USING HEURISTICS IN ECONOMIC DECISION MAKING

Andrijana Muura
Zagreb School of Economics and Management, Croatia
andrijana.musura@zsem.hr
Mirna Korian
Zagreb School of Economics and Management, Croatia
mirna.korican@zsem.hr
Ivija Jelavi
Zagreb School of Economics and Management, Croatia
ivija.jelavic@zsem.hr
A!"ra#"
Classical economic theory considers a man as rational decision maker that takes into account
all relevant information and makes decision that is optimal. This model of decision making
was influential until it failed to predict and explain why people make irrational decisions
regarding money. Field of behavioral economics studies decision making that violates axioms
of rational decision-making model. The research we conducted is about prevalence of
decisions under heuristics.
Ke !ords" rational decisions making, behavioral economics, mental accounting, heuristics
#. $%&'()*C&$(%
)ecision making is defined, according to cognitivist definition, as a result of metal
+rocesses that lead to the selection of a course of action ,or o+inion- among several
alternatives ,Kahneman i &versk, .///-. )e+ending on a conte0t, decision making can take
different forms. So !e can talk about decision making in management, organizations, social
settings, inter+ersonal settings, buing settings etc.
&he histor of decision making models !as marked b several main stream +aradigms
coming from various scientific disci+lines
#
. &heoretical models of ho! +eo+le make decisions
have evolved from the economic +aradigm of the #12/s, through the irrational ,+assive-
model of the #13/s and #14/s, to the cognitive and emotional models of the #15/s and the
#16/s ,Zaichko!sk, #11#-.
7rom the Economic vie!, decision maker is seen as one kno!ing +erfect information
and rationall making choices that bring him the most utilit according to costs. Homo
oeconomicus characterized as motivated b self8interest and ca+able of making rational
decisions. Economic theor of decision making as also kno!n as expected utility theory and
!as considered the major +aradigm in decision making since the Second 9orld 9ar
,Schoemaker, #16.: according to ;lous, #11<-. &his !as a normative rather than a descri+tive
model of behavior because it +redicts ho! +eo+le would behave if the follo!ed certain
a0ioms of rational decision making.
Main a0ioms of E0+ected utilit theor are ,=on %euman and Morgernstern, #16/-"
#- 'ational decision makers should be able to com+are an t!o alternatives ,>lternatives
order-
.- 'ational decision makers should never ado+t strategies that are dominated b other
strategies ,)ominance-
<- Choice bet!een an of t!o alternatives should de+end onl on those outcomes that
differ ,Cancellation-
2- $f ? +refers > over @, and @ over C that ? should +refer > to C ,&ransitivit-
3- 'ational decision makers should al!as +refer a gamble bet!een the best and !orst
outcome to a sure intermediate outcome if the odds of the best outcome are good
enough ,Continuit-, and
4- 'ational decision makers should not be affected b the !a alternatives are +resented
,$nvariance-
&he +roblems arose !hen +eo+leAs choices couldnAt be e0+lained b the theor and !hen the
rationalit !as violated. &hese +roblems led man researchers to abandon e0+ected utilit
theor in search of more useful alternative e0+lanations.
$n the #13/s, as an obvious reaction to the Beconomic manB and under the influence of
@ehaviorism, decision makers are considered to be irrational, im+ulsive, +assive and
vulnerable to e0ternal influences. &his !as the time !hen +schologists 7reud and Maslo!
develo+ed their influential theories on +ersonalit and motivation. >t this +oint, +scholog
became relevant disci+line for e0+laining human behavior in different a++lied settings.
;arallel !ith the Cognitive revolution in the #14/s, decision maker has started to be seen as a
+roblem solver in active search for information, starving to make best +ossible decisions
regarding his limitations. $nto account are taken the structure and functions of mental
1
Econom, +scholog, +schoanalsis, neurobiolog, com+uter science etc.
+rocesses. Social +scholog, es+eciall findings in social cognition, gave us insight on ho!
does economics of our brain +rocesses influence the !a !e +erceive, organize and use
information about the !orld around us.
9hen )aniel Kahneman and >mos &versk +ublished their C;ros+ect theor"
)ecision making under riskD, in Science magazine in #151, the !rote about heuristics and
+robabilit estimations, directl confronting economic models of rational decision making.
