Keith M. Marzilli Ericson, John Myles White, and Jonathan D. Cohen,
“Money Earlier or Later? Simple Heuristics Explain Intertemporal Choices
Better than Delay Discounting.” NBER Working Paper No. w20948, February 2015.
• A series of “Money Earlier or Later” (MEL) choice problems are given to 1000 participants on Amazon’s Mechanical Turk service. Each MEL problem asks a person to choose between a Small-Early option (x1, t1), where x1 is the amount of money to be received t1 time periods from now, and a Large Late option (x2, t2); the names of the options recognize that x1<x2, and t1<t2. So, are you willing to wait until time t2 (instead of t1) to receive a larger payment of x2 (instead of the smaller but earlier payment of x1)?
• Problems with existing models of discount rates are what motivate this experiment. We have already seen why exponential discounting is inconsistent with common choice behavior. But even hyperbolic or quasi-hyperbolic discounting, though they can generate a present bias, cannot explain the magnitude effect, where multiplying up the dollar amounts by a common factor leads to lower revealed discount rates: a person who will take $10 today instead of $13 a week from now (often) will not take $1000 today instead of $1300 one week from now.
• The authors propose that in MEL problems, people employ rules of thumb, heuristics, so they call their model the ITCH model, for Intertemporal Choice Heuristics. In the ITCH models, the four factors that people employ to make their decision are the absolute (x2-x1) and relative ((x2-x1)/(x1+x2)/2) differences in monetary amounts and, the absolute (t2-t1) and relative ((t2-t1)/(t1+t2)/2) time delays. These four factors are combined via a weighted sum, which turns out to be fairly stable across individuals and “frames” for the MEL problems. The use of average time and delay in determining relative changes provides a sort of reference point interpretation to the heuristic.
• ITCH explains decreasing impatience (with time) and the absolute magnitude effect: If both the early and late options are delayed by a week, the relative time delay falls, so the use of a lower discount rate results. Alternatively, increasing the stakes proportionally increases the absolute payoff, and again, a lower discount rate will be chosen by the heuristics.
• Calibration of the model on a subset of the data shows that relative money is a much larger factor than absolute money, whereas relative and absolute time have similar weights. (But the time periods were rather paltry, and were presented always in absolute form, so a different approach could raise the decision weight of the relative time component.)
• In predicting the out-of-sample data, the ITCH model out-performs all the tested alternatives such as exponential discounting or quasi-hyperbolic discounting.
• So, perhaps people do not have “a” discount rate, but rather, use some rules of thumb to make intertemporal trade-offs.
Tuesday, June 30, 2015
People are Not Exponential Discounters, and That’s OK
Some Notions Drawn, as I Recall, from Rabin (2002) and Frederick, Loewenstein, and O'Donoghue (2002)
• Would you rather have $20 now or $21 one week from now? If you choose the immediate $20 – a perfectly reasonable choice – then you discount monetary rewards by at least 5 percent per week. Would you rather have $20 now, or $250 one year from now? If you are an exponential discounter, and you preferred the immediate $20 in the initial situation, then you must prefer the immediate $20 to $250 one year hence, as 1.05 to the 52nd power is more than 12.6. If the question concerned two years from now, you would turn down $3100 in two years’ time for an immediate $20.
• Would you rather have $20 now or $22 one week from now? If you chose the immediate $20, then you discount by at least 10 percent per week. Would you rather have $20 now, or $2800 one year from now? If you are an exponential discounter, you must still want the $20, as 1.10 to the 52nd power is more than 140. In two years’ time, you’d turn down $400,000 (1.1 to the 104th power is more than 20,000) for an immediate $20.
• Rabin showed that the sort of risk aversion over small-stakes gambles that most people display is inconsistent with expected utility theory, because such behavior would necessitate crazy choices for higher stakes gambles. What is demonstrated above is rather analogous, that the sort of time preference that people display for small stakes, short time-frame situations is not consistent with exponential discounting, because it would necessitate crazy choices for longer time-frame choices.
• Would you rather have $20 now or $21 one week from now? If you choose the immediate $20 – a perfectly reasonable choice – then you discount monetary rewards by at least 5 percent per week. Would you rather have $20 now, or $250 one year from now? If you are an exponential discounter, and you preferred the immediate $20 in the initial situation, then you must prefer the immediate $20 to $250 one year hence, as 1.05 to the 52nd power is more than 12.6. If the question concerned two years from now, you would turn down $3100 in two years’ time for an immediate $20.
• Would you rather have $20 now or $22 one week from now? If you chose the immediate $20, then you discount by at least 10 percent per week. Would you rather have $20 now, or $2800 one year from now? If you are an exponential discounter, you must still want the $20, as 1.10 to the 52nd power is more than 140. In two years’ time, you’d turn down $400,000 (1.1 to the 104th power is more than 20,000) for an immediate $20.
• Rabin showed that the sort of risk aversion over small-stakes gambles that most people display is inconsistent with expected utility theory, because such behavior would necessitate crazy choices for higher stakes gambles. What is demonstrated above is rather analogous, that the sort of time preference that people display for small stakes, short time-frame situations is not consistent with exponential discounting, because it would necessitate crazy choices for longer time-frame choices.
Hardisty, Appelt, and Weber (2013), on Magnitude Effects in Intertemporal Choice
David J. Hardisty, Kirstin C. Appelt, and Elke U. Weber, “Good or Bad, We Want it Now: Fixed-cost Present Bias for Gains and Losses Explains Magnitude Asymmetries in Intertemporal Choice.” Journal of Behavioral Decision Making 26: 348–361, 2013.
• A positive discount rate means that you want to capture gains immediately, and postpone losses as long as possible. Why would people have a positive discount rate? (1) opportunity cost; (2) uncertainty (for instance, you might not actually have to pay that cost if it is postponed); (3) resource slack, the belief that your budget won’t be as tight in the future; and (4) preferences themselves display present bias, or impatience.
• The magnitude effect: people discount future small gains much more highly than they discount substantial sums. This will be the case, for instance, if preferences have a sort of fixed cost present bias. People might be willing to pay $4, for instance, to achieve an immediate reward rather than wait for a larger, later reward. This fixed cost will induce people to move to take small gains immediately, but for larger amounts (which involve larger future gains, too), they are willing to wait.
• In the loss domain, there is evidence for small or even reverse magnitude effects: small losses are discounted less than large losses. A fixed cost present bias explains observed magnitude effects for gains, but does not predict asymmetric magnitude effects. People with a fixed cost present bias would still want to postpone losses, contrary to some empirical evidence.
• Hardisty, Appelt, and Weber argue that people want to resolve uncertainty right away, now. Such resolution is not their only concern, but all else equal, it means that gains are taken right away and that losses are realized right away. Further, this resolution bias is insensitive to magnitude, while the other factors, such as uncertainty and opportunity costs, tend to scale with magnitude. As a result, the resolution bias yields greater discount rates for gains and smaller ones for losses. Further, small losses will involve negative discounting. In the experiments, zero and negative discount rates are common in the small loss condition.
