Las Vegas uses flashing lights and ringing bells to create an illusion of reward and to encourage risk taking. Insurance company offices present a more somber mood to remind us of our mortality. Every marketer knows that context and presentation influence our decisions.
For the first time, economists are studying these phenomena scientifically. The economists are using a new technology that allows them to trace the activity of neurons inside the brain and thereby study how emotions influence our choices, including economic choices like gambles and investments.
For instance, when humans are in a "positive arousal state," they think about prospective benefits and enjoy the feeling of risk. All of us are familiar with the giddy excitement that accompanies a triumph. Camelia Kuhnen and Brian Knutson, two researchers at Stanford Uni-versity, have found that people are more likely to take a foolish risk when their brains show this kind of activation.
But when people think about costs, they use different brain modules and become more anxious. They play it too safe, at least in the laboratory. Further-more, people are especially afraid of ambiguous risks with unknown odds. This may help explain why so many investors are reluctant to seek out foreign stock markets, even when they could diversify their portfolios at low cost.
If one truth shines through, it is that people are not consistent or fully rational decision makers. Peter Bossaerts, an economics professor at the California Institute of Technology, has found that brains assess risk and return
separately, rather than making a single calculation of what econ-omists call expected utility.
Researchers can see on the screen how people compartmentalize their choices into different parts of their brains. This may not always sound like economics but neuro-economists start with the insight-borrowed from the econ-omist Friedrich Hayek -- that resources are scarce within the brain and must be allocated to competing uses. Whether in economies or brains, well-functioning systems should not be expected to exhibit centralized command and control.
Neuro-economics is just getting started. The first major empirical paper was published in 2001 by Kevin McCabe, Daniel Houser, Lee Ryan, Vernon Smith and Theodore Trouard, all economics professors. (McCabe, Houser and Smith are colleagues of mine at George Mason University.)
A neuro-economics laboratory at Cal Tech, led by Colin Camerer, a math prodigy and now an economics professor, has assembled the foremost group of interdisciplinary researchers. Many of the early entrants, who have learned neurology as well as economics, continue to dominate the field.
Investors are becoming interested in the money-making potential of these ideas. Imagine training traders to set their emotions aside or testing their objectivity in advance with brain scans. Futuristic devices might monitor their emotions on the trading floor or in a bargaining session and instruct them how to compensate for possible mistakes.
Are the best traders most adept at reading the minds of others? Or is trading skill correlated with traits like the ability to calculate and ignore the surrounding caldron of human emotions?
More ambitiously, future research may try to determine when a short-term price bubble will collapse. Does the market tide turn when people stop smiling, adjust to their adrenalin levels or make different kinds of eye contact?
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