USING HEURISTICS IN ECONOMIC DECISION MAKING
Andrijana Muura
Zagreb School of Economics and Management, Croatia
[email protected]
Mirna Korian
Zagreb School of Economics and Management, Croatia
[email protected]
Ivija Jelavi
Zagreb School of Economics and Management, Croatia
[email protected]
Abstract
Classical economic theory considers a man as rational decision
maker that takes into account all relevant information and makes
decision that is optimal. This model of decision making was
influential until it failed to predict and explain why people make
irrational decisions regarding money. Field of behavioral economics
studies decision making that violates axioms of rational
decision-making model. The research we conducted is about
prevalence of decisions under heuristics.Key words: rational
decisions making, behavioral economics, mental accounting,
heuristics1. INTRODUCTION
Decision making is defined, according to cognitivist definition,
as a result of metal processes that lead to the selection of a
course of action (or opinion) among several alternatives (Kahneman
i Tversky, 2000). Depending on a context, decision making can take
different forms. So we can talk about decision making in
management, organizations, social settings, interpersonal settings,
buying settings etc.
The history of decision making models was marked by several main
stream paradigms coming from various scientific disciplines.
Theoretical models of how people make decisions have evolved from
the economic paradigm of the 1940s, through the irrational
(passive) model of the 1950s and 1960s, to the cognitive and
emotional models of the 1970s and the 1980s (Zaichkowsky,
1991).
From the Economic view, decision maker is seen as one knowing
perfect information and rationally making choices that bring him
the most utility according to costs. Homo oeconomicus characterized
as motivated by self-interest and capable of making rational
decisions. Economic theory of decision making as also known as
expected utility theory and was considered the major paradigm in
decision making since the Second World War (Schoemaker, 1982;
according to Plous, 1993). This was a normative rather than a
descriptive model of behavior because it predicts how people would
behave if they followed certain axioms of rational decision making.
Main axioms of Expected utility theory are (Von Neuman and
Morgernstern, 1980): 1) Rational decision makers should be able to
compare any two alternatives (Alternatives order)
2) Rational decision makers should never adopt strategies that
are dominated by other strategies (Dominance)
3) Choice between any of two alternatives should depend only on
those outcomes that differ (Cancellation)
4) If X prefers A over B, and B over C that X should prefer A to
C (Transitivity)
5) Rational decision makers should always prefer a gamble
between the best and worst outcome to a sure intermediate outcome
if the odds of the best outcome are good enough (Continuity),
and
6) Rational decision makers should not be affected by the way
alternatives are presented (Invariance)
The problems arose when peoples choices couldnt be explained by
the theory and when the rationality was violated. These problems
led many researchers to abandon expected utility theory in search
of more useful alternative explanations.
In the 1950s, as an obvious reaction to the "economic man" and
under the influence of Behaviorism, decision makers are considered
to be irrational, impulsive, passive and vulnerable to external
influences. This was the time when psychologists Freud and Maslow
developed their influential theories on personality and motivation.
At this point, psychology became relevant discipline for explaining
human behavior in different applied settings. Parallel with the
Cognitive revolution in the 1960s, decision maker has started to be
seen as a problem solver in active search for information, starving
to make best possible decisions regarding his limitations. Into
account are taken the structure and functions of mental processes.
Social psychology, especially findings in social cognition, gave us
insight on how does economics of our brain processes influence the
way we perceive, organize and use information about the world
around us.
When Daniel Kahneman and Amos Tversky published their Prospect
theory: Decision making under risk, in Science magazine in 1979,
they wrote about heuristics and probability estimations, directly
confronting economic models of rational decision making. Since
then, a field called Behavioral economics started to develop.
Researcher started to use cognitive psychological techniques to
explain documented deviations of economic decision making from
neo-classical theory of Homo oeconomicus Behavioral economics has
started to be applied to explain a number of psychological effects
and phenomena related to making (irrational) economic decisions.
Focus of Behavioral economics is on process of decision making
especially around questions: Are the assumptions of utility or
profit maximization good approximations of real behavior?, and Do
individuals maximize subjective expected utility? (Camerer et al.,
2004).
A particularly unrealistic assumption about rational decision
maker is that rational actors maker their choice in context which
gives them absolute information and details of the present
situation, including opportunities and risks about the future
(Kahneman, 2002). Accumulated evidence comes from research on
framing and mental accounting. Framing Mental accounting is
established by economist Richard Thaler, and defined as process of
grouping gains and losses into separate mental accounts that affect
how decisions are made (Brendl et al., 1998). In mental accounting
theory, framing means that the way a person subjectively frames a
transaction in their mind, or, the way that one situation (problem)
is presented, will determine the (perception of) utility they
receive or expect (Thaler, 1985).
To test the existence and prevalence of heuristics and
behavioral economic phenomena was present in the part of the
student population, we conducted a research.2. METHOD
2.1. Participants
Four hundred and fifty students (N=450) participated in the
study. Participants were economy students from Zagreb School of
Economics and management (N=238) and psychology students (N=212)
from Faculty of Philosophy (University of Zagreb, Croatia). The
sample of student included freshmen, sophomores, juniors and
seniors.
