the limits of (economic) rationality

A dual book review in the WSJ by David Shaywitz of Ori and Rom Brafman's Sway and Flirting With Disaster by Marc Gerstein and Michael Ellsberg...

Both books relate to the field of "behavioral economics"-- for which the Nobel Prize in econ was awarded to Daniel Kahneman a few years back. It is a fascinating sub-field in econ-- and one that extends the basic models of econ into occasional but important territory.

To note, econ typically assumes "rationality"-- that people do a decent job in weighing costs and benefits of the actions they take (recognizing the important constraint of limited and costly-to-obtain information). But rationality seems like quite a stretch as we analyze some of the things we do....

Shaywitz opens with an interesting and typical example:

Consider Linda, a 31-year-old woman, single and bright. As a student, she was deeply concerned with discrimination and social justice and also participated in antinuclear protests. Which is more probable? (a) Linda is today a bank teller; (b) Linda is a bank teller and active in the feminist movement.

When psychologists Daniel Kahneman and the late Amos Tversky conducted an experimental survey in the early 1980s asking people to answer this simple question, they discovered, to their surprise, that most respondents picked "b," even though this was the narrower choice and hence the less likely one. It seems that saliency – in this case, Linda's passionate political profile – trumps logic.

Over the past quarter-century, Mr. Kahneman and his colleagues have gone on to identify a range of flaws in our critical faculties, reshaping the study of economics by challenging the assumption that a person, when faced with a choice, can be counted on to make a rational decision....

"Sway," by brothers Ori and Rom Brafman, is the latest addition to this literature. It offers a breezy introduction to the science of decision-making and shows the many ways in which logical thought can be subverted or "swayed."...

While the Brafmans are amused by our irrationality, Marc Gerstein is troubled by it and wants to understand why we have such difficulty recognizing our mistaken thinking before it is too late. In "Flirting With Disaster," Mr. Gerstein (assisted by Michael Ellsberg) explores the psychology underlying a series of disasters, including the Challenger explosion, the flooding of New Orleans, the collapse of Arthur Andersen and the fall of Long-Term Capital Management, a hedge fund run by supposed "geniuses." Mr. Gerstein believes that each disaster resulted from a series of bad decisions that could have easily been avoided....

Mr. Gerstein concludes that there are too many disincentives to speaking up; he would like to see more whistleblowers. He would also like us to pay more attention to warnings from experts. An important question raised by "Flirting With Disaster," though, is whether unheeded expert warnings are either as significant or as potentially useful as he implies. It seems probable that there is an element of selection bias here: Such warnings may be extremely common, especially in high-risk activities such as space flight or options trading – we just notice them when they happen to be both ignored and right....

As Mr. Gerstein urges, though, we could all do more – in our personal and professional lives – to reduce error, learn from mistakes and resist the passive acceptance of a flawed status quo. The question is whether we're rational enough to respond to the challenge.