When we speak about bounded rationality theory, we are dealing with the behavioral finance and the different psychological biases exhibited by human beings' behaviors. These biases explain some of the different well known anomalies and imperfections in financial markets.

Differences between theory and reality are not the fault of the reality, as market "anomalies" make believe. But are the fault of the theories. Economists are very clever in rerversing cause and effect. The appropriate route is "from homo economicus to homo sapiens".

The attached may be of some use. The boundaries to rational valuation models, the constraints on the information sets those models/theories have to operate on, is typified by macro-financial behavior observed in US equity markets. Companies buy back their stock in progressively increasing quantities over economic and market booms.This is elaborated in the attachment. Again, at a macro-level, they are forced to sell stock after large market declines, thus exaccerbating the dilution of EPS, etc that occurs with SPOs anyway. Cooper (2008) describes this 'anomalous' behavior (anomalous here being used to describe 'inconsistent with popular EMH understandings'). I go into a fair deal of detail in the attached chapters but, in broad strokes two of the three main theoretical candidates of corporate fianncial structure struggle to accomodate the observations presented in the chapters attached (trade-off and Pecking order theories) and the third, market-timing theory, fails completely. I adavnce an alternative theory and hope (and to some lesser extent) believe it fills in aimportant gaps in this area. you also getting a half-decent summary of existing theory in these chapters.

There may be something of use in the attached

Bounded rationality is seen in US Equity markets in the progressive company repurchase of equity as markets rise and increasing issue of new equity in falling markets. The limits to rationality encourage companies to view a rising market as evidence for the assumption of future rises. In this context equity is implicitly expensive relative to debt financing. This leads companies to increase debt (and reduce equity, consecutive with rising markets. Balance Sheet consolidation forces companies to pay down debt after substantial and sustained market falls. In simple terms, the market discounts price trend reversal, acting as though any trend of all but the most modest duration, provides a basis for forecasts. I.e. a rising market will continue to rise, a falling market will continue to fall. Because markets do experience recurrent collapses and because selling equity at subdued prices exaccerbates the dilutionary effects of equity issue more generally (you have to sell more to get the same injection of capital) this is not optimal. However, just as long as markets rise it works well for the company as EPS and other fundamentals improve on the back of relatively (to equity) cheap debt financing. Trade off theory and Pecking order theory struggle to account convincingly for these observations (the cyclical flow of macro-financing) convincingly. If we are to accept trade off theory we have to make a further assumption that markets discounted the debt-induced increase in bankruptcy risk simply because the market had arecent history of price increases yet we know market reversals are recurrent. If we prefer pecking order theory then it is difficult to make the case that the pecking order increases the favorability of debt at a time when investors are paying high prices for equity. As per pecking order theory internal funds come at no adverse selection cost, equity is the next cheapest, followed by debt. Why the adverse selection issue would be greatest when investors are bidding equity (and companies are increasing debt, while reducing equity) it is not clear. Intuitively, we can imagine lenders would be much more wary (and require compensation) after a market collapse. The third main (category of ) theory of corporate financing, market-timing theory, does not help much here either. It contends taht companies will use periods of price run-up to sell equity. At a macro-financial level this does not happen, the reverse in fact. Each of these theories assume taht collectively corporate fianncing behavior optimises capital structures (in different ways) rationally operating on complete information. have developed a tentative theory taht addresses observed cyclical corporate financing flows. Essentially, this is the extrapolative expectations theory of corporate fianncial structure in which markets assume the continuation of current trends in their behavior and use this assumption to 'optimise' their behavior. Due to the limits to rationality (operating on what amount to future guesses) markets recurrently (but not periodically) 'get it wrong' and very expensively so. This seems to define an essential role for bounded rationality in the formation of corpoarte financial structures.

Thank you all for your explanation on how 'bounded rationality theory'’ modify or complement corporate finance theories. More theories that integrate insight from bounded rationality theory with corporate finance theories (based on rationality concept) are desirable. More contribution are welcome.

In my view, it wont have much of effect in the main stream finance. U cant have "second best option ", as a bench mark in the financial decesions, when the optimum exists! Can you?

