American Economic Association Why Bounded Rationality? Author(s): John Conlisk Source: Journal of Economic Literature, Vol. 34, No. 2 (Jun., 1996), pp. 669-700 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2729218 Accessed: 20/10/2008 21:54 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. 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Very special thanks for many years of helpfui insights are due to Richard Day and Luigi Ermini. Hamlet: "What a piece of work is a man! how noble in reason! how infinite in faculties!" Hamlet, II.2.319. Puck: "Lord, whatfools these mortals be!" Midsummer Night's Dream, III.3.116. NEARLY EVERYONE would see the ring theme. Most references are to the truth as between Hamlet and Puck. last 15 years, though many earlier works Including Hamlet and Puck. Hamlet is are also cited. A longer version of the feigning madness, and Puck is just being, survey, including many more references, well, puckish. Model-writing economists, is available from the author on request. however, tend not to the middle but to the "infinite in faculties" extreme. Al- I. Spoiling a Good Story: Evidence of though the postulate of unbounded ra- Bounds on Rationality tionality has dominated economic model- ing for several decades, the dominance is Should the facts be allowed to spoil a good story? relaxing. Is this encouraging? Why Michael Lovell (1986, p. 120) bounded rationality? Lovell asked this question about un- In this survey, four reasons are given bounded rationality in forecasting (about for incorporating bounded rationality in rational expectations). We can ask it economic models. First, there is abun- about unbounded rationality in general. dant empirical evidence that it is impor- We know there are critical physiological tant. Second, models of bounded ratio- limits on human cognition (Herbert Si- nality have proved themselves in a wide mon 1990, p. 7), but are the limits im- range of impressive work. Third, the portant to economics? Do they spoil any standard justifications for assuming un- of the good story told by the standard bounded rationality are unconvincing; theory of optimizing behavior? To be their logic cuts both ways. Fourth, delib- clear, the question is not whether eration about an economic decision is a bounds on rationality are always impor- costly activity, and good economics re- tant. They are not; there are many con- quires that we entertain all costs. These texts in which the hypothesis of un- four reasons, or categories of reasons, bounded rationality surely works well. are developed in the following four sec- Rather the questions are whether,bounds tions. Deliberation cost will be a recur- on rationality are often enough impor- 669 670 Journal of Economic Literature, Vol. XXXIV (June 1996) tant to include in economic analysis and, gerate confirming over disconfirming if so, when. evidence relative to initial beliefs; give The evidence sketched in this section answers that are highly sensitive to logi- will be put in two categories, direct evi- cally irrelevant changes in questions; do dence and confounded evidence, though redundant and ambiguous tests to con- the dividing line is vague. The "direct" firm an hypothesis at the expense of de- category will concern studies, mostly ex- cisive tests to disconfirm; make frequent perimental, which test economic ration- errors in deductive reasoning tasks such ality more or less directly by testing the as syllogisms; place higher value on an cognitive abilities relevant to economic opportunity if an experimenter rigs it to decisions. The "confounded" category be the "status quo" opportunity; fail to will concern tests in which rationality hy- discount the future consistently; fail to potheses are entertained jointly with adjust repeated choices to accommodate other hypotheses in economic settings. intertemporal connections; and more. In such experiments, the mental tasks A. Direct Evidence-Rationality Tests put to people are often simple, at least on Single Individuals relative to many economic decisions; There are many studies in which single whereas their responses are frequently individuals are faced with decisions way off. Most important, reasoning er- which have objectively correct answers rors are typically systematic. Psycholo- and which test the kinds of reasoning gists hypothesize that subjects make sys- frequently ascribed to agents in eco- tematic errors by using decision nomic theory. Do subjects do well in "heuristics,"or rules of thumb, which fail such tests? Often not. to accommodate the full logic of a deci- Hundreds of studies of this type have sion, as when a person makes systematic been done, mostly by psychologists but forecast errors by using adaptive rather more recently by experimental econo- than rational expectations. The system- mists also. There is a mountain of ex- atic errors are often referred to as "bi- periments in which people: display ases," and the general topic often carries intransitivity; misunderstand statistical the label "heuristics and biases." independence; mistake random data for The sheer number of experiments re- patterned data and vice versa; fail to ap- porting biases is so great that a sizable preciate law of large number effects; fail number of books and long survey papers to recognize statistical dominance; make have been written just to review the evi- errors in updating probabilities on the dence. For example, see the books by basis of new information; understate the Hal Arkes and Kenneth Hammond significance of given sample sizes; fail to (1986), Robin Hogarth (1980), Daniel understand covariation for even the sim- Kahneman, Paul Slovic, and Amos Tver- plest 2X2 contingency tables; make false sky (1982), and Richard Nisbett and Lee inferences about causality; ignore rele- Ross (1980); and see the survey papers vant information; use irrelevant informa- by John Payne, James Bettman, and Eric tion (as in sunk cost fallacies); exaggerate Johnson (1992), Gordon Pitz and Natalie the importance of vivid over pallid evi- Sachs (1984), and Slovic, Sarah Lichten- dence; exaggerate the importance of fal- stein, and Baruch Fischhoff (1988). For lible predictors; exaggerate the ex ante mini-surveys aimed at economists, see probability of a random event which has George Loewenstein and Richard Thaler already occurred; display overconfidence (1989), Tversky and Thaler (1990), and in judgment relative to evidence; exag- Kahneman, Jack Knetsch, and Thaler Conlisk: Why Bounded Rationality? 671 (1991). For examples of bias experiments initial expertise, better opportunities to by economists, see David Grether and learn, and the like. Although such design Charles Plott (1979) on preference re- conditions do attenuate biases, the at- versals, Grether (1992) on Bayes rule tenuation is typically limited. The pre- tests, and John Sterman (1989) and Rich- vailing overall impression is that biases ard Herrnstein and Drazen Prelec (1991) are not fragile effects which easily disap- on suboptimal decisions in the face of pear, but rather substantial and impor- dynamic complications. tant behavioral regularities. On debias- At the same time that psychologists ing, see the discussions in Raymond view heuristics as a source of bias, they Battalio, John Kagel, and Komain Jiran- also view heuristics as critical to problem yakul (1990, p. 28), Berndt Brehmer solving (Rudolf Groner, Marina Groner, (1980), Grether (1992), Hogarth (1980, and Walter Bischof 1983; Allan Newell ch. 5), Fischhoff (1982), Nisbett and Simon 1990, section II; and Payne, and Ross (1980, pp. 251-54), Payne, Johnson, and Bettman 1993). At first Bettman, and Johnson (1992, pp. 106, glance, this seems puzzling. Why not 114-16), Robert Slonim (1994), and condemn problem solving which leads to Slovic, Lichtenstein, and Fischhoff systematic error? The answer is simple. (1988, pp. 683-85, 688-89). Deliberation cost. For a boundedly ra- As Vernon Smith (1989, 1991) and tional individual, heuristics often provide Smith and James Walker (1993) empha- an adequate solution cheaply whereas size, market discipline, through repeated more elaborate approaches would be un- transactions with significant stakes, can duly expensive. As Pitz and Sachs (1984, be potent in attenuating discrepancies p. 152) put it, "a tradeoff exists between between optimizing and observed behav- cognitive effort and judgmental accu- ior; whereas psychological studies of de- racy." It is ironic that this economic biasing typically do not include such tradeoff should be better recognized in market forces. However, Smith and psychology than in economics. Experi- Walker also emphasize that attenuation mental and selected other economists is a matter of degree.