Human behavior, particularly the decision-making process in uncertain situations, has been studied through two contrasting approaches in economics. One is the ‘Rationality Approach’, which employs mathematical models based on a set of axioms and seeks to provide an analytical solution, similar to the economic models of efficiency and equilibrium. It includes the normative and descriptive models of decision-making under uncertainty. The second and relatively new approach is the ‘Behavioral Approach,’ i.e., the study of human behaviour in actual circumstances and emphasis on the importance of psychological factors influencing it.

Simon H.A. (1978)¹, in his Nobel prize lecture, said, “Economic science has focused on just one aspect of Man’s character, his reason, and particularly on the application of that reason to problems of allocation in the face of scarcity.” He questioned the assumption of rationality and changed the way economists think today.

This research paper briefly presents, in the first section, the historical perspectives of the ‘rational economic behaviour argument’ that dominated economic thought until the late twentieth century. The second section analyses the concept of ‘bounded rationality.’ The third section introduces Behavioral Economics BE and the contributions of Daniel Kahneman and Amos Tversky are discussed in the fourth section.

I. Historical Perspectives of ‘Rational’ Economic Behavior:

The perfect rational ‘homo œconomicus’ who possesses complete information about the choices available and has an analytical mind to foresee the results of choosing within these alternate options, and possesses the decision-making to identify the option that maximizes utility, has been at the heart of economic analysis and has passed through a long process of evolution.

a. Classical and Neoclassical Rationality:

In Wealth of Nations, 1776, Adam Smith said that economic behavior is motivated by self-interest and is guided by the ‘Invisible Hand’. Without using the term, he defended ‘rational’ behavior. He claimed that when people behave according to self-interest, they automatically make the best decisions for themselves and ensure the best for society. In 1789, Bentham presented the concept of utilitarianism based on ‘hedonistic rationality’, which claims that human actions aim to achieve maximum ‘net pleasure’. His idea of choice between pleasure-giving and pain-giving activities was of deliberate choice, i.e., choice made by reasoning and not merely by instincts. He suggested felicific calculus for the ‘measurement of utility.’ J.S. Mill’s Political Economics, 1848², states that economics “is concerned with him [Man] solely as a being who desires to possess wealth, and who is capable of judging the comparative efficacy of means for obtaining that end.”Mill rejected the idea of a hedonic measure of utility. In the 1870s, through the work of Jevons, Menger, and Walras, the concept of utility maximization regained popularity. In 1871, William Stanley Jevons started the ‘marginal revolution’, which revolutionized economic theory and paved the way for neoclassical economics. Jevons argued, “We always treat feelings as being capable of more or less, and I now hold that they are quantities capable of scientific treatment. Our estimation of the comparative amounts of feeling is performed in the act of choice or volition.”³Soon, mathematics entered the sphere of economics as a tool to define and analyse the economic behaviour of man as a ‘utility maximizing agent’.

Gossen's laws in 1854, and L. Walras’s ‘Elements of Pure Economics’ in 1874, resulted in the ‘Mathematical School of Economics’, which introduced a complex and exhaustive general equilibrium model based on simultaneous equations. However, Marshall’s Principles of Economics (1890), which laid the foundation of the Neoclassical school, dominated.

b. Utility:

Edgeworth was the next important economist who chose to analyze the rational economic man mathematically. In 1881, he introduced the generalized utility function and the indifference curve analysis for ordinal measurement of utility. However, he faced tough competition from the Marshallian neoclassical approach. With Pareto (1895), ordinal measurement of utility gained popularity, shifting the flow of thought away from the cardinal approach towards an ordinal interpretation based on indifference curves. P. A. Samuelson (1947) referred to this change as a “shift in emphasis away from the physiological and psychological hedonistic, introspective aspects of utility.”⁴

