Optimization is forward-looking: It is trying to anticipate the range of possibilities that might occur in the future. But ex-post rationality is backward-looking: guided by hindsight and what you could have done differently in the past if only you had known. Ex-post rationality often shows little regard for how much your current problems actually resemble your past experience. I saw this phenomenon myself, a long time ago, in one of the business games that I played with some experienced managers. I set up a laboratory market with only one product, and the participants’ earnings depended on the price they and the other players charged for this product. I used teams of three or four managers each to make the pricing decisions for the “firms” in the game. In the first round, one such team was discussing what price to charge. One person said, “In the paper industry, we apply a markup of 2 percent. So let’s take 2 percent.” Someone else said, “No, no! In the pharmaceutical industry, we apply a 100 percent markup.”
The game, of course, was neither about the paper industry nor about pharmaceuticals. Sharing these different perspectives therefore helped the entire team to make a better decision. If these participants had acted alone rather than as a team, they would have uncritically applied their respective industry experience, even though it was not necessarily relevant to the game environment.
S+B: This may happen in your experiments, but how about the real world?
SELTEN: Managers are human beings, too, you know! They also respond in the same way. For instance, the decision making in many organizations suffers because people are guided too much by experience without really understanding why something worked in the past. This gives you the wrong generalizations. You need to know not only what was good in the past, but also why it was good.
S+B: Your psychological explanation of behavior doesn’t fit well with how many of us like to think of ourselves.
SELTEN: Of course many people may be surprised. But it can be proved through experiments that people are not conscious of the reasons why they make a decision. In one experiment by Timothy Wilson and Richard Nisbett, subjects had to select one out of three nightgowns that were presented to them. It turned out that the last nightgown was selected much more often than the first, although the order in which the nightgowns were presented was determined randomly, with all six orders appearing with the same frequency. If you asked people afterward, “Did it matter to you that this was the last nightgown?” they would say, “No, no, no, not at all. It was the texture. It was the color. It was this or that.” They would violently reject the idea that the sequencing of their options had any influence on their decision…but it did.
People do not know what has influenced their decision and often invent reasons for their choice afterward. Only a small part of decision making reaches the conscious mind, while most decision making, just as most thinking, is below this threshold of consciousness. You know what you are thinking, but you do not know why you are thinking it.
S+B: What is the goal of your experimental work in economics?
SELTEN: The first question of experimental economics is to find regularities in people’s behavior — consistent ways in which people respond to situations. The next challenge is to invent clear and precise theoretical models that describe this behavior.
S+B: I gather you are favoring models of “bounded rationality.” Can you describe this idea in more detail?