What is bounded rationality?

Bounded rationality is a concept in economics and decision-making that suggests individuals are rational but within certain limits or constraints.

Unlike the traditional economic assumption of perfect rationality, where people are expected to have unlimited cognitive abilities and access to complete information, bounded rationality recognizes that people have limited cognitive resources, incomplete information, and face time constraints, all of which affect their decision-making processes.

As a result, individuals tend to make decisions that are "good enough" rather than optimal, focusing on satisficing (finding a satisfactory solution) rather than fully optimising.

The concept was introduced by economist Herbert Simon in 1957 as an alternative to the notion of perfect rationality in economic models.

Key Features of Bounded Rationality:

1. Limited Information: People don't have access to all the information they need to make the best decision.
2. Cognitive Limitations: People have limited mental capacity to process and analyze complex information.
3. Time Constraints: People often don't have enough time to thoroughly evaluate all options, so they make quick decisions based on limited analysis.
4. Satisficing Behaviour: Instead of searching for the best possible option, individuals settle for a choice that meets their minimum criteria or is "good enough."

Interesting Examples of Bounded Rationality:

1. Investment Decisions in the Stock Market:

• Context: Imagine an individual investor trying to decide which stocks to buy. In theory, if they were perfectly rational, they would gather all available information about every stock, analyze the entire market, and make the decision that maximizes their expected return.
• Bounded Rationality Example: In reality, the investor has limited time and cognitive capacity. They might only look at a few key factors, such as recent stock performance, headlines, or advice from friends or financial news channels. Instead of conducting an in-depth analysis of the market, they may choose stocks that seem good enough based on their limited understanding. They could end up investing in a well-known tech stock simply because it's familiar, even though better-performing, lesser-known stocks may exist.
• Outcome: The decision is not necessarily the optimal one but satisfies the investor’s cognitive limits and time constraints.

2. Choosing a Health Insurance Plan:

• Context: Suppose an individual is selecting a health insurance plan from a list of several options. The plans vary in cost, coverage, network of doctors, and other complex factors. Perfect rationality would imply that the individual evaluates every option in great detail to choose the plan that minimizes cost and maximizes coverage based on their expected healthcare needs.
• Bounded Rationality Example: Due to the complexity of the decision and the overwhelming amount of information, the individual may instead opt for the most familiar plan, or the one recommended by their employer or friends, without fully understanding its pros and cons. They may not read through the fine print or compare the details of each option, instead picking one that seems "good enough" based on surface-level characteristics, such as a lower premium or fewer out-of-pocket costs.
• Outcome: The choice is made not because it's the best possible plan but because it meets their basic criteria while saving time and cognitive effort.

Why Bounded Rationality Matters in Economics:

1. Realistic Models: Bounded rationality offers a more realistic framework for understanding how individuals make decisions in complex and uncertain environments. It explains why people don't always make optimal choices, as assumed in traditional economic models of perfect rationality.
2. Policy Implications: Recognising bounded rationality helps policymakers design better policies by simplifying information or decision processes. For example, making choices easier (through nudges or default options) can help individuals make better decisions, especially in areas like retirement savings or healthcare.
3. Behavioural Economics: The concept of bounded rationality is central to behavioural economics, which studies how psychological and cognitive factors influence economic decision-making. It challenges the traditional notion of the "homo economicus" (the perfectly rational economic agent) and introduces insights about how real humans behave in markets.

In summary, bounded rationality reflects the fact that while individuals aim to make rational decisions, they are constrained by limited information, cognitive limitations, and time, leading them to make decisions that are satisfactory rather than perfectly optimal.