Forms of Bounded Rationality in Economic Theory

Chapter 1 Bounded Rationality You regard men as in�nitely sel�sh and in�nitely farsighted. The �rst hypothesis may perhaps be admitted in a �rst approximation, the second may call for some reservation. H.Poincar� to L.Walras 1.1 Introduction The term bounded rationality is thought to have been coined by the Nobel laureate Herbert Simon, so who better than him to de�ne it? In The New Palgrave Dictionary of Economics, Simon de�nes bounded rationality as �...ra- tional choice that takes into account the cognitive limitations of the decision- maker - limitations of both knowledge and computational capacity�[111]. So, a boundedly rational decision-maker must be limited in some sense. Simon mentions two kinds of limitations. First, s/he can be limited in knowledge, in the sense that s/he does not possess all the relevant information for making her/his decisions. In fact, in some cases information is spread among people and, when possible, is not costless to obtain them. Simon speaks about the information gathering process [110]. The decision-maker may even prefer to formulate her/his plan and take her/his decisions without all the relevant in- formation because the cost may not justify the higher satisfaction they would allow. In other cases information is just not available. The second limita- tion concerns the computational capacity of the decision maker. Even if s/he owned all the relevant information it may not be so easy to evaluate correctly the results related to all possible available choices. For instance, in order to �nd the best choice, the decision maker has to be able to solve optimization problems which sometimes require the use of sophisticated mathematical in- struments. In [111] Simon also suggest how theories of bounded rationality can 5