# A snippet on bounded rationality

by on March 1, 2018

A comment 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.

{ 31 comments }

1

steven t johnson 03.01.18 at 5:17 pm

Hazlitt’s lesson has already incorporated the irrationality of consumer preferences. Irrationalities due to cognitive limitation in calculating opportunity costs doesn’t seem any different. Someone who prefers this cell phone plan rather than that one is still revealing preference. Like taste, non disputandum.

The notion that someone from outside or above can objectively decide that preferences are wrong on basis of their putative origins in bounded rationality has to demonstrate that they can do better than the market, which is precisely what Hazlitt (and his buddy von Misese) deny, with sneers and curses. Even the efficient markets hypothesis can only be refuted by demonstrating a better job can be done some other way, not by demonstrating the market is perfect.

To defend capital markets on these grounds, you need only falsify reality so that any competitive system is deemed a failure. And so far as I can tell the insistence on falsifying reality to some degree is well-nigh universal in economics. At the very least, technological innovation is always attributed to capitalism while the historic methods of capital accumulation are always abstracted. The benefits of American food crops, not one of which was developed by capitalism, are assumed to be the product of capitalist development, even as non-capitalist Ming China grows enormously. The ugly beginnings of capitalism in the Wars of Religion and imperial conquest disappear, by simply redefining capitalism as beginning later. A theory of what determines the general profit rate is no more a topic for polite discussion than the way God fathered Jesus. And business cycles are rather like clothing malfunctions, something only a churl would comment on out loud.

The general presumption as pretty much any mainstream economist would see it (so far as I can tell, at least,) is that scarcity and ignorance are themselves nature. Wanting an impossible abundance and equality is childishness, wanting the impossible as an act of will, in defiance of all reason. I really cannot see how you can accept the premise that consumers really are sovereign (and consumption is the essence of economic activity,) that prices are equivalent to opportunity costs (to phrase it crudely,) and that exchange as a part of the process of production for profit=exchange to satisfy needs and wants. I think libertarians would be crazy if it weren’t so obvious they lie about everything…but it is not at all clear how they aren’t right about pointing out the illogic in the notion of market failure after you’ve assumed marginal utility and the general equilibrium of the market.

2

CJColucci 03.01.18 at 6:11 pm

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.

Somewhere, I think it may have been a Dilbert cartoon, I heard this phenomenon referred to as a “confusopoly.” I admit to being victimized by it myself, but won’t do the work to find out whether I can get a better deal on my phone service, etc. I justify it to myself, when I feel the need to justify it at all, with the thought that one confusopolist’s deal is likely to be just about as bad as another’s and that neither has much incentive to offer anything noticeably better. I wonder if anyone has made an empirical study of whether that cynical/lazy view of the matter is accurate, or whether we’re leaving money on the table.

3

Marcus Pivato 03.01.18 at 6:23 pm

Hi John. In one of the footnotes, you write:

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.

(At least, I assume this is a footnote; I can’t find the relevant asterisk in the text, but I assume it is probably after the sentence “One Lesson economics ignores this. In the standard One Lesson model of decision making, human beings are replaced by â€˜rational agentsâ€™ who are assumed to be members of the species Homo Economicus.”) I would nuance this slightly. As far as I know, most of the criticisms of government policy within economics have more to do with (1) policymakers being imperfectly informed (about the preferences, endowments, and/or capabilities of economic agents); (2) policymakers having improperly aligned incentives (in a word, being corrupt); or (3) superintelligent homo economicus agents perfectly anticipating and thereby neutralizing any intended effect of government policy. I can’t think of too many models where government policy is ineffective because the government itself is a boundedly rational agent. (This is not to say that these criticisms are always correct —I share your general antipathy towards the “markets always good, government always bad” approach to economics. But it is important not to mischaracterize them.)

Also, I realize that you could probably write a whole book about bounded rationality, and so you are making an effort here to be as brief as possible, and hence not developing the theme in as much detail as you would like. But perhaps it would be helpful to identify three distinct sources of “bounded rationality” in humans, which operate at three different levels.

