Beyond Behavioural Economics: Cognitive Economics

In the realm of economic theories, where choices appear as outcomes of stable preferences, Cognitive Economics introduces a novel perspective. This field, blending insights from economics, neuroscience, and cognitive psychology, seeks to unravel the mysteries of human decision-making, challenging conventional wisdom.

Classical Economics assumes that choices derive from stable preferences, whereas Behavioral Economics ventures into the picture to point out that these choices might be errors or psychological biases. However, Behavioral Economics has no integrated explanation for these irregularities. This is where Cognitive Economics comes in, as it seeks to explore the thought processes behind our decision-making, analyzing the way our brains store, process and retrieve information. 

A pioneer in the study of this subject is Nicola Gennaioli (chair of Behavioral Finance at Bocconi University); he delves into the concept of “representativeness”, originally introduced by Kahneman and Tversky (1981). Decision makers, according to this view, tend to overweight representative features of a group or phenomenon, creating a stereotype. Picture this: when you think of an Irishman, the image of a redhead might spring to mind because it is more frequent among the Irish. However, this tendency can lead us astray, as only a 10% of the Irish population actually possesses this trait.

Gennaioli’s work incorporates this model of belief formation in different economic domains. Take the stock market paradox: stock analysts who are more optimistic perform worse than the rest. During the last 35 years, investing in the 10% of stock analysts who are more optimistic yields on average 3% a year, while investing the most pessimistic a staggering 15% a year. Why does this happen? Representativeness steps in – after observing stock earnings growth in a firm, investors think that it might be the next Google, as “Googles” are the most representative among the firms with strong earnings, the problem of course is that they are rare in absolute terms. As a result, expectations become too optimistic and future performance disappoints. In related work, it is shown that the same model of expectation formation can count for booms and busts in the volume of credit and interest rates spreads. 

Cognitive economics goes beyond financial markets and addresses societal issues like racial or gender discrimination. Gennaioli’s work highlights that our memory is not as objective as we think. We tend to selectively forget non-stereotypical experiences. Which means that after the formation of a stereotype, events following the same pattern will reinforce our beliefs, while those who do not will be forgotten. This explains not only why stereotypes come into existence (representativeness), but also why they persist over time.

In a recent study published in Psychological Review, Gennaioli and his co-authors explore how context impacts memory recall. Their findings reveal that our brains prioritize recalling past experiences based on interference. This implies memories encoded in the long-term memory (LTM) are subject to interference when recalled by the short-term memory (STM).

For example, consumers are more likely to purchase convertible cars on sunny days or overspend on warm clothing during abnormally cold days in winter, as current weather conditions trigger the recall of similar circumstances, causing consumers to overvalue these items.

In conclusion, Cognitive Economics is becoming a key frontier in the study of human behavior. There are two major advantages to this approach. Firstly, we can derive effective guidance on how to change and correct our beliefs. Second, because memory and attention are in use in every one of our decisions, this approach can explain a large variety of phenomena without having to resort to exotic preferences. Ultimately, Cognitive Economics stands as a unifying theory, offering a comprehensive understanding of human behavior, whether it be rational or irrational.

“We have very little idea of how little we know.”

Daniel Kahneman – Nobel Prize for Economics (2002)

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Bibliography:

• Bordalo, Pedro and Gennaioli, Nicola and La Porta, Rafael and Shleifer, Andrei, Diagnostic Expectations and Stock Returns (September 2017). NBER Working Paper No. w23863, Available at SSRN: https://ssrn.com/abstract=3042437
• Bordalo, Pedro and Gennaioli, Nicola and Shleifer, Andrei, Stereotypes (May 2014). NBER Working Paper No. w20106, Available at SSRN: https://ssrn.com/abstract=2436715
• Bordalo, Pedro and Coffman, Katherine and Gennaioli, Nicola and Shleifer, Andrei, Beliefs About Gender (December 2016). NBER Working Paper No. w22972, Available at SSRN: https://ssrn.com/abstract=2890104
• Tversky A, Kahneman D. Judgments of and by representativeness. In: Kahneman D, Slovic P, Tversky A, eds. Judgment under Uncertainty: Heuristics and Biases. Cambridge: Cambridge University Press; 1982:84-98. doi:10.1017/CBO9780511809477.007