Bounded rationality and self control

Bounded rationality

Herbert Simon, writing in the 1950s, pioneered the idea that individuals, faced with time constraints, restricted access to information, and with ‘cognitive limitations’ cannot solve problems optimally, but take short-cuts by employing rules to save on mental processing time and energy. Cognitive limitation does not mean that individuals are somehow inferior, but that even the ‘smartest’ cannot necessary make fast and accurate assessments of the benefits of all individual decisions. This, Simon argued, meant that individuals often relied on ‘rules of thumb’ and other norms to help out when confronted with complex decisions. That individuals routinely take short cuts in terms of thinking is shared by most behavioural economists.

Bounded self-control

The second area for behavioural economists is to question the idea that individuals are able to exercise self-control when presented with certain choices.

The assumption of diminishing marginal utility

In traditional theory, the additional benefit from consumption of a good or service will decline with each extral unit consumed - marginal utiity will diminish. The second unit provides less marginal utility than the first, and the third less than the second, and so on. The assumption of diminishing marginal utility underpins traditional economic thinking - indeed, it is one way that economists derive the basic downward sloping demand curve. But is this an accurate description of the compulsive gambler, or the over-eater?

Lack of self control

While an individual may feel fuller after each unit of food consumed, self-control may not be exerted, and the individual eats an amount larger than is optimal for their immediate health and life expectancy. This difficulty in exerting self-control may, clearly, be shaped by the primitive biological instinct to  ‘eat as much as you can at times of a food shortage’, but why would this view still be driving the excessive eating of an otherwise intelligent individual who we assume knows full well that there is no food shortage and that there will definitely be food tomorrow. Here, individual psychology is at odds with the predictions of traditional economics. Traditional economic theory accepts that some goods are habit forming, but rarely goes beyond this to suggest, perhaps, that irrational economic decision making is far more widespread than assumed.

A good example of how individual’s self-control is limited is the tendency for individuals to over-react to new information when it is presented. A study by Werner De Bondt and Richard Thaler (1985)1 showed that when investors were exposed to a series of ‘good news’ stories about investments they would tend to over-value the investment, while ‘bad news’ stories about other investment would lead to an under-valuation of the investment. They have, in short, over-reacted to the data which indicates that absolute self-control was not exercised.

This lack of self-control can also explain the phenomenon of under-saving for retirement. Even though individuals may be bombarded with information about the importance of saving for retirement, it would mean that consumption spending out of current income would have to be somewhat less to enable savings to be put into a savings scheme. This would be the ‘rational choice’ – but individuals are not exercising self-control in terms of current consumption, and hence under-saving. Behavioural psychologists Ted O’Donoghue and Matthew Rabin (1999)2 argued that individuals are much more impatient when confronted with a short term decision (about consumption) and may take the ‘I must have it now’ option, compared with long term decisions (about saving), where individuals are much more patient, and take a ‘I’ll start saving for my retirement next year’ attitude, and hence procrastination prevents a rational decision being made. Again, the fear of losing a certain amount of short term consumption may be much greater than the expected benefit of increased consumption in the future, through savings today.

1De BONDT, Werner F. M. and Richard THALER, 1985. Does the Stock Market Overreact? [805]
2O’DONAHUE, Ted, and Matthew RABIN. 1999. Procrastination in Preparing for Retirement. Behavioral Dimensions of Retirement Economics. Brookings Institution, 1999.

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