1. Our brains are products of evolution, and hence, optimized for solving the sorts of problems encountered by small groups of hunter-gatherers living in the proverbial “savanna” —not modern industrial civilization.

2. Many computational problems are just hard —even for our most powerful computers. Computer scientists have a rich theory of “computational complexity”. All of modern cryptography is based on the fact that some computational problems are simply very hard to solve. The homo economicus model implicitly assumes all computational problems can be solved in zero time.

3. In some cases, it isn’t even clear how to pose the computational problem. For example, in many decision environments, it isn’t even clear what the correct probability distribution should be —even assuming you could exhaustively list all possible contingencies. Even if you were a committed expected utility maximizer equipped with an infinitely fast computer, it isn’t clear what to do in such a situation.

Given these sources, we should not be at all surprised that people are boundedly rational. In fact, it would be much more surprising if they conformed to the homo economicus model.

4

fgw 03.01.18 at 8:09 pm

This is just a quibble and not entirely serious, but this analogy seems more complicated than you write: “For example, we can naturally throw and catch objects much better than any other animal.” Granted, I can’t think of any other species I’d take over Willie Mays in center field but if you consider birds plucking fish out from under the surface of water, falcons birds out of the air, bats echolocating insects in the dark, cheetahs running down antelopes, frogs snatching flies with their tongues it isn’t so self evident. Although you are right, we do have a highly evolved module for hand-eye coordination coupled to manual dexterity. Still, catching and throwing aren’t so much natural as learned motor behaviors that rely on a distinct set of innate abilities.

5

John Quiggin 03.01.18 at 9:22 pm

Thanks for all these comments. Some brief responses:

@1 I’m not assuming general equilibrium, just describing how the standard GE argument goes and what it assumes.

@2 I would have liked to use the Dilbert “confusopoly” cartoon as an illustration,. Sadly, Scott Adams has gone so far over to the dark side, I’m not willing to reward him

@3 I agree with all this. Regarding the footnote, the primary reference is to the “calculation debate” of the 1930s

6

John Quiggin 03.01.18 at 9:24 pm

@4 Agreed on all this, and particularly the last sentence. I tried to cover a lot of ground in a short space, which means glossing over lots of complications.

7

J-D 03.01.18 at 11:32 pm

Marcus Pivato

1. Our brains are products of evolution, and hence, optimized for solving the sorts of problems encountered by small groups of hunter-gatherers living in the proverbial â€œsavannaâ€ â€”not modern industrial civilization.

Since you mention it …
… this is not a solid conclusion. There is strong evidence of adaptive evolutionary change over the period of mere thousands of years since our hunter-gatherer origins: some of it affecting most or all human populations, such as a general decline in tooth size (because you can get away with smaller teeth if you’ve got an agriculturalist’s diet); some of it affecting only some populations, such as adult lactase persistence (which is useful if you’ve got dairy herds that you can extract milk from). I don’t know of any equally strong evidence of evolutionary change in human cognitive abilities over the same time-scale, but it’s not clearly impossible.
fgw
You’ve got plenty of examples there of behaviour equivalent to or approximating catching, but none of throwing. I expect you could find examples of animals throwing, but I am more doubtful that any of them would be as good at it as humans. Even if you consider frogs to be throwing their tongues (which seems a stretch to me), their range is strictly limited.

I grant that John Quiggin does seem to be discussing catching ability rather than throwing ability, and there (as he admits) I think you have him.

8

Peter T 03.02.18 at 12:13 am

Worth noting that discussions of rationality very often assume shared ends, where really rationality only applies to means. For instance, the overwhelming majority of people believe in an afterlife. It is therefore rational for them to suffer pain or death in this life if doing so assures them of heaven/nirvana/esteem as an ancestor/reincarnation as a cat. Likewise the prospect of wounds or death does not deter those want to be heroes. Hector knows he is going to die in battle – for him it’s a plus.

Ben Franklin’s anecdote assumes that the tradesman’s aim is riches. If, instead, the tradesman aims at a modest sufficiency and content, going fishing is a more rational choice.

Of course, behind this is the further conundrum that people very often are uncertain about what they want, so much so that we remark on those who are apparently clear on their goals.

