Bounded Rationality

The bounded rationality theory of economic behavior states that people make judgments based on a limited amount of information and their cognitive capacity. This is in contrast to the common assumption in economic models that people are rational and can easily make optimal decisions.

According to the theory, rational individuals will make satisfactory decisions instead of optimal ones. This is due to the limitations that the theory deconstructs the idea of "perfect" rationality. Perfect rational decisions are often impossible in practice due to the natural decision problems and constrained computational resources available.

Key Takeaways                                                               

• Bounded rationality is a concept proposed by Herbert A. Simon, an American political scientist, in his 1957 book "Models of Man." It states that humans base their decisions on their limited knowledge and cognitive capacity.
• It goes against the common belief in economic models that people are fully rational and capable of making logical decisions.
• Bounded rationality differs from the actual concept of rationality, which assumes humans have complete knowledge of their alternatives and consequences.
• The bounded rationality decision-making model states that individuals choose satisfactory results instead of the best.

Bounded rationality theory was coined by Herbert A. Simon, an American political scientist. Rationality took the central place in this behavior theory and thus forms the main explaining element. According to Simon, "decision" is the bridge that connects rationality and behavior, while a "choice" is selecting one from the practical behavioral alternatives. Every behavior involves a practical selection, whether it is conscious or not. The process of arriving at this selection is called a decision. Rationality is a factor in decisions assuming that the agents are inherently rational. It is, otherwise, the relationship of efficacy between predetermined goals and the means to achieve them.

Rationality involves :

• Listing all behavioral alternatives that are available and possible 
• Determining all of the outcomes and consequences that will result from each of these alternatives that a person can adopt in the future. (either in a deterministic manner or in the form of probabilistic distributions)
• And comparing the alternatives with an evaluation done by the sets of consequences that will follow each of them. It should be following predetermined goals such as utility, profit, or any other specified pay-off function.

Bounded Rationality Theory

Many social science models assume that humans are rational beings, as they make decisions by choosing the best alternative and not through emotions. The bounded rationality theory disagrees with this assumption. The Herbert Simon bounded rationality uses terms like "substantive" and "procedural" to differentiate between the notions of rational human behavior. According to this, an agent is rational if they have a clear idea for success and won’t accommodate for less than the best. At the same time, an agent being procedurally rational will stem from their decisions due to a series of processes involving deliberation, time, and intensity that vary according to the choices. Thus, the concepts of "bounded" and "procedural" rationality are similar and close to the idea of "satisficing," another concept Simon promoted.

The following examples given shall give readers a basic understanding of Herbert Simon bounded rationality.

Example #1

Dave is a web developer. He gets a client call stating they would like to discuss the work details in 5 minutes. This is a big company that has heavily funded for the project. He cannot let them go, stating he does not have time to quote a price for his services. As a web developer, he has to discuss many details on the call. He has to look into the input into the website and customize it according to the taste and preferences of the interested parties.

He has to optimize the details in the content to make it the best for users. Developers usually quote based on the work done. However, Dave now has less time and does not have the luxury of comparing and deciding the price. He obviously would quote a higher price than his previous assignment to make a quick decision. It is not that he has no experience in his field or does not know how to price the services he offers. It is the time that presses him to make a quick decision. In short, the decision may not be rational, as this assignment may demand more work from him.

Example #2

A day-to-day example may be cafeterias. Suppose Dan wants to have a cup of coffee before starting work. He goes intending to get a coffee to his liking. However, the place was already overflowing when he arrived. He had to make a hasty decision to choose the coffee. He did not know different types of coffee because he had to get to work fast. So the most logical thing a person could do is to choose whatever was on the menu. This was not a rational decision but one that was bound by constraints.

Decisions are choosing between alternatives ( subjected to various factors). Generally speaking, the decisions made by individuals align with their goals, objectives, and values. Though rationality is something that people strive for, their level of knowledge often constraints it. Nevertheless, the rational decision is possible because the bounded set of criteria on which it is based corresponds to a closed system of variables. This suggests that one can make judgments without considering potential outcomes resulting from knowledge biases.

 According to the theory of decision-making, an economic man (Homo economicus) has all the knowledge. This is because they are aware of all possible courses of action and the outcomes of each one. They consider all available options. The economic man's rationality indicates that their preferences are exhaustive and transitive and that the options are perfect substitutes. On the other hand, they make judgments to maximize their utility.

The concept of the bounded rationality model approaches the decision-making process from a different point of view. It opines that even in relatively simple problems, one cannot make decisions with a maximum utility because it is difficult to test all viable options or alternatives. People tend to differ in their goals, values, and desires as they are all influenced by environmental factors. They have an impact on a person's decision-making process. Individual beliefs that they have chosen the best option may be false because the person may be unaware of some alternatives that are genuinely beneficial to them. Or they may believe that some opportunities are advantageous to them when they are not. As a result, the final decisions may not always have to be the best decisions.