Bounded Rationality

Arsalan Tahir

2011-02-0473

Lahore University of Management sciences

 “Findings from the behavioral economics theory has left no doubt about the failure of rational
choice as a descriptive model of human behavior but having criticized the fundamental
assumption of rationality in neo-classical economics, Behavioral economics has failed to
provide a coherent alternative. This paper explores several instances where human’s cognitive
constraints made them act like an irrational being and provide a detailed summary of the
criticism put forward by behavioral economists. In the end it describes the limitations of
behavioral economics and the role of psychology in economics.”

Introduction

Recent developments in the field of Behavioral Economics has enhanced the role of

psychology in economic theory and provided an entirely different framework to approach the

decision making models. To understand the origins we must go back to the golden age of

standard rationality theory when the models of idealized decision makers were becoming

increasingly well defined and it was thought that the model can be applied to any kind of

complex problem. This raised the problem of whether it was legitimate to ascribe individuals

with the ability to perform extremely complex decision-making processes or the models are only

suitable for the use of experts. It was this dilemma that resulted in the emergence of behavioral

economics and prompted Simon to use the term “bounded rationality ... to denote the whole

range of limitations on human knowledge and human computation that prevent economic actors

in the real world from behaving in ways that approximate the predictions of classical and

neoclassical theory” (Simon 1987a, 222)

Challenge to neo-classical economics

From the view point of behavioral economists the most important development in the

field of Behavioral Economics occur with the emergence of new branch of psychology called

“behavioral decision making” (BDM). The main theme of BDM researcher is summarized in the

word of Dawes: “Basically, behavioral decision making is the field that studies how people make
decisions. Because all types of people are making all sorts of decisions all the time, the field is

potentially very broad. What has characterized the field both historically and theoretically is the

comparison of actual decision making with certain principles of rationality in decision

making.”(Dawes 1998)

After the emergence of BDM, one of the first criticisms that bring the attention of neo-

classical economists was from Tversky and Kahneman’s two research projects namely judgment

under uncertainty: Heuristics and biases which basically shows that people rely on a limited

number of heuristic principles which reduce the complex tasks of assessing probabilities and

predicting values to simpler judgmental operations (Tversky and Kahneman 1974). The other

project that brings criticism to the expected utility theory as a descriptive model of decision

making under risk was the development of an alternative called prospect theory1.Central to their

critique of orthodox decision theory was the observation of what they later called “framing

effects2,” in which “seemingly inconsequential changes in the formulation of choice problems

caused significant shifts of preference” (Tversky and Kahneman 1981).

During the 1980’s the work of Thaller, in his paper called “Towards a positive theory of

consumer choice”, brings another criticism to the standard economic theory. This paper argues

that the “exclusive reliance on the normative theory [of consumer choice] leads economists to

make systematic, predictable errors in describing or forecasting consumer choices” (Thaler

1980). In his paper, Thaller was interested in developing an adequate descriptive theory of

human decision making. He discussed several anomalies that result in the deviation from the

ideal expressed by normative economic theories. The most common anomalies discussed were

the underweighting of opportunity costs, the failure to ignore sunk cost, the influence of

considerations of regret and self control problems. In a follow-up paper, ‘Mental Accounting and
1
Prospect theory was basically an adapted version of expected utility theory which was modified in order to
account for discrepancies in expected utility theory
2
The idea that gains and losses are determined by application of a reference point predicted framing effects
Consumer Choice (Thaler1985), Thaller developed “a new model of consumer behavior ... using

a hybrid of cognitive psychology and microeconomics” (Thaller 1985, 199). In this Thaller was

using cognitive psychology to determine in what ways our decision choice diverge from

prediction of standard economics theory and how it can be used to discover a better alternative of

human choice theory.

