Bounded Rationality

According to bounded rationality, we are not inclined to find all the necessary information to make a rational decision due to cognitive and temporal limitations. This restriction causes us to make choices that are merely satisfactory rather than continuing to search for the best option.

Our choices are still logical considering the information realistically available to us, but not in terms of all the possible information out there. While it is difficult to behave according to perfect economic rationality, which maximizes benefits while diminishing costs, making decisions based on bounded rationality can cause us to be inconsistent with our objectives.

The corporate world contains a complex web of decision-making. While organizations strive to make choices that reflect their economic values, individuals making choices do not function perfectly rationally. Instead, unconscious prejudices and motives often sway humans, which makes meeting financial goals more difficult.  

On top of that, employees must make snap judgments within stressful environments that will have a lasting impact on the rest of the organization. With time, money, and resource constraints, decision-making may only be satisfactory rather than most effective for meeting the company’s objectives.

Decision-making becomes all the more complex when the optimal choice for an employee does not align with the optimal choice for the rest of the company. In this case, the rationality of the employee is bound by their obligation to put the organization's needs before their own. While pushing back against self-serving inclinations, they may only be able to make a sufficient choice for the company rather than having the capacity to make the best choice possible. 

In short, bounded rationality is sometimes a necessary imperfection when decision-making exists as part of a complex network rather than an individual entity.

As with “cage-free” eggs, tech companies can market digital products as “environmentally friendly” to convince consumers to make morally responsible choices. For example, music listeners may use online streaming services such as Spotify because they seem more sustainable than material options like vinyl or CD players. The perceived environmental benefit, combined with the convenience of listening to music on your phone, may convince listeners to download Spotify thinking they have the best of both worlds.

Unfortunately, this assumption could not be more wrong. All data centers combined produce two percent of the world’s carbon footprint—almost equivalent to that of the airline industry.¹¹ However, the ease of streaming platforms may discourage listeners from further looking into how these services rely on data centers to provide instantaneous listening.

Bounded rationality may prevent us from using AI software most effectively. Let’s say after struggling to write an email to your boss to request time off for vacation, you decide to turn to ChatGPT for help. You quickly type your request in, and an automated response appears before you within seconds. Although the email is quite generic, you convince yourself it’s “good enough” and send it off. 

Being restricted in time and energy encourages you to settle for a vague response rather than going back and prompting ChatGPT with more details. For example, you could stress that your trip will be a mental recharge that will increase your future productivity or that the location you are visiting will offer enriching education you can incorporate into your work. Rather than helping the algorithm to produce the optimal response, you settle for the first result that may not guarantee you get your time off.

To overcome bounded rationality, we can take a bit more time to incorporate specific details into our requests for AI tools to help them generate the best results possible.

We make hundreds of decisions every day. Since we have to sift through so many options quickly, it is impossible to research and map out the potential effects of each. Think about how much information would have to be stored in our brains at any given moment for us to be able to make perfectly rational decisions!

Due to limited brain capacity, time, and available information, we have to make decisions using mental shortcuts known in cognitive science as heuristics. While heuristics make it easier for us to make snap judgments, they limit our ability to exercise logic, sometimes leading us toward mediocre choices.

Although bounded rationality helps us make satisfactory choices, that does not mean that those choices are optimal. Economists refer to us as “satisficers” instead of “homo economicus,” meaning “perfect rational human.”² We make “good enough” decisions instead of the best ones, leading us to choose inconsistently.

We must be aware of our poor decision-making because businesses try to benefit from them using marketing tactics. Companies often label their products with enticing qualifiers with little-to-no meaning, such as the term “cage-free” on a carton of eggs. Other labels include “organic,” “sugar-free,” or “whole-wheat.” These qualifiers are vague and often do not mean what we assume they do. We may be satisfied by buying what we believe are ethical or healthy options when in reality, we are not achieving the most optimal decision to meet our objectives.

