The Rationality of Behavioral Biases
11 Pages Posted: 3 Jan 2018 Last revised: 9 Mar 2018
Date Written: December 29, 2017
Ignoring supposedly irrelevant information can be a strictly dominated decision approach, and thus irrational. The resulting unbiased decision can be improved upon by shrinking the decision toward an arbitrarily chosen reference point. By doing so, the decision-maker incurs a bias, but reduces the variance of the decision, which raises his expected utility. This dominance result highlights the difference between probability theory and statistical inference. The finding further suggests that when the decision-maker faces considerable uncertainty, his behavior should exhibit biases from an evolutionary standpoint. Examination of the known features of the anchoring effect provides additional support for this view.
Keywords: Decision Making under Uncertainty, Behavior Economics, Anchoring Effect, Decision Theory, James-Stein Shrinkage
JEL Classification: B20, C10, C11, D03, D81
Suggested Citation: Suggested Citation