The question here importantly relates to optimality. Most theories (perhaps all currently well-circulated theories) assume that companies not only target optimal financing relationships but, also, that they are good at it. If this is true we need to find an 'informational" (and by this I mean new and precipitous informational input) into stock prices at the point of their periodic collapse. If we cannot do this then we cannot explain an inherent corporate optimizing financing function empirically when stock repurchases are greatest just before market crashes (and, also, why issues of new stock are greatest shortly after those crashes). Clearly, this is a 'buy high, sell low' strategy if strategy it is at all.

I think, a Basic reorientation is appropriate: Rethinking economics: From homo economicus (including bounded rationality) to homo sapiens: Human decision making modelled according Discrete Choice. 

Ioannis ...

Neo-classical theory is prescriptive; it is based on optimizing outcomes (Ryan, et al., 2002) refer to it as normative).  It assumes that people are optimizers rather than satisficers.  Behavioral finance is descriptive; it seeks to identify how people actually function, even if that functioning is in some sense less than optimal.  A simplistic distinction is between Bayes and Pareto. 

When one refers to "second best options" that implies a value judgment as to what should be the goal.  Whether some decision is in fact optimal depends on the goal to be attained.  Not all goals are financial in nature; other domains often affect goal setting by people (e.g., I can spend 6 more hours a day working to maximize my income or I can spend those 6 hours with my family).

Daniel and Titman (1999) state "Many economists would agree that their notion of rationality should not be taken too literally. First, this notion implicitly assumes that individuals have an unlimited ability to both observe and process information. In reality, of course, individuals have limited processing ability and hence use vague, ad hoc rules to translate the information they receive into estimates of cash flows and company valuations."  That is the essence of bounded rationality.  It recognizes that our ability to gather and process information is not infinite, consumes resources, including time, and is subject to cognitive processing errors, many of which are quite predictable.   That is contrary to the neo-classical definition of a rational actor as noted by Professor Matemilola that "economic agents are on average rational, and make decisions based on all available information to find the optimal choice." 

There is much research from behavioral psychology that people are in fact not optimizers in the neo-classical rational actor sense and make decisions based on partial information (in part because many decisions, including economic ones, are time sensitive as to when they must be made; in part because we cannot know with certainty the outcomes of decisions made at the time we must make them),  take into consideration factors other than pure economic outcomes, and make predictable errors in cognitive processing.  For example, research shows the existence of overconfidence (AKA "hubris") in many decisions.  See for example Lovallo and Kahneman (2003), Roll (1986), and Daniel and Titman (1999), among many such studies.

References:

Daniel, K. & Titman, S. (1999). Market Efficiency in an Irrational World. Financial Analysts Journal, 55(6), 28-40

Lovallo, D., & Kahneman, D. (2003). Delusions of Success, Harvard Business Review, 81(7), 56-63

Roll, R. (1986). The Hubris Hypothesis of Corporate Takeovers. The Journal of Business, 59(2), 197-216

Ryan, B., Scapens, R. W., & Theobald, M. (2002).  Research Method and Methodology in Finance & Accounting (2E), Hampshire, UK: Cengage

David,

thanks a lot for the literature review. Market, is our constraint in modelling behaviour. Making decisions in finance, usually forces you to fit the existing market prices. Your "other" model, has to perform, and reproduce traded cashflows. Once you do that, you may price away "exotic" assumptions too. Put it in another way, it is more about how can you hedge your risks, and not agent views, that determine actions.

Although the traditional corporate finance theoretical models assumption that economic agents are fully rational (uses all available information in decision making) appears unrealistic. Despite its limitation, I think we can integrate insights from the traditional corporate finance theory and behavioral finance theory (based on concept of bounded rationality) to explain the present capital market. The traditional corporate finance and behavioral finance theories seems to have evolved independently, but they may complement each other, especially if we could see the meeting points, where insights from both theories are complementary. Contributions are welcome.

I agree ... there are some interesting insights to be gained by exploring the boundary of the neoclassical and behavioral theories.  One of my current projects is reframing the EMH to reconcile the neoclassical formulation and behavioral findings.  One apparent weakness of the neoclassical formulation is that it does not address the mechanism(s) by which information is incorporated into price ... it seems to just postulate it is, as if by magic.  The behavioral side seems to suggest some possible mechanisms, but those would require abrogating some of the neoclassical assumptions about rationality, etc.  The more I explore, the more interesting it gets.  No paper yet but perhaps I'll get it to that point in time.