bounded-rationality

Bounded Rationality: Why Our Cognitive Biases Aren’t as Irrational as You Think

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: satisfy and suffice.

Many models, especially in economic theory and social sciences still rely on the 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 being 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 biases, 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: 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 confound 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)
  • in an uncertain world in many cases ignore all the information and look at the one good reason to make a decision works best
  • 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

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Gennaro Cuofano

Creator of FourWeekMBA.com | Head of Business Development at WordLift.io | International MBA

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