Linking rational inattention theory with behavioral economics…

A superb note from Anton Cheremukhin and Antonella Tutino of Dallas Fed.

They say we should look at rational inattention theory to understand irrational responses:

Market prices are often driven by choices later viewed as mistakes. Waves of optimism or pessimism sometimes dramatically move prices; a burst bubble of euphoria can bring significant macroeconomic consequences. A sudden change of sentiment may occur when a large number of stock market professionals consistently err by holding on to stocks for too long when they should sell, or by selling equities too quickly when they should be holding on to them. Yet, these individuals are specialists with every incentive to evaluate stocks correctly.

Behavioral experiments show that in laboratory conditions, people behave like market participants.[1] When faced with the same question repeatedly within any single experiment, they frequently change their minds. Why are people so inconsistent? Do rational people blunder? Theories on how individuals and groups reach decisions don’t provide a satisfactory answer. By and large, the mystery of costly human errors remains unsolved. Understanding why such mistakes occur can help researchers interpret change in observed behavior and carries implications for the behavior of financial markets.

Weighing the cost of making decisions may provide an answer.[2] A rational person may be willing to err if the cost of making a mistake is less than the cost of a precise and correct evaluation of each option. A rational person balances the gain from a consistently beneficial choice with the cost of paying attention—that is, the cost of being precise. Though information is abundant, not all of it is necessary to make a well-informed choice. Inattention to some information is a perfectly rational response in these circumstances.

So you have a prospect theory kind of curve which shows people choose averse/riskier option depending on their attention to the question.

We can illustrate the implications of rational inattention. Suppose a person is asked to choose between option A, which provides a guaranteed payout of $10, and a risky option B. Classical rational choice theory holds that if the value of option B is higher than that of option A, the person should choose option B. It makes no difference how much better option B is; if the person is asked to choose 100 times, option B should be selected 100 times.

Experimental data testing the theory show that people do not behave in the predicted manner. Chart 1 compares the prediction of rational choice theory with observed responses to an experiment in which the A and B choices are offered. The data suggest that it is very common for a person to pick the better option only 70 to 80 times out of 100, even if that option is unquestionably superior.

Rational inattention theory can explain this seemingly erratic behavior.[3] It postulates that rational people are prone to mistakes if they believe that the effort of making an informed choice is greater than the benefit of a correct choice. Further, this theory not only helps clarify individual preferences but also plays a pivotal role in discerning what a person considers a costly mistake. For instance, a risk-averse individual may favor a safe and informed choice over a riskier and more profitable bet. By contrast, a risk-loving person may lean toward more risky gambles, even without fully analyzing the properties of such an option, if the stakes are high enough.

While rational choice theory predicts deterministic outcomes—sure events—the thrust of rational inattention theory stems from its focus on expressing the likelihood of people’s choices in terms of probability. A rationally inattentive person behaves in terms of “odds,” flipping a coin as each choice is made. While the outcome of a particular choice is unpredictable, rational inattention theory predicts the probability of each occurrence.

The theory helps understand asset market bubbles etc. Need to read more on the topic..

3 Responses to “Linking rational inattention theory with behavioral economics…”

  1. Linking rational inattention theory with behavioral economics… « Knowledge Team Says:

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  2. Prospect Theory and Entrepreneurship | Startup Iceland Says:

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