Bounded Rationality

Back to blogging after a 4 week hiatus aka summer vacation. I’ve spent the past weeks relaxing but also reading, and one of the books that made the biggest impression on me was Complexity. It was recommended by Bill Gurley in this podcast, and is about the story of the Santa Fe institute and their research.

This is not supposed to be a book review. But the one thing that really stuck with me after reading the book, is how important the concept ofBounded Rationality is, and I’ll try to explain it here.

The Santa Fe institute was unknown to me before I read the book. In short, it’s an interdisciplinary institute founded in the 1980’s focusing on complex adaptive systems. Where a lot of research focuses on order and equilibrium and throw in as many assumptions as necessary to have something orderly to investigate, the Santa Fe Institute focuses on real-life scenarios with emergent structures that never reach any equilibrium (which is how the world operates generally).

Classic economics, the kind I was taught at school, operates under the mantra that “all models are wrong, but some are useful”, and try to simplify the world to the point where their models disconnect from reality. While many such models continue to be useful, it’s astonishing how many things they fail to predict.

Research on complexity takes a different approach to this. Instead of simplifying the world, complexity research tries to understand the full picture.

Early on, the Santa Fe Institute understood that the only way to go at complexity is to look at the individual agents it consists of. Agents can be anything from organizations to molecular cells, but here I’ll talk about agents as people - as that is what I mostly relate to.

If you understand how every agent act all the time, you’ll be able to make very very good predictions.

Most regular economics assumes that all agents are rational, and subsequently tries to make predictions. And all such predictions fail because people are not rational. This is where it get’s interesting. Are people not rational?

If you ask me, I’ll definitely say I’m rational. I am agreeable to reason. Still, a lot of things I do would probably be considered irrational. What is happening at these moments? Am I mentally disconnecting at these moments?

The concept of Bounded Rationality gives an alternative explanation.

If I do something others consider irrational, I don’t believe it’s because I disconnect mentally. It is just that the information I have available when making certain decision is limited (read: bounded).

It could be that I don’t understand all the data available to make the decision. It could be that I don’t understand what my best alternative actually is. Or a combination of the two. I still make decisions - either because I’m not able to gather more information, or the decision is irrelevant enough that I don’t bother collecting more information.

I believe this explains why people act more rational as the stakes are higher. With higher stakes, you spend more resources gathering information, and as a result your bounded rational decision is less bounded.

More generally, the outcome is that many of my decisions will appear rational within my bounded environment, but still be irrational. And every prediction that is made assuming my rationality will be wrong.

This is very interesting. And has implications for how we make preditions about the world.