On the Contributions of Herbert A.

Simon to Economics
Author(s): Albert Ando
Source: The Scandinavian Journal of Economics, Vol. 81, No. 1 (1979), pp. 83-93
Published by: Wiley on behalf of The Scandinavian Journal of Economics
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 ON THE CONTRIBUTIONS OF
HERBERT A. SIMON TO ECONOMICS

Albert Ando

University of Pennsylvania, Philadelqhia, Pa., USA

I. Introduction

The contributions of Herbert A. Simon are extremely vast and diverse, ranging
from philosophy and methodology of science, applied mathematics, through
various aspects of economics, computer science, management science, political
science, cognitive psychology to the study of human problem-solving behavior.
What makes his work truly remarkable is that he not only has had something
fundamental and original to say in almost all of these areas, but he developed
almost all of his many ideas precisely and far enough to serve as a basis for
empirical work, which he himself has undertaken on many occasions. Today,
in many of these areas, we can recognize the characteristic stamp of Simon's
work imbedded in their basic body of knowledge.
Given this vastness and diversity of Simon's contribution, it is obviously
impossible to summarize it in a few pages. Throughout his writings, however,
there runs a consistent theme: to construct a comprehensive framework for
modelling and analyzing the behavior of man and his organizations faced with
a complex environment, recognizing the limitation of his ability to comprehend,
describe, analyze and to act, while allowing for his ability to learn and to
adopt. This limitation of human abilities is crucial not only in determining
the behavior of many and his society, but also in formulating the methodology
of science becaause the scientist is also a man with limited intellectual
capacity.'
In this review of Simon's work, I shall attempt to illustrate how the applica-
tion of this theme to four quite different areas has led Simon to critical
contributions in each of these topics. The first is the problem of describing
the goals and criteria of the decision maker in some approximate manner
which makes it possible to solve the decision problem. The second is a discus-
sion of the relationship between the dynamic adjustment processes in economics
and the study of the limits of man's capacity to adapt to complex changes in

1 In his Karl Taylor Compton Lectures at MIT, which was later published as The Science8
of the Artificial, Simon stated his basic view of human behavior as a hypothesis: "A man,
viewed as a behavioral system, is quite simple. The apparent complexity of his behavior
over time is largely a reflection of the complexity of the environment in which he finds
himself" (p. 25).

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 84 A. Ando

environment. The third is the strategy of how approximately to describe the

environment so that it is both comprehensible and manageable for decision
makers. The fourth is the validation and discovery of scientific hypotheses,
with an example taken from Simon's work on the size distribution of firms,
income, city sizes, and other social entities.
It should be emphasized that these four topics are not meant to cover most
of Simon's work, not even the most important ones. They are, instead,
illustrations of Simon's work with his characteristic originality and his view
of human behavior, taken from areas that are most familiar to economists.'

II. A Simplified Criterion Function and its Implications:

Certainty Equivalent Theorem

In the well-known work by Simon and his coauthors, a solution to the problem
of scheduling production, the work force, and inventories to meet uncertain
and fluctuating demand over time is decsribed in detail.2 For an abstract
theorist, the problem is a fairly simple one. Information about sales for future
periods can be summarized as a joint probability distribution. The cost
function is assumed to be known, however complex. Thus the problem becomes
one of dynamic programming, in which the total expected cost is minimized
subject to the probability distribution of sales, the relation between production
and the work force, and the identity among sales, inventory and production.
The theorist can then write down a set of conditions under which a solution
to this problem would exist, and perhaps characterize the nature of the solu-
tion.
But the manager who is faced with the problem of deciding how many
workers to hire and at what level production should be maintained for the
initial period must go beyond the mere existence and qualitative charac-
terization of the solution. He needs a concrete decision rule which translates
the initial conditions and information about future sales into employment
and production with reasonable effort within reasonable time. In general, the
dynamic programming problem arising from the situation of this sort involves,
at best, such an enormous amount of computation that it cannot easily be
solved for all practical purposes, even with the aid of today's most powerful
computer, or any computer that may become available in the foreseeable
future.

