Bounded rationality

Bounded rationality is the idea that when individuals make decisions, their rationality is limited by the tractability of the decision problem, the cognitive limitations of their minds, and the time available to make the decision. Decision-makers in this view act as satisficers, seeking a satisfactory solution rather than an optimal one. 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.

Some models of human behavior in the social sciences assume that humans can be reasonably approximated or described as "rational" entities (see for example rational choice theory, or Downs Political Agency Models). Many economics models assume that people are on average rational, and can in large enough quantities be approximated to act according to their preferences. The concept of bounded rationality revises this assumption 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.

Origins

The term was coined by Herbert A. Simon. In Models of Man, Simon points out that most people are only partly rational, and are irrational in the remaining part of their actions. In another work, he states "boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information". Simon describes a number of dimensions along which "classical" models of rationality can be made somewhat more realistic, while sticking within the vein of fairly rigorous formalization. These include:

• limiting the types of utility functions
• recognizing the costs of gathering and processing information
• the possibility of having a "vector" or "multi-valued" utility function

Simon suggests that economic agents use heuristics to make decisions rather than a strict rigid rule of optimization. They do this because of the complexity of the situation, and their inability to process and compute the expected utility of every alternative action. Deliberation costs might be high and there are often other concurrent economic activities also requiring decisions.

Model extensions

As decision-makers have to make decisions about how and when to decide, Ariel Rubinstein proposed to model bounded rationality by explicitly specifying decision-making procedures. This puts the study of decision procedures on the research agenda.

Gerd Gigerenzer opines that decision theorists have not really adhered to Simon's original ideas. Rather, they have considered how decisions may be crippled by limitations to rationality, or have modeled how people might cope with their inability to optimize. Gigerenzer proposes and shows that simple heuristics often lead to better decisions than theoretically optimal procedures.

Huw Dixon later argues that it may not be necessary to analyze in detail the process of reasoning underlying bounded rationality. If we believe that agents will choose an action that gets them "close" to the optimum, then we can use the notion of epsilon-optimization, which means we choose our actions so that the payoff is within epsilon of the optimum. If we define the optimum (best possible) payoff as $U^{*}$, then the set of epsilon-optimizing options S(ε) can be defined as all those options s such that:

$U(s)\geq U^{*}-\epsilon$.

The notion of strict rationality is then a special case (ε=0). The advantage of this approach is that it avoids having to specify in detail the process of reasoning, but rather simply assumes that whatever the process is, it is good enough to get near to the optimum.

From a computational point of view, decision procedures can be encoded in algorithms and heuristics. Edward Tsang argues that the effective rationality of an agent is determined by its computational intelligence. Everything else being equal, an agent that has better algorithms and heuristics could make "more rational" (more optimal) decisions than one that has poorer heuristics and algorithms. Tshilidzi Marwala and Evan Hurwitz in their study on bounded rationality observed that advances in technology (e.g. computer processing power because of Moore's law, artificial intelligence and big data analytics) expand the bounds that define the feasible rationality space. Because of this expansion of the bounds of rationality, machine automated decision making makes markets more efficient.

Relationship to behavioral economics

Further information: Behavioral economics

Bounded rationality implies the idea that humans take reasoning shortcuts that may lead to suboptimal decision-making. Behavioral economists engage in mapping the decision shortcuts that agents use in order to help increase the effectiveness of human decision-making. One treatment of this idea comes from Cass Sunstein and Richard Thaler's Nudge. Sunstein and Thaler recommend that choice architectures are modified in light of human agents' bounded rationality. A widely cited proposal from Sunstein and Thaler urges that healthier food be placed at sight level in order to increase the likelihood that a person will opt for that choice instead of less healthy option. Some critics of Nudge have lodged attacks that modifying choice architectures will lead to people becoming worse decision-makers.

Influence on social network structure

Recent research has shown that bounded rationality of individuals may influence the topology of the social networks that evolve among them. In particular, Kasthurirathna and Piraveenan have shown that in socio-ecological systems, the drive towards improved rationality on average might be an evolutionary reason for the emergence of scale-free properties. They did this by simulating a number of strategic games on an initially random network with distributed bounded rationality, then re-wiring the network so that the network on average converged towards Nash equilibria, despite the bounded rationality of nodes. They observed that this re-wiring process results in scale-free networks. Since scale-free networks are ubiquitous in social systems, the link between bounded rationality distributions and social structure is an important one in explaining social phenomena.

See also

• Administrative Behavior
• Altruism
• Analysis paralysis
• Ars longa, vita brevis
• Carnegie School
• Concept driven strategy
• Cognitive bias
• Cognitive miser
• Ecological rationality
• Framing (social sciences)
• Homo economicus
• Neoclassical economics
• Organizing principle
• Parametric determinism
• Potential game § Bounded rational models
• Prospect theory
• Psychohistory
• Rational ignorance
• Satisficing
• Social heuristics
• Subjective theory of value
• Substitution bias (psychology)
• Tragedy of the commons
• Transaction cost
• Utility maximization problem

Further reading

• Bayer, R. C., Renner, E., & Sausgruber, R. (2009). Confusion and reinforcement learning in experimental public goods games. NRN working papers 2009-22, The Austrian Center for Labor Economics and the Analysis of the Welfare State, Johannes Kepler University Linz, Austria.
• Elster, Jon (1983). Sour Grapes: Studies in the Subversion of Rationality. Cambridge, UK: Cambridge University Press. ISBN 0-521-25230-X.
• Gigerenzer, Gerd & Selten, Reinhard (2002). Bounded Rationality. Cambridge: MIT Press. ISBN 0-262-57164-1.
• Hayek, F.A (1948) Individualism and Economic order
• Kahneman, Daniel (2003). "Maps of bounded rationality: psychology for behavioral economics" (PDF). The American Economic Review. 93 (5): 1449–75. doi:10.1257/000282803322655392.
• March, James G. (1994). A Primer on Decision Making: How Decisions Happen. New York: The Free Press. ISBN 0-02-920035-0.
• Simon, Herbert (1957). "A Behavioral Model of Rational Choice", in Models of Man, Social and Rational: Mathematical Essays on Rational Human Behavior in a Social Setting. New York: Wiley.
• March, James G. & Simon, Herbert (1958). Organizations. John Wiley and Sons. ISBN 0-471-56793-0.
• Simon, Herbert (1990). "A mechanism for social selection and successful altruism". Science. 250 (4988): 1665–8. doi:10.1126/science.2270480. PMID 2270480.
• Simon, Herbert (1991). "Bounded Rationality and Organizational Learning". Organization Science. 2 (1): 125–134. doi:10.1287/orsc.2.1.125.
• Tisdell, Clem (1996). Bounded Rationality and Economic Evolution: A Contribution to Decision Making, Economics, and Management. Cheltenham, UK: Brookfield. ISBN 1-85898-352-5.
• Williamson, Oliver E. (1981). "The economics of organization: the transaction cost approach". American Journal of Sociology. 87 (3): 548–577 (press +).

External links

• Mapping Bounded Rationality by Daniel Kahneman
• Artificial Intelligence and Economic Theory chapter 7 of Surfing Economics by Huw Dixon.
• "Resource Bounded Agents". Internet Encyclopedia of Philosophy.