The End of Rational Economics

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The End of

Rational Economics
Your company has been operating on the premise that people – customers, employees, managers – make logical decisions. It’s time to abandon that assumption. | by Dan Ariely IN 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the U.S. Federal Reserve once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.” Jacob Thomas

78 Harvard Business Review


July–August 2009



July–August 2009


Harvard Business Review 79


in the


We are now paying a terrible price for our unblinking faith in the power of the invisible hand. We’re painfully blinking awake to the falsity of standard economic theory – that human beings are capable of always making rational decisions and that markets and institutions, in the aggregate, are healthily self-regulating. If assumptions about the way things are supposed to work have failed us in the hyperrational world of IN BRIEF Wall Street, what damage have they done in other institutions » The global economic crisis has and organizations that are also shattered two articles of faith in standard economic theory: made up of fallible, less-thanthat human beings usually make logical people? And where do rational decisions and that the corporate managers, schooled market’s invisible hand serves as in rational assumptions but who a trustworthy corrective to imbalrun messy, often unpredictable ance. We need to replace these businesses, go from here? and other assumptions and adopt We are finally beginning to una new approach. derstand that irrationality is the real invisible hand that drives hu» Behavioral economics is founded on the premise that man decision making. It’s been a human beings are fundamenpainful lesson, but the silver lintally irrational and motivated by ing may be that companies now unconscious cognitive biases. see how important it is to safeThis emerging discipline offers a guard against bad assumptions. radically different view about the Armed with the knowledge that ways people and organizations human beings are motivated by really operate. cognitive biases of which they are largely unaware (a true invisible » By adopting an experimental approach, firms can discover the hand if there ever was one), busitruth underlying their assumpnesses can start to better defend tions about customers, employees, against foolishness and waste. operations, and policies. The emerging field of behavioral economics offers a radically different view of how people and organizations operate. In this article I will examine a small set of long-held business assumptions through a behavioral economics lens. In doing so I hope to show not only that companies can do a better job of making their products and services more effective, their customers happier, and their employees more productive but that they can also avoid catastrophic mistakes.


Behavioral Economics 101
Drawing on aspects of both psychology and economics, the operating assumption of behavioral economics is that cognitive biases often prevent people from making rational decisions, despite their best efforts. (If humans were comic book characters, we’d be more closely related to Homer

Simpson than to Superman.) Behavioral economics eschews the broad tenets of standard economics, long taught as guiding principles in business schools, and examines the real decisions people make – how much to spend on a cup of coffee, whether or not to save for retirement, deciding whether to cheat and by how much,...
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