• A positive discount rate means that you want to capture gains immediately, and postpone losses as long as possible. Why would people have a positive discount rate? (1) opportunity cost; (2) uncertainty (for instance, you might not actually have to pay that cost if it is postponed); (3) resource slack, the belief that your budget won’t be as tight in the future; and (4) preferences themselves display present bias, or impatience.
• The magnitude effect: people discount future small gains much more highly than they discount substantial sums. This will be the case, for instance, if preferences have a sort of fixed cost present bias. People might be willing to pay $4, for instance, to achieve an immediate reward rather than wait for a larger, later reward. This fixed cost will induce people to move to take small gains immediately, but for larger amounts (which involve larger future gains, too), they are willing to wait.
• In the loss domain, there is evidence for small or even reverse magnitude effects: small losses are discounted less than large losses. A fixed cost present bias explains observed magnitude effects for gains, but does not predict asymmetric magnitude effects. People with a fixed cost present bias would still want to postpone losses, contrary to some empirical evidence.
• Hardisty, Appelt, and Weber argue that people want to resolve uncertainty right away, now. Such resolution is not their only concern, but all else equal, it means that gains are taken right away and that losses are realized right away. Further, this resolution bias is insensitive to magnitude, while the other factors, such as uncertainty and opportunity costs, tend to scale with magnitude. As a result, the resolution bias yields greater discount rates for gains and smaller ones for losses. Further, small losses will involve negative discounting. In the experiments, zero and negative discount rates are common in the small loss condition.
Ifcher and Zarghamee (2011) on Positive Affect and Time Preference
John Ifcher and Homa Zarghamee, “Happiness and Time Preference: The Effect of Positive Affect in a Random-Assignment Experiment.” American
Economic Review 101: 3109–3129, December 2011.
• Mild positive affect has many beneficial correlates, including increased self-control. But does happiness cause low discounting of the future or does low discounting cause happiness?
• This article describes an experiment that tries to get at the causality question. The experiment allows discount rates to be measured fairly well, but instead of examining happiness directly, only positive affect is tested.
• The experiment revealed that indeed, people with an induced positive affect discount at a lower rate, they display more self-control, or less present bias.
• One of the hurdles that the experiment works hard to overcome is to be able to compare present and future payments where the transaction costs and hassle of receiving the payments are similar in both cases.
• The experiment involved questions such as: How much money would you need to be paid today to forgo the opportunity to receive m dollars t days from now? The questions involved m’s ranging from about $11 to about $51, and t's ranging from one day to 56 days.
• The experiment reproduces the usual finding that longer delays to receive a payment fixed in size are less valuable to someone in the here and now.
• Mild positive affect has many beneficial correlates, including increased self-control. But does happiness cause low discounting of the future or does low discounting cause happiness?
• This article describes an experiment that tries to get at the causality question. The experiment allows discount rates to be measured fairly well, but instead of examining happiness directly, only positive affect is tested.
• The experiment revealed that indeed, people with an induced positive affect discount at a lower rate, they display more self-control, or less present bias.
• One of the hurdles that the experiment works hard to overcome is to be able to compare present and future payments where the transaction costs and hassle of receiving the payments are similar in both cases.
• The experiment involved questions such as: How much money would you need to be paid today to forgo the opportunity to receive m dollars t days from now? The questions involved m’s ranging from about $11 to about $51, and t's ranging from one day to 56 days.
• The experiment reproduces the usual finding that longer delays to receive a payment fixed in size are less valuable to someone in the here and now.
Markle, Wu, White, and Sackett (2014) on Reference Points in Marathons
Alex Markle, George Wu, Rebecca J. White, and Aaron M. Sackett, “Goals as Reference Points in Marathon Running: A Novel Test of Reference Dependence.” Fordham University Schools of Business Research Paper No. 2523510, November 12, 2014 [subsequently updated].
• Marathoners are asked for a time goal prior to the race; the notion is that these goals serve as reference points through which prospect theory-style preferences pivot.
• Runners also are asked to indicate how happy they will be with meeting their time goal, or with beating it, or with not meeting it. Answers to these questions suggest that runners believe that their experience utility will display loss aversion, with the time goal as reference point.
• Actual satisfaction with marathon performance indeed tracks performance relative to the time goal with loss aversion and diminishing sensitivity. People overestimate their degree of loss aversion (or their benefit from success), but nevertheless they do experience some aversion (or benefit).
• Unlike the standard prospect theory gain-loss function, the satisfaction experienced by runners takes a jump discontinuity at the reference point.
• Runners who indicated that their time goal was particularly important seem to display larger loss aversion.
• The existence of additional reference points, such as past best time or most recent marathon time, also can mediate results.
• Note that reference-dependent preferences might be “rational” if, as here, actual experienced utility displays reference dependence.
• Marathoners are overly optimistic about their chances of meeting their time goal.
• Marathoners are asked for a time goal prior to the race; the notion is that these goals serve as reference points through which prospect theory-style preferences pivot.
• Runners also are asked to indicate how happy they will be with meeting their time goal, or with beating it, or with not meeting it. Answers to these questions suggest that runners believe that their experience utility will display loss aversion, with the time goal as reference point.
• Actual satisfaction with marathon performance indeed tracks performance relative to the time goal with loss aversion and diminishing sensitivity. People overestimate their degree of loss aversion (or their benefit from success), but nevertheless they do experience some aversion (or benefit).
• Unlike the standard prospect theory gain-loss function, the satisfaction experienced by runners takes a jump discontinuity at the reference point.
• Runners who indicated that their time goal was particularly important seem to display larger loss aversion.
• The existence of additional reference points, such as past best time or most recent marathon time, also can mediate results.
• Note that reference-dependent preferences might be “rational” if, as here, actual experienced utility displays reference dependence.
• Marathoners are overly optimistic about their chances of meeting their time goal.
Heffetz and List (2014) on Reference Points and Endowments
Heffetz, Ori and John A. List, “Is the Endowment Effect an Expectations Effect?” Journal of the European Economic Association 12(5): 1396-1422, October 2014.
• Three experiments are conducted to test the Koszegi and Rabin (2006) version of prospect theory, in which the reference point consists of recent expectations for future consumption. In part, Koszegi and Rabin were motivated by List’s evidence that endowment effects dissipate with market experience.
• A pared-down description of the experimental set-up: Subjects flip a coin to determine whether they are assigned a mug or a pen. After this assignment, in the Strong Expectations condition, they are told that there is a 99% chance that the good (mug or pen) that they were assigned by the coin flip is what they have to keep, but there is a 1% chance they will be allowed to trade for the other item. (That is, Strong Expectations means that you virtually own the good that was randomly assigned.) In the Weak Expectations condition, the probability is reversed, so the assignment is very unlikely to be binding. Then (eventually), subjects have to choose which good they want. Only after that do they learn whether their choice matters, or whether the realization of the randomization dictated that they had to stick with their assignment.
• The Koszegi and Rabin model suggests that under Strong Expectations, the coin-flip assignment should affect preferences – but not under Weak Expectations. What Heffetz and List found, however, is that the assignment matters a lot, with no difference between the Expectation conditions.