1 The work of Simon best known to economists, that on the logic of rational decis
and of heuristic decision making, sometimes referred to as the theory of bounded
rationality, is summarized in the companion review article by William Baumol. Probably
the most ambitious undertaking by Simon to model human problem solving behavior is
reported in his monumental book with Allen Newell entitled Human Problem Solving.
Although his findings reported in this book are of major potential importance to
economists, they are at such a micro level that most economists are likely to find them
somewhat remote from their everyday concern. See also Simon (1976), listed in the Biblio-
graphy.
2 Holt, Modigliani, Muth & Simon (1960) and (1956), listed in the Bibliography.

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 On the contributions of Herbert A. Simon to economics 85

In this situation, Simon saw that, if the cost function can be approximated
by a quadratic function, the probability distribution of the future sales can be
replaced by its first moments and the problem can be enormously simplified.
This proposition has become known as the "Certainty Equivalent Theorem".
Given this particular feature of the problem, the remaining problem is whether
or not some quadratic function can serve as a satisfactory approximation of
the true cost function. Since the true cost function is not known with
certainty, the manager and researchers must answer this question through a
variety of informal analysis.
Once the certainty equivalent theorem was understood and the decision
was made that a particular quadratic function is a "satisfactory" approxima-
tion, then the minimization of this "approximate" cost subject to the con-
straints mentioned earlier can be carried out relatively easily. The desired
decision rule can then be formulated.
In this example, the final result appears as though it is an application of
the maximizing principle, but in a very critical way it is not. We do not
know how good the quadratic approximation to cost really is. We do not even
know that a particular quadratic function chosen by the team of researchers
is the "best" among all possible quadratic functions. Hence, in spite of a
maximization technique used to complete the solution, the solution described
by Holt, Modigliani, Muth and Simon is not a solution ot the maximization
problem in the sense of classical economics, but a "satisficing" solution.
Hence, Simon and his colleagues stressed the importance of continually
checking how satisfactorily the decision rule is performing in each practical
application of this procedure.
The crucial point of this example, however, is that the decision maker
could not have obtained a straight maximizing solution even if he tried.
First, he would not have been able to write out the exact cost function and
the exact description of constraints (probability distribution of all future sales).
Secondly, even if he succeeded in writing out the "true" problem, the
maximization of the "true" problem would have been beyond his computa-
tional capacity however augmented by, say, the most powerful computer that
may become available in the foreseeable future.
Hence, in order either to describe the behavior of a decision maker faced
with the problem like the one in the above example, or to assist him in im-
proving his performance, the researcher must understand, in addition to the
formal theory of maximization proper (the choice among known alternatives),
the process by which alternative decisions to be considered are generated as
well as the characteristics of efficient and feasible computational procedure
involved. This is one aspect of the basic message of Simon, one that most
economists, particularly those who have attempted to serve and advise
businessmen and government officials, can readily appreciate.

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 86 A. Ando

III. Adaptive Behavior and the Dynamic Adjustment Process

If the ability of individuals and organizations to comprehend, describe, and

respond to their environment is without limit, then their behavior reflects
nothing but their goals and the characteristics of their environment. If any
change occurs in the environment, such a change will be instantaneously and
completely reflected in the behavior of the decision makers concerned. The
comparative static analysis of economics clearly depends on this assumption,
and discussion of growth paths described in the literature of neoclassical
economics also takes this assumption for granted. But we know that, at
least some of the time, economic agents do not respond to changes in the
environment instantaneously and completely. While some of these delays
may reflect the proper maximizing response to uncertain signals of the
environment, at least some of these delays simply reflect the inability of
decision makers to comprehend the change in enivronment accurately, to
compute the new maximizing response, and then to act immediately. This
last type of delay is the prime cause of the dynamic adjustment process of
economics, and it is the type of behavior which applied econometricians are
forced to deal with often, without much guidance from economic theory for it
proper formulation.
Because economists are accustomed to formulating all behavior of decision
makers as a constrained maximization problem, the initial inclination of
economic theorists in their attempt to deal with the dynamic adjustment
responses of decision makers is to formulate a new, more complex constained
maximization problem in which the cost of adjustment depends on the speed
and other details of adjustment. We have just noted, however, that at least
some of the delays in decision makers' response to changes in environment
are simply the reflection of the inability on the part of decision makers to
comprehend the change in the environment, to carry out the necessary com-
putations to select the new maximum, and to act promptly upon the new
decision. Then any attempt to describe dynamic adjustment behavior in
general as the consequence of solving an augmented constrained maximization
problem incorporating adjustment costs is doomed to failure. This is because
the maximization problem incorporating the adjustment costs by definition
must be substantially more complex than the original one. Surely, we cannot
suppose that decision makers get around the difficulty of their inability to
solve a maximization problem by solving another, much more difficult one.
Simon not only recognized this problem but also went on to formulate
a very different theory of human problem solving behavior that explicitly
recognizes the limitation of human ability to adapt to changes in environment.
His findings and theory, reported in his book with Allen Newell, Human
Problem Solving, is formulated for the behavior of individuals in the context
of laboratory experiments, and therefore it cannot be directly used to handle

