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Behavioural Economics: You aren’t as Rational as You Think

Behavioural Economics

Behavioural EconomicsIt turns out that you aren’t as rational as you may have thought. So, traditional economic theories that assume you are, are… well, flawed. We need an approach that accounts for self-interest and lazy mental short-cuts. Enter Behavioural Economics.

We’ve already told the foundation story of Behavioural Economics in our Management Thinkers series. There we looked at the two men who received Nobel Prizes in Economics for their work in the field:

  1. Daniel Kahneman won his in 2002
  2. Richard Thaler won his in 2017

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Cognitive Bias – Getting it Wrong

Cognitive Bias

Cognitive BiasYour brain is wired to think fast. So, to do this, it needs to take shortcuts, that psychologists call heuristics. But these shortcuts don’t always give the right answer. They give rise to cognitive bias.

Cognitive bias is the result of the shortcuts. If every car door you’ve ever encountered opens outwards, it’s a good bet that the next one you encounter will too. That’s a bias in your assumptions. Usually, it serves you well. One day, it may let you down.

But the cognitive biases that we need to worry about are those that are baked into our mental operating system. We make the mistakes without realising it. They lead to bad decisions – sometimes to catastrophe.

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Systems Thinking

Systems Thinking

Systems ThinkingSystems thinking is a big idea that’s remarkably… simple.

It’s a simple idea about complex phenomena. And the principle virtue of systems thinking is that it reminds us that the real world is far from simple.

Indeed, when we try to apply simple solutions to complex problems, the solution tends to fail: often spectacularly. And it’s systems thinking that points us in the right direction. We need to think about the whole messy, complex, inter-connected system, if we are to have any chance of finding a solution that makes our problem better.

If only politicians could grasp this simple fact.

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Holacracy: Circles within Circles

Holacracy

HolacracyFor hundreds of years, there has been little to challenge traditional hierarchies for their ability to organise at scale. Holacracy is doing just that.

It’s a form of Adhocracy, which we covered in an earlier article. But, whilst we are way past ‘peak adhocracy’, it seems that holacracy is is thriving.

Holacracy is a modern attempt to reform traditional hierarchies. It keeps the aspect of senior level overviews and subordinate focus. But it gives a far greater autonomy to individuals, and a more substantial decision authority to small teams at the focus of operations and change.

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The Pareto Principle | The 80-20 Rule

The Pareto Principle | The 80-20 Rule

The Pareto Principle | The 80-20 RuleThe Pareto Principle – also known as the ’80-20 Rule’ – is one of those ideas that crops up in many places. It is ubiquitous because it is an expression of a general principle of nature. It is an example of a power law. Extremely long rivers are rare. Small ones are very common. A small number of words appear frequently within a language, whilst there are very many words that we hardly use at all.

But what makes the Pareto Principle a valuable version of this phenomenon is that it is easy to articulate and understand. And it is therefore easy for managers to apply, to get better results. Consequently, since Joseph Juran rediscovered and named the idea in the 1930s, it has become an indispensable snippet of knowledge, for anyone in management.

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The Paradox of Choice

The Paradox of Choice
The Paradox of Choice
The Paradox of Choice

One is no choice at all. And two is a dilemma. Three is a poor choice. And four is a bit better. The  more choices we get, the happier we are.

Not so fast‘ says Barry Schwartz. Beyond a certain point, more choices make us less happy. And that’s the paradox of choice.

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The Wisdom of the Crowd

The Wisdom of the Crowd
The Wisdom of the Crowd
The Wisdom of the Crowd

Why do many countries have a legal system that favours a jury over a judge to determine guilt or innocence? The answer is that humans have many times discovered the wisdom of the crowd.

In its modern form, crowdsourcing ideas has become fashionable. But written evidence for this big idea goes back a long way. In his ‘Politics’ Aristotle classifies constitutions.

So why are the many wiser than individual experts? 

It turns out that they aren’t always. But they can be. The better question is when are the many wiser than individual experts?

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The Halo Effect

The Halo Effect
The Halo Effect
The Halo Effect

The thing about cognitive biases is their pervasiveness. They can affect all areas of our thinking. But some have a bigger impact on management, leadership, and business decisions. And one example is the Halo Effect.

The halo effect can take a single example of excellence, and create the impression that we have a star in our midst. This could be company results, an effective middle manager, or a new hire.

With all of these, we have the ability to see something great and assume it is part of a pattern. The evidence for this may be lacking. Indeed, it may be a one-off hot-spot in a field of mediocrity.

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System 1 and System 2

System 1 and System 2
System 1 and System 2
System 1 and System 2

In understanding how we think, one big idea has dominated in recent years. It became widely known through Daniel Kahneman‘s phenomenal best-seller, ‘Thinking, fast and slow’. It’s the idea that we process information in two ways. There are two parallel thinking systems in our minds: System 1 and System 2.

There are many terms for these two systems. They have been called:

  • associative and rule-based
  • implicit and explicit
  • intuitive and analytical
  • experiential and rational
  • and many more

The terms System 1 and System 2 are marvellously neutral. They first emerged in a paper by Keith Stanovich and Richard West. But it’s Kahneman’s adoption of this language and the popularity of his book that gave them fame.