Since then, a field called @ehavioral economics started to develo+. 'esearcher started to use
cognitive +schological techniEues to e0+lain documented deviations of economic decision
making from neo8classical theor of Homo oeconomicus @ehavioral economics has started to
be a++lied to e0+lain a number of +schological effects and +henomena related to making
,irrational- economic decisions. 7ocus of @ehavioral economics is on +rocess of decision
making es+eciall around Euestions" C>re the assum+tions of utilit or +rofit ma0imization
good a++ro0imations of real behaviorFD, and C)o individuals ma0imize subjective e0+ected
utilitFD ,Camerer et al., .//2-.
> +articularl unrealistic assum+tion about Crational decision makerD is that rational
actors maker their choice in conte0t !hich gives them absolute information and details of the
+resent situation, including o++ortunities and risks about the future ,Kahneman, .//.-.
>ccumulated evidence comes from research on framing and mental accounting. 7raming
Mental accounting is established b economist 'ichard &haler, and defined as +rocess of
grou+ing gains and losses into se+arate mental accounts that affect ho! decisions are made
,@rendl et al., #116-. $n mental accounting theor, framing means that the !a a +erson
subjectivel frames a transaction in their mind, or, the !a that one situation ,+roblem- is
+resented, !ill determine the ,+erce+tion of- utilit the receive or e0+ect ,&haler, #163-.
&o test the e0istence and +revalence of heuristics and behavioral economic +henomena
!as +resent in the +art of the student +o+ulation, !e conducted a research.
.. ME&G()
$%&% 'ar"i#i(an"!
7our hundred and fift students ,%H23/- +artici+ated in the stud. ;artici+ants !ere
econom students from Zagreb School of Economics and management ,%H.<6- and
+scholog students ,%H.#.- from 7acult of ;hiloso+h ,*niversit of Zagreb, Croatia-.
&he sam+le of student included freshmen, so+homores, juniors and seniors.
$%$% In!"ru)en"
&he surve !as consisted of nine h+othetical situationsIEuestions gathered from the
studies of Kahneman and &versk, &haler and @rendl et al. ,Kahneman and &versk .///:
&haler, #16/: @rendl et al., #116-. Some of the Euestions included t!o versions that differed
in relevant element. Each surve Euestion included t!o or more ans!ers to choose so the
+artici+ant !as forced to ans!er. >lso, each Euestion !as directing to a certain heuristic or
kno!n +henomena.
*%$% Da"a
)ata !as analzed using chi8sEuare method in testing difference according to
freEuencies obtained in the original studies. 'esults are divided b four inde+endent
variables" #- 7ield of stud, .- Se0, <- Stage of stud, and 2- Source of financing. &he results
!ill be discussed generall, taking into account average number of choices made under the
e0+ected heuristics.
<. 'ES*J&S >%) )$SC*SS$(%
Tale &% ;ercentage of ans!ers I choices made under the heuristics of mental accounting
,ma0H1-
Prevalence of choices made under the heuristics of
mental accounting
Heuristic
present;
44%
Heuristic
absent;
56%
(n five out of nine Euestions ,34K- the results !ere not as e0+ected, meaning that the
+artici+ants didnAt gave ans!ers under the s+ecific heuristics. (n four out of nine ,22K-
Euestions !e obtained the results similar to ones in original research studies. $t seems that
data about +revalence of heuristics of mental accounting is not universall +resent or at least
our research did not confirm it.
Tale $% ;ercentage of choices made under the heuristics of mental accounting bet!een stud
grou+s ,ma0H1-
Difference between study groups regarding the
usage of heuristics
Economy
students;
%
Psychology
students;
!"%
(n seven out of nine ,56K- Euestions the students of +scholog !ere giving heuristical
ans!ers. Econom students !ere statisticall differentl less under the effect of heuristics
com+aring to students of +scholog. &he gave more irrational ans!ers on t!o Euestions.
9e can assume that some characteristics of students that stud econom make them more
rational !hen !e talk about mone.
Tale *. &he +ercentage of students susce+tible to heuristic of mental accounting regarding
the source of financing
#usceptibility to heuristics of mental accounting
regarding the source of financing
#elf$
financed;
56%
%inanced by
parents;
44%
Student that have contact !ith mone seem to make more choices under the heuristics ,34K-
com+aring to ones that are financed b their +arents ,22K-. 9e can e0+ect that e0+erience
!ith mone makes +eo+le create mental accounts to economicall mani+ulate !ith time and
energ.
Mental accounting is best described b e0am+le of theatre ticket ,Kahneman and &versk,
.///-"
&rade8off #" $magine that ou have decided to see a +la !here the admission is L#/ +er ticket.
