In real life, decisions made by individual are easily deviated from the judging criteria, showing the behaviors of bounded rationality. Simon indicated that “the bounded rationality is a property of an agent or a person who makes decisions that behaves in a manner that is nearly optimal with respect to its goals and resources. (Franco 2009) This is because of, firstly human being have limited discernment and cognitive ability, also human are unable to know everything; secondly the environment is complex, when people face the complicated and uncertainty would, information is not complete due to vast uncertainty choice. Moreover, the rationality cannot play a role because of people are likely influenced by different situations. The report would analyze three concepts which are mental accounting, anchoring effect and conjunction fallacy to help to generate a better understanding of bounded rationality.
Behavioral economics is on the strength of the science of judgmental heuristics that could be to depend on reflexively by people. According to Furnham that heuristics are characterized as an ‘intuitive, rapid, and automatic system’ which ‘reduce the complex tasks of assessing probabilities and predicting values to simpler judgmental operations’ (Furnham 2010)The anchoring effect is one of the cognitive heuristics. Anchoring effect is a bias which people easily rely on the information of first impression as reference frame when making decisions. The first piece of information or previous information, as an anchor, could affect current performance; that information might be not highly applicable to the information judgment or even irrelevant thought. Also personal attributes and characteristic which are more deemed to an anchor are fixed and constant.
The other respondent is a salesman in a Sony store. Last week I went to city Sony store, a customer who looks like a student was looking for a brand new computer. Firstly one shop assistant briefly introduces different type and function of computers, the student expresses a strong purchase intention. Then the shop manager came and provide more detailed introduction of computer’s performance. Finally this student made her choice and started bargaining. Stalemate in their time, the shop manager said he is going to report to their boss to find out whether she can get more discount. After few minutes he walked up and said that is the lowest price, what they can do is offer her some gifts. The student was very satisfied and made payment. At this point, the computer engineer came when started to install the computer, and told her whether she needs a protection film to protect the screen, otherwise it is easy to scratch, also keyboard cover etc. The student felt make sense. At the end, she not only purchased computer, but also some accessories.
This is typically anchoring effect. Customer would feel sensitive if the shop manager promotes those accessories before they purchase computer, they might increase bargaining power and would not easily pay. However after customer paid for computers, they are willing to accept accessories because they feel accessories is relatively cheap compare to the expensive computer, moreover they do need these accessories. In general, the numbers which initially provide would affect consumers’ answer. Experienced salesman always offer a higher price before bargaining, accordingly a higher anchor exists in people’ mind. Seller fetches higher price even that consumer try to bring the price down. There is another example, which is when a business launches a new product, they will carefully discuss the positioning promotion plan, such as which good shelf the products should be placed in. If a new drink is published and placed beside Coca Cola and Pepsi, consumer would accept its high price and visa versa.
Anchoring effect is everywhere and inevitable. So how to avoid falling into anchoring effect can help consumer become a better financial planner. Firstly, putting forward an affordable price at the start when negotiation, with the purpose of offering an anchor to the seller. Besides buyer should notice that the loss of could not sell products is much more than the loss of a low price deal for seller. However refusing negotiate is a more wise than bargaining when face an unreasonable high price, it helps consumer to build a hopeful reference standard.
Mental accounting was proposed by Behavioral Science Professor Richard Thaler, he believes, “mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.” (Thaler 1999)In other words, except financial accounting, there is another managerial accounting exist in people’s mind, which called mental accounting, to influence people to make decision in real life. Consumers usually divide any expenditure and income of equal value into different accounts. For example, we usually put salaries into ‘hard to get rich’ account, regard annual bonus as an added gift, and put a winning lottery into ‘pie-in-the-sky’ account. The money in the ‘hard to get rich’ account is expensed precisely and carefully; for annual bonus, we often have relaxed attitude to treat it, for example, we might go to shopping center to purchase an expensive dress as a gift which are reluctant to spend money to buy at ordinary times. The money in the ‘pie-in-the-sky’ account is the most valueless, imagine that people who win five million dollars would become openhanded and extravagant. This is how mental accounting works.
My friend went to a fashion store and took a fancy to a very beautiful dress, but it costs about $320. She thought it is too expensive and gave up finally. But in her birthday party, her husband bought that dress for the birthday gift. It makes her very happy.