9

Moz of Yarramulla 03.02.18 at 1:42 am

people very often are uncertain about what they want,

…and often completely wrong about what will make them happy.

Apart from the notorious “won the lottery, committed suicide a year later” cases, people often do things that make them unhappy and avoid the things that make them happy. For me, if I feel sad and antisocial the solution is often to go out and do something productive and social. Sitting at home going “you all suck” just makes me more unhappy even though it’s what I feel like doing. There are more general examples, but that’s the one I remind myself of :)

10

nastywoman 03.02.18 at 9:57 am

I just wish there would be more ”bounded rationality” concerning prices – but damn – there seems to be just too many people out there who want what I want for whatever price?

And that should be included in any lesson about e-conomix in the first place.
There is just too much demand out there for too much expensive stuff – which makes the much to much expensive stuff even more expensive – as has somebody else lately here shopped for a ticket for Hamilton or a Gucci purse?

And what’s with these US Hotel prices lately if there is too much going on ”in town” – or prices for a glass of whine in homeland restaurants – or even for the latest craze – the beercraze? – why isn’t there more ”bounded rationality” for all these kind of stuff where there seems too many who are willing to pay a 1000 bucks for a simple T-shirt from Jay-Z?

Is this the new lesson for e-comix in the 21th century?

11

MisterMr 03.02.18 at 12:51 pm

I have a problem with the concept of “utility” as it is used in economics (at best of my understanding), and while it isn’t a critic to your book and isn’t really about euristics, I’ll put it here anyway (yay internet!).

Basically I think that “utility” and the concept of a general equilibrium of utilities hold only for consumption goods, or for that fraction of capital goods that is consumed as part of the production of consumption goods, but not for wealth and for the accumulation of wealth as such.

For example, if Donald Duck has 1\$, and he chooses to spend it in ice creams, or in flowers for Daisy, this is an “utility” comparison; if Daisy Duck gets one dollar, and chooses between spending it now or spending it tomorrow, this again is an utility comparison; but if Scrooge McDuck has 1\$ and he simply stockpiles it with other dollars, this isn’t an utility comparison but wealth accumulation.

I think this is relevant because many economic phenomena like bubbles, “saving gluts” , etc. are easily explainable if we understand that a substantial part of “demand” is not due to a desire of utility (consumption), but to a desire of wealth (drive to accumulation).

Incidentally I think this is the whole point of Marx’s crisis theory.

But what is the difference between Scrooge’s behavior and Donald’s and Daisy’s behavior?
Well it’s simple, it’s that Donald and daisy are converting or planning to convert abstract wealth into consumption, whereas Scrooge isn’t planning to do this, he is just accumulating because the social structure of capitalism pushes him to act this way.

The problem in other words is that IMO economic theory assumes that all economic behavior is motivated by desire of consumption (C-M-C), whereas a large part of it is motivated by desire of accumulation (M-C-M’).

12

nastywoman 03.02.18 at 1:52 pm

”because many economic phenomena like bubbles, â€œsaving glutsâ€ , etc. are easily explainable if we understand that a substantial part of â€œdemandâ€ is not due to a desire of utility (consumption), but to a desire of wealth (drive to accumulation).”

but there are all of these car collectors who not only have this ”drive to accumulation” but also have this drive to drive all their many cars they have accumulated and thusly ”consume” them and I always wondered what Marx would have to say about that one – and do you know that one of the best so called ”investments” of the last years was to accumulate not totally consumed Ferraris and that ”Communism” is ”if everybody drives a Ferrari”?

13

nastywoman 03.02.18 at 2:03 pm

– and driving across America and having to eat out every day there definitely isn’t enough â€bounded rationalityâ€ out there anymore if it takes about 400 bucks -(excluding service) just to invite three friends who like to have a drink or two with their food?

And on top of it one has to wait to even get seated BE-cause the restaurants are ”packed” – as far too many Americans are able to pay that – and if one has to check in one Hotel after another with prices which know no â€bounded rationalityâ€ at all one has to ask:
Who is able to pay that?

