A snippet on bounded rationality

A Crooked Timbercomment on my last post, about Chapter 2 of my book-in-progress, Economics in Two Lessons, convinced me that I needed to include something about bounded rationality. I shouldn’t have needed convincing, since this is my main area of theoretical research, but I hadn’t been able to work out where to work this into the book. I’m still not sure, but at least I’ve written something I’m reasonably happy with. Comments, praise and criticism welcome as usual.

Human beings are incredibly clever at processing and responding to information. We have a general capacity for reasoning that far exceeds that of other animals. In addition, genetic and cultural evolution has equipped us with a variety of cognitive ‘modules’ enabling us to perform specific tasks rapidly and efficiently. For example, we can naturally throw and catch objects much better than any other animal.
We can improve our ability to catch thrown objects in a couple of ways. One, based on general reasoning involves estimating the speed and trajectory of the object, and running to the point where we expect it to fall within our reach. Going further, we can use mathematics and physics to make incredibly accurate predictions, enabling humanity to send spaceships to the edge of the solar system and beyond with exact knowledge of the course they will follow.

Such rational optimization takes a lot of time and mental effort however. To catch a ball flung in the air, a much simpler solution is the ‘gaze heuristic’. A catcher using the gaze heuristic observes the initial angle of the ball and runs towards it in such a way as to keep this angle constant. This heuristic works well in practice. It is therefore described, by Gerd Gigerenzer, as ‘ecologically rational’ for the environment in question. Heuristics are examples of cognitive modules.

Heuristics work well in the environments in which they evolve. However, they may fail in other environments. Beginning with the work of Daniel Kahneman and Amos Tversky, and taken further by Richard Thaler, researchers have examined ways in which heuristics may lead to good decisions in some contexts and bad ones in others. Given our cognitive limits, good decision making requires a mixture of heuristics and rational calculation.

One Lesson economics ignores this. In the standard One Lesson model of decision making, human beings are replaced by ‘rational agents’ who are assumed to be members of the species Homo Economicus. Rational agents have an infinite capacity to calculate the consequences of their actions under every possible contingency. Not only that, but they can use their reasoning capacity to model the actions of other agents, taking account of the fact that the other agents are modelling them, and so on, ad infinitum. In economics jargon, this assumption is referred to as ‘common knowledge of rationality’.

The problem of making decisions under uncertainty is an important case where bounded rationality plays a crucial role. The efficient markets hypothesis rests on the assumption that market participants are rational agents making decisions to maximize their ‘expected utility’.
It has long been known, however, that real-life choices aren’t consistent with the theory of expected utility and that more general and flexible models are needed. Much of my career as an academic economist has been devoted to this task.

One aspect of the problem is that people tend to place more weight than they should (at least according to expected uility theory) on low probability extreme events, like winning the lottery or dying in a plane crash. It’s possible to develop models of this behavior involving weighted probabilities, but these aren’t necessarily consistent with the rationality required for the efficient markets hypothesis.
Another, more fundamental, difficulty is that we can’t possibly be aware of all contingencies relevant to a decision. Contingencies of which we suddenly (and often painfully) become aware have been described as ‘unknown unknowns’ and ‘Black Swans’. When participants in financial markets, unaware of their own unawareness, attempt to apply rational optimization to an incomplete model of the world, the results can be disastrous. Financial crises typically involve a rapid spread of awareness about a possibility (such as a simultaneous default by a number of borrowers) that had previously been disregarded.

Bounded rationality is most significant in choices involving time and uncertainty, but it can arise in ‘spot’ markets where these factors are not important. Dominant firms in a market (for example the market for phone and Internet service) sometimes offer a vast and confusing range of options. The idea is that consumers with the time and ability to pick out the best offer will do so, rather than defecting to a competitor, while more loyal customers will stick with bad deals, on the mistaken assumption that there is nothing better on offer.
More generally, given our bounded rationality, it is possible to have too many choices, most of which from each other only marginally. This point has been stressed by psychologists such as Barry Schwartz, who argues that too much choice can lead to depression.

The fact that our reasoning capacity is bounded limits is another instance of Lesson 2. Prices give us information about opportunity costs, but only if we have the capacity to process that information. We will consider some responses this problem in Part 4.

