Behavioural Economics made the Gartner Emerging Technology Hype Cycle again this year. Unfortunately I don’t have access to that report, so I’ve really little clue about why a theory is on the same curve with wikis, SOA and other, well, technologies. So, my knowledge of the report is based on snippets I found by searching the web. Anyway, for those who do not know Behavioral Economics, here’s a short primer on the subject.

In short, Behavioural Economics tries to explain why people make decisions that are against traditional rationality axioms. This traditional concept of perfect rationality is something that decision criteria like expected utility, on which many of classical economic models are built on, assume. Expected utility does recognize that people are risk averse and prefer smaller certain amounts of money to chance of winning more (see for example, Deal or No Deal -tv show.) 

Value function as described by the Prospect Theory. All you need to know is that this graph tells that people really hate losing.

Now, people systematically act differently than these traditional models predict. Turns out, people really hate losing. This phenomenon is called Loss Aversion and it means that even a small chance of (perceived) loss makes us nervous. Interestingly enough, when at loss, people are willing to bet the farm to get back to break-even. There are many interesting stories in the world of finance of people catching this “get-evenitis” like for example LTCM, Nick Leeson and, recently, Societe Generale. These two are just few of many different heuristics and biases people tend to have in their decision making. These “anomalies” are not covered by traditional models of decision making.

The history of Behavioural Economics goes back to the 1970s and many see Kahneman and Tversky’s 1979 paper Prospect Theory: An Analysis of Decision Under Risk (Econometrica, 1979) as a culmination point for the theory. This paper tries to offer a framework to explain the many anomalies (compared to rational decision making) they explored in an earlier paper, Judgement Under Uncertainty: Heuristics and Biases (Science, 1974). For their efforts, Kahneman won 2002 Nobel prize for psychology. Anyway, recently there has been more interest in Behavioural Finance, which basically just builds on the Economics side and is so practically the same thing.

So, Beahavioural Economics aren’t anything new, but so far it has had few applications. One of the main reasons for this is that it is basically a descriptive theory. In a really good book on the topic, Beyond Greed and Fear, author Hersh Shefrin explicitly warns the reader not to try to use any of the anomalies in the book for his/her advantage.

So, why should an IT manager be interested in this emerging technology that will, by Gartner’s estimates, hit the mainstream in 5-10 years? True, the topic is somewhat sexy filled with sexy terms like Gambler’s Fallacy, Money Illusion, Winner’s Curse and so on and cool jargon is something that is required of every hot new tech (like microblogging, cloud computing and wikis!). It is easy to get excited about the topic and that’s probably why Gartner has set Behavioural Economics as a “technology trigger” just rising to the “peak of inflated expectations”, because many might bitterly find out that in addition to awareness to one’s decision biases, one might not get that much more out of it.

Another Ph.D. student in my field told me that he was interested in behavioural decision making because he expected it to improve his poker skills. He had a successful sports betting background (which paid his M.Sc.) but he was moving to Texas Hold’Em. The thing was, he was interested in how to win a given game and not just more games in the long-run. In last December’s the Economist, there was a good article on poker and howw many academics are getting interested about researching it. In the end, this student came to conclusion that while the issues are interesting, the theory, as it is, is quite worthless to him in improving success in a given game. I guess this just highlights the problem that so far there’s very little you can apply the knowledge to.

So, what’s in it for an IT manager? There is, of course, the dark side to behavioural economics, which is closely related to marketing. Because, as a popular psychology book tells us, we’re Predictably Irrational, wouldn’t it make sense to exploit this predictability, say, for example in marketing and sales? By framing options differently in a web page you can make people behave differently and – Okay, seriously, a reality check. We’ve got a Nobel-worthy theory and Gartner thinks we should be using it for mere web design and perhaps for internal decision making?

As stated before, behavioural decision making is mostly a descriptive theory. It only gives us explanations why people act the way they do. What it can’t give is a prescriptive framework for making people act in a specific way and even if it did, there are huge ethical aspects to be considered about. So, a fail to see what Behavioral Economics can give to an IT manager – expect what it gives to everyone else. One thing to keep in mind is that Gartner’s curve is literally named “hype” cycle, so it no doubt deserves its place there.

Richard Thaler, a famous behavioural finance economist, recently wrote a book, Nudge (here’s a Q&A at Freakonomics blog), and in my opinion the title gives a good summary of what behavioural economics can or should give us. Just a “nudge” for better decision making and expanding our freedom of choice – not exploiting our biases for an extra buck.

The thing is, we all make these systematic errors in decision making – it’s built-in. The best you can do is educate yourself against them, because in 5-10 years, “choice engineering” (what Gartner really means) might just be mainstream. And knowing your biases might just improve your everyday decision making abilities, anyway.

If you’re interested, a good place to get an “executive summary” is Harvard Business Review’s article “The Hidden Traps in Decision Making” by Hammond, Keeney and Raiffa. I haven’t read Predictably Irrational, but I guess it’s in the Freakonomics-territory in terms of how approachable it is for general public and, given the author’s background, more suitable for the marketing folk. I haven’t yet started Nudge, but I imagine it is in the same territory. Then there’s also “Sway”, but I’m not so sure about that. Beyond Greed and Fear is best suited for the finance folks and is the only one of the bunch that requires basic knowledge of stock markets and finance/economics.

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