Study Notes

Bounded Rationality and

Theories of Decision
Making
Bounded rationality and theories of Decision Making

Rational decision-making model/theory

Rational decision making is a multi-step process for making choices between alternatives. The
process of rational decision-making favors logic, objectivity, and analysis over subjectivity and
insight.

A rational decision would thus, be one which is based on proper analysis and reasoning such
that it would make sense as to why an alternative is chosen over the other alternative(s). A
rational decision would follow the steps of decision making of defining/identifying the
goal(s)/problem, identifying the criteria for making the decision, identifying alternatives,
evaluating alternatives and choosing an alternative (i.e. making a final decision).

The Rational Decision-Making Model assumes that:

 people will make choices that maximize benefits

and minimize any costs
 An individual has full and perfect information on
which to base a choice
 Measurable criteria exist for which data can be
collected and analyzed
 An individual has the cognitive ability, time, and
resources to evaluate each alternative against the
others

Some of these assumptions are unrealistic and over-simplified.

 People rarely have full (or perfect) information. For example, the information about
unorganized market products may not be available to a consumer. Also, sometimes the
time and resources to acquire all information may be too high. As such, some complex
models rely on probability in order to describe outcomes rather than the assumption that
a person will always know all outcomes.
 Individual rationality is limited by their ability to conduct analysis and think through
competing alternatives. The more complex a decision, the greater the limits are to
making completely rational choices.
 The rational-decision-making model does not consider factors that cannot be quantified,
such as ethical concerns or the value of altruism. It leaves out consideration of personal
feelings, loyalties, or sense of obligation. Its objectivity creates a bias toward the
preference for facts, data and analysis over intuition or desires.
 Rather than always seeking to optimize benefits while minimizing costs, people are often
willing to choose an acceptable option rather than the optimal one. This is especially true
when it is difficult to precisely measure and assess factors among the selection criteria.

Given these concerns and limitations, alternate theories of decision making evolved like the
Bounded rationality theory and prospect theory.

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Bounded rationality and theories of Decision Making

Bounded rationality

Decision-making is limited to the finite amount of information an individual has access to. With
limitations on information, true objectivity is impossible. Decisions are therefore intrinsically
flawed. A satisficer will recognize this necessary imperfection and prefer faster but less perfect
decisions while a maximizer will take a longer time trying to find the optimal choice. This can be
viewed as a spectrum, and each decision (depending on the risk of a mistake) can be viewed
with varying levels of perfection.

Bounded rationality is a concept proposed by Herbert Simon that challenges the notion of
human rationality. According to him, rationality is bounded because there are limits to our
thinking capacity, available information, and time.

Bounded rationality is based on three main limitations that result in sub-optimal decision
making:
1. Cognitive Limitations,
2. Imperfect Information, and
3. Time Constraints

Figure 2: Herbert Simon’s Bounded Rationality model

According to Simon, because of bounded rationality, the decision made is ‘satisficing’ in nature
i.e. they only satisfy and suffice but not maximise. Thus, a decision maker is looking for a
satisfactory solution for a problem in the given situation and the constraints and not for the ideal
solution as that may lead to an endless search.

It is also referred to as administrative or satisfying approach to decision making.

Herbert’s Decision-making theory/ Behavioural theory

Behavioral approach to decision-making is also known as descriptive approach and

administrative model. This theory was proposed by Herbert A Simon, in which he attempts to
explain how decisions are made in real life situations. A manager has to make decisions under
different conditions and situations.

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Bounded rationality and theories of Decision Making

He showed that humans went through three essential stages in the act of problem solving and
decision making. He called these the Intelligence, Design, and Choice stages.

Figure 2: Herbet Simon’s Decision making model

1. Intelligence Phase – The problem is identified and information is collected concerning

the problem. The problem and opportunities are thoroughly investigated. This can be a
long process as the decision to be made comes from the information.
2. Design phase – the design phase develops criteria for decision making and identifies
the several possible solutions. This phase may involve a lot of research into the
available alternatives.
3. Choice phase - in this phase a choice is made from amongst the alternatives that meet
the criteria and a final decision is made.

Prospect theory

Prospect theory is a psychology theory that describes how people make decisions when
presented with alternatives that involve risk, probability, and uncertainty. It holds that people
make decisions based on perceived losses or gains. As per the theory, given the choice of
equal probabilities, most people would choose to retain the wealth that they already have, rather
than risk the chance to increase their current wealth. People are usually averse to the possibility
of losing, such that they would rather avoid a loss rather than take a risk to make an equivalent
gain.

The prospect theory is sometimes referred to as the loss-aversion theory. The theory was
introduced by two psychologists, Daniel Kahneman, and Amos Tversky.

