Bellerbys Economics - Mr Stephenson

Friday, January 25, 2008

Behavioural Economics

Classical economics assumes that people make rational choices based on supply and demand, competition, accessability and so on - economists often refer to this perfectly rational person as homo economicus.

However, in reality we know this is a myth. People often make totally irrational choices (especially when it comes to marriage!) and the rapidly growing field of behavioural economics attempts to analyse the reasons behind this irrational behaviour - in other words to see how rational it can be.

Game Theory can apply to this field like any other. One interesting game is called The Ultimate Game. In this game, there are two people. One person is given £10 and is asked to divide the money between himself and the other person. If the second person agrees with the division, it's fine. However, if the other person does not agree, nobody gets any money.

Reason tells us that if the first person offers the second person £1 and keeps £9, the second person should agree - because after all, both people gain by this. However, in experimental conditions, 93% of people rejected this offer. The minimum that a majority of people would accept was between £3 and £4. Why is this? I'm afraid I don't know - I'm one of the 7% that would have accepted!

A second game is this: If I ask someone the likely probability of throwing a 4 on a dice, most people with any background in Maths would say 1 in 6. However, in experimental conditions, people were told that the last three times the dice had been thrown (and that it was a fair dice) the number 4 had come up. When asked what number would come up next time, nearly 50% said 4.

A third area is in marriage. Ideally, the rational way to choose a marriage partner is to go out with maybe 10 or 20 (or a 100) different girls over a period of time - and then choose the best one - but just you try explaining that to them. Instead, you have to choose your marriage partner heuristically - meaning it has to be the last one you go out with.

Behavioural economics has enormous implications for sales and marketing (fashion fads and so on) but equally so for trading. George Soros once wrote that the moment he realised that traders behaved with a 'pack mentality' on the stock market and not a rational mentality was the day he realised he would soon be rich.

A good book on this subject is "Irrationality" by Stuart Sutherland and the wikipedia entry is also pretty good:


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