• Experiments by Marzilli Ericson and Fuster, alternatively, found a big effect of strong v. weak expectations in a different experimental set-up. Heffetz and List run two experiments similar to those of Marzilli Ericson and Fuster, but do not replicate their results. Instead, Heffetz and List basically continue to find that the random assignment matters, and that the Expectations condition has no effect – contrary to Koszegi and Rabin and to Marzilli Ericson and Fuster.
• Three experiments are conducted to test the Koszegi and Rabin (2006) version of prospect theory, in which the reference point consists of recent expectations for future consumption. In part, Koszegi and Rabin were motivated by List’s evidence that endowment effects dissipate with market experience.
• A pared-down description of the experimental set-up: Subjects flip a coin to determine whether they are assigned a mug or a pen. After this assignment, in the Strong Expectations condition, they are told that there is a 99% chance that the good (mug or pen) that they were assigned by the coin flip is what they have to keep, but there is a 1% chance they will be allowed to trade for the other item. (That is, Strong Expectations means that you virtually own the good that was randomly assigned.) In the Weak Expectations condition, the probability is reversed, so the assignment is very unlikely to be binding. Then (eventually), subjects have to choose which good they want. Only after that do they learn whether their choice matters, or whether the realization of the randomization dictated that they had to stick with their assignment.
• The Koszegi and Rabin model suggests that under Strong Expectations, the coin-flip assignment should affect preferences – but not under Weak Expectations. What Heffetz and List found, however, is that the assignment matters a lot, with no difference between the Expectation conditions.
• Experiments by Marzilli Ericson and Fuster, alternatively, found a big effect of strong v. weak expectations in a different experimental set-up. Heffetz and List run two experiments similar to those of Marzilli Ericson and Fuster, but do not replicate their results. Instead, Heffetz and List basically continue to find that the random assignment matters, and that the Expectations condition has no effect – contrary to Koszegi and Rabin and to Marzilli Ericson and Fuster.
Abeler et al. (2011) on Reference Points and Effort Provision
Johannes Abeler, Armin Falk, Lorenz Goette, and David Huffman,
“Reference Points and Effort Provision.” American Economic Review 101: 470-492, April 2011.
• An experiment is conducted in which people engage in a tedious and pointless task, but one that requires some attention.
• The participants do not know with certainty how much they will be paid. They know that they will either receive a fixed fee (of which they are informed), or their accumulated, piece-rate earnings, each with equal probability.
• The experiment varied only the fixed fee, which is either low (3 euros) or high (7 euros). The relevant choice for the worker is how long to work.
• For an expected utility maximizer, the size of the fixed fee will not influence the decision about how long to work. (This claim requires the assumption that utility is separable in money and effort.) Even for a prospect theory decider, if the reference point is the status quo prior to the experiment, the size of the fixed fee will not influence the decision about how long to work.
• If the worker is a prospect theory decider whose reference point is determined by the fixed fee – perhaps by fixing expectations of earnings – then the fixed fee size will influence the amount of work, as losses relative to the fixed fee will be quite aversive.
• Sure enough, the participants worked longer when the fixed fee was higher. Further, the most common stopping point occurred when the accumulated earnings equaled the fixed fee, so the payment involved no uncertainty at all.
• Workers whose responses to a series of questions suggest that they are particularly loss averse are also relatively more likely to stop working at the no-risk point.
• An experiment is conducted in which people engage in a tedious and pointless task, but one that requires some attention.
• The participants do not know with certainty how much they will be paid. They know that they will either receive a fixed fee (of which they are informed), or their accumulated, piece-rate earnings, each with equal probability.
• The experiment varied only the fixed fee, which is either low (3 euros) or high (7 euros). The relevant choice for the worker is how long to work.
• For an expected utility maximizer, the size of the fixed fee will not influence the decision about how long to work. (This claim requires the assumption that utility is separable in money and effort.) Even for a prospect theory decider, if the reference point is the status quo prior to the experiment, the size of the fixed fee will not influence the decision about how long to work.
• If the worker is a prospect theory decider whose reference point is determined by the fixed fee – perhaps by fixing expectations of earnings – then the fixed fee size will influence the amount of work, as losses relative to the fixed fee will be quite aversive.
• Sure enough, the participants worked longer when the fixed fee was higher. Further, the most common stopping point occurred when the accumulated earnings equaled the fixed fee, so the payment involved no uncertainty at all.
• Workers whose responses to a series of questions suggest that they are particularly loss averse are also relatively more likely to stop working at the no-risk point.
Pope and Schweitzer (2011) on Tiger Woods and Persistent Bias
Devin G. Pope and Maurice E. Schweitzer, “Is Tiger Woods Loss Averse? Persistent Bias in the Face of Experience, Competition, and High Stakes.”
American Economic Review 101: 129-157, February 2011.
• The notion of a reference point is central to prospect theory, but how can reference points be identified? In the game of golf, the idea of “par” provides a sort of natural reference point.
• Prospect theory suggests that people view the outcomes of risky decisions not in overall terms, but as gains or losses relative to their reference point. To perform worse than par (a bogey or double bogey, say), is a loss relative to the reference point of par. To perform better than par (an eagle or birdie, say) is a gain relative to the reference point.
• Prospect theory suggests that people are loss averse, being more concerned with negative departures from the reference point than with “equivalent” upward departures. Missing a putt for par will result in a loss (relative to the reference point), whereas missing a putt for birdie will still, in itself, not cause a loss.
• Imagine two otherwise identical putts, one for birdie and one for par. In terms of monetary payoffs, both are identical for a given golfer – but they are not identical in terms of the gains/losses coding. Professional golfers perform better at such putts when they are for par than when they are for birdie. That is, the disutility associated with being on the loss side of the ledger seems to induce improved performance from golfers. A golfer who performed as well on birdie putts as he or she did on identical par putts would earn tens, even hundreds of thousands of dollars more per year.
• Professional golfers appear to be loss averse as opposed to “fully rational,” even though they are experienced actors in a highly competitive setting, and where the monetary stakes associated with departures from rationality are quite significant.
• The notion of a reference point is central to prospect theory, but how can reference points be identified? In the game of golf, the idea of “par” provides a sort of natural reference point.
• Prospect theory suggests that people view the outcomes of risky decisions not in overall terms, but as gains or losses relative to their reference point. To perform worse than par (a bogey or double bogey, say), is a loss relative to the reference point of par. To perform better than par (an eagle or birdie, say) is a gain relative to the reference point.
• Prospect theory suggests that people are loss averse, being more concerned with negative departures from the reference point than with “equivalent” upward departures. Missing a putt for par will result in a loss (relative to the reference point), whereas missing a putt for birdie will still, in itself, not cause a loss.
• Imagine two otherwise identical putts, one for birdie and one for par. In terms of monetary payoffs, both are identical for a given golfer – but they are not identical in terms of the gains/losses coding. Professional golfers perform better at such putts when they are for par than when they are for birdie. That is, the disutility associated with being on the loss side of the ledger seems to induce improved performance from golfers. A golfer who performed as well on birdie putts as he or she did on identical par putts would earn tens, even hundreds of thousands of dollars more per year.
• Professional golfers appear to be loss averse as opposed to “fully rational,” even though they are experienced actors in a highly competitive setting, and where the monetary stakes associated with departures from rationality are quite significant.
