1. Bounded Rationality: The Two Cultures Konstantinos Katsikopoulos Max Planck Institute for Human Development Center for Adaptive Behavior and Cognition (Deputy Director) October 30, 2014 Masters Course on Pluralism in Economics, University of Hamburg

2. Don’t worry if you are not sure what bounded rationality is. My point today is exactly that there are different versions of it.

3. Herbert Simon

4. C. P. Snow

5. Culture here means an approach to research on bounded rationality that has technical aspects (data, models) as well as story telling aspects. I will argue for the following: There exist two distinct cultures of research on bounded rationality and they lead to two different approaches to theory, practice and policy.

6. The two cultures of bounded rationality: Idealistic: pursues a minimal departure from neoclassical economics ideals of omniscience and optimization of a utility function (by adding factors such as probability weighting or inequity aversion to the utility function). Pragmatic: accepts that people sometimes ignore information and use simple rules of thumb in order to achieve satisfactory outcomes. Katsikopoulos (2014), Journal of Economic Methodology

7. Technical aspects of bounded rationality

8. (10, ½ ; 0, ½) or (4, 1)?

9. The unbounded rationality solution: Decide for (10, ½; 0, ½) over (4, 1) if v(10) × ½ + v(0) × ½ > v(4).

10. Kahneman and Tversky (1979), Econometrica Brandstätter, Gigerenzer and Hertwig (2006), Psychological Review

11. Brandstätter et al (2008), Psychological Review Katsikopoulos and Gigerenzer (2008), Journal of Risk and Uncertainty

12. Katsikopoulos (2014), Journal of Economic Methodology

13. (1), (2) and (3): Optimization and satisficing

14. (4), (5) and (6): Testing the models

15. Ken Binmore

17. Utility function of responder: x –  [(1 – x) – x] where  > 0 measures the responder’s envy due to earning less than the proposer; Utility function of proposer: (1 – x) –  [(1 – x) – x] where  > 0 measures the proposer’s discomfort due to earning more than the responder. Possible rules of proposer: offer x = ½ or the largest possible x which is smaller than ½; Possible rules of responder: accept all x > 0 or only those x > x* where x* is what she offers. Fehr and Schmidt (1999), Quarterly Journal of Economics Hariskos et al (2014), Working Paper

18. Story telling aspects of bounded rationality

19. The two stories: Idealistic: People systematically behave irrationally, but because they are in principle able to figure out how to behave rationally, they should keep trying to do so (frustrating). Pragmatic: If people are educated to use the right tool in the right situation, they do well (empowering). Bond (2009), Nature; Katsikopoulos (2014), Journal of Economic Methodology

20. Katsikopoulos (2014), Journal of Economic Methodology

21. There exist two distinct cultures of research on bounded rationality and they lead to two very different approaches to theory, practice and policy. Time will tell what will come out of this tension. But if we are not aware that it exists or do not analyze it, we cannot hope to make something good out of it.