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American Economic Association

Rationality as Process and as Product of Thought


Author(s): Herbert A. Simon
Source: The American Economic Review, Vol. 68, No. 2, Papers and Proceedings of the
Ninetieth Annual Meeting of the American Economic Association (May, 1978), pp. 1-16
Published by: American Economic Association
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RICHARD T. ELY LECTURE

Rationality as Process and as Product of Thought


B, HERBERT A. SIMON:~

This opportunity to deliver the Richard or that, nor about the late lamented Phillips
T. Ely Lecture affords me some very per- curve. But monetarists could rejoice in
sonal satisfactions. Ely, unbeknownst to Ely's uncompromising statement of the
him, bore a great responsibility for my eco- quantity theory (p. 298, italics), and in his
nomic education, and even for my choice of assertion that "the solution of the problem
profession. The example of my uncle, of unemployment depends largely upon in-
Harold Merkel, who was a student of Com- direct measures, such as monetary and
mons and Ely at Wisconsin before World banking reform"- Ely does go on to say,
War I, taught me that human behavior was however, that "we shall recognize that so-
a fit subject for scientific study, and ciety must offer a willing and able man an
directed me to economics and political opportunity to work" (p. 528).
science instead of high energy physics or
molecular biology. Some would refer to this I. Rationality in and out of Economics
as satisficing, for I had never heard of high
energy physics or molecular biology, and I have more than personal reasons for di-
hence was spared an agonizing weighing of recting your attention to Ely's textbook.
alternative utiles. I simply picked the first On page 4, we find a definition of eco-
profession that sounded fascinating. nomics that is, I think, wholly charac-
Ely's influence went much further than teristic of books contemporary with his.
that. My older brother's copy of his Out- "Economics," he says, "is the science
lines of Economics -the 1930 edition-was which treats of those social phenomena that
on our bookshelves when I prepared for are due to the wealth-getting and wealth-
high school debates on tariffs versus free using activities of man." Economics, that is
trade, and on the Single Tax of Henry to say, concerns itself with a particular
George. It provided me with a sufficiently subset of man's behaviors-those having to
good grounding in principles that I was later do with the production, exchange, and
able to take Henry Simons' intermediate consumption of goods and services.
theory course at the University of Chicago, Many, perhaps most, economists today
and the graduate courses of Frank Knight would regard that view as too limiting.
and Henry Schultz without additional They would prefer the definition proposed
preparation. in the International Encyclopedia of the
The Ely textbook, in its generation, held Social Sciences: " Economics . . . is the
the place of Samuelson or Bach in ours. If it study of the allocation of scarce resources
would not sound as though I were denying among unlimited and competing uses" (vol.
any progress in economics over the past 4, p. 472). If beefsteak is scarce, they would
half century, I might suggest that Ely's say, so are votes, and the tools of economic
textbook could be substituted for any of our analysis can be used as readily to analyze
current ones at a substantial reduction in the allocation of the one as of the other.
weight, and without students or teacher be- This point of view has launched economics
ing more than dimly aware of the replace- into many excursions and incursions into
ment. Of course they would not hear from political science and her other sister social
Ely about marginal propensities to do this sciences, and has generated a certain
amount of hubris in the profession with
*Carnegie-Mellon University. respect to its broader civilizing mission. I
I
2 AMERICAN ECONOMIC ASSOCIATION MAY 1978

would suppose that the program of this rationality, but a very particular and special
meeting, with its emphasis upon the rela- form of it-the rationality of the utility
tions between economics and the other maximizer, and a pretty smart one at that.
social sciences, is at least partly a reflection But international flows have to be
of that hubris. balanced. If the program of this meeting
aims at more active intercourse between
A. Rationality in Economics economics and her sister social sciences,
then we must ask not only what economics
The topic of allocating scarce resources will export, but also what she will receive in
can be approached from either its norma- payment. An economist might well be
tive or its positive side. Fundamental to the tempted to murmur the lines of the
approach from either side are assumptions tentmaker: "I wonder often what the
about the adaptation of means to ends, of Vintners buy-One half as precious as the
actions to goals and situations. Economics, stuff they sell."
whether normative or positive, has not My paper will be much concerned with
simply been the study of the allocation of that question, and before I proceed, it may
scarce resources, it has been the study of be well to sketch in outline the path I
the rational allocation of scarce resources. propose to follow in answering it. The argu-
Moreover, the term "rational" has long ment has three major steps.
had in economics a much more specific First, I would like to expand on the
meaning than its general dictionary theme that almost all human behavior has a
signification of "agreeable to reason; not large rational component, but only in terms
absurd, preposterous, extravagant, foolish, of the broader everyday sense of ra-
fanciful, or the like; intelligent, sensible." tionality, not the economists' more spe-
As is well known, the rational man of eco- cialized sense of maximization.
nomics is a maximizer, who will settle for Second, I should like to show that eco-
nothing less than the best. Even his expec- nomics itself has not by any means limited
tations, we have learned in the past few itself to the narrower definition of ra-
years, are rational (see John Muth, 1961).1 tionality. Much economic literature (for
And his rationality extends as far as the example, the literature of comparative in-
bedroom for, as Gary Becker tells us, "he stitutional analysis) uses weaker definitions
would read in bed at night only if the value of rationality extensively; and that litera-
of reading exceeded the value (to him) of ture would not be greatly, if at all,
the loss in sleep suffered by his wife" improved by substituting the stronger
(1974, p. 1078). definition for the weaker one.2 To the
It is this concept of rationality that is eco- extent that the weaker definition is ade-
nomics' main export commodity in its trade quate for purposes of analysis, economics
with the other social sciences. It is no will find that there is indeed much that is
novelty in those sciences to propose that importable from the other social sciences.
people behave rationally-if that term is Third, economics has largely been preoc-
taken in its broader dictionary sense. cupied with the results of rational choice
Assumptions of rationality are essential rather than the process of choice. Yet as
components of virtually all the sociological, economic analysis acquires a broader
psychological, political, and anthropo- concern with the dynamics of choice under
logical theories with which I am familiar. uncertainty, it will become more and more
What economics has to export, then, is not essential to consider choice processes. In
the past twenty years, there have been im-
'The term is ill-chosen, for rational expectations in
the sense of Muth are profit-maximizing expectations
only under very special circumstances (see below). 2For an interesting argument in support of this
Perhaps we would mislead ourselves and others less if proposition from a surprising source, see Becker
we called them by the less alluring phrase, "consistent (1962). What Becker calls "irrationality' in his article
expectations. ' would be called "bounded rationality" here.
VOL. 68 NO. 2 RICHARD T. ELY LECTURE 3