* the sole exception to this model of unbounded rationality is in the case of economic policymakers and, in particular, central planners, whose cognitive limitations are taken for granted

* Baseball fielders learn the gaze heuristic through trial and error, or through ‘cultural transmission’ (that is, advice from coaches or fellow players. But it can also be arrived at the as the solution to an optimization problems.

25 thoughts on “A snippet on bounded rationality

  1. JQ, is the word differ missing after the word which in the quoted sentence?

    “More generally, given our bounded rationality, it is possible to have too many choices, most of which from each other only marginally.”

  2. “The fact that our reasoning capacity is bounded [by] limits is another instance of Lesson 2. “

  3. Agreed, a discussion of bounded rationality is important to your book. Please, also consider my point about markets on the other thread; namely the importance of the historicity of markets and their construction and maintenance in different forms by political authority, institutions, customs etc. Without making and exploring that point you leave unchallenged and unenlightened the reader’s a priori assumptions about what markets are and/or ought to be.

  4. HI John

    I feel you can’t talk about bounded rationality without at least some mention of Simon.

    Perhaps insert a para after your current third para (the one ending “heuristics are examples of cognitive models”) with something like:

    Herbert Simon developed the concept of bounded rationality to describe the limitations humans face in processing information. He coined the term “satisficing” to describe how people generally gather only as much information as is sufficient to satisfy our needs. Humans rarely attempt to gain all relevant information to inform their choices, a near impossible task. Being roughly right, or good enough, is all that most people need in everyday life. This concept has led to extensive further interest in how we make use of cognitive “rules of thumb” or heuristics.

    hope this helps


    Stephen Bartos

  5. Hi, Economics in Two Lessons is wonderfully elegant. Makes economics accessible to the general public.

    I have a query/suggestion. Might you discuss what we are maximising here: achieved wellbeing or freedoms (per Amartya Sen’s Capability approach)?

    Also, how would we aggregate individual wellbeing/freedoms? How do we measure the maxim and? Presumably distributional issues need to be considered.

    There is no place to address these issues in Economics in One Lesson. But these issues could be considered in Two Lessons.

  6. PS: bounded rationality also comes in at the level of social choice, not just private choice. We likely have legitimate differences over what the maxim and should be and how to incorporate distributional matters. So there is a role for public discussion and public reasoning.

  7. A couple of paragraphs lack spacing.

    In the last footnotes sentence, either
    “But it can also be arrived at as the solution to optimization problems.”
    “But it can also be arrived at as the solution to an optimization problem.”

    …and this just before that
    ” …‘cultural transmission’ (that is, advice from coaches or fellow players.”



  8. @Svante
    My bad html. Again then:

    A couple of paragraphs lack spacing.

    In the last footnotes sentence, either

    “But it can also be arrived at [the] as the solution to [an] optimization problems.”
    “But it can also be arrived at [the] as the solution to an optimization problem[s].”

    …and this just before that

    ” …‘cultural transmission’ (that is, advice from coaches or fellow players.”

    […transmission’, that is,]

  9. You should push this further. For instance, Stiglitz’ theorem that with asymmetric information (the normal case under bounded rationality) all markets fail, and there is usually a conceivable policy intervention that would improve matters. But policy interventions are likely to fail for the same reasons. Real life is second best all the way down.

    You could also draw the lesson from Kahneman’s point that intuitive heuristics are easy and rigorous thinking hard – very hard if you think of statistics. The heuristics fail because they are short cuts. Rigorous thinking is too hard to try, most of the time. So the Idols rule us.

  10. John – is there a multi-person analog of the gaze heuristic ie rules of thumb we use either in situations where we expect that we will need to take into account the decisions of some number of other individuals but are making an individual decision, or where some set of people know that they need to make a decision accounting for many perspectives and diverse outcomes at the individual level. I suppose that i am thinking that we believe that representational democracy is such a social or political heuristic, but also that we tend or appear to collapse such multiple perspective decision-making into a set of individual decisions, with minimal accounting for effects of and on others (social externalities perhaps).

