Bounded Rationality

What is Bounded Rationality?

Bounded rationality is a concept that portraits the limitations of rational thinking in decision making processes. It describes the boundaries experienced by individuals facing the choice to move forward or not with a certain transaction.

Bounded rationality is a concept proposed by Herbert Simon that challenges the notion of human rationality as implied by the concept of homo economicus. Rationality is bounded because there are limits to our thinking capacity, available information, and time (Simon, 1982). Bounded rationality a core assumption of the “natural assessments” view of heuristics and dual-system models of thinking (Gilovich et al., 2002), and it is one of the psychological foundations of behavioral economics.

Bounded rationality is the idea that, when individuals make decisions rationality is limited by: the tractability of the decision problem; the cognitive limitations of the mind; and, the time available to make the decision. Decision-makers, in this view, act as satisficers, seeking a satisfactory rather than an optimal solution. Therefore, humans do not undertake a full cost-benefit analysis to determine the optimal decision, but, rather, choose an option that fulfils their adequacy criteria.

Herbert A. Simon proposed bounded rationality as an alternative basis for the mathematical modeling of decision-making, as used in economics, political science, and related disciplines. It complements “rationality as optimization”, which views decision-making as a fully rational process of finding an optimal choice given the information available. Simon used the analogy of a pair of scissors, where one blade represents “cognitive limitations” of actual humans and the other the “structures of the environment”, illustrating how minds compensate for limited resources by exploiting known structural regularity in the environment.

Many economics models assume that agents are on average rational, and can in large enough quantities be approximated to act according to their preferences in order to maximise utility. With bounded rationality, Simon’s goal was “to replace the global rationality of economic man with a kind of rational behavior that is compatible with the access to information and the computational capacities that are actually possessed by organisms, including man, in the kinds of environments in which such organisms exist.”

In short, the concept of bounded rationality revises notions of “perfect” rationality to account for the fact that perfectly rational decisions are often not feasible in practice because of the intractability of natural decision problems and the finite computational resources available for making them.

What Does Bounded Rationality Mean?

This idea was developed by Herbert Simon, an economist and a Nobel Prize winner, who intended to describe the factors that played a key role in decision-making processes and how the rationality of these processes was impaired by certain considerations. He identified three essential limitations experienced by the person making a given choice.

The first one is the availability of information, since the person entering the transaction has to make an informed decision with all the information he currently possesses. This information is not always reliable or profound enough to provide a sound rational argument for agreeing or not to the operation.

Secondly, cognitive limitations come into play, since as human beings we have limited knowledge and comprehension of facts and this reduces our ability to rationally decided about certain issues. Subjectivity, in these cases, makes it appearance, where the individual fill the gaps of his cognitive ability with pure instinct.

Finally, there are time boundaries, since not all decisions have a time frame that is long enough for the individual to analyze the situation adequately to come up with the most rational solution. These boundaries limit ourselves as human beings to be fully rational economic entities, as many authors proposed at some point in history.

Bounded rationality basically tones down a lot of the assumptions that go into homo economicus. Satisficers are a more diverse bunch, with unique tastes and preferences that change over time. Satisficers are not particularly good at making consistent decisions or predicting consequences of their choices. They often decide things, not out of calculated self-interest, but for other reasons, social norms, ethics, fairness, love, peer pressure, and so on. Sometimes they even decide things on a whim, with little or no thought of the consequences.

Satisficers almost never have full information about a choice, and the time and energy needed to get more information is usually just not worth the bother. They often don’t even know exactly what they want, or what will make them happy. While homo economicus, generally speaking, gets happier by buying more things, the satisficer is more complicated, and is often more concerned about how they’re doing in relation to other people.

The satisficer obviously looks a lot more like a human being than homo economicus does. But this makes the satisficer much harder to predict. Their decision-making process is complex, and incorporates a lot of different variables. They’re shaped by other people and the economic situation they find themselves in. All this makes it harder to make sweeping claims about what satisficers will do in a given situation. And even the satisficer is a simplification of how people actually behave! Turns out we’re a pretty complicated bunch.