Monday, June 29, 2015
Barberis (2013) on 30 Years of Prospect Theory
Nicholas C. Barberis, “Thirty Years of Prospect Theory in Economics: A Review and Assessment.” Journal of Economic Perspectives 27(1): 173-96,
2013.
• Prospects are evaluated with decision weights not equal to probabilities, and with valuation tied not to overall wealth, but to gains and losses relative to a reference point. Besides probability weighting and reference dependence, prospect theory also invokes loss aversion and diminishing sensitivity.
• Diminishing sensitivity with respect to losses is equivalent to risk seeking: the pain of losing $900 is more than 90 percent of the pain of losing $1000.
• The probability weighting function overweights low probabilities and underweights high probabilities. These weights are not interpreted (within prospect theory) as mistakes.
• What is the relevant reference point? Koszegi and Rabin (and others) take the reference point to be recent expectations. People then gain when consumption is larger than expected consumption; therefore (perhaps), I do not like to hear praise for a book that I intend to read.
• The overweighting of low probability, good outcomes, helps to explain the interest in lotteries, and the low average return to some positively skewed financial securities.
• Prospect theory is carried over to riskless choice via the endowment effect. The endowment effect comes in two forms, exchange asymmetries and willingness-to-pay/willingness-to-accept gaps; both can follow from loss aversion.
• Some behaviors that looks like contradictions of prospect theory (such as the eroding of the endowment effect among experienced traders) could reflect different reference points.
• Prospects are evaluated with decision weights not equal to probabilities, and with valuation tied not to overall wealth, but to gains and losses relative to a reference point. Besides probability weighting and reference dependence, prospect theory also invokes loss aversion and diminishing sensitivity.
• Diminishing sensitivity with respect to losses is equivalent to risk seeking: the pain of losing $900 is more than 90 percent of the pain of losing $1000.
• The probability weighting function overweights low probabilities and underweights high probabilities. These weights are not interpreted (within prospect theory) as mistakes.
• What is the relevant reference point? Koszegi and Rabin (and others) take the reference point to be recent expectations. People then gain when consumption is larger than expected consumption; therefore (perhaps), I do not like to hear praise for a book that I intend to read.
• The overweighting of low probability, good outcomes, helps to explain the interest in lotteries, and the low average return to some positively skewed financial securities.
• Prospect theory is carried over to riskless choice via the endowment effect. The endowment effect comes in two forms, exchange asymmetries and willingness-to-pay/willingness-to-accept gaps; both can follow from loss aversion.
• Some behaviors that looks like contradictions of prospect theory (such as the eroding of the endowment effect among experienced traders) could reflect different reference points.
Kahneman (2011) on Prospect Theory
Daniel Kahneman, “Prospect Theory.” Chapter 26, pages 278-288, in Thinking, Fast and Slow, New York: Farrar, Straus and Giroux, 2011.
• Outcomes (the carriers of utility) often seem to be associated with gains or losses relative to some reference point, not to overall states of wealth. Many people can’t generate a precise estimate of their wealth.
• Consider choosing between the prospects (+$900; 1) and (+$1000, $0; .9, .1). They have the same expected value, but we would expect that most people would choose the certainty of gaining $900 to the risky option.
• Now consider choosing between the prospects (-$900; 1) versus (-$1000, $0; .9, .1); many people would choose the risky prospect over the certainty of losing $900. People who are risk averse with respect to gains become risk loving with respect to losses.
• In physical sensations and in many other ways we respond to differences from a reference point. Is a bowl of water warm? The answer depends on the environment, holding the temperature of the water constant.
• Might loss aversion be an evolutionary adaptation, in that threats to the status quo are more urgent than are improvements?
• Consider the prospect (+$x, -$100; .5, .5); how much does x have to be for you to be willing to accept this gamble? For most people, it is between $150 and $250, indicating a “loss aversion ratio” of 1.5 to 2.5.
• Prospect theory ignores anticipated disappointment and regret, though these seem to matter in many actual choices.
• Outcomes (the carriers of utility) often seem to be associated with gains or losses relative to some reference point, not to overall states of wealth. Many people can’t generate a precise estimate of their wealth.
• Consider choosing between the prospects (+$900; 1) and (+$1000, $0; .9, .1). They have the same expected value, but we would expect that most people would choose the certainty of gaining $900 to the risky option.
• Now consider choosing between the prospects (-$900; 1) versus (-$1000, $0; .9, .1); many people would choose the risky prospect over the certainty of losing $900. People who are risk averse with respect to gains become risk loving with respect to losses.
• In physical sensations and in many other ways we respond to differences from a reference point. Is a bowl of water warm? The answer depends on the environment, holding the temperature of the water constant.
• Might loss aversion be an evolutionary adaptation, in that threats to the status quo are more urgent than are improvements?
• Consider the prospect (+$x, -$100; .5, .5); how much does x have to be for you to be willing to accept this gamble? For most people, it is between $150 and $250, indicating a “loss aversion ratio” of 1.5 to 2.5.
• Prospect theory ignores anticipated disappointment and regret, though these seem to matter in many actual choices.
Barberis (2013) on Tail Events
Nicholas Barberis, “The Psychology of Tail Events: Progress and Challenges.” American Economic Review 103(3): 611-16, 2013.
• “Tail events” are low probability, but high impact outcomes, like a huge stock market crash.
• Analysis of human reactions to tail events focuses on the perceived probability of the event, and, with that probability given, how the outcome itself is judged.
• People tend to overestimate the probability of rare, but monumental events, whether the outcomes are superb (like winning the lottery) or disastrous (like being victimized by terrorists).
• Even when people assess probabilities objectively, however, they tend to put “excessive” weight on the outcomes tied to tail events. Hence they might be willing to pay to avoid a very unlikely but large loss, at the same time they are willing to pay to buy a very unlikely chance at a windfall: the rare outcome of the big loss is overweighted, as is the rare outcome of the big win. This overweighting is a feature of preferences and (probably?) cannot be said to be a mistake.
• The excessive weight on low-probability outcomes indicates that positive skewness (a lottery-like low probability of a big win) is valuable to people, so that shares of stocks of individual companies that offer such skewness do not have to have as high of an expected return to attract buyers.
• But the excessive weight placed on low probability events also implies that negative skewness (a small probability of a large loss) is aversive, so that assets that are negatively skewed (such as the overall stock market, which might crash) require a premium in terms of expected returns to attract buyers; this approach offers an explanation for the equity premium puzzle.
• “Tail events” are low probability, but high impact outcomes, like a huge stock market crash.
• Analysis of human reactions to tail events focuses on the perceived probability of the event, and, with that probability given, how the outcome itself is judged.
• People tend to overestimate the probability of rare, but monumental events, whether the outcomes are superb (like winning the lottery) or disastrous (like being victimized by terrorists).
• Even when people assess probabilities objectively, however, they tend to put “excessive” weight on the outcomes tied to tail events. Hence they might be willing to pay to avoid a very unlikely but large loss, at the same time they are willing to pay to buy a very unlikely chance at a windfall: the rare outcome of the big loss is overweighted, as is the rare outcome of the big win. This overweighting is a feature of preferences and (probably?) cannot be said to be a mistake.