portant advances in our understanding of when, as a result of external obstacles


procedural rationality, particularly as a or of an internal lack of adaptation, the
result of research in artificial intelligence satisfaction of their erotic needs in
and cognitive psychology. The importation reality is frustrated. We see that they
of these theories of the processes of choice then take flight into illness in order that
by its help they may find a satisfaction
into economics could provide immense to take the place of what has been
help in deepening our understanding of the frustrated . . . We suspect that our
dynamics of rationality, and of the patients' resistance to recovery is no
influences upon choice of the institutional simple one, but compounded of several
structure within which it takes place. motives. Not only does the patient's
We begin, then, by looking at the broader ego rebel against giving up the
concept of rationality to which I have re- repressions by means of which it has
ferred, and its social science applications. risen above its original disposition, but
the sexual instincts are unwilling to
B. Raitiotitilit! iin tlie OthlerSocial renounce their substitutive satisfaction
so long as it is uncertain whether
Sciences: Functional Analysis reality will offer them anything bet-
ter.
Let me provide some examples how ra-
tionality typically enters into social science Almost all explanations of pathological be-
theories. Consider first so-called "social havior in the psychoanalytic literature take
exchange" theories (see, for example, this form: they explain the patient's illness
George Homans). The central idea here is in terms of the functions it performs for
that when two or more people interact, him.
each expects to get something from the The quotation from Freud is illustrative
interaction that is valuable to him, and is of a kind of functional reasoning that goes
thereby motivated to give something up far beyond psychoanalysis and is widely
that is valuable to the others. Social ex- used throughout the social sciences, and
change, in the form of the "inducements- especially anthropology and sociology. Be-
contributions balance" of Chester I. Bar- haviors are functional if they contribute to
nard and the author ( 1947), has played an certain goals, where these goals may be the
important role in organization theory, and pleasure or satisfaction of an individual or
in even earlier times (see, for example, the guarantee of food or shelter for the
George Simmel) was a central ingredient in members of a society. Functional analysis
sociological theories. Much of the theoriz- in this sense is concerned with explaining
ing and empirical work on the topic has how "major social patterns operate to
been concerned with determining what maintain the integration or adaptation of
constitutes a significant inducement or the larger system" (see Frank Cancian). In-
contribution in particular classes of ex- stitutions are functional if reasonable men
change situations-that is, with the actual might create and maintain them in order to
shape and substance of the "utility func- meet social needs or achieve social goals.
tion." Clearly, the man of social exchange It is not necessary or implied that the
theory is a rational man, even if he is never adaptation of institutions or behavior pat-
asked to equate things at the margin. terns to goals be conscious or intended.
It is perhaps more surprising to discover When awareness and intention are present,
how pervasive assumptions of rationality the function is usually called ma-nifest,
are in psychoanalytic theory-confirming otherwise it is a latent function. The func-
the suspicion that there is indeed method in tion, whether it be manifest or latent,
madness. In his Fiv'e Lectures Sigmund provides the grounds for the reasonable-
Freud has this to say about neurotic ill- ness or rationality of the institution or be-
nesses: havior pattern. As in economics, evolu-
tionary arguments are often adduced to
We see that human beings fall ill explain the persistence and survival of
4 AMERICAN ECONOMIC ASSOCIATION MA Y 1978

functional patterns, and to avoid assump- same requirements could not be satisfied in
tions of deliberate calculation in explaining some other way. Thus, for example,
them. societies can satisfy their functional needs
In practice, it is very rarely that the for food by hunting or fishing activities, by
existence or character of institutions are agriculture, or by predatory exploitation of
deduced from the functions that must be other societies.
performed for system survival. In almost all
cases it is the other way round; it is empi- C. Functional Analysis in Economics
rical observation of the behavior pattern
that raises the question of why it persists- Functional analysis of exactly this kind,
what function it performs. Perhaps, in an though with a different vocabulary, is com-
appropriate axiomatic formulation, it would monly employed by economists, especially
be possible to deduce that every society when they seek to use economic tools to
must have food-gathering institutions. In "'explain" institutions and behaviors that
point of fact, such institutions can be ob- lie outside the traditional domains of
served in every society, and their existence production and distribution. Moreover, it
is then rationalized by the argument that occurs within those domains. As an
obtaining food is a functional requisite for example, the fact is observed that indi-
all societies. This kind of argument may viduals frequently insure against certain
demonstrate the sufficiency of a particular kinds of contingencies. Attitudes are then
pattern for performing an essential func- postulated (for example, risk aversion) for
tion, but cannot demonstrate its which buying insurance is a functional and
necessity-cannot show that there may not reasonable action. If some people are ob-
be alternative, functionally equivalent, be- served to insure, and others not, then this
havior patterns that would satisfy the same difference in behavior can be explained by
need. a difference between them in risk aversion.
The point may be stated more formally. To take a second example, George
Functional arguments are arguments about Stigler and Becker wish to explain the fact
the movements of systems toward stable (if it is a fact-their empiricism is very
self-maintaining equilibria. But without casual) that as people hear more music,
further specification, there is no reason to they want to hear still more. They invent a
suppose that the attained equilibria that are commodity, ""musicappreciation" (not to
reached will be global maxima or minima of be confused with time spent in listening to
some function rather than local, relative music), and suggest that listening to music
maxima or minima. In fact, we know that might produce not only immediate enjoy-
the conditions that every local maximum of ment but also an investment in capacity for
a system be a global maximum are very appreciating music (i.e., in amount of en-
strong (usually some kind of 'convexity" joyment produced per listening hour). Once
conditions). these assumptions are granted, various
Further, when the system is complex and conclusions can be drawn about the de-
its environment continually changing (that mand for music appreciation. However,
is, in the conditions under which biological only weak conclusions follow about listen-
and social evolution actually take place), ing time unless additional strong postulates
there is no assurance that the system's mo- are introduced about the elasticity of de-
mentary position will lie anywhere near a mand for appreciation.
point of equilibrium, whether local or A rough "'sociological" translation of the
global. Hence, all that can be concluded Stigler-Becker argument would be that
from a functional argument is that certain listening to music is functional both in pro-
characteristics (the satisfaction of certain ducing pleasure and in enhancing the
functional requirements in a particular way) pleasure of subsequent listening-a typical
are consistent with the survival and further functional argument. It is quite unclear
development of the system, not that these what is gained by dressing it in the garb of
VOL. 68 NO. 2 RICHARD T. ELY LECTURE 5

marginalism. We might be willing to ment then explains why employment rela-


grant that people would be inclined to in- tions are so widely used in our society.
vest more in musical appreciation early in The translation of these examples of eco-
life than later in life (because they would nomic reasoning into the language of func-
have a longer time in which to amortize the tional analysis could be paralleled by exam-
investment) without insisting that costs and ples of translation scholarship which run in
returns were being equated at the margin, the opposite direction. Political scientists,
and without gaining any new insights into for example, long ago observed that under
the situation from making the latter certain circumstances institutions of
assumption. representative democracy spawned a multi-
A sense of fairness compels me to take a plicity of political parties, while under other
third example from my own work. In my circumstances, the votes were divided in
1951 paper, I defined the characteristics of equilibrium between two major parties.
an employment contract that distinguish it These contrasting equilibria could readily
from an ordinary sales contract, and then be shown by functional arguments to result
showed why reasonable men might prefer from rational voting decisions under dif-
the former to the latter as the basis for es- ferent rules of the electoral game, as was
tablishing an employment relation. My observed by Maurice Duverger, in his
argument requires a theorem and fifteen classic work on political parties, as well as
numbered equations, and assumes that by a number of political scientists who pre-
both employer and employee maximize ceded him. In recent years, these same
their utilities. Actually, the underlying results have been rederived more
functional argument is very simple. An em- rigorously by economists and game
ployee who didn't care very much which of theorists, employing much stronger
several alternative tasks he performed assumptions of utility maximization by the
would not require a large inducement to ac- voters; it was hard to see that the
cept the authority of an employer-that is, maximization assumptions have produced
to permit the employer to make the choice any new predictions of behavior.4
among them. The employer in turn would
be willing to provide the necessary induce- D. Summary
ment in order to acquire the right to
postpone his decisions about the em- Perhaps these examples suffice to show
ployee's agenda, and in this way to that there is no such gap as is commonly
postpone some of his decisions whose out- supposed between the view of man
comes are contingent on future uncertain espoused by economics and the view found
events.3 The rigorous economic argument, in the other social sciences. The view of
involving the idea of maximizing behavior man as rational is not peculiar to eco-
by employer and employee, is readily trans- nomics, but is endemic, and even ubiqui-
latable into a simple qualitative argument tous, throughout the social sciences. Eco-
that an employment contract may be a nomics tends to emphasize a particular
functional ("reasonable") way of dealing
with certain kinds of uncertainty. The argu- 4For an introduction to this literature, see William
H. Riker and Peter C. Ordeshook, and Riker. Anthony
Downs' book belongs to an intermediate genre. While
it employs the language of economics, it limits itself to
3Recently, Oliver Williamson has pointed out that I verbal, nonrigorous reasoning which certainly does
would have to introduce slightly stronger assumptions not make any essential use of maximizing assumptions
to justify the employment contract as rational if one of (as contrasted with rationality assumptions in the
the alternatives to it were what he calls a "contingent broader sense), and which largely translates into the
claims" contract, but the point of my example is not economic vocabulary generalizations that were al-
affected. To exclude the contingent claims contract as ready part of the science and folklore of politics. In the
a viable alternative, we need merely take account of next section, other examples of this kind of informal
the large transaction costs it would entail under real use of rationality principles are examined to analyze
world conditions. institutions and their behavior.
6 AMERICAN ECONOMIC ASSOCIATION MAY 1978

