Inductive Reasoning, Bounded Rationality and the Bar Problem

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 an “ecology” that does converge to an equilibrium pattern.