Behavioral economics — an overview

An emerging hybrid discipline brings new insights into why people buy

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Abstract

This is a cool new discipline combining psychology with economics. It’s relatively new as an academic area of inquiry, but has gained rapid acceptance in the past few decades. There are practical applications for marketers, researchers, and consumers. What I found was that the terminology was a bit difficult, so I focused on trying to make it easy to understand. It is a work-in-progress; as I learn more, I’ll try to improve it, and comments and feedback are welcome. — tom sulcer March 2011

See the shovel? Hear the jackhammer? They’re muted right now but that doesn’t mean that this article is undergoing constant improvement. I appreciate feedback! Write a comment below. My aim is to make this the best overview source on behavioral economics on the web. Like it? Add weblinks to it. — tom sulcer october 11, 2011

Overview

Behavioral economics sounds abstract and fuzzy, but it’s essentially as if there had been a merger between economics and psychology. Like, professors from both departments got together to solve common problems.

Think of a tall cold drink of economics; now, add a twist of psychology like a squeezed lemon. Voila: behavioral economics. It’s economics with a twist.

And the twist of behavioral economics takes the cold hard calculus of rational economic decision-making and flavors it with the realization that hey, we’re not all super-rational beings. We get emotional. We buy on impulse. We are not computers. We’re human. And it tweaks the equations and formulas.

The result? Better predictions. More precise theories. New tools. Tighter models of consumer behavior. The wealth of new insights and techniques can help businesses grow. They can help measure your customers and get inside their heads. Sophisticated models are possible. It can make your firm’s marketing efforts smarter. For consumers, it helps to know how marketers think. Strategies here can help us bargain more effectively, and see through strategies designed to drain our wallets.

Here are a few insights about consumer behavior that we’re studying. Did you know that…

  • A person’s most treasured possession rarely has financial value.
  • Increasing price sometimes increases sales.
  • Most preventive measures happen after a crisis. Case in point: Levees in New Orleans.
  • Happiness isn’t based on money but autonomy.
  • Entrepreneurial deals don’t emphasize the team.

The qualities that create life satisfaction are: autonomy (the feeling of having chosen and of being able to exercise authority in one’s activities), competence, relatedness and self-esteem. — Behavioral Economics Consulting Group website. [1]

Are we rational consumers?

Consider that:

  • Blockbuster customers paying those late fees. It’s a huge money-maker for the video rental chain when people miss a day or two and pay the fine. What’s happening? Is there a forecasting error? Did consumers forget to watch the video during the week, and then decide to keep it a day longer so as not to lose their earlier investment (a phenomenon which will explore called loss aversion)?

  • Is Netflix any better? The monthly fee often translates into a higher per-movie fee, based on actual numbers of movies watched. For many customers, renting a video one-at-a-time would be cheaper than a monthly subscription. But why do they do this?
  • Credit card teaser rates. Why do people fall for them? Large proportions of consumers fail to pay off their balance each month, resulting in accumulating and punitive fees, often with balances in the thousands of dollars. What’s going on?

  • Health club annual memberships. People pay the annual fee, then don’t show up that much. Why? It would be cheaper to pay $10 per visit, but the annual fee along with their subsequent few visits translates into a much higher overall cost.

  • New car add-ons. If a new car costs $25,000, does this fact blind the customer into not noticing that it’s rather expensive to pay $600 for a car stereo add on? Psychologists have explanations for this phenomenon.

  • Buy 10 CDs for a penny! But sign this contract for ten more CDs. Don’t forget to return them if unwanted. Guess what? Enough people forget to return subsequent CDs to make it a profitable business promotion.

  • Why do people (especially men) avoid annual check-ups? This can be particularly dangerous if a long-term serious condition such as cancer is not caught in time. [2]

  • Irrational wine buyers? Why do owners of wine bottles bought earlier at $10 per bottle hang on to them (or drink them!) when the price of their wine bottles rises to $200 per bottle? What’s going on? [2]

 

  • Dubious marketer lingo. Discounts versus surcharges. Consumers prefer discounts and hate surcharges, even when the outcomes are equal (starting from a higher price and moving down to a discount, or from a lower one and adding a surcharge — what’s better? The discount appears better). Another dubious term: savings. It’s marketer-speak for “spendings”. Save $10! $25 off! Marketers are really saying spend money, but you’ll spend less money if you buy now. Why these terms? Behavioral economists explore why. [2] [3]

  • Corporate slogans playing on the consumer consciousness. Consider Ford Motor’s Quality is job 1. Nike’s Just do it! Google’s Do no evil. Behavioral economics suggests that simplified but catchy corporate talk helps employees keep in tune with a company’s mission, and helps consumers connect with a company’s culture. The Ritz-Carlton lets any employee spend up to $2000 to solve a guest’s problem, and Camerer argues that the $2000 number is memorable and large and an effective way to signal the firm’s commitment to customer happiness. [4]

Behavioral economics points us towards general lessons or truths about consumers. And these lessons can be applied in diverse circumstances. For example, here are a few lessons with applications to diverse areas:

Lesson one: we’re influenced heavily by peers. This we know. But we can apply this principle again and again towards growing businesses, reaching out to consumers. There’s an efficiency here: by following the judgment of the crowd, we don’t need to think through every choice for ourselves; this is a smart strategy if the crowd is right (which it often is). But of course it’s faulty if the crowd is wrong (which happens too.) But much of advertising and marketing is built upon this very premise. It’s possible for behavioral economists to study this phenomenon too, and develop new theories for successful application to business problems.

