Question

What is Rational Expectation? How are “rational” economic agents expected to behave? What is Bounded Rationality? As an outcome, how does bounded rationality differ from rational expectations?

Answer 1

In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid.[1] Rational expectations ensure internal consistency in models involving uncertainty. To obtain consistency within a model, the predictions of future values of economically relevant variables from the model are assumed to be the same as that of the decision-makers in the model, given their information set, the nature of the random processes involved, and model structure. The rational expectations assumption is used especially in many contemporary macroeconomic models. Rational behavior refers to a decision-making process that is based on making choices that result in the optimal level of benefit or utilityfor an individual. The assumption of rational behavior implies that people would rather take actions that benefit them versus actions that are neutral or harm them. Most classical economic theories are based on the assumption that all individuals taking part in an activity are behaving rationally. Behavioral economics is a method of economic analysis that considers psychological insights to explain human behavior as it relates to economic decision-making. According to rational choice theory, the rational person has self-control and is unmoved by emotional factors. However, behavioral economics acknowledges that people are emotional and easily distracted, and therefore, their behavior does not always follow the predictions of economic models. Psychological factors and emotions influence the actions of individuals and can lead them to make decisions that may not appear to be entirely rational.For example, an individual may choose to invest in the stock of an organic produce operation, rather than a conventional produce operation, if they have strong beliefs in the value of organic produce. They may choose to do this regardless of the present value of the organic operation compared with that of the conventional operation, and despite the fact that the conventional operation would earn a higher return.

Bounded rationality is the idea that rationality is limited, when individuals make decisions, by the tractability of the decision problem, the cognitive limitations of the mind, and the time available to make the decision. Decision-makers, in this view, act as satisficers, seeking a satisfactory solution rather than an optimal one.

Herbert A. Simon proposed bounded rationality as an alternative basis for the mathematical modeling of decision-making, as used in economics, political science and related disciplines. It complements "rationality as optimization", which views decision-making as a fully rational process of finding an optimal choice given the information available.Simon used the analogy of a pair of scissors, where one blade represents "cognitive limitations" of actual humans and the other the "structures of the environment", illustrating how minds compensate for limited resources by exploiting known structural regularity in the environment.Many economics models assume that people are on average rational, and can in large enough quantities be approximated to act according to their preferences. The concept of bounded rationality revises this assumption to account for the fact that perfectly rational decisions are often not feasible in practice because of the intractability of natural decision problems and the finite computational resources available for making them.

Bounded rationality describes humans making decisions within the constraints of incomplete and imperfect information, limited time, and restricted computational ability. Rationality is thus “bounded” by their limitations even though people try to decide rationally.