Bounded Rationality

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Definition Bounded Rationality?

"Bounded Rationality" is a term for the phenomenon that cognitive blinders prevent people from seeing, seeking, using, or sharing relevant, accessible, and perceivable information during decision-making. The bounded rationality phenomenon challenges traditional rationalist perspectives and suggests that the rationality of actual human and company behavior is always partial, or ‘bounded’ by human limitations.

This management concept recognizes that decision making takes place within an environment of incomplete information and uncertainty. Herbert Simon (also known for Design Thinking) pointed out that most people are only partly rational, and are in fact emotional and irrational in the remaining part of their actions. They experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information.

The point of bounded rationality is not only that people might decide differently if they had more or different information. But is also includes that they can't process all the information even if they had it.

Opportunistic Behavior

One major source of bounded rationality is Opportunistic Behavior by other parties. Opportunism can be defined as: self-interest seeking by an agent (an economic or business party) in a deceptive way (with guile). Or more neutrally as: flexibly adapting to changing circumstances to maximize self-interest. A simple example of opportunistic behavior is a person having a travel insurance who claims sunglasses from his insurer while he didn't lose them at all, suspecting the insurance company is unlikely to investigate relatively small claims.

Types of Opportunistic Behavior

We can distinguish a spectrum of opportunism, ranging from very clear forms, such as lying, cheating and stealing, to more subtle forms in which incomplete or (partly) incorrect information is given.

Furthermore, opportunistic behavior can be:

• Ex ante opportunism / upfront (also called adverse selection): exploiting precontractual information asymmetries.
• Ex post opportunism / afterwards (also called moral hazard: exploiting information asymmetries by not bearing the full consequences.

Safeguarding against Opportunistic Behavior. Prevention

A pioneer in the field of opportunistic behavior is O.E. Williamson. In The Economic Institutions of Capitalism (1985), Williamson explains that the problem with opportunistic behavior is not that everybody is continually acting in an opportunistic way, but that it is so costly to ascertain the trustworthiness of individuals ex ante.

Laws, contractual arrangements, certain corporate governance instruments, corporate transparency and various forms of risk management are amongst the instruments and safeguards to prevent opportunistic behavior.

Consequences of Opportunistic Behavior

A major consequence of opportunistic behavior is that it prevents business parties from relying on each other as much as they should to achieve maximal efficiency.
Opportunism is a main factor behind the prisoner's dilemma and the free rider problem, in which someone consumes a resource without paying for it in any form (or pays less than the full cost of its production).

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