Tag: behavioral economics

Real-world Endowment

Sep 20

One of economists’ common critiques of the study of behavioral economics is the reliance on college students as a subject pool. The argument is that this population’s lack of real-world experience (like paying taxes, investing in stock, buying a house) makes them another kind of people, one that conceptualizes their decisions in altogether different ways. And although many decision-making studies in behavioral economics have shown that young adults do not act much differently than adult adults when it comes down to their core behavior (think of MDs whose diagnoses are influenced by defaults and the framing of choices, for example), the argument persists as a sweeping dismissal of using students as the main testing ground.

One area where we can test this assumption is with the endowment effect. Simply put, the endowment effect shows that we value the things we own more than identical products that we don’t own. This causes a mismatch between buyers and sellers, where buyers are often willing to spend less than the seller deems an acceptable price.

If we are to assume that consumers hold constant, well-defined preferences, this puts the stability of valuations into question. As such, the endowment effect has puzzled economists for quite some time because in principle, valuations should not be affected by ownership; if a purple hat is worth $15 to you, it should be worth $15 to you whether or not you have purchased it, and this value should remain consistent both before and after you purchase it.

Let’s say that undergraduate A receives a mug and is asked how much money she would require to sell it to undergraduate B. Studies find that undergraduate A will have a much harder time parting with the very same mug that undergraduate B has no attachment to. Now, these students don’t have much experience with real-world markets. So the question is — would those who do have experience in these markets behave differently than their inexperienced undergraduate counterparts?

In his senior research paper, Sean Tamm studied exactly this*. He approached 30 car salespeople and 46 realtors, a population that presumably has much experience with negotiating their maximum willingness to accept (when selling items), as well as with a maximum willingness to pay (when purchasing items). He endowed half of these participants with mugs, and asked the sellers what it would take to sell the mugs and the buyers what it would take to buy the mugs. And despite the extensive real-world market experience of these participants, willingness to accept was about three times higher than willingness to pay, demonstrating that even expert negotiators are susceptible to the endowment effect. This is consistent with previous research, showing an overvaluation of owned goods of about 2.5 times that of unowned goods.

This is just one more example of real-world experience not playing the protective role that we often assume comes with experience. It also suggests that our brains and the way we make decisions are similar, and that for the most part, students are operating under the same constraints as those with much more experience. In the end, we may just have to accept that students are real people (most of the time).

*“Can Real Market Experience Eliminate the Endowment Effect?” by Sean Tamm, Stetson University

Swiss Army People

Aug 01

Plato once said that people are like dirt. They can nourish you or stunt your growth.  This seems sage and reasonable, but I think people are more like Swiss Army knives (To be fair, Plato did not have the benefit of knowing of such a tool, so I don’t think I’m detracting from his comparison in the least). Swiss Army knives, as we all know, are incredibly versatile, and have a tool for almost any situation. Need to open a package—it’s got a knife! Sharing beers with friends on the beach—it’s got an opener! Have something in your teeth—there’s a toothpick for that! Need to do a little electrical work—it’s a got a tool that can strip wires! The downside is that Swiss Army knives are not particularly good for any specific purpose because any really intricate task is going to require much more specific tools.

People are a lot like Swiss Army knives from this perspective, and I am saying this with tremendous appreciation.  A lot of the research in behavioral economists criticizes people for various ineptitudes: why we don’t save money, why we don’t exercise, why we text and drive. And it’s true, there’s a lot to criticize and a lot that goes wrong in our decision-making processes, but when you consider just how versatile we are, it’s very impressive. Essentially, we do a lot of things sort of OK. We can reason moderately well about money, we’re often pretty good with various relationships, we’re fairly moral, and most of the time we don’t kill ourselves or others. Not bad if you think about it this way!

Now, some people are more like the specialty tools, like post hole diggers, or lemon zesters, or cigar cutters; in these cases these individuals are truly excellent in certain domains. But often these people aren’t the best at navigating the world in a pragmatic fashion. There are often savants, like Kim Peek (the person that Rain Man is based on), who certainly can’t handle the day-to-day on their own, but have extraordinary abilities in other spheres. And plenty of geniuses have similar problems; take Bobby Fischer’s statelessness and detentions, or van Gogh’s famously self-detrimental tendencies and ultimate suicide. If everyone were like these folks, our species would surely be in peril. If people were all specialized, and could only think numerically, or long-term, or probabilistically, what would life be like? Neither rich nor long.

Of course these people provide inspiration and spur progress, and we admire and celebrate many of them (who don’t put their genius to antisocial use), but we should be grateful that most of us are more like Swiss Army knives.

