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Chapter 1: Q 7 (page 15)

Explain, in your own words, the rationality assumption, and contrast it with the assumption of bounded rationality proposed by adherents of behavioral economics.

Short Answer

Expert verified

The rationality assumption states that people take the decision very carefully so as not to incur a loss while the bounded rationality is based on a simple method available to them.

Step by step solution

01

Step 1. Bounded Rational Behavior.

Bounded rationality behavior explains that people are rational but not completely as they do not examine every possible choice given to them but instead sort among the alternatives.

02

Step 2. Assumptions.

Rationality assumptions state that people make their decisions such that they do not incur a loss. On the other hand, bounded rationality do not consider every choice instead they make a choice by a simple method.

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Most popular questions from this chapter

Discuss the difference between microeconomics and macroeconomics.

Consider two models for estimating, in advance of an election, the shares of votes that will go to rival candidates. According to one model, pollsters’ surveys of a randomly chosen set of registered voters before an election can be used to forecast the percentage of votes that each candidate will receive. This first model relies on the assumption that unpaid survey respondents will give truthful responses about how they will vote and that they will actually cast a ballot in the election. The other model uses prices of financial assets (legally binding IOUs) issued by the Iowa Electronic Markets, operated by the University of Iowa, to predict electoral outcomes. The final payments received by owners of these assets, which can be bought or sold during the weeks and days preceding an election, depending on the shares of votes the candidates actually end up receiving. This second model assumes that owners of these assets wish to earn the highest possible returns, and it indicates that the market prices of these assets provide an indication of the percentage of votes that each candidate will actually receive on the day of the election.

(a) Which of these two models for forecasting electoral results is more firmly based on the rationality assumption of economics?

(b) How would an economist evaluate which is the better model for forecasting electoral outcomes?

In what way do small talk and gossip represent the use of simplifying assumptions?

Under what circumstances might people appear to use rules of thumb, as suggested by the assumption of bounded rationality, even though they really were behaving in a manner suggested by the rationality assumption?

Consider the following statements, based on a positive economic analysis that assumes that all other things remain constant. For each, list one other thing that might change and thus offset the outcome stated.

(a) Increased demand for laptop computers will drive up their price.

(b) Falling gasoline prices will result in additional vacation travel.

(c) A reduction of income tax rates will result in more people working.
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