form of rationality-maximizing be- gravel are elongated along a north-south


havior-as its preferred engine of explana- axis, and that the boulders embedded in
tion, but the differences are often dif- them are not as smooth as those usually
ferences in vocabulary more than in found on beaches. To explain these facts,
substance. We shall see in a moment that in he evokes a structural, and not at all quanti-
much economic discussion the notion of tative, hypothesis: that these phenomena
maximization is used in a loose sense that is were produced by the process of glaciation.
very close to the common sense notions of In the first instance, he does not try to
rationality used elsewhere in the social explain the depth of the glacial till, or esti-
sciences. mate the weight of the ice that produced it,
One conclusion we may draw is that but simply to identify the basic causative
economists might well exercise a certain process. He wants to explain the role of
amount of circumspection in their glaciation, of erosion, of vulcanization, of
endeavors to export economic analysis to sedimentation in producing the land forms
the other social sciences. They may dis- that he observes. His explanations,
cover that they are sometimes offering morever, are after-the-fact, and not predic-
commodities that are already in generous tive.
supply, and which can therefore be dis-
posed of only at a ruinously low price. On A. Toward Quialitative Analysis
the other side of the trade, they may find
that there is more of interest in the modes As economics expands beyond its central
and results of inquiry of their fellow social core of price theory, and its central concern
scientists than they have generally been with quantities of commodities and money,
aware. we observe in it this same shift from a
highly quantitative analysis, in which
II. On Applying the Principle of Rationality equilibration at the margin plays a central
role, to a much more qualitative institu-
What is characteristic of the examples of tional analysis, in which discrete structural
functional analysis cited in the last section, alternatives are compared.
whether they be drawn from economics or In these analyses aimed at explaining in-
from the other social sciences, is that they stitutional structure, maximizing assump-
are not focused on, or even much tions play a much less significant role than
concerned with, how variables are equated they typically do in the analysis of market
at the margin, or how equilibrium is altered equilibria. The rational man who some-
by marginal shifts in conditions (for times prefers an employment contract to a
example, shifts in a supply or demand sales contract need not be a maximizer.
schedule). Rather, they are focused on Even a satisficer will exhibit such a
qualitative and structural questions, typi- preference whenever the difference in
cally, on the choice among a small number rewards between the two arrangements is
of discrete institutional alternatives: sufficiently large and evident.
Not "how much flood insurance will a For this same reason, such analyses can
man buy?" but "what are the structural often be carried out without elaborate
conditions that make buying insurance ra- mathematical apparatus or marginal cal-
tional or attractive?" culation. In general, much cruder and
Not "at what levels will wages be simpler arguments will suffice to
fixed'?" but "when will work be performed demonstrate an inequality between two
under an employment contract rather than quantities than are required to show the
a sales contract'?" conditions under which these quantities are
If we want a natural science analogy to equated at the margin. Thus, in the recent
this kind of theorizing, we can find it in works of Janos Kornai, Williamson, and
geology. A geologist notices deep scratches John Montias on economic organization,
in rock; he notices that certain hills of we find only rather modest and simple ap-
VOL. 68 NO. 2 RICHARD T. ELY LECTURE 7

plications of mathematical analysis. In the ings of an 'overcentralized' system


ways in which they involve principles of ra- structure. (1) Superordinates are
tionality, the arguments of these authors re- overburdened with responsibility for
semble James March and the author's Or- the detailed direction and coordination
ganizations more closely than Paul of their subordinates' activities. (2)
Samuelson's Folundations.- This 'petty tutelage' deprives subor-
dinates of the opportunity to make de-
What is the predominant form of reason- cisions that might increase the payoff
ing that we encounter in these theoretical of the organization of which they are a
treatments of social institutions? Do they part. . . Why not loosen controls
contain arguments based on maximizing . . . When controls are
assumptions? Basically, they rest upon a loosened, unless the incentive system
very simple form of causal analysis. is modified to bring about greater
Particular institutional structures or harmony between the goals of super-
practices are seen to entail certain unde- visors and supervisees, it may induce
sirable (for example, costly) or desirable producers to shift their input and
(for example, value-producing) conse- output mix in directions that . . . vi-
tiate any benefits that might be reaped
quences. Ceterlis p(iribiIs, situations and by the organization as a whole from the
practices will be preferred when important exercise of greater initiative at lower
favorable consequences are associated with tiers. [p. 215]
them, and avoided when important unfa-
vorable consequences are associated with Here two costs or disadvantages of
them. A shift in the balance of conse- centralization (burden on supervisors,
quences, or in awareness of them, may mo- restriction of choice-set of subordinates)
tivate a change in institutional arrange- are set off against a disadvantage of
ments. decentralization (goals of subordinates di-
Consider the following argument from vergent from organization goals).
Montias typical of this genre of analysis, What can we learn about organization
which relates to the balance in organiza- from an argument like this? Certainly little
tions between centralization and or nothing about the optimal balance point
decentralization. between centralization and decentralization
in any particular organization. Rather, we
Decentralizing measures are gener- might derive conclusions of these kinds:
ally aimed at remedying two shortcom-
1. That increasing awareness of one of
the predicted consequences may cause an
5A notable exception to this generalization about the organization to move in the direction of
economic literature on organizations is the work of centralization or decentralization. (For
Jacob Marschak and Roy Radner on the theory of
teams. These authors chose the strategy of detailed, example, an egregious case of "suboptimiz-
precise analysis of the implications of maximizing ing" by a subordinate may cause additional
assumptions for the transmission of information in or- centralized controls to be instituted.)
ganizations. The price they paid for this rigor was to 2. That new technical devices may tilt
find themselves limited to the highly simplified situa-
tions where solutions could be found for the
the balance between centralization and
mathematical problems they posed. We need not, of decentralization. For example, invention
course, make an either-or choice between these two and adoption of divisionalized profit and
modes of inquiry. While it may be difficult or impossi- loss statements led toward decentralization
ble to extend the formal analysis of the theory of teams of many large American business firms in
to problems of real world complexity, the rigorous
microtheory may illuminate the workings of important
the 1950's; while reduction in information
component mechanisms in the complex macrositua- costs through computerization led at a
tions. The methodological issues in choosing between later date to centralization of inventory
analytic tractability and realism are quite parallel to control decisions in those same firms.
those involved in the choice between laboratory and
field methods for gathering empirical information
Of course Montias' conclusions could
about social phenomena. Neither one by itself marks also be derived from a more formal
the exclusive path toward truth. optimization analysis-in fact he presents
8 AMIERICAN ECONOMIC ASSOCIATION MAY 1978

such an analysis on the two pages following sions about working capital with little or no
the passage quoted above. But it is not attention to their impact on inventory
clear that anything new is added by the for- levels, while production and marketing
malization, since the par-ameter-simputed to executives made decisions about inventory
the system are largely unmeasured and un- without taking into accounit impacts on
measurable. liquidity. The introduction of computers
There is something to be said for an changed the ways in which executives were
Ockham's Razor that, eschewing assump- able to reach decisions; they could now
tions of optimization, provides an explana- view them in terms of a much wider set of
tion of behavioir that is consistent with interrelated consequences than before. The
either optimizing or satisficing procedures perception of the environment of a decision
on the part of the human agents. Par-simony is a function of-among other things-the
recommends that we prefer the postulate information sources and computational ca-
that men are reasonable to the postulate pabilities of the executives who make it.
that they are supremely rational when Learning phenomena are also readily
either one of the two assumiiptions will do handled within this framework. A number
our work of inference as well as the other.6 of the changes intr-oducedinto planning and
control procedul-es in eastern European
B. Pro(e(lItral RatioulialitU countries during the 1960's were instituted
when the governments in question learned
The kind of qualitative analysis I have by experience of some of the dysfunctional
been describing has another virtue. In com- consequences of trying to control produc-
plex situations there is likely to be a tion by means of crude aggregates of
considerable gap between the real environ- physical quantities. An initial distrust of
ment of a decision (the world as God or prices and market mechanisms was
some other omniscient observer sees it) and gradually and partially overcome after
the environment as the actors perceive it. direct experience of the disadvantages of
The analysis can then address itself either some of the alternative mechanisms. These
to normative questions-the whole range learning experiences could be paralleled
of consequences that shoutl(l enter into de- with experiences of American steel com-
cisions in such situations-or descriptive panies, for example, that experimented
questions, including the questions of which with tonnage incentives for mill department
components of the situation are likely to be superintendents.
taken into account by the actors, and how A general proposition that might be
the actors are likely to represent the situa- asserted about organizations is that the
tion as a whole. number of considerations that are
In the precomputer era, for example, it potentially relevant to the effectiveness of
was very difficult for managers in business an organization design is so large that only
organizations to pay attention to all the a few of the more salient of these lie within
major variables affected by their decisions. the circle of awareness at any given time,
Company treasurers frequently made deci- that the membership of this subset changes
continually as new situations (produced by
'Ockham is usually invoked on behalf of the par- external or internal events) arise, and that
simony of optimizing assumptions, and against the ad- "learning" in the form of reaction to
ditional aid hoc postulates that satisficing models are
thought to require in order to guLaranteeuniqueness of perceived consequences is the dominant
solutions. But that argument only applies when we ar-e way in which rationality exhibits itself.
trying to deduce unique equilibr-ia, a task quite dif- In a world where these kinds of adjust-
ferent from the one most institutional writers set for ments are prominent, a theory of rational
themselves. However, I have no urge to enlarge on
this point. My intent here is not polemical, on behalf of
behavior must be quite as much concerned
satisficing postulates, but rather to show how large a with the character-istics of the rational ac-
plot of common ground is shared by optimizing and tors-the means they use to cope with un-
satisficing analysis. Again, compare Becker (1962). certainty and cognitive complexity-as
VOL. 68 NO. 2 RICHARD T. ELY LECTURE 9

