So happens for other sorts of large real-world economic decisions? Buying cars, selecting a mortgage or saving for retirement. Do people make good cautious decisions when the stakes get large? Do they attend to the details knowing how much more is on the line?
Our decision making abilities are not that great
You know the answers. The same biases found in the small decisions in the grocery store or laboratory also appear in the biggest decisions of our lives. We don’t have special machinery that we can suddenly turn on when we face a big decision. We’re stuck with the same brain circuits that helped our ancestors forward for food and track down prey but never evolved to compare fixed and adjustable-rate mortgages.
There are two fundamental types limitations on her decision-making. The first involves constraints on our cognitive abilities. Much as we might hate to admit it there are limits on her intellectual capacities. We can’t know everything, remember everything, compute everything. Some people work well with numbers and data, some can do complex calculations in their head. Other people have more difficulty with numbers and they adopt different strategies for making decisions but none of us is a supercomputer.
We don’t process information in absolute terms for example but in relative terms in comparison to a point of reference. Even though a silver medal is objectively better than a bronze medal after they win Olympic bronze medalist tend to be happier than silver medalist. That’s because they adopt different reference points. The bronze medalist think I did well enough to earn a metal while the silver medalist think I didn’t do enough to earn gold. Our brains are set up to use reference points.
We do not have unlimited time to make decisions
That’s a way of simplifying the decision process and using reference point does help in many circumstances as we’ll see in future lectures, but if we adopt the wrong reference point we lose perspective on what really matters. Put yourself in the place of a distant ancestor walking through grassland out of the corner of your eye you see a flash of movement a glint of sunlight and you react you immediately run for safety just eluding a predators clutches.
Each of us exists because some of her ancestors made decisions very rapidly avoiding a predator diffusing a violent situation steering away from a car crash in the road ahead. Real world decision-makers don’t always have the luxury of waiting, waiting until all the information is collected. Time constraints affect her economic decisions as well when deciding whether to purchase a home time is both your friend and enemy.
Acting slowly gives you more time to gain information and deliberate on this largest of all purchases, but acting slowly also carries opportunity costs someone else they put in an offer or interest rates may increase. These two limitations cognitive abilities and time constraints prevent us humans from being the ideal rational decision-makers posited by traditional economics.
The bounded rationality theory
We cannot make optimal decisions that always lead to the best outcome even if we wanted to, but we can recognize these limitations and try to optimize the decision process. The economist psychologist Herbert Simon introduced the idea of bounded rationality or rationality within limits.
Simon contended that the key challenges for real-world decision-making were in acquiring the right information, in simplifying the decision process and in adopting strategies for decision-making. We can’t overcome these challenges by becoming even more analytic and deliberative in our decisions.
Instead we adopt rules called heuristics that allow us to prioritize some information over other that simplify complex decisions into something manageable and that give us strategies that can be implemented quickly and with little effort. Those heuristics help us improve our odds of making a good decision even in the face or limitations.
But, like us, they’re not optimal, they’re just good enough most of the time over the two dozen lectures of this course we will explore many aspects of the decision-making process. Our biases are often surprising an counterintuitive and it is easy to just dismiss them as odd features of human nature, but they are oddities their clues.
Out limitations point to the deeper general principles that govern decision-making that show we aren’t rational decision-makers and you’ll start to recognize the limitations of your own thinking. Knowing your limitations won’t make them just go away they are too deeply rooted in your biology.
It is very difficult to change the basic mechanisms of decision-making, but that shouldn’t be a depressing thought it should be liberating. We are real people with real limitations making your way through a constantly changing world. We don’t need to be perfectly rational we just need to be good enough.