The work of Tversky, Kahneman and Thaller (discussed above) present some of the

earlier challenges faced by neo-classical economics and mark the beginning of a whole new

dimension in field of economics. Now I need to consider some of the examples to demonstrate

how human beings actually behave when faced with complex decisions and what are the hidden

mechanisms that deviates them from the predictions of human rational choice theory.

Examples to demonstrate inadequacies of Standard economic theory

Framing Effects

Kahneman and Tversky (1981) demonstrated several phenomenon to predict the human

choice behavior which was consistent with prospect theory but not with Expected utility theory.

The two authors developed a theory in which value is assigned to gains and losses rather than to

final assets. With this they were able to carry out framing effects because what counts as a gain

and what counts as a loss is relative to the frame i.e. the theory predicts subjects to change their

behavior when going from one frame to another as following experiment indicates: Kahneman

and Tversky (1981) asked the following pair of concurrent decisions.

First examine both decisions, and then indicate the options you prefer.

Decision (i). Choose between:

A. a sure gain of $240 [84 percent]

B. 25% chance to gain $1000, and

75% chance to gain nothing [16 percent]

Decision (ii). Choose between:

C. a sure loss of $750 113 percent]

D. 75% chance to lose $1000, and

25% chance to lose nothing [87 percent]

The majority choice in decision (i) is risk averse: a riskless prospect is preferred to a risky

prospect of equal or greater expected value. In contrast, the majority choice in decision (ii) is risk

taking: a risky prospect is preferred to a riskless prospect of equal expected value. This pattern of

risk aversion in choices involving gains and risk seeking in choices involving losses is because

the value function is S-shaped, the value associated with a gain of $240 is greater than 24 percent

of the value associated with a gain of $1000, and the (negative) value associated with a loss of

$750 is smaller than 75 percent of the value associated with a loss of $1000. Thus the shape of

the value function contributes to risk aversion in decision (i) and to risk seeking in decision (ii).

Moreover, the underweighting of moderate and high probabilities contributes to the relative

attractiveness of the sure gain in (i) and to the relative aversiveness of the sure loss in (ii)

(Kahneman and Tversky 1981). The choices given above were both identical and from the view

point of standard economic theory the decisions should be consistent in both problems but still

the subjects changed their decisions from (i) to (ii).

Endowment effect

In standard economic theory demand is a function of price and wage but it does not

depend upon the endowment of a person. Thaller in his 1980 paper coined the term endowment

effect to define an experimental finding that people value a good more if it is a part of their

endowment. Ariely (2008) in his predictably irrational describe a detailed experiment to

demonstrate the tendency of people to value a good more if it is a part of their endowment. He

got a list of students who had won the lottery ticket to basketball tournament and those who had
not and started telephoning them. He first called to the one who wasn’t lucky enough to get the

ticket and asked what the maximum he’s willing to pay for the ticket? $175 he replied. Next he

called the one who got the ticket and asked what the minimum he’s willing to sell his ticket for?

$2400 he replied. What was really surprising, though, was that in all his phone calls, not a single

person was willing to sell a ticket at a price that someone else was willing to pay. From a rational

perspective both the ticket & non-ticket holders should have thought of the game in exactly the

same way and there should be a price at which willingness to pay is equal to willingness to buy.

Ariely (2008) gives the following reasons for this predictably irrational behavior. First we

fall in love with what we already have. Second, we focus on what we may lose rather than what

we may gain. Third, we assume that other people will see the transaction from the same

perspective as we do. Due to these reasons there is such a huge difference between willingness to

buy and sell. Another example demonstrating endowment effect is the "30-day money back

guarantee." If we are not sure whether or not we should get a new sofa, the guarantee of being

able to change our mind later may push us over the hump so that we end up getting it. We fail to

appreciate how our perspective will shift once we have it at home, and how we will start viewing

the sofa—as ours—and consequently start viewing returning it as a loss. We might think we are

taking it home only to try it out for a few days, but in fact we are becoming owners of it and are

unaware of the emotions the sofa can ignite in us (Ariely 2008).

