Rationally irrational – How do we make decisions?

Understanding the thinking processes that impact how decisions are actually made.

Jari Melgin, 22.12.2017

The 2017 Nobel Prize for economics was awarded to Richard Thaler, one of the founders of behavioral economics. He follows the pioneering work of Daniel Kahneman, a researcher in psychology, whose “Thinking Fast and Slow” has become an international bestseller. An anecdote from Kahneman’s book recalls the moment when he visited the neighboring Department of Economics and was told, to his surprise, that economic theory was based on the assumption that people are rational beings maximizing their personal utility. Kahneman knew from his research that people are certainly not rational, and he challenged the established truths of the dismal science.

Kahneman knew from his research that people are certainly not rational, and he challenged the established truths of the dismal science."

Although behavioral economics is part of the standard curriculum in business schools today, the majority of our education still assumes that humans are selfish beings motivated to maximize profit. How many times have we heard “The target of a private company is to maximize shareholder wealth” – a statement that has even been canonized in corporate law.

Another famous management scholar, Herbert Simon, coined the concept of bounded rationality – the cognitive skills of humans being too limited to analyze and understand all aspects of rational decision-making. Rather than maximizing, Simon argued that we tend to ‘satisfy’, that is accept decisions that are good enough. Kahneman proposes that we have two thinking systems – “System One” and “System Two”. The preferred first system reflects intuitive thinking and requires little energy, while the second is based on complex analytical work and requires effort.

We also tend to use various behavioral biases to make shortcuts in reasoned analytical thinking, thus minimizing the effort needed to come to a conclusion."

We also tend to use various behavioral biases to make shortcuts in reasoned analytical thinking, thus minimizing the effort needed to come to a conclusion. Behavioral economists have identified and proven numerous biases. For example, people have a tendency to base decisions on loss avoidance rather than expected outcomes as we experience losses more strongly than gains.

Our minds are also easily fooled by framing, in other words providing a number that influences our understanding of the correct value. Just think about fashion pricing – shops may sell very few items at full price, but the original price imprints us with a monetary value, framing our mind to believe the fabulous discounts offered in seasonal sales. And it is easy to fall for the confirming evidence trap – basing our decisions on anecdotal personal experience, but only looking for and accepting evidence that supports our pre-determined view.

Understanding the limits of human rationality makes us better decision-makers."

Understanding the limits of human rationality makes us better decision-makers. Guggenheim and Espoo Metro, both large public projects, are good examples. Both projects were supported by extensive analytical work by civil servants and consulting companies, but they also relied heavily on an understanding of behavioral biases. Espoo Metro was sold to decision-makers as a 700 million Euro project, framing minds to a number which was incomprehensibly high, and in reality was exceeded by hundreds of millions. In Guggenheim, the strategy was apparently to confuse rather than convince, providing complex information to busy decision-makers, whose bounded rationality was unable to grasp all the nuances of the financing package.

In executive education, we need not only to teach the tricks and tools of rational decision-making, but also to make managers aware of the personal limits of rationality to improve their skill as decision-makers. Admitting to our bounded rationality and behavioral biases does not remove the need for solid analysis and systematic decision-making, but it improves our understanding of the thinking processes that impact how decisions are actually made.

Professor of practice Jari Melgin is one of the main Instructors in the Aalto Financial Executive Program. The behavioral aspects of decision making are discussed in depth during the module days. The program is designed for finance executives who want to gain a holistic view of leading and developing the financial functions in an organization. Read more

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