Definition: Bounded rationality is a concept that portraits the limitations of rational thinking in decision making processes. It describes the boundaries experienced by individuals facing the choice to move forward or not with a certain transaction.
What Does Bounded Rationality Mean?
This idea was developed by Herbert Simon, an economist and a Nobel Prize winner, who intended to describe the factors that played a key role in decision-making processes and how the rationality of these processes was impaired by certain considerations. He identified three essential limitations experienced by the person making a given choice.
The first one is the availability of information, since the person entering the transaction has to make an informed decision with all the information he currently possesses. This information is not always reliable or profound enough to provide a sound rational argument for agreeing or not to the operation.
Secondly, cognitive limitations come into play, since as human beings we have limited knowledge and comprehension of facts and this reduces our ability to rationally decided about certain issues. Subjectivity, in these cases, makes it appearance, where the individual fill the gaps of his cognitive ability with pure instinct.
Finally, there are time boundaries, since not all decisions have a time frame that is long enough for the individual to analyze the situation adequately to come up with the most rational solution. These boundaries limit ourselves as human beings to be fully rational economic entities, as many authors proposed at some point in history.
Mr. Lockwell decided to buy a new washing machine. He spent the last two hours of his day researching the best models available, prices and warranties to come up with three options he considers suitable for what he is currently looking for. He decided to visit a local home appliance’s store and a salesman approached him to help him choose. As Mr. Lockwell suspected, the three options he considered the best ones were a little bit more expensive than he anticipated and the salesman was prompted to offer a different one, cheaper than his other choices.
He is now facing the decision of which one to buy and the concept of bounded rationality applies here since Mr. Lockwell now doesn’t have all the information he needs, since he doesn’t know everything about the cheaper washing machine he is being offered. On the other hand, his limited knowledge about appliances cause him to be in a disadvantage to make a rational decision about the purchase, and finally, he has a limited time frame since he has to get back to work in an hour and he really needs his washing machine to be delivered tomorrow.