Trap of Zero Cost

Have you ever consider why things that we never consider purchasing become incredibly

appealing when they are free? Dan Ariely provides a detailed analysis of why a product with

zero cost is attractive and people always chose such product even when standard economic

theory describes such decision as irrational? According to Ariely “Most transactions have an

upside and a downside, but when something is free! We forget the downside. Free gives us such
an emotional charge that we perceive what is being offered as immensely more valuable than it

really is.”(Ariely2008). Now suppose you were offered a choice between a free $10 Amazon gift

certificate and a $20 gift certificate for seven dollars. Think quickly. Which would you take?

(Ariely 2008)

To their surprise most of the people opted for free $10 gift certificate which gives the

earning of $10 as compared to $20 certificate which gives the earnings of $13. According to

standard economic theory rational choice would be to go for $20 certificate but most of the

people acted in the opposite direction. When the same experiment was conducted offering the

$10 gift certificate for one dollar and the $20 certificate for eight dollars. This time most of the

participants jumped for the $20 certificate. (Ariely 2008)

The example illustrates the simple fact that when choosing between two products we

often overreact to the free one. It also illustrates the limitations of human cognition when

confronted with the choice of free product.

Social Vs Market Norms

We all simultaneously live in two different worlds i.e. the one where social norms prevail

and the one where market norms prevail (Ariely 2008). If we keep both of these worlds separate

our life is pretty simple but when the two worlds collide the problem sets in: Take sex, for

instance. We may have it free in the social context, where it is, we hope, warm and emotionally

nourishing. But there's also market sex, sex that is on demand and that costs money. This seems

pretty straightforward. We don't have husbands (or wives) coming home asking for a $50 trick;

nor do we have prostitutes hoping for everlasting love (Ariely 2008). Ariely demonstrates that

people sometimes make irrational choices when they are confronted with social and market

norms.
 For instance few years ago the AARP asked some lawyers if they would offer less

expensive services to needy retirees, at something like $30 an hour. The lawyers said no. Then

the program manager from AARP had a brilliant idea: he asked the lawyers if they would offer

free services to needy retirees. Overwhelmingly, the lawyers said yes (Ariely 2008). So what was

going on $0 is certainly no better than $30 but in the latter case they decided to volunteer their

time in the name of social norm not the market norm. So people when confronted between

market and social norm often make choices not predicted by human rational choice theory.

The influence of arousal and Self control

There is a tendency in human to fall in impulsive behavior in a pattern that they lose self

control and often make irrational decisions. Ariely (2008) studied a group of students in two

different states: cold and aroused and asked them three different sets of questions in both aroused

and cold state. One set of questions asked about sexual preferences, second set of questions

asked about the likelihood of engaging in immoral behavior such as date rape and third set of

questions asked about likelihood of engaging in behaviors related to unsafe sex. The results

showed that when participants were in a cold, rational, superego-driven state, they respected

women; they were not particularly attracted to the odd sexual activities we asked them about;

they always took the moral high ground; and they expected that they would always use a

condom. Across the board, they revealed in their unaroused state that they themselves did not

know what they were like once aroused. Prevention, protection, conservatism, and morality

disappeared completely from the radar screen. They were simply unable to predict the degree to

which passion would change them (Ariely 2008).

The experiment simply tells us the effect that different states causes in our decision

making process and how irrational a person behaves when he is in an excitatory state. The

experiment above also demonstrates the problem of self control.

Some other examples

In the discussion above I’ve discussed some examples and demonstrated instances where

our cognitive capacity imposes limits to our understanding of the world as rational actors. Apart

from above examples there are several other instances that can be quoted to describe the failure

of standard economic theory one such example is Allais Paradox which came as challenge to

expected utility theory’s independence axiom and proved that normative theory is not valid.

