Editorial. Recognising irrationality

For a hundred years economics was built on the assumption that humans acted rationally. Then along came Amos Tversky and Daniel Kahneman and said no, they act irrationally. And they demonstrated this proposition sufficiently well for Kahneman to win the economics Nobel in 2002 for “having integrated insights from psychological research into economic science, especially concerning human judgement and decision-making under uncertainty”.

Tversky died in 1996 and two days ago, Kahneman also died. With his passing economics has lost two savants who must be ranked with John Maynard Keynes. What Keynes did for macroeconomics Tversky and Kahneman did for microeconomics. They stood the analytical framework of economics on its head. That’s what Thomas Kuhn had called a paradigm shift. It happens when you are forced to revisit received wisdom and completely revise the theories held till then. The Tversky-Kahneman theories are now collectively known as behavioural economics. Though it’s in economics he left a permanent mark, Kahneman was primarily a psychologist. His training and method was to observe how humans behaved in different situations. The experiments he conducted threw up some strange findings. One of these was that people attach more importance to losses than gains. There appears to be a strong element of ‘a bird in the hand is better than two in the bush’ in the way people evaluate financial gain and loss. Another was the ‘peak-end’ rule which says people remember the end of an unpleasant experience less badly if it ends better than what they had earlier experienced. For example, a severe beating followed by unlimited beer makes people recall the beating less badly.

Kahneman and Tversky more-or-less completely overturned the classic work of John von Neumann and Oskar Morgrnstern who had invented game theory in the 1930s. They had assumed people made rational decisions. No, says prospect theory, they don’t. Decision-making under risk and uncertainty tended to be quite erratic and not what rationality would predict. Subsequently there’s been a lot of research on and applications of these theories. Kahneman himself hadn’t really intended it this way. Behaviour, when faced with financial gain and loss, was his main focus. It was a purely academic exercise to begin with and remained that way for close to two decades. But it acquired a life of its own in the mid-1990s after Kahneman wrote a paper saying that people are more likely to act in ways that don’t necessarily maximise their gains and utility. Pakistan is a case in point, as are many other societies and countries. The paper discussed the implications of irrational behaviour in substantial detail.

So where do we go with these conclusions? Not very far because uncertainty is inherently unpredictable. However, it is nevertheless worth bearing in mind that people and societies do often behave rationally. In Kahnemanian terms, given a 50:50 chance of loss or gain, we can’t really predict which course of action or which outcome they will choose. In short, be careful because unpredictability is hard wired in humans.

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