Bounded Rationality and Economic Organization

29 November 2007 at 5:32 am Nicolai Foss 1 comment

| Nicolai Foss |

While many economists and management scholars agree that bounded rationality is important to the understanding of economic organization and there is no shortage of calls for integrating it more with existing theory (e.g., here), how exactly this should be done has been unclear. A problem is that there are so many different conceptions of bounded rationality. Thus, should Ariel Rubinstein´s approach be foundational in attempts to integrate BR with organizational economics? Or the behavioral tradition that stems from Tversky and Kahneman’s research? Or something else?

Moreover, it seems to be notoriously more difficult to work with cognitive assumptions derived from bounded rationality ideas than to doctor utility functions, which may explain why we currently see more research on how alternative specifications of agent motivation (rather than agent cognition) influence economic organization. It is therefore not surprising that to the extent that bounded rationality appears in the organizational economics literature, it is either as a label for “something that makes contracts incomplete” (Williamson, Hart) or as “whatever makes agents commit errors of evaluation” (Sah and Stiglitz) or “whatever makes agents’ information processing speed less than infinite” (team theory). Anything seems to go when it comes to modelling BR, and one is often left wondering what exactly BR is.

A partial exception to this vagueness is the line of research pioneered by Sharon Gifford. Following Simon, Gifford in her work consistently models bounded rationality as limited attention that needs to be economized, and she traces various organizational responses to this. Her 1992 JEBO paper sets out her research program in quite accessible terms (some of her later work is rather mathematically involved). A particularly interesting application is her paper on firm boundaries. Here is the abstract:

This paper presents a novel explanation of the decision by a firm to make an input within the firm rather than to out-source the production to another firm. Due to the limited attention of the manager/entrepreneur, time spent overseeing production in-house has an opportunity cost: the neglect of potential new products/markets. Outsourcing production economizes on attention, but writing and negotiating contracts also has an opportunity cost: the neglect of current operations. This paper derives the endogenous transaction costs of writing a contract with another party and shows that positive transaction costs are not sufficient for the optimal internalization of transactions. However, positive net transaction costs results in the optimal decision to produce the input internally. In addition, although there are larger firm sizes of higher value than obtainable under the optimal policy, the optimal policy maximizes the social value of each individual transaction.