Do you sometimes act rationally? Well, the thing is we are mostly irrational but think we are not. We go out of our way to assume rationality as a pre-condition of our decision making. However the world has a choice architecture predicated on a series of bets we make, sometimes they appear rational. Sometimes they are not. And sometimes we might have a lemon on our hands. That's just poker. Today we take a long look at the reasons for doing behavioural economics, and how can we make it move to the toolbox of everyday decision making from a novel lens which has to be used with a specialist knowledge.
The Paradox of Rationality in Economics and Everyday Life
Rationality is a theory that suggests that people act rationally to maximise benefits and minimise costs. If that sounds familiar, it's because a similar theory – called economic rationality – has dominated the Western philosophical tradition for over two thousand years. This view of rationality assumes people have fixed preferences, a calculation problem and unlimited time and resources at their disposal to make their decisions. However, new research in the field of behavioural economics has revealed that people's actual decisions do not always conform to this model of rationality.
Over the years, rationality has been criticised for its failure to account for human behaviour and emotion by both philosophers and psychologists. Although human decision-making is often believed to be primarily driven by rational processes, recent research has shown that this is not always the case. Our decision-making process is a complex interplay between different psychological factors, including emotion, which plays a major role in how we perceive and evaluate the world around us.
Psychologist Daniel Kahneman and economist Amos Tversky showed that people are naturally biased, lazy and extremely bad at making complex decisions under conditions of economic uncertainty. Their research provided evidence suggesting that people do not always act rationally when making important life decisions. So does this mean that people aren't rational after all? Of course not! It just means that our model of rationality needs to be updated to account for the new scientific evidence on human decision-making.
Another criticism of rationality is that it fails to account for individual differences in how people approach problem-solving and make decisions. Unlike computers, human beings experience complex emotions like fear, anxiety, guilt, pride and anger, all of which influence the way we behave and how we evaluate things. These emotional elements play a critical role in our decision-making process and often play a bigger role than rationality does. In fact, studies have shown that people are much more likely to make decisions that are emotionally driven rather than rationally driven. For example, when people experience stress or anxiety, they tend to make quick, impulsive decisions with little or no thought or planning involved.
Behavioural Economics: A study of irrational behaviour in economic decision making
The old model of economics that asserts that people make decisions based on logic and reason has proven to be inadequate in accounting for the complexity and diversity of human behaviour in the real world. In this model, people make decisions based on cold, hard logic that is devoid of emotion and rationalisation. One of the major problems with the neoclassical theory of economics is that it assumes that humans are always rational in their decision-making. This assumption is clearly flawed and fails to explain many important economic phenomena such as market bubbles and the 'inequity aversion' bias.
Given the shortcomings of economics in accounting for these emotional and motivational factors, it is no wonder that economists are not invited to parties very often...or to any parties at all!
In "Predictably Irrational", Dan Ariely provides a number of interesting examples of behavioural anomalies that demonstrate that we are simply not as rational as we like to think we are. According to Ariely, our behaviour and choices are influenced by a number of factors including scarcity, social pressure and cultural attitudes. For example, research has shown that we tend to overvalue things that we own (i.e. things that we already have) and undervalue things that are available for free (i.e. things that we don't have). This phenomenon is known as 'hedonic adaptation' and it explains why we tend to spend more money on the latest gadgets even though we don't really need them. Similarly, we also tend to underestimate the cost of something unless we really think about it and resist the urge to purchase it. This is known as the 'endowment effect'. Research has shown that we are also influenced by social norms and social expectations when it comes to making decisions.
There is no doubt that the old model of rationality is flawed but this does not mean that we should discard the notions of rationality altogether. Instead, it means that we need to update our understanding of what it means to be rational, to incorporate the new research findings and advances in psychology that have allowed us to better understand the way humans actually think and behave.
The trend towards a flatter world, which is becoming more and more connected and interdependent due to advances in technology, represents a major challenge for human systems. The current financial crisis clearly demonstrates the fragility of the global financial system and the importance of systemic risk management. It also revealed the limitations of traditional economic theories and models when applied to complex systems. One of the main insights from this crisis is that old ways of thinking about the economy are no longer fit for purpose, and we need new models that are appropriate for the complex and dynamic world we live in. These new approaches should draw on a wide range of disciplines including philosophy, psychology, anthropology, sociology, statistics, mathematics and biology.
To understand how human beings make their decisions in complex environments we need to adopt an integrated perspective that incorporates behavioural economics and psychological research alongside more traditional approaches such as economic theory. So rather than focusing purely on rationality and self-interest, we should be looking at other factors that may influence behaviour such as risk perception, expectations and emotion.
Takeaways: The need to doubt and test EVERYTHING
Now that we understand a few things about irrationality and faulty heuristics, how can we use this information to our advantage? The first step is to recognise the biases that we all have so that we can correct them when possible. This will involve learning how to spot them and learning to test our assumptions against other evidence. In addition, it is important to remember that people make mistakes (and so do robots) so it is important to test everything carefully before making a decision.
Also, Not enough importance is given to experiments in businesses or policy. Taking an experimental approach allows us to explore different possibilities in a way that we can't usually do with conventional methods. It helps to address issues such as unintended consequences and ethical dilemmas since we can observe the effects of different scenarios and make better-informed decisions as a result.
By testing hypotheses through experiments we are in a better position to identify and understand which variables are important and why.
We will talk more about ethical considerations later but it is important to keep this in mind as we begin to consider the ways in which we might use experiments to solve some of the big challenges facing us today. Probably.
Thank you for reading The Behavioural Review. Stay irrational!