Lesson two: we’re more afraid of losing what we’ve got than possibly winning more. It’s not just money, but psychological variables too — people are more keen to avoid regret and embarrassment, rather than making choices which have risk but have more substantial possible future payouts, according to Michigan State’s A. Allan Schmid. [5] This principle is less well known, but there are numerous applications: we market products which will help people hold what they’ve got, rather than strive for more.

Lesson three: when decisions are complex, we simplify the choices. Here the obvious application is: keep messages simple! Find the rule of thumbs that people use. But knowing exactly how consumers apply these rules of thumb, such as which laundry detergent to buy or which airline to fly on, can be helpful.

Behavioral Economics as an academic discipline

Traditional economics presumes
people are rational.
Drawing: SilverStar ccsa3.0

Traditional economics sees people as rational, calculating, weighing costs versus benefits and making smart choices. It allows simple yet powerful models such as the idea that the price of a good is a function of how scarce it is and how much people want it. Oil? Scarce commodity much in demand. Therefore, it will have a high price. Water? Less scarce commodity. Price will be lower. Basic stuff from introductory college economics.

But this model has been criticized as simplistic, hobbled by assumptions including one which some economists call “unbounded rationality” — that consumers have limitless power to process information and make decisions accordingly. But they don’t.

There is debate about how far back to search for when thinkers were noticing problems with the strict rational model. Some suggest that even Adam Smith, in his Theory of Moral Sentiments, had picked up psychological variables to help explain economic phenomena. John Maurice Clark, a professor at the University of Chicago from 1915 to 1926, reportedly argued in the Journal of Political Economy in 1918:

“The economist may attempt to ignore psychology, but it is sheer impossibility for him to ignore human nature. If the economist borrows his conception of man from the psychologist, his constructive work may have some chance of remaining purely economic in character. But if he does not, he will not thereby avoid psychology. Rather, he will force himself to make his own, and it will be bad psychology.” [6]

Behavioral economists noticed that the reason-based models, which assumed that people made rational choices from a principle of self-interest, didn’t always work. There were other factors at play. They didn’t discard the old models, rather, they wanted to augment them with insights from psychology and social studies to make the models more powerful and precise. It is a cross-disciplinary approach bringing in insights to classical economics from disciplines such as the social sciences as well as human behavioral ecology, neuropsychology, game theory, and cognitive psychology. [7]

Herbert Simon.

Nobel prize winner Herbert Simon, in 1955, suggested a better assumption for economists was what he called “bounded rationality”. [6] Simon suggested it was smart to assume that people have only so much brainpower, only so much time in the day, only so much patience, that humans make the best decision possible given these limits. Our rationality is bounded.

Humans can veer from the straight path of reason by making faulty judgments — and these can be extensive — as well as bad choices. Evidence of our non-rational behavior in financial matters abounds. In 1982, economist Kahneman listed a subset of such behaviors, in arenas ranging from retirement planning, to negotiating price, to investing, and beyond. Some examples include:

  • overconfidence — there have been many studies showing that people routinely overestimate their relative abilities and chances.


  • loss aversion — tendency by people to strongly prefer avoiding losses rather than getting benefits. A rational perspective would be that avoiding losses and making gains should even out — that is, a rational person shouldn’t prefer one to the other. Another way of saying it: “the disutility of giving up an object is greater than the utility associated with acquiring it”. That is, we’ll hang on to losers and sell winners, when we shouldn’t. [7] [6]

  • decision paralysis — why do Americans stash $1.2 million in low-yielding bank and savings accounts instead of money market accounts which could yield possibly double as much? Behavioral economists suggest it’s that when confronted by decisions, they’ll avoid it, and do nothing. [8]

  • status quo bias — “individuals have a strong tendency to remain at the status quo, because the disadvantages of leaving it loom larger than advantages,” They’ll choose the default option when they should choose something else, perhaps. They’ll prefer non-action to action, with sometimes unfortunate results.

  • rejecting “found” money — when employers promise to add $1 to every $1 contributed by an employee into a 401(k) plan, it’s a huge freebie. Why do employees not take advantage of such a generous offer? Some estimates suggest that half of American workers don’t take advantage of tax-deferred retirement plans, even workers who at age 59 and a half (who could make withdrawals without a penalty.) [8]

  • mental accounting — treating windfall money differently from “regular” money. We’ll risk the windfall money (maybe when we shouldn’t) and won’t risk the earned money (maybe when we should?). [8] A coffee mug which was “earned” through hard work is often seen as more valuable than a coffee mug which was merely given to somebody — behavioral economists noticed that people would sell the “earned” mug for more money than the “free” mug. [9] Brain imaging studies suggest that “earned” money causes more of a reaction in the nucleus accumbens (a brain area associated with predicted reward) than the same amount of money which was unearned. [9] [10]