with the characteristics of the objective en- defect of the SEU formulation is that when
vironment in which they make their deci- it has been subjected to test in the labora-
sions. In such a world, we must give an ac- tory or the real world, even in relatively
count not only of substantifve rtitiontlity- simple situations, the behavior of human
the extent to which appropriate courses of subjects has generally departed widely
action are chosen-but also procedural ra- from it.
tioalI/ity-the effectiveness, in light of Some of the evidence has been surveyed
human cognitive powers and limitations, of by Ward Edwards. and more recently by
the proceduri-es used to choose actions. As Daniel Kahneman and Amos Tversky.
economics moves out toward situations of They describe experimental situations in
increasing cognitive complexity, it be- which estimates formed on the basis of
comes increasingly concerned with the initial information are not revised nearly as
ability of actors to cope with the com- much by subsequent information as would
plexity, and hence with the procedural be required by Bayes' Theorem. In other
aspects of rationality. In the remainder of situations, subjects respond largely to the
my talk, I would like to develop this con- information received most recently, and
cept of procedural rationality, and its im- take inadequate account of prior informa-
plications for economic analysis. tion.
Behavior that is radically inconsistent
III. Mind as the Scarce Resource with the SEU framework occurs also in
naturalistic settings. Howard Kunreuther et
Until rather recently, such limited atten- al. have recently carried out extensive
tion as was paid by economists to proce- studies of behavior and attitudes relating to
dural, as distinct from substantive, ria- the purchase of flood insurance by persons
tionality was mainly motivated by the prob- owning property in low-lying areas. They
lems of uncertainty and expectations. The found that knowledge of the availability of
simple notion of maximizing utility or profit insurance, or rates, and of objective risks
could not be applied to situations where the was very imperfect, and that the actual de-
optimum action depended on uncertain en- cisions whether or not to insure were re-
vironmental events, or upon the actions of lated much more to personal experience
other rational agents (for example, im- with floods than to any objective facts
perfect competition). about the situation-or even to personal
The former difficulty was removed to subjective beliefs about those facts. In the
some degree by replacing utility maximiza- face of this evidence, it is hard to take SEU
tion with the maximization of subjective ex- seriously as a theory of actual human be-
pected utility (SEU) as the criterion of ra- havior in the face of uncertainty.8
tionality. In spite of its conceptual For situations where the rationality of an
elegance, however, the SEU solution has action depends upon what others (who are
some grave defects as either a normative or also striving to be rational) do again, no
a descriptive formulation. In general, the consensus has been reached as to what
optimal solution depends upon all of the constitutes optimal behavior. This is one of
moments of the frequency distributions of the reasons I have elsewhere called im-
uncertain events. The exceptions are a perfect competition "the permanent and
small but important class of cases where ineradicable scandal of economic theory'
the utility or profit function is quadratic and (1976b, p. 140). The most imaginative and
all constraints are in the form of equations
rather than inequalities.7 The empirical 8Kunreuther et al. point out that the theory cannot
be "saved" by assuming utility to be radically non-
7In this case the expected values of the environ- linear in money. In the flood insurance case, that in-
mental variables serve as certainty equivalents, so thal terpretation of the data would work only if we were
SEU maximization requires only replacing the un- willing to assume that money has strongly increasing
known true values by these expected values. See the marginal utility, not a very plausible escape route for
author ( 1957). the theory.
10 AMERICAN ECONOMIC ASSOCIATION MAY 1978

ambitious attempt to resolve the difficulty A. Search and Tealnms


was the von Neumann-Morgenstern theory
of games, which is embarrassing in the Decision procedures have been treated
wealth of alternative solutions it offers. more explicitly in the small bodies of work
While the theory of games reveals the that have grown up in economics on the
potential richness of behavior when ra- theory of search and on the theory of
tional individuals are faced with conflict of teams. Both these bodies of theory are
interest, the capability of reacting to each specifically concerned with the limits on the
other's actions (or expected actions), and ability of the economic actor to discover or
possibilities for coalition, it has provided no compute what behavior is optimal for him.
unique and universally accepted criterion Both aspire not only to take account of
of rationality to generalize the SEU cri- human bounded rationality, but to bring it
terion and extend it to this broader range of within the compass of the rational calculus.
situations. Let me explain what I mean by that distinc-
The so-called 'rational expectations" tion.
models, currently so popular (and due origi- Problems of search arise when not all the
nally to Muth), pass over these problems alternatives of action are presented to the
rather than solving them. They ignore rational actor ab initio, but must be sought
potential coalitions and attempted mutual through some kind of costly activity. In
outguessing behavior, and correspond to general, an action will be chosen before the
optimal solutions only when the losses are search has revealed all possible alterna-
quadratic functions of the errors of esti- tives. One example of this kind of problem
mate.9 Hence they do not correspond to is the sale of a house, or some other asset,
any classical criterion of rationality, and la- when offers are received sequentially and
beling them with that term, rather than the remain open for only a limited time (see the
more neutral "consistent expectations," author, 1955). Another example which has
provides them with a rather unwarranted been widely cited is the purchase of an au-
legitimation. tomobile involving travel to dealers' lots
Finally, it should be remarked that the (see Stigler, 1961). In both these examples,
main motivation in economics for develop- the question is not how the search is carried
ing theories of uncertainty and mutual ex- out, but how it is decided when to terminate
pectations has not been to replace substan- it-that is, the amount of search. The ques-
tive criteria of rationality with procedural tion is answered by postulating a cost that
criteria, but rather to find substantive cri- increases with the total amount of search.
teria broad enough to extend the concept of In an optimizing model, the correct point of
rationality beyond the boundaries of static termination is found by equating the
optimization under certainty. As with marginal cost of search with the (expected)
classical decision theory, the interest lies marginal improvement in the set of alterna-
not in howrdecisions are made but in wt,hat tives. In a satisficing model, search
decisions are made. (But see, contra, such terminates when the best offer exceeds an
analyses as Richard Cyert and Morris De- aspiration level that itself adjusts gradually
Groot.) to the value of the offers received so far. In
both cases, search becomes just another
9That is, only under the conditions where the un- factor of production, and investment in
certainty equivalents of fn. 8 exist. Under other cir- search is determined by the same marginal
cumstances, a "rational" person would be well principle as investment in any other factor.
advised, if he knew that all others were following the However cavalierly these theories treat the
"'rational expectations" or "consistent expectations"
rule, to recalculate his own optimal behavior on that
actual search process, they do recognize
assumption. Of course if others followed the same explicitly that information gathering is not a
course, we would be back in the "outguessing" situa- free activity, and that unlimited amounts of
tion. it are not available.
VOL. 68 NO. 2 RICHARD T. ELY LECTURE 11

