Out of all of the various areas and branches of economics, none has captured my interest more than ‘behavioural economics’. This studies the links between psychology and economics to try to discover more about how the individual thinks when faced with decisions. It brings to light the irrationality of the human being, and the flaws of many classical economic models, which assume rational behaviour at all times.
Israeli psychologist Daniel Kahneman was one of the pioneers of this field of study. It was when I first learned about Prospect Theory (which he developed with Amos Tversky) at university that a whole new world was opened to me. By developing the Kahneman-Tversky value function, they introduced (and demonstrated) the concept of loss aversion. This explains (a phenomenon that many people may consider to be ‘obvious’) will behave very differently when faced with losing something than when faced with gaining something. We value losses much more highly than gains of the same amount.
For example, what would you do if you were faced with a choice between the following 2 options?
(i) taking £10
(ii) gambling on a coin toss: heads means you win £50, tails means you have to pay me £20
I would bet that most of you would not choose the second option, even though it would be statistically the ‘better’ choice, and the choice that standard economics would presume you would make.
Finally, I’d like to draw your attention to an inspirational talk by Daniel Kahneman for TED, where he explains the difference between memories, experiences and memories of experiences.