  • following the herd off the cliff — why do people sell their stocks in a downturn when logic suggests that that’s the time to buy? They’re doing what everybody else does. Often this is a mistake. [8]

  • fads — yes it happens. Beany babies. Even tulip bulb speculation in Holland several hundred years ago. [8]
  • poor negotiating — one mistake is letting the other party establish a “base rate” when bargaining a price. [8]

But there have been studies suggesting that the fear of losing material possessions is twice as strong as the motivation to get new possessions. [11] Tversky and Kahneman studied how people handle complex decision matters and, when confronting numerous variables and uncertainty, often simplified the decision by using so-called rules of thumb — cognitive bypass roads — or what the psychologists called heuristics. [6]

The discipline got a big boost in 2002 when the Nobel Prize was awarded to Kahneman and game theorist Vernon Smith. The Nobel commission suggested that their work was influential because it integrated “insights from psychological research into economic science … thereby laying the foundation for a new field of research … (by demonstrating) how human decisions may systematically depart from those predicted by standard economic theory.” [7]

While much of the research has studied Americans, there have been efforts around the world looking at consumers of differing persuasions. Analysts Thaler and Cronqvist examined the decisions by Swedish workers, when confronted by a choice about how to invest their social security accounts, called PPM’s, and found that Swedes who actively invested with their own pensions chose more expensive, less diversified funds, and lost serious money as a result. Their fellow citizens who chose the default plan, chosen by planners, did better. [6] The Swedish investors may have fallen under the spell of an extrapolation bias (seduced by high returns of high-tech funds) or of a familiarity bias (choosing low-yield Swedish funds rather than higher-yield ones abroad.) Wordings matter — the Swedish advertising campaign regarding these choices may have established a “powerful frame” pushing people to actively choose their own investments when they would have been better off choosing the default option. [6]

People sometimes make mistakes procrastinating, and the variable of time can interfere with smart decision-making. For example, an article in The Atlantic suggested that a gift card to a spa was more likely to be used if it had a short expiration period such as a month or two. Gift cards which took a whole year to expire, in contrast, were less likely to be used. Behavioral economists suggest that the more rational choice — a card with a longer time expiration period — would be more valuable since it offers a consumer many more opportunities to use it. But in practice, people misplace the cards, forget, keep putting it off until the opportunity has gone by, according to Suzanne B. Shu and Ayelet Gneezy in the Journal of Marketing Research. People not only put off unpleasant tasks such as cleaning out the garage, but they put off pleasant ones too like going to a spa. Again, as we know, human behavior is not always strictly rational. [12]

Shu and Gneezy found similar results when experimenting with coupons for a local food establishment. There were more redemptions for a coupon that expired in three weeks than for a coupon that expired in two months. Why? People got busy and lost track of time; one said “I kept thinking I could do it later.” The researchers concluded that the pressure cooker of the shorter deadline helped people to stop procrastinating and enjoy themselves. [12]

Researchers studied taxicab driver choices. Guess what? Taxi drivers
are not rational either. They’re human like us. Photo: Uris.

In 1997, behavioral economists found that taxicab drivers often didn’t make smart choices over time. A “good” day for taxicabs is when it’s raining steadily or when there was a convention in town because demand for taxicab rides is strong making it easy to find customers at every turn. So a smart long term strategy is to work harder and longer when it’s raining, and when it’s sunny, to work fewer hours. But what economists found was that many drivers, especially inexperienced ones, made a general mistake of thinking they had to earn a minimum number of dollars each day. With this shortsighted thinking, taxicab drivers would keep working even on sunny days when there were fewer passengers, when the more rational choice should have been to have gone home. And on rainier days, drivers quit too early. The rational choice would have been for the taxicab drivers to adjust their hours according to weather conditions so that their wages would fluctuate from day to day, and earn more money during rainy days, but many weren’t doing this. Why? They paid a fixed daily rental rate for their cab, and possibly this suggested to them that they needed to bring in a minimum number of dollars each day. They were thinking short-term, not long term. The technical terms for these types of mistakes include “loss aversion” and “mental accounting.” [13] [14]

In contrast, when people think about the future, the benefits can seem large but costs seem to be non-existent. This is kind of a perceptual illusion that can distort how people make decisions. For example, a planned trip to New Zealand, six months in the future, can have one thinking about seeing the vistas and mountains and waterfalls, but when the time approaches to actually buy the ticket, bear the costs, and cope with issues such as parking and luggage and inability to do errands, the costs seem to loom larger in the imagination. As a result, sometimes people choose their familiar routines while they’d be happier making the journey. [12]

Nobel laureate Thomas Schelling used the following phrase to describe the difficulty of being human: the intimate contest for self-command. It’s a constant battle between the would-be disciplined person and the pleasure-seeking hedonist. Do we get up at 6am to lift barbells? Or do we sleep late and eat that donut? The disciplined person, according to Schelling, is thinking about future virtues, while the pleasure-seeker gives in to present urges. According to the philosopher Spinoza, a person operating under the authority of reason and self-control would weigh correctly the balance between current sacrifices and future benefits, and make the right choice; but as Spinoza argued, humans are emotional creatures, and emotion trumps reason in most situations for most people.