In the documentary, Super Size Me 2: Holy Chicken!, director Morgan Spurlock explores the requirements for restaurants to label foods with certain qualifiers that may mislead customers.³ For instance, fast-food restaurants are allowed to say that their meat is made from “free-range” chicken if the chickens have the option of going outside for part of the day.⁴ That does not actually mean that they go outside. As Spurlock exposes in the film, farmers can get away with constructing a fenced space that only extends a few feet outdoors which they open up for a few minutes each day to convince consumers that they are being ethical.

If we want to avoid being taken advantage of by strategic marketing, we must remain aware that they are playing into our bounded rationality. Businesses know that we lack time to inform ourselves about the fine print of each qualifier or look at the nutritional labels of every product we buy. However, we can fight back by thinking twice before we purchase an item only because of its labeling.

Unfortunately, being aware of bounded rationality does not help us to overcome it; understanding the limits to our thinking capacity and available information does not make those restrictions disappear. It is also useless to try to acquire all the details about different options when deciding. This process would take too long, and even if we had access to all the necessary information, it would be too much for us to process. 

Since we will always be individually restricted by bounded rationality, working in groups or teams can help us overcome some limitations. People come to the table with diverse capabilities and expertise, helping to fill in any knowledge gaps. Working on a task together can also reduce the time and effort each of us has to exert on it, meaning that we may have more resources to dedicate to in-depth research and deciding upon the best option possible.

Companies and professionals can also use a form of choice architecture called nudges, a thought-out design of environments under which people make better decisions. Nudges could help us overcome bounded rationality and make optimal rather than satisfactory choices. For example, grocery stores can place the healthiest items at eye level to make us more likely to choose that option rather than leaving us dependent on misleading labels.

Economist Herbert A. Simon, who won the Nobel Prize for his work in behavioral science, first proposed the idea of bounded rationality in 1955 to counter the commonly held belief that being economical was equivalent to being rational.6 Under existing economic theories, being “rational” meant that when an individual chooses between alternative courses of action, they always pick the optimal option. This theory was called “rationality as optimization,” and Simon’s work was very influential in displacing such models.

Simon did not believe existing economic understandings of rationality adequately represented the kind of decisions people actually made. He proposed bounded rationality to consider the “access of information, and the computational capacities that are actually possessed by organisms, including man, and the kinds of environments in which such organisms exist."⁶ In other words, he wanted his theory to consider various limitations, including available information, varying mental capacities, and time. 

Simon famously used a scissor metaphor to describe why the traditional economy theory was insufficient for looking at decision-making.6 One blade represented a human’s mental capacity, and the other blade represented the environment under which we make decisions. German psychologist Gerd Gigerenzer, who supported Simon’s model, explained its significance as the following:⁷ If we look at either blade of a pair of scissors alone, we cannot understand how it cuts. It is necessary to look at both blades—both our mental capacity and our environmental factors—to fully understand how the scissors cut. In other words, we must address personal and situational factors to grasp what causes rationality to be bound while decision-making fully.

In the business world, decision-making occurs in complex systems with competing influences, such as when organizational objectives do not match individual goals.

In financial terms, what is rational for a business is what will make them the most money. However, consumers are starting to demand companies become more ethical in their practices, especially concerning environmental issues. These pressures lead to conflicting priorities for decision-makers who want to maintain their reputation with consumers while prioritizing financial gain.

Along with his team, Jens Roehrich, a researcher interested in supply-chain management, examined how 12 companies handled these conflicting interests. Roehrich wanted to see if bounded rationality affects companies’ use of sustainable supply chains, which are more environmentally friendly but often cost more.⁸ 

The researchers found that a primary concern of managers was balancing the trade-off between cost and reputation, as well as what capabilities and resources were available. These trade-offs demonstrate that organizations rarely abide by perfect rationality, and instead, their decision-making is bound by different influences and capacities. 

Instead of choosing the cheapest supply chain, which would be economically optimal, decision-makers often settled on a compromise between costs and reputation by picking a supply chain that was a higher cost but more sustainable. This instance demonstrates that sometimes bounded rationality is actually more ethical than perfect rationality because it encourages us to “settle” for decisions that benefit people or cause outside ourselves.

