Bounded rationality concepts and applications

Bounded Rationality

The concept of bounded rationality recognizes that "it is impossible to comprehend and analyze all of the potentially relevant information in making choices" (JF, 1996). The term therefore reflects the fact that while managers are assumed to be rational, this is not necessarily the case. While of course some managers are not rational at all, bounded rationality highlights that even when managers attempt to be rational, they are faced with challenges to the perfect application of rational thought.

Rationality as a concept is based on perfect information, as well as the ability to effectively process that information. These are preconditions that are seldom met in the real world. For example, managers almost never have all of the relevant information. First, there are acquisition costs for information, which effectively limit how much a manager is going to gather. Furthermore, managerial decisions are based on expected future consequences, and the reality is that managers will never know perfectly the future consequences. In a purely rational world, there would not actually be any profit, because everything would be priced precisely at its intrinsic value. So this imperfect information is not all bad -- purely rational managers would never "beat the market," so to speak, because they would be impossible.

Another bound on rational decision making is the ability of the manager to process the information effectively. It is assumed that a rational manager will not allow emotion to enter into the decision-making process, but the interpretation of some data might be quite sophisticated. There might be advanced statistical techniques required, or more likely some qualitative knowledge required that the manager maybe does not have. If all data must be quantified, then there will be error arising from how the qualitative information is operationalized -- it will never be operationalized perfectly. So a manager is never going to be able to understand all of the data perfectly, even where there are no biases. And there will always be biases and emotions. Further, some managers just aren't that smart. The same set of data can be interpreted different ways by people with different intelligence and different training. Rational thinking theory pretty much assumes that all managers are equal in their cognitive abilities, but that condition does not hold in the real world.

Lastly, managers may not have the time to gather and process all of the information. They must work within these constraints. They might approach an issue from a strictly rational perspective, but without enough time to gather all available information and process it properly, a manager will need to make a decision with imperfect information. Not surprisingly, this leads to imperfect decisions.