And the answer is: Tons of tourist too – who get stuck in traffic for hours everywhere and a friend just missed her plane because it took her out of Manhattan 2 hours to JFK.

This town – this homeland” needs a lot more â€bounded rationalityâ€!

14

steven t johnson 03.02.18 at 3:23 pm

It occurs to me that seeing the market as the most successful instrument for satisficing the economy maintains the libertarian purist stance on free markets while incorporating the notion of bounded rationality.

15

ccc 03.02.18 at 11:15 pm

Quiggon #0: “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.”

Ok, but quite general. Is it not also relevant to highlight how background inequality generates assymetrical bounding? E.g. Mullainathan et al 2013 “Poverty Impedes Cognitive Function”, http://science.sciencemag.org/content/341/6149/976

16

John Holbo 03.03.18 at 12:01 am

“Quiggon”

I think the preferred spelling is Qui-Gon. Short for Qui-Gon Jinn. But we call him John.

http://starwars.wikia.com/wiki/Qui-Gon_Jinn

“In death, Jinn was able to utilize his incomplete immortality training to return as a disembodied voice.”

Economics training may afford something of the sort. Maybe (if you go over to the dark side) you can return as a perfectly efficient market?

17

LFC 03.03.18 at 2:28 am

J Holbo @16

Off the topic of bounded rationality, but given your tastes (and since you’ve entered this thread) I’m surprised you don’t mention G.B. Shaw much. I think his style in the prefaces to the plays, e.g., would be to your liking. Just today I happened to be glancing at the preface to The Devil’s Disciple, not one of his great achievements to be sure, but the preface is cool: self-deprecating, sardonic, etc. Drove me to the dictionary to look up the word mountebank, whose etymology and meaning I’d forgotten.

Ok, back to bounded rationality, Herbert Simon et al., etc.

18

John Holbo 03.03.18 at 2:34 am

“Off the topic of bounded rationality, but given your tastes (and since youâ€™ve entered this thread) Iâ€™m surprised you donâ€™t mention G.B. Shaw much.”

True confession: I’ve never read the darn stuff. I probably should. That’s why I’m going to keep blegging recommendations. As you may guess, I’m trying to write stuff.

19

LFC 03.03.18 at 3:18 am

@JH
Well, you’ve read a *lot* of stuff that I haven’t. But I think Shaw — some of the prose, more than the plays actually (except maybe late stuff like Back to Methusela) — might appeal to you. Now to be honest, much or most of his prose I haven’t read, but his music and drama criticism is what I think might appeal. That plus the prefaces to the plays. (On my shelf is an old Viking Portable Lib. edition of Shaw, ed. Stanley Weintraub. Might be one place to start.)

How it wd intersect w your interests as revealed in yr blogging here, I’m not exactly sure. But Shaw had a wide variety of interests, some of them offbeat, was a crank on certain subjects, had pretty good and much less good moments politically speaking, and lived a v. long time. So there’s a lot there.

p.s. Geo (G. Scialabba) took Shaw’s criticism of Shakespeare seriously (as revealed on occasion here). That’s not the aspect of Shaw that appeals to me, nor do I think it’s GBS at his best. I happen to share the conventional view that a lot of Shakespeare is great. And Shaw himself perhaps owed more to Shakespeare than he prob wanted to admit. But we digress…

20

Barkley Rosser 03.03.18 at 3:37 am

I see Tversky, Kahneman, and Thaler, but not Herbert Simon. On bounded rationality it is Herbert Simon, Herbert Simon, and Herbert Simon, and especially when one starts talking about heuristics.

21

ccc 03.03.18 at 9:13 am

John Holbo #16 (and John Quiggin): for the typo sorry I am!

While on the topic of Star Wars: “I think therefore I am” said Yoda pointing to a childhood photo.

22

John Holbo 03.03.18 at 10:35 am

On Quiggin’s behalf, I forgive the typo.

23

nastywoman 03.03.18 at 1:51 pm

– and about the topic of ”the possibility to have too many choices, most of which from each other only marginally and that too much choice can lead to depression” – this Barry Schwartz guy doesn’t know what he is talking about – as none of my (American) friends haven’t any problem whatsoever with choosing ALWAYS the absolut IT stuff –
and ONLY if they can’t afford IT –
THAT definitely can lead to depression.

