January 07, 2005

A bit of behavioral economics

I seem to have always known that the holy grail of demand and supply finding an equilibrium that will reflect the correct prize for a product or service was a mirage. Nobody has perfect information about the product they are about to buy, and very few people seem to make rational decisions these days. Both of which are prerequisites for the theory of demand and supply to hold true.

I stumbled across Daniel Kahneman's Nobel lecture in economics that deals with decison making under ucertainty, which is pretty much all the time. What he claims is that our intuition is prone to systematic errors, which affect our ability to make rational decisions. These systematic errors are consistently biased towards risk aversion. For example: most people will say no to a gamble where they have 50% chance of losing 10$ and 50% chance of winning 15$, even though it is quite obvious that the gamble is worthwhile. Typically the upside has to be twice the downside for people to take the gamble because they are risk averse.

Also, he argues that people are more sensitive to changes than to final states. What this means is that what we see and feel depends on previous stimulation, and not so much the overall state of things. If for instance we put one hand in very cold water and the other in very hot water and after a little while put both of our hands in lukewarm water one will feel that the lukewarm water is hot, and the other will feel that the lukewarm water is cold. The hands are more sensitive to the previous condition of hot/cold water than to the overall state of lukewarm water. So the memory of an episode, and the way we will react to similar episodes at a later time are not so much dependant on the how good or bad the episode was, but rather how the episode ended.

These findings also apply to economics, and have been shown to be consistent in a large number of tests.

So think of this next time you buy stock, it has pretty severe consequences on the market.

Daniel Kahnemann's Nobel price lecture

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