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Bounded Rationality: What Next?

The theory of bounded rationality, proposed by Herbert Simon, states that a decision maker’s rationality is restricted by cognitive and computational limitations, societal influences and inadequate resources that hinder them from arriving at optimal decisions. Standard models, theories and methods characterized by the assumption of rationality do not factor in elements such as time constraints, information asymmetry, cognitive biases, societal norms, institutional regulations and emotions, of course. For instance, people often resort to affect heuristics – mental shortcuts that guide decision-making rather than taking the time to study the situation and the risks involved, hence distorting perception.

Simon also introduced two cognitive styles. ‘Maximizers’ constantly seek to make optimal decisions to max out benefits while ’satisficers’ settle for choices that are good enough, especially when faced with complex decisions. For example, while deciding what to order at a restaurant, you could either scour the menu, analyze the ingredients and speculate the taste of each meal or ask around for everybody’s opinions, anticipate the after-effects of having each dish and make an informed decision or simply rely on your past experiences and familiarity associated with a certain dish and make a decision. The former would most certainly provide the optimal outcome, but it also involves going to unreasonable lengths in doing so.

The recent years have seen the rise of behavioral economics – a newer subset of economics that seeks to provide a more holistic understanding of economic behavior and decision making. Richard Thaler, touted the father of behavioral economics, introduced the “planner-doer” model in order to explain people’s failure in meeting their goals, namely, saving adequately for retirement. People face a trade-off between long term financial security and short-term desire for present wants and needs. He noted that in the process of decision-making, people suffer from various biases - loss aversion bias due to which they view savings as current losses rather than future gains; the endowment effect due to which they value currently owned assets higher than their market value; status quo bias whereby they tend to stay in the state of inertia despite the choice to improve their situation; hyperbolic discounting whereby people tend to favor immediate gratification rather than delayed gratification (to name a few) and simply a lack of self-control and procrastination. He propagated the idea that a particular behavior can be encouraged by removing obstacles and setting the default to what is favorable i.e., by incorporating ‘nudges’. For example, automatically enrolling employees in retirement savings plan, or encouraging organ donations by presuming people’s willingness to donate organs after death in order to promote favorable outcomes.

Another discrepancy in the rationality theory is that people never have perfect information either due to inaccessibility or simply the unavailability of such information or resources. A study conducted by the London School of Economics has contributed to a collective shift in the UK’s financial regulations operations. It reveals that too much information can be detrimental; an overload of information tends to hinder people in making optimal decisions. Therefore, providing information about an insurance policy’s value for money or the seller’s commission has little effect on buyers even though they say they wanted that information. Even if perfect knowledge were uniformly presented to each one of us, how we interpret it and put it to use will differ vastly from person to person due to inconsistencies in underlying mental frameworks and tendencies.

Daniel Kahneman’s prospect theory is an alternative that attempts to explain consumer behavior. According to his theory, people fear losses more than they value gains; they weigh negative outcomes more heavily than their potential gains. For instance, people would rather accept a deal that offers a 50% probability of gaining $2 over one that has a 50% probability of losing $1.

The assumption of rationality is in a way, biased in itself since it leans towards facts, data, analysis and logic and has no consideration for behavior guided by moral codes, ethics, personal experiences, intuition, loyalties, obligations, expectations and so on. Consequently, there is a growing need for more comprehensive models and tests which is perhaps being realized by the development of complex models that rely on probability rather than simply perfect knowledge in order to achieve accuracy in future-based judgements, at least to an extent.

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Breaking Down Consumer Preferences

Consumer preferences are subjective tastes, dictated by levels of satisfaction obtained from among bundles of goods. These levels of satisfaction are often measured in terms of utility. A rational individual is assumed to exhibit monotonicity in preferences ie., they will always prefer bundles consisting more goods or at least, more of one good and no less of the other since more is always preferred to less. An individual will choose basket A if it gives him more satisfaction than basket B.

The driving force behind having to make choices – work vs leisure, cooking at home vs eating at a restaurant, public vs private transportation, buying vs renting an apartment or in the case of businesses – what to produce, how to produce, for whom to produce is – scarcity of resources in the face of unlimited wants. This, of course, involves opportunity costs i.e., forgoing the benefits of the next best alternative. Therefore, the opportunity cost of a consumption bundle also plays a crucial role in determining consumer choices.

Fast food is cheaper and less healthy than organic food. Somebody who is health-conscious and able to spend more on organic food will most probably opt for organic food but somebody who cannot afford organic produce or does not prioritize his health might opt for fast food. When an individual chooses organic food, his opportunity cost involves health risks and hospital bills and in the second instance when the individual chooses fast food, his opportunity cost is a healthier lifestyle and added expenses.

Consumer preference theory makes three primary assumptions with regards to consumption bundles – 

Completeness assumes that the consumer is perfectly capable of making a decision and understand its consequences.

Reflexivity assumes that any bundle is at least as good as itself.

Transitivity assumes consistency in consumer preferences. For instance, if one prefers bundle A to B and B to C, it is implied that A is preferred to C.

Utility can be measured using two approaches – either cardinal or ordinal (assuming that satisfaction can be measured). The cardinal approach seeks to quantify utility obtained from different consumption bundles allowing for easy comparison. For example, an individual obtains 7 utils from consuming a chocolate, 3 from an apple and so on.

On the other hand, the ordinal approach is a relative measure whereby consumption bundles are ranked according to tastes and preferences. Regardless of the approach, the law of Diminishing Marginal Utility is always at play (as long as normal goods are concerned). It states that with everything else held constant, utility obtained from a particular good or bundle diminishes as consumption increases of the same increases.

These preferences are mapped out in the form of indifference curves. An indifference curve represents all the bundles that avail the same level of satisfaction to the consumer, thus making them indifferent. Bundles that lie below the curve avail lower levels of satisfaction and the ones above it avail higher levels of satisfaction but are subject to budget constraints and hence, non-optimal.

For example, an individual seeking to rent an apartment must allocate some of their income to do so. If set too low, they under-utilize their resources and if set too high, they leave little to meet other expenses. A suitable apartment would be one that not only fits the budget but also gives them satisfaction through several factors such as a good neighborhood, amenities, proximity to work and so on, thereby maximizing their utility.

Therefore, in order to arrive at the optimal consumption bundle, we need to merge budget lines with indifference curves to map out the best choice – the one that checks both affordability and satisfaction.

In the real world however, it is not so simple. It is hard to overlook the fact that the assumption of rationality oversimplifies consumer decisions but it is equally hard to do without it. As behavioral economics rightly points out, people are not a hundred percent rational; they are heavily influenced by cognitive limitations and societal conditioning leading them to produce less than optimal results and making it trickier to predict consumer behavior. Despite the obvious disadvantages, one cannot deny that consumer choice theory forms the basis for economics and is key in driving everything from business decisions to government policies.