Virtuous and Adverse Selection within Economic Organizations

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Biases in human behavior

The paper shows that biases in individual’s decision-making may result from the process of mental editing by which subjects produce a “representation” of the decision problem. During this process, individuals make systematic use of default classifications in order to reduce the short-term memory load and the complexity of symbolic manipulation. The result is the construction of an imperfect mental representation of the problem that nevertheless has the advantage of being simple, and yielding “satisficing” decisions. The imperfection origins in a trade-off that exists between the simplicity of representation of a strategy and his efficiency. To obtain simplicity, the strategy’s rules have to be memorized and represented with some degree of abstraction, that allow to drastically reduce their number. Raising the level of abstraction with which a strategy’s rule is represented, means to extend the domain of validity of the rule beyond the field in which the rule has been experimented, and may therefore induce to include unintentionally domains in which the rule is inefficient. Therefore the rise of errors in the mental representation of a problem may be the "natural" effect of the categorization and the identification of the building blocks of a strategy. The biases may be persistent and give rise to lock-in effect, in which individuals remain trapped in sub-optimal strategies, as it is proved by experimental results on stability of sub-optimal strategies in games like Target The Two. To understand why sub-optimal strategies, that embody errors, are locally stable, i.e. cannot be improved by small changes in the rules, it is considered Kauffman’ NK model, because, among other properties, it shows that if there are interdependencies among the rules of a system, than the system admits many sub-optimal solutions that are locally stable, i.e. cannot be improved by simple mutations. But the fitness function in NK model is a random one, while in our context it is more reasonable to define the fitness of a strategy as efficiency of the program. If we introduce this kind of fitness, then the stability properties of the NK model do not hold any longer: the paper shows that while the elementary statements of a strategy are interdependent, it is possible to achieve an optimal configuration of the strategy via mutations and in consequence the sub-optimal solutions are not locally stable under mutations. The paper therefore provides a different explanation of the existence and stability of suboptimal strategies, based on the difficulty to redefine the sub-problems that constitute the building blocks of the problem’s representation

From Bounded Rationality to Behavioral Economics

The paper provides an brief overview of the “state of the art” in the theory of rational decision making since the 1950’s, and focuses specially on the evolutionary justification of rationality. It is claimed that this justification, and more generally the economic methodology inherited from the Chicago school, becomes untenable once taking into account Kauffman’s Nk model, showing that if evolution it is based on trial-and-error search process, it leads generally to sub- optimal stable solutions: the ‘as if’ justification of perfect rationality proves therefore to be a fallacious metaphor. The normative interpretation of decision-making theory is therefore questioned, and the two challenging views against this approach , Simon’s bounded rationality and Allais’ criticism to expected utility theory are discussed. On this ground it is shown that the cognitive characteristics of choice processes are becoming more and more important for explanation of economic behavior and of deviations from rationality. In particular, according to Kahneman’s Nobel Lecture, it is suggested that the distinction between two types of cognitive processes – the effortful process of deliberate reasoning on the one hand, and the automatic process of unconscious intuition on the other – can provide a different map with which to explain a broad class of deviations from pure ‘olympian’ rationality. This view requires re-establishing and revising connections between psychology and economics: an on-going challenge against the normative approach to economic methodology.Bounded Rationality, Behavioral Economics, Evolution, As If

The dual process account of reasoning: historical roots, problems and perspectives.

Despite the great effort that has been dedicated to the attempt to redefine expected utility theory on the grounds of new assumptions, modifying or moderating some axioms, none of the alternative theories propounded so far had a statistical confirmation over the full domain of applicability. Moreover, the discrepancy between prescriptions and behaviors is not limited to expected utility theory. In two other fundamental fields, probability and logic, substantial evidence shows that human activities deviate from the prescriptions of the theoretical models. The paper suggests that the discrepancy cannot be ascribed to an imperfect axiomatic description of human choice, but to some more general features of human reasoning and assumes the “dual-process account of reasoning” as a promising explanatory key. This line of thought is based on the distinction between the process of deliberate reasoning and that of intuition; where in a first approximation, “intuition” denotes a mental activity largely automatized and inaccessible from conscious mental activity. The analysis of the interactions between these two processes provides the basis for explaining the persistence of the gap between normative and behavioral patterns. This view will be explored in the following pages: central consideration will be given to the problem of the interactions between rationality and intuition, and the correlated “modularity” of the thought.

Decomposition patterns in problem solving

The paper develops a theory of biases in decision making. Discovering a strategy for solving a game is a complex problem that may be solved by decomposition; a player decomposing a problem into many simple sub- problems may easily identify the optimal solution to each sub-problem: however it is shown that even though all partial solutions are optimal, the solution to the global problem may be largely sub-optimal. The conditions under which a decomposition process gives rise to a sub- optimal solution are explored, and it is shown that the sub-optimalities ultimately originate from the process of categorization that governs the creation of a decomposition pattern. Decisions based on a strategy discovered by decomposition are therefore frequently biased . The persistence of biased behaviours, observed in many experiments, is explained by showing the stability of different and non optimal representations of the same problem. An application to a simplified version of Rubik cube is finally developed.