● Expected value was the first theory to analyze decision-making under risk. In 1738, Bernoulli introduced the theory of systematic bias, based on the psychophysical model, where he utilized the St. Petersburg paradox coin toss game to illustrate his perspective on expected value and presented the ‘utility function’ to explain behavior during decision-making. His analysis laid the foundation of the utility function, which dominated economic analysis for the next three hundred years. He assumed that utility is subjective, the marginal utility of wealth declines with increasing wealth, and people are risk-averse due to their attitude towards the value of payoffs. Von Neumann and Morgenstern, in their book ‘Theory of Games and Economic Behavior’ (1944), presented a rational model of individual decision-making based on three axioms of subjective expected utility analysis, i.e., transitivity, dominance, and invariance. The von Neumann–Morgenstern utility function explains all three conditions of risk: risk-averse, risk-neutral, and risk-loving behavior. They thus laid the foundation of ‘expected utility’, which soon developed as the dominant paradigm for choice under uncertainty.

Along with all these ideas, rationality continued to dominate economic thought. The term ‘homo œconomicus’ was first used by Maffeo Pantaleoni in 1889 in ‘Principii di Economia Pura’, to describe how a rational individual’s actions are motivated by the desire “to obtain a given result with the smallest comparative means; or, conversely, to obtain any maximum result with any given means”.⁵

c. Pareto’s homo œconomicus:

Pareto refined this concept through his critical analysis of M. Pantaleoni and in ‘Manuale D’Economia Politica’ (1906), and gave his analysis of ‘ophelimity’ (power to give satisfaction) and the Pareto Optimum. He discarded the concept of Bentham’s hedonism and presented an abstract, mechanical homo œconomicus, which became the foundation of ‘pure economics.’ Pareto’s homo œconomicus was “merely a choice machine selecting the best means to achieve his ends,” which paved the way for experimental economics.

Thus, the definition of homo œconomicus and rationality has a long intellectual history, and the concept of rationality continued to dominate until Herbert Simon introduced the concept of Bounded Rationality⁶.

II. Rationality Depends on Bounded Rationality. Herbert Simon’s Principle of Bounded Rationality:

In 1952, Herbert Simon, in his book ‘Models of Man’, challenged ‘homo œconomicus’. In his research article, “A Behavioral Model of Rational Choice” (1955), he presented an alternative view for developing empirical models of human behavior that avoids the neoclassical assumptions of utility functions. He argued that due to limited cognitive abilities, incomplete information, and time constraints and uncertainties, humans behave with ‘bounded rationality’ BR i.e., people may make choices that are not in their long-run interests. Thus, human decisions can be rational, irrational, or inconsistent because rationality is limited or ‘bounded’.

To quote Simon (1957), “The principle of bounded rationality: The capacity of the human mind for formulating and solving complex problems is minimal compared with the size of the problems whose solution is required for objectively rational behavior in the real world or even for a reasonable approximation to such objective rationality.”⁷Thus, Simon laid the foundation of the concept that a lack of information about all alternatives, uncertainties, and cognitive inabilities bounds rationality.

Moving away from the idea of global rationality of ‘homo œconomicus,’ Simon tried to reexamine the process of decision-making. He stated that individuals, when making decisions, do not aim to maximize utility by choosing the optimal alternative; instead, they aim for the best possible decision or ‘satisficing.’ To quote Simon (1957) again,

“The key to the simplification of the choice process in both cases is the replacement of the goal of maximizing with the goal of satisficing, of finding a course of action that is ‘good enough.’ This substitution is an essential step in the application of the principle of bounded rationality.”⁸

The optimization models of rational economists focus on the outcome of the decision-making process, i.e., maximization of utility. Simon’s ideas shifted the focus of rationality from the optimum choice towards the ‘decision-making process’, which leads to the outcome. By 1976, Simon emphasized ‘procedural rationality’. He stated that individuals guided by bounded rationality utilize information acquired through their experiences and process it according to their cognitive abilities to make informed choices and decisions.

As this transition from rationality to bounded rationality was taking place in economics, Psychology, which too is primarily concerned with the cognitive processes of the human mind rather than its results, entered into the arena of economics, and ‘Behavioral Economics’ BE came into being.