The theory of teams, as developed by ming problems use various forms of highly
Marschak and Radner, goes a step farther selective search-for example branch-and-
in specifying the procedure of decision. bound methods that establish successively
That theory, as is well known, is concerned narrower limits for the value of the op-
with the improvement that may be realized timum, and hence permit a corresponding
in a team's decisions by interchange of in- narrowing of search to promising regions of
formation among the team members. But the space. It becomes a matter of
here the theory does not limit itself to deter- considerable practical and theoretical
mining the aggregate amount of information interest to evaluate the relative computa-
that should be transmitted, but seeks to cal- tional efficiency of competing search
culate what messages should be exchanged, procedures, and also to estimate how the
under what conditions, and at what cost. cost of search will grow with the size of the
The content of the communication as well problem posed. Until recently, most
as the total amount of information becomes evaluation of search algorithms has been
relevant to the theory. empirical: they have been tested on sample
In its attitude toward rationality, the problems. Recently, however, a body of
theory of teams is as "classical,," however, theory-called theory of computational
as is search theory. The bounds on the ra- complexity-has grown up that begins to
tionality of the team members are answer some of these questions in a more
''externalized" and represented as costs of systematic way.
communication, so that they can be folded I cannot give here an account of the
into the economic calculation along with theory of computational complexity, or all
the costs and benefits of outcomes. of its implications for procedural ra-
tionality. A good introduction will be found
B. Rational Search Procedures in Alfred Aho et al. One important set of
results that comes out of the theory does re-
To find theories that compare the merits quire at least brief mention. These results
of alternative search procedures, we must have to do with the way in which the
look largely outside the domain of eco- amount of computation required to solve
nomics. A number of such theories have problems of a given class grows with the
been developed in the past thirty years, size of the problems-with the number of
mainly by management scientists and re- variables, say.10
searchers in the field of artificial in- In a domain where computational re-
telligence. An important example is the quirements grow rapidly with problem size,
body of work that has been done on integer we will be able to solve only small prob-
programming. lems; in domains where the requirements
Integer programming problems resemble grow slowly, we will be able to solve much
linear programming problems (to maximize larger problems. The problems that the real
some quantity, subject to constraints in the world presents to us are generally
form of linear equations and inequalities), enormous compared with the problems that
with the added condition that certain vari- we can solve on even our largest com-
ables can only take whole numbers as their puters. Hence, our computational models
values. The integer constraint makes inap- are always rough approximations to the
plicable most of the powerful computa- reality, and we must hope that the approxi-
tional methods available for solving linear mation will not be too inexact to be useful.
programming problems, with the result that
integer programming problems are far less I'Most of the theorems in computational complexity
tractable, computationally, than linear have to do with the "worst case," that is, with the
maximum amount of computation required to solve
programming problems having comparable any problem of the given class. Very few results are
numbers of variables. available for the expected cost, averaged over all prob-
Solution methods for integer program- lems of the class.
12 AMERICAN ECONOMIC ASSOCIATION MA Y 1978

We will be particularly concerned that com- mentary, but it is already known that there
putational costs not increase rapidly with are some cases where such modifications
problem size. reduce exponential or NP-complete prob-
It is customary in the theory of computa- lem classes to polynomial-complete
tional complexity to regard problems of a classes.
given size as "tractable" if computations The theory of heuristic search, cultivated
do not grow faster than at some fixed power in artificial intelligence and information
of problem size. Such classes of problems processing psychology, is concerned with
are known as "polynomial complex." devising or identifying search procedures
Problems that grow exponentially in com- that will permit systems of limited com-
plexity with size are not polynomial com- putational capacity to make complex deci-
plex, since the rate of growth of computa- sions and solve difficult problems. (For a
tion comes to exceed any fixed power of general survey of the theory, see Nils
their size. Nilsson.) When a task environment has pat-
A large and important class of problems terned structure, so that solutions to a
which includes the general integer program- search problem are not scattered randomly
ming problem, as well as standard schedul- throughout it, but are located in ways re-
ing problems, all have been shown to have lated to the structure, then an intelligent
the same level of complexity-if one is system capable of detecting the pattern can
polynomial complex, then all are; if one is exploit it in order to search for solutions in
not polynomial complex, then none are. a highly selective way.
These problems have been labeled "NP- One form, for example, of selective
complete." It is conjectured, but not yet heuristic search, called best-first search,
proven, that the class of NP-complete assigns to each node in the search space an
problems is not polynomially complex, but estimate of the distance of that node from a
probably exponentially complex. solution. At each stage, the next increment
The significance of these findings and of effort is expended in searching from the
conjectures is in showing that computa- node, among those already reached, that
tional difficulties, and the need to approxi- has the smallest distance estimate (see, for
mate, are not just a minor annoying feature example, the author and J.B. Kadane). As
of our world to be dealt with by manu- another example, when the task is to find a
facturing larger computers or breeding good or best solution, it may be possible to
smarter people. Complexity is deep in the assign upper and lower bounds on the
nature of things, and discovering tolerable values of the solutions that can be obtained
approximation procedures and heuristics by searching a particular part of the space.
that permit huge spaces to be searched very If the upper bound on region A is lower
selectively lies at the heart of intelligence, than the lower bound on some other region,
whether human or artificial. A theory of ra- then region A does not need to be searched
tionality that does not give an account of at all.
problem solving in the face of complexity is I will leave the topics of computational
sadly incomplete. It is worse than incom- complexity and heuristic search with these
plete; it can be seriously misleading by pro- sketchy remarks. What implications these
viding "solutions" to economic questions developments in the theory of procedural
that are without operational significance. rationality will have for economics defined
One interesting and important direction as "the science which treats of the wealth-
of research in computational complexity getting and wealth-using activities of man"
lies in showing how the complexity of prob- remain to be seen. That they are an integral
lems might be decreased by weakening the part of economics defined as "the science
requirements for solution-by requiring so- which treats of the allocation of scarce
lutions only to approximate the optimum, resources" is obvious. The scarce resource
or by replacing an optimality criterion by a is computational capacity-the mind. The
satisficing criterion. Results are still frag- ability of man to solve complex problems,
VOL. 68 NO. 2 RICHARI) T. ELY LECTURE 13

and the magnitude of the resources that direct consequences of actionis taken to
have to be allocated to solving them. reach specific goals or solve specific prob-
depend on the efficienicy with which this lem s.
resource, mind, is deployed. In a world where inforimationis relatively
scar-ce, and where problems for decision
C. Atteutitoi (as the Sca(rc ReSOlur(c are few and simple, information is almost
always a positive good. In a world where
Finally, I would like to tuin from the attention is a major scarce resource, in-
rather highly developed approaches to formation may be an expensive luxury, for
procedural rationality that I have been dis- it may turn our attention from what is im-
cussing back to the more qualitative kinds portant to what is unimportant. We cannot
of institutional issues that were consider-ed afford to attend to information simply be-
in the previous section of this paper. Many cause it is there. I am not awar-ethat there
of the central issues of ouI time are ques- has been any systematic development of a
tions of how we use limited information and theory of information and communication
limited computational capacity to deal with that treats attention rather-than information
enormous problems whose shape we barely as the scarce resource. '' Some of the
gras p practical consequences of attention
For many purposes, a modern govern- scarcity have already been noticed in busi-
ment can be regarded as a parallel comput- ness and government, where ear-ly designs
ing device. While one part of its capability of so-called "management information
for rational problem solving is directed to systems" flooded executives with trivial
fire protection, aniother is directed to pav- data and, until they learned to ignor-ethem.
ing highways, and another to collecting distracted their attention fi-om mor-e im-
refuse. For other- important purposes, a por-tant matters. It is probably true of
government, like a human being, is a serial contemporary organizations that an au-
processing system. capable of attending to tomated information system that does not
only one thing at a time. When impor-tant consume and digest vastly more informa-
new policies must be for-mulated. public tion than it produces and distributes harms
and official attention must be focused on the perfor-mance of the organization in
one or a few matters. Other conceins, no which it is incorpor-ated.
matter how pressing! must wait their turn The management of attention and tracing
on the agenda. When the agenda becomiles indirect consequences of action are two of
crowded, public life begins to appear more the basic issues of procedural rationality
and more as a successioni of crises. When that confront a modern society. There ar-e
problems become interrelated, as ener-gy other-s of comparable importance: what de-
and pollution problemilshave become, there cision-making procedure is rational when
is the constant danger- that attention the basic quantities for making marginal
directed to a single facet of the web will comparisons are simply not known'? A few
spawn SOiutiOlnSthat disregaid vital conse- years ago, I served as chairman of a Na-
quences for the other facets. When oil is tionial Academy of Sciences (NAS) commit-
scarce, we retur-nto coal, but forget that we tee whose job it was to advise the Congress
must then deal with vastly increased quan- on the control of automobile emissions (see
tities of sulfur oxides in ouI ur-banair. Or NAS, Coordinating Committee on Air
we outlaw nuclear power stations because Quality Studies). It is easy to formulate an
of radiation hazards, but fail to make al- SEU model to conceptualize the problem.
ternative provision to meet ouI enler-gy There is a production function for automo-
needs. It is futile to talk of substantive ra- biles that associates different costs with dif-
tionality in public affairs without consider- ferent levels of emissions. The laws govern-
ing what procedural means are available to
order issues on the public agenda in a ra- IISotne unsystematic remarks on the subject will be
tional way! and to inlSUre attentionto the in- found in the author ( 1976a, chs. 13, 14).
14 AMERICAN ECONOMIC ASSOCIATION MAY 1978