    One view of society appears to believe that markets achieve this multiple-perspective optimization, and so markets are a heuristic. But that we then are encouraged to think about engaging in them as individuals, with a sort of ideally minimal set of social constraints (laws, regulations etc).

    Given that the 2 things that distinguish Homo sapiens are our sociality (outlined nicely by Nowak and Highfield in “Supercooperators”) and as you point out our information processing ability, it seems odd that we don’t seem to think or talk about our collective heuristics that much, or perhaps do so but in the hope that markets and voting occasionally and other social institutions are sufficiently robust that we can avoid thinking harder about an effectively infinitely complex problem (optimisation in an n x n-dimensional space, where n is the number of individuals involved – of course we could add dimensions for other species, times etc).

    Maybe forms of bounded rationality are in fact all we can manage – anything else is just too hard?

    Thanks for the book chapters – the way you have talked about opportunity cost is really neat: especially the multiple-perspective nature of it. Makes me think that effectively we make use of the wisdom of crowds to derive workable estimates of opportunity costs – which is what Hayek said was the important thing about distributed information processing.


  11. I’ve been following this discussion about economics in two lessons with a kind of bounded rationality I suppose – ie not trying to read it all but reading enough to see where it’s going. I wrote a bit of a rant (which I won’t publish at the moment) expressing frustration. The short version I think is that you are not engaging (as far as I can see) with some of the key limitations of (mainstream) economic thinking – perhaps because the discussion has been framed as a response to Hazlitt and free market theory?

    A short hand for the areas that you don’t seem to be engaging with are the issues around anthropocentricity vs ecological consciousness, and the issues around ethic of care. I’ve just read Doughnut Economics which seems to engage with those issues, while still seeming ‘mainstream enough’ not to appear whacky to mainstream economists? (Not that I’m against seeming whacky, I’m in favour of it, but I can see why someone might not want to ifthey want to have an influence in economics).

  12. Mostly people know they dont have all the information and they dont even want it all. As long as their future looks ok. People have the useful ability to be happy today despite feeling that there may be problems tomorrow .

    Its difficult to work out whats going on with some decisions .I sold a motorcycle for $3-4000 less than I could have if I had simply got a new battery ,serviced the carbies ,put fresh fuel in and cleaned it – so a buyer could ride it – and then waited a bit. It had been in storage for 4 years. There was alot of emotional investment in that bike ,it was childhood dream and mid life crisis. $3000 is not insignificant to me but I dont regret what I did. Coming around to the idea that it had to go was a long process. Spending $350 on the starter motor hurt much more than the $3000 I wont get. In the end I just wanted to get rid of it ,I thought of giving it away to a worthy person rather than selling to the first interested party. Although I know the value in it ,in my mind it was written off. It seemed better to destroy it rather than let it end up in the wrong hands. The buyer trusted me and will find that he is rewarded for that trust.

    Its odd how an amount of money can demand so much worry in one context and then in another it is barely noticed .My house is supposed to have gone up in value by about $1000 a week since Ive owned it ,but that $350 killed and I didnt want to spend 50 cents more on the bike.

  13. @Val

    I agree. Your key point is correct in my view: “not engaging (as far as I can see) with some of the key limitations of (mainstream) economic thinking”.

    John Ralston Saul said something in relation to globalisation which can be applied to all capitalist economics: “It was really an idea that you could reorganise the world through an economic spectrum… and that money was real. You can always tell you’re in deep trouble when people start thinking money’s real.”

    I would add that we can tell we are in deep trouble when people think economics is more important than any other subject and that economic considerations should be the prime determinant of every policy. But let’s give JRS the last words.

    “Nevertheless, I think democracies are capable of reforming the system, and there’s a long list of things that need to be done. One of them, shut down the business schools, they’re at the core of the problem… for the last thirty years there’s been a sort of intellectual cleansing in economics departments, so there’s only one way of thinking.”

  14. Worth viewing:

    Hedges interviewing John Ralston Saul:

    h t t p s://www.youtube.com/watch?v=kXUJEWNHweE

  15. @Ikonoclast
    Sounds right! I’d really like to see JQ engaging with some of these big questions but I’m just not really seeing it.