III. Behavioral Economics:

Behavioral economists employ a psychological perspective on the human decision-making process in economics, rather than the mathematical models of rationality. Using psychology, sociology, anthropology, and biology, BE attempts to predict how people make economic decisions using experiments and empirical evidence. The assumption of rationality is questioned by behavioral economists, who argue that, in actual circumstances, people often violate the axioms of the expected utility function discussed in Section 1.

The basic argument of behavioral economists is that rationality encourages people to choose the best option. Still, they often make mistakes. They make irrational choices because factors like multiple choices, biases, heuristics, loss aversion, mental fatigue, social norms, and uncertainties influence their decision-making process.⁹ Behavior, when it is influenced by psychological factors and emotions, at the moment of making decisions, is often ‘irrational or inconsistent.’ Past experiences also influence present choices. Losses are weighed more than gains, resulting in a tendency toward loss aversion. Further, cognitive biases also affect decision-making. Social preferences, incentives, and nudges all influence rationality.

The Prospect theory of Israeli cognitive psychologists Daniel Kahneman and the late Amos Tversky (1979) brought a revolutionary change in the rationality concepts and laid the foundation of BE to explore how cognitive biases play an essential role in the decision-making process. ¹⁰ The following section is a brief analysis of the concepts propounded by them about bounded rationality.

IV. Daniel Kahneman and Tversky: A Map of Bounded Rationality:

“Our research attempted to obtain a map of bounded rationality, by exploring the biases that separate the beliefs that people have and the choices they make from the optimal beliefs and choices assumed in rational-agent models” Daniel Kahneman, Nobel Prize Lecture, Dec.8.2002.¹¹

Kahneman and Tversky presented their research on human behavior with BR - a study of how decision-making takes place under uncertainty and is influenced by ‘heuristics and biases’ using empirical evidence in the ‘Prospect Theory’ of choice under risk and ‘concepts like loss aversion’ and ‘framing effects. Kahneman and Tversky argue that people lack statistical skills and therefore they make decisions by using judgmental heuristics. Kahneman and Tversky (1973) said, “In making predictions and judgments under uncertainty, people do not appear to follow the calculus of chance or the statistical theory of prediction. Instead, they rely on a limited number of heuristics that sometimes yield reasonable judgments and sometimes lead to severe and systematic errors.”¹²

Through their research and arguments, Daniel Kahneman and Amos Tversky brought decision-making in economics into the sphere of Simon’s bounded rationality. They used the notion of ‘a map of bounded rationality’ wherein rational choices are ‘bounded’ by people’s biases and beliefs.

i. Daniel Kahneman and Amos Tversky: ‘Architecture of Cognition: Two Systems’:

Several behavioral models, based on empirical evidence from experiments, were developed by Daniel Kahneman and Amos Tversky. They argued that consumer behavior shows ‘irrational judgment’ because it is ‘bounded’ by emotions, beliefs, and cognitive and psychophysical determinants. According to their arguments, intuition-based thinking creates impressions and feelings, takes the form of beliefs and biases, and influences focused and controlled thinking as well as conscious choices.

As psychologists, Kahneman and Tversky define reasoning and intuition as two distinct ways in which the human mind thinks before making decisions. Reasoning is a deliberate, ‘slow’ thought process that results in the formation of concepts, and intuitions result from ‘fast’ observations and lead to perceptions that may be impulsive, irrational, and erroneous. The ‘Architecture of Cognition’ explains these systems (Fig.1)

Fig. 1: Three Cognitive Systems

Source: Kahneman (2003).

The process of System 1, intuitive thinking, is shown in the first sub-box, while that of System 2, reasoning, is outlined in the second sub-box. Intuitive thinking requires no conscious effort, whereas reasoning is a deliberate process. Psychologists have conducted experiments on mental activities and concluded that System 2 is an ‘effortful function’ that demands concentration, time, and attention. When the human mind uses System 1, some perceptions and impressions are formed quickly; when it uses System 2, explicit, intentional judgments are made. System 1 does 98% of thinking tasks, and System 2 does the remaining 2%. System 1 sends intuitions and suggestions to System 2, which then forms beliefs. With the same inputs, the two systems get different results. Based on this architecture, Kahneman and Tversky explained the phenomenon of accessibility.

ii. The Accessibility Phenomenon:

“Attributes that are routinely and automatically produced by the perceptual system 1, without intentional efforts, have been called natural assessments.” Travesky and Kahneman 1984¹³.

