Behavioural economics and the knowledge firm

This blog has two primary themes:

• behavioural economics
• the economics of knowledge

I believe they are closely linked, because behaviour is derived from the knowledge that people have about the world (or more strictly their mental model of the world, which may not actually be accurate knowledge).

Knowledge, in the economy, is influenced by many things. But at least one type of entity specialises in influencing it: the knowledge firm.

Knowledge firms include professional services firms, consultancies, marketing and media companies. Their distinguishing characteristic is that their work is not about manipulating physical objects but influencing the minds of people. This is done by creating messages and communicating them.

Therefore, knowledge firms are in the business of second-order influence of behaviour. Traditional firms offer products to which people respond based on their existing perceptions and preferences. Knowledge firms actively change the perceptions and preferences that people use to make their decisions.

Fortunately for these companies, people are not rational. In a world of perfectly informed rational actors, there is really no role for this kind of business. It's the various departures from rational behaviour that create the opportunity - and requirement - for knowledge firms to exist. And so, by understanding those departures, we can help knowledge firms to operate more effectively.

The list of departures from rationality is long. Here is the list I've been working from in some recent research:

• Hyperbolic discounting
  
• Loss aversion
  
• Habit-forming
  
• Framing
  
• Satisficing
  
• Peer defaults
  
• Heuristics
  
• Limited cognitive power
  
• Overconfidence
  
• Risk miscalculation
  
• Animal spirits
  
• Reciprocity
  
• Mental accounting
  

There are plenty of others, for example at Wikipedia. Depending on your model of the mind, many different items in these lists may originate from the same cause.

Just to take a couple of simple examples:

• Marketing firms take advantage of framing to create adverts. By creating subconscious associations between emotional goods (such as comfort or success) and products (such as fabric softener or cars) marketers influence people to buy products that they might not otherwise buy, or to pay a higher price for the same thing.
• Accounting firms allow people to use satisficing to make financial decisions. Instead of having to evaluate all possible risks and returns in a decision to invest or lend money, people can rely on an audit statement to decide that a decision is "good enough".
• Law firms can take advantage of the existence of heuristics. A law firm, when it creates a contract that governs the behaviour of two parties, restricts the likely behaviour of each one to a limited set of dimensions. Each party can operate as if the other will behave according to the contract, and avoid the time required to predict and evaluate every possible behaviour.

Knowledge firms have little reason to exist in a world of rational-maximisers. Every firm should understand its place in the ecosystem of cognitive bias in order to know how to position itself, what skills to develop and how to sell its services.