The Hindu Business Line : Matters of the mind

Let’s leave the Sensex alone and step out for a little walk in the more… how to put it… eclectic areas of finance and economics. To the usual mix of profits and inflation, statistics and economic theories, let’s throw in a little bit of psychology.

Behavioural economics, conversationally described as the attempt to define or may be explain economic activity in the context of human psychology, sounds like a pretty spiffy science. But it has been around for a long, long time. Or at least since Adam Smith. (The Wealth Of Nations guy. Famous fellow. Famous book. )

Adam Smith is widely considered the father of modern economics. Or at least of the modern economics text book. His Wealth of Nations is still a seminal work and provides stellar rationales for free markets and laissez faire government policies.

Twenty years before he wrote his masterpiece, he wrote a less known book called the Theory of Moral Sentiments. I am not going to go into the details of the book. To simplify it to a line, Smith states that human beings develop certain natural laws based on a certain sympathy for the fellow man. He said that humans tend to put themselves in the other person’s shoes when making emotional choices.

“Would it hurt if someone drove this spear through my head as I intend to do, to this man here?” This was probably the first popular attempt at establishing a set of behavioural economics principles.

All about ‘homo economicus’

Soon economists came up with the concept of ‘homo economicus’. Never heard of it before? Think again. During those lessons in business school, or in those textbooks, remember how those theories and notes used to begin? With that standard disclaimer?

“Let us assume man acts in a rational manner. That he is looking to make as much money as possible. With minimal labour. We are especially not talking about freelance writers here…”

Well, that rational, self-centred and overall lazy person is who we are referring to by the term ‘homo economicus’. The Economically Rational Man. The man who is looking to generate the most wealth from the least labour. The smallest element of the industrial and economic machine, if we will. The little guy who makes things happen. Buys. Sells. Bargains. Outsources. Merges and Acquires. And so on.

The adoption of this concept was the next big step in Behavioural Economics.

And then, inexplicably, nothing happened for the next hundred years or so. With increasing talk of the concept of utility and with the emergence of cognitive psychology in the 1960s, economists started wondering what was up with good old homo economicus. With more insight into brain functioning, researchers began to wonder if there was a deeper explanation to how and why human beings took certain economic decisions.

“Wait Sidin! Please tell us about some research in this field will you? We just love the academic references in your column!”

Ok ok. Fine. Here you go.

Prospect Theory

In 1979, Daniel Kahneman and Amos Tversky published a landmark paper in the journal ‘Econometrica’ in 1979. (Yes, the journal does sound like a Heavy Metal band.)

In Prospect Theory, Kahneman and Tversky tried to explain how decisions were taken by people when they had to choose between alternatives of uncertain risk — for instance, whether to buy, say, fire insurance during Diwali for the shop, or lock the place down and go home to chill with the family.

To put it in a nutshell, they discovered that human beings tend to overreact to small probability events while under-reacting to large and medium probabilities (If you want to read up on the paper, it is available on the Internet).

Prospect Theory opened up an important window into explaining economic human behaviour. The implications of this, when you think about it, are staggering. Why do people invest? How much more will we pay for equities vis-À-vis government bonds? You’ll have to wait to know more, since I have run out of space. Have a good weekend, and see you next Sunday.

(The writer, an alumnus of IIM-A, was a management consultant before quitting to work as a freelance writer, author and general handyman. He blogs at www.whatay.com)

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