• The excessive weight on low-probability outcomes indicates that positive skewness (a lottery-like low probability of a big win) is valuable to people, so that shares of stocks of individual companies that offer such skewness do not have to have as high of an expected return to attract buyers.
• But the excessive weight placed on low probability events also implies that negative skewness (a small probability of a large loss) is aversive, so that assets that are negatively skewed (such as the overall stock market, which might crash) require a premium in terms of expected returns to attract buyers; this approach offers an explanation for the equity premium puzzle.
Sunstein (2013) on Misfearing
Cass Sunstein, “If Misfearing is the Problem, is Cost-Benefit Analysis the Solution?” Chapter 13, pages 231-242, in The Behavioral Foundations of Public Policy, Eldar Shafir, editor, Princeton: Princeton University Press, 2013.
• The usual rationale for cost-benefit analysis (CBA) is that it promotes economic efficiency; nevertheless, perhaps the better argument for CBA is that it allows improved responses to the mis-fears of the public.
• The idea is that CBA is sort of a System 2 check on System 1 errors, to employ the terminology of Kahneman.
• People can misfear for multiple reasons, including the availability heuristic, informational cascades, excessive insensitivity to changes in probabilities, and the tendency to think that high-risk activities also involve small benefits.
• CBA is built around willingness-to-pay (WTP). But isn’t it the case that WTP depends on perceptions of risks and benefits, so that WTP itself might be the product of misfearing? Can we take preferences as given in conducting a CBA, or do we have to recognize that preferences and perceptions can be shaped?
• “Incompletely theorized agreements” are possible (and common?), where people can pragmatically agree upon a policy even though they have separate (and incompatible?) reasons for supporting the policy.
• The usual rationale for cost-benefit analysis (CBA) is that it promotes economic efficiency; nevertheless, perhaps the better argument for CBA is that it allows improved responses to the mis-fears of the public.
• The idea is that CBA is sort of a System 2 check on System 1 errors, to employ the terminology of Kahneman.
• People can misfear for multiple reasons, including the availability heuristic, informational cascades, excessive insensitivity to changes in probabilities, and the tendency to think that high-risk activities also involve small benefits.
• CBA is built around willingness-to-pay (WTP). But isn’t it the case that WTP depends on perceptions of risks and benefits, so that WTP itself might be the product of misfearing? Can we take preferences as given in conducting a CBA, or do we have to recognize that preferences and perceptions can be shaped?
• “Incompletely theorized agreements” are possible (and common?), where people can pragmatically agree upon a policy even though they have separate (and incompatible?) reasons for supporting the policy.
Loewenstein, John, and Volpp (2013) on Leveraging Behavioral Biases to Help People
George Loewenstein, Leslie John, and Kevin G. Volpp,
“Using Decision Errors to Help People Help Themselves.” Chapter 21, pages
361-379, in The Behavioral Foundations of Public Policy, Eldar Shafir, editor, Princeton: Princeton University Press,
2013.
• The oddly named “Theory of the Second Best” indicates that if there are some number n of conditions that must hold for things to be fully optimal (first best), then that is no reason to believe that moving from n-2 of those conditions holding to n-1 of the conditions holding represents an improvement. Perhaps your “first best” is to go to the cinema with your special friend to watch a touching romantic comedy. But if your special friend is not available (or perhaps has found someone new), then going to a romantic comedy might not be an improvement over the status quo of wallowing at home.
• Loewenstein, John, and Volpp apply the notion of the second best to fight behavioral fire with behavioral fire: harnessing departures from rationality to counteract other departures from rationality. Maybe overoptimism can be used to cancel out excessive risk aversion?
• Asymmetric paternalism is an intervention that helps “irrational” people make better decisions, without imposing in a serious way upon the decisions of rational people.
• The self-serving fairness bias: what favors me is fair. This bias can prevent the settlement of disputes between two parties. It can be used to promote a settlement, however, because both parties might be willing to trust a “neutral” mediator who can impose a settlement.
• The stickiness of default options and the attractiveness of lotteries are two biases that can be used to promote weight loss, exercise, medical compliance, public transport use, and charitable contributions.
• Lottery prizes are good motivators thanks in part to the overweighting of small probabilities. A daily lottery that lets you know if you won or not, but only pays if you were in compliance with the desired behavior on the day you won, also adds anticipated regret into the mix.
• Some commercial entities (e.g. casinos) have significant pecuniary incentives to appeal to our less-than-rational impulses. But some firms, such as health insurers or employers who gain from our better compliance with medical protocols, have monetary incentives to make our decision making more “rational.”
• Loewenstein, John, and Volpp note a number of biases that many people seem to display in their decisionmaking. These biases include narrow bracketing; the hot-cold empathy gap; projection bias; and present bias.
• “Narrow bracketing” occurs when decisions are examined in isolation (perhaps as potential changes from the status quo) rather than holistically.
• The “hot-cold empathy gap” refers to our inability to predict how we will behave in the “hot” state (perhaps when we are very hungry or angry) when we are examining our behavior while in the “cold” state.
• “Projection bias” is the idea that people predict that their future preferences will be pretty much the same as their current preferences. But there might be hedonic adaptation, or a change in visceral factors. Projection is one explanation underlying the advice not to go grocery shopping on an empty stomach.
• People save too little not because the rate of return to savings is too low, but (in part?) because of a “present bias” or an interest in instant gratification. The “Save More Tomorrow” plan allows people to (semi-)commit to savings increases at a later date, and this program has been quite successful in spurring savings.
• Is it distasteful or unethical to take advantage of common decision errors for paternalistic purposes?
• The oddly named “Theory of the Second Best” indicates that if there are some number n of conditions that must hold for things to be fully optimal (first best), then that is no reason to believe that moving from n-2 of those conditions holding to n-1 of the conditions holding represents an improvement. Perhaps your “first best” is to go to the cinema with your special friend to watch a touching romantic comedy. But if your special friend is not available (or perhaps has found someone new), then going to a romantic comedy might not be an improvement over the status quo of wallowing at home.
• Loewenstein, John, and Volpp apply the notion of the second best to fight behavioral fire with behavioral fire: harnessing departures from rationality to counteract other departures from rationality. Maybe overoptimism can be used to cancel out excessive risk aversion?
• Asymmetric paternalism is an intervention that helps “irrational” people make better decisions, without imposing in a serious way upon the decisions of rational people.
• The self-serving fairness bias: what favors me is fair. This bias can prevent the settlement of disputes between two parties. It can be used to promote a settlement, however, because both parties might be willing to trust a “neutral” mediator who can impose a settlement.
• The stickiness of default options and the attractiveness of lotteries are two biases that can be used to promote weight loss, exercise, medical compliance, public transport use, and charitable contributions.
• Lottery prizes are good motivators thanks in part to the overweighting of small probabilities. A daily lottery that lets you know if you won or not, but only pays if you were in compliance with the desired behavior on the day you won, also adds anticipated regret into the mix.