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 On the contributions of Herbert A. Simon to economics 87

behavior of economic agents in real markets or other very complex situations.

The task of extracting implications about market and nationwide economic
behavior from such micro findings through complex processes of aggregation
will be extremely difficult, and will not be accomplished overnight. Even for
this purpose, however, Simon has made some beginning in organizing an
analytical framework, as I shall indicate in the next section. Thus, his work can
serve as the starting point for our understanding of the basic characteristics
of partial and delayed responses of economic agents to complex changes in
their environment. Simon's work in this area, therefore, is a unique and
singularly important contribution to the understanding of dynamic adjust-
ment processes in society.

IV. Simplified Description of Environment; Near Decomposability,

Hierarchical Structure, and Causal Relationships'

As we have indicated earlier, Simon visualizes the study of man's adaptation

to a very complex environment as the central issue of the social sciences.
Given this vision, it is natural that he is concerned with the problem of
describing man's environment approximately, and as simply as possible, while
retaining its critical features. It is important for descriptive purposes since
man's behavior obviously depends on his understanding of the environment;
and for normative purposes because an accurate enough description of the
environment is the first step in prescribing "optimal" or "satisfactory"
decision rules.
Very early in his career Simon noted that the description and analysis
of very complex systems can be enormously simplified if the whole system
can be divided into a number of subsystems in such a way that each subsystem
can be analyzed independently of one another. For the purpose of understand-
ing more macro relationships, each subsystem may be represented by an
aggregate variable so that the relationships among the subsystems can be
analyzed without explicit attention being given to the internal structures of
the subsystems. He observed that this type of simplification is quite common
in the natural sciences, where an analysis of a macro structure often takes
micro structures as given elements, while in an analysis of micro structures
the interactions among very distant objects are ignored.
He then recognized that the possibility of this simplification depends on our
ability to arrange elementary variables of the system in such a way that each
elementary variable belongs to one, and only one, group of these variables.
Relationships among the variables within a group are then very much stronger
than relationships between any pair of variables not belonging to the same

1 See Simon (1952), Simon (1953), Simon & Ando (1961), and Simon (1962), listed in the
Bibliography. For another, somewhat related idea on causality among economic rela-
tionships, see Wold (1949).

