Decision Making as Output and Bounded Rationality

 

The classical economics theories proceed on the assumption of rational agents. Rationality implies the economic agents undertake actions or exercise choices based on the cost-benefit analysis they undertake. The assumption further posits that there exists no information asymmetry and thus the agent is aware of all the costs and benefits associated with the choice he or she has exercised. The behavioral school contested the decision stating the decisions in practice are often irrational. Implied there is a continuous departure from rationality. Rationality in the views of the behavioral school is more an exception to the norm rather a rule. The past posts have discussed the limitations of this view by the behavioral school. Economics has often posited rationality in the context in which the choices are exercised rather than theoretical abstract view of rational action. Rational action in theory seems to be grounded in zero restraint situation yet in practice, there are numerous restraints that impose certain constraints in the exercise of choices. These have been discussed in the previous posts.

 

Since there exists cognitive constraints or constraints in processing of available information, rationality is thus bounded and not unbounded as assumed by the classicalists. Therefore, one proceeds with the assumption of bounded rationality. The conclusions however would not differ greatly in theory if these assumptions are overlooked for simplicity. While the bounded rationality is discussed at certain length in the past, the current post too seeks to view bounded rationality through a slightly different point of view. The analysis posits on the principles of production analysis or in specific, the context of output maximization subject to cost constraints.

 

Different combinations of inputs can result in the production of same level of output what in economics is termed as isoquants. The firm can choose different combinations so as to be able to produce desired level of output. While in the long run, the output remains fixed and thus the focus would remain on minimizing the costs, the short run scenario is usually different. In the short run, the firm can choose to produce higher quantum of output yet it remains constrained by the costs of inputs given the finite budget it has at its disposal. Therefore, the focus of the firm in the short run would be to pursue a strategy of maximizing the output subject to the cost constraints. The same principle will apply to decision making of economic agents. The decisions what they take or the choices they exercise can be termed as an output produced by an economic agent. Therefore the choices they exercise can be subject to the same treatment as one analyses the output.

 

In the production of tangible or intangible output, the constraints of costs are measurable. Yet, the economic agent’s exercise of choice is subject to constraints that might not be measurable. For instance there are cognitive constraints. As the individuals seeks to engage in cost benefit analysis, there are certain constraints in terms of cognitive abilities of gathering and processing information. There is no doubt that there exists a desire to gather and process all the available information. Yet the information that is available might not be complete. There might be information that would complete this gap but it might hidden or at least the cognitive limitations prevent the economic agent from accessing and processing the information. In the context of output maximization, there are inputs to be considered. In the exercise of choices, there are several inputs that go into the decision making. The economic agent would obviously consider the costs and benefits of the exercise of choice. There would be thought process that would bring about these benefits and costs and whether the net benefits would be positive for the decision to be worth it. Therefore, there exists a thinking process, albeit institutively at times, but nevertheless a decision making is done through the analysis of inputs. Yet these inputs which an economic agent would use to build his or her choice is not unbounded. There exists numerous constraints in terms of information. Certain amount information might not be available. Certain information might be available but would be too costly to process. There might be transaction costs in terms of comparative analysis of various choices that are possible to be exercised. There are costs attached to secure certain information which might be available only to the few. Some information might be possible to be accessed only by a few. While the others by observing the actions of these selected few can seek to decode the signals thus the input framework for decision making, it might not be feasible or there might be time constraints. Time constraints might be independent of several other factors. Information might be available but the processing abilities might not exist in the economic agent. They might possess cognitive constraints which prevents the economic agent from realizing the full impact either positive or negative of the choices they are planning to exercise. In many context, there would be spillovers and in some cases there would be unintended consequences which might not have been accounted for. In certain cases, while certain spillovers might have been accounted for, it might cover only a certain portion. Thus as one observes, there are numerous constraints in terms of securing, accessing and processing information from multiple inputs that would seek to prevent maximization of output or utility that is expected by the economic agent.

 

Thus as we saw rationality is not unbounded. It is not something wherein the economic agent would be able to judge and leverage all information in terms of decision making. This is not even factoring in the memory aspect wherein the decision maker might not remember the past instances of results of similar exercises of choice. Thus the ability to make a choice becomes a function of the associated and available information and the processing abilities. Thus it becomes bounded by set of certain constraints. The bounded rationality is not irrational. There exists a different between irrationality and rationality. It might be perceived to be irrational but those actions when viewed in the context of their exercise are not irrational. While psychology might assume the agents to be irrational something that behavioral school also subscribes to, yet when one views it through the prism of costs and benefits and the cognitive abilities, the decisions are in fact rational. They turn out to be suboptimal because of these cognitive limitations.