ing the chemistry of the atmosphere de- IV. Conclusion


termine the concentrations of polluting
substances in the air as a function of the In histories of human civilization, the
levels of emissions. Biomedical science invention of writing and the invention of
tells us what effects on life and health can printing are always treated as key events.
be expected from various concentrations of Perhaps in future histories the invention of
pollutants. All we need do is to attach a electrical communication and the invention
price tag to life and health, and we can cal- of the computer will receive comparable
culate the optimum level of pollution con- emphasis. What all of these developments
trol. have in common, and what makes them so
There is only one hitch-which will be important, is that they represent basic
apparent to all of you. None of the relevant changes in man's equipment for making ra-
parameters of the various "production tional choices-in his computational ca-
functions" are known-except, within half pabilities. Problems that are impossible to
an order of magnitude, the cost of reducing handle with the head alone (multiplying
the emissions themselves. The physics and large numbers together, for example) be-
chemistry of the atmosphere presents a come trivial when they can be written down
series of unsolved problems-particularly on paper. Interactions of energy and envi-
relating to the photochemical reactions af- ronment that almost defy conceptualization
fecting the oxides of nitrogen and ozone. lend themselves to at least approximate
Medical science is barely able to detect that modeling with modern computers.
there aricehealth effects from pollutants, The advances in man's capacity for
much less measure how large these effects procedural rationality are not limited to
are. The committee's deliberations led im- these obvious examples. The invention of
mediately to one conclusion-one that algebra, of analytic geometry, of the cal-
congressmen are accustomed to hearing culus were such advances. So was the
from such committees: We need more re- invention, if we may call it that, of the
search. But while the research is being modern organization, which greatly
done, what provisions should be incor- increased man's capacity for coordinated
porated in the Clean Air Act of 1977 (or the parallel activity. Changes in the production
Acts of 1978 through 2000, for that matter)? function for information and decisions are
For research won't give us clear answers central to any account of changes over the
then either. What constitutes procedural ra- centuries of the human condition.
tionality in such circumstances'? In the past, economics has largely
"Reasonable men" reach "reasonable" ignored the processes that rational man
conclusions in circumstances where they uses in reaching his resource allocation de-
have no prospect of applying classical cisions. This was possibly an acceptable
models of substantive rationality. We know strategy for explaining rational decision in
only imperfectly how they do it. We know static, relatively simple problem situations
even less whether the procedures they use where it might be assumed that additional
in place of the inapplicable models have computational time or power could not
any merit-although most of us would change the outcome. The strategy does not
choose them in preference to drawing lots. work, however, when we are seeking to
The study of procedural rationality in cir- explain the decision maker's behavior in
cumstances where attention is scarce, complex, dynamic circumstances that in-
where problems are immensely complex, volve a great deal of uncertainty, and that
and where crucial information is absent make severe demands upon his attention.
presents a host of challenging and funda- As economics acquir-es aspirations to
mental research problems to anyone who is explain behavior under these typical condi-
interested in the rational allocation of tions of modern organizational and public
scarce resources. life, it will have to devote major energy to
VOL. 68 NO. 2 RICHARD T. ELY LECTURE 15

building a theory of procedural rationality MauriceDuverger,Political Parties, rev. ed.,


to complement existing theories of substan- New York 1959, (Les Partis Politiques,
tive rationality. Some elements of such a Paris 1951).
theory can be borrowed from the neighbor- W. Edwards, "Conservation in Human In-
ing disciplines of operations research, formation Processing," in Benjamin
artificial intelligence, and cognitive Kleinmuntz, ed., Formal Representation
psychology; but an enormous job remains of Human Thought, New York 1968.
to be done to extend this work and to apply RichardT. Ely, Outlines of Economics, rev.
it to specifically economic problems. ed., New York 1930.
Jacob Marschak, throughout his long S. Freud,"Five Lectures on Psychoanalysis"
career, had a deep belief in and commit- (originally "The Origin and Development
ment to the interdependencies and comple- of Psychoanalysis" 1910) in The Com-
mentarity of the several social sciences. I plete Psychological Works of Sigmund
have shared that belief and commitment, Freud, Vol. 11, London 1957.
without always agreeing with him in detail GeorgeHomans,Social Behavior. Its Elemen-
as to the precise route for exploiting it. The tary Forms, New York 1961.
developments I have been describing D. Kahneman and A. Tversky, "On the Psy-
strengthen greatly, it seems to me, the ra- chology of Prediction," Psychol. Rev.,
tional grounds for both belief and commit- July 1973,80, 237-51.
ment. Whether we accept the more Janos Kornai, Anti-Equilibrium, Amsterdam
restricted definition of economics that I 1971.
quoted from Ely's textbook, or the wider Howard Kunreuther et al., Protecting Against
definition that is widely accepted today, we High-Risk Hazards. Public Policy Les-
have every reason to try to communicate sons, New York 1978.
with the other social sciences, both to find James G. March and Herbert A. Simon, Organi-
out what we have to say that may be of zations, New York 1958.
interest to them, and to discover what they Jacob Marschak and Roy Radner, Economic
can teach us about the nature of procedural Theory of Teams, New Haven 1972.
rationality. John M. Montias, The Structure oJ Economic
Systems, New Haven 1976.
REFERENCES J. F. Muth, "Rational Expectations and the
Theory of Price Movements," Econo-
Alfred V. Aho et al., The Design and Analysis metrica, July 1961,29, 315--35.
of Computer Algorithms, Reading 1974. Nils Nilsson, Problem-Solving Methods in
Chester 1. Barnard, The Functions of the Artificial Intelligence, New York 1971.
Executive, Cambridge 1938. A. Rees, "Economics," in International
G. S. Becker, "Irrational Behavior and Eco- Encyclopedia oJ the Social Sciences, 1968,
nomic Theory," J. Polit. Econ., Feb. 4, 472.
1962, 70, 1--13. William H. Riker, The Theory oJ Political
_ "A Theory of Social Interations," Coalitions, New Haven 1962.
J. Polit. Econ., Nov./Dec. 1974, 82, and Peter C. Ordeshook, An Introduc-
1063-93. tion to Positive Political Theory, New
F. M. Cancian, "Functional Analysis," in Jersey 1973.
International Encyclopedia of the Social Paul Samuelson, Foundations of Economic
Sciences, 1968, 6, 29-42. Analysis, Cambridge 1947.
R. M. Cyert and M. H. Degrott, "Sequential GeorgeSimmel,Soziologie, Berlin 1908.
Strategies in Dual Control," Theory Herbert A. Simon, "A Formal Theory ot the
Decn., Apr. 1977, 8, 173-92. Employment Relation," Enconometrica,
Anthony Downs, An Economic Theory ojf July 1951, 19, 293-305.
Democracy, New York 1957. , 'A Behavioral Model of Rational
16 AMERICAN ECONOMIC ASSOCIATION MAY 1978

