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«What is Bounded Rationality? Paper prepared for the Dahlem Conference 1999 by REINHARD SELTEN May 1999 Abstract The paper deals with bounded ...»

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SFB Discussion Paper B-454

What is Bounded Rationality?

Paper prepared for the Dahlem Conference 1999

by REINHARD SELTEN

May 1999

Abstract

The paper deals with bounded rationality understood in the tradition of H.A. Simon. Fundamental problems and theoretical issues

are discussed. Special emphasis is put on aspiration adaptation theory. Further remarks concern basic models of decision

behavior (like learning and expectation formation), reasoning, and the connection between bounded rationality and motivation.

Keywords Bounded rationality, learning, aspiration adaptation theory JEL Classification Codes C91, D83 Acknowledgements Support by the Deutsche Forschungsgemeinschaft through the Sonderforschungsbereich 303, the European Union through the TMR research network ENDEAR (FMRX-CT98-0238), and the Land Nordrhein-Westfalen is gratefully acknowledged.

Address Laboratorium für experimentelle Wirtschaftsforschung Uni Bonn Adenauerallee 24-42 53113 Bonn, Germany Phone 49-228-73-9192 Fax 49-228-73-9193

1. Introduction Modern mainstream economic theory is largely based on an unrealistic picture of human decision making. Economic agents are portrayed as fully rational Bayesian maximizers of subjective utility.

This view of economics is not based on empirical evidence, but rather on the simultaneous axiomization of utility and subjective probability. In the fundamental book of Savage the axioms are consistency requirements on actions with actions defined as mappings from states of the world to consequences (Savage 1954). One can only admire the imposing structure built by Savage. It has a strong intellectual appeal as a concept of ideal rationality. However, it is wrong to assume that human beings conform to this ideal.

1.1 Origins At about the same time when Savage published his book, H.A. Simon created the beginnings of a theory of bounded rationality (Simon 1957). He described decision making as a search process guided by aspiration levels. An aspiration level is a value of a goal variable which must be reached or surpassed by a satisfactory decision alternative. In the context of the theory of the firm one may think of goal variables like profit and market share.

Decision alternatives are not given but found one after the other in a search process. In the simplest case the search process goes on until a satisfactory alternative is found which reaches or surpasses the aspiration levels on the goal variables and then this alternative is taken. Simon coined the word Asatisficing@ for this process.

Often satisficing is seen as the essence of Simon=s approach. However, there is more to it than just satisficing. Aspiration levels are not fixed once and for all, but dynamically adjusted to the situation. They are raised, if it is easy to find satisfactory alternatives and lowered if satisfactory alternatives are hard to come by. This adaptation of aspiration levels is a central idea in Simon=s early writings on bounded rationality.

Three features characterize Simon=s original view of bounded rationality: Search for alternatives, satisficing, and aspiration adaptation.

1.2 Aim of this essay It is difficult to gain an overview of the literature on bounded rationality accumulated since Simon=s seminal work. No attempts in this direction will be made here. Instead of this, only a few selected topics will be discussed with the aim of conveying insights into the essential features of bounded rationality.

The author looks at the subject matter from the point of view of economic theory. He is convinced of the necessity of reconstructing microeconomics on the basis of a more realistic picture of economic decision making. Moreover he thinks that there are strong reasons for modelling boundedly rational economic behavior as non-optimizing. The material presented here reflects this conviction. More about the non-optimizing character of boundedly rational decision making will be said in the remaining sections of the introduction.

A comprehensive coherent theory of bounded rationality is not available. This is a task for the future. At the moment we must be content with models of limited scope.

1.3 Bounds of rationality Full rationality requires unlimited cognitive capabilities. Fully rational man is a mythical hero who knows the solutions of all mathematical problems and can immediately perform all computations, regardless of how difficult they are. Human beings are very different. Their cognitive capabilities are quite limited. For this reason alone the decision behavior of human beings cannot conform to the ideal of full rationality.

It could be the case that in spite of obvious cognitive limitations the behavior of human beings is approximately correctly described by the theory of full rationality. Confidence in this conjecture of approximate validity explains the tenacity with which many economists stick to the assumption of Bayesian maximization of subjectively expected utility. However, there is overwhelming experimental evidence for substantial deviations from Bayesian rationality (Kahneman, D. P.

Slovic and A. Tversky, 1982). People do not obey Bayes= rule, their probability judgements fail to satisfy basic requirements like monotonicity with respect to set inclusion, and they do not have consistent preferences, even in situations involving no risk and uncertainty. A more detailed discussion of these matters will not be given here but can be found elsewhere (e.g. Selten 1991).





The cognitive bounds of rationality are not the only ones. A decision maker may think that a choice is the only rational one, e.g. to stop smoking, but nevertheless not take it. Conclusions reached by rational deliberations may be overridden by strong emotional impulses. The lack of complete control over behavior is not due to motivational bounds of behavior rather than to cognitive ones.

1.4 Concept In this paper the use of the term bounded rationality follows the tradition of H. A. Simon. It refers to rational principles underlying non-optimizing adaptive behavior of real people. Bounded rationality cannot be precisely defined. It is a problem which needs to be explored. However, to some extent it is possible to say what it is not.

Bounded rationality is not irrationality. A sharp distinction should be made here. The theory of bounded rationality does not try to explain trust in lucky numbers or abnormal behavior of mentally ill people. In such cases one may speak of irrationality. However, behavior should not be called irrational simply because it fails to conform to norms of full rationality. A decision maker who is guided by aspiration adaptation rather than utility maximization may be perfectly rational in the sense of everyday language use.