Behavioral economist Colin F. Camerer thinks that behavioral economics offers better understanding of how things work. He wrote: “a fruitful direction for constructing better economic explanations is to search for empirically sound assumptions about individual behavior, which correspond to human psychology, to serve as analytically tractable foundations for economic theorizing.” [14] He criticized traditional economists for being unable to explain things like cigarette addiction, strikes by workers, in which strong behaviors and  human emotions have a powerful impact on economic decisions. [14] Camerer suggests humans can be impulsive, sometimes short-sighted or myopic, and lack self-control.[13]

Behavioral economics allows “economic agents to be impulsive and myopic, to lack self-control, to keep track of spending and earnings in separate “mental accounting” categories, to care about the outcome of others (both altruistically and enviously), to construct preferences from experience and observation, to sometimes misjudge probabilities, to take pleasure and pain from the difference between their economic state and some set of reference points, and so forth. [14] [15] He argued that the challenge is to express human impulsiveness, for example, within the structure of neoclassical economics “to make better predictions than theory does now.”[16]  He suggested that people use systematic decision-making procedures which sometimes lead to make irrational decisions; if behavioral economics can examine these faulty decision-making procedures, then we’ll all be better off. [14]

What is mental accounting? We put money in different mental “accounts,” depending on where it came from. Money from an unexpected rich aunt such as an inheritance or gambling luck is often treated more lightly than if it was earned working hard, day-to-day, in a tough job. We’ll risk the windfall money in a heartbeat, while the earned money (which should be treated the same) is used for day-to-day expenses.

Coins in a jar can be deceptive. Photo: Ferdi (wc)

One professor described what is known as the winner’s curse with the following experiment. Fill a jar full of coins and ask students to try to guess how valuable the filled coin jar is (they can’t empty it out and count the coins but only look at it from outside.) Ask students to bid on the coin jar — the winning bid gets to keep the coins (actually they’ll be paid in dollar bills so they won’t fret about having to cope with so many coins.) What happens? Chances are one or more students will overbid — pay $150 for a jar with only $110 worth of coins perhaps. Why? The so-called winner’s curse issue was mentioned in a paper by three Atlantic Richfield engineers, and has been observed in different experimental settings. [17]

Behavioral economists, including Columbia University Business professor Ran Kivetz, identify two contrasting human patterns as dysfunctional:

  • hyperopia — excessive far-sightedness such that people delay today’s pleasure so much that they don’t enjoy life overall. Examples: hoarding cash. Classic case: the character of Mr. Scrooge in Dicken’s “A Christmas Story.” [12]

  • myopia — short-sighted behaviors focusing on good things today rather than benefits tomorrow. Examples: overeating, failing to save for retirement. [12]

The solutions for both types of problems sometimes involve precommitment and deadlines. To make coupons or gifts more valuable, marketers impose a binding commitment on a person. Gift cards have a use-it-or-lose-it deadline which focuses the consumer mind. It helps to have a justification as well. Disneyland overcomes consumer inertia by giving visitors either free passes or discounts on their birthdays — and the “birthday” is the justification for a person to enjoy himself or herself and bring others along. [12]

Behavioral economists have studied subjects like savings and consumption patterns. In a classical economic model, people behaving rationally would try to smooth out consumption, despite situations in which income amounts varied at different times in their lives. For example, people in their thirties and forties tend to be at or near peak earning power, so sensible people would save during these years, while perhaps borrowing in their youth and early twenties (perhaps to pay for education). If handled properly, people would have saved enough money for a comfortable retirement. This is the theory. But people don’t behave rationally. Generally findings suggest that people are not as disciplined as they should be, sometimes failing to borrow adequately in their youth, and failing to save enough during their peak earning years. There is concern that many people will be unable to afford a comfortable retirement. So-called “forced savings”, such as mortgages (which force people to build up equity in their houses) as well as annual tax refunds (which return a chunk of money each tax year) help offset the trend, somewhat, but the general pattern seems to be that many people are not making sensible long term savings decisions. There are some indications that programs such as 401(k) and Individual Retirement Accounts (or IRAs) have been somewhat helpful in getting people to save, but the overall savings will not be sufficient to meet the needs of most retirees. Studies by O’Donoghue and Rabin (1999) suggest that what is happening is what behavioral economists term “hyperbolic discounting” — people fail to appreciate the long term benefits and become impatient to solve present needs. But there is a more fundamental problem at work here.

What’s at issue?

Behavioral economics takes into account issues such as lack of self-control. People know intellectually that it is not good to eat that second sandwich or smoke that third pack of cigarettes or failed to exercise around that track. There are diet plans, health foods, weight-loss centers, but to no avail: there are many overweight and obese humans struggling with weight-loss issues. Being heavy isn’t rational. It takes discipline to save.