Choice," Quart. J. Econ., Feb. 1955, 69, A rtificial Intel., Fall 1975, 6, 235-48.
99-118. G. J. Stigler, "The Economics of Informa-
, "Dynamic Programming Under tion," J. Polit. Econ., June 1961, 69,
Uncertainty with a Quadratic Criterion 213-15.
Function," Econometrica, Jan. 1956, 24, and G. S. Becker, "De Gustibus non
74-81. est Disputandum," Amer. Econ. Rev.,
,(1976a) Administrative Behavior, 3d Mar. 1977,67, 76-90.
ed., New York 1976. Oliver E. Williamson, Markets and Hierar-
, (1976b) "From Substantive to chies, New York 1975.
Procedural Rationality," in Spiro J. National Academy of Sciences, (NAS) Co-
Latsis, ed., Method and Appraisal in ordinating Committee on Air Quality
Economics, Cambridge 1976. Studies, Air Quality and Automobile
andJ. B. Kadane,"Optimal Problem- Emission Control, Vol. 1 summary rep.,
Solving Search: All-or-None Solutions," Washington 1974.
Gigerenzer, Selten - Bounded Rationality, the adaptive toolbox, MIT
Press, 2002

2
What Is Bounded Rationality?
Reinhard Selten
Juridicum, University of Bonn, Adenauerallee 24-42, 53113 Bonn, Germany

ABSTRACT

This chapter discusses the concept of bounded rationality as it is understood in the


tradition of H.A. Simon. Fundamental problems and theoretical issues are presented,
with special emphasis on aspiration adaptation theory. Further remarks concern basic
modes of decision behavior (like learning and expectation formation), reasoning, and the
connection between bounded rationality and motivation.

INTRODUCTION

Modern mainstream economic theory is largely based on an unrealistic picture


of human decision making. Economic agents are portrayed as fully rational
Bayesian maximizers of subjective utility. This view of economics is not based
on empirical evidence, but rather on the simultaneous axiomization of utility
and subjective probability. In the fundamental book of Savage (1954), the
axioms are consistency requirements on actions, where actions are defined as
mappings from states of the world to consequences. One can only admire the
imposing structure built by Savage. It has a strong intellectual appeal as a
concept of ideal rationality. However, it is wrong to assume that human beings
conform to this ideal.

Origins

At about the same time that Savage published his book, H.A. Simon created the
beginnings of a theory of bounded rationality (Simon 1957). He described deci-
sion making as a search process guided by aspiration levels. An aspiration level
is a value of a goal variable that must be reached or surpassed by a satisfactory
14 Reinhard Selten

decision alternative. In the context of the theory of the firm, one may think of
goal variables like profit and market shares.
Decision alternatives are not given but found, one after the other, in a search
process. In the simplest case, the search process goes on until a satisfactory alter-
native is found that reaches or surpasses the aspiration levels on the goal vari-
ables, and then this alternative is taken. Simon coined the word "satisficing" for
this process.
Often, satisficing is seen as the essence of Simon's approach. However, there
is more to it than just satisficing. Aspiration levels are not permanently fixed but
are rather dynamically adjusted to the situation. They are raised if it is easy to
find satisfactory alternatives, and lowered if satisfactory alternatives are hard to
acquire. This adaptation of aspiration levels is a central idea in Simon's early
writings on bounded rationality.
Three features characterize Simon's original view of bounded rationality:
search for alternatives, satisficing, and aspiration adaptation.

Aim of This Essay


It is difficult to gain an overview of the literature on bounded rationality accu-
mulated since Simon's seminal work, and no attempts in this direction will be
made here. Instead, I discuss only a few selected topics with the aim of convey-
ing insights into the essential features of bounded rationality.
I approach the subject matter from the point of view of economic theory. I am
convinced of the necessity of reconstructing microeconomics on the basis of a
more realistic picture of economic decision making. Moreover, I think that there
are strong reasons for modeling boundedly rational economic behavior as
nonoptimizing, and the material presented here reflects this conviction. More
about the nonoptimizing character of boundedly rational decision making will
be said in the remaining sections of the introduction.
A comprehensive, coherent theory of bounded rationality is not available.
This is a task for the future. At the moment we must be content with models of
limited scope.

Bounds of Rationality
Full rationality requires unlimited cognitive capabilities. Fully rational man is a
mythical hero who knows the solutions to all mathematical problems and can
immediately perform all computations, regardless of how difficult they are. Hu-
man beings are in reality very different. Their cognitive capabilities are quite
limited. For this reason alone, the decision-making behavior of human beings
cannot conform to the ideal of full rationality.
It could be the case that, in spite of obvious cognitive limitations, the behav-
ior of human beings is approximately described by the theory of full rationality.
Confidence in this conjecture of approximate validity explains the tenacity with
What Is Bounded Rationality? 15

which many economists stick to the assumption of Bayesian maximization of


subjectively expected utility. However, there is overwhelming experimental ev-
idence for substantial deviations from Bayesian rationality (Kahneman et al.
1982): people do not obey Bayes's rule, their probability judgments fail to sat-
isfy basic requirements like monotonicity with respect to set inclusion, and they
do not have consistent preferences, even in situations involving no risk or uncer-
tainty. (For a more detailed discussion, see Selten 1991.)
The cognitive bounds of rationality are not the only ones. A decision maker
may think that a choice is the only rational one (e.g., to stop smoking) but never-
theless not take it. Conclusions reached by rational deliberations may be over-
ridden by strong emotional impulses. The lack of complete control over
behavior is not due to cognitive bounds of behavior but rather to motivational
ones.

Concept
In this chapter, the use of the term bounded rationality follows the tradition of
H. A. Simon. It refers to the rational principles that underlie nonoptimizing adap-
tive behavior of real people. However, bounded rationality cannot be precisely
defined. It is a problem that needs to be explored. Nevertheless, to some extent it
is possible to say what it is not.
Bounded rationality is not irrationality. A sharp distinction should be made
here. The theory of bounded rationality does not try to explain trust in lucky
numbers or abnormal behavior of mentally ill people. In such cases, one may
speak of irrationality. However, behavior should not be called irrational simply
because it fails to conform to norms of full rationality. A decision maker who is
guided by aspiration adaptation rather than utility maximization may be per-
fectly rational in the sense of everyday language use.
Sometimes the term bounded rationality is used in connection with theories
about optimization under some cognitive bounds. An example of this is the
game theoretic analysis of supergames under constraints on the operating mem-
ory (Aumann and Sorin 1989). The task the players have to solve is much more
complicated with these constraints than without them. The paper by Aumann
and Sorin is a remarkable piece of work, but it is not a contribution to the theory
of bounded rationality. The same must be said about the recent book on
"bounded rationality macroeconomics" (Sargent 1993). There, the assumption
of rational expectations is replaced by least square learning, but otherwise an op-
timization approach is taken without any regard to cognitive bounds of rational-
ity. Here, too, we see a highly interesting theoretical exercise that is, however,
far from adequate as a theory of boundedly rational behavior.
Subjective expected utility maximization modified by some isolated cogni-
tive constraints does not lead to a realistic description of boundedly rational d^
cision making in a complex environment. Moreover, there are reasons to believe
that an optimization approach fails to be feasible in many situations in which not
16 Reinhard Selten

