TROY, N.Y. — It’s common for people to make a decision they later regret. Mistakes and errors in judgment happen to everyone, and no one has the benefit of hindsight in the moment. Now, a new economic decision-making theory from Mina Mahmoudi, a lecturer in the Department of Economics at Rensselaer Polytechnic Institute, suggests a new explanation as to why humans so often tend to go with the adequate choice instead of the optimal choice.
Dr. Mahmoudi’s theory focuses on relative thinking. She hypothesizes that people often use ratios while making a decision when they should really deal in absolutes. Conversely, the opposite may also be true. Many people may tend to think in terms of “all-or-nothing” when a more balanced approach would be advisable.
“Effectively solving some economic problems requires one to think in terms of differences while others require one to think in terms of ratios,” Dr. Mahmoudi says in a university release. “Because both types of thinking are necessary, it is reasonable to think people develop and apply both types. However, it is also reasonable to expect that people misapply the two types of thinking, especially when less experienced with the context.”
A sale is a sale — not matter how much you save?
For example, if given the choice between saving $5 on a $25 product or saving $5 on a $500 product, prior research shows that most people will opt to save on the lower cost ($25) item. Why? Well, most would argue $5 off of $25 is a pretty good deal because the ratio of cost to savings is higher.
Dr. Mahmoudi argues, however, that at the end of the fiscal day $5 saved is $5 saved – regardless of an item’s cost. According to her theory the perfect, or optimal, choice would be for the consumer to look at the absolute savings and work equally hard to save $5 on each product. Ideally, a shopper should solve this problem using differences, but many habitually make unreasonable decisions due to ratio thinking.
“Understanding how the cognitive and motivational characteristics of human beings and the operating procedures of organizations influence the working of economic systems is of critical importance,” Dr. Mahmoudi concludes. “Many economic behaviors such as imitation occur and many economic institutions like inventories exist because people cannot maximize or because markets are not in equilibrium. Our model provides an example of a behavior that occurs because people cannot maximize.”
Researchers say they can apply this new decision-making model to any number of behavioral economic experiments across the gambling industry, financial markets, and many others.
The study is published in the journal Review of Behavioral Economics.