Bounded Rationality in Industrial Organization

oundedly rational counterpart. Next year is the 50th anniversary of Strotz’s (1956) seminal
work on time inconsistency. The rule-of-thumb approach is even older. The application of
these ideas to industrial organization has waxed and waned, but by now it amounts to a
substantial literature.
I begin this essay with a discussion of several old literatures. I do this both because
I think it is useful to recount what happened before 1990, and because it provides an
opportunity to explain what the different boundedly rational approaches are, what are
their strengths and weaknesses, and where they have been most successful. I think all
three methodologies are useful and that anyone interested in boundedly rational industrial
organization should be fluent with each of them.
I then turn to the more recent literature on boundedly rational IO. Here, I see the literature
as having divided into two main branches. The first is growing out of the industrial
organization literature. Papers in this branch typically begin with one of two observations:
the IO literature on some topic is unsatisfying because aspects of the existing rational models
aren’t compelling; or the IO literature has had little to say about some topic (perhaps
because rational modeling would have been awkward). They then propose models with
some boundedly rational elements and discuss how they add to the literature on the topic.
The second branch is growing out of the psychology and economics literature. Papers in this
branch typically start by noting that the psychology and economics literature has shown
that consumers depart from rationality in some particular way. They then explore how a
monopolist would exploit such a bias, what the effects would be under competition, etc. I
provide overviews of each of these literatures and discuss some general themes.
Readers of this survey will note that the literatures I discuss remain sparse. Most
topics in IO have little or no boundedly rational work on them. Most behavioral biases
have received little or no consideration in IO, and even when they have been discussed it
is only the most basic IO questions that have been asked. This makes it an exciting time
to work in the field.
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