BY AVANIDHAR SUBRAHMANYAM

In times of war, we should consider the impact of human biases in order to help consumers and investors make wise economic decisions.

The premise of economics has historically been based on the ideology that individuals are rational decision-makers. However, a new line of thinking proposes that to understand actual market-related phenomena, we need to accept that human beings are governed by a number of nonrational considerations. Studies show that humans are overconfident, full of biases and gamble even though the odds are stacked against them. In addition, they overestimate the impact of dramatic, easily recalled events, such as a war.

Let’s look at how these human characteristics are played out during wartime. We have faced stiff resistance in the war with Iraq. Why are we surprised? I propose it is overconfidence: We went to war, in part, thinking our way of government is the best there is; hence, the Iraqi people cannot but welcome liberation and the prospect of democracy. Overconfidence can, at times, cause serious miscalculations of the likely future effect of our actions, which, in turn, can have a deleterious impact on resources and wealth.

Recent research has shown that investor moods do affect the stock market. For example, markets are affected by religious and cultural occasions, as well as the weather. When American soldiers are engaged in combat — and we receive 24-7 news reports of past and imminent casualties on television, radio and the Internet — optimism is impeded, depressing trading activity and stock market levels. The danger lies in a self-fulfilling cycle, when investors become irrationally pessimistic by overestimating the impact of a war. This causes firms to invest less, which, in turn, causes further depression in the stock market, and so on.

Let me finally consider the recent spike in gasoline prices. On the face of it, the direct consequences of a war on oil supplies appear limited. The United States has enough leverage on other oil-rich nations to ensure that oil supplies are not disrupted in any way. I believe there is another reason for gasoline price increases: Consumers are willing to pay them.

Because of demand inelasticity, gasoline producers have a lot of discretion in pricing. Were producers to increase prices by 30% in normal times, there would be consumer outrage, followed by possible political repercussions. However, during war, consumers are willing to pay more money for gas because they assume that the cost is somehow war-driven. In this case, opportunistic oil companies and suppliers will be only too happy to raise prices.

The more we learn about our biases, the higher the standard of communication we demand from our leaders; the more we suppress emotional reactions to dramatic events, the better our institutions and markets will function and, consequently, the better off we will be as a community.

Subrahmanyam is professor of finance at The Anderson School.