So perhaps it’s an ”age thing” – like old dudes -(or academics?) being overwhelmed about too much choice?

24

Robert 03.03.18 at 3:27 pm

I can see the appeal of the title referring to two lessons.

The second lesson, as I understand it, includes market failures, macroeconomics and recessions, and bounded rationality. I’ve also seen here and there an awareness of implications of the Sonnenschein-Mantel-Debreu theorems.

In thinking about some of the above comments, here and on previous threads, I think of Thorstein Veblen on conspicuous consumption, a Marxist idea that some accumulate capital so as to have power over one another, and the need for a clarification that the absence of all these details is not enough for a claim that market outcomes are “fair”.
(I think of Veblen and Galbraith as important sources for feminist economics.) Maybe somewhere you also want to work in a discussion of principal agent problems and information asymmetries.

All this seems like too much for a single second lesson. Maybe in the conclusion, you might mention the need for additional lessons – which would not be merely the development of a less popular, more technical exposition. When one goes this far, the question arises of whether the first lesson, in trying to understand actually existing capitalism, is even a good place from which to start.

Perhaps those who start from the first lesson, like in many textbooks on microeconomics,
seem to be driven by propertarian ideology. I suppose you might mention the CORE textbook, somewhere, which I have not read.

25

Robert 03.03.18 at 3:31 pm

By the way, for literature that is of historical importance on the development of ideas about opportunity costs, I prefer Wicksteed’s Common Sense of Political Economy over Marshall’s Principles. It is like the Austrian approach, but originally in English – so it fits with my limitations.

I recall that somewhere you call Robbins an one-lesson economist. Does his Essay on the Nature and Significance of Economic Science appear in the recommended readings?

26

alfredlordbleep 03.03.18 at 4:53 pm

@various
n****woman should take in the famous lines of Keats again if she
seeks respite from her star-spangled consumption.

As, supperless to bed they must retire,
And couch supine their beauties, lily white;
Nor look behind, nor sideways, but require
Of Heaven with upward eyes for all that they desire.

27

nastywoman 03.03.18 at 6:51 pm

”n****woman should take in the famous lines of Keats again if she
seeks respite from her star-spangled consumption.”

I can’t – (respite) – the US economy would collapse without my – ME (I) – and my many besty friends) star-spangled consumption.

28

John Quiggin 03.04.18 at 6:15 pm

@20 I will definitely cite Simon
@25 I omitted the reference to Robbins in further reading for Chapter 1. Here’s what I’ve added “Robbins (1932) is an early and influential example of the fallacious idea that a value-free economics can have anything useful to say.”

29

John Quiggin 03.04.18 at 6:18 pm

I was a big Shaw fan in my teens, and still like him today, though with more awareness of his flaws (I remember my Year 9 teacher saying “I wonder when you’ll see through Shaw”, which seems pretty perceptive in retrospect though it took me a while to see her meaning). I’ll look for some Shaw quotes to use as chapter epigraphs,

Also, a Qui-gon Jinn quote would be fun but he was a Jedi of few words, IIRC.

30

alfredlordbleep 03.04.18 at 7:24 pm

Howdy, JQ
There’s for instance early Shaw, Mrs Warren’s Profession, packing a punch more than a hundred years on. Alas, still pertinent.
(But too on-the-nose for fastidious comedy lovers):

CROFTS [. . .] Come! you wouldnâ€™t refuse the acquaintance of my motherâ€™s cousin the Duke of Belgravia because some of the rents he gets are earned in queer ways. You wouldnâ€™t cut the Archbishop of Canterbury, I suppose, because the Ecclesiastical Commissioners have a few publicans and sinners among their tenants. Do you remember your Crofts scholarship at Newnham? Well, that was founded by my brother the M.P. He gets his 22 per cent out of a factory with 600 girls in it, and not one of them getting wages enough to live on. How dâ€™ye suppose they manage when they have no family to fall back on?