Co pyriglll © IFAC Dvnamic Mode llin)i alld

Control of I\atiol1al Economies . Edinburgh.

L' K. 1989

A BOUNDED RATIONALITY DECISION

PROCESS MODEL
K. D. Wall
"'m'al Postgraduate School MUllifl'e:v, CA 939-13. ['SA

Abstract. A model of decision making under bounded rationality is presented that combines
satisficing behavior with learning and adaptation through environmental feedback. The aspira-
t ions, or goals, of the decision maker dynamically adjust in response to t he observed sequence of
past decisions and their corres ponding effect s on the deci sion maker's objective functio n. A simple
linear res ponse model is employed to represent the beliefs of the decision maker concerning the
causal connection between hi s/ her deci sions and the resulting objective fun ction valu e. The com-
bination of t hese simple elements yields a decision process model rich in dynamic behavior; it can
exhibi t optimizing behavior in the long-run and chaoti c pseudo-random search in the short- run.
As such , the model bridges the gap between substanti ve rat ionality and procedural rationality.

Kev Words. Bounded rationality, adaptation, learning, aspirations, expectations, chaotic dynamics

Such considerations have not been lost on many prominent

INTRODUCTION
Modern economic t heory proceeds from t he assumpt ion
that firm s and consumers rationally seek to maximi ze pro-
fit s and personal utility subj ect to the constrain ts imposed
by technology and fin ance. The ant icipated response of
agents to environment al changes are conseq uen tl y derived
from the solution of sop hi sticated optimal control problems.
This approach is elegant and admits the application of
powerful mathematical analyses.
As a faithful refl ection of reality, however, this charac-
terization of decision making leaves much to be desired. It
only takes casual introspection concern ing our own decision
making to reveal significant departures from t he perfectly
rational, optimizing paradigm of homo econimus. This per-
sonal observation is reinforced by an extensive literat ure
from experimental psychology , the overwhelming conclu-
sion of which is that the optimizing paradigm cannot be
reconciled with observed regu larit ies in the choices actually
made by experimental subjects in scienti ficall y controlled
settings. A stimulating sampling of t hese findings can be
found in Kahnernann , Slovic, and Teversky (1982) and
Shoemaker( 1980,1982).
The academic economist adh ering to the perfectly rational,
optimizing paradigm may well respond by citing from
Friedman (1953). He would argue most strongly that
economic agents can be modeled "as if" t heir actions issued
from the solut ion of nonlinear programming problems. He
would maintain that the neoclassical paradigm is a useful
descripti on of t he kind of behavior toward which actual
decision making strategies, like rules-of-thumb, event ually
lead.
economists. Baumol and Quandt (1964) , Cyert and March
(1962) , Day (1967), March and Simon (1958), Simon
(1955,1957), Nelson and Winter(1973), Radner (1975), and
Winter (1971) , among others, have given theoretical direc-
t ion. Theoretical research in th is area, however, has not
experienced the rapid growth of other subjects like rational
expectations, partly owing to the limi ted framework avail-
able for empirical investigation of bounded rat ionality
based on actual market data. Withou t the infusion of fresh
empirical findings , non-neoclass ical models of behavior
have lacked the source of new input and direction which the
elegant econometrics of Hansen and Sargent (1981) have
brought to rat ional expectations.
The primary purpose of this paper is to address this em-
pirical gap by offering a model that embraces t he tenets of
Simon's concept of bounded rationality in an empirically
operational form. The exposition begin s with a statement of
the conceptual framework and t hen proceeds to its imple-
mentation in concrete operational terms. Some properties
and behavior of t he resu lting model t hen are studied , and a
brief discussion of the methodology necessary to em ploy the
model in empirical research is give n.
