Markets for Managers: A Managerial Economics Primer

CHAPTER 11 Behavioural Economics

‘We favour the visible, the embedded, the personal, the narrated, and the tangible; we scorn the abstract.’

—Nassim Taleb¹

In his book Thinking, Fast and Slow Daniel Kahneman tells the story of his visit to a professional investor, who had just bought tens of millions of dollars of stock in Ford Motor Company. ‘When I asked how he made that decision, he replied that he had recently attended an automobile show and had been impressed. “Boy, do they know how to make a car!” was his explanation’.² Kahneman points out that the investor preferred to trust his raw emotion, rather than confront what would determine whether he would make a profit, i.e. establish whether the stock was underpriced. ‘The question that the executive faced (should I invest in Ford stock?) was difficult, but the answer to an easier and related question (do I like Ford cars?) came readily to his mind and determined his choice.’³ This chapter aims to do two things. To shed light on the times when we ask the wrong question, and to also explain what economists believe is the right question. We're going to investigate two big questions:

1. Are people rational?
2. Are markets efficient?

Economists may disagree on this issue, but the reason why they may give conflicting answers is because they are defining ‘rationality’ and ‘efficiency’ in different ways.⁴ Thus far, the concept of ‘rationality’ that we've used has been a fairly loose one. It simply means that – at the margin – incentives ...