# Bounded rationality

Bounded rationality is the idea in decision-making, rationality of individuals is limited by the information they have, the cognitive limitations of their minds and the finite time they have to make a decision. It was proposed by Herbert A. Simon 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.[1] Another way to look at bounded rationality is that, because decision-makers lack the ability and resources to arrive at the optimal solution, they instead apply their rationality only after having greatly simplified the choices available. Thus the decision-maker is a satisficer, one seeking a satisfactory solution rather than the optimal one.[2] Simon used the analogy of a pair of scissors, where one blade is the "cognitive limitations" of actual humans and the other the "structures of the environment"; minds with limited cognitive resources can thus be successful by exploiting pre-existing structure and regularity in the environment.[1]

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).[3] 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 finite computational resources available for making them.

## Origins

The term is thought to have been 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".[4] 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
• 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.[3]

Huw Dixon later argues that it may not be necessary to analyze in detail the process of reasoning underlying bounded rationality.[5] 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, that means you choose your actions so that the payoff is within epsilon of the optimum. If we define the optimum (best possible) payoff as ${\displaystyle U^{*}}$, then the set of epsilon-optimizing options S(ε) can be defined as all those options s such that:

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 introduced the concept of flexibly bounded rationality which prescribed that the bounds that define the theory of bounded rationality are flexible due to the fact that there have been advances in information processing techniques, missing data estimation technology, computer processing capability due to Moore’s Law and artificial intelligence. For example if one estimates a missing piece of information then the bounds in the theory of bounded rationality are moved for better decision making. Similarly when the limits of processing power are improved according to Moore's Law then the bounds in bounded rationality are moved for better decision making. When better artificial intelligence techniques are produced again the bounds of bounded rationality are moved for better decision making. [6]

## Relationship to Behavioral Economics

Bounded rationality implicates 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."[7][8] 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.[9]

## Notes

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3. Mancur Olson, Jr. ([1965] 1971). The Logic of Collective Action: Public Goods and the Theory of Groups, 2nd ed. Harvard University Press, Description, Table of Contents, and preview.
4. Oliver E. Williamson, p. 553, citing Simon.
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7. Nudge (book)
8. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1583509
9. http://www.libertylawsite.org/liberty-forum/free-to-err-behavioral-law-and-economics-and-its-implications-for-liberty/

## References

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• Hayek, F.A (1948) Individualism and Economic order
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• 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.
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