• Some commercial entities (e.g. casinos) have significant pecuniary incentives to appeal to our less-than-rational impulses. But some firms, such as health insurers or employers who gain from our better compliance with medical protocols, have monetary incentives to make our decision making more “rational.”
• Loewenstein, John, and Volpp note a number of biases that many people seem to display in their decisionmaking. These biases include narrow bracketing; the hot-cold empathy gap; projection bias; and present bias.
• “Narrow bracketing” occurs when decisions are examined in isolation (perhaps as potential changes from the status quo) rather than holistically.
• The “hot-cold empathy gap” refers to our inability to predict how we will behave in the “hot” state (perhaps when we are very hungry or angry) when we are examining our behavior while in the “cold” state.
• “Projection bias” is the idea that people predict that their future preferences will be pretty much the same as their current preferences. But there might be hedonic adaptation, or a change in visceral factors. Projection is one explanation underlying the advice not to go grocery shopping on an empty stomach.
• People save too little not because the rate of return to savings is too low, but (in part?) because of a “present bias” or an interest in instant gratification. The “Save More Tomorrow” plan allows people to (semi-)commit to savings increases at a later date, and this program has been quite successful in spurring savings.
• Is it distasteful or unethical to take advantage of common decision errors for paternalistic purposes?
Friday, June 19, 2015
Some Material Connected to Machina (1987)
Mark Machina, “Choice under Uncertainty: Problems Solved and Unsolved.” Journal of Economic Perspectives 1(1): 121-154, Summer 1987.
- A short review of choice under uncertainty: The general prospect (or lottery) is (x1, x2, …, xn; p1, p2, …, pn), where the xi’s are monetary outcomes and the pi’s are the associated probabilities.
- The expected value of the prospect (x1, x2, …, xn; p1, p2, …, pn) is p1x1+p2x2+…+pnxn = Σ pixi.
- The expected utility of the prospect (x1, x2, …, xn; p1, p2, …, pn) is p1 U(x1) + p2 U(x2) +…+ pn U(xn) = Σ pi U(xi), where U(x) is the von Neumann-Morgenstern utility function defined over monetary outcomes xi. The standard model of choice under uncertainty is that a person will choose among prospects in such a manner as to maximize her expected utility.
- A person is risk averse if, when endowed with a riskless prospect, she always declines fair bets (bets that offer her the same expected value as her riskless prospect) – and this is equivalent to diminishing marginal utility of income.
- Machina (1987) and the Triangle Diagram: Fix the (three) dollar outcomes at x1, x2, x3; let x1<x2<x3.
- With outcomes fixed but probabilities variable, every prospect (x1, x2, x3; p1, p2, p3) can be represented by a point in the unit simplex, which can be graphed as a triangle on p1-p3 axes (because p2 must equal 1-p1-p3, we only need a two-dimensional graph to indicate every prospect).
- Indifference curves for an expected utility maximizer will be linear in this space. Iso-expected value lines also will be linear.
- We can use the diagram to speak about stochastic dominance; mean-preserving spreads; and risk preferences.
- Expected utility maximization requires that individual choices adhere to the "independence axiom": If the prospect P* is preferred to the prospect P, then the compound prospect aP* + (1-a)P’ is preferred to aP + (1-a)P’, for all prospects P’ and for all 0<a<1.
- The independence axiom implies indifference curves that are linear in the probabilities, and hence, are straight, parallel lines within the triangle diagram. Nonetheless, many different choices seem to indicate that people have indifference curves that “fan out,” as opposed to being parallel lines.
- One common departure from the independence axiom (and hence from expected utility maximization) is the Allais Paradox (which can be neatly illustrated within the Triangle Diagram). Here's the setting:Alternative 1 Alternative 2Situation A: ($1M;1) ($5M, $1M, $0; .1,.89,.01)Situation B: ($1M,$0; .11,.89) ($5M,$0; .1,.9)The "M" indicates that all dollar payoffs above involve millions of dollars. People typically choose alternative 1 in situation A, and alternative 2 in situation B. These two choices are inconsistent with expected utility maximization. [Why? To prefer alternative A1 to alternative A2, as an expected utility maximizer, you must have EU(A1) > EU(A2). This inequality can be rewritten as 1u($1) > .1u($5) + .89u($1) + .01u($0), and this inequality can be further simplified to .11u($1) > .1u($5) + .01u($0)*. If you also prefer alternative B2 to alternative B1, then, as an expected utility maximizer, EU(B2) > EU(B1). This inequality can be rewritten as .1u($5) + .9 u($0) > .11u($1) + .89u($0), and this inequality can be further simplified to .1u($5) + .01u($0) > .11u($1), or equivalently, .11u($1) < .1u($5) + .01u($0). Compare this with inequality *; they contradict each other. Therefore, you cannot be an expected utility maximizer: there are no values for u($5), u($1), and u($0) such that your choices could be consistent with expected utility maximization.]
Loewenstein and Thaler (1989) on Intertemporal Choice
George Loewenstein and Richard H. Thaler, “Intertemporal Choice.” Journal of Economic Perspectives 3(4): 181-193, Autumn, 1989.
• In choices over time involving money, people should discount at the interest rate – or at least so says standard optimization. But people are inconsistent in their revealed discount rate choices.
• The discount rates that people implicitly employ seem to depend upon the magnitude of the sums involved, whether a gain or a loss is being evaluated, the time delay, and other factors. Discount rates fall with the length of time delay and the size of the reward, and discount rates are higher for gains than for losses.
• Discount rates that vary with the time delay imply the possibility for dynamic inconsistency. If discount rates decline over time delays, for instance, then people will overconsume in the present, relative to their prior plans.
• Workers seem to have a taste for increasing wage profiles over time, and economists have a hard time talking them out of it even when the standard economics arguments point in the other direction. Loss aversion, or fears of future self-control lapses, probably are part of the explanation.
• Savoring and dread also alter time preferences in ways that do not conform neatly to the standard model.
• In choices over time involving money, people should discount at the interest rate – or at least so says standard optimization. But people are inconsistent in their revealed discount rate choices.
• The discount rates that people implicitly employ seem to depend upon the magnitude of the sums involved, whether a gain or a loss is being evaluated, the time delay, and other factors. Discount rates fall with the length of time delay and the size of the reward, and discount rates are higher for gains than for losses.
• Discount rates that vary with the time delay imply the possibility for dynamic inconsistency. If discount rates decline over time delays, for instance, then people will overconsume in the present, relative to their prior plans.
• Workers seem to have a taste for increasing wage profiles over time, and economists have a hard time talking them out of it even when the standard economics arguments point in the other direction. Loss aversion, or fears of future self-control lapses, probably are part of the explanation.
• Savoring and dread also alter time preferences in ways that do not conform neatly to the standard model.
Wednesday, June 17, 2015
Frederick, Loewenstein, and O'Donoghue (2002) on Time Discounting
Shane Frederick, George Loewenstein, and Ted O'Donoghue, “Time Discounting and Time Preference: A Critical Review.” Journal of Economic Literature 40(2): 351-401, June, 2002.
• Samuelson’s discounted utility model (DU), 1937: utility is additively separable across time, with future utility discounted exponentially at a constant rate.
