Why is Bounded Rationality an Important Concept?
The concept of bounded rationality describes the idea that people make decisions based on the information available, the cognitive limitations of their minds, and the finite amount of time available for evaluating the merits of different decision options. These limitations imply that a decision-maker lacks complete information about all possible options, the wherewithal to optimize decision outcomes, and foresight of the consequences associated with the individual decision options. Accordingly, the notion of bounded rationality considers decision-makers as satisficers since they will always choose the option that will satisfy their wants and needs without evaluating every single possibility. If the aforementioned limitations are not acknowledged, decision-makers will act with overconfidence and this will prevent them from making satisfactory decisions.
Bounded rationality is an important concept and a central idea in behavioral economics because it provides insights into how individuals decide between different choices. Bounded rationality follows the assumption that decision-makers are risk-averse. This means that decision-makers prefer decisions that maximize positive outcomes while at the same time minimizing the likelihood of negative outcomes or adverse events. However, due to time limits and lack of complete information on all available decision options and their respective outcomes, decision-makers settle on the most promising decision without necessarily considering each and every other option.
Since limitations are a key defining feature in every decision that has to be made, decision-makers opt to satisfice. This means that they opt for the most satisfactory decision rather than the most optimal one. A satisfactory decision is one that is good enough to satisfy the decision maker’s needs but could be optimized if some limitations are relaxed. Generally, decision-makers are not good at making consistently perfect decisions or predicting the unintended consequences of decisions. Rather, they make decisions out of self-interests and related reasons such as love, social norms and peer pressure. In this regard, there are high chances that some decisions are made with little or no regard for their consequences at all. Even if decision-makers had all the information needed to make a decision, the time, energy and resources necessary to evaluate all the information could not be worth the effort. Therefore, only the information that is readily available and looks important is considered and utilized in the decision-making process.
Bounded rationality is widely applied in organizations to inform various kinds of decisions. Rationality requires organizations to choose between different alternatives. In reality, however, only a selected number of options is considered. The organization’s absolute rationality is bounded by the lack of time and knowledge. Therefore, organizations aim to satisfy rather than maximizing options. That is, the organization may settle for good enough decisions instead of committing resources into the process of establishing the best outcome possible.
An example of bounded rationality is when a potential investor compares different investment options to select the one that will result in profit. In this case, the investor’s decision making process is complex and involves a myriad of variables. Regardless of the impact of the variables incorporated, the investor is bound by three crucial limitations. First, the investor lacks information about the characteristics of each investment option and how they will behave in the future. The little information that the investor may have is not always perfect or reliable enough to provide a rational basis for selecting one investment option while rejecting the rest. Secondly, the investor’s decision making process is impeded by cognitive limitations. As a human being, the investor has limited comprehension and knowledge of all possible facts about each investment option. The investor relies on instincts to fill gaps in cognitive capability, resulting in reduced ability to make rational investment decisions. Lastly, the investors’ decision making process is time bound. Investment decisions can only be made within a limited time frame. However, the time frame is not always long enough to accord the investor the luxury of analyzing investment options adequately. A limited timeframe hinders the investor from being fully rational.
In conclusion, the concept of bounded rationality implies that decision makers try as much as possible to make the most reasonable decisions based on the information available about various options. However, the available information may not be perfect, especially if it involves complex issues such as selecting the best investment option from a myriad of available options. Moreover, decision makers may not have the knowledge and skills necessarily to make perfect interpretation of the imperfect information available. This means that decision makers do not always make decisions that optimize their own good or the good of others. Rather, they try to be as reasonable as possible by making decisions based on rigorous and careful evaluation of the positive and negative outcomes of different decision options.
Does Williamson Think That Efficiency Increases With Organizational Size? http://ijbssnet.com/journals/Vol_10_No_7_July_2019/8.pdf
Williamson does not think that that efficiency increases with organizational size. Williamson argues that firms have the main purpose of economizing transaction costs. In Williamson’s view, cost considerations and efficiency are integral in the growth of the firm. Transaction costs exacerbate market failures, leading to suboptimal or inefficient allocation of resources. Firms consequently internalize these failures, paving the way to the emergence of an economic system that allows for efficient allocation of resources. Williamson demonstrates that the internationalization process is associated with costs and that these costs lead to a reduction in the incentives that firms gain from increasing in size. In other words, Williamson thinks that growth in organizational size increases transaction costs, which makes firms less efficient.
Williamson considers the issue of why big organizations exist, yet their growth does not lower costs or increase efficiency. One possibility for this scenario is that big firms are seeking to bolster profits not by attaining the highest levels of efficiency and reducing transaction costs but by raising pricing levels. This is the reason why, for example, firm mergers and acquisitions exist. As firms merge or acquire rivals, they grow in size, which increases transaction costs. On the positive side, the growth process leads to the elimination of a rival firm from the market. Thus, the new entity gains more market power, enabling it to influence pricing. Therefore, regardless of the level of inefficiency or costs occasioned by size, firms will always continue to grow if doing so can accord them the opportunity to maximize economic incentives.
Following from the example of firm mergers, Williamson states that limits to the size of the firm are driven mainly by the increasing cost of delegation. As the firm increases in size, so does the size of bureaucracy and hierarchy and hence the cost of managing the firm. Williamson’s theory implies that large firms suffer from the inability to replicate the incentives of residual income of the firm owner. This is because large firms tend to be more secure and less dependent from the decisions of a single individual. Increasingly, large firms are more dependent on market forces, and thus they look for income insurance to compensate for reduced efficiency.
