Economics Bounded Rationality Questions Medium
Bounded rationality and prospect theory are both concepts within the field of behavioral economics that aim to explain how individuals make decisions under conditions of uncertainty. While bounded rationality focuses on the limitations of human cognitive abilities to process information and make optimal decisions, prospect theory explores how individuals evaluate and make choices in situations involving potential gains or losses.
Bounded rationality suggests that individuals have limited cognitive resources and are unable to fully process and analyze all available information when making decisions. Instead, they rely on heuristics, or mental shortcuts, to simplify the decision-making process. These heuristics can lead to biases and deviations from rational decision-making.
Prospect theory, on the other hand, focuses on how individuals perceive and evaluate potential gains and losses. It suggests that people do not evaluate outcomes in absolute terms, but rather in relation to a reference point, such as their current status or a previous experience. Prospect theory also highlights that individuals tend to be risk-averse when facing potential gains and risk-seeking when facing potential losses. This means that people are more willing to take risks to avoid losses than to achieve gains.
The relationship between bounded rationality and prospect theory lies in the fact that both theories acknowledge the limitations of human decision-making and provide insights into how individuals deviate from rationality. Bounded rationality explains the cognitive constraints that lead to simplified decision-making processes, while prospect theory explains how individuals evaluate and respond to potential gains and losses. Together, these theories provide a more comprehensive understanding of how individuals make decisions in real-world economic situations.