Attention is a finite resource. Because people have a limited capacity for acquiring and processing information, they must rationally select which information to prioritize and which to put on the back burner. By ignoring information that seems less valuable or more difficult to understand, people often end up making decisions that are based upon incomplete data.
Nathaniel Neligh, assistant professor in the Department of Economics at the University of Tennessee, Knoxville’s Haslam College of Business, studies this concept — called rational attention — and how it pertains to economics and business. “As economists, we model people as allocating their resources in a profit-maximizing way,” he says. “In the realm of attention, that means they will pay little attention to things that are too costly to understand or have little impact on payoffs. In other words, they will be ‘rationally inattentive’ to those things.”
Neligh explains three major areas where rational inattention can have surprising effects on personal finances.
Consumers make choices based on a wide variety of factors (e.g., features, price, quality). For each purchasing decision, certain factors will take precedence, while others will matter less or not at all. Rational inattention helps people ignore the factors they don’t care about so they can focus on the ones that are important to them.
“People will pay less attention to product features that are harder to see and understand,” Neligh says. “A great example of this is energy usage and lightbulbs. People do not pay attention to the energy savings from more efficient bulbs, so they will often buy the less expensive inefficient bulbs, which will cost more in the long run.”
Most investors don’t have the time, energy or ability to find and consider all the relevant information when making decisions about their portfolio. Therefore, they’re likely to make those decisions based on the information that is easiest to obtain or comprehend, which might not lead to the best possible investment performance.
“It takes effort to learn about a stock, so people usually only learn about and invest in a small handful of them,” Neligh says. “This means that most people have less diverse portfolios than they should, which means they face more risk than they would if they had perfect information.”
When inflation escalates (as has recently occurred), it’s on everyone’s mind. However, during periods when inflation is minimal, people don’t think much about it — they focus their attention elsewhere and may not notice signs of oncoming inflation, such as grocery prices gradually increasing.
“If prices for a product are low or have been stable over a long time, people stop paying attention to them,” Neligh says. “This makes people less sensitive to the price, which can give firms the opportunity to raise prices without seeing a drop in demand. I think this might explain a lot of what happened recently with egg prices.”
Reduce Demands on Attention
Although rational inattention can produce negative consequences, avoiding such problems is a challenge. Using rational attention may be an imperfect way to make decisions, but in today’s overcrowded attention environment, it’s a smart strategy.
“If you have attention to spare, calculating the cost savings for lightbulb efficiency is a good idea, but most people don’t,” Neligh says. “The best advice I can offer is to try to reduce extraneous drains on attention where possible.”
While reducing attention drainers may be easier said than done on the individual level, Neligh says policy makers have opportunities to help consumers lessen their cognitive load in ways that could produce long-term positive effects.
“Maybe add labeling requirements that make lightbulbs list their expected energy usage cost, or demand that companies include taxes and fees in listed prices,” he suggests. “These types of requirements make it less mentally taxing for people to do their comparison shopping.”
“Experimental Tests of Rational Inattention,” a paper Neligh co-authored with Mark Dean (Columbia University), is forthcoming in the Journal of Political Economy.
Stacy Estep, writer/publicist, email@example.com