only an optimal solution must be found but also a method of how to find it. More
will be said about this in the next section.
Boundedly rational decision making necessarily involves nonoptimizing
procedures. This is a central feature of the concept of bounded rationality pro-
posed here. Other features will become clear in later parts of this chapter.
Much of human behavior is automatized in the sense that it is not connected
to any conscious deliberation. In the process of walking, one does not decide af-
ter each step which leg to move next and by how much. Such automatized rou-
tines can be interrupted and modified by decisions, but while they are executed
they do not require any decision making. They may be genetically prepro-
grammed (e.g., involuntary body activities) or they may be the result of learn-
ing. Somebody who begins to learn to drive a car must pay conscious attention to
much detail, which later becomes automatic.
One might want to distinguish between bounded rationality and automatic
routine; however, it is difficult to do this. Conscious attention is not a good crite-
rion. Even thinking is based on automatized routine. We may decide what to
think about, but not what to think. The results of thinking become conscious, but
most of the procedure of thinking remains unconscious and not even accessible
to introspection. Obviously the structure of these hidden processes is important
to a theory of bounded rationality.
Reinforcement learning models have a long tradition in psychology (Bush
and Mosteller 1955) and have recently become popular in research on experi-
mental games (Roth and Erev 1995; Erev and Roth 1998). These models de-
scribe automatized routine behavior. Reinforcement learning occurs in human
beings as well as animals of relatively low complexity, and one may therefore
hesitate to call it even boundedly rational. However, a theory of bounded ratio-
nality cannot avoid this basic mode of behavior (see section on Reinforcement
Learning).
The concept of bounded rationality has its roots in H.A. Simon's attempt to
construct a more realistic theory of human economic decision making. Such a
theory cannot cover the whole area of cognitive psychology. The emphasis must
be on decision making. Learning in decision situations and reasoning supporting
decisions belong to the subject matter, but visual perception and recognition, a
marvelously powerful and complex cognitive process, seems to be far from it.
Undoubtedly, biological and cultural evolution as well as the acquistion of
motivational dispositions in ontogenetic development are important influences
on the structure and content of decision behavior. However, boundedly rational
decision making happens on a much smaller time scale. For the purpose of ex-
amining decision processes, the results of biological and cultural evolution and
ontogenetic development can be taken as given. The emphasis on decision mak-
ing within the bounds of human rationality is perhaps more important for the
concept of bounded rationality than the boundaries of its applicability.
Wenceslao Gonzalez

COMMENTS ON SELTEN 77

Nevertheless the necessity for a radical reconstruction of microeconomic


theory becomes more and more visible (Selten 1990, p. 650).
Bounded rationality in Selten can be understood in two different ways
because he distinguishes between cognitive bounds and motivational
bounds. Cognitive bounds are the limits related to the human capability to
think and to compute; whereas motivational bounds are the failures to
behave according to ones rational insights (cf. Selten 1993, pp. 132133).
The first kind cognitive bounds has been stressed by Simon from his
very first papers on bounded rationality to his latest writings on this
issuexvi. The second kind motivational bounds appears more clearly in
Seltenxvii. He discovered these rational limits along with the chain store
paradox: it is not a lack of epistemic power but rather a failure to behave
according to the rational insights. For him, many phenomena of everyday
life can be understood as caused by motivational bounds of rationality.
Somebody who is convinced that it would be best for him to stop smoking
may nevertheless find himself unable to do this (Selten 1993, p. 133).
Between Simons approach (empirically grounded economic
reasonxviii) and Seltens conception (experimentally limited reason) there
is a difference on bounded rationality: the former has accentuated the
cognitive limitations (mainly as a limitation of computational capacity),
whereas the latter offers a broader panorama insofar as motivational
limitations are explicitly added to cognitive limitations. Moreover, Selten
considers that motivation is the mental process which acts as the driving
force of human economic behavior (cf. Selten 1998a, p. 414), and he
emphasizes the second kind of rational limits motivational bounds xix.
He maintains that the motivational limits of rationality are due to the
separation of cognition and decision. The problem is known in philosophy
under the name of acrasia or weakness of the will. A person may know
very well what action is best for him and yet may find himself unable to
take it (Selten 1990, p. 651).
Motivational limits are, then, experimentally based (the experimental
research in recent years has dealt with questions of motivation, such as the
influence of reciprocity, which affect rational decision making), and they
are also analyzed philosophically (both in philosophy of mind and in
ethics). Once their existence is accepted there is a problem: how to
understand the role motivation in economic behavior. In this regard,
Selten explicitly recognizes: I do not claim to be in possession of a valid
theory of human motivation (Selten 1994, p. 43). And his position
includes an important assertion: unfortunately we have no clear
understanding of the interaction of different motivational forces. This is a
78 WENCESLAO GONZALEZ

serious difficulty for the development of a comprehensive theory of


bounded rationality (Selten 2001, p. 32).
Usually in philosophy, motivation is seen as something originally
extrinsic to human will and which moves it towards a chosen endxx,
whereas in Selten it seems to be primarily intrinsicxxi: the human
motivational system determines the goal pursued by boundedly rational
decision making (Selten 2001, p. 32). His remarks on motivation seem to
suggest the idea of a human factor which is not in principle similar to
substantive rationality something more or less established in homo
economicus but is rather regarded as a kind of process related to
procedural rationality (i.e., open to variability and in accordance with
particular circumstances). Motivation appears as a process which includes
human deficiencies: motivation is concerned with what behavior aims at
and how a multitude of fears and desires combine to determine human
action (Selten 1998a, p. 414). In his view, motivation and bounded
rationality are not completely separable (Selten 1998a, p. 414).
Again, in comparison with previous economic views, I think it is an
interesting improvement to maintain that cognitive bounds and
motivational bounds are not disconnected. In other words, it seems to me
that the limits of epistemic rationality and the limits of practical rationality
are related in human economic activity, which is a process with a complex
structure. In the example of reciprocity I do unto you as you do unto
me Selten seems open to this nexus between a bounded rational
cognition and a bounded rational motivation: reciprocity means that there
is a tendency to react with friendliness to friendly acts and with hostility to
hostile acts. This requires an interpretation of acts of others as friendly,
hostile, or neutral. Here boundedly rational cognition enters the picture.
Whether an act is perceived as friendly, neutral, or hostile depends on
boundedly rational reasoning process (Selten 1998a, p. 415).
For Selten, the theory of decision making has three levels: 1) the routine
level, when routine decisions arise spontaneously without any thinking; 2)
the level of imagination, which derives decisions from selected scenarios
the imagined courses of future play of limited length; and 3) the level of
analysis, which requires abstract thinking (cf. Selten 1993, p. 132). These
three levels suggest the idea of increasing room for more complex
situations for the economic decision making than those situations that
should be addressed by the relatively simple principle of bounded
rationality based on cognitive bounds.
Regarding the issue of the relations between the complexity of possible
cases (the recognition that different arguments can apply to different
cases) and the idea of simplicity in economic decision being guided by
COMMENTS ON SELTEN 79

bounded rationality, Selten points to a middle ground: in theories of


limited rationality one should not look for the simplicity of abstract
principles of sweeping generality. A combination of complex case
distinctions with very simple decision rules for every single case seems to
be very typical for limited rationality decision making (Selten 1987, p.
79).
Concerning the future, there is a constant thought in Seltens writings:
the need for an empirically supported general theory of bounded
rationality. In 1993 he foresaw it as an aim for the long run: it will take
decades of painful experimental research until an empirically defendable
general theory of bounded rationality emerges (Selten 1993, p. 118). In a
more recent paper, dated in 2001, he insists on the necessity of that general
theory: a comprehensive, coherent theory of bounded rationality is not
available. This is a task for the future. At the moment, we must be content
with models of limited scope (Selten 2001, p. 14). I think that bringing
economic theory into line with empirical evidence is a project of great
importance.

Faculty of Humanities, University of A Corua


Ferrol, Spain

NOTES
i
Bernoulli 1738, pp. 175192, translated in Bernoulli 1954, pp. 2336. Cf. Roth 1988,
p. 974, reprinted in Roth 1993, p. 3.
ii
Even though Volker Hselbarth in 1967 lists 20 publications before 1959, R. Selten
stresses that experimental economics as a field of economic research did not emerge before
the 1960s (Selten 1993, p. 118).
iii
The same year 1985 the Fifth World Congress of the Econometric Society included a
paper on experimental economics, cf. Roth 1986, p. 245.
iv
Cf. Sauermann and Selten 1959, pp. 42771; Sauermann 1967, pp. 959.
v
Cf. Sauermann and Selten 1962, pp. 577597. Cf. Selten 1990, pp. 649658, especially,
p. 649.
vi
John Nash considers that the book A General Theory of Equilibrium Selection in Games,
written by J. Harsanyi and R. Selten, is very controversial (Nash 1996, p. 182).
vii
Selten 1991a, p. 21. The application of Bayesian methods makes sense in special
contexts. For example, a life insurance company may adopt a utility function for its total
assets; subjective probabilities may be based on actuarial tables. However, a general use of
Bayesian methods meets serious difficulties. Subjective probabilities and utilities are
needed as inputs. Usually these inputs are not readily available (Selten 1991a, p. 19).