ehud & Stanford, William, 1988. "Finite Rationality and Interpersonal Complexity in Repeated Games," Econometrica, Econometric Society, vol. 56(2), pages 397-410, March.
- Eliaz, K., 2001.
"Nash Equilibrium When Players Account for the Complexity of their Forecasts,"
2001-6, Tel Aviv.
- Eliaz, Kfir, 2003. "Nash equilibrium when players account for the complexity of their forecasts," Games and Economic Behavior, Elsevier, vol. 44(2), pages 286-310, August.
- Gary Charness & Matthew Rabin, 2002.
"Understanding Social Preferences with Simple Tests,"
The Quarterly Journal of Economics,
Oxford University Press, vol. 117(3), pages 817-869.
- Charness, Gary & Rabin, Matthew, 2001. "Understanding Social Preferences with Simple Tests," Department of Economics, Working Paper Series qt4qz9k8vg, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
- Gary Charness & Matthew Rabin, 2003. "Understanding Social Preferences with Simple Tests," General Economics and Teaching 0303002, EconWPA.
- Charness, Gary & Rabin, Matthew, 2002. "Understanding Social Preferences with Simple Tests," Department of Economics, Working Paper Series qt3d04q5sm, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
- Charness, Gary B & Rabin, Matthew, 2001. "Understanding Social Preferences With Simple Tests," University of California at Santa Barbara, Economics Working Paper Series qt0dc3k4m5, Department of Economics, UC Santa Barbara.
- Kalyan Chatterjee & Hamid Sabourian, 1998.
"Multiperson Bargaining and Strategic Complexity,"
CRIEFF Discussion Papers
9808, Centre for Research into Industry, Enterprise, Finance and the Firm.
- Binmore, Ken & McCarthy, John & Ponti, Giovanni & Samuelson, Larry & Shaked, Avner, 2002.
"A Backward Induction Experiment,"
Journal of Economic Theory,
Elsevier, vol. 104(1), pages 48-88, May.
- Karni, E. & Safra, Z., 1988.
"Behaviorally Consistent Optimal Stopping Rules,"
9-88, Tel Aviv.
- Philippe Jehiel, 2001. "Limited Foresight May Force Cooperation," Review of Economic Studies, Oxford University Press, vol. 68(2), pages 369-391.
- Steven M. Goldman, 1980. "Consistent Plans," Review of Economic Studies, Oxford University Press, vol. 47(3), pages 533-537.
- Douglas Gale & Hamid Sabourian, 2005. "Complexity and Competition," Econometrica, Econometric Society, vol. 73(3), pages 739-769, 05.
- Itzhak Gilboa & David Schmeidler, 1989.
"Maxmin Expected Utility with Non-Unique Prior,"
- Enrica Carbone & John Hey, .
"A Test of the Principle of Optimality,"
99/9, Department of Economics, University of York.
- John Hey & Jinkwon Lee, 2005. "Do Subjects Separate (or Are They Sophisticated)?," Experimental Economics, Springer, vol. 8(3), pages 233-265, September.
- Raj Chetty & Adam Szeidl, 2007.
"Consumption Commitments and Risk Preferences,"
The Quarterly Journal of Economics,
Oxford University Press, vol. 122(2), pages 831-877.
- John D. Hey, 2005.
"Do People (Want To) Plan?,"
Scottish Journal of Political Economy,
Scottish Economic Society, vol. 52(1), pages 122-138, 02.
- Matthew Rabin & Richard H. Thaler, 2001. "Anomalies: Risk Aversion," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 219-232, Winter.
- Xavier Gabaix & David Laibson & Guillermo Moloche & Stephen Weinberg, 2006. "Costly Information Acquisition: Experimental Analysis of a Boundedly Rational Model," American Economic Review, American Economic Association, vol. 96(4), pages 1043-1068, September.
- Uzi Segal, 1985.
"The Ellsberg Paradox and Risk Aversion: An Anticipated Utility Approach,"
UCLA Economics Working Papers
362, UCLA Department of Economics.
- Segal, Uzi, 1987. "The Ellsberg Paradox and Risk Aversion: An Anticipated Utility Approach," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(1), pages 175-202, February.
- Cubitt, Robin P & Starmer, Chris & Sugden, Robert, 1998. "Dynamic Choice and the Common Ratio Effect: An Experimental Investigation," Economic Journal, Royal Economic Society, vol. 108(450), pages 1362-80, September.
- Lee, Jihong & Sabourian, Hamid, 2007. "Coase theorem, complexity and transaction costs," Journal of Economic Theory, Elsevier, vol. 135(1), pages 214-235, July.
- R. A. Pollak, 1968. "Consistent Planning," Review of Economic Studies, Oxford University Press, vol. 35(2), pages 201-208.
- Read, Daniel & Loewenstein, George & Rabin, Matthew, 1999. "Choice Bracketing," Journal of Risk and Uncertainty, Springer, vol. 19(1-3), pages 171-97, December.
When requesting a correction, please mention this item's handle: RePEc:cca:wpaper:90. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Giovanni Bert)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.