The End of Rational Economics
http://hbr.harvardbusiness.org/2009/07/the-end-of-rational-economics/ar/1In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the U.S. Federal Reserve once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “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.”
We are now paying a terrible price for our unblinking faith in the power of the invisible hand. We’re painfully blinking awake to the falsity of standard economic theory—that human beings are capable of always making rational decisions and that markets and institutions, in the aggregate, are healthily self-regulating. If assumptions about the way things are supposed to work have failed us in the hyperrational world of Wall Street, what damage have they done in other institutions and organizations that are also made up of fallible, less-than-logical people? And where do corporate managers, schooled in rational assumptions but who run messy, often unpredictable businesses, go from here?
We are finally beginning to understand that irrationality is the real invisible hand that drives human decision making. It’s been a painful lesson, but the silver lining may be that companies now see how important it is to safeguard against bad assumptions. Armed with the knowledge that human beings are motivated by cognitive biases of which they are largely unaware (a true invisible hand if there ever was one), businesses can start to better defend against foolishness and waste.
The emerging field of behavioral economics offers a radically different view of how people and organizations operate. In this article I will examine a small set of long-held business assumptions through a behavioral economics lens. In doing so I hope to show not only that companies can do a better job of making their products and services more effective, their customers happier, and their employees more productive but that they can also avoid catastrophic mistakes.
Behavioral Economics 101
Drawing on aspects of both psychology and economics, the operating assumption of behavioral economics is that cognitive biases often prevent people from making rational decisions, despite their best efforts. (If humans were comic book characters, we’d be more closely related to Homer Simpson than to Superman.) Behavioral economics eschews the broad tenets of standard economics, long taught as guiding principles in business schools, and examines the real decisions people make—how much to spend on a cup of coffee, whether or not to save for retirement, deciding whether to cheat and by how much, whether to make healthy choices in diet or sex, and so on. For example, in one study where people were offered a choice of a fancy Lindt truffle for 15 cents and a Hershey’s kiss for a penny, a large majority (73%) chose the truffle. But when we offered the same chocolates for one penny less each—the truffle for 14 cents and the kiss for nothing—only 31% of participants selected it. The word “free,” we discovered, is an immensely strong lure, one that can even turn us away from a better deal and toward the “free” one.
For the past few decades, behavioral economics has been largely considered a fringe discipline—a somewhat estranged little cousin of standard economics. Though practitioners of traditional economics reluctantly admitted that people may behave irrationally from time to time, they have tended to stick to their theoretical guns. They have argued that experiments conducted by behavioral economists and psychologists, albeit interesting, do not undercut rational models because they are carried out under controlled conditions and without the most important regulator of rational behavior: the large, competitive environment of the market. Then, in October 2008, Greenspan made his confession. Belief in the ultimate rationality of humans, organizations, and markets crumbled, and the attendant dangers to business and public policy were fully exposed.
Unlike the FDA, for example, which forces medical practitioners and pharmaceutical companies to test their assumptions before sending treatments into the marketplace, no entity requires business (and also the public sector) to get at the truth of things. Accordingly, it’s up to firms to begin investigating basic beliefs about customers, employees, operations, and policies. When organizations acknowledge and anticipate irrational behavior, they can learn to offset it and avoid damaging results. Let’s take a closer look at a few examples.
The Dark Side of Teamwork
A few years ago, my colleagues and I found that most individuals, operating on their own and given the opportunity, will cheat—but just a little bit, all the while indulging in rationalization that allows them to live with themselves. (See “How Honest People Cheat,” HBR, February 2008.) We also found that the simple act of asking people to think of their ethical foundations—say, the Ten Commandments—or their own moral code before they had the opportunity to cheat eliminated the dishonesty.
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