Sometimes the word bounded rationality is used in connection with theories about optimization under some cognitive bounds. An example for this is the game theoretic analysis of supergames under constraints on the operating memory (Aumann and Sorin, 1989). The task the players have to solve is much more complicated with these constraints than without them. The paper by Aumann and Sorin is a remarkable piece of work but it is not a contribution to the theory of bounded rationality. The same must be said about the recent book on Abounded rationality macroeconomics@ (Sargent 1993). There, the assumption of rational expectations is replaced by least square learning but otherwise an optimization approach is taken without any regards to cognitive bounds of rationality. Here, too, we see a highly interesting theoretical exercise which, however, is far from adequate as a theory of boundedly rational behavior.

Subjective expected utility maximization modified by some isolated cognitive constraints does not lead to a realistic description of boundedly rational decision making in a complex environment.

Moreover, there are reasons to believe that an optimization approach fails to be feasible in many situations in which not only an optimal solution must be found but also a method of how to find it.

More will be said about this in the next section.

Boundedly rational decision making necessarily involves non-optimizing procedures. This is a central feature of the concept of bounded rationality proposed. Other features will become clear in later parts of this paper.

Much of human behavior is automatized in the sense that it is not connected to any conscious deliberation. In the process of walking one does not decide after each step which leg to move next and by how much. Such automatized routines can be interrupted and modified by decisions but while they are executed they do not require any decision making. They may be genetically preprogrammed like involuntary body activities or they may be the result of learning. Somebody who begins to learn driving a car has to pay conscious attention to much detail which later becomes automatized.

One might want to distinguish between bounded rationality and automatized routine. However, it is difficult to do this. Conscious attention is not a good criterion. Even thinking is based on automatized routine. We may decide what to think about but not what to think. The results of thinking become conscious, but most of the procedure of thinking remains unconscious and not even accessible to introspection. Obviously the structure of these hidden processes is important for a theory of bounded rationality.

Reinforcement learning models have a long tradition in psychology (Bush and Mosteller 1955) and have recently become popular in research on experimental games (Roth and Erev 1995, Erev and Roth 1998). These models describe automatized routine behavior. Reinforcement learning occurs in men as well as animals of relatively low complexity and one may therefore hesitate to call it even boundedly rational. However, a theory of bounded rationality cannot avoid this basic mode of behavior (see section 3.3) The concept of bounded rationality has its roots in H. A. Simon=s attempt to construct a more realistic theory of human economic decision making. Such a theory cannot cover the whole area of cognitive psychology. The emphasis must be on decision making. Learning in decision situations and reasoning supporting decisions belong to the subject matter, but visual perception and recognition, a marvelously powerful and complex cognitive process, seems to be far from it.

Undoubledly biological and cultural evolution as well as the accquistion of motivational dispositions in ontogenetic development are important influences on structure and content of decision behavior. However, boundedly rational decision making happens on much smaller time scale. For the purpose of examining decision processes the results of biological and cultural evolution and ontogenetic development can be taken as given. The emphasis on decision making within the bounds of human rationality is maybe more important for the concept of bounded rationality than the boundaries of its applicability.

1.5. Impossibility of unfamiliar optimization when decision time is scarce Imagine a decision maker, who has to solve an optimization problem in order to maximize his utility over a set of decision alternatives. Assume that decision time is scarce in the sense that there is a deadline for choosing one of the alternatives. The decision maker has to do his best within the available time.

It is useful to distinguish between familiar and unfamiliar problems of this kind. A problem is familiar if the decision maker knows the optimal way to attack it. This means that he knows what to do by prior training or mathematical investigation or that the problem is so simple that a suitable method immediately suggests itself.

In the case of an unfamiliar problem the decision maker must devise a method for finding the alternative to be chosen before it can be applied. This leads to two levels of decision making activities which both take time.

level 1: Finding the alternative to be chosen level 2: Finding a method for level 1 What is the optimal approach to the problem of level 2 ? One can hardly imagine that this problem is familiar. Presumably a decision maker who does not immediately know what to do on level 1 will also not be familiar with the task of level 2. Therefore he has to spend some time finding an optimal method for solving the task of level 2. We arrive at level 3.

It is clear that in this way we obtain an infinite sequence of levels k = 2, 3,... provided that finding an optimal method for level k continues to be unfamiliar for every k.

level k: Finding a method for level k!1 It is reasonable to assume that there is a positive minimum time which is required for the decision making activities at each level k. Obviously this has the consequence that an optimization approach is not feasible when decision time is scarce.

Admittedly the reasoning which has led to the impossibility conclusion is not based on a precise mathematical framework and therefore cannot claim the rigor of a formal proof. Nevertheless it strongly suggests that a truly optimizing approach to unfamiliar decision problems with constrained decision time is not feasible.

Trying to optimize in such situations is like trying to build a computer which must be used in order to determine its own design, an attempt which is doomed to fail. The activity of optimizing cannot optimize its own procedure.

The impossibility of unfamiliar optimization, when decision time is scarce, would not be of great importance if most optimization problems faced by real people were familiar to them in the strict sense explained above. It is clear that the opposite is true.

2. Aspiration adaptation theory

As has been argued in the preceding section, there are reasons to believe that unfamiliar optimization is impossible within the cognitive bounds of rationality, when decision time is scarce.

This raises the following question: How can we model the non-optimizing behavior of boundedly rational economic agents? The author was involved in an early attempt to answer this question (Sauermann and Selten 1962). Only recently this aspiration adaptation theory has been made available in English (Selten 1998). This sign of a continued interest in the theory has encouraged the author to present a condensed exposition here. Experiences with a course on bounded rationality suggest that aspiration adaptation theory is a good starting point for conveying insights into the problem area and the modelling possibilities.



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