‘Economic decision-making‘ has been conceptualized in a variety of ways by researchers. As such, Mina Mahmoudi, a lecturer in the Department of Economics at Rensselaer Polytechnic Institute, has proposed a new theory of economic decision-making that explains why humans, in general, choose judgments that are just sufficient rather than optimal.
Existing theories about ‘economic decision-making
Many times, theorists have tried to figure out how external circumstances affect an individual’s “economic decision-making”.
In general, economists have been effective in determining these criteria using one of the four models. The standard model, ultimatum bargaining model, imperfect commitment model, and strategic altruism model are the four options.
Each of these theories explains why people make some decisions more frequently than others. However, none of these ideas, in general, address situations in which individuals lack the ability to make optimal decisions based on their knowledge of available options. That is because it is impossible for humans to look at all alternatives; therefore, they can never know all available choices accurately enough in real-time.
It isn’t until after a decision has been made that economists consider what factors may have affected that choice. Furthermore, it is possible that these factors will change from case-to-case.
Nonetheless, there are a number of elements that can influence how people make judgments. Humans make optimal decisions on occasion, and on occasion, they do not; one thing is certain: humans do not always make the best decisions. Finally, even though a decision appears suboptimal at first glance based on available data, it may be the best option given a different set of circumstances.
Mahmoudi’s theory of ‘economic/financial decision making
In research published on 7 May 2022 in the Review of Behavioral Economics, Dr. Mahmoudi theorized an aspect of relative thinking explaining people may use ratios in their decision-making when they should only use absolute differences. The inverse is also possible.
In order to explain this behavioral anomaly, Dr. Mahmoudi has developed ‘a ratio-difference theory’ that gives weight to both ratio and difference comparisons. This theory seeks to more accurately capture the manner by which a boundedly rational decision-maker might operationally distinguish whether one alternative is better than another.
Dr. Mahmoudi stated that effectively solving some economic problems requires one to think in terms of differences while others require one to think in terms of ratios. “Because both types of thinking are necessary, it is reasonable to think people develop and apply both types. However, it is also reasonable to expect that people misapply the two types of thinking, especially when less experienced with the context, added Dr. Mahmoudi.
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Understanding how the cognitive and motivational characteristics of human works
Previous research has indicated that if given the choice between saving $5 on a $25 item or $500 on a $500 item, individuals would prefer to save money on the lower-cost item. Because the cost-to-savings ratio is higher, customers believe they are receiving a better deal. In fact, the $5 saved is the same for both purchases, therefore the ideal, or best, option would be to focus on the total savings and work equally hard to save each $5. People should employ differences to address this dilemma, however many people appear to make irrational conclusions because they think in ratios.
Mentioning that understanding how the cognitive and motivational characteristics of human beings and the operating procedures of organizations influence the working of economic systems is of critical importance, Dr. Mahmoudi said, “Many economic behaviors such as imitation occur and many economic institutions like inventories exist because people cannot maximize or because markets are not in equilibrium. Our model provides an example of a behavior that occurs because people cannot maximize“.
This model, according to experts, can be used in a range of behavioral economic experiments, including those in the gaming sector and financial markets. Furthermore, the discovery can be applied to how people make judgments in economic games, real estate, and a variety of other areas. Future research could lead to a greater understanding of how people make decisions on a regular basis and how this affects their success.