Bounded Rationality….We are only humans…

From the assumptions in the field of Economics, one that is constantly criticized in and outside the field is rationality. Among many things of human existence, perhaps the concept of wpid-Photo-Aug-19-2013-322-PMrationality is just as overrated as consistency (I won’t get to my issue with consistency just yet, that’s perhaps topic for another post).Rationality subdivides itself into some other definitions, but the underlying principle is that economic agents (consumers, firms, etc.), knowing what is best for them given an economic environment, wouldn’t choose alternatives that go against their best interest. Seems like a reasonable enough assumption, and it has also proven to be an important ally and building block in Microeconomic theory

However, as economists take a step forward and observe reality, individuals often fail to behave in compliance with the models based on rationality assumption. Does this mean humans are then irrational and all models based on rationality assumptions should be discarded? Not at all. In fact, this sheds further light into our comprehension of human nature. Economic agents’ decision making process is intendedly rational, as describes Jones (1999), [click here for the paper Bounded Rationality] but they often cannot do so.

“The assumption of bounded rationality recognizes that limits on knowledge, foresight, skill and time constrain individuals’ ability to solve complex problems. Because of bounded rationality, a firm cannot write a contract ahead of time that covers all contingencies. That is, in the terminology of the theory of the firm, bounded rationality implies that contracts are of necessity incomplete.”

(Waldman & Jensen, 2001, p. 18)

“Bounded rationality refers to limits on the capacity of individuals to process information, deal with complexity, and pursue rational aims. Boundedly rational parties cannot contemplate or enumerate every contingency that might arise during a transaction.”

(Besanko, Dranove, Shanley, & Schaefer, 2009, p. 113)

A complete contract is then one that eliminates the opportunity for all parties involved to shirk, since it contains a specific responsibility and consequences for every contingency that might occur regarding that transaction described in the contract. If all contracts are incomplete due to bounded rationality, we shall seek to comprehend throughout this course the implications of such for economic agents and market structures.

Reference

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2009). Economics of Strategy: John Wiley & Sons.

Jones, B. D. (1999). Bounded rationality. Annual review of political science, 2(1), 297-321.

Waldman, D. E., & Jensen, E. J. (2001). Industrial organization: theory and practice: Addison Wesley Longman.

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