What is bounded rationality?
Bounded rationality is an idea from behavioral economics and finance. It says that people and companies cannot always make the best decisions because:
- They do not have all the information they need
- They have to decide quickly
- Their brains can only process so much
Satisficing instead of optimizing
When people have bounded rationality, they try to make decisions that are “good enough” or satisfactory. This is called satisficing. They do not try to make the absolute best decision possible (called optimizing).
Imagine you want to buy a used car. If you had perfect rationality, you would look at every single used car for sale, compare all factors like price, mileage, features, etc. in detail, and pick the single best one. But this would take a huge amount of time and effort.
With bounded rationality, you would look at a few cars, find one that meets your needs and seems like a good enough deal, and buy that one. It might not be the absolute best possible car, but it is satisfactory given the limited time and information you have. You have satisficed rather than optimized.
Why bounded rationality happens
There are a few main reasons why people have bounded rationality:
Lack of information
Making the best decision requires having all relevant facts. But in the real world, we rarely have perfect information. There are often many unknowns and uncertainties involved. Companies have to decide based on the limited information available to them.
Time constraints
Very often, we have to decide quickly. We do not have the luxury of taking all the time we need to gather every fact and thoroughly analyze every possibility. Think about stock market trading – decisions to buy or sell have to be made rapidly. There is no time for a perfectly rational analysis.
Cognitive limitations
Even if we had all information and unlimited time, our brains can only process and evaluate so much. We are not computers and cannot consider millions of factors and possibilities to determine the absolute best course of action. Our thinking power is bounded.
Implications for economics and finance
The idea of bounded rationality has major implications for economics and finance. Many traditional economic theories assume that people and firms behave in a perfectly rational way, always making optimal decisions to maximize benefits and minimize costs.
Questioning economic models
However, research in behavioral economics shows this is not how people actually behave. Due to bounded rationality, individuals and organizations often make suboptimal decisions and act in seemingly irrational ways.
This means that many economic models based on rational behavior do not match up with reality. Behavioral economists argue that models need to account for the bounded nature of human decision-making in order to be accurate.
Impact on financial markets
Bounded rationality can lead people to make poor financial choices. Consumers may take on mortgages or loans that are not ideal because they do not fully understand the terms or fail to consider all options.
Companies may make investments or mergers that are satisfactory in the short-term but suboptimal in the long run. Investors may follow trends or have knee-jerk reactions to news rather than coolly analyzing fundamentals.
Some researchers believe that bounded rationality contributed to economic crises like the 2008 financial crisis. For example, many people took out adjustable-rate mortgages without considering the possibility of rates going up in the future.
Nudges and choice architecture
Understanding bounded rationality can help policymakers and companies guide people toward better decisions without restricting freedom of choice. This involves tactics like:
Providing relevant information
Giving people the most important facts they need to decide, in an easy to understand format, can help them make more rational choices. For example, requiring credit card companies to clearly display key terms like the interest rate.
Changing default options
People often go with the default or recommended choice because they do not have the information or mental energy to fully analyze other options. Setting good defaults can nudge better decisions. For instance, having retirement savings plans as opt-out rather than opt-in leads to much higher participation.
Simplifying processes
Complex, multistep processes introduce more opportunities for bounded rationality to lead to suboptimal choices. Simplifying things like tax filing, college applications, and government services can promote more rational behaviors.
