Bounded Rationality

Took third in the 1957 Belmont Stakes. Not really but it is a good name for a thoroughbred and maybe someday.

“Bounded Rationality” is a term used in academic circles* as a short form description for the reason or reasons why we do not make optimal economic decisions. The term can be more easily understood and its concept more easily digested when it is compared against the concept of “unbounded” or unlimited rationality, meaning Spock-like (as in Star Trek) reasoning. If unbounded rationality is pure logic then bounded rationality is something short of that, in other words, rationality within limits or boundaries, hence the term itself.

Recall that classic economic theory assumes that individual economic decision makers have unbounded rationality. They will unfailingly maximize their utility at the least possible personal cost. While useful as an analytical tool this view does not reflect the real world.

In his 1982 book Models of Bounded Rationality and Other Topics In Economics, Herbert Simon (Nobel Laureate) describes three unavoidable constraints under which we make economic decisions. The first is that we are given limited and often unreliable (or inaccurate) information with which to make our decision. The second is that our mind has a limited capacity to evaluate and process the available information and finally, we only have a limited amount of time to make that decision. These constraints function as boundaries on our ability to be “rational.”

Dr. Simon and other commentators came to describe the real world quality of economic decisions of individuals as “satisficing”, meaning satisfactory (as opposed to rational or optimal). One example of the sub-optimal approach in making a decision is our use of rules of thumb. Others would be the use of judgmental heuristics, some of which I have discussed in past Observations and no doubt will discuss in the future.

What this all means is that we have to take into account the unavoidable limits on rationality clients encounter when asked to solve economic dilemma and the mental tools (heuristics) they use to do so, that is, if we want to intelligently manage risk. Except, of course, for those of you who deal with Mr. Spock. In which case, live long and prosper. Now for the rest of us “Scotty! (this is sub-optimal) I need more power!” To which Scotty replies...

*Academics (or Academicians if you will), their studies and writings serve an invaluable purpose in expanding our understanding of our environment. Nevertheless some of these folks apparently don't get out much and do have a tendency to use what I think are non-descriptive terms for their concepts and often write in a fashion which lay people might just consider, shall we say, obtuse. If asked I would say to them -you don't have to give us the answer but at least let us figure out what the question is.

This Observation should be considered in conjunction with my Observation of September 30, 2009. If you did not receive a copy of that Observation and would like to receive one just let me know.