Inductive Reasoning, Bounded Rationality and the Bar Problem

Abstract

This paper draws on modern psychology to argue that as humans, in economic decision contexts that are complicated or ill-defined, we use not deductive, but inductive reasoning. That is, in such contexts we induce a variety of working hypotheses or mental models, act upon the most credible, and replace hypotheses with new ones if they cease to work. Inductive reasoning leads to a rich psychological world in which an agent's hypotheses or mental models compete for survival against each other, in an environment formed by other agents' hypotheses or mental models---a world that is both evolutionary and complex. Inductive reasoning can be modeled in a variety of ways. The main body of the paper introduces and models a coordination problem---``the bar problem''---in which agents' expectations are forced to be subjective and to differ. It shows that while agents' beliefs never settle down, collectively they form and ``ecology that does converge to an equilibrium pattern.

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