AEM414 - notes1_Notes - Lecture I Introduction Standard...

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Lecture I – Introduction Standard economic theory predicts behavior based upon rational choices . A simple definition of a rational choice might be: a choice calculated to maximize the well-being (utility) of the individual. As a model of behavior, this is appealing. It seems reasonable that individuals would try to do the best they can for themselves. Suppose I wish to predict behavior in some situation using rational choice theory. I would need to know: the distribution of payoffs resulting from each possible action. I could then determine which action would result in the highest average payoff, and use this as a prediction. This is a simple way to predict actions, if I know everything . What does everything include? Suppose I am trying to predict the portfolio of stocks an individual would hold. I would need to know the risk and payoff of each possible stock, the enjoyment the individual would get from using their money for current consumption, the utility of money for future consumption, how long the individual expects to live, and the utility of bequeathing money to descendents. Beyond this, is it costless for the individual to determine the best portfolio for them? Certainly not. It takes time, effort and expense to arrive at a good decision. How does one model these costs? In the absence of good models of costs regarding learning, understanding and decision-making, models usually make simplifying assumptions like: perfect information, perfect learning, costless and perfect decision-making. These models require quite a lot of the individual. Even without these simplifying assumptions, rational choice may be very demanding. Let’s examine this problem from the other perspective. Suppose I am an individual who wants to make good decisions. I need to:
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1. Completely understand the distributions of payoffs from each possible action (as far as is optimal). 2. Know each possible action. 3. Have well formed and understood preferences. 4. Learn at an optimal rate (taking account of my costs of learning). 5. Not make mistakes Certainly this requires a lot also. Have you ever made mistakes? I’ve graded students’ tests and homeworks before. While rational choice theory is a reasonable tool to use when the modeler and those being modeled can agree on payoffs, preferences and possible actions, there are many systematic and predictable behaviors that defy rational explanation. Have you ever done something you knew you would regret? Ever used a ‘rule of thumb’ for a decision? The purpose of this course is twofold. First, you will need to manage or market to imperfect individuals. In this case it will be useful for you to understand individuals’ imperfections, and learn to use and manipulate them. Second, you are an imperfect individual, and also susceptible to deviations from rationality. Understanding your own tendencies toward mistakes, or misperceptions may help you to improve your own decisions. Your success will depend critically on your ability to make better decisions
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AEM414 - notes1_Notes - Lecture I Introduction Standard...

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