Bounded Rationality

Bounded rationality is a grand theme that cuts across various areas of the social sciences, sharing a common interest in the determinants and the consequences [Page 107]of human action. At the root of this concept stands explicit recognition that when dealing with a problem of choice, humans—be they consumers, producers, or policymakers—can rely on limited capacity, at best, to process relevant information, and their decisions will be affected by cognitive or cultural biases. Applied to consumer demand, bounded rationality entails a range of situations in which individuals cannot scrutinize at once the entire spectrum of goods and services, are not always capable of matching their preferences with the appropriate purchases, or do not have continual knowledge of the variety of ways in which needs can be met. Such conditions lead to suboptimal outcomes, meaning that individuals settle, at least temporarily, for second-best solutions. The integration of these intuitive notions in the broader scheme of decision-making theory has spurred profound revisionism within the social sciences, especially concerning the way in which the formulation of decisions is understood and operationalized.

The notion of bounded rationality first surfaced in a series of writings published by Herbert Simon in the 1940s and 1950s. The versatility of the concept combined with the eclecticism of Simon's opus granted rapid diffusion in fields as diverse as political science, economics, theories of organization, cognitive psychology, and computer science. From his early writings to his later works in the 1980s, Simon's chief preoccupation has been to understand how individuals search, collect, and use information and how they form judgment accordingly under the joint effect of personal biases and cognitive limitations.

His interest in the process and not merely the outcomes of decision making places him in stark contraposition to the orthodoxy: whereas the axiom of full rationality in standard economics sees consumers and producers as having stable preferences, being fully informed of all conceivable ranges of options and thus being able to optimize under all circumstances, Simon's procedural models portray decision making as the buildup of heuristics from experience and social interaction. Whereas fully rational agents optimize, boundedly rational agents “satisfice” in the sense that temporary setbacks are integral to long-term learning and the achievement of desired outcomes. Methodological approaches built on bounded rationality are concerned with the cognitive processes adopted by individuals to cope with uncertainty as well as with the characteristics of the environment in which they operate. As Simon himself put it (2000, 25) “in the real world rational behaviour is as much determined by the ‘inner environment’ of people's minds, both their memory contents and their processes, as by the ‘outer environment’ of the world on which they act, and which acts on them.”

Bounded rationality bears strong influence on modern theories of economic organization. The evolutionary economics agenda (Nelson and Winter 1982) epitomizes the integration of the concept in the study of business strategy, managerial behavior, and competitive performance (see Foss 2003 for a review). This approach departs from standard rational choice axioms of mainstream economics and emphasizes the experiential, localized, and socially held nature of knowledge. Decision making under these circumstances is embodied in the concept of routines, that is, repeated patterns of actions that are regarded as the vehicle by which firms align internal abilities and external targets over time. By limiting the sphere of decision making to a manageable spectrum of options, routines confer stability to business conduct while at the same time being a source of organizational inertia. Modified operative conditions or the appearance of inefficiencies urge firms to change their routines, but bounded rationality makes such changes neither regularly feasible nor easy to implement. In turn, differential ability in searching, creating, applying, or adapting organizational routines is viewed in evolutionary approaches as a powerful selection mechanism for firms' survival or decline.

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