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Bounded Rationality – Knowing Our Limits

Rational doesn’t mean that her decisions are entirely based on reason, but that they are consistent, they weighed different potential outcomes in a manner that maximally reaches our goals. In this article we are going to discuss how that model of rationality doesn’t always match how we approach real-world decisions.

Simplifying real life

Benjamin Franklin the American founding father and polymath was famous for his aphorisms: simple rules for everyday life. Within the pages of Poor Richard’s Almanack he set forth proverbs that contained much wisdom in few words. “Lend money to an enemy and you will gain him, to a friend and you will lose him”, “necessity never made a good bargain”, or “fish and visitors stink in three days”. At their core proverbs are simplifications they give us some rules to follow rules that seem like sound advice most of the time.

“Lend money to an enemy and you will gain him, to a friend and you will lose him”. We can easily appreciate the wisdom in that simple statement: if we lend money to an enemy, she will appreciate our kindness and start seeing us more favorably, we are no longer there enemy but someone connected to them, but when we lend money to a friend there is a risk that that money will change our relationship. We are no longer just a friend but a partner in an economic transaction.

A method for making complex decisions

Benjamin Franklin was famous for these proverbs, even though he was simultaneously one of the most famous statesmen and scientists of his time we still think of him as the ultimate American pragmatist, someone who simple rules for life helped innumerable people through complex decisions, but ironically Franklin didn’t necessarily followed his own simple rules when he made decisions. In the 1770s Franklin corresponded with the English scholar Joseph Priestly.

Like Franklin Priestley was a polymath who made seminal contributions the diverse fields. As a chemist Priestley invented the method for infusing carbon dioxide into drinking water, creating soda water, as a philosopher his writing set the stage for the development of utilitarianism. Priestley treated Franklin as a scientific mentor and continually sought out his advice. In one 1772 letter to Priestley, Franklin explained his method for making complex decisions.

Franklin first took a piece of paper and drew a line down the middle, he wrote Pro at the top of the left the paper and Con at the top right, then over the next few days each time he thought of a reason for or against the decision he wrote that reason in the appropriate column. Once he thought that he had listed every reason that could influence his decision, he then estimated the weight it should be given to each reason.

Compensatory decision-making

If the weight of a pro reason was approximately equal to that of a con reason he then drew lines through them to cancel them out. He even allowed for differences in relative weight. If two of the pro reasons seem equivalent to three of the con reason hit cancel all those out. Once he had canceled everything out that he could he looked to see what side had something left and he choose accordingly. What a remarkable process!

He listed factors that could influence his decision estimated their weights and then effectively just added everything up in what he called a Prudential algebra. But, let’s think for a minute about the two types of advice given by Benjamin Franklin. The first type is evident in this letter to priestly Franklin describes trying to obtain as much information as possible and then trading off positive and negative factors against each other in a rational almost mathematical manner.

It’s a prototypical example of what behavioral economists now call compensatory decision-making, the advantages of a particular choice can trade off against and compensate for its disadvantages. But through the proverbs and Poor Richard’s Almanack Franklin provides advice of a very different type, he gives us simple rules that help make decisions. When we follow those rules we are to obtain as much information as possible, we aren’t adopting a complex algebraic strategy for weighing the pros and cons of our decision.

By following the proverb we make good decisions most of the time, while avoiding some obvious mistakes and with out having to think too hard. tThese proverbs support what behavioral economists call heuristic decision-making, following simple rules that usually lead to good decisions. Yet, it’s true that different factors like reward, probability, risk and time that feed into our decisions and how we integrate those factors consciously and subconsciously to reach a decision.

Bounded rationality

For many relatively simple decisions all of us follow a compensatory process, we trade off rewards against risks effort against time, but for complex decisions we are not Benjamin Franklin. Few people ever adopt a sort of explicit calculus necessary for true compensatory decision-making, instead we simplify, we find a simple rule that helps us make sense of a complex situation.

The use of simple rules to help make good decisions most of the time has become one of the major themes in behavioral economics: it’s called bounded rationality. The term bounded rationality makes sense because our decision-making process isn’t rational, at least under the traditional economic definition. We aren’t compensatory decision-makers, we aren’t consistent decision-makers and we surely aren’t optimal decision-makers.

We don’t always choose the option that’s best for us. We are, however, surprisingly good at taking complex situations and simplifying them it is something manageable.