2.2. Instrument
The survey was consisted of nine hypothetical
situations/questions gathered from the studies of Kahneman and
Tversky, Thaler and Brendl et al. (Kahneman and Tversky 2000;
Thaler, 1980; Brendl et al., 1998). Some of the questions included
two versions that differed in relevant element. Each survey
question included two or more answers to choose so the participant
was forced to answer. Also, each question was directing to a
certain heuristic or known phenomena.
3.2. Data
Data was analyzed using chi-square method in testing difference
according to frequencies obtained in the original studies. Results
are divided by four independent variables: 1) Field of study, 2)
Sex, 3) Stage of study, and 4) Source of financing. The results
will be discussed generally, taking into account average number of
choices made under the expected heuristics. 3. RESULTS AND
DISCUSSION Table 1. Percentage of answers / choices made under the
heuristics of mental accounting (max=9)
On five out of nine questions (56%) the results were not as
expected, meaning that the participants didnt gave answers under
the specific heuristics. On four out of nine (44%) questions we
obtained the results similar to ones in original research studies.
It seems that data about prevalence of heuristics of mental
accounting is not universally present or at least our research did
not confirm it. Table 2. Percentage of choices made under the
heuristics of mental accounting between study groups (max=9)
On seven out of nine (78%) questions the students of psychology
were giving heuristical answers. Economy students were
statistically differently less under the effect of heuristics
comparing to students of psychology. They gave more irrational
answers on two questions. We can assume that some characteristics
of students that study economy make them more rational when we talk
about money. Table 3. The percentage of students susceptible to
heuristic of mental accounting regarding the source of
financing
Student that have contact with money seem to make more choices
under the heuristics (56%) comparing to ones that are financed by
their parents (44%). We can expect that experience with money makes
people create mental accounts to economically manipulate with time
and energy. Mental accounting is best described by example of
theatre ticket (Kahneman and Tversky, 2000): Trade-off 1: Imagine
that you have decided to see a play where the admission is $10 per
ticket. As you enter the theater you discover that you have lost a
$10 bill. Would you still pay $10 for a ticket to the play?
Trade-off 2: Imagine that you have decided to see a play where
the admission is $10 per ticket. As you enter the theater you
discover that you have lost the ticket. The seat is not marked and
the ticket cannot be recovered. Would you pay $10 for another
ticket?
46% of participants, after loosing money decided to buy theatre
ticket in comparison to 88% of participant that, after loosing
theatre ticket decided to buy another one. Participants in the lost
ticket condition obviously integrated the cost of a new ticket with
the previous loss, but participants in the lost money condition are
not (Kahneman and Tversky 2000). Mental accounting is considered to
be a self-regulatory mechanism where financial outcomes are
categorized into already defined mental accounts which are part of
peoples financial knowledge or understanding. Otherwise, there is
no reason why participants didnt choose to buy tickets evenly in
two conditions. Mental accounting is concerned with the future
spending also. When expenditures in certain category are made,
people are taking into account future consumption differently
depending on which mental account they use money from. These
evaluations are important and people bring them into buying
decisions. To people, money is not fungible and amount of money in
cash and in check is not the same.
Research shows that people spend more when using credit cards
instead of cash. The feel of money is real and more salient in the
given moment than the little plastic card that is used to pay for
goods. And this is only one example how to utilize the fact that
people dont make rational decisions when it comes down to
money.
Having experience with money sets up mental accounts so each
time we have experience with it, our brains organize this
experience. Heuristics that we have are mental shortcuts that
affect the decisions we make and the way we reason. The positive
thing about them is that they economize or time and energy but the
negative side is that they often lead to wrong conclusions and
false ideas about the sources of our thinking. They make us people
psychologicus and not rational decision makers. Unless we take
effort to consider all the possibilities and when the decision we
make are important (Aronson, 2005). 4. CONCLUSIONThe research
showed that our data is only partially as we expected. Students of
psychology and students that are self-financing are more
susceptible to usage of heuristics when making economic decisions.
Students of economy and students with less contact with money are
making less irrational decisions. Before relying on results from
research on mental accounting and other studies of judgment and
decision making it is important to consider different variables
that make people more or less susceptible to heuristics. Generally,
people have tendencies to make irrational decisions.5.
LITERATUREAronson, E., Wilson, T. D. and Akert, R. M. (2005).
Social Psychology. Zagreb: MATE:
Brendl, C. M, Markman, A. B. i Higgins, E. T. (1998). Mental
accounting as self-regulation: Reprezentativeness to goal derived
categories. Journal for Social Psychology,, 29, 89-104.Camerer, C.,
Loewenstein, G. i Rabin, M. (2004). Avdvances in Behavioral
Economics. Princeton University Press.
Kahneman, D. and Tversky, A. (2000). Choices, values and frame.
Cambridge
University Press.