Knowing this, behavioral economists have suggested programs at companies to encourage savings. In many firms, employees have to choose to enroll in a 401(k) plan, that is, if they do nothing, they won’t be enrolled. But behavioral economists argue that the default option should be the opposite — employees would have to act to prevent being enrolled in a 401(k) program. This simple step has gone a long way towards increasing participation in 401(k) plans. Further, a plan entitled “Save More Tomorrow” (with the acronym, SMarT) was proposed by Thaler and Benartzi (2004) in which employee contribution rates are tied annually to coincide with raises. What happens is that when raises go up, contributions to 401(k) plans go up too, so the employee doesn’t feel any present pain about taking the smart long-term steps of increased savings. There are indications that strategies like these have shown good results in encouraging savings. According to one report, the average savings rate jumped from 4% to 12% over a period of two years. [6]

A behavioral economist
with numerous degrees.
But, someday, reading
this knol on B.E. will
lessen the need for
such education?
Picture of Sara Wedeman.

Market researchers have been following new developments in behavioral economics with an eye to using what’s learned to help clients make money. But it requires diverse skills; for example, one behavioral economist had advanced degrees in clinical psychology and business as well as experience in market research, banking, and consulting.[18] At present, there are few researchers actively applying behavioral economics methods, although it appears that this is changing.

Here’s another problem studied by behavioral economists. Most Americans get a tax refund after the end of the year, but there have been numerous studies showing that too much income is withheld. This isn’t rational. The rational choice would be to change the withholding rate so the April 15th tax refund would be minimal. In effect, Americans are loaning their money to the government, interest-free, year after year, because of faulty mental accounting.

The traditional economics principle that people act from self-interest is known not to always apply. In many cases, people act from altruism. They’re generous. They contribute to charities or donate their time for causes they believe in. And actions like these have a hard time being explained in the traditional framework of economics.

Since behavioral economists know that people, against reason, are unlikely to save for retirement, it’s possible to put together plans to outwit their bad impulses, and to encourage saving. One successful idea applied in many firms was called a “pre-commitment strategy” and it worked like this. Most firms were having trouble getting employees to contribute to a 401(k) retirement plan which was, for most practical purposes, in their best interests, since the savings would compound annually and serve them well in later life. Rather, employees preferred to get their whole paycheck now rather than saving. So, in a plan developed by University of Chicago economist Richard H. Thaler and by University of California (Los Angeles) economist Shlomo Benartzi, employers would prompt employees to pledge to have part of their future raises added automatically to their retirement account. Employees agreed. By making the pledge, it did not lessen their current paycheck; so employees “reasoned” that they weren’t giving up anything. But when a year went by and the employee got a raise, then the sacrifice would hit — but the employee wouldn’t object because of his or her earlier pledge. It was an intelligent strategy to outthink humans for their own good. [12]

Behavioral economists have studied how people make decisions by looking at the frame or sunglasses they use to see things. The frame can make a great deal of difference in how people see things and what they choose to do. In a study by Tversky and Kahneman (1981), 600 people were supposedly affected by a hypothetical deadly disease, and in an experiment, subjects were asked to make one of two choices:

  • option A saves 200 people’s lives
  • option B has a 33% chance of saving all 600 people and a 66% possibility of saving no one

People preferred A. In a followup problem, the experiment was repeated but these options were given:

  • option C means 400 people will die
  • option D means there’s a 33% chance that no people will die and a 66% probability that all 600 will die

People preferred D.

What’s noteworthy is that in all four situations, the expected probability is that 200 people will live and 400 people will die. So, to a rational person, it shouldn’t matter whether they chose any of the alternatives. But people did have preferences — preferring A to B, and preferring D to C. Why? Behavioral economists suspect that the language couching the problem shifted. So that when an option reads “400 people will die”, it’s looked at less favorably, then the converse statement “200 people will live”. The jargon term is called framing. People avoid risk when a positive frame is posed, but seek risk when a negative frame is posed. People’s choices change when a different frame is moved around the choice. [19]

Behavioral economics have studied bidders in competitive bidding situations, and have found that the winner’s curse factor can apply to contractors bidding on a particular project. There’s a huge risk of overbidding or making flawed estimates of likely costs for projects.[20]

Behavioral economics is closely linked to the rapidly developing field of game theory. Researchers are exploring how people think about proposed alternatives, how they strategize and make choices. The classic case is the ”Prisoner’s Dilemma” in which two people can choose to either compete or cooperate: if both compete, both lose, but if one competes and the other cooperates, the competing player wins big while the cooperating player loses; if both cooperate, both win, but win marginally. There have been numerous studies done to test different parameters, and to see what happens over the long term. If players play in a Prisoner’s Choice game for long periods of time, perhaps competing for money or rewards, what happens is that there is a strong likelihood in both players eventually settling for a strategy of mutual cooperation. Players who compete find that their opponent does likewise in a classic “tit-for-tat” strategy of retaliation, and that over time, both players suffer from competing. But there have been models applied to different areas, such as gaming, lotteries, charity drawings, and research is ongoing. Research into an “ultimatum game” suggests that in some situations, a player will choose to abandon even a slight reward if it means that the other player gets punished for bad choices.

