The 4 Cs of rationality

In order to be perfectly rational, people should have

1)COMPLETE information
2)COGNITION and not emotion driving decision making
3)COMPUTATIONAL abilitz
4)CONSISTENCY with the axioms of choice

COMPLETENESS OF INFORMATION
Completeness includes information about
All outcomes and associated probabilities
All future events that are relevant to the decision
All attributes, including those whose value may not be observable
All relevant contextual factors needed to interpret and evaluate these data z

COGNITION

We know that emotions like regret, potential regret, guilt, sympathy or many
others could drive decision making

COMPUTATIONAL ABILITY
-Need to calculate the utility of options, where U=wiui(xi)
-This requires the brain to perform elementary information processing tasks, much
like a computer
-E.g., transforming, multiplying, adding, discounting

BOUNDED RATIONALITY
When computation is constrained, humans act as if they are boundedly rational.
This term is attributed to Nobel laureate Herb Simon

CONSISTENCY WITH THE AXIOMS OF CHOICE

von Neumann and Morgenstern (1947); Theory of Games and Economic Behavior
An axiom is a proposition that is considered to be self-evident. Its truth is taken for
granted, and serves as a starting point for deducing and inferring other (theory
dependent) truths.

AXIOMS: Completeness and Continuity

Completeness: For all X and Y, we have X Y, or X Y, or indifference
Continuity:There exists some probability such that a gamble between the best and
the worst outcome is as attractive as receiving a sure intermediate outcome.

AXIOM: Transitivity
If X Y, Y Z, then X Z
3 applicants; decision rule:

IQ

Experience
(yr)

120

110

100

if the difference in IQ is > 10, choose the more intelligent one.

If the difference in IQ is < 10, choose the one with more experience
This rule would result in:
B A, C B, but A C

AXIOM: Substitution
If a DM is indifferent between two possible outcomes (X and Y), they will be
indifferent between two lotteries which offer these outcomes with equal
probabilities, if the lotteries are identical in every other way. I.e., the
outcomes can be substituted.

Independence axiom independence of irrelevant alternatives

Cancellation principle

Allais Paradox

-- violation of the cancellation principle

Most people choose A

choose B

Most people

However, A = A and B = B (because an 89% probability of winning 1 million

has been replaced with a 89% probability of winning 0 in all the options

(cancellation), so substitution has been violated!

In conclusion
The axioms and other elements of rationality form the cornerstone of a normative
theory called the expected utility theory (and its variants)
A normative theory is not intended to describe how people actually behave
But how people would (or should) behave if they followed certain requirements of
rational decision making
If a persons preference satisfies certain assumptions (axioms), his preference can
be described by a utility function.