Bounded Rationality and Decision Making

“The principle of bounded rationality [is] the capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required for objectively rational behavior in the real world — or even for a reasonable approximation to such objective rationality”

-       (Simon, H, A, Administrative behaviour: a study of decision-making processes in administrative organization -1962)

 

This quote by Herbert Simon is a reflection of how his model of bounded rationality deviates from the 'standard' model of economic rationality. To understand the concept of bounded rationality, and how it assimilates psychological perspectives into economics, it is important to first grasp the ideals of what the standard model of economic rationality says.

The standard model originates from the classical economics doctrine, and is a decision-making framework that is both, descriptive and normative in nature. Descriptive in nature, as it is expected to precisely describe (based on empirical observation) the behaviour of humans and how they make decisions, and normative in the sense that, it is expected to pass value judgements as to how humans should behave to achieve their objective, optimally.

The model states that the decision maker is homo economicus i.e. they are perfectly and completely rational in all aspects. This means, when faced with a decision, the person is completely aware of all other alternatives and always prefers to choose the decision that maximizes his/her utility and satisfaction, in the most optimal way. Further, we follow certain axioms in decision making such as-

-               Completeness Axiom- States that an individual can compare all available options and then order these alternatives according to their preferences.

-       Transitivity Axiom- States that the choices that individuals make are always consistent, that is if the individual prefers apples over oranges and prefers bananas over apples, then he will prefer bananas over oranges.

  A simple real-life example to explain this is- imagine you go to the stationary shop to buy a pen. Now, the standard model states that we, being rational beings would be aware of all the alternative pens that exist and possess information of the utility/satisfaction each alternative pen provides.

 

We would then always choose to buy the pen that provides us maximum utility. This seems to be the ideal, best-case scenario, but is this what happens?

 Human Aspect of Decisions and Actions

 The psychological aspect tends to divert from the explanations of the standard model. The human aspect states that if a person were to misjudge what is in his/her best self-interest, then it should not be perceived as a lapse in rationality, but instead, it can be attributed to influences such as lack of complete knowledge, information asymmetry or a cognitive failure to process all available information, within the given time. Work done by behavioural economists such as Kahneman and Tversky elucidate the last point. They have stated various cognitive biases and heuristics that play a major role in decision-making process such as-

(i)            Anchoring Bias- Have you ever wondered why salesmen begin negotiating by quoting such high prices? Why posted full fares on airlines tend to be significantly higher than the price that the average economy-class passenger typically pays? This is due to the Anchoring Bias, which states that People are over-reliant on the first piece of information they hear, and hence make decisions keeping that information in mind. 

  

(ii)           Confirmation bias- All the empirical evidence points to the fact that undeniably, climate change is real. However, a major portion of the population believes this to be false and their perception is that no such thing is happening, even though the evidence suggests otherwise. This is due to the confirmation bias which states that we tend to listen only to the information which confirms our preconceptions.

(iii)  Availability heuristic- A smoker might come to the conclusion that smoking is not unhealthy, because his uncle used to smoke daily and still lived to be 90 years old. This, is however incorrect as there is empirical evidence that proves that smoking is injurious to health, but due to this heuristic, the smoker makes a different decision. The availability heuristic states that People overestimate the importance of available information.

 These are just a few of the psychological biases that affect a person’s decision-making process. This shows that there exist deviations from the standard economic model of decision making and thus, came into existence Herbert Simons bounded rationality model of decision making.

 Thus, bounded rationality doesn’t assume individual rationality in the decision-making process. While people, may want to choose the option that maximizes their utility and satisfaction, they cannot always achieve that, as decision-making demands complete information, greater time, and cognitive abilities than they possess.

 Thus, they often settle for “bounded rationality’ in decisions.