The Art of Smart Thinking

„What a piece of work is a man, how noble in reason, how infinite in faculties, in form and moving how express and admirable, in action how like an angel, in apprehension how like a god!“

— Shakespeare’s Hamlet

The art of smart thinking

Shakespeare’s Hamlet believed man to be a rational creature, but we’re not always such logical thinkers.
For example, here’s a simple arithmetic question: A bat and ball cost a dollar and ten cents. The bat costs a dollar more than the ball. How much does the ball cost?Most people respond quickly and confidently, insisting that the ball costs 10 cents. This answer is both obvious and wrong. (The correct answer is five cents for the ball, $1.05 for the bat).

Psychologist Daniel Kahneman was awarded in 2002 the Nobel Prize for challenging the assumption of human rationality in modern economics.

Kahneman showed that people often times rely on so-called heuristics when making economic decisions. Heuristics are mental shortcuts that people use everyday to simplify the complexity of decision making.

Rational decision making is comprised of  two key factors: what is true and what we do. We naturally want to buy things for the best price; to save the most money, but often we get tricked or choose the second best option, because of the shortcuts our minds make.

 

Availability Heuristic

We find it difficult to estimate probabilities. Instead of thoroughly considering the likelihood, we take shortcuts and draw conclusions. The reason why we make these shortcuts is that using our memories is much easier than thinking fresh; it takes effort not to rely on our past experiences.
For example, say you buy a new iPhone just one week after your partner loses theirs. Because of your personal experience, you are more likely to overestimate the risk of losing your phone, even though the actual chances might be low.

 

Scarcity Heuristic

It is our natural human instinct to think that goods that are rare are therefore valuable. In general this is true, but merchants have picked up on this assumption of ours and used false advertising to make us rush and buy their products. Have you ever rushed to pay for a hotel room you found online, because the site said it was the last room available for the special rate? This is exactly the psychology businesses use to make us buy more, by thinking that the deal is too good to miss out on.

 

Prospect Theory

Research shows that we fear loss much more than we should. In fact, Nobel laureate Daniel Kahneman found that the subjective positive value x is smaller than the subjective negative value of -x. What does this mean? It means that if you take away $10 from someone, the negative effect will be much larger than the positive effect of giving that same person $10. Our fear of loss is excessive, and we do everything we can to minimize the chances of loss, even when it doesn’t make sense.
For example, many people buy insurance with a new electronics purchase, even though the risk is most likely low. It often makes very little sense to insure a product of low value, but when buying the product, we think about how bad losing that item could be, and overestimate the risk of loss or damage and the emotional effect it would have.
Renaissance of heuristicsIn the last years, however, the positive aspects of heuristics have been emphasized as well. For instance, the renowned scientist Gerd Gigerenzer argues that heuristics not only help us save time and make satisfactory decisions but in many instances even outperform rational decisions. However, knowing about the human follies can help you in the context of economic decision making and prevent unnecessary mistakes.