>s ou enter the theater ou discover that ou have lost a L#/ bill. 9ould ou still +a L#/ for a
ticket to the +laF
&rade8off ." $magine that ou have decided to see a +la !here the admission is L#/ +er ticket.
>s ou enter the theater ou discover that ou have lost the ticket. &he seat is not marked and the
ticket cannot be recovered. 9ould ou +a L#/ for another ticketF
24K of +artici+ants, after loosing mone decided to bu theatre ticket in com+arison to 66K
of +artici+ant that, after loosing theatre ticket decided to bu another one. ;artici+ants in the
lost ticket condition obviousl integrated the cost of a ne! ticket !ith the +revious loss, but
+artici+ants in the lost mone condition are not ,Kahneman and &versk .///-. Mental
accounting is considered to be a self8regulator mechanism !here financial outcomes are
categorized into already defined mental accounts which are part of peoples financial
knowledge or understanding. Otherwise, there is no reason why participants didnt choose
to buy tickets evenly in two conditions.
Mental accounting is concerned with the future spending also. When expenditures in
certain category are made, people are taking into account future consumption differently
depending on which mental account they use money from. These evaluations are
important and people bring them into buying decisions. To people, money is not fungible
and amount of money in cash and in check is not the same.
Research shows that people spend more when using credit cards instead of cash.
The feel of money is real and more salient in the given moment than the little plastic card
that is used to pay for goods. And this is only one example how to utilize the fact that
people dont make rational decisions when it comes down to money.
Having experience with money sets up mental accounts so each time we have
experience with it, our brains organize this experience. Heuristics that we have are mental
shortcuts that affect the decisions we make and the way we reason. The positive thing
about them is that they economize or time and energy but the negative side is that they
often lead to wrong conclusions and false ideas about the sources of our thinking. They
make us people psychologicus and not rational decision makers. Unless we take effort to
consider all the possibilities and when the decision we make are important (Aronson,
2005).
2. C(%CJ*S$(%
&he research sho!ed that our data is onl +artiall as !e e0+ected. Students of +scholog
and students that are self8financing are more susce+tible to usage of heuristics !hen making
economic decisions. Students of econom and students !ith less contact !ith mone are
making less irrational decisions. @efore reling on results from research on mental accounting
and other studies of judgment and decision making it is im+ortant to consider different
variables that make +eo+le more or less susce+tible to heuristics. Menerall, +eo+le have
tendencies to make irrational decisions.
3. J$&E'>&*'E
Aronson, E., Wilson, T. D. and Akert, R. M. (2005). Social Psychology. Zagreb:
MATE:
+rendl, C. M, Mar,)an, >. @. i Hi--in!, E. &. ,#116-. Mental accounting as self8
regulation" 'e+rezentativeness to goal derived categories. Journal for ocial !sychology", #$,
618#/2.
Ca)erer, C., .oe/en!"ein, M. i Rain, M. ,.//2-. %vdvances in &ehavioral 'conomics.
;rinceton *niversit ;ress.
Ka0ne)an, ). and Tver!,1, >. ,.///-. Choices" values and frame. Cambridge
*niversit ;ress.
Ka0ne)an, ). ,.//.-. Ma+s of @ounded 'ationalit" ;scholog for @ehavioral Economics.
The %merican 'conomic (eview, 1< ,3-.
Mor-en!"ern, (. and 2on Neu)an, N. ,#16/-. &heor of Mames and Economic @ehavior.
%N" ;rinceton *niversit ;ress
T0aler, '. G. B&o!ards a +ositive theor of consumer choiceB ,#16/- Journal of 'conomic
&ehavior and )rgani*ation, #, <184/
T0aler, '. G. BMental accounting and consumer choiceB ,#163- +arketing cience, 2 , #118
.#2.
'lou!, S. ,#11<-. &he +scholog of judgment and decision making. %e! Oork" McMra! P
Gill.
3ai#0ov!,14 N. J. ,#11#-. Con!u)er e0avior5 1e!"erda14 "oda14 and "o)orro/% @usiness
Gorizons ,Ma8Nune- )o!nloaded from *'J"
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>;;E%)$?
