How much rationality is enough?

Last week I had the great good fortune to attend the Max Planck Institute at Leipzig’s first conference on Rigorous Theories of Business Strategies in a World of Evolving Knowledge. The conference spanned and intense four days of presentations, exploration, and discussion on formal approaches to business strategy. Participants were terrific and covered the scholarly spectrum: philosophers, psychologists, game theorists, mathematicians, and physicists. Topics included cooperative game theory, unawareness games, psychological micro-foundations of decision making, and information theory. It was heartening to see growth in the community of formal theorists interested in strategy and my guess is that the event will spawn interesting new research projects and productive coauthoring partnerships. (Thanks to our hosts, Jurgen Jost and Timo Ehrig for organizing and sponsoring the conference!)

If one had to pick a single, overarching theme, it would have to be the exploration of formal approaches to modeling agents with bounded rationality. For example, I presented on subjective equilibrium in repeated games and its application to strategy. Others discussed heuristic-based decision making, unawareness, ambiguity, NK-complexity, memory capacity constraints, the interaction of language and cognition, and dynamic information transmission.

Over the course of the conference, it struck me just how offensive so many of my colleagues find the rationality assumptions so commonly used in economic theory. Of course, rational expectations models are the most demanding of their agents and, as such, seem to generate the greatest outrage. What I mean to convey is the sense that displeasure with these kinds of modeling choices go beyond dispassionate, objective criticism and into indignation and even anger. If you are a management scholar, you know what I mean.

Thus, at a conference such as this, we spend a lot of time reminding ourselves of all the research that points to all the limitations of human cognition. We detail how humans suffer from decision processes that are emotional, memory constrained, short-sighted, logically inconsistent, biased, bad at even rudimentary probability assessment, and so on. Then, we explore ways to build formal models in which our agents are endowed with “more realistic” cognitive abilities.

Perhaps contrary to your intuition, this is heady stuff from a modeler’s point-of-view: formalizing stylized facts about real cognition is seen as a worthy challenge … and discovering where the new assumptions lead is always amusing. From the perspective of many management scholars, such theories are more realistic, better able to explain observations of shockingly stupid decisions by business practitioners and, hence, superior to the silly, overly simplistic models that employ a false level rationality.

I am not mocking the sentiment. In fact, I agree with it. Indeed, none of the economists I know dispute the fact that human cognition is quite limited or that perfect rationality is an extreme and unrealistic assumption. (This isn’t to say there aren’t those who believe otherwise but, if there are, they are not acquaintances of mine.) On the contrary, careers have been made in game theory by finding clever ways to model some observed form of irrationality and using it to explain some observed form of decision failure. If this is the research agenda then, surely, we have hardly scratched the surface.

Yet, as I thought about it during the MPI conference last week, it dawned on me that our great preoccupation with irrational agents is misdirected. That animals as cognitively limited as us often, if not typically, fail to achieve rational consistency in our endeavors is no puzzle. What else would you expect? Rather, the deep mystery is how agents so limited in rational thought invent democracy, create the internet, land on the moon, and run purposeful organizations that succeed in a free market. Casual empiricism suggests that the pattern of objective-oriented progress in the history of mankind is too pervasive to ascribe to dumb luck. Even at the individual level, in spite of their many cognitive failings, the majority of people lead purposeful, productive lives.

This leads me to remind readers that economists invented the rational expectations model precisely because it was the only option that came anywhere close to explaining observed patterns in economy-level reactions to changes in government policies. This, even though the perfect rationality assumption is axiomatically false. There you have it.

Which leaves open the challenge of identifying which features of human cognition lead to persistent patterns of success in highly unstable environments. I conjecture that our refined pattern recognition abilities play a role in this apparent miracle. Other candidates include our determination to see causality everywhere we look as well as our incredible mental flexibility. Social factors and institutions must be involved — and, somewhere in there, a modicum of rationality and logic. After all, we did invent math.