Turning the Tables: FDR, Tom Sawyer, and me

May 08

Before television and the internet, political candidates had two primary means of getting their image out into the public: live appearances and campaign posters. And given the limited reach of the former, posters were a crucial element in political strategy. How else were candidates supposed to project an image of decisiveness and gravitas?

So when Franklin D. Roosevelt ran for governor of New York in 1928, his campaign manager had thousands of posters printed with Roosevelt looking at the viewer with serene confidence. There was just one problem. The campaign manager realized they didn’t have the rights to the photo from the small studio where it had been taken.

Using the posters could have gotten the campaign sued, which would have meant bad publicity and monetary loss. Not using the posters would have guaranteed equally bad results—no publicity and monetary loss. The race was extremely close, so what was he to do? He decided to reframe the issue. He called the owner of the studio (and the photograph) and told him that Roosevelt’s campaign was choosing a portrait from those taken by a number of fledgling artists and studios. “How much would you be willing to pay to see your work hung up all over New York?” he asked the owner. The owner thought for a minute and responded that he would be willing to pay $120 for the privilege of providing Roosevelt’s photo. He happily informed him that he accepted the offer and gave him the address to which he could send the check. With this small rearrangement of the facts, the crafty campaign manager was able to turn lose-lose into win-win.

This story reminds me of the famed trickster, Tom Sawyer, who duped the neighborhood boys into trading him toys and apples for the chance to whitewash a fence. When one of the boys taunted him for having to work instead of going swimming, Tom responded with all seriousness, “I don’t see why I oughtn’t to like it. Does a boy get a chance to whitewash a fence every day?” Then when the boy asked for a chance to try it, Tom hemmed and hawed until finally the boy said he would give up his apple for a chance to whitewash the fence. Once Tom had one taker, outsourcing the rest of the work to other boys was a snap.

I conducted a similar experiment in a class I was teaching on managerial psychology. One day, I opened my lecture with a brief reading of a poem by Walt Whitman, after which I informed the students I would be doing a few short poetry readings, and that space was limited. I passed out sheets of paper providing students with the schedule of these readings along with a survey. Half of the students were asked whether they would be willing to pay $10 to come listen to my reading; the other half were asked whether they would be willing to listen to my reading in exchange for $10. Sure enough, those in the second group set a price for enduring my poetry reading (ranging from $1 to $5). The first half, however, seemed quite willing to pay to attend my poetry reading (from $1 to about $4). Keep in mind that the second group could have turned the tables and asked to be paid for listening to my recitation, but they didn’t.

In all of these situations, people (the campaign manager, Sawyer, and myself) were able to take a situation of disadvantage or ambiguous value and spin it to their (my) advantage. Once Sawyer pretended to be unwilling to part with the privilege of whitewashing, other boys wanted it, because obviously Tom was hoarding all the fun. When I told my students that space was limited and gave a suggested price for the recitation, I created the idea that this was an experience they would definitely want to have (as opposed to the other group, to whom I insinuated that listening to my reading of Whitman might be less than enjoyable).

I think Twain summed this strategy up best when he wrote the following about Tom: “He had discovered a great law of human action, without knowing it – namely, that in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain.”

A gentler and more logical economics

Jan 10

(this one is a bit long)

Neoclassical economics is built on very strong assumptions that, over time, have become “established facts.” Most famous among these are that all economic agents (consumers, companies, etc., are fully rational, and that the so-called invisible hand works to create market efficiency). To rational economists, these assumptions seem so basic, logical, and self-evident that they do not need any empirical scrutiny.

Building on these basic assumptions, rational economists make recommendations regarding the ideal way to design health insurance, retirement funds, and operating principles for financial institutions. This is, of course, the source of the basic belief in the wisdom of deregulation: if people always make the right decisions, and if the “invisible hand” and market forces always lead to efficiency, shouldn’t we just let go of any regulations and allow the financial markets to operate at their full potential?

On the other hand, scientists in fields ranging from chemistry to physics to psychology are trained to be suspicious of “established facts.” In these fields, assumptions and theories are tested empirically and repeatedly. In testing them, scientists have learned over and over that many ideas accepted as true can end up being wrong; this is the natural progression of science. Accordingly, nearly all scientists have a stronger belief in data than in their own theories. If empirical observation is incompatible with a model, the model must be trashed or amended, even if it is conceptually beautiful, logically appealing, or mathematically convenient.

