Bounded Rationality in Industrial Organization

Several approaches to modeling irrationality can be taken: one can specify rules of thumb,
behavior can be derived as the maximizer of something other than utility/profits; or one can
explicitly introduce cognitive bounds. I’ve stressed two advantages of boundedly rational
approaches: boundedly rational behavior seems more realistic in some applications; and the
tractability of boundedly rational models can sometimes allow researchers to incorporate
additional features into a model. For the next few years at least there is probably also a third
important advantage: after twenty-five years of focusing on rational models, the questions
rational models are best suited to address have been much more thoroughly explored than
questions best addressed in boundedly rational models.
I’ve noted that the current literature on boundedly rational industrial organizaiton
seems to be proceeding along two different branches. One easy way to give advice for the
literature is to suggest that each branch adopt attractive features of the other. In many
papers in the IO branch, the particular form of the departures from rationality is motivated
by little more than the author’s intuition that the departure is plausible. More reliance
on empirical and experimental evidence could be a significant improvement. A relative
weakness of the psychology and economics branch is that the papers are less informed by
the existing IO literature on the topic and don’t live up to existing IO norms in terms of
incorporating consumer heterogeneity, imperfect competition, price discrimination, etc.
Which of the branches of boundedly rational IO is likely to be most successful in the
coming years? Let me say first that I think in the long run the two branches will come
together. Until they do, I think that having both is valuable. My answer to the question of
which will be more successful in the next few years depends on the meaning of successful. If
successful means advancing the IO literature I think the answer is the first branch. Delving
into the IO literature and focusing on topics where the existing explanations are lacking
is the most efficient way to improve a literature. If success is measured by publications or
citations, I think the answer is the second branch. I noted earlier that an attractive feature
of the psychology and economics literature is that the models developed in papers like
Laibson (1997), Fehr and Schmidt (1999), and Eyster and Rabin (2005) are mechanically
very much like rationality and can be grafted into just about any model. This creates many
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