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.
|Bounded Rationality||Bounded rationality is a concept in behavioral economics and decision-making theory that recognizes the limitations of human cognitive abilities when making decisions. It suggests that people often simplify complex decisions and use heuristics (mental shortcuts) due to cognitive constraints such as time, information, and cognitive capacity.|
|Herbert A. Simon||The term “bounded rationality” was introduced by Nobel laureate Herbert A. Simon in the 1950s. Simon argued that in real-world decision-making, individuals cannot always make fully rational choices as described in classical economic models, which assume perfect information and unlimited cognitive capabilities. Instead, people operate within their bounded rationality.|
|Satisficing||One of the key concepts of bounded rationality is satisficing, a portmanteau of “satisfy” and “suffice.” Satisficing means that individuals often seek solutions or make choices that are good enough or satisfactory, rather than trying to find the optimal or perfect solution. This helps save time and mental effort.|
|Limited Information||Bounded rationality acknowledges that individuals have limited access to information and may not be aware of all available options or consequences when making decisions. As a result, they rely on partial information and make judgments based on what they know.|
|Heuristics||To cope with complex decisions, people use heuristics, which are mental shortcuts or rules of thumb. Heuristics simplify decision-making by allowing individuals to quickly assess and choose among options. Examples include the availability heuristic, where people rely on readily available information, and the anchoring and adjustment heuristic, where they start from a reference point and adjust.|
|Bounded Willpower||Bounded rationality also extends to self-control and willpower. Individuals may have limited willpower to resist temptations or make disciplined choices. This concept is relevant in behavioral economics, where understanding the limits of self-control is crucial in designing strategies for personal and societal improvement.|
|Biases and Errors||Bounded rationality can lead to cognitive biases and decision-making errors. Individuals may fall prey to confirmation bias, overconfidence, and other biases when processing information or making judgments. These biases can result in suboptimal decisions.|
|Behavioral Economics||Bounded rationality is a central concept in behavioral economics, a field that combines insights from psychology and economics to study how individuals deviate from perfectly rational behavior. Behavioral economics helps explain real-world decisions and has implications for policy, marketing, and finance.|
|Adaptive Strategies||While bounded rationality acknowledges human limitations, it also recognizes that individuals develop adaptive strategies to make reasonably good decisions in their specific environments. These strategies may vary depending on the context and the available resources.|
|Implications||Understanding bounded rationality has implications for designing decision support systems, public policies, and marketing strategies. It emphasizes the importance of providing clear and simple information, reducing cognitive load, and aligning choices with individuals’ cognitive capabilities. It also highlights the need for nudges and interventions to improve decision-making.|
|Key Take||Bounded rationality is a concept that recognizes the inherent cognitive limitations of individuals when making decisions. It highlights the importance of simplicity, heuristics, and adaptability in navigating complex choices and has significant applications in the fields of economics, psychology, and decision science.|
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 or 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 never be 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 that 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.
The whole behavioral school of thought today is mostly based on Kahneman’s and Tversky’s work on heuristics and biases.
Kahneman and Tversky are two pillars of modern behavioral economics, and indeed those that most of all have influenced policies in the field.
There is a core issue underlying the Kahneman and Tversky definition of bias and heuristics.
Where in the world of Herbert Simon, heuristics are seen as a very effective shortcut (actually working much better than other more complex models of the real world) that help humans successfully deal with the context in which they are.
In Kahneman’s view, heuristics mostly lead to biases or errors of understanding of the real world.
This negative view of human psychology has led Kahneman to formulate a whole bunch of biases or errors that humans supposedly make. Still, as it turned out to be, rather than being errors, the definition of real-world from these academics turned out to be wrong.
In other words, most experiments led to a wide list of psychological errors, almost as if a human is a collection of a bunch of misconceptions about the real world; it turned out those experiments were manufacturing a fake context, which does not exist in the real world.
For instance, if you take a bias like loss aversion used as one of the many examples of human biases, you realize that this has been tested as if humans had unlimited ability to take losses.
Instead, more contextual models of the world, like ergodicity, show us that humans are highly contextual creatures (this is what Herbert Simon meant with bounded rationality) acting according to the fact that we do not have unlimited lives.
This simple fact got missed from most behavioral psychology research of the last two decades and it led to a whole bunch of mistakes.
Source: Nassim Nicholas Taleb at The Logic of Risk Taking
As you can see above, we live in a world where each of us is constrained by time probability. Meaning if you take too many risks, you go broke, and that will affect your whole life.