Example

When the precept being violated is to “buy footwear that fits one’s feet” (an admonition that will no doubt find wide acceptance), the consumer’s action might be to purchase a pair of shoes that is instead one-half size too large. This behaviour would be considered boundedly rational if the shoes being purchased were needed for a wedding this afternoon and if a perfectly fitting pair could be obtained for certain only by visiting each of 10 geographically dispersed shoe shops. In this instance, thinking of the decision maker simply as an optimizer of comfort would lead to puzzlement at his selection, but the purchase of poorly fitting shoes looks reasonable enough when the consumer’s limited knowledge of the retail environment is considered.

Alternatively, when the precept being violated is to “draw electoral boundaries in such a way as to equalize the populations within the voting districts created,” the planner’s action might be to try to ensure merely that no two populations differ by more than 1 percent. This behaviour would be considered boundedly rational if the costs of computing an acceptable boundary configuration were to increase with the level of accuracy required, because it would then be appropriate to tolerate small inequalities in district populations to save significant computational costs.

In each of the two previous examples, an action that is undoubtedly suboptimal in a certain narrowly defined choice problem (among pairs of shoes or electoral partitions) can be “rationalized” by considering the totality of the decision-making environment. In the first case, purchasing a pair of shoes that is one-half size too large does not appear inappropriate given the consumer’s time constraint and ignorance of exactly where a better-fitting pair can be found. Similarly, creating voting districts with populations that are approximately but not exactly equal seems sensible given that improving the partitioning could be computationally expensive.

This general phenomenon—that boundedly rational behaviour can be made to look fully rational by broadening the scope of the choice problem to which it is seen as a response—has led some commentators to suggest that models of optimal decision making are adequate for social scientific purposes as long as the environment in which an agent chooses is always described “comprehensively.” But even if this is true in principle (which is by no means obvious), for the claim to have any practical significance, one must be willing both to declare a particular description of the agent’s environment to be comprehensive and to commit to a new, more general rationality precept such as, in the electoral partition example, to “minimize 1,000 times the maximum absolute difference between district populations in percentage terms minus the cost of computation in dollars.” If the planner fails to consistently obey any rule of this sort or if repeated broadenings of scope are needed to preserve the appearance of optimal decision making, a good case can be made for restricting attention to the simple problem of creating voting districts (without reference to computational costs) and for imagining the planner to be boundedly rational.

Individual effects

According to the decision-making process of bounded rationality, we are not inclined to find out all the necessary information that would be required to make a rational decision, because of cognitive and temporal limitations. This causes us to make choices that are satisfactory rather than optimal.

Our choices are still rational, considering the information that is realistically available to us, but may not be rational in lieu of all the possible information and resources. While it is difficult to behave according to perfect economic rationality, which is to maximize benefits while diminishing costs, making decisions based on bounded rationality can cause us to be inconsistent with our objectives.

Systemic effects

In any organization or institution, there are complex webs of decision-making.

The decisions that ought to be made by institutions are often with economic principles in mind, but these do not take into account the reality that humans do not function in a perfectly rational way.

While organizations want to make decisions that reflect their economic values and objectives, these decisions are made by individuals. Individuals are influenced by more than mere logic, and sometimes, decision-making individuals in companies have to make quick decisions that will impact the rest of the organization. With constraints like time, the choice that is made may only be satisfactory rather than optimal for the company’s objectives.

Rationality becomes all the more complex in a company where an individual’s optimal choice may not match the optimal choice for the company. Here, the rationality of CEOs and other decision-makers are bound in a different way, by their environment which asks them to put the needs of the company before their own. Bounded rationality is sometimes a necessary imperfection when we understand decision-making as part of a network, rather than theorize rationality based on a ‘perfect’ subject that is not a part of these complexities.

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