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88 A. Ando

group. Simon initially considered the limiting case in which weaker rela-
tionships among elementary variables are exactly zero's. This led him to a
definition of causality among variables in scientific discussion and a reinter-
pretation of identification conditions in simultaneous equations estimation
procedures.
A few years later, Simon took the critical step of replacing zero's for
relations between any pair of elementary variables belonging to two separate
subsystems by epsilon's (8's) representing a very small interaction between
them compared with interactions among variables belonging to the same
subsystem. He also understood more explicitly the system under considera-
tion as a dynamic one.
Let us call the earlier, exactly decomposable system A, and the second, only
approximately decomposable system B. Simon was then able to prove several
propositions, the most important of which are the following: (1) Provided that
the e's are small enough, if the subsystems of A are stable, then the subsystems
of B are also stable, and the subsystems of B will reach internal equilibria
which are approximately the same as those of A in the short run; and (2) over
a much longer period, subsystems of B will interact with each other and
gradually approach the overall equilibrium position of the whole System B,
while maintaining the internal equilibrium position of each subsystem.
These results serve as the justification for a particular way of approximately
describing the complex environment faced by human problem solvers. In the
short run (depending on the size of the 8's), we can approximate the more
complex system B by system A, and treat each subsystem as though it were
independent of the others. In the longer run (again depending on the size of
the e's), we can represent each subsystem of B by an aggregate variable and
consider relations among these aggregate variables without paying explicit
attention to the internal structure of each subsystem. We should note that this
hierarchical structure of the world need not be limited to two tiers, but can
be of many layers for a very complex system.
Hence, if man's environment is indeed capable of being described as nearly
decomposable, then, as the system becomes more and more complex, the
number of variables that the decision maker must deal with at any one
time need not necessarily increase. A greater complexity of the system can
be viewed as a larger number of layers, and hence would not necessarily
results in much greater complexity of the problem with which the decision
maker must be concerned at any one point in time.
Simon believes that man's environment does indeed have a nearly de-
composable representation most of the time, and speculates on reasons why
nature and society naturally tend to form such a structure.' While this is a
strong hypothesis, it does enable ordinary decision makers to cope with their

1 Simon (1962) and (1969), listed in the Bibliography.

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 On the contributions of Herbert A. Simon to economics 89

environment, and scientists to proceed with their task of describing and

analyzing both natural phenomena and human behavior. Indeed, scientists
have almost always acted as though they believed in this hypothesis. Simon's
contribution, therefore, is to have made explicit conditions under which this
very common way of approximating the environment can be justified. He has
thereby provided important guidance for future theorizing not only in the
social sciences but also in the natural sciences.

V. Validation and Discovery of Scientific Hypotheses,

with an Illustration from Studies of Size Distribution

A sciensific hypothesis does not arise from a complete vacuum. Usually, a

scientist, or a generation of scientists, notice some regularity in the data
generated by nature, and summarize it as a simple generalization (hypothesis).
Such a generalization is seldom exactly true, but a rough approximation to the
reality. With such a hypothesis in hand, the scientist is interested in a number
of questions, such as "is the degree of approximation of the hypothesis to the
reality good enough for the purpose at hand?" and "what causes the discre-
pancies between the hypothesis and observed facts?" The importance of the
former in evaluating the value of scientific propositions is obvious, while the
endeavor to answer the second, by finding limiting conditions under which
the deviations of facts from the hypothesis might be expected to decrease,
occupies the most of the scientist's time, and the progress of our scientific
knowledge depends heavily on the success of this endeavor.
At this point, if the scientist applies the standard statistical testing
procedure to his hypothesis, it is certain that any hypothesis of this type will
eventually be rejected at any level of significance as the sample size increases,
however close the original approximation may have been. For, the standard
statistical testing procedure is designed to answer the question: "how likely is
it that the deviations between the hypothesis and the observed data have
arisen by chance alone?". Answering this question does not contribute much
to our ability to judge whether the hypothesis is a satisfactory enough approxi-
mation, nor does it suggest limiting conditions under which the deviations
between observed facts and hypothesis might become smaller.
This methodological problem has been well known to mathematical sta-
tisticians and to experienced scientist.' Natural scientists faced with this
problem often resort to two sources of information that have proved helpful
in suggesting limiting conditions. One is to perform more carefully controlled
experiments, with more accurate measuring instruments. The second is to
organize an "explanation" why the hypothesis should fit the observed facts
under a set of ideal conditions. For economists, however, the first of these