BOUNDED RATIONALITY
The descriptive model of decisionmaking presented here
owes its conceptuali zation to Simo!] 's theory of bounded
rationality, the essence of which may be captured in t hree
main statements. First, and foremost, the processes of de-
cision making is dominated by t he effects of complexity on
the limited abili t ies of humans to process large amounts of
information. In particular, humans suffer from information
overloading and computational inadequacies . As a result:

Such arguments can be compelling, and the neoclassical
paradigm has had impressive success in accounting for
certain empirical regulariti es. All of this suggests that
mathematical optimization as a characterization of lonq-
run economic equilibrium needs to be taken seriou sly . If,
however, we are instead interested in the d1Jnamic response
of economic agents to an unanticipated change in the envi-
ronment, it is just as surely necessary to model precisely
how decisions are actually made. Neoclassical short-run
optimization models are not the answer in such circum-
stances, for they are qualitat ively indistingu ishable from
their long-run cousins. They still assume complete
information , just wh at is not available in t imes of rapid
change and transition'
[A] Solutions are simple-minded.
Second, the search process used to find a suitabl e solution
obeys four principles. New altern at ive solutions are
synthesized from the modification of existing decision rul es
or the currently implemented solution. Alternatives are
more often considered one at a t ime - very seldom are all
the feasible alternatives available simultaneously. The
search for a new or better solution is undertaken only when
it is deemed necessary ; only when it is observed that goals
are not being met. When search for a solu t ion is under-
taken, a satisficing mode is used; t he fi rst solution found
t hat is "good enough" is implemented and search terminat-
ed. Therefore, the search for alternatives is:

473
474 K. D. Wall
[B] local;
[C] sequential;
[D] motivated by goals;
[E] and employs satisficing behavior.
Third, there is adaptaion and learning with respect to the
formation of goals, search strategies, and the information
set upon which the decision process relies. Goals are defined
by Simon in terms of the aspirations of the decision maker
and these are defined, in part, by the experiences of the
decision maker. Search strategies, through experience, are
found to be either adequate or deficient and in need of
alteration. Exactly what constitutes relevant and impor-
tant information to which the decision maker must pay
attention also comes from experience and the lessons of
success and failure. Thus, there must be mechanisms for
adaptation and learning in the formation of:
[F] aspirations;
[G] search strategies;
[H] attending the environment.
The manifestation of these tenets in mathematical terms
depends directly upon the type of problem under study. In
economics the underlying decision problem is that faced by
a single decision maker who must select the values of N
decision variables at time t so as to maximize the value of
some objective function, f. The decision variables are repre-
sented by an N-vector, ~(t), indexed by t, the time at
which their values have been fixed. The objective function
is then written as a function of ~(t), f = f(t) = f(~(t)). The
choice of ~(t) is limited by constraints and so the decision
maker must select ~(t) from some set of feasible alterna-
tives denoted by $(t). Time is assumed to evolve discrete-
ly so t takes its values from the set integers, .;f. The
decision variables are assumed to be continuously valued so
",(t) takes its values in $n. The objective function f is
assumed to be a continously differentiable mapping from
$n to $1. The problem faCing our decision maker for each
value of t can now be stated as:
max f(t) = f(",(t)) subject to ",(t) C $(t).
At the end of each time period the decision maker observes
the resulting performance - the actual value of f(t) - and
any other variables of interest. Time is incremented by one
period and the decision process repeated.
Given this framework for the problem, the disiderata of a
behaviorally based model incorporating bounded rationality
are implemented as follows. First, consideration of [A] - [C]
suggests decision rules specifying a change in decision
variables relative to previous values:
~(t+1) = ",(t) + ~",(t+1)
= ",(t) + 0:(t+1)g(t+1) (1 )
where g( t) represents the local search direction and 0:( t)
denotes the step length to be taken along this direction.
