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Behavioral Economics: Incentives

This week’s topic of incentives gave me trouble trying to figure out what to write, as incentives is such a broad topic that can be discussed in so many different ways. Incentives are the motivation of why a person acts a particular way.

I eventually decided that I would focus in on the strange mystery of how too much of an incentive can actually do more harm than good. I then found Dan Pink’s TED Talk that better summarizes these findings than I would be able to. Below you can view a RSA Animate’s re-mixed version:

As always, if you want to read one paper these findings are based on, you can do so here.

Behavioral Economics: Money Illusion

A short topic this week, but an important one nonetheless. Money Illusion refers to the tendency of people to think of currency in nominal terms (its face value), rather than real terms (its purchasing power).

Consider the following question presented to people:

Suppose Adam, Ben, and Carl each received an inheritance of $200,000, and each used it immediately to purchase a house. Suppose that each of them sold the house a year after buying it. Economic conditions, however, were different in each case:

  • When Adam owned the house, there was a 25% deflation. A year after Adam bought the house, he sold it for $154,000 (23% less than he paid).
  • When Ben owned the house, there was no inflation or deflation. He sold the house for $198,000 (1% less than he paid for it).
  • When Carl owned the house, there was a 25% inflation. A year after he bought the house, Carl sold it for $246,000 (23% more than he paid).

Please rank Adam, Ben, and Carl in terms of the success of their house transactions.

Looking at this nominally, or at face value, it would appear that Carl did the best, selling the house for 23% higher than it was originally worth. However, looking at the real values, Carl really lost 2%, while Adam did the best, gaining 2%. The participants of the study were confused as well, the majority of the people thinking Carl did the best.

This is just a small example of a way Money Illusion can affect rational judgment. In fact, according to Investopedia, “Money illusion is often cited as a reason why small levels of inflation are actually desirable for an economy. Having small levels of inflation allows employers, for example, to modestly raise wages in nominal terms without actually paying more in real terms. As a result, many people who get pay raises believe that their wealth is increasing, regardless of the actual rate of inflation.”

Why are people’s reactions so easily determined by the nominal change in value? One reason is that it can quite simply be attributed to a general lack of financial education. So, next time you are making a purchase or gauging your reaction to a change in monetary values, don’t fall victim to Money Illusion!

To read more about Money Illusion, click here.

Behavioral Economics: Prospect Theory

One of the most well-known economic theory papers is Prospect Theory, written by Kahneman and Tversky. Prospect Theory discusses how people violate Expected Utility Theory by valuing gains and losses differently from one another

Before we get into Prospect Theory (PT), here’s a little background on Expected Utility Theory (EUT). EUT discusses how a decision maker chooses between risky or uncertain prospects by comparing their expected utility values. The framing and process of choosing should be irrelevant; in other words, people should always come to the same choice no matter how it is asked.

But, as we discussed last week, people are not rational beings, and while EUT describes how we should act, PT helps us understand how we actually act.

One simple study to illustrate PT:

Two groups of people were asked to choose between two options. The first group of people were asked to choose between:
a) 75% chance at winning $5000, 25% chance at winning nothing.
b) 100% chance of winning $3000.

The second group of people were given a similar, but opposite, choice:
a) 75% chance at losing $5,000, 25% chance at losing nothing.
b) 100% chance of losing $3000.

In the first situation, the majority of people chose option B, the sure win. The strange thing is that of the second group of people, the majority chose option A, taking on risk. According to EUT, people should value the gain of $5,000 (or $3,000) the same as a loss of the same amount. But they don’t, and that is how PT is relevant in our everyday choices.

valuefunctionThe graph to the right is the value function, an important part of PT. As you can see, losses are more pronounced, meaning that people value a loss as being more significant than they value a gain of the same amount. This is known as loss aversion, and is an anomaly along with the framing effect (which we discussed last week) and others that play a large role in PT.

PT goes beyond just discussing how people act irrationally given choices of risk. PT also discusses some other ways in which people make flawed decisions, such as quickly simplifying choices in our head. An example of this is rounding percentages higher or lower than they should be. (For example, we often round .1% and other tiny percentages to 1% to be able to wrap our minds around it better, but this places too high a weight on that choice.)

If you are interested in studying the Prospect Theory more in depth, feel free to read the original paper by Bykaheman and Tversky or check out this link.

