Cognitive Economics: A New Perspective on Economic Decision-Making

Remember the last time you tried to buy a health insurance policy. I suppose most clauses in the contract, in the off chance that you read them, were very difficult to understand. Or, consider the time when you were deciding which laptop to buy. Deciding what would be the best laptop is not often an easy decision and is often filled with regrets.

Many real-world economic decisions share some similarities with the problems stated above. We need to make a choice between, say, two options, without knowing a priori which one is better for us. Before making a decision, due diligence is required. Problems of this variety have been studied by economists for a long time, with one important caveat. Such problems are called decisions under uncertainty, where the outcome of our action is not fully known at the time of making the decision.

Neoclassical economics models the above situation as a decision problem where all information about the decision is available. This means that if we give the economic agent all the information, she will make the correct choice. When these models were built in the 1980’s and 1990’s, lack of information was indeed the most important constraint. However, we are increasingly living in a world where information is available, often in excess of what we need. For example, recent disclosure policies make it mandatory for the insurance companies to reveal all relevant decisions in their contract.

Do we think, in the age of information, economic agents make fewer mistakes when making decisions? Perhaps, unsurprisingly, the answer is an emphatic no! Just having access to information is not enough. One needs to read it, understand it, and implement it in their individual context. All these processes are cognitively costly, which the neoclassical economics models did not consider.

The new paradigm of cognitive economics starts with the assumption that cognition is costly; all humans would prefer to optimise it. This is why giving information is not the same as ensuring the information is assimilated in decision-making. The research involves theoretical modelling of decision-making under cognitive constraints and experimental methods to understand the mechanisms behind behaviour, specifically, whether cognition has a role to play, and empirical evidence to understand where these constraints matter the most.

In my research, I construct theoretical models to predict choices under cognitive constraint. For example, I am interested in how such cognitive constraints play a role when agents are interacting with other strategic agents, like a buyer and seller, or a regulatory agency and a firm. Can one party, say the seller, manipulate the choice of another agent, say the buyer, knowing the other agent is cognitively constrained? Surprisingly, it is often difficult to do so when agents know that they are cognitively constrained.

I also conduct experiments to understand the drivers of decision-making. I explore whether agents use simple heuristics when making complex decisions. How does the effort put into making good decisions change when the problem becomes more difficult?

Cognitive economics as a field is in its infancy. We are only scratching the surface and trying to understand how cognition plays a role in decision-making and how our policy-makers need to be cognizant of it. If not, well-meaning policies can become disastrous. For example, forcing firms to reveal all relevant information can lead to firms manipulating the system by revealing a lot of irrelevant information, which in turn can make it harder to make better decisions.