Finance , psychology , economics and the design of successful institutions

The theory of rational efficient markets dominated financial economics three decades ago. In recent years, however, psychology-inspired behavioral finance has overshadowed it. Both critics and proponents of the use of psychology in economics and finance base their positions on the premise that psychology primarily deals with human fallibility, systematic mistakes and biased judgment (Kahneman, Slovic and Tversky, 1982). The association of psychology with pathology seems to imply that normative behavioral economics and the design of successful institutions must focus on a benevolent paternalism aimed at saving individuals from themselves. This paper, in contrast, discusses how simple psychological processes frequently, but not always, function well in their respective environments. Using the concept of ecological rationality and the key findings of psychology in economics, three lessons for designing successful institutions are proposed.