&% $magine that ou have decided to see a +la !here the admission is </ kunas +er ticket. >s
ou enter the theater ou discover that ou have lost </ kunas. 9ould ou still +a </ kunas
for a ticket to the +laF
$magine that ou have decided to see a +la !here the admission is </ kunas +er ticket. >s ou enter
the theater ou discover that ou have lost the ticket. &he seat is not marked and the ticket cannot be
recovered. 9ould ou +a </ kunas for another ticketF
2. Oou decided to bu a double size bed. Oou enter the sho+ !here the beds of different sizes
,#4/, #6/ and .// cm- cost 5//, #/// and #3// kunas. %o!, all three sizes were now priced
3// kunas. 9hich size are ou most likel to buF
a- #4/
b- #6/
c- .//
*% Oou bu an e0+ensive membershi+ in a tennis club. 'ight after ou +ut do!n the mone,
!hich is nonrefundable, ou hurt our ankle.
Oou bu a chea+ membershi+ in a tennis club. 'ight after ou +ut do!n the mone, !hich is
nonrefundable, ou hurt our ankle.
a- Oou grit our teeth and continue to +la
b- Oou give u+ the +la and go home
6% Oou are about to +urchase a calculator from a store. &he calculator cost 33/ kunas. $f ou
!alk ./ minutes to a ne! store, ou could save .3 kunas and bu the same jacket for 3.3
kunas. 9ould ou !alkF
Oou are about to +urchase a shirt from a store. &he shirt cost #// kunas. $f ou !alk ./ minutes to a
ne! store, ou could save .3 kunas and bu the same shirt for 53 kunas. 9ould ou !alkF
a- Oes
b- %o
7% Oou receive 3// kunas and offer to toss a coin. $f head ou get #// kunas. $f tail, ou loose
#// kunas. 9ill ou gambleF
Oou have a chance to receive 3// kunas right a!a or acce+t gamble of tossing a coin that can bring
ou 4// kunas or 2// kunas. 9ill ou gambleF
a- Oes
b- %o
8% &!o college students are visiting a gambling casino. Each has !on L.3 in the same gamble.
tudent % received a winnings-check that he can cash at an time and student & received cash.
%o!, student % considers !hether he should +artici+ate in the follo!ing gamble" Ge !ould
have to +ut his L.3 winnings-check on the gambling table. &he chance of losing is 3/K, the
chance of !inning is also 3/K. $f he loses, his L.3 !innings8check goes to the casino. $f he
!ins, he gets L.3 in cash and gets back his L.3 !innings8check from the table. tudent &
considers +artici+ating in this same gamble as !ell. Ge !ould, ho!ever, have to +ut his L.3 in
cash on the table. $f he loses, his L.3 cash go to the casino. $f he !ins, he gets L.3 in cash and
gets back his L.3 stake from the table. $n our o+inion, !ho is more likely to acce+t this
gambleF
;lease circle" Student > Student @
9% $magine t!o college students are visiting a gambling casino. $n front of the casino each
student finds L.3 cash and +uts the mone in his !allet. Each student +as the L.3 entrance
fee to enter the casino. tudent % +as !ith check and student & +as !ith cash. %either
student has decided et !hether to gamble or not. @oth students consider the follo!ing
gamble" Oou +ut L.3 in cash on the gambling table. Oou have a 3/K chance of losing and a
3/K chance of !inning. $f ou lose, our mone goes to the casino. $f ou !in, ou get L.3 in
cash in addition to getting back the L.3 ou +ut on the table. $n our o+inion, !ho is more
likely to acce+t this gambleF
;lease circle" Student > Student @
:% $magine t!o college students are visiting a gambling casino. $n front of the casino student %
finds L.3 cash and +uts the mone in his !allet. Student > and student @ +a the L.3 entrance
fee and enter the casino. $nside the casino student & finds L.3 cash and +uts the mone in his
!allet. @oth students do not kno! et !hether to gamble or not. @oth students consider the
follo!ing gamble" Oou +ut L.3 on the gambling table. Oou have a 3/K chance of losing and a
3/K chance of !inning. $f ou lose, our mone goes to the casino. $f ou !in, ou get L.3 in
cash in addition to getting back the L.3 ou +ut on the table. $n our o+inion, !ho is more
likel to acce+t this gambleF
;lease circle" Student > Student @
;% $magine that ou are the +resident of an airline com+an, and ou have to decide !hether to
invest # million euros into the develo+ment of a ne! +lane for !hich a com+etitor alread has
an advantage.
$magine that ou are the +resident of an airline com+an, and ou have to decide
!hether to invest # million euros into the develo+ment of a ne! +lane for !hich a
com+etitor alread has an advantage. Oou have alread invested 1 million euros in this
investment.
9ill ou investF
a- Oes
b- %o