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March 19, 2010

Rational Decision Making: Myth or Reality?

Andrea Davila ’11
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How do we make decisions? If you believe classical economic models, decision making is a process of choosing the most rational and self-serving option. But, as Professor Stephan Meier’s research shows, many people’s decisions substantially deviate from this ideal. In fact, some individuals make consistently suboptimal choices, which can have an enormous effect on public policy and corporate strategy.

Meier’s research is focused on behavioral strategy, a subgroup of the growing field of behavioral economics. Behavioral economics marries standard economic theory with research in the field of psychology, often with surprising results.

Fruit or Chocolate?

In a famous experiment from 1998, Daniel Read and Barbara van Leeuwen of Leeds University Business School looked at how well individuals predict hunger and the effect of appetite on making choices. In the study, the researchers asked participants, “Deciding today, would you choose to eat fruit or chocolate next week?” Seventy-four percent of respondents chose fruit for next week. However, when the same respondents were asked about their choice a week later, 70 percent of them now picked chocolate, without regard to what was previously chosen. While this may not seem surprising to any chocolate lover, this effect is called present bias and it reveals an inconsistency in decision making not previously accounted for in economic theory and strategy.

Meier’s current research looks at the effect that present bias has on the financial services industry and the strategies firms can employ to provide benefits to both the nonrational consumer and the firm. In recent papers, he examined the links between present bias and credit card borrowing, showing that the association between higher credit card balances and present-biased individuals is robust — in other words, if you are the type of person who switched from fruit to chocolate, you will be more likely to have more credit card debt.

Capturing Value from Irrational Choices

Traditional for-profit financial services firms have used the irrational tendencies of consumers to their benefit — and even to the consumers’ detriment — which can result in long-term consumer attrition but high short-term profit margins. Meier suggests these firms might instead capitalize on the non-rationality of their consumers by offering products that benefit both parties, both to maintain long-term relationships and attempt to do well by doing good. For example, a firm could create a Christmas club account, which would allow consumers to save money in a non-interest bearing account for a specific purpose, such as the holiday.

Both the banks and the present-biased consumer benefit from this arrangement. Although it may seem like “doing well by doing good” is the social sector’s strength, there is also a lesson here for corporate firms: Think long term when building value for donors and design giving strategies that recognize and allow for nonrational decision making.

Meier encourages firms, both in the public and private sector, to “recognize people may make suboptimal decisions, but they are often systematic about these decisions. Since they are not random, firms can build on these behavioral patterns and predict how consumers may make decisions, designing products that maximize long-term value to the firm, not just squeezing short-term profits.”

This article also appeared in the Social Enterprise Club alumni newsletter. Learn more about the Social Enterprise Club and the Social Enterprise Program.

Photo credit: Flickr/The Consumerist

Comments

by Akash Trivedi | March 19, 2010 at 12:01 PM

This is an interesting concept. It would be interesting to see how this could be applied to health care. If a physician is able to apply incorporate the irrational aspects of the patient into his/her practice, he/she may be able to keep the patient healthier. This, in turn, would help reduce the cost of healthcare.

by J Gruszynski | March 24, 2010 at 2:29 PM

It's both: myth and reality. False dichotomies apply. Those of us who have been primary economic actors in things like marketing and sales for the last few decades have always found it laughable that academics even delude themselves into believing that economic decisions are primarily rational - empirically, it's self-evident that most are not. We use this fact daily. There is no "rational" buying/purchasing process that really is rational and it's trivial to take advantage of that fact. Part of this is due to sloppy definitions about what "rational" is. If you define it as predicate logic applied to empirically observed facts, then most economic is certainly not rational - even a little bit. If you allow for sloppier decision heuristics applied to imperfectly determined facts, they that's close to reality. This is not necessarily a bad thing or even in conflict with "apparent" rational decision evidence at a macroeconomic level. In the latter case, as long as the decisions have an empirical predictability and/or repeatability, you can have an aggregate appear rational even if all the microdecisions are perfectly irrational. The heuristics of behavioral finances are quite repeatable in a statistical sense. Irrationality does not equal maximum entropy randomness! That's the short answer. Too many folks are sloppy in their thinking about this and presume such an identity. They think: rational is orderly so irrational must be disorderly or even maximally disordered (maximum entropy). Learn so math folks! Part of the problem is also presuming that aggregate behaviors are linearly related to behavior of what's being counted. Such linearity is not even the case for aggregate qualifying for central distributions (which are actually very rare in economic reality). Since most systems aggregated don't have the event independence required to qualify central distributions (or CLT), it's even less wise to presume such a linearity. This is how stuff like behavioral finance can exist as scientifically valid phenomena yet have macroeconomics see things as nominally rational. There is *no* paradox; only naive models and ignorance about what models are and (can) say. Behavioral finance is a "Well, Duh!" phenomena to anyone who's done marketing or sales in the real world.

by Ann Hewitt Worthington '82 | March 30, 2010 at 8:49 PM

All good points. Behavior, while irrational, can be very predictable.

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