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Today's FT contains an interesting article on page 4: "The dismal science turns its attention to happiness". The gist is that next year sometime several economists at Princeton will launch an index to measure happiness on a country-wide scale. Daniel Kahneman, who's work (with Amos Tversky) on the role and import of human behavior on economic decision making, is the chief architect of the forthcoming index; we have referenced his Nobel-prize winning work in our discussion of non-linear markets in a few articles over the last several months.

The details of how they plan to implement the index are unimportant at this point; the aim is to develop a measure of well being that can be applied macroscopically (in developing government policies aimed ostensibly at increasing this index) and microscopically (for individual businesses where employee satisfaction directly benefits the bottom line). The libertarian in me winces at the quote from Britain's Cabinet Office that "there is a case for state intervention to boost life satisfaction." Only a socialist could possibly believe that more government programs will lead to increased happiness for those being offered these programs. But I digress.

It's the understanding that employees' well being has a direct impact on profits that is the interesting aspect to see here. Why? The fact that they are creating such an index suggests that there is a growing realization among entrepreneurs that classical, equilibrium economics - in which human beings are considered entirely rational - is sorely lacking in its real world application. That employees have wildly diverging tastes, goals, and time preferences is a given. That these tastes, goals, and time preferences each have their own unique weight in those employees' everyday economic decision making was a factor that was simply ignored in classical econometrics. Employee satisfaction is simply a direct function of the net present value of the future income stream from their job. Right?

Wrong, of course. There are many factors, some rational (like the net present value of their future compensation) and some irrational (things like respect, self worth, accomplishment, heck even the color of an office matters) that go into the complex milieu of job satisfaction.

But I am entirely disinterested in how this impacts, say, the productivity of Wal Mart's salesforce. I am interested in the fact that mainstream economists and companies are starting to realize that human beings are not entirely rational. My theory of non-linear markets - that asset markets represent the complex interplay of both rational and irrational decision making on the part of investors small and large - rests on this growing understanding. So as I read articles like those in today's FT on the increasing importance of behavioral economics, I smile wide seeing the realization spread that understanding how to run a business - just like understanding how to run a portfolio - depends on understanding that human beings are irrational.

Tversky and Kahneman have proven as much in their research. Now that understanding is making its way into application.

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