Symbiosis International Education Centre 2007 M.B.A SNAP TEST - Question Paper

By the late 1970s, economic rationality was not only the orthodoxy, it began to effect events in the real world. Macroeconomic policy, notably in America and Britain, fell into the hands of believers in the theory of “rational expectations”. This stated that, rather than forming expectations on the basis of limited info drawn from previous experience, people take into account all available info. This includes making an right assessment of government policy. Thus, when governments announced that they would do whatever was necessary to bring down inflation, people would adjust their expectations accordingly.

In the identical way, Wall Street investment firms, too, increasingly, fell under the spell of the “efficient markets hypothesis”, an economic theory that assumes that the prices of financial assets such as shares and bonds are rationally based on all available info. Even if there are many stupid investors, went the theory, they would be driven out of the market by rational investors who could profit by trading against the investments of the foolish. As a result, economists scoffed at the notion that investors could consistently earn a higher return than the market avg. by picking shares. How times have changed. a few of those identical economists have now become investment managers — although their performance has suggested that they should have paid heed to their earlier beliefs about the difficulty of beating the market.

During the 1980s, macroeconomic policies based on rational expectations failed to live up to their promise (although this was probably because people rationally refused to believe government promises). And the stockmarket crash of October 1987 shattered the confidence of many economists in efficient markets. The crash seemed to have occurred without any new info or cause. Thus, the door of the ivory tower opened, at 1st only slightly, to theories that included irrational behavior. Today there is a growing school of economists who are drawing on a vast range of behavioral traits identified by experimental psychologists which amount to a frontal assault on the whole idea that people, individually or as a group, mostly act rationally.

A quick tour of the key observations made by these psychologists would make even Mr. Spock’s head spin. For example, people appear to be disproportionately influenced by the fear of feeling regret, and will often pass up even benefits within reach to avoid a small risk of feeling they have failed. They are also prone to cognitive dissonance: holding a belief plainly at odds with the evidence, usually because the belief has been held and cherished for a long time. Psychiatrists sometimes call this “denial”.

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