Furthermore, these two quantities are chosen on the basis
of an information set J( t) gathered from experience:
g(t+1) = 1lIt(J(t)) (2)
0:(t+1) = IlIM(t)). (3)
Realistic modeling would suggest that J(t) be very simple
and limited in its scope. In consideration of [D] - [F] the
decision maker is presumed to hold at the end of time t an
aspiration level a( t+ 1) representing a value of the objective
function f(.) which he/she believes is satisfactory and a
reasonable goal to attain in the next time period. Motiva-
tion for continued search is provided by percieved failure to
achieve the currently defined goal; i.e.,
If f(~(t)) < a(t+1), continue to pursue
searching for a better alternative. (4)
On the other hand, if satisfactory performance has been
achieved then terminate searching; Le.,
If f(",(t)) > a(t+1), set 0:(t+1) = 0 and
stop the search process. (5)
Finally, adaptation and learning requires that a(t+1) be
adjusted to changing experience based on J(t):
a(t+1) = 1lI3(J(t)). (6)
THE OPERATIONAL MODEL
Any empirical implementation of the model described by
(1) - (4) requires concrete form for J(t) and the mappings
llIi, i = 1, 2, 3. Broad guidance in such a task is provided
by three overriding considerations. First, research in cog-
nitive psychology has found that humans employ simple
linear relationships to capture causal connections between
variables and that linear models capture a great deal of this
behavior (Dawes and Corrigan, 1974). Second, there is evi-
dence of persistence and inertia in the formation of beliefs
and in the processing of information used to modify rela-
tionships (Edwards, 1968; Einhorn, 1980). Third, percep-
tion and judgement suffer from Significant biases with
directly observed data subjectively assessed and interpreted
(Kahneman, Slovic, and Teversky, 1982, Parts II-IV). The
simplest possible mechanisms should be em- ployed with
the focus primarily on linear relationships.
With these considerations in mind the information set is
assumed to consist of nothing more than past and current
observations on f(t) and ",(t). Thus
J(t) = {f(T), ~(T); T = t, t-1 , t-2, .... }. (7)
This is to be contrasted with the information set assumed
in the neoclassical optimizing paradigm where complete in-
formation about f assumed; i.e., the functional form of f(t)
and all parameters, derivatives, etc. A further restriction
can be placed on Eq. 5 by requiring a finite "memory" and
this is done below by inclusion of only the current and N
previous observations are required.
Equations (2) and (3) are replaced by a set of operations
consistent with [D] - [G] but involving only simple linear
functions. To wit, the decision maker at the beginning of
period t+ 1, holding aspirations a( t+ 1) , chooses "'( t+ 1) to
force the expected objective function, fe, at the end of the
period to equal a( t+ 1). Algebraically this amounts to
requiring "'( t+ 1) satisfy the constraint
a(t+1) = fe(t+1) = fe(",(t+1)).
Furthermore, the decision maker uses a linear representa-
tion of reality in constructing re:
fe(t+1) = f(t) + £t'~~(t+1). (8)
The desired increment to ~(t) can then be obtained by
computing the minimum norm solution to this equality
constraint; Le.,
~~(t+1) = [a(t+1) - f(t)]£t/lI£tI1 2.
= {[at t+ 1)-f( t)l/ lI£tll }{£t!II£tll}
= 0:(t+1)g(t+1)
The step length is seen to depend upon the difference be-
tween the achieved objective and the desired value of the
objective. Thus, if the decision maker is close to his/her
goal then a small step is taken, while large discrepancies
between the actual and desired objective value will lead to
more bold search. If the decison maker has acheived the
goal then no step is taken and satisficing behavior obtains.
The search direction is seen to be a unit vector which
 A Bounded Rationality Decision Process Model
approximates the direction of steepest ascent but uses only
"backward looking" information. It does, however, change
with experience and therefore embodies the learning and
adaptation required by [G].
The N-vector ~t represents the decision maker's best
estimate of the sensitivity of f( t) to changes in 2>( t). It is
comprised of nothing more than simple finite first differ-
ences derived from J(t). This formulation follows after the
work of Cyert and March (1962) and Day (1967) who argue
that humans employ finite first difference approximations
when dealing with the concepts of derivative and gradient.
In the one-dimensional case where 2>(t) is a scalar ~t is
simply
~t = c(t) = [f(t) - f(t-1)]![x(t) - x(t-1)].
In the multi-dimensional case ~t is defined by:
~f(t) = ~t'[ 2>(t) - 2>(t-1) ] Step 5.
~f(t-N+1) = ~t'[2>(t-N+1) - 2>(t-N)].