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Bounded rationality and theories of Decision Making

The key features of the Prospect theory are:

 Certainty - When presented with several options to choose from, humans show a strong
preference for the option with certainty. They are willing to sacrifice the option that offers
more potential income in order to achieve more certainty. For example, while buying life
insurance, a person has an option to choose a term insurance or an endowment
insurance. A term insurance will cover for life risk; however, if you survive, there is no
money return. In endowment insurance, if you survive by the end of the insurance
period, you get back the amount you had paid as premium. Most people will choose an
endowment plan since it provides a guaranteed of return of money while in term
insurance one feels the money is lost!

 Small probabilities - People tend to discount very small probabilities even if there is a
possibility of losing all their wealth. By discounting the small probabilities, people end up
choosing higher-risk options with higher probabilities.

 Relative positioning - Relative

positioning means that people tend to
focus less on their final income or wealth,
and more on the relative gains or losses
that they will get. If their relative position
does not improve with increases in
income, they will not feel better off. This
means that people tend to compare
themselves to their neighbors, friends,
and family members, and are less
interested in whether they are better off
than they were some years back. For
example, if everybody in the office gets a
20% raise, no individual will feel better
off. However, if the person gets a 10%
raise, and other people fail to get a raise,
that person will feel better off and richer
than everyone else.

 Loss aversion - People tend to give more weight to losses rather than gains made by
taking a certain option. For example, if a person makes Rs.20,000 in profits and
Rs.10,000 in losses, the person will focus on the loss even though they emerged with a
Rs.10,000 net gain. This shows that people are more concerned about losses rather
than gains. Source: management and business studies

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Bounded rationality and theories of Decision Making

The theory describes the decision-making process in two phases, which include:
a) Editing phase - The editing phase refers to how people involved in decision-making
characterize the options for choice or the framing effects. The effects explain how a
person’s choice is influenced by the wording, order, or method in which the choices are
presented. Example – the framing effect can be demonstrated by the choices that
cancer patients are given. Usually, cancer patients are presented with the choice of
undergoing surgery or chemotherapy to treat their illnesses, and they make a decision
based on whether the outcome statistics are presented in terms of survival rates or
mortality rates. Once the choices have been framed ready for decision-making, the
theory enters the second phase.
b) Evaluation phase - In the evaluation phase, people tend to behave as if they would
make a decision based on the potential outcomes and choose the option with a higher
utility. The phase uses statistical analysis to measure and compare the outcomes of
each prospect. The evaluation phase comprises two indices, i.e., the value function and
the weighting function, which are used to compare the prospects.

Prospect theory reflects that, contrary to rational choice theory, people fear losses more than
they value gains, so they weigh the probabilities of negative outcomes more heavily than their
actual potential cost. Prospect theory is very useful for explaining people’s apparent irrational
behavior. Kahneman and Tversky found that losses had more emotional impact than the
equivalent amount of gain for people.

Pre-dispositioning theory of Decision making

Pre-dispositioning theory was founded by Aron Katsenelinboigen, a Professor at Wharton

School, who sorted out indeterministic systems such as chess, business, economics, and other
fields of knowledge plus made an essential advance in elaboration involving styles and types of
decision-making.

Pre-dispositioning theory is focused on the intermediate stage between a complete order and a
complete disorder. According to Katsenelinboigen, the system develops gradually, going
through several stages, starting with incomplete and inconsistent linkages between its elements
and ending with complete and consistent ones. In his analysis on styles and methods,
Katsenelinboigen referred to the game of chess, saying that "chess does disclose various
methods of operation, notably the creation of predisposition-methods which may be applicable
to other, more complex systems.

Some other models of Decision making

There are three broad models discussed in decision making – normative, descriptive and
prescriptive.

 Normative model discusses ‘how people should’ make decisions and inferences.

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Bounded rationality and theories of Decision Making

 Descriptive model discusses ‘how people actually do’ make decisions and inferences.
 Prescriptive models guide decision makers towards the ideals encoded by normative
models within the context of a real, often ill-defined problem, mindful of their cognitive
characteristics.

The difference between the three models is summarised below:

Normative Descriptive Prescriptive

Focus How people should How and why people Help people make good
decide with logical decide the way they do decisions; prepare people
consistency to decide
Criterion Theoretical adequacy Empirical validity Efficacy and usefulness
Scope All decisions Classes of decisions tested Specific decisions for
specific problems
Operational Analysis of alternatives; Prevention of systematic Processes and
focus determining preferences human errors in inference procedures; end-to-end
and decision making decision life-cycle