Instead, behavioral psychologists, when testing some human biases, tested them as if, each of us had ensemble probability (in short, there was no time dependence), as if we were in a simulated world with many lives.
That turned into a major crisis in behavioral economics, in which foundations have been shaken by the fact that most of these experiments could not be replicated.
And the whole school of thought of heuristics as the primary avenue to biases and of the nudging school (you can influence people to do things by leveraging those biases) has been shaken to its foundation.
Bounded rationality and Artificial Intelligence
We’re making the same mistake now, with the development of new technologies, like artificial intelligence.
Also, here, many academics and practitioners in the field act as if a human is just a set of tasks, not considering that there are many more facets of being a human that science doesn’t grasp yet (or perhaps might never grasp).
This leads to a dystopian view of the world, where AI can take over humans any time soon and a world where Artificial General Intelligence is possible.
Instead, it’s critical to recognize the huge limitations that AI has, as of now, the fact that it’s not conscious at all. And AI works in a completely different way than humans.
Where humans can adapt to many contexts which are ambiguous and noisy and where there is extremely conflicting information about what the problem at hand is.
The AI thrives, instead, in a narrow context, highly controlled, where we give it a clear definition of the problem.
If we realize that, we can move to a human-in-the-loop AI approach, where humans can focus on designing the proper context for AI to thrive.
But it’s the human that defines what problems are worth solving, what context it makes sense to have the AI operate within, and sets the boundaries and guardrails for that.
That’s a critical point to take into account for the future development of AI, as otherwise, the risk, is putting too much confidence into machines which will leave us awry.
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:
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:
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:
Bounded Rationality Examples in Business
Jeff Bezos is one of the business people that throughout his career as an entrepreneur in building Amazon from scratch, has leveraged various mental frameworks very close to the concept of bounded rationality.
Indeed, he understood the difference between linear and non-linear thinking and how intuition, driven by bounded rationality, could be used to create breakthroughs for Amazon.
Let’s explore some of these examples.
As the story goes, when Jeff Bezos had to decide whether to leave his well-paid job and consolidated position on Wall Street to start a venture on the nascent Internet, he didn’t use spreadsheets or complicated mental equations.
In short, he imagined himself as an old man at the end of his career and how he would have looked at his life back in the grand scheme of things.
And with that visualization, he imagined he would have regretted not having tried to start what would later become Amazon.
The regret minimization framework is extremely powerful because it is a via negativa framework. In other words, it tries to avoid having major regrets by taking a long-term vision.
Indeed, balancing long-term with short-term decision-making is probably one of the most complex human endeavors.
Another mental framework, in the bounded rationality domain, was the use of the “day one” mindset within Amazon.
This is another bounded rationality approach because it helps cut through the decision-making process in very uncertain times.
When Amazon finds itself in an important turn of events, it determines how the company will look in the long term.
Day One helped the company be on track to its long-term vision. The Day One mindset is about keeping a startup mindset as the company grows.
Customer obsession has been the driving principle of Amazon since the onset. In a tech company like Amazon, which leveraged data to improve its operations.
This bounded rationality mental model critically helped Amazon maintain its focus while scaling up.
The Working Backwards Method has been critical at Amazon as a product development methodology where you focus on the customer needs.
A backward working framework does exactly that. It helps simplify the development process of a product with the customer in mind.
Amazon has led the way there.
This is one of the most powerful mental models. of the digital business world.
Bounded Rationality: the 2008 financial crisis case study
In the early 2000s, the US housing market experienced a period of rapid growth and increased demand for mortgage-backed security (MBS) investments.
One company that capitalized on the trend was Countrywide Financial, a lender that originated and sold thousands of these securities to investors.
Countrywide was also a stock market darling with a 23,000% increase in share price between 1982 and 2003 the best of any Fortune 500 firm over that period.
But in the years preceding the 2008 GFC, Countrywide’s lending practices became increasingly risky and aggressive.
Executives ignored warning signs about the housing market and continued to approve loans to borrowers who could not meet their repayments.
The company’s business model was built on the approval of subprime mortgages to borrowers who did not meet the traditional criteria for obtaining a loan.
Lending practices were based on the assumption that house prices would continue to rise, which, in theory, would enable borrowers to refinance or sell their homes before their mortgages reset to higher interest rates.
This strategy was based on the heuristic that housing prices would always increase, and therefore, borrowers would always have the means to repay their loans.
However, Countrywide Financial did not consider a downturn in the housing market or indeed the potential that borrowers would default on their loans.
Countrywide’s lack of consideration for potential risks demonstrates bounded rationality. The company’s decision-making was hampered by its incomplete understanding of the market and reliance on heuristics rather than a detailed analysis of potential outcomes.
