Sunday, April 1, 2012

Behavioral Decision Making Theory

Classical decision theory in economics was developed under the assumption of rationality and certainty. Behavioral decision-making theorists develop their theory under the assumption that individuals have cognitive limitations and in organizations and world uncertainty exists and information is often ambiguous and incomplete.

If the model that economists use can be placed at one end, then a completely irrational model termed as social model can be placed at the other end various behavioral models can be placed in between.

Social Model - Freud

The social model is approximated by Sigmund Freud's explanation of humans. According him humans are bundles of feelings, emotions and instincts. Their behavior is largely guided by their unconscious desires. Certainly, the completely irrational person and his decision making process described Freud is too extreme to be useful to explain decision making and develop methods to improve it.

Simon's Bounded Rationality Model

Simon described his decision making model as follows:

1. Managers attempt to arrive at satisfactory solutions or good enough solutions. They are looking for adequate profit or share of the market.

2. They recognize that real world is extremely complex and work with simple models as the best way of solving problems.

3. Because they are happy satisfactory solution, they will not find all possible alternatives.

4.  They use techniques of decision making like using rules of thumb, tricks of the trade or use precedents etc. which do not make impossible demands on their capacity for thought.

Simon's model is also a maximization model but it is bounded by acceptable solution.

Judgmental Heuristics and Biases Model

Kahenmann and Tversky suggested that decision makers rely on heuristics (simplifying strategies or decision rules) even though these heuristics can result in biases.

The judmental heuristics reduce the information needs on the decision makers and help him:

1. by providing an easy method to take decision.
2. by providing simple rules of thumb and substituting complex information collection and calculation.
3. by saving considerable mental activity and cognitive processing.

The heuristics and biases can be described under:

1. The availability heuristic

Managers take decisions based on their knowledge and experience related to the problem at hand.

2. The representativeness heuristic

Managers make decisions based on their knowledge regarding a similar issue occurred earlier. One can say, if similar issues occurred number of times, the modal value becomes the representative value and managers use that for decision making.

3. The anchoring and adjustment heuristic.

They start with an available figure and arrive at a solution by making required adjustments to it. One popular example is calculating the salary of a person based on salary at the earlier job.

Fred Luthans, Organizational Behavior, 9 edition, 200, Pp. 366-74.

Came across an article - a chapter from the Handbook on Organization Psychology on Cognitive Processes in Strategic Management (Som Sekhar Bhattacharya brought the copy of it). The first part of the chapter states that strategic decision also are made with the heuristics like representativeness.

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