Rational and Behavioral Economics: Mental Processes Associated with Decision-making

Some techniques of psychology that study the behavior of individuals as decision-makers can provide explanations for their irrational behavior by invoking certain mental processes:

– the fear of losses and the attraction aroused by the big gains;

– enthusiasm and resignation;

– interest and disinterest;

– optimism and pessimism;

– euphoria and panic, etc.

The personality of a decision-maker, their introverted or extroverted character, predisposition to reason or intuition can also provide ways of understanding for some complex aspects of decision-making processes.

The theoretical basis of the analysis of mental processes is provided by cognitive psychology which studies how individuals perceive, memorize, learn, think, and decide. Empirical and theoretical studies of this branch of the science of psychology have revealed and interpreted some aspects of mental processes that can induce an irrational dimension of decisions:

– errors in processing information on the circumstances of decisions;

– the subjectivity of the perceptions, memory, and attention of the decision-makers;

– the role of emotions experienced by decision-makers;

– recourse to intuition, etc.

Theorists of cognitive psychology have revealed various traits of one’s personality decision-makers who may influence the degree of the irrationality of its acts:

– pragmatism or idealism;

– degree of confidence in professional skills;

– preference for unique or routine solutions;

– inclination for reasoning or intuition;

– risk aversion or preference, etc.

The problems of the rationality of decision-making processes are studied in the so-called descriptive approaches to decision theory, which present the concrete conditions under which decision-makers act in practice. These pragmatic approaches are, somewhat, in opposition to the normative ones, which, with a more theoretical character, are focused on the ideal conditions under which decisions should be based and adopted. For many of the normative approaches, the decision-maker is embodied by a perfectly rational individual, who acts only in his/her own interest. He/she, faced with a decision-making issue, will first seek to obtain complete information on it so as to fully understand all its circumstances. He/she will then identify them all the possible and feasible solutions choosing, from these, the one with the maximum utility.

Studies of the descriptive approaches revealed certain impediments to their fulfillment conditions. A person’s actions are not always governed by rationality, sometimes intervening intuition, emotional reactions, etc. A decision-maker may be guided by other considerations such as those philanthropic (in fact, sometimes one’s own interest is not easy to identify). In practice, complete information on the circumstances of the decision is not always straightforwardly obtained. Sometimes the pressure of time prevents decision-makers from seeking complete information. However, even if this information is available, the decision-maker may have certain cognitive limitations, which would prevent them from fully understanding the problem.

Such situations can be framed in the concept of limited rationality. Decision-making processes are characterized by rationality, limited by aspects such as the cognitive limits of the decision-maker or the pressure of time.

Directly associated with limited rationality is the use of so-called decision-makers heuristic methods that involve simple rules, based on the experience of similar situations; these are also known as rules of thumb – finger rules; the origin of the term is not known exactly. Such rules, although they cannot give rigor to the decision-making act, have the advantage of simplicity and efficiency. However, in the event of an erroneous classification of the decision-making situation, their application may have unfavorable consequences.

One of the best-known theories associated with the use of Heuristic methods is the model of satisfaction. It describes a situation in which a decision-maker, instead of thoroughly evaluating all decision-making options, he/she examines briefly one by one, stopping when they find a satisfactory one.

Many of the methods of cognitive psychology were taken over by the so-called behavioral economics, which is an approach to interpret, from psychological and sociological perspectives, decisions from economic activities. This approach differs fundamentally from the traditional branches of economics by the fact that, in doing the analysis, the decision-maker does not unconditionally accept the hypothesis but rather highlights the natural defects of human nature.

Behavioral economics studies have revealed for decision-making processes in the economic field, deviations from a rational behavior that come from both limits of cognitive aspects of the decision-maker as well as some emotional states he/she goes through. An important component of behavioral economics addresses financial activities, especially those associated with capital markets. For this reason, behavioral finance can be seen as a branch of behavioral economics.

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