The Rationally Inattentive Manager

Abstract

We analyze the ordering decisions of a manager who acquires demand information to make inventory decisions. Human beings' cognitive ability in information acquisition is imperfect by nature. We adopt the rational inattention theory to model the information acquisition activity. By reformulating the rational inattention decision problem, we find that rational inattention theory resembles the free energy principle (Friston 2009, 2010) that is used to model brain activities. Therefore, rational inattention theory gets a neurocognitive foundation. We obtain closed-form solutions of the optimal action strategies, which is a discrete distribution although the states are continuous. The process of resulting the optimal action strategies shows that the essence of the process, as a neurocognitive activity, is to think until nothing to think. The optimal action strategies themselves show that an effective thinking is hard to obtain unless think one more step. We also study the impact on decisions once the primitive information is contaminated. If the primitive information is contaminated by, for example, data sampling errors, the acquired information will be eclipsed by the contamination and exhibit certain features that mistaken the ordering decisions by acquiring information if the primitive information were clean. The specific forms of the well-known one-to-one correspondence between action and signal are also restricted by the contamination. We propose an empirical approach to identify the optimal ordering quantities, and the approach works only if the information contamination is separated from the estimation of the unconditional optimal ordering strategies.