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Business News/ Opinion / Views/  Kahneman’s work refreshed and expanded economic thinking

Kahneman’s work refreshed and expanded economic thinking

  • The Nobel winner’s work explains how the decisions we take are not always rational. His academic exertions expanded Economics beyond its traditional mould and gave us key insights.

Kahneman’s theory is relevant for running any business, especially if it is consumer-facing.

The first thing students learn in Economics is that human beings act rationally. So, when a price comes down, we buy more of the product. This was the micro part of the story. Summed up, this created a macro picture, which tautologically led to rational decisions. The assumption of rationality was based on the tenet of self-interest made popular by Adam Smith. It was among the underlying assumptions of classical economic theorists.

The first thing students learn in Economics is that human beings act rationally. So, when a price comes down, we buy more of the product. This was the micro part of the story. Summed up, this created a macro picture, which tautologically led to rational decisions. The assumption of rationality was based on the tenet of self-interest made popular by Adam Smith. It was among the underlying assumptions of classical economic theorists.

Things have been turned upside down by behavioural economists, including Professor Daniel Kahneman of Princeton, who died recently. No, we are not always rational and hence do not always take the right decision. Kahneman, a student of psychology who did not formally study Economics, achieved global fame as our leading behavioural economist after his book Thinking, Fast and Slow was published, explaining his work with his late friend Amos Tversky.

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Things have been turned upside down by behavioural economists, including Professor Daniel Kahneman of Princeton, who died recently. No, we are not always rational and hence do not always take the right decision. Kahneman, a student of psychology who did not formally study Economics, achieved global fame as our leading behavioural economist after his book Thinking, Fast and Slow was published, explaining his work with his late friend Amos Tversky.

Kahneman showed that a $5 discount on a product costing $15 would make us drive miles to get this benefit, while we would not do so if the $5 off came on something priced at, say, $115. That’s absence of rationality, as the $5 figure looks different based on the ‘anchor’ or vantage point we take. His book became epochal and we can see ourselves in such situations very often.

The concept of thinking ‘fast’ can be related to impulsive behaviour, like when we do things instinctively, often without any rationale. Over-eating is a good example; we know it is not good, yet indulge in it at times.

Kahneman believed such impulsive behaviour is really strong and guides us more often than not. It is literally a kind of auto-pilot response driven by cognitive bias. Just a few years ago, when covid struck, the standard response of most governments was similar, with lockdowns being imposed. It was not well-conceived, as no country thought of its consequences and simply took a cue from China mindlessly. Kahneman’s theory of a snappy response thus holds for governments too. The Israeli attack on Gaza, where Hamas is based, would qualify as a case of ‘fast’ thinking on the part of a government.

Contrast this with the second form of behaviour that Kahneman describes: thinking ‘slow’, so as to arrive at deliberative or logical decisions. For example, we may decide to buy a house in a particular locality after thinking it through. This differs vastly from a decision taken at an individual level of buying a mobile phone, say, or a pair of shoes, where impulse may be a major driving factor. The Hamas attack on Israel last October was probably of this variety.

Kahneman’s theory is relevant for running any business, especially if it is consumer-facing. Companies have to distinguish between products with steady demand based on people’s needs and those that can be swayed by impulse. The difference shapes how advertising services are employed to drive demand for products and services with distinct drivers. This holds more so for new products. Even human vulnerabilities are leveraged by marketers, with attributes like skin complexion or health associations being highlighted to derive an impulsive response. Super markets also know how to display their goods so that a stroll through the racks will lead one to impulse temptations. The goods that we want would anyway be placed on interior shelves while we are exposed to products that can trigger ‘fast’ thinking purchases.

Hence, while marketers had already worked their way through our minds in designing products and marketing strategies, the field of Economics owes much to Kahneman and others for formalizing these actions through rigorous theory based on human psychology. It’s important because impulsive thinking is common even in formulating public policy, as we saw during the pandemic, with deliberation given very little space.

Kahneman’s theory applies to much that we encounter in our lives. Especially telling is the notion of ‘loss aversion,’ which can be traced to his theory. Yes, most of us are willing to forgo potential gains once we evaluate the possible loss that goes along with it. This explains why the stock market, though catching on in the country, still scares a large number of retail investors who hear of crashes and the like. Kahneman explained this through Prospect Theory, which showed that individuals prefer a lower gain that’s certain over a less-likely higher profit. We value losses and gains differently and feel worse about losing $100 than we feel good about making the same amount.

It is probable that most actions taken in financial markets, including those for foreign exchange or domestic bonds, are driven by ‘fast’ thinking dealers. This has been worried about for long, as taking decisions based on price movements does not allow much time to think; only micro-seconds are available. ‘Slow’ thinking belongs to the realm of research, where the past is analysed and patterns ascertained.

Kahneman’s contribution to the universe of academic thought has been remarkable, as his work explains how many of the decisions taken by us are not rational. This also means that Economics as a subject has expanded out of its traditional mould and branched into deeper recesses, like Econometrics first and now Behavioural Economics.

These are the author’s personal views.

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