In Blink: The Power of Thinking Without Thinking, Malcolm Gladwell explains that by necessity or instinct, many decisions are made on the basis of first impressions. Snap judgments can lead to less-than-optimal choices when products—such as new cars—or people—such as potential employees, marital prospects, or presidential candidates—look better than they really are. Gladwell calls this the Warren Harding effect in reference to the twenty-ninth president of the United States, who looked winningly presidential to over 60% of the voters, but turned out to be a poor leader with a scandal-ridden administration. Harding reportedly said of himself, “I am not fit for this office and never should have been here.” Clearly, Harding, and those who voted for him, made some mistakes due to limits on information and intelligence.

Dubious about models based on rationality and full information, Nobel laureate Herbert Simon explained that rationality is bounded by limitations in the ability of decision makers to formulate and solve complex problems. In Models of My Life, Simon argued that even Albert Einstein could not match the mental gymnastics ascribed to the fictional “economic man.” Simon coined the phrase bounded rationality to describe the limits on optimal decision making that result from imperfect intelligence and the scarcity of time and information. Bounded rationality causes missteps, as when a price that ends in “99” makes a consumer perceive the amount as being lower than it really is.

Simon also studied the judgmental heuristics—rules of thumb—that people use to simplify decisions when constrained by time, information, or cognitive ability. Consumers and managers are like chess players: they cannot fully analyze every possible sequence of actions that will follow their move. Instead, they must rely on instincts, experience, advice, short-cuts, and guesswork. For example, rather than making pricing decisions by evaluating the consumer response and subsequent profit from every possible price point, many managers use the simple “keystone” technique of doubling the wholesale price of each good to establish the retail price. The next FYI box explains that people often stick with the way things are rather than exploring their options. Simon felt that such heuristics led to decisions that were satisfactory but not optimal, and described this type of decision making as satisficing.

Neoclassical theories rest on assumptions of rationality that are sometimes at odds with observed human behavior. For example, some theories of consumer choice are valid under the assumption that the amount an individual would be willing to pay for a good and the amount he or she would accept to give up an identical good are the same. However, researchers have found endowment effects, meaning that people place a higher value on what they have than on what they don’t have. In a famous example, Daniel Kahneman, Jack Knetsch, and Richard Thaler found that, after randomly selecting half the students in a class to receive coffee mugs, students without mugs were willing to pay less than half as much to buy one as the people with a mug had to be paid to give one up.

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Behavioral economists use the concept of loss aversion to explain evidence that consumers consider sunk costs—those costs that have already been incurred and cannot be recovered—in their decision making. No matter how much money one has sunk into a project, it would be rational to abandon that project if the future benefits do not exceed the future costs. Yet some people choose to overeat in order to finish expensive meals, go to bad plays because they paid a lot for season tickets, or stick with a failing stock because they have invested so much money in it. An additional reason that people choose to stick with failing stocks is excessive optimism.

Excessive Optimism Crime provides an important example of bounded rationality in the form of excessive optimism. Neoclassical models treat crime as a rational activity, the price of which is the expected punishment. This implies that more severe punishments or higher rates of apprehension or conviction will deter crime. Yet a study of the knowledge and mindset of criminals found that most criminals do not have the information required to perform cost-benefit analysis before committing their crimes. Specifically, 76% of the convicted criminals in the study either had no thought that they might be caught or had no idea of the punishment for their crime, or both. Among the violent offenders, 89% lacked the information necessary to perform cost-benefit analysis. So in order to solve the crime problem, policy makers must go beyond the tenets of neoclassical economics and be open to solutions that address psychological problems and informational shortcomings.

Unfortunately, crime is just the tip of the iceberg of poor decisions caused by excessive optimism. Here are some additional examples:

Even when good information is available, people may not use it wisely. Because people are capable of stubbornness, bias, and misjudgment to their own downfall, the improper use of information can lead to unfortunate and inefficient resource allocations.

Framing It is standard procedure at several international hotel chains to place a card in the bathrooms of guest rooms with a message along the following lines:

Save Our Planet. Every day millions of gallons of water are used to wash towels . . . A towel on the rack means “I will use again.” Thank you for helping us conserve the Earth’s vital resources.

If the hotels were really bent on saving Earth’s resources, they would provide recycling bins, organic cotton sheets, and carpets made from recycled fibers. The pitch to avoid washing towels may have more to do with saving the financial resources of the hotels, but customer participation depends on how the appeal is framed.

Framing is the creation of context for a product or idea, and context matters. Richard Thaler found that a typical consumer would pay no more than $1.50 for a good brand of beer from a grocery store but would pay up to $2.65 for an identical beer from a fancy hotel, even if a friend was bringing that beer to the consumer to drink at the same beach either way. Brand managers spend millions of dollars to frame their brand names because, for example, consumers perceive apparel differently after seeing Maria Sharapova wear it, and they perceive a hotel differently knowing that Brad Pitt stays there. Consumers pay more for a cup of coffee at Starbucks than at McDonald’s, not because the Starbucks coffee itself is necessarily better (a 2007 Consumer Reports taste test suggests that McDonald’s coffee is actually better), but because of the image and ambiance in which Starbucks coffee is framed.