Another challenge came with the criticism on hyperbolic time discounting model3. The skeptics

of hyperbolic time discounting model says that subjects have a tendency to choose earlier,

smaller rewards over later, larger rewards when the earlier reward offers immediate consumption

but reverse this preference when both rewards are delayed (Laibson 1997). Also the standard

economic theory was challenged on the assumption that choice of an agent depends only on his

own monetary payoff but there are several models that explains that choice of agent not only

depend on his own monetary payoffs but also depends on the monetary payoffs of others. One

example of such a model is the experiments on ultimatum bargaining4 introduced by Guth,

Schmittberger and Schwarze (1982). Apart from all this there is a tendency in rational choice

theory for heuristic5 biases. Kahneman and Tversky (1974) demonstrated that our heuristics does

not estimate correct probabilities of events and therefore lead to incorrect decisions. For example

availability heuristic involves basing the probabilities of an event on the ease with which relevant

instances come to mind. The problem in this case is failure in memory retrieval i.e. if we have

difficulty retrieving specific instances from our memory, our estimates of probabilities will be

biased.

3
. It assumes that intertemporal choices do not depend on the decision date.
4
A simple bargaining game in which proposer makes an offer and the responder accepts or rejects. A rejection
leaves both players with zero payoffs. Responders routinely rejects small offers and therefore do not maximize
their monetary payoffs.
5
Heuristics are rules that we use to grapple with probabilities of events.
 Although behavioral economics emerged as a discipline to incorporate the cognitive

sciences in the field of economics to encounter human decision problems but quite recently they

have faced some of the criticism from neo-classical economics as well. We now discuss some of

the criticisms on behavioral economics

Criticism on Behavioral economics and the role of Psychology in economics

The critics of Behavioral economics points out that behavioral economics has been most

successful in documenting the failures of normative theory but it has failed to provide a coherent

alternative, it lacks a theoretical foundation which causes number of problems for behavioral

economics. First, empirical analysis can show the inadequacy of mainstream theory, but it does

little to help develop alternatives. Second, without a coherent theory it is difficult to develop new

applications. Third, the policy influence of Behavioral economics is limited by its inability to

predict, beyond what has been observed, circumstances in which anomalous behavior will arise

or how it will respond to policy changes. Finally, it is hard to judge the welfare implications of

policy if we do not understand the origins of such behavior (Cohen and Dickens 2001).

Quite recently behavioral economics has received much criticism on its theoretical

principles based on descriptive behavior of human rationality rather than normative. For example

the so called impulsive behavior i.e. falling into temptation has been criticized on the grounds

that our rationality is not necessarily in conflict with our impulsivity but it rather facilitates the

action of our impulsive self not override them. Take Eliot Spitzer who lost his job as governor

of New York because of his “impulsive” behavior in visiting prostitutes. Yet the fact is that he

paid months in advance (committing himself to seeing prostitutes rather than the other way

around) and in one case flew a prostitute from Washington D.C. to New York – managing to

violate Federal as well as State law in the process (Levine 2009). One can demonstrate several
other instances like this being discovered in normative theories to challenge the current

theoretical structure of behavioral economics.

Conclusion

Much of the behavioral economics arise from the fact that thinking mechanisms in

human being have been constrained by their cognitive capacities. And this fact has led

behavioral economists to conclude that we, so called rational beings, actually act very

irrationally in several instances. Throughout this paper I’ve discussed in great details the

challenges to rationality theory but the basic point remains simple. For the economic theory to

develop and become more incorporative of human decision making behavior, it will have to

consider psychology particularly cognitive science as an integral part of standard economic

theory. Although the current psychological approaches to human behavior are not without

criticism but they have also been quite successful in describing the shortcomings of economic

approaches. To sum up we can say that by understanding the limits to human cognitive abilities

one can reach a model capable of predicting human behavior in a more practical manner.

References

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Laibson, David. 1997. Golden Eggs and Hyperbolic Discounting. Quarterly Journal of

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