Perfect economic rationality predicts that we make decisions that will give us the best financial outcome—which, of course, is typically not the case. 

Imagine you won a contest and can pick between two options for your reward. Either you can receive $100 today, or you can wait one month and receive $110. The perfect rational individual would wait one month to receive the greater sum, but most people are likely to be satisfied with receiving $100 immediately. 

Several studies have demonstrated bounded rationality in these kinds of scenarios. For example, when buying large appliances, customers are more likely to buy models with a low initial price with high energy rates. These appliances cost us more long-term than if customers chose models with a higher initial price but lower energy rates.⁹ Bounded rationality means that we are limited by our inability to quickly calculate how much electricity will cost over the years, causing us to make a satisfactory decision at the time but not optimal overall. 

In another study, when participants were asked whether they would prefer a free meal at a fancy French restaurant or a local Greek restaurant,¹⁰ most chose the French restaurant. However, when asked whether they would prefer the French meal in two months or the Greek meal in one month, 57% of participants who had initially chosen French said they would rather have the Greek meal sooner.

These short-term gratification studies show that humans do not act according to perfect economic rationality. Instead, other factors influence our decisions: convenience, desire for immediate gratification, limited available information, or other cognitive biases. 

What it is

Bounded rationality describes the way that humans make decisions that depart from perfect economic rationality since we are limited by our mental capacity, the information available to us, and time. Instead of striving to make the “best” choices, we often settle on making merely satisfactory choices. 

Why it happens

To act according to perfect rationality would require us not to be influenced by any cognitive biases, to be able to access all possible information about potential alternatives, and to have enough time to calculate the pros and cons of each. 

Since it is next to impossible to make decisions that satisfy all of these factors, we take shortcuts and make decisions that satisfy us, even if they are not the most optimal. We make choices within our temporal and cognitive limitations to the best of our understanding and ability. We may still be rational, just not perfectly so. 

Example 1 - Supply chain management

According to a model based on perfect economic rationality, company decision-makers would make choices for their supply chain that would yield the greatest profit. However, such a model would not take into account other factors like reputation or sustainability. Many companies make decisions for their supply chain where cost is one of many factors influencing the decision-making process. Bounded rationality considers some of the trade-offs that managers have to make, meaning their decisions cannot always align with perfect economic rationality. 

 Example 2 - Short-term temptations

Bounded rationality can encourage us to make decisions that satisfy us in the short term, either because we are tempted by immediate gratification or because we cannot calculate long-term outcomes. This leads to decisions that could be more optimal over time, such as buying appliances that have a lower initial price but cost us more over time because of energy costs.

How to avoid it

It is difficult to avoid bounded rationality because the limitations that cause us to veer from perfect economic rationality are not ones we can change. The effort required to make the best choice is often not worth the difference in benefit gained between a satisfactory and an optimal choice.

However, it can be useful to get multiple opinions on the best decision. Working as a team helps us overcome bounded rationality by lessening limitations. We gain multiple perspectives that lessen cognitive biases and more time to learn about the possible alternatives to arrive at the most optimal outcome.

Does Emotion Affect Our Ability To Make Rational Decisions?

In this article, TDL’s Tiantian Li discusses a number of studies that examine what parts of our brains are activated by different decision motivators. Li explores how bounded rationality is represented through brain function, and whether damage to some parts of the brain could actually lead to more rational decision-making.

Algorithms for Simpler Decision-Making: Fighting Irrationality with Nonrationality

In this article, Jason Burton, who has a background in cognition and computation, discusses the drawbacks of algorithms that are programmed as perfectly rational agents. Burton suggests that such algorithms, which are supposed to aid us in making decisions, are not actually useful because they do not take into account the “big world of uncertainty” that we live in. Instead, he argues for algorithms that stay true to the bounded rationality under which humans make decisions.