Bounded Rationality Theory

Expected Utility?
• Expected utility is an economic term summarizing the utility that an entity or
aggregate economy is expected to reach under any number of circumstances.
The expected utility is calculated by taking the weighted average of all possible
outcomes under certain circumstances, with the weights being assigned by
the likelihood, or probability, that any particular event will occur.
• Expected utility theory is used as a tool for analyzing situations where
individuals must make a decision without knowing which outcomes may
result from that decision, i.e., decision making under uncertainty.
• These individuals will choose the action that will result in the highest expected
utility, which is the sum of the products of probability and utility over all
possible outcomes. The decision made will also depend on the agent’s risk
aversion and the utility of other agents.
• The theory of subjective expected utility (SEU theory) underlying neo-
classical economics postulates that choices are made: (1) among a given,
fixed set of alternatives; (2) with (subjectively) known probability
distributions of outcomes for each; and (3) in such a way as to maximize
the expected value of a given utility function (Savage, 1954).
• These are convenient assumptions, providing the basis for a very rich and
elegant body of theory, but they are assumptions that may not fit
empirically the situations of economic choice in which we are interested.
• The standard SEU theory is presumably not intended as an account of the
process that human beings use to make a decision. Rather, it is an
apparatus for predicting choice, assuming it to be an objectively optimal
response to the situation presented.
• Its claim is that people choose as if they were maximizing subjective
expected utility. And a strong a priori case can be made for the SEU theory
when the decision-making takes place in situations so transparent that the
optimum can be reasonably approximated by an ordinary human mind.
Prospect theory
• Prospect theory is a psychology theory that describes how people make
decisions when presented with alternatives that involve risk, probability,
and uncertainty. It holds that people make decisions based on perceived
losses or gains.

• Given the choice of equal probabilities, most people would choose to

retain the wealth that they already have, rather than risk the chance to
increase their current wealth. People are usually averse to the possibility of
losing, such that they would rather avoid a loss rather than take a risk to
make an equivalent gain.

• It measure and compare the outcomes of each prospect.

rational choice theory
• Rational choice is the process of determining what options are available and then choosing the
most preferred one according to some consistent criterion.
• Agents are said to be rational if their preferences are complete—that is, if they reflect a
relationship of superiority, inferiority, or indifference among all pairs of choices—and are logically
ordered—that is, they do not exhibit any cyclic inconsistencies.
• Completeness means that if we face an agent with two choices, she will necessarily have an
opinion on which she likes more.
• The rational expectations theory posits that individuals base their decisions on human rationality,
information available to them, and their past experiences.
• The rational expectations theory is a concept and theory used in macroeconomics.
• Economists use the rational expectations theory to explain anticipated economic factors, such as
inflation rates and interest rates.
• The idea behind the rational expectations theory is that past outcomes influence future
outcomes.
• The theory also believes that because people make decisions based on the available information
at hand combined with their past experiences, most of the time their decisions will be correct.
Bounded Rationality
• Herbert Simon introduced the term ‘bounded rationality’ as a shorthand for
his brief against neoclassical economics and his call to replace the perfect
rationality assumptions of homo economicus with a conception of
rationality tailored to cognitively limited agents.
• The term homo economicus, or ‘economic man’, denotes a view of humans
in the social sciences, particularly economics, as self-interested agents who
seek optimal, utility-maximizing outcomes
• Behavioral economists and most psychologists, sociologists, and
anthropologists are critical of the concept of homo economicus . People
are not always self-interested, nor are they mainly concerned about
maximizing benefits and minimizing costs. We may make decisions under
uncertainty with insufficient knowledge, feedback, and processing
capability (bounded rationality); we sometimes lack self-control; and our
preferences change, often in response to changes in decision contexts.
• Rationality is bounded because there are limits to our thinking capacity,
available information, and time (Simon, 1982). Bounded rationality a core
assumption of the “natural assessments” view of heuristics and dual-
system models of thinking (Gilovich et al., 2002), and it is one of the
psychological foundations of behavioral economics.
• Broadly stated, the task is to replace the global rationality of economic
man with the kind of rational behavior that is compatible with the access
to information and the computational capacities that are actually
possessed by organisms, including man, in the kinds of environments in
which such organisms exist. (Simon 1955a: 99)
• ‘In Models of Man’, Simon points out that most people are only partly
rational, and are irrational in the remaining part of their actions.
• In another work, he states "boundedly rational agents experience limits in
formulating and solving complex problems and in processing (receiving,
storing, retrieving, transmitting) information".
Dual-system theory

• This is a concept that individuals have two different sets of

decision-making processes. The first is impulsive, fast and
acts without thinking.
1.The first is impulsive, fast, emotional and acts without
thinking – but relies on heuristics and past
knowledge/experience.
2.The second element of our decision-making system is a
more cognitive, deliberate, thinking process which can take
in a greater range of data than just our own experience.
• Simon suggests that economic agents use heuristics to make decisions rather than a strict rigid rule of
optimization. They do this because of the complexity of the situation.
• An example of behaviour inhibited by heuristics can be seen when comparing the strategies in easy
situations (e.g Tic-tac-toe) verses the strategies in difficult situations (e.g Chess). Both games, as
defined by game theory economics are finite games with perfect information and therefore
equivalent.
• However, within chess mental capacities and abilities are a binding constraint therefore optimal
choices are not a possibility. Thus, in order to test the mental limits of agents, complex problems such
as chess should be studied to test how individuals work around their cognitive limits and what
behaviours or heuristics are used to form solutions
• Note:
• Heuristics are simple strategies or mental processes that humans, animals, organizations and
machines use to quickly form judgments, make decisions, and find solutions to complex problems.
This happens when an individual focuses on the most relevant aspects of a problem or situation to
formulate a solution.
• Some heuristics are more applicable and useful than others depending on the situation. Heuristic
processes are used to find the answers and solutions that are most likely to work or be correct.
However, heuristics are not always right or the most accurate
• A finite game is played for the purpose of winning, an infinite game for the purpose of continuing the
play.
 Application in Macro economics
• some of the most important disputes in macroeconomic theory can be traced to disagreements as to just
where the bounds of human rationality are located. For example, one of the two basic mechanisms that
accounts for underemployment and business cycles in Keynesian theory is the money illusion suffered by
the labour force - a clear case of bounded rationality.
• In Lucas's rational expectation theory of the cycle, the corresponding cognitive limitation is the inability
of businessmen to discriminate between movements of industry prices and movements of the general
price level - another variant of the money illusion.
• Thus the fundamental differences between these theories do not derive from different inferences drawn
from the assumptions of rationality, but from different views as to where and when these assumptions
cease to hold - that is, upon differences in their theories of bounded rationality.
• Note
• In economics, money illusion, or price illusion, is the name for the human cognitive bias to think
of money in nominal, rather than real, terms. In other words, the face value (nominal value) of money is
mistaken for its purchasing power (real value) at a previous point in time.
• The rational expectation theory believes that because people make decisions based on the available
information at hand combined with their past experiences.
Application in Business
• Most consumers and businesses donot have sufficient information to
make fully-informed judgements when making their decisions.
• The increasing complexity of product also makes life difficult.
• Bounded rationality suggests that consumers and business opt to
satisfy rather than maximise
• They will use rules of thumb and approximates when active in
difference markets.
• https://www.behavioraleconomics.com/resources/mini-
encyclopedia-of-be/bounded-
rationality/#:~:text=Bounded%20rationality%20is%20a%20concept,ti
me%20(Simon%2C%201982).
• https://www.youtube.com/watch?v=eTXkZURBq7k
• https://www.youtube.com/watch?v=4Lusy6Vmvh8