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0001
Iv. 3Bounded
Rationality
The tenn 'bounded rationality ' is used to designate rational choice
that takes into account the cognitive limitations of the decision maker -
limitations of both knowledge and computational capacity . Bounded
rationality is a central theme in the behavioral approach to economics ,
which is deeply concerned with the ways in which the actual decision -
making process influences the decisions that are reached.
The theory of subjective utility (SEU theory ) underlying neo-classical
economics postulates that choices are made : ( 1) among a given , fixed set
of alternatives ; (2) with (subjectively ) known probability distributions of
outcomes for each; and (3) in such a way as to maximize the expected
value of a given utility function (Savage, 1954). These are convenient assumptions
, providing the basis for a very rich and elegant body of theory ,
but they are assumptions that may not fit empirically the situations of
economic choice in which we are interested .
Theories of bounded rationality can be generated by relaxing one or
more of the assumptions of SEU theory . Instead of assuming a fixed set
of alternatives among which the decision maker chooses, we may postulate
a process for generating alternatives . Instead of assuming known probability
distributions of outcomes , we may introduce estimating procedures
for them , or we may look for strategies for dealing with uncertainty that
do not assume knowledge of probabilities . Instead of assuming the max -
imization of a utility function , we may postulate a satisficing strategy . The
particular deviations from the SEU assumptions of global maximization
introduced by behaviorally oriented economists are derived from what is
known , empirically , about human thought and choice processes, and
especially what is known about the limits of human cognitive capacity for
discovering alternatives , computing their consequences under certainty or
uncertainty , and making comparisons among them .
Generation of alternatives Modern cognitive psychology has studied in
considerable depth not only the processes that human subjects use to
choose among given alternatives , but also the processes ( problem -solving
processes) they use to find a possible course of action (i .e., actions that
will solve a problem ) ( Newell and Simon , 1972). If we look at the time
allocations of economic actors , say business executives, we find that perhaps
the largest fraction of decision -making time is spent in searching for
possible courses of action and evaluating them (i .e., estimating their consequences
). Much less time and effort is spent in making final choices, once
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292 Behavioral Economicsand Bounded Rationality
the alternatives have been generated and their consequences examined .
The lengthy and crucial processes of generating alternatives , which include
all the processes that we ordinarily designate by the word 'design', are left
out of the SEU account of economic choice .
Study of the processes for generating alternatives quickly reveals that
under most circumstances it is not reasonable to talk about finding 'all
the alternatives ' . The generation of alternatives is a lengthy and costly
process, and one where, in real -world situations , even minimal completeness
can seldom be guaranteed . Theories of optimal search can cast some
light on such processes, but , because of limits on complexity , human
alternative -generating behavior observed in the laboratory is usually best
described as heuristic search aimed at finding satisfactory alternatives , or
alternatives that represent an improvement over those previously available
( Hogarth , 1980).
Evaluation of consequences Cognitive limits , in this case lack of knowledge
and limits of ability to forecast the future , also playa central role in
the evaluation of alternatives . These cognitive difficulties are seen clearly
in decisions that are taken on a national scale : whether to go ahead with
the construction of a supersonic transport ; the measures to be taken to
deal with acid rain ; Federal Reserve policies on interest rates; and , of
course, the supremely fateful decisions of war and peace.
The cognitive limits are not simply limits on specific information . They
are almost always also limits on the adequacy of the scientific theories
that can be used to predict the relevant phenomena . For example available
theories of atmospheric chemistry and meteorology leave very wide
bands of uncertainty in estimating the enVironmental or health consequences
of given quantities and distributions of air pollutants . Similarly
, the accuracy of predictions of the economy by computer models is
severely limited by lack of knowledge about fundamental economic
mechanisms represented in the models ' equations .
Criteria of choice The assumption of a utility function postulates a consistency
of human choice that is not always evidenced in reality . The
assumption of maximization may also place a heavy (often unbearable )
computational burden on the decision maker . A theory of bounded
rationality seeks to identify , in theory and in actual behavior , procedures
for choosing that are computationally simpler , and that can account for
observed inconsistencies in human choice patterns .
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Bounded Rationality 293
Substantive and procedural rationality Theories of bounded rationality ,
then , are theories of decision making and choice that assume that the
decision maker wishes to attain goals, and uses his or her mind as well as
possible to that end; but theories that take into account in describing the
decision process the actual capacities of the human mind .
The standard SEU theory is presumably not intended as an account of
the process that human beings use to make a decision . Rather , it is an
apparatus for predicting choice, assuming it to be an objectively optimal
response to the situation presented. Its claim is that people choose as if
they were maximizing subjective expected utility . And a strong a priori
case can be made for the SEU theory when the decision making takes
place in situations so transparent that the optimum can be reasonably
approximated by an ordinary human mind .
