What is... | July 4, 2018

What is bounded rationality?

How being more (or less) rational can play out in your financial decisions.

We are all human – simply human; we have quirky ideas, develop habits, and make assumptions. When we make decisions about money, these tendencies (and many others) are at play, giving us a kind of limited – or bounded – rationality.

Bounded rationality doesn’t help with traditional economists’ approach to modelling markets and behaviour. Yet as an approach to life and money, it does actually make a lot of sense.

The late social scientist and father of the concept of bounded rationality, Herbert A Simon, explains in his book The Sciences of the Artificial that this mirrors our environment.

“The apparent complexity of our behaviour over time is largely a reflection of the complexity of the environment in which we find ourselves,” he says.

Rational and reasonable
When behavioural scientists talk about rationality, they’re talking about how people reason, with a view to achieving their particular goals within their specific environment. Often, there are particular conditions or limited resources available.

“Rational economic players” would ensure they have everything they need to make the right choices, in the most efficient way possible. 

When we talk about bounded rationality we relax some of the assumptions around how people come to the best, most reasonable and efficient decision.

Understanding how people really go about making decisions can help promote good money choices.

Constraints on choice
Our choices can be limited by many factors. Typical constraints on decision-making, such as risk and uncertainty around the outcomes of our decisions, can mean there’s not enough information about the options available to us or the level of complexity in a situation.

So it can be really difficult to work out the best thing to do in any given set of circumstances, including when it comes to money. This is our rationality being bounded.

Our decisions, whether about money, career, or romance, can be understood as rational, within the restrictions of the situation we are in.

Bounded rationality means that our decisions are limited by thinking capacity, available information and time, as well as the many other things that typically influence our choices (a few examples are social norms, ethics, fairness, love and peer pressure).  

We aren’t black-and-white when it comes to decision-making, about money or anything else.

In your daily life
Instead, we all tend to use predictable methods of making sense of the world. We look for patterns, simplify problems (perhaps by using a rule of thumb or heuristic) and respond to feedback that may strengthen or encourage us to discard our ideas.

In this way, we aim to fill the gaps in our understanding in a continually evolving process. This enables us to keep rolling with the “punches” and changes that life throws at us, as we make decisions from moment to moment. It can afford us a certain amount of creativity and flair when making decisions.

Dating might be an example. What if we focused on considering every possible partner out there, rather than choosing someone from a given group of people? We’d complicate the process enormously.

To choose thoroughly and rationally, assessing all relevant factors, we’d need to not only compare individuals but do so against our expectations or aspiration levels, for example (which in any case will likely change over time).

"Things often depend”
So our decisions, whether about money, career, or romance, can be understood as rational, within the restrictions of the situation we are in.

Our “bounded-ly" rational approach can be seen every day. Do you typically pick the same coffee in the morning, from the same café, even though your tastes have changed?

Most likely, too, you dramatically simplified the criteria you used when you chose your current home, because viewing many properties is time-consuming and annoying. Bounded rationality can be extremely useful, and is at play in everything we do. It pays to watch out for it.


eZonomics team
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