Lesson 3 Bounded Rationality and Unintended Consequences

Open Ended

Do you ever make decisions that you later regret? (we all do)

Why does this happen

​Lesson 3: Bounded Rationality and Unintended Consequences

By Brian Feltus

​Unit 1: Introduction to Economics and Decision-Making

Rational Choice Theory

• In an ideal world, people would always make optimal decisions that provide them with the greatest benefit and satisfaction.

• In economics...

  • Rational Choice Theory states that when humans are presented with various options under the conditions of scarcity, they would choose the option that maximizes their individual satisfaction.

Rational Choice Theory

• assumes that...

  • people make rational decisions by effectively weighing the costs and benefits of every option available to them.

  • The final decision made will be the best choice for the individual.

  • The rational person has self-control and is unmoved by emotions and external factors and, therefore, knows what is best for themself.

Rational Choice Theory

• Provides a framework for understanding how individuals make decisions based on their own self-interest

• Is the foundation for most of the major economic models used to forecast or predict how economic policies, such as taxes and regulations, can influence the decisions of individuals and businesses, and ultimately impact the overall economy

Bounded Rationality

• In reality, people are imperfect decision makers

• Bounded Rationality: there are limitations to human rationality and decision making

• Individuals make decisions based on what they know, not what they should know

  • People may not have access to all relevant information.

  • People have limited expertise and experience.

  • People have limited time to make decisions

Bounded Rationality

• We often make satisfactory decisions rather than the best possible decisions.

• We settle for making “good enough” decisions

Bounded Rationality

• In addition to time and knowledge constraints, we are also susceptible to cognitive bias

• Cognitive Bias: a systematic error in thinking, affecting how we process information, perceive others, and make decisions that can lead to irrational thoughts or judgment

• Are often based on our perceptions, memories, or individual/societal beliefs

• are unconscious and automatic processes that lead to quicker decision-making:

  • mental shortcuts

  • generalizations

  • emotional reactions

  • social pressures

Bounded Rationality

• Common Examples of Cognitive Bias:

  • Herd Mentality – The tendency to conform to the behaviors and beliefs of the people around you

  • Confirmation Bias – The tendency to search for information that supports our preconceptions and to ignore or distort contradictory evidence.

  • Overconfidence – The tendency people have to be more confident in their own abilities

  • Anchoring Bias– The tendency of relying too heavily on the first piece of information (the “anchor”) encountered when making decisions or estimates. Use that initial information as a reference point for subsequent judgements

Bounded Rationality

• Take a minute to look at this image

• It outlines many specific biases and their common causes

Consequences of Bounded Rationality and Cognitive Bias

• Unintended Consequences: the unforeseen and unexpected outcomes that can arise from actions or policies, often differing from the intended effects

• Even well-intentioned decisions may have unforeseen, harmful consequences

Consequences of Bounded Rationality and Cognitive Bias

• Unintended Consequences: China's War On Sparrows:

  • The Problem:

    • In the late 1950s China was experiencing food shortages, losing a lot of grain crops to pests.

  • The Solution:

    • The Chinese government created new policies to remove and exterminate all sparrows to reduce crop loss.

  • The Unintended Consequences

    • Without sparrows to eat them, insects like locust increased in population and consumed even more crops.

    • 55 million died from the famine made worse by the removal of sparrows.

    • The Chinese government paid to bring in 250,000 sparrows from Russia to reduce their insect population.

Consequences of Bounded Rationality and Cognitive Bias

• Intended Consequences

  • Sometimes bias can create intended consequences that contribute to long term problems far beyond the decision or policy itself

  • Example: Redlining

    • The US Government’s 1930s discriminatory homeownership programs created long term consequences for some communities.

To Review

• Humans are not perfectly rational in their decision-making, instead we have bounded rationality.

• We have limited knowledge, time, that leads us to settle for making “good enough” decisions (hopefully).

• We are also susceptible to cognitive bias involving emotions, social pressures, and mental shortcuts that affect how we see and interpret the world.

• These limitations can contribute to significant consequences, both intentional and unintentional.

Classwork Activity: Cases of Unintended Consequences

• In Canvas, open the assignment: Cases of Unintended Consequences.

• Select one and open the link to the article discussing the case.

• Answer all 4 questions thoughtfully in full sentences (this will be a classwork grade).

• Discuss as a class.