The strategy of odd or just-below pricing—setting prices that end in an odd number or just below an even dollar amount—is about framing as well. In terms of damage to the pocketbook, there’s little difference between paying $4.99 and paying $5.00. But the human mind finds it easier to accept a price of $4.99. Consumers subconsciously downplay the importance of the cents at the end of a price, and place more emphasis on the dollar amount at the beginning. Thus, $4.99 might seem close to $4.00, even though it is only a penny shy of $5.00. Also, prices ending in “99” or “95” convey the idea of a discount to bargain-hungry shoppers. Thomas Kibarian tested the influence of prices with odd-numbered endings by sending out three versions of a direct mail catalog for women’s clothing. The catalogs were identical except for the prices, which ended with either 00, 99, or 88. The catalogs with prices ending in 99 generated 8% more sales volume and attracted more consumers than those with prices ending in the even numbers. Managers at upscale department stores such as Nordstrom are aware of the psychology of pricing as well, but they use the contrasting strategy of ending prices with even numbers, symbolic of their high-end brand image.

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It’s rational to spend money, retire, or take vacations that decrease earnings, as long as the value of the resulting benefits exceeds the value of the money forgone. Yet sometimes people forgo money in irrational ways. Bounded willpower—willpower constrained by limits on the determination needed to do difficult things—can be the cause. The effects include spending too much money and earning too little money, but it isn’t all about money. Bounded willpower can also explain decisions to do too little homework, procrastinate too much, overeat, or throw a career-ending temper tantrum in front of the boss.

In the analysis of behavior, it is important not to categorize everything that causes problems as irrational. Economists Gary Becker and Kevin Murphy pointed out that even the use of potentially addictive substances can be rational if the benefits outweigh the costs. They showed that people who care more about the present than the future are more prone to addiction because they discount future problems related to health, relationships, and finances when weighing them against ongoing desires for addictive substances. Becker and Murphy argue that when heavy drinkers and smokers say they want to quit but cannot, it may be a matter of the long-term benefits of quitting falling below the short-term costs of making that adjustment.

While some addictions may be rational, humans are subject to temptations and emotions that can lead them astray. Anger, jealousy, frustration, and embarrassment can overcome willpower and trigger irrational responses. Take, for example, the Wendy’s customer who shot manager Renal Frage due to anger over not receiving enough packets of chili sauce. Similar examples appear frequently in the news.

Neoclassical economic models rest on assumptions of self-interested behavior, which is seldom in short supply. But some behavior exhibits elements of altruism uncharacteristic of Homo economicus. Warren Buffet is apparently not Homo economicus, having donated $2.6 billion to charity in 2013. Americans recycled or composted almost 87 million tons of materials in 2011 to the benefit of the environment and future generations. And the Bureau of Labor Statistics estimates that in 2012, 26.5% of the U.S. population volunteered some of their time to help less fortunate individuals. Charitable efforts can be self-serving if they bring attention, gratitude, tax advantages, or other benefits to the donors. But to the extent that some decisions are made selflessly, bounded self-interest—self-interest that leaves room for concerns about the welfare of others—represents a third category of deviance from neoclassical economic models.

Economists have examined the human struggle between self-interest and fairness with experiments involving ultimatum games and dictator games. In an ultimatum game, one person, whom we shall call the divider, has an amount of money, say $10, to divide between herself and another person, whom we shall call the recipient. After the divider makes the allocation, the recipient can either accept that division or reject it. If the allocation is rejected by the recipient, neither side gets anything. A rational, wealth-maximizing recipient will accept any positive share of the money, because some money is better than the alternative of no money. When working with such recipients, a rational, wealth-maximizing divider would allocate the smallest possible positive amount to the recipient: one cent. However, much experimentation has revealed strong interest in fair allocations, and punishment for those who make unfair allocations. Daniel Kahneman, Jack Knetsch, and Richard Thaler found that the typical recipient rejects anything less than a 23% share of the money to be divided, and that the average divider offers 45% of the money to the recipient. Related research has found fairness to be important even with changes in the culture of the participants, the amount of money at stake, and opportunities to learn from experience with the game.

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In the dictator game, the recipient has no choice but to accept the divider’s allocation. Thus, a rational, wealth-maximizing divider would give nothing to the recipient. Kahneman, Knetsch, and Thaler gave 161 students the option of dividing $20 evenly with an anonymous other student or giving the other student $2 while keeping $18. Even though the recipients had no say in the matter, 76% of the dividers gave half of the money to the recipient, again exhibiting substantial interest in fairness.

Clearly there is more to decision making than wealth maximization. Customers may pay more for a product that causes less harm to other people or the environment, as managers at Toyota discovered when their relatively expensive but environmentally friendly Prius Hybrid flew out of showrooms faster than the company could make more. Attracting a new employee by offering a salary that eclipses the salary of existing employees can cause considerable strife due to those employees’ interests in fairness. And there may be no amount of money that can separate a parent from a needy child, as suggested by Derek Fisher’s forfeiture of the remaining three years and $21 million in his NBA contract with the Utah Jazz to be with his ill daughter in 2007.