1 See, for example, Savage (1954), pp. 254-256.

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 90 A. Ando

alternatives is usually not available, because controlled experiments are

difficult to perform in economics, certainly in practice and often even
conceptually. Thus, the problem of making initial empirical generalizations
and then systematically improving them in the light of observed facts is a
particularly difficult one for economists. Yet, economists have not paid as
much attention to the logical structure of this process as they should have,
and their failure to understand this logical structure is one of the most im-
portant reasons for current confusion about interpretation of econometric
studies, and for the lack of communication between econometricians and
economic theorists.
Simon not only saw this problem clearly beginning in 1943 before the
great advances in econometrics took place, and articulted the nature of the
difficulty, but he also laid out informal guidelines that social scientists can
observe in their empirical researches in the absence of a major development in
statistical theory to remedy this difficulty.' His thinking on these questions is
summarized in his essay, "On Judging the Plausibility of Theories".2 While
Simon's statement in this essay is no more than a summary of principles
followed by the best empirical scientists (both natural and social) implicitly
or explicitly over several centuries, it is probably one of the best and briefest
statements of the principles available in the literature, particularly for social
scientists. It should be noted that Simon's concern with this problem and
his ideas on how to resolve it is consistent with his basic view of how a human
problem solver would describe his complex environment, applied to scientists.
Therefore, it is also closely related to his discussion of complexity summarized
in the preceding section of this review.
Beginning in the mid 1950's, Simon undertook a research project on size
distributions of, among other things, firm sizes, city sizes, income of individuals
and word counts which has served to illustrate the methodological point
discussed above.3 Physical nature as we observe it contains many well defined
patterns, providing natural scientists with obvious starting points for their
theorizing about nature. Such well-defined patterns are quite rare in data
generated by social phenomena.
The observation that the size distribution of many things can be very
accurately described by certain types of skew distributions is one of very few
exceptions. That is, suppose one ranks many things, such as the income or
wealth of individuals in a given population, the size of firms in an economy
or an industry, the frequency of words used in a book, the size of cities in a
given geographical area, etc., and plot the logarithm of the size on the vertical
axis against the logarithm of the rank on the horizontal axis. We then find that

1 Most of Simon's work on this subject is collected in Simon (1977); see in particular
Section I of this volume.
2 Simon (1968), listed in the Bibliography.
3Simon (1955) and Ijiri & Simon (1977), listed in the Bibliography.

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 On the contributions of Herbert A. Simon to economics 91

the observations line up very closely on the linear line with the slope of
negative unity.
That the relationship is linear and has extremely close fit in many cases is
striking enough, but the additional fact that the slope is very close to negative
unity makes this observation an obvious and striking candidate for an
empirical generalization. Yet it is not an exact relationship, and hence it
also calls for specifying some limiting, ideal set of conditions under which the
deviation of observed data from this distribution would tend to vanish. For
this purpose, Simon sought to construct an "explanation" of why the size
distribution of so many different phenomena should take this particular
form. Because the same regularity of patterns appears among so diverse
phenomena having no obvious common mechanism, Simon suggested chance
operating through the laws of probability as a plausible candidate for explain-
ing this regularity.
It was known for some time, due to the work of Yule and others, that the
simplest kind of stochastic process that will yield skew distributions described
above as the steady state distribution is based on the following assumption,
known as the strong Gibrat assumption (taking the case of the distribution
of the size of firms as our example):

Year to year changes in firm sizes are goverend by a simple Markoff process in
which the probabilities of the size changes of any specified percentage magnitudes
are independent of a firm's present absolute size.

In this strong form, it is fairly easy to point out instances in which the
actual growth behavior of firms contradict this assumption. In a series of
articles beginning in 1955, Simon was able, for purposes of deriving the Yule
distribution as the steady state distribution, to replace the above assumption
by a much weaker one in which the expected percentage change in the size
of the totality of firms in each size stratum is assumed to be independent of
stratum. This "explanation" or theory enabled Simon and his later collabora-
tor, Injiri, to look for situations in which the basic distribution would fit
particularly well, and to predict specific departures of data from the basic
distributions when the underlying assumptions are known to be violated in a
certain way.'
Simon began his work on the size distribution as that of identifying a
striking regularity of empirical observations and providing scientific explana-

1 In the case of word counts, Benoit Mandelbrot proposed an entirely different explana-
tion for its observed skew frequency. It involved the assumption that the frequencies
are determined so as to maximize the number of bits of information, in the sense of
Shannon, transmitted per symbol. It seems that Mandelbrot's assumption is open to a
number of serious doubts and in any case it cannot be generalized to phenomena other
than word counts, and therefore of no interest to economists. I mention Mendelbrot's
work here only because the controversy between Simon and Mandelbrot on the subject of
word counts was rather famous in the 1950's. See Mandelbrot (1959) and Simon (1960),
listed in the Bibliography.

