Sunday, December 11, 2011

Predictably Irrational: Chapter 2

Dan Ariely is a behavioural economist who refutes the idea that we are fundamentally rational. Through empirical data, experiments and anecdotes, he illustrates that our irrationality can actually be predicted. He then presents ways in which we can make more rational decisions, both as investors and as people.

The supply/demand curves that are taught in beginner economics courses are elegant and intuitive. But they don't tell the whole story. They assume demand and supply are independent, but they are not. Scarcity, pricing, promotions and other factors can affect demand, throwing those elegant models out of whack.

The key to understanding this has to do with understanding anchoring. When a gosling emerges from its egg, it follows the first moving thing it sees until adolescence. Usually, that's its mother (and so that works out alright), but it doesn't have to be. In the same way, we humans often get anchored to an initial decision or price or method, and don't even realize we are anchored to it.

Ariely illustrates this with a series of experiments, where he demonstrates that that the price people are willing to pay for something is related to a random number they thought about before deciding on the price. As such, we can be manipulated by advertisers into anchoring our perceived price for something at a high number.

For example, Ariely describes how the discoverers of black pearls could not get ordinary shopkeepers to stock their product. However, once the pearls were put on display at a high price and with other precious gems, all of a sudden demand soared.

Ariely recommends questioning one's repeated actions in order to avoid falling prey to this bias. For example, if you are always buying a coffee from Starbucks, ask why. It might be because you've always done it, rather than because you are getting value.

Ariely also notes that seeing as how demand/supply curves do not describe the market perfectly, there may be a need for regulation and policies to correct for inefficiencies. If our decisions were rational, there would be no such need.

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