Kahneman, D. (2002). Maps of Bounded Rationality: Psychology for
Behavioral Economics. The American Economic Review, 93 (5).
Morgenstern, O. and Von Neuman, J. (1980). Theory of Games and
Economic Behavior. NJ: Princeton University PressThaler, R. H.
"Towards a positive theory of consumer choice" (1980) Journal of
Economic Behavior and Organization, 1, 39-60Thaler, R. H. "Mental
accounting and consumer choice" (1985) Marketing Science, 4 ,
199-214.
Plous, S. (1993). The psychology of judgment and decision
making. New York: McGraw & Hill.
Zaichovsky, J. L. (1991). Consumer behavior: yesterday, today,
and tomorrow. Business Horizons (May-June) Downloaded from URL:
http://findarticles.com/p/articles/mi_m1038/is_n3_v34/ai_10815913APPENDIX
1. Imagine that you have decided to see a play where the admission
is 30 kunas per ticket. As you enter the theater you discover that
you have lost 30 kunas. Would you still pay 30 kunas for a ticket
to the play?
Imagine that you have decided to see a play where the admission
is 30 kunas per ticket. As you enter the theater you discover that
you have lost the ticket. The seat is not marked and the ticket
cannot be recovered. Would you pay 30 kunas for another ticket?2.
You decided to buy a double size bed. You enter the shop where the
beds of different sizes (160, 180 and 200 cm) cost 700, 1000 and
1500 kunas. Now, all three sizes were now priced 500 kunas. Which
size are you most likely to buy?a) 160
b) 180
c) 200
3. You buy an expensive membership in a tennis club. Right after
you put down the money, which is nonrefundable, you hurt your
ankle.
You buy a cheap membership in a tennis club. Right after you put
down the money, which is nonrefundable, you hurt your ankle.
a) You grit your teeth and continue to play
b) You give up the play and go home
4. You are about to purchase a calculator from a store. The
calculator cost 550 kunas. If you walk 20 minutes to a new store,
you could save 25 kunas and buy the same jacket for 525 kunas.
Would you walk?
You are about to purchase a shirt from a store. The shirt cost
100 kunas. If you walk 20 minutes to a new store, you could save 25
kunas and buy the same shirt for 75 kunas. Would you walk?
a) Yes
b) No
5. You receive 500 kunas and offer to toss a coin. If head you
get 100 kunas. If tail, you loose 100 kunas. Will you gamble?You
have a chance to receive 500 kunas right away or accept gamble of
tossing a coin that can bring you 600 kunas or 400 kunas. Will you
gamble?
a) Yes
b) No
6. Two college students are visiting a gambling casino. Each has
won $25 in the same gamble. Student A received a winnings-check
that he can cash at any time and student B received cash. Now,
student A considers whether he should participate in the following
gamble: He would have to put his $25 winnings-check on the gambling
table. The chance of losing is 50%, the chance of winning is also
50%. If he loses, his $25 winnings-check goes to the casino. If he
wins, he gets $25 in cash and gets back his $25 winnings-check from
the table. Student B considers participating in this same gamble as
well. He would, however, have to put his $25 in cash on the table.
If he loses, his $25 cash go to the casino. If he wins, he gets $25
in cash and gets back his $25 stake from the table. In your
opinion, who is more likely to accept this gamble?
Please circle: Student A Student B
7. Imagine two college students are visiting a gambling casino.
In front of the casino each student finds $25 cash and puts the
money in his wallet. Each student pays the $25 entrance fee to
enter the casino. Student A pays with check and student B pays with
cash. Neither student has decided yet whether to gamble or not.
Both students consider the following gamble: You put $25 in cash on
the gambling table. You have a 50% chance of losing and a 50%
chance of winning. If you lose, your money goes to the casino. If
you win, you get $25 in cash in addition to getting back the $25
you put on the table. In your opinion, who is more likely to accept
this gamble?
Please circle: Student A Student B
8. Imagine two college students are visiting a gambling casino.
In front of the casino student A finds $25 cash and puts the money
in his wallet. Student A and student B pay the $25 entrance fee and
enter the casino. Inside the casino student B finds $25 cash and
puts the money in his wallet. Both students do not know yet whether
to gamble or not. Both students consider the following gamble: You
put $25 on the gambling table. You have a 50% chance of losing and
a 50% chance of winning. If you lose, your money goes to the
casino. If you win, you get $25 in cash in addition to getting back
the $25 you put on the table. In your opinion, who is more likely
to accept this gamble?
Please circle: Student A Student B
9. Imagine that you are the president of an airline company, and
you have to decide whether to invest 1 million euros into the
development of a new plane for which a competitor already has an
advantage.
Imagine that you are the president of an airline company, and
you have to decide whether to invest 1 million euros into the
development of a new plane for which a competitor already has an
advantage. You have already invested 9 million euros in this
investment.
Will you invest?
a) Yes
b) No
Economy, psychology, psychoanalysis, neurobiology, computer
science etc.
