A maximum entropy model of bounded rational decision-making with prior beliefs and market feedback

TL;DR

This paper introduces an information-theoretic maximum entropy model for bounded rational decision-making that incorporates prior beliefs and market feedback, providing insights into agent behavior and belief evolution.

Contribution

It develops a novel maximum entropy framework integrating prior beliefs and market feedback within Smithian competition, extending decision-making models to include bounded rationality and temporal dynamics.

Findings

Model verified with Australian housing market data

Incorporation of prior beliefs affects agent decision outcomes

Framework allows analysis of belief evolution over time

Abstract

Bounded rationality is an important consideration stemming from the fact that agents often have limits on their processing abilities, making the assumption of perfect rationality inapplicable to many real tasks. We propose an information-theoretic approach to the inference of agent decisions under Smithian competition. The model explicitly captures the boundedness of agents (limited in their information-processing capacity) as the cost of information acquisition for expanding their prior beliefs. The expansion is measured as the Kullblack-Leibler divergence between posterior decisions and prior beliefs. When information acquisition is free, the homo economicus agent is recovered, while in cases when information acquisition becomes costly, agents instead revert to their prior beliefs. The maximum entropy principle is used to infer least-biased decisions based upon the notion of Smithian competition formalised within the Quantal Response Statistical Equilibrium framework. The incorporation of prior beliefs into such a framework allowed us to systematically explore the effects of prior beliefs on decision-making in the presence of market feedback, as well as importantly adding a temporal interpretation to the framework. We verified the proposed model using Australian housing market data, showing how the incorporation of prior knowledge alters the resulting agent decisions. Specifically, it allowed for the separation of past beliefs and utility maximisation behaviour of the agent as well as the analysis into the evolution of agent beliefs.