In fact, her money and her husband money are the family’s capital, but why she feels different with the same money spending according to different reasons. This study finds that the expenditure of mental accounting can be divided to four parts, which are daily necessities expenditures, home contribution expenditures and personal development expenditures, expenditures of emotional connection and recreational expenditures. According to irreplaceable of mental accounting, $320, as daily necessities expenditures, is too expensive to purchase a dress, however, the husband purchase it as a birthday gift which can be treated as expenditures of emotional connection. This amount of money can improve their relationship, so rewards are priceless. Consequently, people are willing to accept gifts from their family or friends, but they will not purchase for themselves.
According to above example, emotional connection and interpersonal relationship is significantly important for human beings, the investment of emotional for people is much more than other expenditures in everyday life. As a consequence, merchants could use these different festivals such as mother’s day, Christmas etc. to gain bigger sales. For example, a beautiful wrapped chocolate in Saint Valentine’s Day, coupons in Christmas, these special offers is negligible for merchants, but it can attract more consumers’ attention.
In usual, most of us could be influenced by mental accounting; we have different attitudes to handle the equivalent value of money, hence different decision comes out. From the point of view of economics, there is no any difference among salary, bonus and lottery, but people make three different decisions when spending them.
Tversky and Kahneman believe that the representativeness heuristic is a means of assessing the probability of an uncertain event or the value of a quantity by comparing it to a mental model (Berendsen 2012)
Conjunction fallacy is one of the result that causes by representativeness heuristic, which states the declare that there are two independent events, the probability of both events will happen cannot be higher than the probability than one of the events alone will happen.
I made 20 questionnaire surveys and handed into Finc6013 lecture. The question is that ‘the probability of healthy man who have heart disease is higher’ or ‘the probability of healthy men who are over 55 years old and have heart disease is higher’. There are 6 students chosen B and only 14 students chosen A. I was surprised that the result of this question is against the results of Linda problem. People think an event with more materials and details is more likely to happen. In fact it was not the case; every added detail makes things uncertainty. Two events can be happened independent or conjunction, the probability of conjunction events happened cannot higher than the probability of any independent event occurs. However in reality, people sometimes linked probability and quantity together by mistake when making decision, they consider that there is a higher probability of conjunction events. According to the investigation result above, there are three reasonable defenses for conjunction fallacy. Firstly the representativeness heuristic is identified as the cognitive tools valid for evaluating subjective probabilities.
The conjunction fallacy is attributed to the representativeness heuristic. It states that if the probability that the event is included in a classification is decided by how representative the event is of include in this classification. Consequently the conjunction fallacy proceed when the combination events is rated as more representative of the aimed classification than either the event alone. Conjunction fallacy can be occurred both in situation whether heuristic is applicable. Hence conjunction fallacy might have no any relationship with the heuristic. Secondly, there is an argument that informant misconception the investigative mission representatively used to study the phenomenon when investigator is doing survey. However it is undeniable that there is value for the investigation, for example some high quality levels of conjunction fallacies are surveyed, and misinterpretations are appropriately controlled in the survey.
Thirdly informants are likely to use an incorrect rule to gibe rise to conjunction fallacy happen when associating the probability of single events. There are some experimental results shows those informants assume the probability of conjunctive events is equal to the weighted average of the probability of event alone. Therefore if the probability of even A is rated to be greater than the probability of event B, but lower than the probability of event C, informants might debate that the probability of conjunction event A and B is lower than the probability of event A, however meanwhile they consider the probability of conjunction event A and C is greater than the probability of A. This is regard as conjunction fallacy effect. The reason is informants use an incorrect rule for combining probability.
Conjunction fallacy is increasingly questionable, it is common phenomenon though when people making decision in reality. On the basis of the characteristics of perceptual selectivity, the characteristics of information are more distinct and stimulation is stronger, people are more sensitive to their perception. Moreover, situational circumstances can influence human’s perception. Because decision making is conducted on the basis of human’s perception, the general and specific information and situational circumstances play a significant role on people’s decision making behaviors. (Nilsson 2010)
Although science and technology are advancing, and research measures of human being is always improving, to some extent, mental process stays at hypothetical stage up to now. This report discussed three decision making trap which are mental accounting, anchoring effect and conjunction fallacy. No matter which decision people try to make, it is important that they are supposed to search more information to choose the best alternatives, then they are able to gain experience through every decisions.
Berendsen, A., Hadilich, S. and Amersfoort, J.
2012, Looking at “Linda”: Is the Conjunction Fallacy Really a Fallacy?, viewed 27 March 2014,
Franco, R. 2009, ‘The conjunction fallacy and interference effects’, Journal of Mathematical Psychology, vol. 53, no. 5, pp. 415-422, viewed 30 March 2014,ScienceDirect,
Furnham, A. 2010, ‘A literature review of the anchoring effect’, The Journal of Socio-Economics, vol.
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