The natural assessments or intuitions are easily accessible due to their spontaneity. Both genetic factors and acquired skills, practices, and experiences determine accessibility. When the mind is confronted with a situation, some impressions are generated from the accessible natural assessments. Accessibility is also affected by associative activation with stimuli. Prospect theory illustrates how accessibility influences rationality.

iii. The Prospect Theory and Loss Aversion:

“The proposition that decision makers evaluate outcomes by the utility of final asset positions has been retained in economic analysis for almost 300 years. This is remarkable because the idea is easily shown to be wrong; I call it Bernoulli’s error”. Kahneman, 2003.¹⁴

The Prospect Theory, as developed by Kahneman, D., and Tversky, A. (1979, 2003), is a decision-making theory that seeks to explain consumer behavior in uncertain situations using psychological concepts. The essence of their work is that human judgment is often based on intuitions and therefore differs from the judgments predicted by fundamental principles of probability.

The expected utility theory, as proposed by Bernoulli (David Bernoulli, 1738), assumes that states of wealth have a specified utility, and rational choice decisions are made to maximize the utility of wealth. Further, “the decision outcomes are assumed to be determined entirely by the final state of endowment and are therefore ‘reference independent”¹⁵(Kahneman and Tversky, 1979). As per this assumption, according to Bernoulli, in the case of uncertainties, also decisions are ‘optimum.’ Kahneman and Tversky disagree with this view, arguing that, due to its axioms (as discussed in Section 1), the measurement of subjective expected utility is complicated in real-life conditions. Empirical evidence reveals that decision-makers systematically violate the tenets of the expected utility theory. The prospect theory examines the gaps between expected utility theory and the psychology of real-life decision-making, explaining the phenomenon of risk aversion. The psychological factors of prospect theory attempt to provide a descriptive and empirical approach to explain choice from a common rather than an individual perspective.

The prospect theory states that utility is evaluated based on changes from a reference point rather than absolute outcomes. When evaluating utility, people are more sensitive to changes in wealth relative to a ‘reference point’ that may result from their decision-making, rather than the final value of wealth itself. In other words, the losses and gains are significant. The ‘reference point,’ usually their status of wealth, is critical. Further analyzing behavior, Tversky and Kahneman (1992) conclude that people tend to be more averse to losses than attracted by gains of the same size. Through their experiments, they estimate that the value attached to a loss is about twice the value attached to an equal gain. This psychological tendency is called ‘loss aversion.’

“Prospect theory distinguishes two phases in the choice process: framing and valuation. In the framing phase, the decision maker constructs a representation of the acts, contingencies, and outcomes that are relevant to the decision. In the valuation phase, the decision maker assesses the value of each prospect and chooses accordingly.”¹⁶ (Tversky, A. and Kahneman, D. 1992)

A choice decision passes through two processes. It is ‘edited’ at a ‘reference point’ related to the decision being made. The outcome of the decision is then ‘evaluated’ as a gain if it exceeds this ‘reference point’ and as a loss if it falls short of the ‘reference point’. The expected utility function thus derived is S-shaped and has the following characteristics (Fig.2):

· Concave for gains (risk aversion) and convex for losses (risk seeking);

· Shows diminishing sensitivity to change in both directions;

· Has a kink at zero or the reference point because it is steeper for small losses than for small gains;

Fig. 2. A Schematic Value Function for Changes

Source: Fig. 3 A Schematic Value Function for Changes in Kahneman and Tversky, 1979.

