bounded-rationality

What Is Bounded Rationality And Why It Matters

Bounded rationality is a concept attributed to Herbert Simon, an economist and political scientist interested in decision-making and how we make decisions in the real world. In fact, he believed that rather than optimizing (which was the mainstream view in the past decades) humans follow what he called satisficing.

A quick intro to bounded rationality

Many models, especially in economic theory and social sciences still rely on unbounded rationality to make predictions about human behavior. Those models have proved wholly ineffective, and they do not reflect the real world.

In the last decade cognitive theories that look at humans as a bunch of flawed beings that due to their biological limitations commit a series of errors (the so-called biases) has taken over. I supported this theory on this blog. However, what might seem biased, at a more in-depth look are in reality unconscious rationality (what we call gut feelings) that helps us survive in the real (uncertain) world.

Bounded rationality is a framework that proves way more robust – I argue than any other. That is why it makes sense to look at it to understand what bounded rationality really means.

Bounded rationality – more than a theory is a warning to economists and social scientists – that can be summarised as the study of how people make decisions in an uncertain world. As pointed out by Greg Gigerenzer, there are at least three meanings attributed to unbounded rationality:

  • optimization: there are constraints in the outside world that don’t allow us to get all the data available
  • biases and errors: there are constraints in our memory and cognitive limitations that limit our decision-making ability
  • bounded rationality: how do people make decisions when optimization is out of reach.

The first two don’t admit the existence of an uncertain world. Why? When you study decision-making under risk, the assumption is that we live in a certain world, where given all the data available we can compute that risk. What economists like to call optimization under constraints. This is true only in a small world, where everything can be calculated.

The second assumes that due to our limited cognitive abilities we deviate from solving problems accurately, thus we fall into biases and cognitive errors. While the first emphasizes on rationality, the second focuses on irrationality.

The third concept, which is what bounded rationality really is about was elaborated by Herbert Simon. He asked the question, “how do people make decisions when optimization is out of reach?” In short, how do people make decisions in an uncertain world?

There are a few things to take into account when thinking about bounded rationality:

We don’t live in a small world

In a small world, given enough data, we can compute the consequence of many actions and behaviors.

In the real world, risk cannot be known either modeled

In many disciplines, especially economics and finance at the academic level, the assessment of risk is central. However, what we cal risk implies something that can be computed. In fact, in the financial toolbox, there are many measures of risks.

However, those are often worthless, since they start from the assumption that given enough data you can put a precise number on the risk you’re undertaking.

However, that is not the case. In the real world, there are hidden variables that can be never taken into account even if you have zillions of data

Optimization is not bounded rationality

Many confuse optimization for bounded rationality. They are opposite concepts. Optimization starts from the assumption that we live in a small world where you can compute risk.

Bounded rationality starts from the assumption that we live in an uncertain world where we can’t assess risk. That is why we have a toolset of heuristics that work more accurately than complicated models in the real world

Biases are not errors but heuristics that work in most cases to make us avoid screw-ups

In short, heuristics rather than being shortcuts that are fast but inaccurate. Those are instead quick, effective and in most cases more accurate than other forms of decision making (in the real world)

Satisficing: Look at the one good reason

In an uncertain world in many cases ignore all the information and look at the one good reason to make a decision works best

Survival is rationality in the real world

Put in this form rationality is not a matter of beautiful mathematical models, but it is about survival. What survives might be then called rational

Bounded rationality explained

Books to read to enhance your bounded rationality

With technological advancements, there is more and more available information at a cheaper cost (actually information nowadays is free). Also, technology also gives us the impression that we live in a world that we can control.

All it takes is enough information and we’ll be able to be successful in business. That is why you need to have the latest news, the newest gadget, and follow the latest trend.

This kind of approach can live you astray! As you get access to more and more information, this also improves the noise exponentially.

Thus, rather than getting better at making decisions you become way worst. With an even worse consequence: you’re not aware of that. The fact that you have a lot of data makes you believe that you know best.

Therefore, I believe there are three aspects to take into account in the modern, seemingly fast-changing world:

  • have at your disposal a simple yet effective toolset for decision-making in the real world
  • develop the ability to ignore information that isn’t needed
  • know when to trust your gut feelings rather than relying on complex models

In this respect, three books can help you with that. Two books are from Gerd Gigerenzer, a German psychologist who has studied bounded rationality and heuristics in decision making. The third is from Nicholas Nassim Taleb, author of The Black Swan and the Incerto Book Series. 

Risk Savvy: How to Make Good Decisions

In the past century, the leap forward for humanity was to teach to most of us how to read and write. If that was enough in a modern world where information was still scarce.

Nowadays with the advent of social media and the increasing speed of the internet, there is another tool that anyone has to master to survive: statistical thinking.

Risk Savvy helps you build the toolbox to become a better statistical thinker. Or to ask better questions that allow you to navigate through the noise of the modern world:

risk-savvy-book

Gut Feelings: The Intelligence of the Unconscious

This book is an excellent introduction to the concept of bounded rationality and heuristics. It is also a fresh perspective on decision-making. Where current prevailing cognitive psychological theories focus on our biases and cognitive errors, this book focuses on why instead those heuristics make a lot of sense.