A new spinoff branch of behavioral economics is called behavioral finance, which has made significant strides in the last decade or so, studying investment decisions.[2] Since there was plenty of market data about stock market fluctuations, and the advent of high power computers meant that it was possible to check things exactly. The neoclassical “efficient market hypothesis” provided clean-cut predictions which were testable in practice, and by applying computers to process reams of data, new findings emerged. Did a stock price accurately reflect what a stock was worth? In many cases it is hard to know exactly what a stock is worth, but it is possible to compare two assets when the values are known, such as closed-end mutual funds (because the price is determined by supply-and-demand forces). Models using behavioral finance theory proved to be good at explaining the discounts relative to the net asset value figures. Predicting the stock market is still difficult, although behavioral finance experts have made inroads into some predictions regarding stock price fluctuations, sometimes incorporating the observation that people tend to over-emphasize new information and forget about more fundamental important information. Behavioral economists speculate that investors are disposed not to take capital losses because to do so would be to admit to themselves that they had made an earlier mistake. New research suggests that investors pay too much attention, when trying to make sense of the market, to their own signals, and tend to “disregard the signals of others, even when these other signals can be inferred from prices”, and theorists have sometimes described such errors as normatively-inappropriate simplification. [1] It falls under the general errors of overconfidence, bounded rationality issues (it’s hard to read other people’s signals accurately in some situations) as well as factors such as limited attention.[2] [21]

Glossary

Here are some of the prevalent terms used by behavioral economists. It’s a weird mix from the world of gambling, gaming, psychology, statistics and economics:

prospect theory — This is a theory about how people deal with risk and reward in game situations. It’s a descriptive model trying to describe real-life choices, not optimal decisions, and was developed by Daniel Kahneman and Amos Tversky as an alternative to the classical economics theory of ”expected utility theory.” Their work is in contrast with classical economics. It was a departure from classical economist and Nobel prize winner Gary Becker who wrote that “all human behavior can be viewed as involving participants who maximize their utility from a stable set of preferences and accumulate an optimal amount of information and other inputs in a variety of markets.” [6] Kahneman and Tversky argued that people don’t always start with a “stable set of preferences” and don’t always update their preference-ordering when new information is learned; rather, people evaluate alternatives according to some rule-based heuristic, and set a reference point — then they compare outcomes to this reference point. Next, they make an evaluation. In contrast to rational decision-making, prospect theory suggests that people decide based on how they perceive their wealth will change, and are prone to factors such as inertia (which often explains why default options are so popular, and why investors may stick with a particular stock allocation even when market changes suggest they should re-allocate it.) The theory is useful in trying to understand how consumers make decisions about buying programs or services where lengthy periods of time are involved, such as life insurance, for example. It also suggests that how consumer choices are worded can have a big impact on what consumers will, in fact, choose. [6]

The traditional economic model of utility is based on the following formula:

  Utility = probability of event * value of event

Behavioral economists add a weighting factor to this model, and the weight has the effect of fixing the distortion (or accounting for the distortion) because of human errors and presumptions. Here’s the new formula:

Utility = probability of event * value of event  * weight

The probability weighting function accounts (or tries to account) for the reality that people tend to overreact to small probability events, but underreact under-react to medium and large probabilities. It’s like a curveball in the equation, adjusting things for human distortions.

mental accounting — This term describes how people label, categorize, and evaluate economic possibilities. It was introduced by Richard Thaler in 1980. In mental accounting theory, the term framing describes how a person subjectively perceives a transaction in terms of what utility they’ll get. 

framing — A frame in a worldview of beliefs which people use to help them understand events. They help a person filter information to enable them to make sense of the world. The ”frame” influences a person’s choice — if the frame suggests a loss or a gain, then a person may choose differently, even though the outcomes are identical. 

mental accounting cost — This is the perceived transaction cost of making a useful decision. 

pseudocertainty effect — This is a concept in prospect theory which refers to a tendency to make risk-averse choices if the expected outcome is positive, but make risk-seeking choices to avoid negative outcomes, as in the example of the hypothetical disease where 200 people were supposed to live.

anchoring — This describes a cognitive bias when humans weigh too heavily (or anchor) one piece of information (to the detriment of other pieces) when making decisions. It was originated by Matthew Dixson (1984). For example, a person considering two tourist destinations may focus excessively on hotel rates for one city, while not considering the pluses and minuses of each destination overall.

anchoring and adjustment — This is a psychological heuristic in which a suggested reference point influences subsequent ideas. In marketing, when a person buys a car for $20,000, that price serves as an anchor to guide subsequent evaluations. After deciding to buy the car, if a salesperson suggests the radio is only $500 more, the $500 seems small compared to the $20,000 spent, so it is presumed that a customer

$4 hamburger. Only $2 more for fries? Seems like a bargain.

may believe the radio is cheap by comparison to the $20,000 car price. But in reality, spending $500 for a radio seems excessive; for example, shopping for just a radio might cause a person to shop for a much less expensive alternative. Marketers can use knowledge of anchoring to tack add-on purchases to big ticket items; consumers, if aware of this effect, can resist them. When asked to guess the percentage of African nations belonging to the United Nations, people who were first asked “Was it more or less than 10%?” guessed lower values (25% on average) than those who had been asked if it was more or less than 65% (45% on average). [22] This method is used in fast food restaurants — a hamburger will cost $4, but fries cost only $2 more. The fries seem inexpensive after buying the burger — what’s only $2 more — but think about it — would you buy fries, alone, for $2? They’re probably only worth half a dollar and cost a restaurant less to make and they’re certainly not the healthiest food. Much of a fast food restaurant’s profit comes from selling consumers fries with their burgers.

