The â€œscienceâ€ of economics has for most of its history relied on theory more than experimentation, which is quite literally the testing grounds of all â€œrealâ€ science.
The birth of behavioural economics in the 1970s permitted economists to start testing theory rigorously, by borrowing empirical methods from psychology and other social sciences to lift the veil behind what makes us, and markets, really tick. How do incentives work?
This 10 minute fly by of economic research on the topic by the Freakonomics team examines a core tenet of economics â€“ utility maximizing. It shows that self-interest is not the only utility that people seek to maximize. Though they may be able to do better on their own, time after time, research shows that people gravitate towards acting as a community when given the opportunity, both giving and taking.
That doesnâ€™t mean our instincts our altruistic either, but â€œAltruism isnâ€™t irrational, because if it were, the only rational people would be sociopaths.â€
That quote comes from an article entitled Altruism in Economics, which discusses an interesting hypothesis: that working together provides an evolutionary advantage.
To see just how short that evolutionary path is, take a look at psychologist Laurie Santoâ€™s Ted Talk, A Monkey Economy as Irrational As Ours (It’s at the bottom of this article in a fascinating investment magazine, Seeking Alpha. Worth a troll.)
Observing a group of chimpanzees she had trained to use currency to trade for food, Santos found monkeys donâ€™t like to save. They often steal from one another and from the market â€œsalesmanâ€. And they display a tendency towards greed. Sound familiar?
Thereâ€™s more, and it speaks profoundly to just how much expanding markets are prone to increasing risk. Confronted with complex decisions we make mistakes, panic and revert to basic instincts. One such instinct is a bias towards thinking in relative, not absolute terms. Another is a bias towards loss aversion. Both lead to a simple and troubling truth: Humans donâ€™t like to lose anything of value that theyâ€™ve obtained, and will actually take on more risk at times in a misguided attempt to save what they already had.
The research gives the lie to the notion that markets are so rational that they can be predicted with computer models. And it sheds important light on ways to reduce risk and improve performance.
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