The Friendship that Changed Economics

Andrew Stark in the Boston Review:

If we frequently fail to properly analyze events in terms of their probabilities, Kahneman and Tversky showed, we just as often overweight their probabilities. Buying a single lottery ticket increases the probability of our winning the jackpot by a very small amount: from zero to one in ten million. But because doing so takes us from the realm of complete impossibility into the seductive realm of possibility, that minuscule increase seems much more significant to us than it actually is. It gives us dreams to savor—buying that beachfront home, retiring and writing our long-deferred novel. The more vividly we envisage something, the more real we think it is likely to be. Thus we inflate the probability of winning.

Kahneman and Tversky spent decades cataloging a rogues’ gallery of such human psychological quirks, many of them evocatively chronicled in Michael Lewis’s lively new history of their collaboration, The Undoing Project. Each paper the duo published chipped away at the foundations of mainstream economics and its notion that people, as a whole, behave in predictably rational ways. After all, orthodox economics assumes, the market will punish us if we do not behave rationally. People who buy lottery tickets will find that they have insufficient money for groceries. Sports teams that pay enormous sums for seemingly hot players will find themselves deserted by fans. Sure, mainstream economists concede, we are not perfect. People, from time to time, unintentionally do things that are not in their own best interest. But as soon as they suffer the consequences, they right themselves.

What Kahneman and Tversky showed is that our irrationalities are not random but systemic, rooted in deep-seated psychological tendencies—such as failing to take probabilities into account in some situations and overweighting them in others.

More here.