Meanwhile, and in a similar vein, investors continued to pay more for MBSs than was warranted. They also failed to properly quantify risk and instead relied on triple-A credit ratings.
Reckless lending practices
The company’s lending practices were influenced by competitive pressures to increase market share and the incentive to generate higher profits through the securitization of mortgages.
Countrywide increased its commissioned sales force by 60% in 2003 to facilitate this growth at all costs mindset. Employees were incentivized to undertake riskier transactions, and since there was no limit to the commissions on offer, many staff became millionaires.
Borrowers were approved for loans with a 0% deposit, while others were approved without their income properly verified. In the pursuit of profit, sub-prime loans were also offered to consumers who easily qualified for prime loans.
In a later interview, former Countrywide president David Sambol described the extent of the company’s predatory tactics: “We had reached a point where the question was, ‘What will we do next – pay borrowers to take loans?'”
These external pressures further constrained the company’s decision-making and limited its ability to consider the potential long-term consequences of its lending practices.
In addition to their carte blanche approval of the company’s lending practices, upper management was also incentivized to make decisions based on short-term performance metrics.
The focus on short-term gains further constrained the company’s decision-making and limited its ability to make rational decisions that may have enabled it to survive the GFC.
- Marketing and Consumer Behavior: Marketers often rely on consumers’ bounded rationality. For instance, they use tactics like decoy pricing, where an additional option is presented to make another option seem more appealing. They also understand that consumers often use heuristics or mental shortcuts (e.g., brand reputation) to make purchasing decisions, especially when overwhelmed with choices.
- Example: A consumer might buy a popular branded soap, not because they’ve analyzed all soap ingredients and benefits, but because they trust the brand.
- Organizational Decision-Making: Companies can’t analyze all available data for every decision due to time and resource constraints. They often rely on rules of thumb, past experiences, and simplified models to make decisions.
- Example: A company might decide to enter a new market not because they’ve analyzed every potential outcome, but because it aligns with their broader strategic goals and past successes.
- Product Design and User Experience: Designers understand that users don’t always make optimal choices when interacting with products or websites. They use principles of bounded rationality to design intuitive interfaces that guide user behavior.
- Example: A software application might have a default setting that suits most users, knowing that many won’t take the time to explore all available options.
- Strategic Planning: When formulating strategy, businesses have to make assumptions about the future, which is inherently uncertain. They make educated guesses based on available information and past trends, even though they can’t predict the future with certainty.
- Example: A company might decide to invest in renewable energy technology based on current trends in regulations and public sentiment, even if the long-term profitability of that decision is uncertain.
- Negotiations: In business negotiations, parties often have to make decisions with incomplete information. They might use heuristics, such as focusing on a few key points or basing decisions on past negotiations, to arrive at an agreement.
- Example: In a business deal, a company might accept terms that are “good enough” rather than holding out for the best possible deal to ensure a timely agreement.
- Hiring and Talent Management: HR professionals and managers don’t have perfect information when making hiring or promotion decisions. They rely on CVs, interviews, and references, all of which provide incomplete pictures of a candidate’s potential.
- Example: An employer might hire a candidate based on a strong reference from a trusted colleague, even if the candidate’s interview performance was not optimal.
- Supply Chain and Logistics: Businesses must make decisions about inventory, distribution, and production with incomplete data about future demand, potential disruptions, and other factors.
- Example: A retailer might stock up on umbrellas based on a weather forecast, even if they can’t be sure when or how much rain will come.
- Bounded Rationality Concept:
- Recognizes limitations in human decision-making.
- Challenges traditional unbounded rationality assumptions.
- Acknowledges cognitive limitations and reliance on heuristics.
- Coined by Herbert Simon.
- Refers to choosing “good enough” solutions over optimal ones.
- Aims for practical and manageable outcomes rather than exhaustive searches.
- Unbounded Rationality Perspectives:
- Optimization under Constraints:
- External limitations prevent gathering all data for optimal decisions.
- Biases and Cognitive Errors:
- Cognitive processes are imperfect and prone to biases.
- Biases may be adaptive shortcuts in coping with complexity.
- Bounded Rationality in an Uncertain World:
- Questions decision-making in unpredictable environments.
- Optimization under Constraints:
- Decision-Making Challenges:
- Real-world uncertainty and hidden variables.
- Risk cannot always be precisely known or modeled.
- Ambiguous contexts and conflicting information.
- Effective mental shortcuts.
