The Gray between the Black and the Red

Hanna Dinkel   HB

Economic decision-making is not “black and white.” There is a definite gray area that behavioral economists can help explain. The 2008 financial meltdown was a wake-up call for many including Alan Greenspan who admitted that he “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.”[1] The economic fallacy that was exposed is the theory that “human beings are capable of always making rational decisions.”[1] In other words, just because you know the consequences of your actions, it does not necessarily mean you will avoid a mistake. Basically, “we have self-control problems that can lead us to knowingly ‘misbehave.’”[2] People’s biased thinking played a part in the 2008 financial crisis because some executives were “overly optimistic about their sense of control.”[2] Because economics involves how humans evaluate rewards and risks, behavioral economists play an important role in explaining the facets of economic decision-making.

Behavioral economics which “explores why people sometimes make irrational decisions, and why and how their behavior does not follow the predictions of economic models” is a relatively new field of study.[3] In addition, Dan Ariely believes that “behavioral economics might have remained in the shadow of standard economic theory if it wasn’t for the financial crisis of 2008 – a massive demonstration of the irrationality of both consumers and Wall Street traders.” [4] Herbert Simon’s concept of “bounded rationality” argues that rational thought alone does not explain human decision-making.[5] Bounded rationality suggests that “most of us make decisions using intuition or rules of thumb” and behavioral economists study the “ways in which these rules of thumb may lead us to do things that diminish our utility in the long run.” [6] Obviously, the financial crisis of 2008 involved a lot of risk-taking and some irrational thinking among many Wall Street experts.

The 2008 financial crisis provided some painful lessons, but hopefully, those organizations see how important it is to safeguard against bad assumptions and recognize the role of behavioral economics in decision-making. “Realizing that human beings are motivated by cognitive biases, businesses can start to better defend against foolishness and waste.”[1] Recognizing our limitations and biases is a good thing. “Companies that make an investment in behavioral experimentation can radically improve decision making and lessen risk.”[1] The financial crisis impacted everyone, from the small business owner to Wall Street executives, and for this reason, everyone should take note of their economic decision-making so as to not repeat those mistakes. “Behavioral economists do believe that by anticipating flawed decisions that regular investors are likely to make, we can beat the market (or at least avoid being ravaged by it).” [7] Let’s all hope that everyone from Main Street to Wall Street pays attention to what the behavioral economists have been trying to tell us in order to avoid another major financial crisis and to stay out of the “red.”

 

[1] Dan Ariely, “The End of Rational Economics,” Harvard Business Review (2009), accessed October 16, 2016, https://hbr.org/2009/07/the-end-of-rational-economics.

[2] Michael Blanding, “The Business of Behavioral Economics,” Forbes (August 11, 2014), accessed October 16, 2016, http://www.forbes.com/sites/hbsworkingknowledge/2014/08/11/the-business-of-behavioral-economics/#4c5da61eb2b8.

[3] “Behavioral Economics,” Investopedia, accessed October 16, 2016, http://www.investopedia.com/terms/b/behavioraleconomics.asp.

[4] Caitlan Carroll, “Behavioral Economics: The Missing Link in the Financial Crisis?” Deutsche Welle (December 25, 2010), accessed October 17, 2016, http://www.dw.com/en/behavioral-economics-the-missing-link-in-the-financial-crisis/a-6323299.

[5] Craig Lambert, “The Marketplace of Perceptions,” Harvard Magazine (2006), accessed October 17, 2016, http://harvardmagazine.com/2006/03/the-marketplace-of-perce.html.

[6] Charles Wheelan, (2010) Naked Economics: Undressing the Dismal Science (New York: Norton, W. W. & Company, 2010), 26.

[7] Charles Wheelan, (2010) Naked Economics: Undressing the Dismal Science (New York: Norton, W. W. & Company, 2010), 166.

 

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