Therefore, if one exists, ~t is any solution to
M(t) = X(t)~t
where X'(t) is the NxN matrix obtained by columnwise
concatenation of the vectors 2>(t-j) - 2>(t-j-1), O<j<N-1. If
the rows of X(t) are linearly independent then a unique
expression exists for ~t:
All that remains to be speci fied is the exact form of (4),
and here we appeal to March and Simon (1958) and March
(1988) as a point of departure. Aspirations are hypothesized
to adjust to experience by a linear adaptive adjustment
mechanism. Two additional terms, however, are added
representing environmental feedback from the ob- served
values of fl t) and the observed rate of change in f( t). The
result is a generalized double exponential smoothing of f(t):
f(t+1) = [l-,O]f(t) + ,Of(t)
r(t+1) = [l-~r(t) + 6[f(t) - f(t-1)]
a(t+1) = [l-tp]a(t) + <pf(t+1) + ,r(t+l).
Aspirations are seen to adjust to exponentially smoothed
estimates of f(t) and ~f(t). Thus it is not only the per-
cieved level of the objective function but also the percieved
rate of change of the objective function that influence aspi-
rations. Goal formation is argued to be significantly affect-
ed by the direction of change of the objective with a rapidly
rising (falling) f(t) leading the decision maker to increase
(decrease) the value of alt+1) above (below) what would
have been the case by keying only on the level of f(t). The
inclusion of a rate of change effect does not appear to have
been considered in the existing li terature.
The model of decision making under bounded rationality
can now be summarized as follows :
Step O. Initialization.
Set t = to, 2>(toj = 2>0, f(to) = fo, and J(to-1) = ~ = Df(n) = D((L\j2>(j)) for -N<j<O and Aj>O. Therefore
{f(to- 1),2>(to-1 ; ... ; f(to-N), 2>(to-N)}
Step 1. Update the information set at end of I?eriod t
(by observing f(t) and remembering 2>(t))
J(t) = { f(t), 2>(t), J(t-1) } (9)
Step 2. Update Aspirations
f(t+1) = [l-,O]f(t) + ,Of(t) (10)
475
r(t+1) = [l-~r(t) + 6[f(t) -f(t-1)] (11)
a(t+1) = [l-tp]a(t) + tpf(t+1) +,r(t+1) (12)
Step 3. Update estimate of the environmental response
~t = X(t)-l~f(t) (13)
Step 4. Determine new decision to implement
!l(t+1) = ~t/lI~tll; (14)
a(t+1) = [a(t+1) -f(t)lIlI~tll; (15)
~2>( t+ 1) = a( t+ 1)!l( t+ 1); (16)
2>(t+1) = 2>(t) + ~2>(t+1). (17)
Implement new decision
Set t = t+ 1, implement decision and return to
Step 1.
DYNAMIC PROPERTIES OF THE MODEL
The model presented above is inherently dynamic, repre-
senting the evolution of decision making over time by a set
of difference equations. In the terminology of dynamic sys-
tems, it is capable of describing transient behavior or the
short-run fluctuations of the decision variables as they are
incrementally altered in the search for a satisfactory so-
lution. For such models two overriding issues arise: (1) the
existence of steady-state, or long-run, solutions; and (2)
the stability of these solutions.
For use of the model in economics it seems reasonable to
demand that the model demonstrate neoclassical optimiz-
ing behavior in the long-run under circumstances where
learning and adaptation would produce an accumulation of
knowledge leading to complete information. In other words,
it seems reasonable to demand that the neoclassical opti-
mum be a solution to the model and that the model be able
to converge to this solution.
The remainder of this section presents some initial results
demonstrating that these demands can be met. First the
following theorem demonstrates that under certain condi-
tions bounded rationality eventually leads to perfectly
optimizing behavior.
THEOREM 1. Consider f: se n .... se l , strictly concave and differ-
entiable on an open bounded set die sen. Let 2>* E dlsatisfy
*
f(2)*) > f(2)) for all 2> E <?f, 2> 2>*, and take art) = f* for all
t . Define 2>(t+1) to be the element of $(t) e dlnearest to
~(t+1) = 2>(t) + a(t+1)!l(t+1)
for t = 1, 2, 3, ... and where the initial conditions have been
assigned so that frO) > f(-l) > .. . > f(-N). Then the
sequence {2>( t)} converges to 2>*.
Proof. The argument is by induction. Let the 1xN
gradient vector of f at a point Q be denoted Df(Q). At time
t = 0 we know from the prescribed initialization that
Df(x(-j))[2>(-j+ll -2>(-j)] > 0 for l<j<N. By construction,
~[2>*- 2>(0)] = Df(n)[2>*- 2>(0)] = Df(Dj2>(j))[2>*- 2>(0)].