“The kink on the value function at the reference point – making the function much steeper for small losses than for small gains – implies that choices are consistent with loss aversion. Due to the diminishing marginal sensitivity to change in the value function, decision-makers become risk-averse towards gains (they value large gains less than proportionally) and risk-loving towards losses (they value large losses less than proportionally).”¹⁷ (Kahneman, D. 2002)

Prospect theory emphasizes short-term outcomes, and utility refers to the transient emotional responses people experience as they transition from one state to another, rather than focusing on long-term outcomes. It replaces the normative and prescriptive approach to utility, as adopted by rational economists, i.e., the Bernoullian error of reference independence, with a realistic approach that is descriptive and considers emotions in the form of gains and losses. The argument is that individuals tend to favour gains over losses when choosing between options.

For example:

Option 1: A free lottery ticket with a prize of Rs. 50.

Option 2: A lottery ticket with a prize of Rs. 100. (The cost of the ticket is Rs . 50.)

The end outcome of buying either lottery ticket is a gain of Rs. 50. Yet the individual will choose option one as he will perceive a net gain without any pain of a loss. Three factors that are important in making this decision are certainty, the isolation effect, and loss aversion.

a. Certainty:

There are two types of certainty: certainty of gain and certainty of loss. People choose an option of gain over an option with greater gain with risks or are ‘risk-averse’. In other words, there is a ‘bias towards certainty.’ When there is a certainty of loss, people take risks to avoid it.

b. Isolation Effect:

The isolation effect, also known as the Von Restorff effect (Hedwig von Restorff, 1933), states that the brain tends to focus on differences between two options rather than similarities, as differences serve as a stimulus and are more likely to be remembered. This affects the behavior because the individuals remember and give greater weight to differences between two stimuli.

c. Loss Aversion:

Loss aversion refers to the tendency to minimize losses rather than maximize gains, which arises because an individual's fear of loss is greater than the joy of gain. The reason is that losses are retained in memory for longer than gains, as they generate a stronger stimulus. When an individual can choose between two options, he tends to place greater weight on the loss and avoid it. Furthermore, Kahneman and Tversky demonstrated empirically that this response varies among individuals.

Kahneman and Tversky use the prospect theory to explain why an individual’s response to loss is much more intense than their response to gain, as described in their concept of loss aversion.

iv. Framing Effects:

“A particularly unrealistic assumption of the rational-agent model is that agents make their choices in a comprehensively inclusive context, which incorporates all the relevant details of the present situation, as well as expectations about all future opportunities and risks.”¹⁸ (Kahneman 1979)

The psychological or mental process during decision-making is termed ‘framing.’ Intuitive decisions depend on the accessibility or availability of information. When decision-making is in progress, the easily accessible features influence the individual, and features of low accessibility are usually ignored. Thus, the decisions are made in a narrow frame environment, or in ‘narrow framing.’

The choice-related decisions made at a particular point in time are influenced by the available information and are therefore framed narrowly. For example, while gambling, the decision to play a bet is made based on the given opportunity rather than a predetermined policy. Similarly, investment decisions are based on immediate market conditions. The gain/loss decisions are thus narrowly framed.

v. Judgment Heuristics:

“People rely on a limited number of heuristic principles which reduce the complex tasks of assessing probabilities and predicting values to simpler judgmental operations. In general, these heuristics are quite useful, but sometimes they lead to severe and systematic errors” ¹⁹ (Tversky and Kahneman, 1974, p. 1124).

Psychology has shown that human behavior is complex because perception, beliefs, emotions, attitudes, and memories of previous decisions influence current decision-making and shape it locally. Behavior adapts to and is dependent on perceptual conditions. In their initial research, Kahneman and Tversky (1974) observed that people frequently fail to analyze and make informed judgments in complex situations and when faced with uncertainty. The architecture of cognition (Sec 4. i.) System 1 scrutinizes information, ranks it according to its relevance, retains the essential, and filters the rest by taking shortcuts called heuristics. Heuristics are thus mental shortcuts of System 1 that decrease the cognitive load of the decision-making process of System 2. Therefore, judgments are based on ‘heuristics’ rather than probability. Heuristic strategies are developed by reviewing current information and connecting it to information gained from similar experiences. Heuristics simplify complex situations by using mental shortcuts, and the human mind often makes judgments that are systematically biased. Kahneman and Tversky conducted several experiments to discuss three heuristics that influence judgment: representativeness, availability, and anchoring and adjustment (Lenovo and Tversky, 2023)²⁰.