Behavioral Economics: Our Decision-Making is Flawed

This is week two of my behavioral economics crash-course, where I’ll be giving a general overview of a few effects and biases that cause people to act irrationally. There’s so many more, some we’ll get to in later weeks, but these are just a few to get us started.

Endowment Effect
The endowment effect is that people often demand much more to give up an object then they would be willing to pay to acquire it.

An experiment illustrating this effect was performed by Dan Ariely at Duke University. Basketball is an important sport at Duke, and students often wait in line for days, taking turns camping out, in order to get a ticket to the game. Even then, using a lottery system, some students are awarded a ticket, while others are not. Ariely asked those who had gotten a ticket how much they would be willing to sell it for and those who had not gotten a ticket, how much they would be willing to buy one for. The buying price averaged around $200, while the selling price was well above $1000.

Why is it that people value what they own more than other people do? Perhaps they become attached to the memories of the item and, according to Ariely, “fall in love with what they already have.”

The endowment effect can apply to any item large or small. (In my class we used pens, and the effect was still prominent.) A good example to remember this by is garage sales. Many times the selling price for some items is so ridiculously high because the owner is reluctant to part with the item.

Status Quo Bias
The status quo bias is the fact that individuals have a strong tendency to try to keep things the way they are. A good example of this is organ donation. A study was done pairing together countries with similar populations, cultures, and beliefs, the only difference being how consent for organ donation is asked. Half of the countries, including the United States, use a system where people can opt-in, and average around 20% of the population giving consent. The other half of the countries use an opt-out system, and average around 80% consent. Why the difference? Individuals want to put in as little effort as possible into decisions, and will go with the flow.

Framing Effect
The framing effect is one of the most relevant anomalies in our every day lives. Essentially, a person’s response can vary depending on how a situation or question is framed. A basic example of this is when you go food shopping, products are labeled 99% fat free rather than 1% fat.

A better example of this can be seen in the following: Two groups of people were asked to judge a custody battle case. The two parents’ traits are as follows:
Parent A –  Parent B
Average income – High income
Average health – Minor health problems
Average work hours – Lots of work-related travel
Reasonably close to child – Very close to child
Routine social life – Very active social life

Half of the participants were asked to which parent would they award sole custody, and 66% responded parent B. The other half of participants were asked to which parent would you deny custody, and 57% chose parent B.

Why is this? Well, the positives or negatives (depending on how the question is worded) stand out against the averages of parent A. Framing techniques are used by advertising, lawyers, and a slew of other ways everyday. It just goes to show that people’s reason-based decision making can be flawed and irrational.

Behavioral Economics: An Introduction

This semester I was lucky enough to get into a special topic economics elective titled Behavioral Economics. As I’ve mentioned in the past, behavioral economics is one of the fields that I find most fascinating, and as this is the first time the class is being offered, I feel fortunate that I was able to get a seat.

The class is set up mainly in a discussion-based format with certain readings, and different topics, dealing with the field each week. I would love to share my newfound knowledge, so I’ve decided to briefly recap what I have been learning each week. Think of it as a mini crash-course in behavioral economics that you don’t even have to leave your computer for!

This first week of class served mainly as an introduction to behavioral economics. A quick background to economics: When economics first came to be, psychology hadn’t yet become a recognized field of study, though many prominent economists at the time moonlighted as some of the first psychologists. The two fields grew together for a time, until the neoclassical revolution began, when economists felt psychology was too shaky a foundation and wanted economics to become more of a natural science.

One important concept that economics presents is that people are represented as being rational individuals, making choices that will always benefit themselves. This composite person used in economics is known as the “Economic Man.” However, more recently, economists have realized that people act in strange, irrational ways and wanted to know more, thus behavioral economics came to be.

Behavioral economics is a sort of blend between economics and psychology, being used to study behavior. While this field mainly relies on experiments to gather data, it differs from psychological experiments in several ways:

  1. Incentives – Behavioral economics experiments usually involve some sort of incentive, usually financial. This attempts to remove any indifference in the subject and keep them focused on the task at hand. It also helps reduce noise in the data.
  2. Repetition – In experiments, subjects will be asked the same exact question in the same exact way several times. This gives the subject the ability to learn about the structure of the experiment.
  3. Truth – Many psychology experiments rely on deception, but by being honest about the intentions of the experiment, subjects in economics experiments will focus on what they are there to do, rather than trying to “find the catch” the entire time.

Now you have a basic understanding and introduction to behavioral economics. Check back next week when we start getting into the really interesting stuff!

 
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