From the concavity of f, Df(2)(O))[2>* - 2>(0)] > 0 and
Df(~Aj2>(j))[2>*- 2>(O)J > Df(2)(O))[2>* - 2>(0)]. Therefore ~[2>*
°
2>(0)] > and !l(1) is an ascent direction with a component
along 2>*- 2>\0) in a direction towards 2>*. If the step along
!l(1) is not 'too" long the algorithm will produce an 2>(1)
with f(l) > frO). In fact any step of length less than 112>* -
2>(0)11 will produce this result.
To show that the algorithm gives such a step length note
that
476
= [f* - f(~(0))]!;o/II!;o1l2
= DfCrJ*)[~* - ~(0)]!;o/II!;o112
and
11 ~(1) - ~(O) 11 ~ IIDf(!J*)[~* - ~(O)lIl/II!;o11
~ Df(!J*) 11 II~* - ~(O) 11/11 Df(!J) 11·
~ p II~* - ~(O)II
where p = II Df(1l*)II/II Df(!J) 1\ . But from the strict concavity
of f, p < 1 and 11 ~(1)-~(0) I < II~* - ~(O)II, so the step to
~(1) is not "too" large so as to over step ~*. Hence f(~(l))
> f(~(O)).
Now assume that for some t = n, f(n) > f(n-1) > f(n-2) >
f(n-3) > ... > f(n-N). By exactly the same arguments as
above, !;n [~* - ~(n)] > 0, so g(n+1) is a direction with a
component along ~* - ~(nl and "towards" ~*. Furthermore,
11 ~(n+1)-~(n) 11 < II~* - ~(n)1I so that f(n+1) > f(n). Thus
f(n) converges monotonically to some upper bound, F, and
by continuity, ~(n) converges to some point .?i such that F
= f(.?i). To see that this upper bound is indeed f*, and that .?i
= ~*, consider (16) rewritten as
II!;nll[~(n+1) - ~(n)] = [f* - f(nl] !;n/ll!;nll.
In the limit as n -l 00, !;n -l Df(.?i), the lefthand side -l 0, and
!;n/lI!;nll -l 1. This implies f(~(n)) -l f* and continuity of f
implies ~(n) -l.?i = ~*. Q.E.D.
The model is thus capable of searching for the neoclassical
optimizing solution given reasonable starting values and
the omniscience to know the maximum attainable value of
the objective function. The learning and adaptation inher-
ent in the naive search scheme of (13) - (17) is sufficient to
seek out the optimum solution when f* is given.
It is unreasonable, however, to assume that f* is initially
available. In realistic situations this information must be
extracted from experience. It thus becomes critical to see if
the model can learn f* as the search proceeds. More specif-
ically, it is of vital interest to ascertain the interaction
between (13) - (17) and the learning and adaptation equa-
tions for asp-irations, (10) - (12). If only a reasonable initial
value for alO) is required, and not f* , then a much more in-
teresting model obtains - one with far more empirical and
theoretical poten tial.
At the present time a proof of Theorem 1 with a(O) = f*
replaced by a(O) > f(O) is not available. All that can be
offered here are the results of some simulation studies.
They are encouraging and demonstrate the considerable
capabilities of the model.
Simulation Example. A very ~ood two dimensional example
is found in Day and Tinney (1968). A firm seeks to maxi-
mize its profit through the manipulation of two decision
variables: X1(t) , its capital-to-labor ratio during period t,
and X2(t), its production level during period t. At the end
of each period the firm observes its profit f(~(t)) = f(X1(t),
X2(t)) = f(t) defined as:
f(~(t)) = lToX1(t)1-lT1 -1)Od(X2(t)_w2x1 (t))/WO]01
-1)02[(X2(t)w1X1 (t))/wO]02 - 500
01 = (1)11 + 1)/(W1 + W2)
~ = (1)12 + 1)/(W1 + W2)
and adds this to its information set composed of past oh-
servations on f(t) and ~(t). It then decides on new a value
for ~ and implements this for period t+ 1. The firm is not
assumed to have any information concerning the form or
parameters of the demand function and is not assumed to
know its supply function.
