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Bounded rationality

from Neva Goodwin

Rationality has become a loaded word in economics, bringing with it the baggage of earlier models that did not anticipate the findings of behavioral economics or take into account other every-day observations. The traditional rationality model includes the assumption that rational behavior is optimizing behavior (“rational economic man maximizes his utility”). In the 1970s an extreme version of this made the further assumption that rational economic actors have “perfect information.” A slightly more modest version says that people will collect information until the perceived costs of acquiring additional information exceed the perceived benefits.

One of the most effective challenges to the traditional assumption of rationality came from Herbert Simon, another non-economist winner of the Nobel Memorial Prize in economics (1978). Considering whether it is indeed possible for people to identify the optimal point at which one should cease gathering additional information, Simon showed that one first needs to have complete knowledge of all possible choices in order to identify that optimal point. Determining what additional information might be out there, and then gathering it, can be very costly in time, effort, and money – if it is even possible. Accordingly, Simon maintained, people rarely optimize. Instead they do what he called “satisficing;” they choose an outcome that would be satisfactory, and then seek an option that at least reaches that standard.

Given constraints of time and other resource limits, satisficing seems to be a reasonable behavior. If an individual finds that the “satisfactory” level was set too low, a search for options that meet that level will result in a solution more quickly than expected, or perhaps even multiple solutions. In this case, the level may then be adjusted to a higher standard. Conversely, if the level is set too high, a long search will yield nothing, and the “satisficer” may lower his or her expectations for the outcome.

Another deviation from rational behavior as traditionally defined has been called “meliorating;” this may be described as starting from the present level of well-being and then taking any opportunity to do better. A simple example is a line fisherman who has found a whole school of haddock but only wants to keep one for his supper. When he catches the second fish he compares it to the first one, keeps the larger, and throws the other back. Each subsequent catch is compared to the one being held in the bottom of the boat. At the end of the day, the fish he takes home will be the largest of all those caught (and the sea-gulls will have become very fat!).

One result of using melioration as the real-world substitute for theoretical optimization is its implication that history matters: People view each successive choice in relation to their previous experience. It is commonly observed, for example, that people are reluctant to accept a situation they perceive as inferior to previous situations. This psychological path dependence – the way feelings about the future depend on previous experience – is relevant to how people feel about rising prices, and even more so to attitudes toward declining wages.

Satisficing and meliorating may both be included under the term “bounded rationality.” The general idea is that, instead of considering all possible options, people limit their attention to some more-or-less arbitrarily defined subset of the universe of possibilities. Usually these subsets consist of the options immediately evident, along with others specifically sought out through some simple decision rule. For example, when deciding what to spend her money on, an individual may at one time confine her consideration to “major expenditures,” such as a college education or an apartment; at another time she might contemplate “expenditures on food”; and at another time she might sit down to work out budget categories, pondering, for example, “How much should I spend on food each month, how much should I devote to entertainment, and how much shall I set aside for a major need like an apartment?” With satisficing or meliorating behavior, people may not choose the “best” options available to them, but they at least make decisions that move them toward their goals.


Neva Goodwin
, “The human element in the new economics: a 60-year refresh for economic thinking and teaching”, real-world economics review, issue no. 68, 21 August 2014, pp. 98-118,
http://www.paecon.net/PAEReview/issue68/Goodwin68.pdf

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