    On the question of money, I’d really like to see a thorough economic analysis of the question: how much of the so-called ‘GDP’ growth that we’ve purportedly seen since GDP was first adopted as a measure, is actually due to work shifting from the unpaid to paid sector? Because historically I know that’s been a huge (and continuing) shift, but I’m yet to see a proper analysis of it by any mainstream economist.

    Maybe it’s been done, but it doesn’t seem to be available in the broader public sphere where interested non-economists like me would see it

  16. On the subject of privileging the economy: in my field of public health it was thought to be a breakthrough when Labor parties started arguing that health promotion and illness prevention were important because they contributed to a healthier workforce and therefore a stronger economy.

    Talk about putting the cart before the horse. One might possibly think that the purpose of ‘the economy’ is to ensure the health and wellbeing of the people, but apparently it’s the other way round.

    People are so desperate to be taken seriously by economists that that was seen as a really good argument.

  17. A clear case of writing from a position of bounded rationality which is too bounded and restricted is writing about economics for the public when one should be writing about political economy. The general public need not economics but political economy. Or they need political economy first to contextualize economics.

    It is possible, after all, to write descriptive and comparative political economy without adopting an ideological bias or at least without adopting a severe bias. Without the kind of contextualization of political economy, economics is essentially meaningless to the layperson citizen. Either that or it becomes simplified and biased dogma. The first big fact obscured is that capitalism and markets operate within their political economies.

    “Perhaps the most basic implication of returning to the study of political economy is to recognize that if market frameworks are to take appropriate account of societal costs and benefits, they must be so designed by political authorities; the economic actors cannot legitimately do this job… ” Bruce R. Scott.

    Of course, for this to work legitimately and fairly, the political authorities must be directed by all the people via an effective democratic system not biased by the power of excessively concentrated wealth.

  18. I will try to read what you have written more carefully and one sitting if I can, but just on the question of that article – I think it starts to get at some of the issues, but I’m not sure it’s fully estimating the thing I’m talking about. For example, there isn’t enough detail to say how ‘child care’ is measured, however ‘child care’ if you want to measure it in monetary terms, has to mean all the time that someone is in a supervisory role with children, not how much time they estimate they are actively ‘caring’ for them (it’s not clear in Landefeld et al what was actually measured by the time use surveys).

    So if a woman in Australia goes from maternity leave (on the government benefit scheme) to full time paid employment, the amount of child care she will need is probably about 45 hours, depending on travel time. In a child care centre, that could be about $6-700 per week. Plus she also moves from an unpaid role to a paid one, so on an average wage for women, that would be about $1400 per week. Then there will be other expenses such as maybe household help, more prepared food purchasing, additional travel etc. So altogether we might be looking at a presumed boost to GDP around $2500 per week, but a lot of that is due to work moving from the unpaid to paid sphere. Plus, both the shift of work from unpaid to paid and the fact that there is some additional ‘real’ activity happening, in turn generate more paid work – eg more child care centres and positions, more roads, cars or public transport, more jobs in the retail sector, more HR and OHS services, more management, more regulation, and so on. So in a sense those women who are going from maternity leave to paid positions in those sectors, are also generating their own jobs.

    Whether that’s a good or a bad thing is not what I am talking about here, and certainly the way domestic/household work is currently organized (subordinated, isolated) means that there are many advantages to going from unpaid domestic household work to paid work. But one impact at the societal level seems to be that there is more money in circulation, but in so far as that represents something real, it seems to be that many women’s ‘productivity’ has increased because they are working too long and hard (although that’s a slightly different issue, so I won’t explore that further here).

    Anyway tldr is that I don’t think the article covers all that, so you have the question: is limited, and possibly misleading, data better or worse than no data? Is it better to say that it’s a question that can’t be answered yet, or cite an article that possibly grossly underestimates the impact?

    few other thoughts:

    Time Use Surveys were developed (at least partly) as an alternative to monetary measures. Think there are some problems with using them to develop monetary estimates – a better alternative might be to convert GDP to a time use measure. However I guess we are a long way from this, given the LNP here made ABS stop even doing Time Use surveys! One of my recommendations, when I eventually get published (I hope!) will be for Public Health to advocate for non-monetary measures to replace GDP as the main measure of national wellbeing.

