Friday, January 31, 2014

Bounded Rationality

It has occurred to me that it would be irresponsible to not address the namesake of this blog at some point. Therefore, in brief here is an explanation of bounded rationality.

Economists generally prefer to view people as perfectly rational individuals.  A perfectly rational being is predictable and easily modeled.  However, at some point even the most die hard academic had to admit that people make suboptimal, or even downright poor decisions.  The acknowledgement of this fact led to a number of changes in economics, the most influential being the rise of Homo Economicus and bounded rationality.

Homo Economicus is a theoretical tool economists use in creating models.  He is a representation of humanity that is perfectly rational, narrowly focused and purely self interested.  He maximizes personal utility at every opportunity and never makes foreseeable mistakes.  Essentially Homo Economicus is a theoretical human who's behavior is easily defined in nearly any situation.  Economists all acknowledge that Homo Economicus is a fiction.  However, in many cases his behavior doesn't diverge all that much from what occurs in reality.  Thus we keep him around in a back closet and shamefully drag him out whenever we need to create a new model of auction pricing, consumer behavior or whatever we're working on that week.

The other concept, and namesake of this blog, is bounded rationality.  Bounded rationality is simply the idea that although humans are basically rational, a great deal of obstacles get in the way of that rationality.  Emotion, time constraint, lack of information, and inability to process sufficient information all are major obstacles to making optimal decisions.

For example, suppose Alice was shopping for health insurance. She has four choices with the following information:  Plan A has a lifetime cost of $6000  and a lifetime benefit of $5000, Plan B has a lifetime cost of $8000 and a lifetime benefit of $10,000, Plan C has a lifetime cost of $3000 and a lifetime benefit of $1000, and Plan D has a lifetime cost of $2000 and no lifetime benefit.

Given only this information it's easy to conclude that Plan B is the best. It's the only plan which provides a benefit that exceeds costs.  However, Alice may not choose Plan B for a variety of reasons.  The first and largest reason she may not choose Plan B is although we have defined future benefits Alice has no way to anticipate them so easily.  She can reasonably approximate future costs of the plans but healthcare utilization is an unpredictable factor.  Thus she can't know for sure what level of benefit each plan will provide.  Here her lack of knowledge has limited her ability to make an optimal decision.

Imagine Alice was only given a short time to choose her health insurance.  This time constraint would very likely further impede her ability to choose wisely.  Rather than conducting comprehensive research on costs and benefits Alice would probably fall back on a heuristic shortcut such as, "choose the cheapest plan that meets my anticipated minimum needs."  While this will often times lead to a selection which is "good enough" it's a decision method which has discarded the goal of optimal selection.  Thus time constraint has led to a non optimal selection method.

Alice may have had a difficult week at work and is too stressed to make a careful selection. She simply wants the decision made so she can put it behind her so she selects mostly at random.  Here emotion has greatly impaired Alice's rationality.

Finally, suppose each plan had innumerable payment schedules, reimbursement plans, copays, deductibles, and similar minutiae which populate health insurance plans.  Alice may very well not be capable of processing all of that information and making intelligent comparisons between plans.  In this case Alice's inability to process information adequately puts her in a situation where her decision is more an informed guess than an optimal selection.

Clearly there are many factors which may impair a person's rational thinking.  By saying individuals exhibit bounded rationality we are simply stating that a person is generally rational within the limitations of their knowledge and abilities.  When that knowledge is incomplete or those abilities insufficient to the task they may exhibit behavior which is clearly suboptimal from the standpoint of Homo Economicus.

That's all for this week. Until next time stay safe and rational.

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