B is for Bias: From Rational Maximizer to Homo Heuristicus

B is for Bias: From Rational Maximizer to Homo Heuristicus

Calin Valsan (Williams School of Business, Bishop's University, Lennoxville, Canada)
Copyright: © 2014 |Pages: 13
DOI: 10.4018/ijabe.2014040103
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Abstract

Standard economic theory assumes rational agents. Individuals are expected to have rational expectations and constantly optimize their choices. Modern economic and financial theory is build under the assumption of rationality. There is plenty of evidence from psychology, however, that individuals are biased and rely heavily on heuristics in order to make decisions. Yet, this is not a mere fluke, a behavioral oddity. Because the social and economic environment in which individuals evolve is complex, behavioral biases represent evolutionary adaptations allowing economic agents to deal with undecidability and computational irreducibility.
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2. Logical Paradoxes: Consistency Vs. Completeness

In 1902, British mathematician Bertrand Russell proposed a paradox that shook the foundations of logic (Russell, 1902). Initially, the paradox made reference to the set of sets who are not members of themselves. Because the paradox was popularized with the help of a charade it became commonly referred to as the barber's paradox: Consider a small town barber who only shaves the men who do not shave themselves. But what about the barber? He could not shave himself, as already explained, because he only shaves those men who do not shave themselves. Perhaps he is shaved by the barber. But then, this could not be, because he would be shaving himself and one already knows he only shaves men who do not shave themselves. And so on. Obviously, one cannot use reason to answer this question.

In antiquity, this paradox was known as the liar's paradox (Barwise & Etchemendy, 1987), and for centuries it was treated as an amusing, yet innocent puzzle by philosophers and moralists. In 1931, however, German mathematician and logician Kurt Gödel dropped a bombshell. Gödel approached Russell's paradox from a different angle and showed that in a system of formal logic, one cannot determine if all statements are true or false, based solely on the axioms of the system. The truly dramatic conclusion, however, contends that a system of formal logical statements cannot be both complete and consistent at the same time (Wang, 1987).

Assume a system L, call it corporate finance, for example. The system relies on a set several postulates A: a1, a2, .aN. These postulates are considered to be self-evidently true, and they could take the following form: a1:“Individuals maximize return and minimize risk,” or a2: “Profit margin is net income to sales,” or a3: “Return on equity is net income to equity,” or a4: “Realized market return is dividend yield plus capital gain yield,” and so on.

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