The homunculus argument arises most commonly in the theory of vision. One may explain (human) vision by arguing that the light from the outside world forms an image on the retinas in the eyes and something (or some'one') in the brain looks at these images as if they are images on a movie screen (this theory of vision is sometimes termed the theory of the Cartesian Theater: it is most associated, nowadays, with the psychologist David Marr).
But the question is: 'who' is it who is looking at this 'internal' movie inside the brain? The assumption here (although this is rarely made explicit) is that there is a 'little man' or 'homunculus' inside the brain 'looking at' this movie. (Alternatively it might be proposed that the images on the retinas are transferred to the visual cortex where it is scanned. But here again, all that has been done is to place a homunculus in the brain behind the cortex.)
The reason why this is a fallacy is that an obvious problem then presents itself: how does the homunculus 'see' this internal movie? The obvious answer is that there is another homunculus inside the first homunculus's 'head' or 'brain' looking at this 'movie'. But how does this homunculus see the 'outside world'?
In order to answer this, we are forced to posit another homunculus inside this other homunculus's head and so forth. In other words, we are in a situation of infinite regress.
This is always a sure sign that an argument has gone wrong. (Another way of putting this is to say that the homunculus argument accounts for a phenomenon in terms of the very phenomenon that it is supposed to explain--that is, homuncular arguments are fallacious for the same reason that a recipe for cake that had, as one of its ingredients, 'cake' is not a real (explanatory) recipe).
Another example is with cognitivist theories that argue that the human brain uses 'rules' to carry out operations (these rules often conceptualised as being like the algorithms of a computer program).
For example, in his work of the '50s, '60s and '70s Noam Chomsky argued that (in the words of one of his books) human beings use Rules and Representations (or to be more specific, rules acting on representations) in order to cognise (more recently Chomsky has abandoned this view: c.f. the Minimalist Program).
Now, in terms of (say) chess, the players are given 'rules' (i.e. the rules of chess) to follow. So: who uses these rules?
The answer is self-evident: the players of the game (of chess) use the rules: it's not the case (obviously) that the rules themselves play chess.
The rules themselves are merely inert marks on paper until a human being reads, understands and uses them. But what about the 'rules' that are, allegedly, inside our head (brain)?
Who reads, understands and uses them? Again, the implicit answer is (and, some would argue, must be) a 'homunculus': a little man who reads the rules and then gives orders to the body to act on them.
But again we are in a situation of infinite regress, because this implies that the homunculus has cognitive process that are also rule bound, which presupposes another homunculus inside its head, and so on and so forth.
Therefore, so the argument goes, theories of mind that imply or state explicitly that cognition is rule bound cannot be correct unless some way is found to 'ground' the regress.
This is important because it is often assumed in cognitive science that rules and algorithms are essentially the same: in other words, the theory that cognition is rule bound is often believed to imply that thought (cognition) is essentially, the manipulation of algorithms, and this is one of the key assumptions of some varieties of artificial intelligence.
Homunculus arguments are always fallacious unless some way can be found to 'ground' the regress. In the psychology and philosophy of mind, 'homunculus arguments' (or the 'homunculus fallacies') are extremely useful for detecting where theories of mind fail or are incomplete.
The Homunculus fallacy is closely related to Ryle's Regress.
A possible counter to this is that the brain as a whole is the homunculus, rather than thinking a specific part must be watching the movie.