Bounded Rationality

Bounded Rationality

It would be so nice if the "invisible hand" of the market, as described by Adam Smith, truly led individuals pursuing their own security and gain to promote the good of the whole. The appeal of this model, where material selfishness becomes a social virtue, has endured for centuries. Unfortunately, the world presents us with multiple examples of people acting rationally in their short-term best interests and producing aggregate results that no one likes. Tourists flock to pristine destinations and then complain about the crowds. Farmers produce surpluses, causing prices to plummet. Fishermen overfish and destroy their own livelihood. Corporations collectively make investment decisions that cause business-cycle downturns. Why does this happen?

Because of what Nobel Prize–winning economist Herbert Simon calls bounded rationality. This concept means that people make quite reasonable decisions based on the information they have, but they don’t have perfect information, especially about more distant parts of the system. Fishermen don’t know how many fish there are, much less how many fish will be caught by other fishermen that same day. Businessmen don’t know for sure what others are planning to invest, what consumers will want, or what their actual market share is. Their information is incomplete and delayed, and their own responses are delayed, leading them to systematically under- and overinvest.

We are not omniscient, rational optimizers, says Simon. Rather, we are blundering "satisficers," attempting to meet (satisfy) our needs well enough (sufficiently) before moving on to the next decision. We do our best to further our own nearby interests in a rational way, but we can take into account only what we know. We rarely see the full range of possibilities. We often don’t foresee, or choose to ignore, the impacts of our actions on the whole system. So instead of finding a long-term optimum, we discover within our limited purview a choice we can live with for now, and we stick to it, changing our behavior only when forced to.

We don’t even interpret perfectly the imperfect information that we do have, say behavioral scientists. We misperceive risk, live in an exaggerated present, and discount the future at rates that make no economic or ecological sense. We don’t give all incoming signals their appropriate weights, and we often don’t let in news we don’t like or information that doesn’t fit our mental models. Which is to say, we don’t even make decisions that optimize our own individual good, much less the good of the system as a whole.

The central insight is that the bounded rationality of each actor in a system—determined by the information, incentives, disincentives, goals, stresses, and constraints impinging on that actor—may not lead to decisions that further the welfare of the system as a whole. When the theory of bounded rationality challenged two hundred years of economics based on Adam Smith, it caused a controversy that is far from over. Economic theory assumes first that homo economicus acts with perfect optimality on complete information, and second that when many individuals do that, their actions add up to the best possible outcome for everybody. Neither of these assumptions stands up long against the evidence, and commonly encountered structures like addiction, policy resistance, arms races, drift to low performance, and the tragedy of the commons can cause bounded rationality to lead to disaster.

The Trap of Position

Replacing people while leaving the system intact may do little to improve its performance. Suppose you are lifted out of your accustomed place and put into a position whose behavior you have never understood. A staunch critic of government becomes part of government; a laborer becomes management; an environmental critic joins a corporation. In your new position, you experience the information flows, incentives, disincentives, goals, discrepancies, and pressures—the bounded rationality—that goes with that position. You might retain your earlier perspective and introduce changes, but the pressures of the new role can work against that. A manager under pressure to cut spending may start treating labor chiefly as a cost. A financier may face incentives to overinvest during booms and pull back during busts. A fisherman with a mortgage, a family to support and imperfect knowledge of the fish population may keep fishing even when the stock is declining. Understanding these pressures helps explain behavior and identify what needs to change.

Redesigning the System

Seeing how individual decisions are rational within the bounds of available information does not provide an excuse for narrow-minded behavior; it provides an understanding of why that behavior arises. What makes a difference is redesigning the system to improve the information, incentives, disincentives, goals, stresses, and constraints that have an effect on specific actors. Change comes first from stepping outside the limited information that can be seen from any single place in the system and getting an overview. From a wider perspective, information flows, goals, incentives, and disincentives can be restructured so that separate, bounded, rational actions actually add up to results that everyone desires. Better, more complete and timelier information can sometimes change behavior with surprisingly little intervention.

A classic example of this is the case of electric meters in a suburb near Amsterdam. The houses were all built at the same time and were nearly identical, except for one detail: in some, the electric meter was in the basement; in others, it was in the front hall. During the energy crisis of the early 1970s, it was discovered that the houses with the meter in the front hall used one-third less electricity. All houses were charged the same price and contained similar families. The difference was simply the position of the meter. The families with high electricity use had the meter in the basement, where people rarely saw it. The ones with low use had the meter in the front hall, where people passed by the little wheel turning around, adding up their bill many times a day. The right feedback got to the right place at the right time.

Some systems are structured to function well despite bounded rationality. In undisturbed ecosystems and traditional cultures, the average individual, species, or population, left to its own devices, behaves in ways that serve and stabilize the whole—these systems are self-regulatory. Since Adam Smith, it has been widely believed that the free, competitive market is one of these properly structured self-regulating systems. In some ways, it is. In other ways, obvious to anyone willing to look, it isn’t. A free market does allow producers and consumers, who have the best information about production opportunities and consumption choices, to make fairly uninhibited and locally rational decisions. But those decisions can’t, by themselves, correct the overall system’s tendency to create monopolies and undesirable side effects, discriminate against the poor, or overshoot its sustainable carrying capacity. To paraphrase a common prayer: God grant us the serenity to exercise our bounded rationality freely in systems that are structured appropriately, the courage to restructure the systems that aren’t, and the wisdom to know the difference.