Complexity and bounded rationality in individual decision problems

Theodoros Diasakos

    Research output: Working paper

    3 Downloads (Pure)

    Abstract

    I develop a model of endogenous bounded rationality due to search costs, arising implicitly from the problem's complexity. The decision maker is not required to know the entire structure of the problem when making choices but can think ahead, through costly search, to reveal more of it. However, the costs of search are not assumed exogenously; they are inferred from revealed preferences through her 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. As long as calibration of the search costs is possible, this can be tested on any agent-problem pair. My approach provides a common framework for depicting the underlying limitations that force departures from rationality in different and unrelated decision-making situations. Specifically, 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.
    Original languageEnglish
    PublisherUniversity of St Andrews
    Number of pages65
    Publication statusPublished - Oct 2013

    Publication series

    NameSchool of Economics & Finance Discussion Paper 1314
    No.1314
    ISSN (Print)0962-4031
    ISSN (Electronic)2055-303X

    Fingerprint

    Dive into the research topics of 'Complexity and bounded rationality in individual decision problems'. Together they form a unique fingerprint.

    Cite this