The difficulty presented to our model of decision making
can be gauged from the contour plot of f(~) displayed in
K. D. Wall
Fig. 1. Profit falls off rapidly for capital-to-labor ratios less
than 0.15 and production rates less than 15000 units. The
"ridges" encountered just prior to these two precipices of-
ten confound many search algorithms by inducing zig-zag-
ging behavior. More importantly, the profit function is
strictly concave only within a neighborhood of~* = [0.3067,
47,274.41 ]' (at which point f* = $183,662.7). Thus for large
values of Xl and X2, strict concavity does not hold.
The first experiment employs an initial aspiration level of
a(O) = $150,000 and initializing decisions of
x( 0 ) = [1.50, 89000]' ;
~(-1) = [1.55, 94000]' ;
~(-2) = [ 1.60, 104000]' .
The parameters for the adjustment equations (10) - (12)
are set at:
/3=0.10,
8 = 0.08,
r.p = 0.08,
'Y = 0.65.
Two restrictions are placed on ~(t) to capture some ele-
ments of realism. First, the firm is assumed to be unable to
reduce its capitaHo-labor ratio below 0.1 and drop
production below 14000 units. Second, the firm's speeds of
adjustment are limited. In anyone period it cannot change
its capital-to-labor ratio and its production by more than
10%. Thus the firm has to choose ~(t) subject to:
~(t) E $(t) = { ~(t): x1(tl ~ 0.1, X2(t) ~ 14,000
and ILlX1(t)/X1(t-l)1 ~ .1, ILlX2(tl/X2(t-1)1 ~ .1}.
Figure 2 displays the decision history in terms of X1(t)
versus X2(t). Figure 3 presents the decision variables as
functions of time, and Fig. 4 displays the behavior of a(t),
f( t), and the smoothed estimate of f as functions of time.
The process converges to the neoclassical optimizing solu-
tion after a period of search in which aspiration first rise
and then fall. Eventually aspirations match actual profit
and search action terminates.
It is interesting to note the behavior over time exhibited by
the decision variables. Figure 3 reveals some interesting
and varied patterns. First the variables change rather
smoothly as the region of the optimum is approached - this
appears much like that of the solution to linear optimal
control problems. Almost random behavior is apparent as
the model searches in the vicinity of the maximum when
aspirations are still high relative to what can be achieved.
As aspirations decrease in the face of frustration, search
activity decreases and finally terminates.
A much more interesting example is presented in Figs. 5-7.
Here a more realistic and challenging situation has been
simulated where the environment is no longer stable. Two
shifts in the , parameters of the profit function have been
introduced, corresponding to shifts in demand curve and in
the factor input supply curves. Over the period of the
simulation there are now three different maxima that must
be sought:
~* = [0.31,47274]', f* = $183663;
~* = [0.86 , 38893]', f* = $135660;
~* = [0.68, 80423]', r. = $254212.
In each case the model locates the maximum, however, the
decision variables now exhibit much more chaotic behavior.
As the environment becomes less stationary search must
stay more active and the decision variables have less
opportunity to converge.
ESTIMATION FRAMEWORK
For the model to be truly useful in empirical research it
must permit estimation and testing in conjunction with
 A Bounded Rationality Decision Process Model
time series data. This requires casting eqs. (9) - (17) in a
form suitable for econometric work and one framework
immediately suggests itself.
Equations (10) - (12) comprise a recursive system of linear
difference equations that bring to mind a state-space
approach employing a Kalman filter for generating model
residuals.
To see this, define as the state a 3xl vector, ll(t), where
ll( t) = [i( t), i( t), a( t )J'
and define 2i(t) to be a vector of (N+l) exogenous, or
predetermined, inputs:
2i(t) = [fit), f(t-l), ... , f(t-N); ,
~(t), ~(t-1), ... , ~(t-N)J .
