Thursday, August 15, 2013

We are not 100% Rational

"Game theory is rational behaviour in social situation."

John Harsanyi, US economist (1920-2000)

Rational behaviour formed the main plank of the economic theories developed prior to the 1980s. However, this is proved otherwise in situations of uncertainty. In fact, the presence of other choices in a set of options seem to matter to people.

It is also found that people have an aversion to ambiguity. So most will shy away from a choice whose future has a completely unknown probability. This is demonstrated in the Ellsberg paradox where people prefer to bet on an urn with 50 red and 50 blue balls, than in one with 100 total balls but the number of blue or red balls is unknown. As US economist Frank Knight once said "risk" can be quantified but not "uncertainty".

From 1980s, behavioural economics is established. It blends psychology with the mathematical techniques of economics. Amos Tversky and Daniel Kahneman are the key thinkers behind this field. One of the most important theory is "Prospect theory". It describes the way people deal with risk. It states that people make decisions based on the potential value of losses and gains, rather than the final outcome, and they are affected by how the question is framed.

There are two key insights from "Prospect theory".
- One hates to lose more than one likes to gain.
- The context matters (i.e. how the problem is framed)

This has wide-ranging influence on marketing and advertising. Dangling a huge discount off an original inflated price works like magic. Crowds will still flock to buy, thinking that they have snagged a good buy. People are also willing to incur greater time and effort to save $5 off from an item which costs $10 but not one costing $100, even though the net saving is the same.

This tendency towards loss-aversion means that , when choices for change are framed in such a way that the consequences are seen as negative, people are more likely to perceive the change as a problem. Knowing this can be used to influence people.

There are many other interesting nuggets of human psychology. We prefer a set of standard options given. We are affected by advertisement. If one puts good choices in easy reach and we are likely to choose them. Inundating people with too many choices, is not effective. Less options is usually better.

Yes, we are not 100% rational. But it does make this world a more interesting place to live in.

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