STREET DOGS

Where psychologists Daniel Kahneman and Amos Tversky went beyond the social science of the time was in demonstrating that people’s errors are not random but predictable. Economists knew that people made mistakes, but believed the mistakes occurred randomly and so cancelled each other out, leaving predictions based on the rational actor model.

Kahneman and Tversky showed that this assumption was wrong. For example, in assessing risks, people use the “availability heuristic”. A mental shortcut, in which we assess risks not by engaging in statistical analysis but by asking whether we can easily think of events in which the relevant risks occurred. If you can think of recent thefts in your neighbourhood, you might have an inflated sense of the danger – if you can’t, you might be far too complacent. The availability heuristic leads to both excessive and insufficient precautions.

Kahneman and Tversky did not claim that people are “irrational”. On the contrary, they urged that our heuristics, or rules of thumb, usually work well. But in some contexts, they fail us, which can lead to systematic mistakes.

Pressing this claim with sceptical economists, Richard Thaler repeatedly encountered an argument that he calls “the invisible hand wave”. The idea is that even if individuals blunder, competitive markets and invisible hands will cure the problem and eventually set them right. Thaler says economists cannot ever finish this argument with both hands remaining still.

To be sure, he is aware of the more sophisticated argument that because of market pressures, prices might turn out to be fully rational even when individuals are not — an argument he deems “certainly plausible, perhaps even compelling. It just happens to be wrong.”