Lecture 1 Revisiting Instrumental Rationality

The Psychology of Economic and Business Decisions

1. Introduction 2. Instrumental Rationality in Economics 3. Components of Rationality 4. Anomalies

1. Introduction
The Psychology of Economic and Business Decisions

Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses (Robbins) The concept of choice underpins economics - a trade-off between alternatives Economists study behaviour in order to explain and predict able to prescribe policies to government Economists use models, which comprises of variables and assumptions, e.g. behaviour = f (ends, means) Variables: what we study, e.g. behaviour, ends, means Assumption underlying economic theory: behaviour or choice is rational

2. Instrumental Rationality
The Psychology of Economic and Business Decisions

Rational choice theory - when faced with several courses of action, people usually do what they believe is likely to have the best overall outcome (Elster 1989) In economics, rational choice is instrumental: the individual has a set of preferences and will choose the action that he correctly calculates to be the most instrumental in satisfying his preferences (i.e. that maximises his utility) The economic man (homo economicus) is assumed to be instrumentally-rational

3. Components of Rationality
The Psychology of Economic and Business Decisions

Elster 1989: Action Preferences

Goals, desires, aims, wants (which give utility) Reason is slave to the passions (David Hume)

A choice between alternative courses of action

Beliefs

Probabilities, expectations

Evidence
Information, data

Axioms: e.g. Complete, Transitive

4. Anomalies
The Psychology of Economic and Business Decisions

There is empirical (real world) evidence that people do not conform to the predictions of instrumental rationality when making economic decisions
People do not always Preferences do not obey axioms, beliefs are not formed take the most correctly, and optimal decisions based on preferences and rational action information are not always taken, e.g. actions influenced by context, framing, order of presentation etc. (Lecs 3, 4) People are not always selfinterested Culture affects decisions People demonstrate pro-social preferences even though this adversely affects their material welfare, e.g. giving to others/charity; being fair; being reciprocal (Lecs 5, 9) People from different cultures behave differently under the same economic circumstances, e.g. Americans are more fair than Peruvian hunter gatherers (Lec 6)

Individual differences Different people behave differently under the same economic affect decisions circumstances, e.g. females more risk averse than males (Lec 7) Wealth

Happiness

Greater material welfare is not strongly associated with greater subjective well being/happiness across individuals, within individuals and across nations (Lec 8)