How do bounded rationality and heuristics challenge traditional economic views?

Bounded rationality and heuristics challenge traditional economic views by questioning the assumption of perfect rationality in decision-making.

Traditional economic theory assumes that individuals are perfectly rational, always seeking to maximise their utility or profit. This means they have complete information, unlimited cognitive processing abilities, and can make complex calculations to determine the best course of action. However, the concepts of bounded rationality and heuristics challenge this view.

Bounded rationality, a term coined by Herbert Simon, suggests that individuals are only 'boundedly' rational. This means that while they aim to make rational decisions, their ability to do so is limited by factors such as incomplete information, cognitive limitations, and time constraints. For example, when deciding which university to attend, a student may not have complete information about all universities, may struggle to process all the information they do have, and may not have enough time to consider all options thoroughly. As a result, they may make a decision that is not perfectly rational, but is 'good enough' given their constraints.

Heuristics, on the other hand, are mental shortcuts or 'rules of thumb' that individuals use to simplify decision-making. They can lead to biases and systematic errors, further challenging the assumption of perfect rationality. For instance, individuals often use the 'availability heuristic', basing their decisions on information that is readily available or easily recalled, even if it is not representative or accurate. This can lead to decisions that deviate from what would be expected if the individual were perfectly rational.

These concepts have significant implications for economic theory and policy. They suggest that individuals may not always act in their best interest, and that their decisions can be influenced by factors such as how information is presented (framing), past experiences, and cognitive biases. This challenges the traditional economic view of the 'rational economic man', and suggests that policies designed to 'nudge' individuals towards certain behaviours may be more effective than those based on the assumption of perfect rationality. For example, behavioural economics, which incorporates insights from psychology into economic theory, has been used to design policies to encourage saving, healthy eating, and other beneficial behaviours.