Bounded Rationality: The Two Cultures

Konstantinos Katsikopoulos Max Planck Institute for Human

DevelopmentCenter for Adaptive Behavior and

Cognition (Deputy Director)

October 30, 2014Masters Course on Pluralism in Economics, University of

Hamburg

Don’t worry if you are not sure what

bounded rationality is. My point today is exactly that there are

different versions of it.

Herbert Simon

C. P. Snow

Culture here means an approach to research on bounded rationality that has technical aspects (data, models) as well as story telling aspects.

I will argue for the following: There exist two distinct cultures of research on

bounded rationality and they lead to two different approaches to theory, practice and policy.

The two cultures of bounded rationality:

Idealistic: pursues a minimal departure from neoclassical economics ideals of omniscience and optimization of a utility function (by adding factors such as probability weighting or inequity aversion to the utility function).

Pragmatic: accepts that people sometimes ignore information and use simple rules of thumb in order to achieve satisfactory outcomes.

Katsikopoulos (2014), Journal of Economic Methodology

Technical aspects of bounded rationality

(10, ½ ; 0, ½) or

(4, 1)?

The unbounded rationality solution:

Decide for (10, ½; 0, ½) over (4, 1) if v(10) × ½ + v(0) × ½ > v(4).

Kahneman and Tversky (1979), Econometrica

Brandstätter, Gigerenzer and Hertwig (2006),

Psychological Review

Brandstätter et al (2008), Psychological ReviewKatsikopoulos and Gigerenzer (2008), Journal of Risk

and Uncertainty

Katsikopoulos (2014), Journal of Economic Methodology

(1), (2) and (3): Optimization and satisficing

(4), (5) and (6): Testing the models

Ken Binmore

Utility function of responder: x – [(1 – x) – x] where > 0 measures the responder’s envy due to earning less than the proposer;

Utility function of proposer: (1 – x) – [(1 – x) – x] where > 0 measures the proposer’s discomfort due to

earning more than the responder.

Possible rules of proposer: offer x = ½ or the largest possible x which is smaller than ½;

Possible rules of responder: accept all x > 0 or only those x > x* where x* is what she offers.

Fehr and Schmidt (1999), Quarterly Journal of Economics

Hariskos et al (2014), Working Paper

Story telling aspects of bounded rationality

The two stories:

Idealistic: People systematically behave irrationally, but because they are in principle able to figure out how to behave rationally, they should keep trying to do so (frustrating).

Pragmatic: If people are educated to use the right tool in the right situation, they do well (empowering).

Bond (2009), Nature; Katsikopoulos (2014), Journal of Economic Methodology

Katsikopoulos (2014), Journal of Economic Methodology

There exist two distinct cultures of research on bounded rationality and they lead to two very different approaches to theory, practice and policy.

Time will tell what will come out of this tension. But if we are not aware that it exists or do not analyze it, we cannot hope to make something good out of it.