Unfortunately, such healthy scientific skepticism and empiricism have not yet taken hold in rational economics, where initial assumptions about human nature have solidified into dogma. Blind faith in human rationality and the forces of the market would not be so bad if they were limited to a few university professors and the students taking their classes. The real problem, however, is that economists have been very successful in convincing the world, including politicians, businesspeople, and everyday Joes not only that economics has something important to say about how the world around us functions (which it does), but that economics is a sufficient explanation of everything around us (which it is not). In essence, the economic dogma is that once we take rational economics into account, nothing else is needed.

I believe that relying too heavily on our capacity for rationality when we design our policies and institutions, coupled with a belief in the completeness of economics, can lead us to expose ourselves to substantial risks.

Here’s one way of thinking about this. Imagine that you’re in charge of designing highways, and you plan them under the assumption that all people drive perfectly. What would such rational road designs look like? Certainly, there would be no paved margins on the side of the road. Why would we lay concrete and asphalt on a part of the road where no one is supposed to drive on? Second, we would not have cut lines on the side of the road that make a brrrrrr sound when you drive over them, because all people are expected to drive perfectly straight down the middle of the lane. We would also make the width of the lanes much closer to the width of the car, eliminate all speed limits, and fill traffic lanes to 100 percent of their capacity. There is no question that this would be a more rational way to build roads, but is this a system that you would like to drive in? Of course not.

When it comes to designing things in our physical world, we all understand how flawed we are and design the physical world around us accordingly. We realize that we can’t run very fast or far, so we invent cars and design public transportation. We understand our physical limitations, and we design steps, electric lights, heating, cooling, etc., to overcome these deficiencies. Sure, it would be nice to be able to run very fast, leap tall buildings in a single bound, see in the dark, and adjust to every temperature, but this is not how we are built. So we expend a lot of effort trying to take these limitations into account, and use technologies to overcome them.

What I find amazing is that when it comes to designing the mental and cognitive realm, we somehow assume that human beings are without bounds. We cling to the idea that we are fully rational beings, and that, like mental Supermen, we can figure out anything. Why are we so readily willing to admit to our physical limitations but are unwilling to take our cognitive limitations into account? To start with, our physical limitations stare us in the face all the time; but our cognitive limitations are not as obvious. A second reason is that we have a desire to see ourselves as perfectly capable — an impossibility in the physical domain. And perhaps a final reason why we don’t see our cognitive limitations is that maybe we have all bought into standard economics a little too much.

Don’t misunderstand me, I value standard economics and I think it provides important and useful insights into human endeavors. But I also think that it is incomplete, and that accepting all economic principles on faith is ill-advised and even dangerous. If we’re going to try to understand human behavior and use this knowledge to design the world around us—including institutions such as taxes, education systems, and financial markets—we need to use additional tools and other disciplines, including psychology, sociology, and philosophy. Rational economics is useful, but it offers just one type of input into our understanding of human behavior, and relying on it alone is unlikely to help us maximize our long-term welfare.

In the end, I do hope that the debate between standard and behavioral economics will not take the shape of an ideological battle. We would make little progress if the behavioral economists took the position that we have to throw standard economics—invisible hands, trickle-downs, and the rest of it—out with the bathwater. Likewise, it would be a shame if rational economists continue to ignore the accumulating data from research into human behavior and decision making. Instead, I think that we need to approach the big questions of society (such as how to create better educational systems, how to design tax systems, how to model retirement and health-care systems, and how to build a more robust stock market) with the dispassion of science; we should explore different hypotheses and possible mechanisms and submit them to rigorous empirical testing.

For instance, in my ideal world, before implementing any public policy—such as No Child Left Behind or a $130 billion tax rebate or a $700 billion bailout for Wall Street—we would first get a panel of experts from different fields to propose their best educated guess as to what approach would achieve the policy’s objectives. Next, instead of implementing the idea proposed by the most vocal or prestigious person in this group, we would conduct a pilot study of the different ideas. Maybe we could take a small state like Rhode Island (or other places interested in participating in such programs) and try a few different approaches for a year or two to see which one works best; we could then confidently adopt the best plan on a large scale. As in all experiments, the volunteering municipalities would end up with some conditions providing worse outcomes than others, but on the plus side there would also be those who would achieve better outcomes, and of course the real benefit of these experiments would be the long-term adoption of better programs for the whole country.

I realize that this is not an elegant solution because conducting rigorous experiments in public policy, in business, or even in our personal lives is not simple, nor will it provide simple answers to all of our problems. But given the complexity of life and the speed at which our world is changing, I don’t see any other way to truly learn the best ways to improve our human lot.

Three questions on Behavioral Economics

Jul 10

1.) What is behavioral economics? How is it different from standard economics?

