The brain is a wondrous organ. As scientists uncover more of its inner workings through brain-mapping techniques,1 our understanding of its astonishing abilities increases. But the brain isn’t the rational calculating machine we sometimes imagine. Over the millennia of its evolution, it has developed shortcuts, simplifications, biases, and basic bad habits. Some of them may have helped early humans survive on the savannas of Africa (“if it looks like a wildebeest and everyone else is chasing it, it must be lunch” ), but they create problems for us today. Equally, some of the brain’s flaws may result from education and socialization rather than nature. But whatever the root cau?e, the brain can be a deceptive guide for rational decision making ( The McKinsey Quarterly: Hidden flaws in strategy -Free Registration Required via Ramnath)
The article is wonderful and the free registration is worth every buck. It provides a very good summary of the insights from behavioural economics and how it is useful to keep in mind while formulating strategy.
We are overconfident. We tend to categorize and treat money differently depending on where it comes from. We have a bias in favour of the status quo. We tend to relate in our minds unrelated events just because they are presented together. We are uncomfortable with the concept of sunk costs. We tend to follow the herd. We err in estimating how happy or sad we will feel in the future becuase of our current actions (we tend to overestimate both the intensity of happiness and unhappiness). Finally, we are prone to false consensus, i.e., we look for evidence which confirms our hypotheses, remember only those facts that reinforce our assumptions (selective memory), judge contrary evidence more harshly than evidence that supports our view(biased evaluation) and we are prone to groupthink, the tendency to agree with every one else in the group.
Incidentally, I have never understood the concept of rationality. Being rational is different from being logical. The rules of logic are fairly well defined, whereas the rules of rational behaviour, according to Economics, seem to be:
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Human beings want some things. They are willing to forgo some other things, or put in some effort, in order to get the things that they want more.
Whatever human beings want, they prefer to have more of it than less of it.
Whatever human beings want, as they get more and more of it, they are willing to expend less and less of additional effort in order to get the next incremental unit. (Also known as the law of diminishing marginal utility. The first two rules are so basic to economics that those rules do not have a name )
There are others (such as the tendency to risk aversion), but the point is that these rules don’t follow from any higher-order principles. They come from observation of human behaviour. So why do we call these rules rational and the new insights we are getting from behavioural economics non-rational?