Financial Daily from THE HINDU group of publications
Sunday, Nov 03, 2002
Financial Daily from THE HINDU group of publications Sunday, Nov 03, 2002 |
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Investment World
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Economics Columns - Simple Economics Of human behaviour and economics B. Venkatesh
ECONOMIC rationality, the concept discussed last week, assumes that we have access to all information (perfect information in economics) for decision-making. This assumption is, however, not valid because it is very costly to gather all the information before we make a decision. The Nobel Prize-winning economist, Mr Herbert Simon, therefore, proposed a concept called bounded rationality. This refers to how people make decisions with limited time and knowledge. Suppose you want to buy a Maruti 800 car. A second-hand car dealer quotes Rs 1 lakh for a two-year-old car, which you think is a reasonable price. You do not know about the quality of this car and, therefore, wonder whether the owner is selling the car because it is of poor quality. You do not buy the car given your limited knowledge about its quality. Based on that, your decision not to buy the car even though it was reasonably priced can be economically rationalised. Better still, consider the stock market where bounded rationality abounds. You think Infosys at Rs 3,700 is rich, and want to sell it. Yet, there are others wanting to buy the stock at that price. How can you explain the difference in opinion? Given the limited information available to us, you may think that Infosys is selling dear at this price, whereas a dozen others may think it is selling cheap. You cannot, therefore, call the buyers irrational. Remember, all buyers may be thinking you are equally irrational in selling the stock, because they think it has the potential to move to, say, Rs 5,000. Mr Simon's bounded rationality as a concept was so powerful that it spawned a new research area called behavioural economics, which studies how people make decisions.
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