A a state space form representation of the decision model
immediately results:
ll(t) = Fs(t-l) + Gz(t)
l:( t) = H(2i( t) )ll( t) + 12(2i( t))
where
(1-,8) 0 0]
E= [
0 (1-0) 0 ,Q = [,80 0 0 ... 0]
-0 0 ... 0 ,
<.p / (l-cp) 0 0 0 ... 0
J:!(2i(t)) = [ Q : Q : ctlll!;tlI2J,
I2(2i(t)) = [~(t-1) - f(t-l)!;tlll!;tlI2J
and l:(t) = ~(t). The state space model is linear in the state
but time-varying in the output equations because of the
terms involving !;t!II!;tIl 2. It should be noted, however, that
this time variation in the coefficient matrix H is due solely
to exogenous variables and may be treated as predetermin-
ed, Estimating the model can be accomplished by a number
of techniques, for example that used in Burmeister, Wall,
and Hamilton (1986) , Kalaba and Tesfatsion (1980,1988),
or Pagan (1980). If one is willing to state stochastic
hypotheses regarding additive disturbances in (18) - (19) ,
then a Gaussian likelihood function can be postulated and
the methods of the first and last references above apply. If
one does not wish to introduce additive random errors then
a least-squares approach can be taken and the methods of
Kalaba and Tesfatsion applied. In either case, the methods
are well developed , tried and true.
DISCUSSION AND CONCLUSIONS
The primary purpose of this paper is the presentation of an
operational model of boundedly rational decision making
that can be used in empirical studies of dynamic economics.
The model's main attributes are: (1) its inherently dynamic
nature, for it naturally explains the dynamic evolution of
decsions by framing them in terms of difference equations;
(2) its ability to depict both neoclassical optimizing
behavior and non-neoclassical suboptimizing behavior; (3)
its very modest assumptions concerning the information set
in the possession of the decision maker; (4) its very modest
demands on the computational and cognitive abilities of the
decision maker; and (5) its explicit incorporation of
learning and adaptation and the simple mechanisms by
which this takes place. Learning and adaptation is the
dominant component in the model, for it determines
whether one obtains the optimizing solution or a
suboptimal result. The former may be charcterized as a
special limiting case where , given a stable environment and
sufficient time, learning and adaptation is adequate to
guide the search to the overall maximum. Suboptimaization
occurs when learning or adaptation allows aspirations to
converge too rapidly to the actual objective function value
thus terminating search prematurely.
The model is but one operationalization of the key
mappings in eqs. (2), (3), and (6). Other operationaliza-
477
tions can be specified, but the ones presented in this paper
are believed to be the most simple. Even so, these simple
specifications, when coupled with learning and adaptation
demonstrate almost amazing abilities.
A number of questions are to be investigated in the near
future. First there is the proof of convergence to the
neoclassical optimum when a(t) is not fixed at h. The
convergence of the algorithm has been demonstrated in
simulation, but is seen to depend in a complicated way on
a(O), the parameters ,8, /, 0, and cp, and the specification of
$(t). A proof appears possible with the aid of a theorem on
algorithmic convergence by Zangwill (1967, Chpt. 11).
Next there is the investigation of the effects of a changing
environment. The second example shows the algorithm
capable of finding new optima as the environment
undergoes shifts. It seems important to establish if limits
exist to the ability of the model to learn enough to keep
pace with rapidly changing environments. For example,
"At what 'speed' of change in the environment does the
model be~in to lose its ability to 'catch up' with the
optimum? '
(18)
Finally, there are a number of normative questions that the
(19)
model can be used to answer. For example, if we assume a
boundedly rational decision maker, as above, how can the
information set be ammended to help the decision maker
converge more rapidly to the maximum. In a rapidly
changing environment, how can the information set be
altered to aid in tracking the optimum and, hopefully , in
catch up with it? In other words , what can be done to
increase learning and speed adaptation? The mod el appears
ideally suited to help in answering these and similar
questions.
Actual use of the model in macro- and micr~conometric
studies has yet to be done. It is hoped that the inherent
dynamics of the model will make it ideal in explaining why
"getting there is half the fun". It may yield useful
econometric estimates of speeds of adjustment and
explanations of the ability of an industry to compete in a
changing world economy , or of the response of a national
economy to shocks in world supplies of energy and capital.
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GAUSS War. 2~ . 1969 11 :00:25 AlII

PROFIT CONTOURS ($1000)

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Figure 1: Profit Function Contours