Theories of bounded rationality are more ambitious in trying to capture
the actual process of decision as well as the substance of the final
decision itself . A veridical theory of this kind can only be erected on the
basis of empirical knowledge of the capabilities and limitations of the
human mind ; that is to say, on the basis of psychological research.
The distinction between substantive theories of rationality (like the
SEU theory ) and behavioral theories is closely analogous to a distinction
that has been made in linguistics between theories of linguistic competence
and theories of linguistic performance . A theory of competence
would characterize the grammar of a language in terms of a system of
rules without claiming that persons who speak the language grammatically
do so by applying these rules . Performance theories seek to capture
the actual processes of speech production and understanding .
The question of the desirability and usefulness of a procedural theory
of decision involves at least two separate issues. First , which kind of
theory , substantive or procedural , can better predict and explain what
decisions are actually reached. Does SEU theory predict , to the desired
degree of accuracy , the market decisions of consumers and businessmen,
or does such prediction require us to take into account the cognitive
limits of the economic actors?
Second, are we interested only in the decisions that are reached, or is
the human decision -making process itself one of the objects of our scientific
curiosity ? In the latter case, a substantive theory of decision cannot
meet our needs; only a veridical theory of a procedural kind can satisfy
our curiosity .
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294 Behavioral Economics and Bounded Rationality
Bounded rationality in neoclassical economics It should not be supposed
that mainstream economic theory has been completely oblivious to
human cognitive limits . In fact , some of the most important disputes in
macroeconomic theory can be traced to disagreements as to just where
the bounds of human rationality are located . For example , one of the two
basic mechanisms that accounts for underemployment and business
cycles in Keynesian theory is the money illusion suffered by the labor
force - a clear case of bounded rationality . In Lucas ' s rational expecta -
tionist theory of the cycle , the corresponding cognitive limitation is the
inability of businessmen to discriminate between movements of industry
prices and movements of the general price level - another variant of the
money illusion . Thus the fundamental differences between these theories
do not derive from different inferences drawn from the assumptions of
rationality , but from different views as to where and when these assumptions
cease to hold - that is , upon differences in their theories of bounded
rationality .
What distinguish es contemporary theories of bounded rationality from
these ad hoc and casual departures from the SEU model is that the former
insist that the model of human rationality must be derived from
detailed and systematic empirical study of human decision - making behavior
in laboratory and real - world situation .
Bibliography
Cyert , R . M . & March , J . G . ( 1963 ) . A Behavioral Theory of the Firm . Englewood Cliffs ,
NJ : Prentice - Hall : 2nd edn . 1975 .
Hogarth , R . M . ( 1980 ) . Judgment and Choice : The Psychology of Decision . New York :
Wiley .
Nelson , R . R . & WinterS . G . ( 1982 ) . An Evolutionary Theory of Economic Change . Cambridge
, Mass . : Harvard University Press .
Newell , A . & Simon , H . A . ( 1972 ) . Human Problem Solving . Englewood Cliffs , NJ : Prentice -
Hall .
Savage , L . J . ( 1954 ) . The Foundations of Statistics . New York : Wiley .
Simon , H . A . ( 1982 ) . Models of Bounded Rationality . 2 vols , Cambridge , Mass . : MIT Press
( especially Sections VII and VIII ) .
Williams on , O . ( 1975 ) . Markets and Hierarchies . New York : Free Press .
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Models of Bounded Rationality
Empirically Grounded Economic Reason
By: Herbert A. Simon
Citation:
Models of Bounded Rationality: Empirically Grounded Economic Reason
By: Herbert A. Simon
DOI: 10.7551/mitpress/4711.001.0001
ISBN (electronic): 9780262283649
Publisher: The MIT Press
Published: 1997
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MIT Press Direct
@ 1997 Massachusetts Institute of Technology
All rights reserved. No part of this book may be reproduced in any form by any electronic or
mechanical means (including photocopying , recording , or information storage and retrieval )
without permission in writing from the publisher .
This book was set in Times Roman on the Monotype " Prism Plus" PostScript Image setter
by Asco Trade Typeset ting Ltd ., Hong Kong , and was printed and bound in the United
States of America .
Library of Congress Cataloging -in -Publication Data
Simon , Herbert Alexander , 1916 -
Models of bounded rationality .
Includes bibliographies and index .
Contents : v . I . Economic analysis and public policy - v . 2. Behavioral economics and
business organization - v . 3. Empirically grounded economic reason .
1. Economics - Address es, essays , lectures . 2 . Social choice - Address es, essays , lectures .
3. Decision -making - Address es, essays, lectures . 4. Economics - Psychological aspects-
Address es, essays, lectures . 5. Industrial organization - Address es, essays, lectures . I . Title .
HB17l .S5633 330 81 - 18620
ISBN 0-262- 19205-5 (v . 1) AACR2
ISBN 0-262- 19206-3 (v . 2)
ISBN 0-262- 19372-8 (v . 3)
~ MITPress ~".; :~ l2 :
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Simon
Models Of Bounded Rationality
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