- Aid decision-making under cognitive constraints and uncertainty.
- Lead to quick, effective, and accurate choices.
- Rationality in an Uncertain World:
- About survival and thriving.
- Adaptive behaviors in complex environments.
- Bounded Rationality in Business:
- Jeff Bezos’ Strategies:
- Regret Minimization Framework: Making decisions based on future regrets.
- Customer Obsession: Focus on customer needs for innovation.
- Day One Mindset: Maintaining a startup mindset as the company grows.
- Working Backwards Method: Building products based on customer needs.
- The Amazon Flywheel: Leveraging customer experience to drive growth.
- Jeff Bezos’ Strategies:
- 2008 Financial Crisis Case Study – Countrywide Financial:
- Ignored warning signs about the housing market.
- Relied on the assumption of perpetual housing price increases.
- Risky and aggressive lending practices.
- Focus on short-term profits over long-term sustainability.
- Upper management incentivized short-term performance metrics.
- Predatory lending practices with little consideration of borrower qualifications.
Additional Case Studies
|1. Limited Information Processing||Bounded rationality acknowledges that individuals have limited cognitive resources to process information and make decisions.||Case Study: In investment decisions, investors often rely on heuristics or simplified rules of thumb, such as past performance, due to the complexity of financial markets.|
|2. Satisficing Rather than Optimizing||People tend to satisfice, meaning they choose options that are “good enough” rather than seeking the optimal solution.||Case Study: When choosing a restaurant for dinner, individuals may select the first one that meets their basic criteria, rather than conducting an exhaustive search for the absolute best restaurant.|
|3. Bounded Search for Alternatives||Decision-makers may limit their search for alternatives, considering only a subset of available options.||Case Study: When job hunting, individuals may apply to a few positions that appear suitable rather than exploring the full range of job openings.|
|4. Rule of Thumb Decision-Making||Bounded rationality involves using simplified decision rules or heuristics to make choices quickly.||Case Study: When shopping for groceries, shoppers may opt for familiar brands or items on sale, relying on heuristics to simplify the decision-making process.|
|5. Context-Dependent Decisions||Decisions are influenced by the context in which they are made, leading to different choices in varying situations.||Case Study: A consumer may choose a luxury car in one context (e.g., for a special occasion) but opt for a budget-friendly car in another (e.g., for daily commuting).|
|6. Cognitive Biases||Bounded rationality recognizes the presence of cognitive biases that affect decision-making, such as confirmation bias and overconfidence.||Case Study: Investors may exhibit overconfidence bias, believing they can consistently beat the market, leading to riskier investment decisions.|
|7. Use of Decision Rules||People often employ decision rules, such as “buy low, sell high” in investing, to simplify complex choices.||Case Study: Traders in financial markets may use the “stop-loss” rule to limit losses by automatically selling an asset if its price falls below a certain threshold.|
|8. Sensitive to Framing Effects||The way information is presented can significantly impact decisions, making individuals sensitive to framing effects.||Case Study: A discount framed as “10% off” may be more appealing than the same discount framed as “a $10 discount” on a product.|
|9. Bounded Self-Control||Individuals may struggle with self-control and make impulsive decisions due to limited willpower.||Case Study: Shoppers may succumb to impulse purchases when confronted with in-store displays of tempting items at the checkout counter.|
|10. Bounded Time and Effort||Decision-makers allocate limited time and effort to complex decisions, potentially leading to suboptimal outcomes.||Case Study: When choosing a retirement plan, individuals may select the default option offered by their employer rather than investing time in a thorough evaluation of alternatives.|
Connected Thinking Frameworks
Main Free Guides:
- Business Models
- Business Strategy
- Business Development
- Digital Business Models
- Distribution Channels
- Marketing Strategy
- Platform Business Models
- Tech Business Model
Other resources for your business:
- Successful Types of Business Models You Need to Know
- The Complete Guide To Business Development
- Business Strategy: Definition, Examples, And Case Studies
- What Is a Business Model Canvas? Business Model Canvas Explained
- Blitzscaling Business Model Innovation Canvas In A Nutshell
- What Is a Value Proposition? Value Proposition Canvas Explained
- What Is a Lean Startup Canvas? Lean Startup Canvas Explained
- What Is Market Segmentation? the Ultimate Guide to Market Segmentation
- Marketing Strategy: Definition, Types, And Examples
- Marketing vs. Sales: How to Use Sales Processes to Grow Your Business
- How To Write A Mission Statement
- What is Growth Hacking?
- Growth Hacking Canvas: A Glance At The Tools To Generate Growth Ideas