Williamson explains that as firms increase in size, they incur increased costs due to bureaucracy and the incentives of workers to act selfishly by providing information that is beneficial to themselves. This action by employees causes managers to bear the cost of filtering information. Moreover, managers are forced to make decisions without complete information. This raise transaction costs as the decisions made by managers (and hence the firm) are not always optimal. This problem becomes worse as the firm grows in size and more bureaucratic layers are added into the organizational hierarchy. Each additional layer leads to an increase in transactional costs, making the organizational less efficient.
The preference of the transaction rationale as the reason for the decline in the efficiency of the firm as size increases results from considerations of power dynamics involved in setting up the firm. Indeed, according to Williamson, the legitimacy of power relations lies in the voluntary nature of employment relationships. This means that growth of the firm depends on the size of the workforce. Large firms have more workers, which results in more powerful authority relations. Such relations are presumed to be in the best interests of both the firm and its workers. However, authority relations magnify transaction costs. This is contrary to the objectives of organizational performance, whose focus is on minimizing transaction costs to the lowest level possible. Williamson maintains that organizational hierarchies and bureaucracies grow in response to the prevailing transaction cost dynamics. Bureaucracies are one of the factors that cause transaction costs to increase, leading to greater inefficiency.
Williamson compares the transaction costs of alternative modes of organizing firm production to determine their impact on firm efficiency. He states that the historical progression of firm production from putting out to the modern firm is best explained not in terms of superior efficiency but the profitability of the latter. More particularly, the putting-out system suffered from work deficiency, poor information flow and general inefficiency as a result of the presence of large distribution apparatus comprising of agents, brokers and other intermediaries. The weak incentive structures of the put-out system made it less efficient. On the other hand, the factory system economized on the various transaction costs and made firms more efficient. However, there are limits on the extent to which firms could be more efficient as they continued to grow.
In summary, Williamson’s general point is that growth in firm size is limited as a result of bureaucratic failures as well as the loss of high powered incentives. Growth in firm size leads to excessive managerial bureaucracy, which offsets any efficiency gains realized from growth.
Organizations Decentralize. What Influences the Decision to do so? To what Extent Might there be Contractual Solutions to the Problems Posed by Decentralization?
Decentralization is a form of organizational structure in which management of the firm is devolved from the central authority to separate groups or units within the firm. Each of the decentralized divisions is responsible for similar products or serving a distinct market. Generally, each decentralized unit has its own management team as well as its own distinct production and marketing functions. With this kind of organizational structure, the top managers at the head office are not responsible for the day to day management at the divisional level. However, they monitor the financial performance of the division and generally make decisions regarding the allocation of resources to the divisions.
The decision to decentralize is influenced by various factors. One of these factors is the improvement in the decision making process. One of the advantages of a decentralized firm structure is that divisional managers and their teams act with great autonomy and thus are better prepared to make major decisions or deal with problems without having to wait for directives from the top managers. For instance, divisional managers can make decisions on how best to capitalize on opportunities available in their respective markets since they have an understanding of the local market conditions. In this regard, the decentralized system allows for resilience and agility and is therefore superior to a type of structure where in which the decision making authority is centralized.
Another factor that influences the decision to decentralize is the prospect of obtaining high efficiency in resource utilization. Resource scarcity is a major problem facing firms and is the reason for increasing competition in the market. Therefore, firms decentralize their production units as well as the decision making authority in order to achieve efficiency in resource use. For example, a firm may decentralize by opening a new production unit close to the source of raw materials. This way, the firm will reduce the cost of transporting raw materials to the old production plant. In a similar manner, a firm may decentralize by opening a new store close to the market. In both cases, the cost of transporting goods decreases, and this results in higher resource efficiency and increased ability to compete in the market.
The third factor that influences decentralization decisions is the prospect of expanding the firm’s innovative capacity. Decentralization gives workers increased freedom to make decisions and experiment with various innovations. Workers feel comfortable when they are allowed to make suggestions for improving firm processes. In any case, employees have the best understanding of their actions and thus their creative ideas and opinions can have major positive impact on the firm’s innovativeness. Besides, workers tend to be more supportive of collaborations with other divisions and departments within the firm. Decentralization facilitates efficient exchanges between workers (with different skills, knowledge and professional backgrounds). These exchanges encourage innovative ideas which, improve the firm’s products, services, processes. Innovation also leads to the creation of superior products that better meet customers’ needs.
The fourth factor that influences firm decentralization is a reduction in the operational workloads of managers at the head office. A higher workload affects the ability of executive managers to make optimal decisions. Decentralization allows for a significant part of operational decisions to be delegated to the divisional managers. With less workload, managers at the head office have the incentive to focus on making business projections and learning about current and future trends in the market. Head office managers also have more time to make strategic decisions and evaluate their outcomes. In the absence of decentralization, managers are forced to focus on many issues, which reduces the prospect of positive outcomes.
The last factor is firm expansion. Expanding firms prefer a decentralized firm structure because it is the system that greatly streamlines the decision making process. For young firms, the decentralized system facilitates more efficient management of the subsidiaries and reduces resource wastage. In addition, each individual subsidiary has a better understanding of trends in the local market and the needs of its consumers. For this reason, it makes more sense for the expansion process to be based on decentralized subsidiaries as each of them operates independently and makes its own operational decisions.
The benefits of decentralization notwithstanding, the process may pose some problems to the firm. These problems are broadly classified as horizontal and vertical dilemmas. The dilemmas are solved through contracting. The decentralized units have a contractual obligation to operate in the best interest of the firm by maximizing net outcomes and minimizing negative outcomes. However, contractual solutions might not be adequate for all problems posed by decentralization. This can be the case for example when divisions lack adequate decision making authority. Overall, decentralization enhances firm efficiency and improves opportunities for positive outcomes.