Theory Of Games And Economic Behaviour - 968 Words

Although rationality provides the foundation for behavioural decision theory, current findings suggest that heuristics and biases have a significant impact on individual decision making. Rationality can only go so far in explaining individual decision making. A large part of early research into decision theory was based on the economic or normative approach, which tries to predict the actions of a so called ‘rational decision maker’. Although Bernoulli (1738) was the first to introduce the concept of utility into decision making, it was Von Neumann and Morgenstern’s book, ‘Theory of Games and Economic Behaviour’ which revolutionised the idea of a rational decision process. Von Neumann and Morgenstern (1947) explicitly outlined the†¦show more content†¦In contrast, EU theory suggests people have different attitudes toward risk – some would be risk averse and prefer the guaranteed payment, even though the expected value is lower, while others would choose the riskier bet. However, EU Theory and the normative approach to decision making are not without criticisms. As with every mathematical model, EU theory is a simplified representation of reality and does not guarantee reliable predictions o f human behaviour. Indeed, empirical evidence suggests the existence of systematic deviations from rationality. As Dawes (1988) wrote, â€Å"People, groups, organizations, and governments make choices. Sometimes the consequences of their decisions are desirable, sometimes not† (p. 2). Hence it can be argued that decision making is not purely rational (where rationality is defined as the decision predicted by EU Theory). In in attempt to create a more psychologically accurate description of decision making, Kahneman and Tversky (1979) developed Prospect Theory, which theorized that individuals have different perceptions when considering losses versus gains. In contrast to EU Theory, which suggests we make decisions that maximise our utility, research by Kahneman and Tversky (1979) found that information is not processed in such a rational way. For example, according to EU Theory, the amount of utility gained by receiving $200 should be equal to receiving $300 and losing $100 as in both situations