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Richard Thaler & Cass Sunstein: Behavioural Economics

Arguably, behavioural economics is Richard Thaler’s baby. And an important baby it is too, being part of an essential late twentieth century trend. At last, economists – spurred on by psychologists and social scientists, stopped seeing people as ‘rational units of intelligent decision making’ and started seeing us as part rational and part irrational bundles of ideas, knowledge, feelings, desires and biases.

It is with these filters, rather than pure rationality, that we make decisions. And that insight was an essential correction to classical economics. It won the psychologist, Daniel Kahneman, a Nobel Prize in economics. His collaborator and mentee, economist Richard Thaler, then led the development of the ideas.

Writing with University of Chicago colleague, Cass Sunstein, they together produced the massive selling book, Nudge. But why is co-authorship enough to justify Sunstein’s place in a management thinker pair, when Thaler led the charge on behavioural economics? The answer lies in Sunstein’s contribution: he’s a constitutional and administrative lawyer with a strong interest in social policy. His thinking helped bring behavioural insights out of the classroom, ad agency, and boardroom, and into public policy.

It’s not just in the supermarket that we get nudged to buy stuff, but when we interact with Government too. And between them, Thaler and Sunstein’s conception of liberal paternalism inspired a number of benign behaviour changes, with no whiff of compulsion. Their ideas were picked up by governments all over the world, including the US, where Sunstein (a former colleague) served in Barack Obama’s administration, and here in the UK, where Prime Minister David Cameron established a Nudge Unit within Government.

Richard Thaler & Cass Sunstein
Richard Thaler & Cass Sunstein

Richard Thaler

Richard Thaler was born in 1945 in New Jersey. He studied at Case Western Reserve University, gaining his BA in 1967. From there, he went to the University of Rochester, for his MA (1970) and PhD (1974).

In his PhD, Thaler started the work that still occupies him today, investigating the economic value of a life. What he found was a huge disparity in people’s evaluation of the worth of one week of their life. When asked to put a value on a week lost, or on a week gained, people needed a high payment to be prepared to give up a week of life. Yet they would be prepared to pay far less to gain an extra week.

This imbalance is, of course, irrational. And that interested psychologists Daniel Kahneman and Amos Tversky. They researched all sorts of biases and shortcuts in our thinking. Thaler became a long term collaborator with the pair.

Thaler stayed in the academic world, holding teaching and research positions at many institutions. His permanent academic homes were the Universities of Rochester (1974-8), Cornell (1978-95) and then Chicago, from 1995 to the present day. It was at Chicago that Thaler met Cass Sunstein.

Cass Sunstein

Cass Sunstein was born in Massachusetts, in 1954. He gained his BA at Harvard College in 1975 and his JD from Harvard law School in 1978. Before returning to academia, Sunstein clerked for justices in the Massachusetts and US Supreme Courts, and served in the Justice department from 1980-1981.

In 1981, he became an Assistant Professor at the University of Chicago, becoming a full Professor in 1985. He remained at Chicago until 2008, when he formally moved to a post at Harvard Law School. However, having become friends with another Chicago Law School professor, Barack Obama, he headed up the Whitehouse Office of Information and Regulatory Affairs from 2009 to 2012.

Behavioural Economics

In 2008, after working together on the ideas in the book for five years, and having known each other for ten, Thaler and Sunstein published a best-selling book, Nudge: Improving Decisions About Health, Wealth and Happiness. This brought the ideas of behavioural economics to a wide audience, and introduced many of us to the term ‘choice architecture’.

Choice Architecture

Choice architecture is a beautifully simple idea. By framing choices in a certain way, we can make it easier – physically, cognitively, psychologically – for people to make one choice rather than another. It’s how supermarkets channel customers and how governments secure compliance.

Choice architects study the heuristics people use to make decisions. These are the mental shortcuts we apply, that save us from having to think too carefully, expend too much effort, and take time over mundane choices. Except these heuristics effectively hard-wire biases into the way we make decisions. These are the biases that choice architects can exploit.

Nudges

A ‘Nudge’ is simply a selection of how to frame (or architect) a choice, so that people can more easily make a choice that will satisfy them. Setting up nudges that satisfy you, at the cost of the chooser is manipulation. If you can avoid forcing your outcomes upon anyone, but make it easy for them to make a choice that suits them, Thaler and Sunstein refer to this as ‘libertarian paternalism’.

The tools that choice architects use are:

  • Setting the right defaults, so the easy choice is the best one
  • Anticipating errors, and therefore making correct behaviour easier
  • Setting up complex choices to highlight the right ones
  • Creating positive incentives for beneficial behaviour

The Behavioural Economics Context

Choice architecture is a subset of behavioural economics. This is the study of how real humans (not the artificial idealised, wholly-rational ‘econs’ of earlier economic theory) behave. Given economic choices, we are not wholly rational. This distorts markets and creates dynamics that do not conform to rational economic theory. This may seem like an obvious observation, but to economists through most of the twentieth century, it was not obvious at all. Year after year, new models and theories worn prestigious prizes. All were based on the myth of the ‘rational actor’.

Now, we know for sure that  this rational actor is an ideal at best and a mythical creature at worst, we can start to do messier, but more realistic economics. That’s behavioural economics or, as Richard Thaler points out, Behavioral Economics: ‘why do the British need a superfluous u?‘, he asks. Because we are not rational, I suppose.

Richard Thaler on Nudge

A lot of great content, though edited with some disconcerting cuts.

 

 

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