Bounded rationality

Bounded rationality is a concept that suggests individuals make decisions based on limited information, cognitive limitations, and time constraints, rather than being perfectly rational actors who always make optimal choices.
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Updated on Jun 3, 2024
Reading time 4 minutes

3 key takeaways

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  • Decision-Making Limitations: Bounded rationality acknowledges that human decision-making is constrained by available information, cognitive limitations, and finite time.
  • Satisficing: Instead of seeking the optimal solution, individuals often settle for a satisfactory solution that meets their minimum criteria, a behavior known as satisficing.
  • Behavioral Economics: The concept is fundamental to behavioral economics, which studies how psychological factors influence economic decision-making.

What is bounded rationality?

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Bounded rationality is a theory introduced by Herbert A. Simon, which challenges the traditional economic assumption of perfect rationality. According to this concept, individuals are rational within the limits of their information and cognitive capabilities, and they make decisions based on these constraints rather than achieving the optimal solution. This approach recognizes that in real-world scenarios, decision-makers often operate under conditions of uncertainty and incomplete information.

Key Characteristics of Bounded Rationality

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Limited Information

  • Access to Information: Decision-makers often have access to only a subset of all possible information, influencing their choices.
  • Information Processing: The ability to process and analyze information is constrained by cognitive limitations and the complexity of the data.

Cognitive Limitations

  • Mental Shortcuts: Individuals use heuristics, or mental shortcuts, to make decisions quickly, which can lead to biases and errors.
  • Memory Constraints: Human memory limitations impact the ability to recall and use relevant information when making decisions.

Time Constraints

  • Urgency: Decision-makers often face time pressures that prevent them from conducting thorough analyses, leading to quicker, less optimal choices.
  • Sequential Decisions: Choices are made in a sequence, with each decision influencing subsequent ones, often under time constraints.

Satisficing

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The concept of satisficing, introduced by Simon, describes a decision-making strategy that aims for a satisfactory solution rather than the optimal one. This approach acknowledges that individuals settle for a “good enough” option that meets their needs and criteria, given the constraints they face.

Real world application

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Business and Management

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  • Strategic Planning: Managers make decisions based on limited information and time, often settling for satisfactory strategies rather than optimal ones.
  • Consumer Behavior: Consumers make purchasing decisions using heuristics and bounded rationality, such as brand loyalty or price anchoring, rather than exhaustive comparisons.

Public Policy

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  • Policy Design: Policymakers use bounded rationality to design policies that are practical and implementable, recognizing that perfect solutions are often unattainable due to constraints.
  • Incrementalism: Policy changes are often made incrementally, reflecting satisficing behavior, where small adjustments are preferred over large, potentially disruptive changes.

Healthcare

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  • Medical Decision-Making: Healthcare providers make decisions based on available patient information, clinical guidelines, and time constraints, often opting for treatments that are satisfactory and feasible.
  • Patient Choices: Patients use bounded rationality when choosing treatments, relying on heuristics like advice from doctors, past experiences, and accessible information.

Economics and Finance

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  • Behavioral Economics: Bounded rationality is a core concept in behavioral economics, explaining why individuals often deviate from perfectly rational economic models.
  • Market Behavior: Investors make decisions based on limited information and cognitive biases, impacting market dynamics and asset prices.
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If you are interested in learning more about decision-making and behavioral economics, consider exploring these topics:

  • Behavioral Economics: The study of how psychological factors affect economic decision-making, incorporating concepts like bounded rationality, heuristics, and biases.
  • Heuristics: Mental shortcuts used to simplify decision-making, often leading to systematic biases and errors.
  • Prospect Theory: A behavioral economics theory that describes how people make decisions involving risk and uncertainty, highlighting biases like loss aversion.
  • Cognitive Biases: Systematic patterns of deviation from rationality in judgment, influencing decisions and behaviors in predictable ways.

These related topics provide a deeper understanding of the factors influencing human decision-making, the limitations of rationality, and the implications for economics, business, and public policy.


Sources & references

Arti

Arti

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Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000 Invezz related data points, has read every piece of research, news and guidance we\'ve ever produced, and is trained to never make up new...