• Anomalies with respect to DU are not mistakes that people want to correct.
• DU doesn’t permit a preference for increasing utility flows over time, holding total discounted utility constant.
• DU assumes that utility in a given period is independent of utility in other periods. Your preference for Italian or Thai food tonight is independent of what you ate yesterday.
• The discount rate in the DU model is the same when applied to all forms of consumption. The per-period discount rate is fixed, implying time consistency.
• Empirical evidence is not kind to the DU model, on many fronts.
• Discount rates don’t appear to be constant; rather, they decrease over time. Further, they seem to vary widely across different types of consumption.
• Gains are discounted more than losses, and small amounts are discounted at a higher rate than larger amounts. Many people like to incur a loss immediately rather than delay it.
• Preferences for increasing returns over time might reflect a fear of limited self-control that would lead to overconsumption if larger amounts were received initially.
• The beta/delta or quasi-hyperbolic model (page 366) formalizes a present bias and dynamic inconsistency. This model can indicate why people might use illiquid assets as a commitment mechanism, and explain the simultaneous existence of substantial savings and credit card debt. Sophisticated present-biased people might seek out commitment strategies.
• Other models involve habit formation, anticipation utility, visceral factors, projection bias, mental accounts, and temptation utility.
• Perhaps there is no isolated concept of time preference that is consistent across applications.
• Samuelson’s discounted utility model (DU), 1937: utility is additively separable across time, with future utility discounted exponentially at a constant rate.
• Anomalies with respect to DU are not mistakes that people want to correct.
• DU doesn’t permit a preference for increasing utility flows over time, holding total discounted utility constant.
• DU assumes that utility in a given period is independent of utility in other periods. Your preference for Italian or Thai food tonight is independent of what you ate yesterday.
• The discount rate in the DU model is the same when applied to all forms of consumption. The per-period discount rate is fixed, implying time consistency.
• Empirical evidence is not kind to the DU model, on many fronts.
• Discount rates don’t appear to be constant; rather, they decrease over time. Further, they seem to vary widely across different types of consumption.
• Gains are discounted more than losses, and small amounts are discounted at a higher rate than larger amounts. Many people like to incur a loss immediately rather than delay it.
• Preferences for increasing returns over time might reflect a fear of limited self-control that would lead to overconsumption if larger amounts were received initially.
• The beta/delta or quasi-hyperbolic model (page 366) formalizes a present bias and dynamic inconsistency. This model can indicate why people might use illiquid assets as a commitment mechanism, and explain the simultaneous existence of substantial savings and credit card debt. Sophisticated present-biased people might seek out commitment strategies.
• Other models involve habit formation, anticipation utility, visceral factors, projection bias, mental accounts, and temptation utility.
• Perhaps there is no isolated concept of time preference that is consistent across applications.
John List (2004) on the Endowment Effect
John A. List, “Neoclassical Theory Versus Prospect Theory: Evidence from the Marketplace.” Econometrica 72: 615–625, 2004.
• Subjects start with one of four endowments: mug; chocolate bar; both; or, neither. Note that mugs and chocolate bars are common, everyday items.
• Subjects are offered the opportunity to trade for the other good (in the mug or chocolate conditions) or forced to trade their endowment for just one of the goods (both condition) or get to choose either the mug or chocolate (none condition).
• Non-dealers were about four times more likely to leave with the endowed good than with the other good. Dealers, though, betray almost no sign of an endowment effect. Further, for non-dealers, more trading experience reduces the endowment effect.
• Note that “trading experience” refers to trading background for goods unconnected to chocolate bars or mugs.
• Subjects start with one of four endowments: mug; chocolate bar; both; or, neither. Note that mugs and chocolate bars are common, everyday items.
• Subjects are offered the opportunity to trade for the other good (in the mug or chocolate conditions) or forced to trade their endowment for just one of the goods (both condition) or get to choose either the mug or chocolate (none condition).
• Non-dealers were about four times more likely to leave with the endowed good than with the other good. Dealers, though, betray almost no sign of an endowment effect. Further, for non-dealers, more trading experience reduces the endowment effect.
• Note that “trading experience” refers to trading background for goods unconnected to chocolate bars or mugs.
Kőszegi and Rabin (2006) on Reference-Dependent Preferences
Botond Kőszegi and Matthew Rabin, “A Model of Reference-Dependent Preferences.” Quarterly Journal of Economics 121(4): 1133-1165, 2006.
· Utility depends on the consumption bundle and on a reference bundle (u(cǀr) for riskless bundles). Consumption utility, here but one component of overall utility, is the standard utility of microeconomic theory. The other component, “gain-loss utility,” reflects the reference bundle.
· Gain-loss utility is assumed to be related to the difference in consumption utility between the bundle chosen and the reference bundle. The model allows for uncertainty both in consumption bundles and in reference bundles.
· The reference bundle is not the status quo; rather, it reflects recent beliefs (probabilistic) about outcomes. Fixing the chosen bundle, a “lower” reference bundle leads to higher utility. The endowment effect follows from loss aversion, since the disutility from loss (for an owner) exceeds the utility from gain for a non-owner. People who acquire items expecting to trade will not suffer from the endowment effect, because they have a different reference bundle.
· A “preferred personal equilibrium” (PPE) is that (unique) consistent equilibrium with the highest expected utility. PPE reduces to the standard model when there is no uncertainty; reference dependence plays no role in a deterministic environment, as there are no surprises.
· Willingness-to-pay for a good depends on the probability that you expect to buy the good and the price you expect to pay. An increase in the likelihood of buying makes for a greater reference “loss” in the event you don’t buy – the “attachment effect.” The more you expect prices to be so low that they will induce you to buy, the more willing you are to buy when the price is higher than expected!
· The “comparison effect” holds the expected likelihood of purchase constant. In this case, a decrease in the price you expect to pay means that a medium price feels like more of a loss, lowering the willingness to pay the medium price. (You would not buy at high prices in any case). This effect involves a contradiction of sorts with the law of demand: lower expected prices can lead to diminished interest in purchasing.
· Taxi drivers and target wages: a driver learns her afternoon wage after she completes her morning shift. If the driver had unexpectedly high morning earnings, she is less likely to drive in the afternoon. Higher expected wages increase the likelihood of working and of staying through the afternoon. As in many other dimensions of economics, whether an event is anticipated or unanticipated leads to large effects on behavior.
· Utility depends on the consumption bundle and on a reference bundle (u(cǀr) for riskless bundles). Consumption utility, here but one component of overall utility, is the standard utility of microeconomic theory. The other component, “gain-loss utility,” reflects the reference bundle.
· Gain-loss utility is assumed to be related to the difference in consumption utility between the bundle chosen and the reference bundle. The model allows for uncertainty both in consumption bundles and in reference bundles.
· The reference bundle is not the status quo; rather, it reflects recent beliefs (probabilistic) about outcomes. Fixing the chosen bundle, a “lower” reference bundle leads to higher utility. The endowment effect follows from loss aversion, since the disutility from loss (for an owner) exceeds the utility from gain for a non-owner. People who acquire items expecting to trade will not suffer from the endowment effect, because they have a different reference bundle.