inequity aversion — This is a concept in game theory which describes a preference for fairness and resistance to inequalities. Professors Fehr and Schmidt postulated that people make decisions to minimize inequity in outcomes, that is, that unequal outcomes made people uncomfortable. Research on inequity aversion began in 1978 when studies suggested that humans are sensitive to inequities in favor of as well as those against them, and that some people attempt to overcompensate when they feel guilty or unhappy to have received an undeserved reward. Sometimes it’s manifested by a stubborn refusal to sacrifice a small potential gain in order to block another person from getting a greater reward based on motives such as jealousy perhaps. But economists have argued that apparently self-destructive choices such as this can be effective in the long run by building an understanding with competitors that mutual cooperation is best overall. [23]

reciprocal altruism — This concept explains how a pattern of repeated altruistic behaviour can occur between the same individuals even if they’re unrelated genetically or even if they don’t belong to the same species. Food sharing is a common example from evolutionary biology. An animal which has too much food is likely to share it with others who have helped him or her out in the past — thus returning the favor — and are less likely to reward others who have been stingy. There is a risk involved that favors will be unreturned at a later time, but when they work well, they can build successful and strong friendships which are mutually beneficial for all parties. Axelrod & Hamilton (1981) found relations between this concept and the basic underpinnings of the problem regarding the The PrisonerΓÇÖs Dilemma. [24] [23] [25]

intertemporal choice — This issue looks at the relative value people give to two or more payoffs at later points in time. The times are usually simplified to today and tomorrow (tomorrow meaning “some time in the future”). The term was introduced by John Rae in 1834 in the “Sociological Theory of Capital”. The model assumes consumer income is constant, that people strive to rationally maximize utility, that investments generate savings (ie i.e. no unproductive assets), and that property can not be divided nor changed. The model poses three types of consumption: past, present and future. When making decisions between present and future consumption, people consider their previous past histories of consumption into account.

hyperbolic discounting — This concept is sometimes called a “time-inconsistent” model of discounting because humans tend to prefer what’s immediately available over long term benefits. Given two rewards, humans prefer one that arrives sooner rather than later. Accordingly, the future rewards’ value is said to be “discounted”, and this discount factor increases with the length between the present and the time of consumption. Since the graph of the distortion resembles a hyperbolic equation, it’s been called “hyperbolic discounting.” Many studies have shown that the constant discount rate (which is based on classical economic theory) doesn’t hold up to this kind of real-world data; but at the same time, the hyperbolic discount model is based on classical exponential discounting, but it’s adjusted to try to make it more accurate. In hyperbolic discounting, valuations fall very rapidly for small delay periods, but then fall slowly for longer delay periods. So even a small waiting period can have a substantially negative effect on the value of a perceived future reward. In the traditional exponential discounting model, valuation falls by a constant factor per unit delay, regardless of the total length of the delay. The standard method showing a person’s hyperbolic discounting curve is by comparing short versus long term preferences. For example, researchers might ask: would you prefer a dollar now or two dollars on Tuesday? The comparison between those two preferences could then be compared by asking respondents the following question: would you prefer a dollar a year from now, or two dollars a year from now, but the Tuesday afterwards? The term describing individuals who leap for the present reward is that their preferences are “present-biased”. This is an important concept for such areas as retirement savings, credit card borrowing, procrastination, and substance addiction. [26] [27] [28]

endowment effect — Thaler wrote a paper examining how wine enthusiasts bought bottles at $10 each, held on to them. When the bottles increased in value to $200 per bottle, the owners didn’t sell them (but sometimes drank them). The owners wouldn’t buy new bottles of the same wine at $200 per bottle. A rational approach would suggest that the wine owners would sell their pricey $200 bottles and buy more bottles at $10, perhaps, or use the money for other purposes; so why were owners hanging on to their precious wine? How was this seemingly irrational behavior explained? Thaler posited that “people often demand much more to give up an object than they would be willing to pay to acquire it” and suggested there was a “status quo bias” as well as an asymmetry again reflecting “loss aversion”.[2]

preference reversal — This happens when, contrary to classical economics theory, A is preferred to B despite being A’s being more expensive. Depending on how questions are asked, a person could choose the seemingly irrational choice of the higher-priced alternative. Research on this was conducted by Thaler and Tversky who suggested led them to suggest an analogy with an umpire. Classical economics would have the umpire say “I call it like I see it” while behavioral economics would have the umpire say “They ain’t nothing till I call them” — the latter statement acknowledging, in effect, that human choice a highly subjective.which emphasizes the subjective nature of human preferences. [4]

money illusion — This happens when people think of money as an absolute amount rather than thinking about its real purchasing power or value. For example, a person may be offered a high-paying job in Paris or a lesser-paying job in Lyon. And they’ll choose the higher-paying Paris job without factoring in the cost of living expenses; after these are factored in, it may be more sensible to take a lesser-paying job in Lyon but where the cost-of-living is significantly less, making the Lyon package more attractive overall (from a classical economic viewpoint). [4]

