Question

Discuss the ”rationality under certainty” and ”rationality under uncertainy” with respect to the following:

a) Provide the definitions.

b) Discuss the implications for real life situations by providing an ex-

ample for (a) an individual (b) a firm

Answer 1

Rationality under certainty: A condition of certainty exists when the decision-maker knows with reasonable certainty what the alternatives are, what conditions are associated with each alternative, and the outcome of each alternative. Under conditions of certainty, accurate, measurable, and reliable information on which to base decisions is available. Example: The managing director of a company has just put aside a fund of $100,000 to cover the renovation of all executive offices. This money is kept in a savings account at a local bank that pays 7.50 percent interest. Half of the money will be drawn out next month and the rest when the job is completed in 90 days. Can the managing director determine today how much interest will be earned on the money over the next 90 days?Given the fact that the managing director knows how much is being invested, the length of investment time, and the interest rate, the answer is yes. Investment of the funds in a local bank branch is a decision made under conditions of certainty. The outcome in terms of interest is known today. Rationality under uncertainty: The ‘Savage Paradigm’ of rational decision making under uncertainty has become the dominant model of individual human behavior in mainstream economics, and is an integral part of most of game theorytoday. However, this model has been criticized as inadequate from both normative and descriptive viewpoints. The various strands of this critical movement form the topic known as ‘bounded rationality.’ This article sketches the historical roots and some current developments of this movement, distinguishing between attempts to extend the Savage Paradigm (‘costly rationality’) and the need for more radical departures (‘truly bounded rationality’). Bounded rationality is the idea that an individual’s ability to act rationally is constrained by the information they have, the cognitive limitations of their minds, and the finite amount of time and resources they have to make a decision. Example: you're walking down the cereal aisle, looking for a healthy cereal. It'd be impossible to research every brand of cereal and compare nutritional information to find the healthiest one, right? Comparing the ingredients between just two cereals is tiring enough, much less trying to compare hundreds of them. You just don't have the time. Instead, you'd probably associate 'healthy' with an ingredient like whole wheat, find a box that says, '100% Whole Grain' and toss it in your basket. You found something that met the criteria for 'healthy,' in your mind, selected it, and moved along, without knowing whether it actually was the best choice.