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 / Summer 2005 / Issue 39(originally published by Booz & Company)


Reinhard Selten: The Thought Leader Interview

SELTEN: Bounded rationality is a subfield of what is now called “behavioral economics.” It is not really one homogenous field, but a broad collection of several approaches from behavioral science. You could say that this movement aims to base economic theory not on abstract notions of perfect rationality, but on the experimentally observed regularities in human economic behavior.

The concept has a long history; the economist and social scientist Herbert Simon introduced it in the 1950s based on his observations of administrative business practice. Simon argued that the traditional picture of rationality in economic theory was both wrong and insufficient. He said people make decisions by “satisficing,” trying to satisfy their aspiration levels just enough to feel comfortable, without necessarily reaching any optimal result. Experiments have shown more and more that such bounded rationality is not the exception; it is pervasive in behavior, and one has to look at it seriously.

S+B: How does the concept of “bounded rationality” fit into economic research?

SELTEN: It affects economics in many different ways. For example, in the standard economic theory of the stock market, your evaluation of a stock that you hold should depend only on your information about the future: on what you expect the future to be, and on what the future development of this company and its stock price will be.

In reality, however, people rely on facts about the past, such as the price they paid for the stock. From the point of view of traditional theory, the original stock price is irrelevant; but for real people it is of extreme importance in a buy–sell decision. Investors are very reluctant to sell at a price lower than the price at which the stock was bought.

S+B: You became famous for your work on game theory. How does that relate to your current emphasis on bounded rationality and the “fiction” of optimal decision making?

SELTEN: On the one hand, I have made the rationality assumptions of game theory even sharper by inventing some new “hyperrational” notions about the nature of equilibrium. On the other hand, there is my work on descriptive game theory and bounded rationality. There seem to be two quite different personalities involved in those types of work, right? Sounds as if I am a split personality!

But don’t worry. I reconcile them through a scientific position, which I call methodological dualism. In my descriptive work, I am concerned with how humans actually make decisions. In the end, only empirical evidence counts in this domain. Whether a theory sounds reasonable may be of some interest, but it’s certainly not decisive. On the other hand, my hyperrational approach to game theory addresses a philosophical question: What should complete rationality be, if it did exist? Imagine someone, a mythical hero, with no cognitive limitations. What would such a rational decision maker do and how could we describe his behavior?

Learning from Inexperience

S+B: How does this line of research apply to radio frequency auctions, the most prominent application of game theory in recent years?

SELTEN: Breaking with their past practice, several governments decided that it would be both fairer and more profitable for the state to auction off frequency bands to the highest bidder. At once, the problem arose of how exactly to design the auction process for these frequencies. For instance, a frequency may not be very useful to a bidder who doesn’t receive it along with a bundle of close-by frequencies. It would therefore be bad to organize the auction sequentially and to auction off one frequency after another. Buyers who bid on one frequency at a time would not have wanted to bid a whole lot because they would be worried about not receiving the right bundle to give this particular frequency a high value.

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