In general, both standard and behavioral economics are interested in the same questions and topics.  The choices people make, the effects on incentives, the role of information etc. However, unlike standard economics, behavioral economics does not assume that people are rational. Instead, behavioral economists start by figuring out how people actually behave, often in a controlled lab environment in which we can understand behavior better, and use this as a starting point for building our understanding of human nature. As a consequence of this different starting point, behavioral economists usually come to different conclusions about the logic and efficacy of almost anything, ranging from mortgages to savings to healthcare in both the personal and business realms.

2.) Even if consumers make mistakes from time to time, wouldn’t the market fix these?

I always found the appeal to the market gods a bit odd. Why would the market fix mistakes instead of aggravating them?  When the Chicago economists sometimes (reluctantly) admits that people make mistakes, they claim that people make different types of mistakes that will eventually cancel each other out in the market. Behavioral economics argues that, instead, people will often make the same mistake, and the individual mistakes can aggregate in the market.  Let’s take the subprime mortgage crisis, which I think is a great example (but a very sad reality) of the market working to make the aggregation of mistakes worse.  It is not as if some people made one kind of mistake and others made another kind.  It was the fact that so many people made the same mistakes, and the market for these mistakes is what got us to where we are now.

3.) Isn’t behavioral economics a depressing view of human nature?

It is true that from a behavioral economics perspective we are fallible, easily confused, not that smart, and often irrational. We are more like Homer Simpson than Superman.  So from this perspective it is rather depressing.  But at the same time there is also a silver lining. There are free lunches!

Take the physical world for example. We build products that work with our physical limitations. Chairs, shoes, and cars are all designed to complement and enhance our physical capabilities. If we take some of the same lessons we’ve learned from working with our physical limitations and apply them to things that are affected by our cognitive limitations—insurance policies, retirement plans, and healthcare—we’ll be able to design more effective policies and tools, that are more useful in the world. This is the promise of behavioral economics – once we understand where we are weak or wrong we can try to fix it and build a better world.

Take again the sub-prime mortgage crisis.  Imagine that we understood how difficult it is for people to calculate the correct amount of mortgage that they should take, and instead of creating a calculator that told us the maximum that we can borrow, it helped us figure out what we should be borrowing.  I suspect that if we had this type of calculator (and if people used it) much of the sub-prime mortgage catastrophe could have been avoided.  This of course is one idea to fix one problem, and there are many ways to think about how to improve our lives along many of the decisions we make every day. This is why I think that behavioral economics is so optimistic, useful, and important for our personal life and for society.

Irrationally yours

Dan Ariely

Asimov on evidence

May 28

One of the things that always amazed me about rational economists is that they don’t update their opinions.

In economics there is a very clear way in which all people are supposed to observe new information and based on it update (what is called Bayesian Updating) their understanding of the world.  And while Bayesian Updating is a big part of economic theory, economists themselves don’t seem to do any of this Updating based on data about real economic behavior of people.

Of course, no experiment is ever perfect, and there are always more questions and alternative possible interpretations – but that rational economists would not update at all?  This is just too odd. Or maybe it is the real proof that we are all somewhat irrational?

Here is what Asimov had to say about believing in data…

“Don’t you believe in flying saucers, they ask me? Don’t you believe in telepathy? – in ancient astronauts? – in the Bermuda triangle? – in life after death?

No, I reply. No, no, no, no, and again no.

One person recently, goaded into desperation by the litany of unrelieved negation, burst out ‘Don’t you believe in anything?’

‘Yes,’ I said. ‘I believe in evidence. I believe in observation, measurement, and reasoning, confirmed by independent observers. I’ll believe anything, no matter how wild and ridiculous, if there is evidence for it. The wilder and more ridiculous something is, however, the firmer and more solid the evidence will have to be.”

Isaac Asimov, The Roving Mind (1997), 43

2008 was a good year for behavioral economics

May 20

Before the financial crisis of 2008, it was rather difficult to convince people that we all might have irrational tendencies.

For example, after I gave a presentation at a conference, a fellow I’ll call Mr. Logic (a composite of many people I have debated with over the years) buttonholed me. “I enjoy hearing about all the different kinds of small-scale irrationalities that you demonstrate in your experiments,” he told me, handing me his card. “They’re quite interesting-great stories for cocktail parties.” He paused. “But you don’t understand how things work in the real world. Clearly, when it comes to making important decisions, all of these irrationalities disappear, because when it truly matters, people think carefully about their options before they act. And certainly when it comes to the stock market, where the decisions are critically important, all these irrationalities go away and rationality prevails.”