    Not clear to me why Landefeld et al did not include voluntary work – seems a big omission – work by Duncan Ironmonger in Victoria 2006 suggested it was worth about 7% of Gross State Product in monetary terms so that’s a big chunk of work to leave out https://www.volunteeringaustralia.org/wp-content/uploads/The-Economic-Value-of-Volunteering-in-Victoria.pdf

    The ABS (when they were allowed to do this) calculated that the monetary value of unpaid work (household and volunteering) was about 48% of Australian GDP in monetary terms. That seems much higher than Landefeld et al (from what I can work out from their article) so would be interesting to see the reasons for this apparent discrepancy.

    Feminist theory now suggests ‘care work’ encompasses a lot more that hasn’t been taken into account by ‘malestream’ economics (that’s the term we used to use about history, I don’t know if it’s also used in economics!), including emotional or affective work. In Landefeld et al the only form of care work recognised is child care – no recognition of care for older people or people with disabilities and chronic conditions, let alone the broader kinds of care work

  19. A couple of random observations on Val’s post. They might or might not be useful to ponder.

    1. With respect to the general theme “a presumed boost to GDP around $2500 per week, but a lot of that is due to work moving from the unpaid to paid sphere…” with women entering the workforce.

    Capitalism operated very adroitly to capture and alienate from workers a part of this new formal economic wealth creation. For example, the move to dual income households probably played a role in house price inflation. At the other end of the scale, the move to no income households (not caused by women entering the workforce but rather by general neoliberal austerity policies) allowed landlords and rentiers to capture more rents derived ultimately from the welfare budget.

    2. Presumably, critics of counting household work will also the criticise the idea of counting say the time a child-caring mother or father might spend chatting on the phone or reading a book while keeping a general eye on the kids. But there are many inspection, supervisory and security jobs in the formal economy where much time is spent doing nothing except maintaining general vigilance and only intervening in a developing emergency, which said emergency could prove very costly if not averted in a timely fashion. I see no essential difference in the two cases.

  20. @Ikonoclast
    Yes, and that supervisory work might include foreseeing a problem such as a possible accident or quarrel, and taking a moment to prevent it, but such apparently minor actions are hardly likely to be all tallied up and counted by parents

    (though I have to say I never managed to read much when my children were under school age!)

    Btw Ikon you also made mention somewhere of the problems of using Robinson Crusoe etc as an example of anything – Kate Raworth also suggests this is not good economic reasoning in Doughnut Economics somewhere, in her polite way (can’t give you page numbers but if you – or anyone – hasn’t read Doughnut Economics yet, I recommend it. It’s not as overtly feminist as I would like to see, but again I think that is her shrewd way of presenting the ideas in a non-confrontational form)

  21. “Perhaps the most basic implication of returning to the study of political economy is to recognize that if market frameworks are to take appropriate account of societal costs and benefits, they must be so designed by political authorities; the economic actors cannot legitimately do this job… ”

    Keep reading the book as it proceeds. There’s a sketch of my approach in the introduction.

  22. This is an exceptional concise and clear outline of buyer behavior! I especially like the part about giving a confusing array of choices to confuse the lazy buyer. My years in marketing taught me that Inertia Marketing works. Buyers have to respond quickly to marketing offers before they move on to the NBT – next big thing. Established customers will often not even bother to check out new deals. Go figure.
    Well done John. You are the best on this area that I have ever read!

  23. @Val

    “The shadow women’s minister suggested restoration of the time use survey would increase the value society places on caring work and could lead to men taking greater responsibility for domestic work.”

    Now there’s a hollow promise thrown out to haul in the memory impaired voter. A promise from the LNP lite mob that only last week yet again voted down any increase in benefits paid to the unemployed. From the mob that kicked single mothers of young infants off sole parent support and onto unemployment support at less than half the rate with the compulsory requirement of mostly useless but taxing weekly demands on time and travel. More tricks from the mob that destroyed Australia’s historic fair industrial relations, working conditions, and pay.

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