Fooled by Randomness and Nudge
Since an article titled ‘Prospect theory: An analysis of decision under risk’ by Daniel Kahneman and Amos Tversky was published in Econometrica in 1979, the field of behavioral economics and finance has expanded substantially. Recent interest to cognitive processes and their relation to decision-making under uncertainty was, in part, triggered by the onset of the financial crisis in 2007 that demonstrated inefficiency of markets and incomparability of real human nature to what economic science assumes humans to be. Numerous books discuss imperfections of human cognition. The primary purpose of this assignment is to compare and demonstrate similarities between two non-technical books, namely, Fooled by randomness by Nassim Nicholas Taleb and Nudge by Richard S. Thaler and Cass R. Sunstein. This paper argues that the two books provide by far the best account of the imperfections of human thinking in terms of assessing probability and chance, and explain potential consequences in terms of policymaking and daily behavior.
Fooled by randomness is dedicated to human assessment of probability and chance. It is dedicated to discussing how we perceive luck and how we tend to assume that certain events in our daily lives were determine or impacted by our own actions while in fact they were an outcome of a series of random events. The book discusses the personal or the individual aspect of understanding flaws in human thinking. Specifically, the book addresses the two important aspects in human thinking: the automatic or the emotional part that acts based on the so-called cognitive biases and the rational brain. The first part makes decisions based upon heuristics that are ingrained into human mind so deeply that humans do not recognize their presence. These heuristics make humans overestimate probabilities of events that are very unlikely to happen (such as the probability of having one’s house struck by a lightning in an area where thunderstorms happen rarely or the probability to die after being bitten by a shark especially after seeing a news piece dedicated to someone being eaten by sharks in some exotic resort location). These shortcuts developed in human brain in prehistoric times when life and death decisions had to be made quickly. For example, in a situation when our pre-historic ancestor had to decide quickly whether to run whenever he spotted a lion or to estimate the probability of being caught by the beast, the first decision would guarantee him or her that he would leave unscathed. While in the contemporary world we do not roam the savannah searching for food and do not have to combat wild beasts, our mind still relies on cognitive biases in decision-making. We simply have too complex lives and we cannot process and analyze everything. This illustrates the working of the intuitive or the automatic part of human brain.
Thaler and Sunstein discuss the two systems in their Nudge as well pointing out that the second system – the Reflective System as they call it following Daniel Kahneman – is more deliberate and self-conscious. They state that the second system is activated when we make complex calculations, decide which route to take when on a trip or when we make important decisions such as whether to go to law school or to business school. We use the second system when we learn something new, when we perform complex actions for the first time, when we write and when we analyze.
The two books provide an excellent account of how we are completely insensitive to probability. Taleb discusses a situation when a cancer patient is presented with information that under his condition he has 78% chance of survival. The number naturally puts the patient in a cheerful mood; however, when presented with statistics that says that the patient has 22% chance of death, the patient becomes gravely upset. This illustrates the so-called “framing effect” – we react to the information and make decisions based on how information is presented to us. Taleb makes an excellent discussion of how those biases interfere with decisions we make and how to learn to recognize emotional reactions to events and information and not become fooled by our own mind that attempts to reduce uncertainty and find a certain pattern in a series of unrelated events. In other words, the book by Taleb is very useful to those who attempt to understand their own relation to probability, chance and flaws in human thinking. It is focused on the individual.
In their book Thaler and Sunstein discuss framing effect and other biases to illustrate how flaws in human thinking can be used for policy decisions. In other words, Thaler and Sunstein discuss benefits of human flaws for choice architecture. Nudge is about collective insensitivity to probability and collective cognitive biases. The book discusses how they can be used for the benefit of the society, not just a single individual. They introduce a simple example of how the framing effect can be used by choice architects to stimulate compliance with existing norms. In Minnesota, groups of taxpayers received four kinds of information. The first kind informed them that their taxes were directed to certain types of good policy initiatives. Others received information that described various forms of punishment for non-compliance with existing tax law. Another group received information on where and how to obtain assistance on filling tax forms and filing their taxes. Finally, the last group received information that 90% of their neighbors have already paid their taxes. Had this piece of information been framed differently (such as 10% of your neighbors did not pay taxes), the result of the experiment would have been different. However, the outcome was that the fourth group of taxpayers paid the most in taxes on time. This example can be used to illustrate how flaws in human perception of themselves are used to provide people with incentives.
Thaler and Sunstein suggested that such incentives can be given to people in all areas of their lives: health, personal savings, taxation, compliance with social norms, investment, and credit markets. Most importantly, policymakers can use them to encourage individuals to change their behavior without having to spend additional money on promotional campaigns. For instance, survey results suggest that students engage in binge drinking; however, it was discovered that very few of them are fully informed how large the problem is in the general population. Since they are only exposed to a small group of other individuals, they cannot produce a correct assessment of the chance of being a binge drinker. In Montana, this notion was used to educate the population with advertisement stating that “Most (70 percent) of teens in Montana are tobacco free”. The campaign led to decreases in smoking.
Thus, it is important to realize that human thinking is naturally flawed. However, it is also important to realize that flaws in our thinking can be easily used by others to manipulate us in either good or bad way. Nudges are everywhere. Therefore, it is important to recognize emotional and rational response to life situations.
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