THE MARKETPLACE OF PERCEPTIONS

In recent times, sub fields in economics such as “neuroecononomics” and “behavioral economics” have garnered much spotlight among both psychologists and economists. Recent articles by the the financial times as well as Harvard magazine have emphasized the growing importance of understanding irrationality in order to analyze the economy and design public policy.

Harvard magazine: http://harvardmagazine.com/2006/03/the-marketplace-of-perce.html

The Financial times: http://www.ft.com/cms/s/2/9d7d31a4-aea8-11e3-aaa6-00144feab7de.html#axzz3IjrHebmI

These two articles reminded me of a Tedx talk I recently watched by the famous behavioral economist: Dan Ariely called: Are we in control of our decisions?

Ariely conducts experiments that analyse how humans make decisions. I found this video particularly interesting because his findings regarding human irrationality significantly undermine the value of the simplified models that are currently used to make predictions about the economy (Non-stochastic models, Qualitative models). The main problem with these models is that they are derived from the neoclassical paradigm which assumes that consumers are rational (Homo Economicus). Of course, we know that these assumptions are neither realistic nor plausible because predictions made from these models are not consistent with real outcomes. Neoclassical economics is often criticized for having a normative bias that “demonstrates the social optimality if the real world were to resemble the model”, but that does not “explain the real world as observed empirically”

The fallacy of these models were analysed by Joseph Stieglitz (won the Nobel Memorial Prize in Economic Sciences in 2001):

 “I only varied one assumption – the assumption concerning perfect information – and in ways which seemed highly plausible. … We succeeded in showing not only that the standard theory was not robust – changing only one assumption in ways which were totally plausible had drastic consequences, but also that an alternative robust paradigm with great explanatory power could be constructed. There were other deficiencies in the theory, some of which were closely connected. The standard theory assumed that technology and preferences were fixed. But changes in technology are at the heart of capitalism. … I similarly became increasingly convinced of the inappropriateness of the assumption of fixed preferences. (Footnote: In addition, much of recent economic theory has assumed that beliefs are, in some sense, rational. As noted earlier, there are many aspects of economic behaviour that seem hard to reconcile with this hypothesis.)”

Ariel’s Research

Ariely’s Tedx talk briefly outlines two characteristics of irrational decision making: asymmetric dominance and the Opt in vs. Opt out system.

One of my favourite examples of asymmetric dominance in the video was the Rome vs. Paris experiment which quite aptly highlights our inability as consumers to objectively value a product’s price without being able to compare it to other products. Consequently, the experiment exposes how firms are able to manipulate our financial decisions through their pricing strategies.

Another interesting case study in the video was the “Opt out vs. Opt in” system in Europe where Ariely demonstrates the importance of understanding human cognitive limitations in order to design effective and favourable healthcare policies: “It’s not because we don’t care, it’s the opposite. We care, it’s difficult and it’s complex. And it’s so complex we don’t know what to do and because we don’t know what to do, we just pick whatever it was that was chosen for us.”  

Is there hope for the future?

Of course the word “irrationality” portrays the human mind as erratic and convoluted. However, Ariely’s research has often concluded that we make “systematic biases” which suggests that irrationality can be predictable.

Thus, quantifying these systematic biases would enable us to incorporate them into future models that will improve the quality of the predictions we make. This would reduce the need for the data that we generate to constantly be revised as well as allow the government to create better policies in order for them to steer the economy more effectively. Moreover, economists like Ariely and Stieglitz are emphasizing the sheer degree to which psychology is fundamental to our understanding of the economy which has drawn recent attention to behavioural economics and other related fields such as neuroeconomics. To take their findings forward, the next steps would be to further quantify their analyses in order for them to be implemented into both policies and economic models on a macroeconomic level.

Further reading   

Predictably Irrational by Dan Ariely

Thinking Fast and Slow by Daniel Kahneman

For more information about Ariely’s research or personal life, visit his website:

http://danariely.com/

Or you can watch his Tedx video:

By Sara Kachwalla

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