Bounded Rationality

Lecture 3
Contents
Human Behavior
Principle of Bounded Rationality
Causes of Bounded Rationality
Cognitive Limitations
Individual & Organizational Responses
Human Behavior
Two extreme cases
Mindless rot behavior
Perfect rationality
Decisions depend on situations
Some decisions are made automatically
Others involve considerable time, effort,
resources, emotions.
Herbert Simon (1957)
Principle of Bounded Rationality
The capacity of human mind for
formulating and solving complex problems
is very small compared with the size of
the problem whose solution is required
for objectively rational behavior in the
real world or even for a reasonable
approximation to such objective
rationality
The decision making Herbert
Simon
Decision making by human beings cannot
be even remotely described by the
rational choice.
Causes of Bounded Rationality
Cognitive limitations
Perceptions are selective
Mental models are grossly simplified and imperfect
Power of deduction are weak and fallible
Lack of knowledge
Knowledge of real world is incomplete
Lack of time
Deliberations take time.
Take decisions before we are ready
Ex: Capital Investment
Problem: When & how to invest
Stochastic, dynamic optimization problem
Knowledge of cost and demand function
Perfect model of the system from which future
behavior of all variables interest rates, demand,
cost etc) and actors (suppliers, workers,
competitors, Govt. etc) is known for decisions
firm makes.
These are influenced by random shocks
Cognitive ability to solve this problem
Time to do so.
Ex: choosing a candidate for a job
Assessing all relevant candidate
characteristics
Predicting likely success and failure of the
candidates
given the attributes and performance history
of all similar applicants
including those who are not selected
Cognitive Limitations
Limited ability to process information
Perception of information is not
comprehensive but selective. Only few
cues are taken into consideration. Those
which are available, salient and concrete
Attention is a scarce resource must be
allocated among competing demands.
We do not use optimization theory but
use heuristics.
Individual & Organizational Responses to
Complexity in Decision Making
Habits Routines & Rules of Thumb
Managing Attention
Goal Formation & Satisficing
Problem decomposition and decentralized
decision making
Habits Routines & Rules of Thumb
These are followed repetitively without
significant effort
Individuals follow a routine (just do it
every day)
Organizations use standard operating
procedures
Rules of thumb is a procedure designed
to yield a pretty good decision quickly
and easily.
Managing Attention
Controlling the information people have
access and attend to is an important
source of power.
Organizations have structures and
routines to control access to information
Formal reporting relationships, agenda
setting, geographical structure, physical
layout of facilities, accounting and
information systems.
Some of the most powerful people in the
organization are executive secretaries
Goal Formation & Satisficing
A Strategy to reduce complexity is goal setting
People adjust their behavior to meet goals.
More specific goals result in selection of cues
and actions
Once goals are met, efforts often stop so that
attention and cognitive ability is used elsewhere
Satisficing (Herbert Simon) behavior in which
effort is reduced once satisfactory solution to a
problem is found.
Goals are adaptive and respond to experience.
Problem decomposition and
decentralized decision making
Sub goals reduce complexity of problem
(decomposition)
In deciding how to achieve a goal, decision
makers tend to ignore or treat exogenous
those aspects which are not directly
related to goal in their perception.
Assumption that achieving sub goals result
in achieving overall goals is often
incorrect.
In Summary
Human beings do not take decisions
according to rational choices and
economic theory
Bounded rationality results from
limitations on our knowledge cognitive
capabilities and time
In many cases both individuals and
organizations make their decisions based
on heuristics.
Thank You