Behavioral Puzzles in Business and Diplomacy

Aug. 3 -- "Why was I so stupid?" In their already classic book Judgement Under Uncertainty, psychologists Amos Tversky and Daniel Kahneman give at least a partial answer to this perennial question.

They describe some of the myriad ways in which we, subject at times to cognitive illusion, act irrationally. Kahneman received the 2002 Nobel prize in economics for his work, and Tversky would have shared it had he not died. Applying many of the Tversky-Kahneman findings to business and the stock market, economist Richard Thaler and others have recently developed the new field of behavioral finance.

It's a burgeoning field with applications that transcend finance and extend to everyday transactions as well as to issues of war and peace. One of its most important insights is that how situations are framed affects our choices in specific ways.

Inconsistent Monetary Choices

Consider a situation in which an imagined benefactor gives $1,000 to everyone in a group and then offers each member of the group the following choice. He promises to a.) give them an additional $500 or else b.) give them either nothing or an additional $1,000, depending on the outcome of a coin flip. Most people choose to receive the additional $500.

Contrast this with the choice people in a different group make when confronted with a benefactor who provisionally gives everyone $2,000 and then offers the following choice to each of them. He will a.) take back from them $500 or else b.) will take from them either nothing or $1,000, depending on the flip of a coin. In this case, in an attempt to avoid any loss, most people choose to flip the coin. The punchline, as it often is, is that the choices offered to the two groups are the same: a sure $1,500 or a coin flip to determine whether they'll receive $1,000 or $2,000.

In another, more complicated study, subjects generally chose to receive $45 with a probability of 20 percent rather than $30 dollars with a probability of 25 percent. This is reasonable since the average gain in the first case is $9 (20 percent of $45), whereas the average gain in the second is only $7.50 (25 percent of $30).