Given these kinds of responses, I was often left scratching my head, wondering why so many smart people are convinced that irrationality disappears when it comes to important decisions about money. Why do they assume that institutions, competition, and market mechanisms can inoculate us against mistakes? If competition was sufficient to overcome irrationality, wouldn’t that eliminate brawls in sporting competitions, or the irrational self-destructive behaviors of professional athletes? What is it about circumstances involving money and competition that might make people more rational? Do the defenders of rationality believe that we have different brain mechanisms for making small versus large decisions and yet another yet another for dealing with the stock market? Or do they simply have a bone-deep belief that the invisible hand and the wisdom of the markets guarantee optimal behavior under all conditions?

As a social scientist, I’m not sure which model describing human behavior in markets-rational economics, behavioral economics, or something else-is best, and I wish we could set up a series of experiments to figure this out. Unfortunately, since it is basically impossible to do any real experiments with the stock market, I’ve been left befuddled by the deep conviction in the rationality of the market. And I’ve wondered if we really want to build our financial institutions, our legal system, and our policies on such a foundation.

As I was asking myself these questions, something very big happened. Soon after Predictably Irrational was published, in early 2008, the financial world blew to smithereens, like something in a science fiction movie. Alan Greenspan, the formerly much-worshipped chairman of the Federal Reserve, told Congress in October 2008 that he was “shocked” (shocked!) that the markets did not work as anticipated, or automatically self-correct as they were supposed to. He said he made a mistake in assuming that the self-interest of organizations, specifically banks and others, was such that they were capable of protecting their own shareholders. For my part, I was shocked that Greenspan, one of the tireless advocates of deregulation and a true believer in letting market forces have their way, would publicly admit that his assumptions about the rationality of markets were wrong. A few months before this confession, I could never have imagined that Greenspan would utter such a statement. Aside from feeling vindicated, I also felt that Greenspan’s confession was an important step forward. After all, they say that the first step toward recovery is admitting you have a problem.

Still, the terrible loss of homes and jobs has been a very high price to pay for learning that we might not be as rational as Greenspan and other traditional economists had thought. What we’ve learned is that relying on standard economic theory alone as a guiding principle for building markets and institutions might, in fact, be dangerous. It has become tragically clear that the mistakes we all make are not at all random, but part and parcel of the human condition. Worse, our mistakes of judgment can aggregate in the market, sparking a scenario in which, much like an earthquake, no one has any idea what is happening. All of a sudden, it looked as if some people were beginning to understand that the study of small-scale mistakes was not just a source for amusing dinner-table anecdotes. I felt both exonerated and relieved.

While this is a very depressing time for the economy as a whole, and for all of us individually, the turnabout on Greenspan’s part has created new opportunities for behavioral economics, and for those willing to learn and alter the way they think and behave. From crisis comes opportunity, and perhaps this tragedy will cause us to finally accommodate new ideas, and-I hope-begin to rebuild.

Standard vs behavioral economics (Supermen of the Mind)

May 05

A few weeks ago at TED I met John Hodgman, and he agreed to watch my version of his mac vs pc videos (he is the guy playing the PC on the apple ads).  He approved.

This is the last one in the set

Irrationality is the real invisible hand

Apr 20

Adam Smith first coined the term “The Invisible Hand” in his important book “The Wealth of Nations.” With this term he was trying to capture the idea that the marketplace would be self-regulating.  The basic principle of the invisible hand is that though we may be unaware of it, an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy. This means that when this invisible hand exists, when we all pursue our own interest, we end up promoting the public good, and often more effectively than if we had actually and directly intended to do so.  This is a beautiful idea, but the question of course is how closely it represents reality.

In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the Federal Reserve Bank once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.”
We are now paying a terrible price for our unblinking faith in the power of the invisible hand.

In my mind this experience has taught us that Adam Smith ‘s version of invisible hand does not exist, but that a different version of the invisible hand that is very real, very active, and very dangerous if we don’t learn to recognize it. Perhaps a more accurate description of the invisible hand is that it represents human irrationality. In terms of irrationality the hand that guides our behavior is clearly invisible — after all recent events have demonstrated that we are largely blinded to the ways rationality plays in our lives and our institutions.  Moreover it is also clear that irrationality does shape our behavior in many ways, pushing and prodding us along a path can lead to destruction. Whether we’re procrastinating on our medical check-ups, letting our emotions get the best of us, or letting conflicts of interest and short term time horizon ruin the financial market, irrationality is certainly involved.

In Adam Smith’s world the invisible hand was a wonderful force, and the fact it was invisible made no difference whatsoever. The irrational invisible hand is a different story altogether – here we must identify the ways in which irrationality plays tricks on us and make the invisible hand visible!

Video: Chapter 13: "What is Behavioral Economics?"

Apr 10
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