Herbert Simon: “Economic Man” and “Bounded Rationality”
Herbert Simon explored the intersection of philosophy, science, politics, economics and a range of other fields and called into question the traditional idea that “economic man” acts rationally. Simon, who was a long-time professor at Carnegie Mellon University, received the Nobel Prize in Economics in 1978. Simon’s diverse research ranged across the fields of cognitive psychology, cognitive science, computer science, economics, management, philosophy of science, sociology, and political science; he helped lay the foundation for behavioral economists around the world. He died in 2001.
His pioneering work around “bounded rationality” was the start of what would lead to many budding economists who challenged the conventional approach to economics. In one of his most important works, ‘A Behavioral Model of Rational Choice’ (1955), he wrote that “traditional economic theory postulates an ‘economic man’, who, in the course of being ‘economic’ is also ‘rational’.”
The assumption is that this person (the “economic man”) has knowledge of the business environment, has an organised and stable system of preferences, and relevant computational skills. “Recent developments in economics, and particularly in the theory of the business firm, have raised great doubts as to whether this schematised model of economic man provides a suitable foundation on which to erect a theory – whether it be a theory of how firms do behave, or of how they ‘should’ rationally behave.”
His conclusion? This notion of economic man “is in need of fairly drastic revision.” The task, he continued, is to replace that assumption of “global rationality” with a kind of rational behaviour “that is compatible with the access to information that are actually possessed by organisms, including man, in the kinds of environments in which such organisms exist.”
The problem is that there are variables to behaviour that psychologists still wrestle with. Simon says, “Actual human rationality-striving can at best be an extremely crude and simplified approximation to kind of global rationality that is implied, for example, by game theoretical models.”
He identified six elements that could be included in models of rational behaviour:
1. A set of behaviour alternatives (or choices or decisions)
2. A subset of behaviour alternatives that the organisation considers or perceives
3. The possible future state of affairs, or outcomes of choice
4. A pay-off function, representing value or utility
5. Information on which outcomes will actually occur if a particular alternative is chosen
6. Information as to the probability that a particular outcome will occur if a particular behaviour alternative is chosen.
Simon then gets into some rather esoteric mathematics and formulae based on those elements. Big math aside, as I see it, he was putting forth a theory of outcomes-based thinking – in the 1950s!
In another influential work on ‘Theories of Bounded Rationality’, Simon says that cognitive “limits” to rationality involve risk and uncertainty, “incomplete information” about alternatives, and complexity in the cost function “or other environmental constraints so great as to prevent the actor from calculating the best course of action.”
Again, this strikes me as recognition of the kind of due diligence with regard to relational contracting and the Vested sourcing business model that is only now being recognised and adopted.
Simon set the course and some precepts for rationality in decision-making that are as valid and thought-provoking today as they were when he first developed them.
In the biographical portion of his Nobel Lecture, he said: “In the ‘politics’ of science, … I have had two guiding principles – to work for the ‘hardening’ of the social sciences so that they will be better equipped with the tools they need for their difficult research tasks; and to work for close relations between natural scientists and social scientists so that they can jointly contribute their special knowledge and skills to those many complex questions of public policy that call for both kinds of wisdom.”
This is the same kind of bridge that is needed today between business people that are seeking to outsource, and their lawyers and stakeholders. When it comes to writing strategic win-win contracts, parties should recognise they will, almost by default, suffer from “bounded rationality” and as such need to create more flexible relational contracts. They will then be able to create sustainable outsourcing deals that are both fair and flexible in nature as “business happens”.