Much of economic thought has revolved around the rationality of decision-making. For example, perfect competition assumes that information is freely available and as a result there would be no incentive for any firm to charge a price above any other firm because consumers would always buy from the cheaper seller. More sophistication to the model is built in through adding various imperfections such as product differentiation, branding, brand loyalty and so on but there is still a base assumption that humans will behave rationally. Rational Expectations theory suggests that people will factor in their expectations of the behavior of inflation into their decision making in determining wage demands, consumption habits and financial decision making.
Kahneman is a psychologist, indeed the first psychologist to be awarded the Nobel Prize in economics. His work, along with Amos Tversky, his long time colleague who sadly died in 1996, applied cognitive psychology to this notion of rational behaviour and changed thinking about the assumptions on which many concepts in economics are based. The work for which he received the Nobel Prize is termed ‘Prospect Theory’
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