Posts Tagged ‘Daniel Kahneman’

In this essay, Alasdair White takes a cold hard look at the current state of consumerism as an economic model and with the help of Daniel Kahneman and Nassim Nicholas Taleb concludes that consumerism and classical microeconomic theory is no long sustainable – it’s time for a re-think!

Are consumerism and the consumer society dead? Well, we’re all consumers but we don’t all live in a consumer society. This begs the questions as to what are consumers and what is a consumer society.

Consumers are those people who acquire, usually by buying, goods and services and then use them before disposing of them, often before the end of their useful life. This has given rise to the idea of a consumer society, which is one in which people often buy new goods, especially goods they want but do not need, and place a high value on owning many things. This, in many ways, is another way of describing economic materialism which is the excessive desire to acquire and consume material goods. It is usually closely connected to a value system that regards social status as being determined by affluence as well as the perception that happiness can be increased through buying, spending and accumulating material wealth.

In purely economic terms, this is directly contrary to the rational self-interest of the individual as an economic actor, a self-interest that is rationally served by the optimisation of the person’s scare economic resources – or, in other words, is best served by getting the best value for the limited money they have available. Very few people have an unlimited source of funds – almost all of us have income which is taxed leaving us with a disposable income from which we have to purchase the goods and services we ‘need’ (the goods and services that without which our health will decline and we will eventually die). This then leaves us with a discretionary disposable income with which to purchase those goods and services we want – and to do that we make decisions as to what to purchase so that we optimise our spending to acquire goods and services that have the greatest value to us. This element of choice, this discretion, means that we can choose to spend now or to save so that we can spend later (deferred expenditure). It also means we can choose to spend on goods that have no essential value but which satisfy an emotional need.

If we are rational, then we will seek to optimise our expenditure and only purchase those goods that are needed and present the greatest value to our long-term self-interest. This, of course, is the direct opposite of what the sellers of goods require us to do. The sellers (or retailers) are operating a business model that requires them to do everything they can to maximise the consumers spending – in other words, to get the consumer to spend the maximum possible amount irrespective of value or need. There is no possible situation in a consumer society in which a retailer can ever act in the consumers’ best interests as the economic objectives of the retailers and the consumers are mutually exclusive.

But why don’t consumers realise this? Why do they persist in believing that the offers from retailers represent something that will benefit them?

The answer is remarkably simple: people are not rational and seldom act in their own best interests. They are easily manipulated, usually by appeals to their emotions, and they seldom think things through to determine what course of action is actually in their real best interests. Essentially people are intellectually lazy, easily swayed by the opinions of others, and in many cases totally unable to think things through. This is where the work of Daniel Kahneman is of such importance. In his book Thinking, Fast and Slow, Kahneman explores the two types of thinking that appear to take place in the human brain. The dominant type is the Fast thinking (system 1) which creates heuristic models – experienced-based problem solving methods that use readily available information (and memories) that may be only loosely applicable and appropriate and usually render a sub-optimal (though often ‘good enough’) answer that contains systematic errors or cognitive biases. We tend to rely on these heuristics even when we shouldn’t, believing that our experience in similar such situations is appropriate in the current situation. This is simply not rational.

In comparison, the Slow thinking (system 2) engages in detailed analysis of all the information available to reach conclusions that a free of cognitive biases, systematic errors and requires consistent and conscious thought. It generally operates in a ‘bounded rationality’ but is still far more accurate than system 1, however it is an energy-intensive and costly process that takes significant amounts of time although it at least ensures that the subject is properly studied and a rational decision is made.

Why do we, as humans, allow our brains to adopt system 1 thinking at the expense of rationality? This is not explored by Kahnemen, possibly because the answer is not to be found within the field of psychology, but within biology. Studies show that an average human being has a resting metabolic rate of 1300 kcals per day (obviously this is dependent on age, gender, size and health, but this is an average) and the brain, which is about 2% of the body weight, consumes around 20% of that just to maintain its normal resting activity – about 260 kcals per day, but when the brain engages in system 2 thinking, the energy consumption increases dramatically and the amount of energy the body needs increases accordingly. This is empirically obvious to anyone who has been a student or has worked with students (or senior school pupils), at the end of a long day of study, they are exhausted and often fall asleep or need to consume high calorific foods before they can do their private study or homework – it is also measurable by studying blood glucose levels and other blood chemistry factors. Now, my hypothesis is that the brain has evolved in such a way that it has learned that deep thinking is costly in terms of energy and, as sources of energy are limited, it has set up decision-making and problem-solving methodologies (heuristic models) that make far lower energy demands while at the same time creating sub-optimal but ‘good enough’ solutions. In other words, our brains have evolved to use non-rational techniques as a way to save energy.