psychic income — In an experiment, students who were asked to proofread pages and paid according to a declining wage schedule. When they handed in their proofread pages, sometimes their word was ignored by merely placing it in a pile, or immediately shredded; in other cases their work was signed and filed away. When ignored or shredded, students finished an average of six pages; when signed and filed, students finished nine pages. How their work was handled affected their motivation significantly — they didn’t only work for money wages, but for appreciation, that is, psychic income. [29]

hindsight bias — When the human brain rewrites memories to conform with present beliefs, there is a possibility of mis-remembering what actually happened. According to Camerer, there has been very little research done into the subject of hindsight bias. [4]

better than average effect – If people are asked to self-assess their driving skills compared to a group, they’ll all be “better than average”. [30] A similar result was found regarding other self-assessments such as I.Q. or skillsets [31] or asking entrepreneurs starting up companies to estimate their chances of success. [32] This is related to the general issue of overconfidence which has been widely reported, including business executives who were often likely to underestimate risk. [33] One study suggests that managerial overconfidence may partially explain why US firms spent $2 trillion on acquisitions between 1998 and 2001, of which $250 billion was “lost by acquiring company shareholders.” [34]

meaning of money — While being manager of consumer research, and within two years, division head at a large financial institution, I supervised several intensive focus-group based studies on what money means to people. One finding (which has since been made public): the contours of financial relationships reflect, rather than cause, behavior patterns around power and sharing. Among those who insist on dominance in a relationship, this dominance extends to control over money. Money doesn’t cause people problems in human relations; rather, the problems are already there, and money issues can reflect these underlying problems. Another finding: financial relationships are a wonderful analytic device for examining people. Are they healthy? Are they dysfunctional? Looking at their attitudes towards money can tell us a lot about who they are. There’s a term from Gestalt therapy, created by Fritz Perls, called contact boundaries, and this is a place where we can meet with people, in the present, to get a sense of what motivates them. And getting a handle on people’s sensibility about money is one of these contact boundaries. It’s not necessary to conduct expensive multi-month couch-based psychoanalytic sessions to get inside people’s heads.

Studies by behavioral economist Dr. Sara Wedeman suggested it was smart to intensely interact with people, and that rather than study the subject of money, it was wise to focus on human nature instead. She wrote:

Put another way, humans invented money. Money didn’t invent us. Money, therefore, is a reflection of our psyches and tells us much about ourselves. Unlike what many people think, money is not an independent agent or the cause of what we do; rather, humans do what humans do, and we can use money as a rationale to justify much of this activity. — Dr. Sara Wedeman [35]

Wedeman’s further investigations examined the place that money inhabits In the domain of meaning. In one study, she reasoned that there were two poles: shame and pride. Persons whose financial status falls short of some internal or external Maginot line feel shame, and those whose status exceeds it experience pride. If one takes this result to the next step, greed can be seen as an unending thirst for pride, for ego fulfillment which, in turn, suggests that people who are fabulously rich but still want more, more, more–are in fact lusting for a feeling of importance, worth, pride, and not for money itself.

 

New frontiers for behavioral economics

Researchers, marketers and thinkers are exploring new ways to apply the new findings. There have been strides to use these concepts to help organizations manage people better. [4] There are efforts to translate ideas about psychological mechanisms into more formal equations and models which can be plugged into fairly sophisticated mathematical models of aggregate phenomena, such as contracting, organizational design, price distributions, asset pricing models and fluctuations, and savings and consumption modeling. [4] A key will be defining terms explicitly and testing assumptions against real-world statistics. Camerer argues that what will be helpful for future efforts is comparing increasingly accurate statistical data — what he calls clear benchmark models — against what classical economic theory would predict, and creating a thorough list of what he terms “anomalies”, that is, discrepancies between what is versus what should be. [4]

The discipline has been applied to studying worker motivations. There are suggestions that wage preferences depend on reference points such as previous wages; this may help explain why a younger worker will object ardently to taking any kind of a reduction in wages, while an older worker may be more tolerant. One hypothesis is as follows: since the older worker may have earned the lower wage in the past, the lower wage serves as a “reference point” meaning that he or she is returning to a previous acceptable wage; in contrast, a younger worker may lack such a reference point and see any lowering of wages as intolerable. [36] Studies by Camerer and Malmendier suggest that psychic income matters, such as appreciation, feeling valued, a sense of accomplishment and self-worth, and that money, in itself, is not the be-all end-all of worker motivation; additional work regarding psychic income was done by Ariely, Kamenica and Prelec in 2004. There have been signs that in some cases, financial incentives may have a negative effect, possibly crowding out more fundamental and heartfelt human motivations. In such a case, a worker may actually lose enthusiasm for a job by being paid too much money if he or she comes to see his or her contribution as solely being motivated by the money. [4] In one experiment illustrating the crowd-out effect, two groups of children (one paid, one volunteer) were asked to color pictures; when the paid group stopped being paid mid-way through the experiment, they stopped tended to stop coloring pictures, while the unpaid group was more likely to keep on coloring pictures. [37] There were studies in the 1990s examining the so-called money illusion which suggested that firms viewed workers as essentially motivated by money, and money alone, as if they cared about nominal wages rather than inflation-adjusted real wages. Psychologists sometimes refer to psychic income by using the term intrinsic motivation, meaning the satisfaction obtained when a worker does something “for its own sake.” [4]

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