In fact, gut feelings are seen quite skeptically in the world of academia and corporations where big words are looked with more respect. This book shows you why gut feeling matters in business as in life:

gut-feelings-book

Skin in the Game: Hidden Asymmetries in Daily Life

Skin in the Game is the bible for understanding how to get along in a world that is plenty of hidden asymmetries:

Skin in the Game: Hidden Asymmetries in Daily Life

Read Next: HeuristicsBiases.

Related Concepts To Bias

commitment-bias
Commitment bias describes the tendency of an individual to remain committed to past behaviors – even if they result in undesirable outcomes. The bias is particularly pronounced when such behaviors are performed publicly. Commitment bias is also known as escalation of commitment.
 
halo-effect
The halo effect is a cognitive bias where the overall impression of a business, brand, or product influences how people feel and think about them. The halo effect was coined by psychologist Edward Thorndike in a 1920 study where military commanders were asked to rate subordinates based on several characteristics.
ikea-effect
The IKEA effect is a cognitive bias that describes consumers’ tendency to value something more if they have made it themselves. That is why brands often use the IKEA effect to have customizations for final products, as they help the consumer relate to it more and therefore appending to it more value.
barnum-effect
The Barnum Effect is a cognitive bias where individuals believe that generic information – which applies to most people – is specifically tailored for themselves.
cashless-effect
The cashless effect is a bias that argues that consumers are likely to spend more money when they don’t have to physically give it up. Physically giving up money is also called “pain of payment” – the more pain a consumer associates with paying, the less likely they are to spend.
dunning-kruger-effect
The Dunning-Kruger effect describes a cognitive bias where people with low ability in a task overestimate their ability to perform that task well. Consumers or businesses that do not possess the requisite knowledge make bad decisions. What’s more, knowledge gaps prevent the person or business from seeing their mistakes.
satisficing
Simon’s satisficing strategy is a decision-making technique where the individual considers various solutions until they find an acceptable option. Satisficing is a portmanteau combining sufficing and satisfying and was created by psychologist Herbert A. Simon. He argued that many individuals make decisions with a satisfactory (and not optimal) solution. Satisfactory decisions are preferred because they achieve an acceptable result and avoid the resource-intensive search for something more optimal.
ooda-loop
The OODA loop was popularized by U.S. Air Force fighter pilot Colonel John Boyd to describe maneuver warfare during the Korean War. The OODA loop is a four-step approach to decision making where strategies must be adjusted quickly. Those four steps comprise observe, orient, decide, and act.
take-the-best-heuristic
The take-the-best heuristic is a decision-making shortcut that helps an individual choose between several alternatives. The take-the-best (TTB) heuristic decides between two or more alternatives based on a single good attribute, otherwise known as a cue. In the process, less desirable attributes are ignored.
The Lightning Decision Jam
The Lightning Decision Jam (LDJ) is a means of making fast decisions that provide quick direction. The Lightning Decision Jam was developed by design agency AJ&Smart in response to the inefficiency of business meetings. Borrowing ideas from the core principles of design sprints, AJ&Smart created the Lightning Decision Jam.
kepner-tregoe-matrix
The Kepner-Tregoe matrix was created by management consultants Charles H. Kepner and Benjamin B. Tregoe in the 1960s, developed to help businesses navigate the decisions they make daily, the Kepner-Tregoe matrix is a root cause analysis used in organizational decision making.
cost-benefit-analysis
A cost-benefit analysis is a process a business can use to analyze decisions according to the costs associated with making that decision. For a cost analysis to be effective it’s important to articulate the project in the simplest terms possible, identify the costs, determine the benefits of project implementation, assess the alternatives.
force-field-analysis
Social psychologist Kurt Lewin developed the force-field analysis in the 1940s. The force-field analysis is a decision-making tool used to quantify factors that support or oppose a change initiative. Lewin argued that businesses contain dynamic and interactive forces that work together in opposite directions. To institute successful change, the forces driving the change must be stronger than the forces hindering the change.
go-no-go-decision-making
In general, terms, go/no-go decision making is a process of passing or failing a proposition. Each proposition is assessed according to criteria that determine whether a project advances to the next stage. The outcome of the go/no-go decision making is to assess whether to go or not to go with a project, or perhaps proceed with caveats.
decision-matrix
A decision matrix is a decision-making tool that evaluates and prioritizes a list of options.Decision matrices are useful when:A list of options must be trimmed to a single choice.A decision must be made based on several criteria.A list of criteria has been made manageable through the process of elimination.
cynefin-framework
The Cynefin Framework gives context to decision making and problem-solving by providing context and guiding an appropriate response. The five domains of the Cynefin Framework comprise obvious, complicated, complex, chaotic domains and disorder if a domain has not been determined at all.
pareto-principle-pareto-analysis
The Pareto Analysis is a statistical analysis used in business decision making that identifies a certain number of input factors that have the greatest impact on income. It is based on the similarly named Pareto Principle, which states that 80% of the effect of something can be attributed to just 20% of the drivers.
scenario-planning
Businesses use scenario planning to make assumptions on future events and how their respective business environments may change in response to those future events. Therefore, scenario planning identifies specific uncertainties – or different realities and how they might affect future business operations. Scenario planning attempts at better strategic decision making by avoiding two pitfalls: underprediction, and overprediction.
heuristic
As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.

Main Free Guides:

 

Other resources for your business:

Published by

Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which reached over a million business students, executives, and aspiring entrepreneurs in 2020 alone | He is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate | Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy | Visit The FourWeekMBA BizSchool | Or Get The FourWeekMBA Flagship Book "100+ Business Models"

Leave a Reply