Peak performance

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The idea of rational profit- and utility maximisation is prominent in economics, but was challenged by Herbert Simon, a winner of the Nobel Prize in economics who died in February. Instead Simon emphasised the idea of bounded rationality in economics. This article explains why that approach deserves to survive its author.

Herbert Simon, who died last month, was an unlikely winner of the Nobel Prize for Economics. He occupied a chair in computer science and psychology. He wore his wide scholarship lightly and made imaginative contributions to every subject he touched. His most important work was probably in the field of artificial intelligence.. In 1978, the Nobel Prize committee chose to honour for challenging the most fundamental premise of economics – the notion of rational, calculating, optimising behaviour. For Professor Simon the notion that companies maximised their profits was absurd, because they could not possibly have the information they would need to do so. What people cannot do, they will not do, was his mantra.

Professor Simon would sometimes use the following powerful analogy. Imagine being told to go to the highest point in England. You would need to survey the whole country. Even after you had located Scafell Pike, you would not know it was the highest point in England until you had been everywhere else.

This objective is obtainable because the Ordnance Survey has done all that laborious work. But while the topography of England is more or less static, the business environment is not. By the time you have found the highest point, it will probably have ceased to be the highest. And there is worse in store. Suppose you located the highest point, and it remained the highest point for long enough to get there. When you arrived, you would find everyone else there as well. The instruction to maximise profits is not implementable and if it were implementable would prove self-defeating.

If all companies have the same objective – to maximise their profits – won’t they all do the same thing? We know the answer – different firms start from different places – but the implications are profound. Professor Simon argued that although it is not realistic to look for the highest point in England, there is a closely related problem that has a solution. Suppose that you are simply asked to make your way to the top of a hill. There is an easy rule that will achieve that result. Keep walking uphill until it is impossible to walk uphill any more.

The business landscape looks like Professor Simon’s picture. BP Amoco is at the top of one mountain, and GlaxoSmithKline near the summit of another. My local newsagent is located on a small mound. Companies do not maximise. They try to find something better than their starting point. They do not survey the entire landscape, they walk uphill.

Simon called this “satisficing”. And he coined the phrase “bounded rationality” to describe the process of choosing the best of the very limited range of options companies have at any time. Within the framework of bounded rationality, many business puzzles fall into place. What could Sir Peter Bonfield mean when he says British Telecommunications paid too much for its mobile phone licences?

But Professor Simon would have understood Sir Peter’s dilemma perfectly well. The prices paid for these licences were absurd. But BT simply did not have the option of dropping out of the race for third generation services in Europe. BT made a bad decision but it was still the best decision the company could have made. We must settle for “satisficing” because our options are constrained not just by the limits of our own knowledge but by the beliefs and actions of others.

The most difficult lesson for the economist in business to learn is that it is easy to be too rational for one’s own good. It is only having discovered that through hard experience that I have come to understand how important Professor Simon’s contribution was. Rationality must always bounded.

What is true of our business lives is true of our everyday activities as well. We do not maximise our utility, as rational economic man is supposed to do. We wouldn’t know how to if we tried. Research on real people shows that most of us have aspirations not very different from our achievements. We are satisfied with our lives if one is in line with the other, even if the levels of both are low. Happy people are mostly to be found sitting on the tops of small hillocks, and are content to be there.

There are some people who are searching for the highest point in England and it is probably good for society that there are. But it is probably not good for them. Some will struggle to the top of Scafell Pike, but more of them are tired and lost in the valleys, taking Prozac.

Herbert Simon believed we should base our analysis on the observed realities of business and personal decision making, rather than on the folk psychology described by “the profit motive” and “rational economic man”. It is an argument that deserves to survive its author.

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