a. Representativeness:

Based on the prototype theory of cognitive science, which explains object and identity recognition, Kahneman and Tversky explain that individuals tend to classify events and situations they face in life into categories or prototypes in their memory. Each person builds categories or prototypes and uses them to make interpretations when faced with new situations or people. This shortcut is called the Representativeness heuristic. When a new object or event is encountered, it is classified into the category represented by a prototype stored in memory.

b. Availability:

This heuristic provides a mental shortcut that relies on immediately accessible information in the mind for making a decision. Thus, decision judgments are often biased by information related to events or situations that are more frequent or probable than others due to their greater availability.

c. Anchoring and Adjustment:

Anchoring results because people usually depend upon pre-existing information or the first information they receive while making decisions. In other words, already available or accessible information serves as an anchor, and the subsequent decisions are made around it using it as a reference point. Such judgments or decisions based on an anchor can be irrational.

These heuristics create cognitive biases. A cognitive bias is not entirely rational; therefore, individuals make illogical conclusions in different situations. These conclusions on heuristics and systematic biases of judgment questioned rationality and gained significance in many subsequent economic research. In his book, Thinking, Fast and Slow (2011), Kahneman presents his two-system model of decision-making and heuristics to explain how individuals are affected by cognitive biases that lead to irrational judgments and predictions. ²¹

CONCLUSION:

Thus, the prospect theory defines utility as gains and losses rather than states of wealth. It shifted the focus of economic thought from rationality and demonstrated that people are boundedly rational, capable of making errors. This shift in focus raised the following questions: why do people fail to maximize utility, how heuristics play an essential role in this, and the most critical question - how can this be prevented? Today, as economists search for answers to these questions, revolutionary developments are being witnessed as behavioral economics, experimental economics, and neuroeconomics emerge as new fields, leading to a departure from normative choice models to descriptive models. Today, psychological research is a fully established source of economic knowledge. The theory of systematic biases and heuristics paved the way for Nobel Prize-winning economist Richard Thaler's concept of “nudges.” A ‘nudge ' is any incentive, reinforcement, or suggestion given to an individual to influence their decision and can be used to improve people’s lives and solve many of society’s major problems. This idea emphasized the need for subtle policy shifts to guide individuals toward rational decisions without using explicit measures. Today, this approach is being widely applied. In the financial sector, Kahneman’s ideas have changed marketing strategies. Inspired by Prospect theory, companies have begun incorporating gamification and reward systems into their marketing strategies. Kahneman and Tversky devoted their entire research to studying boundedly rational judgments. Kahneman’s later works, ‘Thinking, Fast and Slow’ (2011) and ‘Noise: A Flaw in Human Judgment’ 2021, co-authored with Olivier Sibony and Cass Sunstein, are an in-depth exploration into the process of human judgment and human behavior. Today, behavioral economics is being applied in fields such as economic development, finance, marketing, and public policy, as it enables economists to incorporate cognition and behaviour into their analyses. The finance sector operates on the assumption of investor rationality, and behavioral finance posits that investors are prone to cognitive and emotional biases, which frequently lead to irrational decision-making. The cognitive biases of investors, such as herd behavior, hindsight bias, and cognitive dissonance, are essential factors in pricing anomalies in financial markets.²² Similarly, assessment of behavioral intention plays an essential role in Socially Responsible Investing, as it influences the behavior of investors when assessing potential profitability in investment decisions.²³

The legacy of Kahneman’s research has elevated behavioral economics, psychology, and decision-making to new heights, surpassing the limitations of traditional ‘homo œconomicus’ assumptions. Their ideas will continue to guide future generations as they delve into the complexities of human behavior.

CONFLICT OF INTEREST:

The authors have no conflicts of interest.

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Received on 02.09.2025 Revised on 07.11.2025

Accepted on 09.12.2025 Published on 11.05.2026

Available online from May 14, 2026

Asian Journal of Management. 2026;17(2):93-100.

DOI: 10.52711/2321-5763.2026.00015

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