April 10, 2013
By Eric Fish

Daniel Kahneman is an Israeli-American psychologist and winner of the 2002 Nobel Prize in Economic Sciences. Much of his life’s work, which is brought together in his book Thinking Fast and Slow, revolves around the idea that we believe we’re rational people with logical reasons behind our decisions, but often, that’s not actually the case.

Kahneman’s work is based on the premise that our mind has two systems: System 1 - our impulsive and intuitive thinking that’s done subconsciously, and System 2 - our deliberate logical thinking. Kahneman’s research has found that System 1 shapes our individual decisions more than we realize or care to admit. In fact, our impulsive (often illogical) emotions control the risks we take, the important decisions we make and what actually makes us happy. This has reverberating effects in the wider world of business and politics. 

On Mar 23, Kahneman spoke with the EO in Beijing about human psychology and how it may influence business and some of the major issues facing China.

EO: What have people in China been most anxious to ask you about?

Kahneman: I haven’t spoken to a lot of people, but they ask a lot about happiness. There’s a lot of concern about happiness here. 

EO: Incomes have grown exponentially over the past two decades in China, but several surveys have found that people’s happiness has stayed flat or even gone down. Why do you think that is?

Kahneman: This is a common result. Certainly you would expect that, in periods of rapid change, happiness wouldn’t immediately follow. In periods of rapid change there are winners and losers and the losers suffer more than the winners gain, so what you find on average is there might be no change or even a change for the worse. If expectations rise faster than income then you’ll get that result.

EO: China’s new leaders are talking about major economic reforms and restructuring of state-owned enterprises, as well as cleaning up pollution. But many worry vested interests will be too formidable of a challenge. 

Kahneman: Of course. That’s the difficulty with reform generally. There are winners and losers in every social change and every reform. The losers fight a lot harder than the winners. So reforms tend to be more expensive than planned because when you plan initially, you look at the overall balance of costs and benefits. But in reality, the people who are going to bear the costs demand compensation and tend to get it because they scream louder. So reforms tend to be less efficient than planned.

EO: Regardless of political system?

Kahneman: Yes. I think democracies have a bigger problem than more authoritarian systems because in democracies the screams are heard very loudly and are very influential. I’m sure that authoritarian systems have other problems, but democracies have more of that problem because you cannot prevent the losers from screaming bloody murder, and they have a lot of political influence.

EO: In your book you say that we think our core political and religious beliefs are based on System 2 logical thinking, but in fact, they come more from impulsive System 1 thinking and we simply use our logic later to rationalize those beliefs. You say, “When people believe a conclusion is true, they’re also very inclined to believe the arguments that support it, even when those arguments are unsound.” So at the end of the day, are political and religious debates useless?

Kahneman: Yes, in the sense that nobody ever changes their mind, or hardly. So mostly it’s an empty task. It’s good that people talk, but they’re not going to change their minds in general - not through talking.

EO: So what can make somebody change their core beliefs?

Kahneman: People will change their core beliefs when people that they respect, admire and love change. Most of what we believe, we believe because the people we’re close to and trust believe in it. I don’t think that core beliefs can be changed in other ways. They can sometimes be changed by exposure to a completely different life or environment. But when people are in their environment and in their social context, it’s rare that core beliefs will change. Sometimes there are dramatic conversions and dramatic events, but they’re very rare.

EO: What are the dangers of rationalization by System 2 leading to extreme confidence in our beliefs?

Kahneman: Generally in situations of conflict, overconfident optimism is very dangerous. It’s true for lawyers and it’s also true in wars. In wars there are optimistic generals on at least one side of every war or the war wouldn’t start; sometimes on both sides.

EO: Does having power, or feeling like you have power, make people more inclined to go with their instinct?

Kahneman: Yes, there is research that suggests that; that people monitor themselves less and trust themselves more when they feel in power. Leaders have that problem in general because they’re selected for being confident and optimistic, otherwise they wouldn’t be leaders. So being leaders and having powers would certainly enhance that.

EO: Along that same line, often the more confident lawyer wins a case just because the judge or jury is intuitively attracted to confidence. So should some institutions that rely heavily on human judgment, like our legal system for instance, be overhauled somehow?

Kahneman: No. The legal system is imperfect and we are imperfect. I don’t think I have ideas about how to make things better. Human judgment is what it is. You have to create institutions that will force people to think more carefully in some cases, and the legal system is primarily intended to do that. It doesn’t do that perfectly, so confident lawyers win more cases than they deserve to win. But it does that approximately, and better than approximation is hard to achieve.

EO: Another position where human judgment is critical is with CEOs. But you argue that CEOs are very susceptible to the “sunken costs fallacy” and will stick with a bad project when a lot of money has already been spent on it; even if more money could be made by abandoning it and focusing on something better. Is the implication here that CEOs should be changed frequently?

Kahneman: Not necessarily very frequently, but under some conditions a new CEO can do things the existing CEO cannot do. I think that’s well-recognized. When things are going badly, it’s not a matter of punishing a CEO, but sometimes it’s very difficult for a CEO to fix their own mistakes and it’s easier for somebody else to fix them.

EO: In general though you seem to think CEOs get more blame and credit than they deserve. Your research has shown that a CEO with several consecutive successful acquisitions is akin to a basketball player with a “hot hand” (making several baskets in a row). It’s the result of routine statistical streaks rather than a burst of skill. Statistically, what other professions do you think are given too much credence?

Kahneman: I think obviously people who say they can pick stocks well. In big markets like Wall Street, people think that they can pick stocks and I don’t believe them. People make very confident political predictions about the long-term and I don’t believe them. Those are the examples I think have more confidence then they deserve to have.

EO: You write at length about “anchoring” in the business world, where buyers are led to paying or buying more because a number has been subconsciously planted in their mind. For example, if grocery stores put a sign above a product saying “Limit: 12 per customer” they sell twice as much. Or with real estate, if you list an absurdly high asking price on a house, people will end up paying more than they otherwise would have. Is the idea of supply and demand overrated?

Kahneman: The idea that supply and demand is the only thing that matters is false. Other things matter, but supply and demand is extremely important. So if you need one idea to explain what’s going on in the economy, then supply and demand would be that idea. You will not use anchoring to explain the economy. But in addition to supply and demand there are also loss aversion and anchoring that influence economic behavior.

EO: People are flocking toward real estate in China thinking it’s a surefire investment. But at the end of 2011, prices fell in some cities almost overnight by up to 30 percent. Some who’d recently bought homes protested or even vandalized real estate offices. Some worry this kind of unrest could happen on a large scale if the housing bubble bursts.

Kahneman: This is loss aversion, which I talk about a lot. People get used to what they have and feel that they’re entitled. So in the housing market people feel that the real value of their house is the highest price it was ever worth. Anything less than that is a loss and people don’t like losses.