Obviously, if the system 1 heuristics are based on appropriate experiences, then they will become progressively more accurate in their outcomes and so less system 2 thinking has to be undertaken thus releasing the brain to engage in other activity without creating a spike in demand for energy. This, of course, is the basis of repetition or rote learning, repetitive practise, and our ability to provide ‘good enough’ solutions to most of our day-to-day activities. Kahneman builds on this by suggesting that when we do engage in energy-intensive system 2 thinking, the outcome can then be used from the memory and can inform the appropriate heuristic bringing its outcome closer to the optimal.

But Kahneman identifies something else that the brain does which makes our system 1 thinking sub-optimal and that is that the correct frames of reference for the problem, the understanding of risk and probability, and correction of our emotional biases are all active in system 2 but are not active in system 1. Such is our addiction to mistakenly believing that we are rational, we end up believing that all actions have an identifiable cause and if we can identify the cause, then we can control our response. But the shocking truth is that a great deal of what happens to us and in our environment is random in that there is nothing we can do to neutralise the cause or avoid the consequences. This school of thought is brought into clear focus by Nassim Nicholas Taleb whose work on randomness and risk is worth the effort (system 2) of reading and by ‘chaos theory’ which shows mathematically that very small differences in initial conditions (which may have existed at some indeterminate time and location in the past) can yield widely diverging outcomes in otherwise identical systems thus rendering long-term prediction of the outcome impossible. Both these concepts can and do invalidate the predictability which is a fundamental belief in micro-economics (and much else).

The truth of the matter is that behavioural psychology has undermined the foundations of micro-economic theory to such an extent that much of what we have been told is true about our economic activities is in fact unreliable. Take the prevalent and popular consumer model that is promoted so strongly by many societies, particularly western ones. This is, ostensibly, a market-economy model in which supply and demand play a dominant role so that rising demand for goods is matched by rising supply of those goods. But when we delve deeper, it becomes evident that the ‘market’ is a creation of the ‘supply-side’ elements – the producers and retailers – and not of the ‘demand side’ – the consumers. Let me explain.

During the world war that took place between 1939 and 1945, production was revolutionised, no longer were things made by artisans and by hand, machines were created and employed to mass produce the materials of war – everything from ammunition to aircraft were produced on a production line basis that churned out usable end products at a phenomenal rate. This was a classic ‘demand side’ situation: the military required huge quantities of everything and industry geared up to provide it. Costs were not a problem as governments simply printed money or the banks lent it and so production (a supply side element) knew no bounds. The problem was that after 1945/46 demand fell precipitously leaving the economy with a huge ‘over capacity’ on the supply side.

The solution, as far as the policy makers were concerned, was firstly to convert from the production of weapons to the production of consumer products (but involving the same technologies) and then to artificially create a demand via the promotion of consumption through advertising, marketing, bank loans, and governmental policy. Much of this was focused on creating a desire to own goods and services, irrespective of need, and the award of status for owning lots of material possessions. In other words, the creation of a consumer society to provide ‘demand’ for the over abundance of ‘supply’. Little attention was paid to whether these goods were needed, they were presented as being the rightful entitlement of the victors of the recent war: in other words, this was the reward for the privations and destruction endured. All the supply side actors were involved: banks lent money to consumers so that they could buy goods, producers made goods irrespective of need or value, advertisers and the media promoted the idea that greed was good and that owning lots of things was our entitlement and a desirable thing, that it gave us status.

Somewhat inevitably, there were just so many washing machines and other items that any one family could use and so producers started to build in obsolescence, they started creating products that were deliberately designed to break down after a certain period of time so that the consumer felt compelled to purchase a replacement – something that is certainly not in the best interests of the consumer and his or her need to optimise their economic activity, but certainly something that maximised the producers’ side of the equation. It didn’t take long for the consumer to become addicted to this bonanza of products and to create a huge demand bubble that was promoted by advertising and marketing communications in the media and fuelled by cheap loans from the banks.

Inevitably, these bubbles burst, lenders found themselves exposed to defaulting borrowers, many of whom should never have been allowed to borrow in the first place, greed had turned the lenders and the consumers into gluttons, more and more producers were entering the market thus inexorably inflating the supply side while squeezing the demand side by cutting off the supply of money that fuelled the consumer boom. Eventually, the consumers got the message that greed was NOT good, that the markets were a zero-sum game in which people could only obtain if someone else lost. It was not a win-win situation but a strictly win-lose with the consumer on the losing end. Eventually, the consumers stopped consuming, demand dried up and the supply side producers started to cry foul and pressurised their governments ‘to do something to stimulate demand’ – the governments, blinded to the reality of the simple win-lose equation and made up of normal non-rational thinkers, obliged and the result is the monumental mess the western economies are in as we enter 2014.

Bizarrely, governments are even telling us that we should not save our money (deferred spending) but we should spend now. These are the same governments that have no way of funding the pensions that will have to be paid and have been telling people to save for their own retirement. Well, rather obviously, we cannot spend now and save for our retirement … but there again, politicians are not known for their rationality.

Alasdair White is a business school professor, author and publisher. He is the author of three best selling management books and under his pen-name of Alex Hunter, the author of two thrillers.