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Daniel Kahneman, 2002 Nobel winner in economic sciences, reclaimed the forefront of attention again, in part because the 2017 Nobel prize in the economic sciences is awarded to Richard Thaler, a collaborator of Kahneman and a behavioral economist. Thaler is awarded the prized for his seminal contribution that ties psychology with economics and finance, a field created on the foundations developed by Kahneman and Tversky. Kahneman and Tversky are credited with developing the foundational knowledge of behavioral economics that Thaler formalized into the lexicon of the discipline. This article attempts to bring the broad ideas and themes of behavioral economics based on Kahneman’s work. It will be done, in large part, from his groundbreaking book – Thinking, Fast and Slow. The article will also try to explain the broader economic implications of such ideas. In cataloging the breadth of Kahneman’s work, since the 1970s, economists observe that his work influenced, shaped, and formed certain areas of public finance, labor economics, development economics, and social psychology.
The genesis of Kahneman’s work resides in psychology, not in economics. His central view holds that human beings are intuitive-thinkers, and human intuition is imperfect, with the assessment that human choices and judgments depart substantially from the predictions derived from the normative statistical and economic models. Grounded on such deviations between human judgment and standard economic theory, the behavioral economics tends to explain these departures from the standard economic theories to link them to their economic implications.
Most Kahneman and his fellow contributor Amos Tversky’s work entail “heuristics and biases.” This research, broadly, deals with the fact that people use rules of thumb or heuristics to solve statistical problems, often leading to biased estimates and predictions. This happens in broadly two categories. In category one, people, when asked questions that they do not have much idea about the correct answer, tend to recapture a guess from their memory, which often leads their answers influenced by irrelevant frames. One such example involves anchoring heuristic. If a person spins a wheel of fortune between 10 and 65, then if that person writes down the number, say, it is 25, then it is likely that the number 25 will have an anchoring effect on the answer to a question that the person does not have much idea about.
The second category is much more directly involved with economics. The category two heuristic tells that even if respondents receive all the information they need, they still reach wrong answers. Among all the information provided, respondents often ignore the available information. Kahneman tells this magnificent story of an Israeli army officer that the army officer thought that when flight officers are scolded after they land poorly, their next landing improves. On the contrary, if they do great landing and get praised, their next landing gets worse. To this officer, the information regarding the role of chance and the consequent mean reversion in landing quality did not warrant enough qualification to be counted, thereby leading to errors in judgments.
Another major portion of Kahneman’s work can be explained by the metaphor of System 1 and System 2. System 1 is intuitive, fast, sloppy, inspirational, emotional approach to thinking. When we are asked to add two plus two, immediately four jumps to our mind – demonstrating the part of System 1. The things that come naturally to us belong to the System 1. Then there is System 2 – deliberate, rational, suspicious, lazy, and methodical approach to thinking. For instance, the appeal systems of any supreme court of any nation employs System 2 in its decision-making, not System 1. System 2 is costly, time-consuming, and resource intensive. The level of endowment of System 1 and System 2 differs from person to person. With enough practice, for some people, some tasks may move from System 2 to System 1 as they become more proficient at them. If we consider many of our life choices, they fall into the category of System 1, therefore refer to substantial departures from the predictions of the standard economic model. System 1 is humanistic, emotional, but systematically error-prone.
Kahneman and Tversky’s most prominent and interesting contribution to the field of economics may be Prospect theory, which holds four principles. First, people evaluate risky choices based on their prospect of gains and losses with respect to a reference point. Although the definition of reference point has not yet settled in the discipline, it usually means the status quo wealth.
Second, people are mostly loss averse. They are extremely risk averse regarding experimenting with placing small bets around the reference point. People even decline to place a bet even if the odd gives them a 60 percent probability of losing a dollar, implying an inexplicable high level of risk aversion. Kahneman explains such phenomenon saying that the information related to such losses might be processed in part in the amygdala, which treat threats the same way. This second principle led Thaler to define and formalize endowment effect – the finding, both in the lab and in the field, that people place higher reservation price for an object that they own than what they would pay for it when they do not own such object.
Third, people assign less risk in the domain of gains, and assign more risk in the domain of losses. And the fourth principle stipulates that individuals assign overweight to low probability events and underweight to high probability events. For example, people might pay too much for lottery tickets, or expend more on flight insurance at the airport than what the fair weightage of probability would determine, or worry about accidents at nuclear power plants when the likelihood of such events versus their probabilistic alignment do not match in probabilistic models.
Circling back to the role of behavioral economics with respect to the mainstream economics, the origin of clash of behavioral economics with the mainstream economics traces back to the idea of the “first order things.” Standard economics constructs models that embody the market-wide phenomena, bringing the activities of economic agents under elegant theoretical framework. Therefore, mainstream economists argue that the standard economic model describes the first order aspects of the human interactions adequately even though the psychological quirks influence human behavior. However, as it was demonstrated many times that the departure from the standard economic models is substantial and cannot be discounted such errors as mere “rounding errors.”
Although there is a strong counter-argument from the mainstream economists that the market forces remove the effects of psychological factors on prices and allocations, the economist, DellaVigna summarizes a good amount of evidence that the impact of large and costly errors people make in important choices. One such example is that despite advertising typifies emotionality, associativity, and misleading characterizations, advertising is effective as demonstrated by the research of economists Bertran, Shleifer, and Mullainathan. The deviation from such standard economic theory based on rationality does not explain the scope and the breadth of the global advertising industry and its effectiveness. In another instance, while it is shown that, based on empirical results, investors should pick low-cost index funds, they hardly do it. Instead, most investors select high-cost actively managed funds that underperform those index funds.
Such impacts of heuristics and biases impact behavioral finance in substantial way. In large part, it impacts because it paves the path for a natural account of extrapolation — the expectation by investors that the bull market will continue. In other cases, the anchoring bias sets the motion and keeps investors locked in the upward trend. Daniel Kahneman’s body of work helps economists and investors identify the blind-spots, and correct them for alternative theories. It does not discard the standard economic theories, instead, it bolsters them by identifying the deviations of them so that they are addressable.
Marjuk Ahmad, Research Assistant, South Asian Network on Economic Modelling (SANEM). Send responses at email@example.com.