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92 A. Ando

tion (defining exact conditions under which such a regularity should be

observed). But we can easily imagine that, particularly in the case of the
size distribution of business firms, he found this particular line of inquiry
congenial. For one thing, his theory does not require, although it is consistent
with, any sort of maximizing behavior on the part of agents whose size
distribution Simon's theory describes so well. In the second place, this theory
can be viewed as the confirmation of the constant returns to scale for firms (as
distinct from plants), and yet still manages to describe the size distribution
among firms in each industry as well as in the whole economy. This contrasts
very sharply with the classical theory of perfectly competitive markets. In
the classical theory, in order to determine firm sizes, one must assume that
decreasing returns to scale sets in at some point for firms. While most
economists would agree that there are any number of reasons why plants
may be subject to decreasing returns, it is not easy to identifiy acceptable
reasons for decreasing returns for firms. Furthermore, even if we are prepared
to accept that decreasing return does set in at some point, classical theory
would imply that the distribution of the size of firms in any industry should be,
if anything, of even shape, and certainly not that it should be skewed. It is
therefore not surprising that Simon's is the only theory for the explanation
of observed skew distribution of size frequencies that seems both plausible and
is internally consistent.

VI. Conclusions

Simon's scientific contribution, from the point of view of economics, has been
to work out the implications of recognizing the limitation of man to
comprehend, to adapt to, and to affect his environment completely and
instantaneously, as largely assumed in classical economics.' In this sense,
Simon has not tried to replace the existing economic theory with something
alien to it, but rather he has attempted to modify and to generalize it so
that it fits better the real behavior of man and his organizations. In the
process, Simon has exhibited almost unparalleled originality, profound ana-
lytical insight, and an extraordinary ability to extract information from a vast
quantity of data. Among hundreds of items in his bibliography, there are
necessarily some duplications, but there is no item that is either trivial or
otherwise unworthy of a true scientist.
Before him, J. M. Keynes introduced into economics an explicit recogni-
tion that equilibration of markets does not take place instantaneously, that
some price and quantity responses are slow and imperfect, and thus reformu-
lated economic theory-with a macroeconomic emphasis. We can recognize

1 His name is often associated with the notion of "bounded rationality" but his contribu-
tion is far broader than this term indicates, as I have tried to indicate in this review.

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 On the contributions of Herbert A. Simon to economics 93

some parallel between the works of these two men. Simon, however, starts his
reformulation as well as his empirical work at a much more micro level of
individuals, small groups, and organizations such as business firms. Because
at these micro levels theoretical structure is almost necessarily more tedious,
Simon's influence has been slower to penetrate the works of others than
Keynes' was. Also, Simon has not been as active in the formulation of
economic and social policy as Keynes was, and hence he is less well known
publicly.
On the other hand, Simon has paid much closer attention and devoted
a great deal more time and energy to the development of methodology and
to actual empirical work, and therefore it is much easier for serious economists
to take advantage of Simon's initiative and build on it than it was in the
case of Keynes. Simon has not shown any sign of slowing down in his serious
work, and it will be many years before we can evaluate his work in its
entirety. But even now it is already clear that his contribution has been and
will be, directly or indirectly, an important ingredient in every future
economist's knowledge. It will become more and more important and more
and more explicitly recognized as time goes on.

References

Champernowne, D. G.: A model of income Wold, H. 0. A.: Statistical estimation of

distribution. Economic Journal, June,
1953.
Mandelbrot, B.: A note in a class of skew
distribution functions. Information and
Control, pp. 90-99, 1959.
Savage, L. J.: The Foundation8 of Stati8tics.
John Wiley & Sons, New York, 1954.
Simon, H. A.: See the following Bibliogra-
phy.
economic relationships. Econometrica,
Supply. July, 1949.
Yule, C. U.: A mathematical theory of
evolution, based on the conclusions of
Dr J. C. Willis, F.R.S., Philosophical
Transactions, B. 213, pp. 21-83, 1924.

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