Monday, May 2, 2011

Bounded Rationality and Management Decision Making

The concept and associated decision model of bounded rationality was first discussed by Herbert Simon in his celebrated book Models of Man published in 1957 by John Wiley and Sons.

Simon basically stipulates that individual decision making is not rational as assumed by a number of theories, especially dealing with economics issues. Individual decision making is limited by a number of boundary conditions such as the individual's intellectual traits, time, and non perfect information.

Non perfect information for example, can pertain to limited access to reliable information or raw information, information corruption through layered processing and/or simply lack of information.

Usually a number of models dealing with economics and the social sciences assume, for the sake of simplicity that humans on average are rational entities and have sufficient if not more than enough information to make the most rational decision. For example, the basic microeconomic concept of marginal utility rests on this basic assumption of rational choice.

Simon's theory of bounded rationality states that individuals as entities are only partially rational and behaviour as well as decision making is influenced by a number if nonrational factors including emotions, prejudices and other subjective biases (Simon, Herbert (1957). "A Behavioral Model of Rational Choice", in Models of Man, Social and Rational: Mathematical Essays on Rational Human Behavior in a Social Setting. New York: Wiley).

When applied to management decisions, managers, usually because of time constraints, lack of information, and cognitive factors usually make numerous daily decisions and seek to make the best possible decision considering the circumstances, rather than the optimal decision; the optimal decision would be the most rational decision under perfect circumstances. Perfect circumstances include perfect information.

This also implies that a particular manager faced with the same challenge but at different time may make a different decision at that time.

So instead of employing purely rational problem optimization techniques, mainly because of the complexity of the situation, cost/time and cognitive limitations, managers will opt for a heuristic approach to problem solving (such as trial and error, best or educated guesses, and past experiences) to come up with the best decision possible which may or may not approach an optimal decision, if such exists.

Bounded Rationality Explained Through an Example

The concept of bounded rationality can be illustrated by a simple purchasing example:
John wishes to buy a new and expensive stereo system. John, in trying to decide on a particular brand consults with a number of friends, relatives as well as trade journals. John decides to purchase ReasonableStereo. While at the store, the saleswoman, Janet, explains and proves to John that he can do much better with his budget if he goes for OptimalStereo. OptimalStereo gives better value for money with respect to cost, performance and fidelity, design, warranties as well as style.
John nevertheless, even if he would receive more value for his money with OptimalStereo, OptimalStereo being the rational choice, opts for ReasonableStereo.

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