· A “preferred personal equilibrium” (PPE) is that (unique) consistent equilibrium with the highest expected utility. PPE reduces to the standard model when there is no uncertainty; reference dependence plays no role in a deterministic environment, as there are no surprises.
· Willingness-to-pay for a good depends on the probability that you expect to buy the good and the price you expect to pay. An increase in the likelihood of buying makes for a greater reference “loss” in the event you don’t buy – the “attachment effect.” The more you expect prices to be so low that they will induce you to buy, the more willing you are to buy when the price is higher than expected!
· The “comparison effect” holds the expected likelihood of purchase constant. In this case, a decrease in the price you expect to pay means that a medium price feels like more of a loss, lowering the willingness to pay the medium price. (You would not buy at high prices in any case). This effect involves a contradiction of sorts with the law of demand: lower expected prices can lead to diminished interest in purchasing.
· Taxi drivers and target wages: a driver learns her afternoon wage after she completes her morning shift. If the driver had unexpectedly high morning earnings, she is less likely to drive in the afternoon. Higher expected wages increase the likelihood of working and of staying through the afternoon. As in many other dimensions of economics, whether an event is anticipated or unanticipated leads to large effects on behavior.
Rabin and Thaler (2001) on Risk Aversion and the Failures of Expected Utility
Matthew Rabin and Richard H. Thaler, “Risk Aversion,” Journal of Economic Perspectives 15(1): 219-232, Winter 2001.
· In
the expected utility (EU) model, risk aversion is equivalent to diminishing marginal
utility of income.
· Any
meaningful risk aversion over small stakes is inconsistent with EU
maximization, as it requires a crazy unwillingness to take on risk at larger
stakes. In other words, EU maximizers must be effectively risk neutral for
small stakes, such as those in laboratory experiments. Nonetheless, people
display risk aversion at small stakes.
· Extended
warranties and rental car insurance are purchased by many people, though the
small stakes (relative to lifetime wealth) and high prices involved imply that
they should be unattractive to expected utility maximizers.
· Small-scale
risk averse behavior is consistent with loss aversion, where the status quo is the
reference point, and with mental accounting (narrow bracketing), a failure to
look at the situation in the bigger picture.
· Even the money pump argument offers more support for loss aversion and narrow bracketing than for expected utility maximization, as people are not reliably turned into money pumps. They are more likely to purchase those ill-advised warranties, for instance, when the warranties are tied to the purchase of the good itself, thereby promoting an isolated view of the transaction; for most decisions, consumers will not be so misled. An expected utility maximizer who bought such a warranty, however, would then necessarily agree to all sorts of ridiculous purchases.
· The rate-of-return on stocks (as opposed to bonds, say) seems to be excessive, even though there should be some premium for holding stocks because stocks are riskier than bonds. This “equity premium puzzle” might be due to loss aversion and narrow bracketing. The day-to-day fluctuations in stock prices cause many short-term losses for shareholders. The equity premium comes from the fact that loss-averse investors require compensation to put up with all of the short term (mental accounting) losses.
· Even the money pump argument offers more support for loss aversion and narrow bracketing than for expected utility maximization, as people are not reliably turned into money pumps. They are more likely to purchase those ill-advised warranties, for instance, when the warranties are tied to the purchase of the good itself, thereby promoting an isolated view of the transaction; for most decisions, consumers will not be so misled. An expected utility maximizer who bought such a warranty, however, would then necessarily agree to all sorts of ridiculous purchases.
· The rate-of-return on stocks (as opposed to bonds, say) seems to be excessive, even though there should be some premium for holding stocks because stocks are riskier than bonds. This “equity premium puzzle” might be due to loss aversion and narrow bracketing. The day-to-day fluctuations in stock prices cause many short-term losses for shareholders. The equity premium comes from the fact that loss-averse investors require compensation to put up with all of the short term (mental accounting) losses.
Monday, June 15, 2015
Thaler, Sunstein, and Balz (2013), "Choice Architecture"
Richard H. Thaler, Cass R. Sunstein, and
John P. Balz, “Choice Architecture.” Chapter
25 in Eldar Shafer, ed., The Behavioral
Foundations of Public Policy, Princeton University Press, 2013.
· Choice
architects are people who arrange the context in which other people make
decisions. Contextual details, even seemingly innocuous ones, can have
significant effects on choices. “A well-designed system expects its users to
err and is as forgiving as possible [p. 7].”
· Default
settings matter; sometimes a mandated choice (as opposed to a default setting
with an override option) might be a good idea. Alerts and checklists help to
prevent errors.
· The
provision of feedback helps people to overcome mistakes.
· Do
people know the relationship between their choices and their welfare? Do people
know the costs of using a credit card? Perhaps standardized disclosures – Record,
Evaluate, and Compare Alternative Prices (RECAP) – would lead to better
decision making.
· Can
choice be structured so as to facilitate learning? Do you want all your book
recommendations to be based on what people similar to you have enjoyed?
· The
salience of a choice dimension goes a long way to determining its impact. Do
people make optimal taxi v. car ownership decisions?
Rabin (2002) on Psychology and Economics
Matthew
Rabin, “A Perspective on Psychology and Economics.” European Economic Review 46: 657 – 685, 2002.
- “Ceteris paribus, the more realistic our assumptions about economic actors, the better our economics [page 658].” Rabin is implicitly taking on Milton Friedman’s discussion in his 1953 essay “The Methodology of Positive Economics,” where Friedman suggests that the realism of assumptions is not a test of the value of a theory; rather, theories should be judged on their ability to predict the data or explain the evidence.
- The departures of behavior from traditional economics assumptions are both common and systematic. We are not fully rational, fully self-controlled, or fully self-interested.
- Three important behavioral regularities are loss aversion, the endowment effect, and an interest in behaving in a reciprocal fashion. Further, people seem to have preferences not over final outcomes alone, but over changes from a reference point – standard economics assigns utility only over final outcomes.
- The standard economics assumption of exponential discounting of future costs and benefits has never had any empirical justification. The “behavioral” assumption of a present bias not only is more realistic, but it also explains common behaviors such as undersaving and procrastination that are hard to square with exponential discounting. Further, the standard approach to risk aversion is like the standard approach to discounting, obviously wrong and incapable of explaining common behavior.
- The argument that markets would punish irrational behavior doesn’t mean we shouldn’t study such behavior – rather the opposite, actually. The fact that in some settings a bias dissipates is not to say that people do not have such a bias or that it cannot have meaningful implications.
Wednesday, June 10, 2015
Inaugural Post (June 10, 2015)
For the last few years I have been teaching a course entitled "Behavioral Economics and Policy." For most class meetings, two articles constitute the assigned readings. (They are a different two articles every class meeting, you see, as the students complained when it was the same two articles, day after day after day.) My practice is to post bullet-point summaries of the articles on our course website after each class. The idea behind this blog is that it will become a repository of those summaries, along with other behavioral economics material, perhaps.
I must warn any readers who stumble upon these outlines that they are not actually faithful summaries of the original articles. Most material is omitted altogether, and sometimes a bullet point or two reflect more of a commentary than a summary. If you want to really learn what the articles say, you should go to the articles themselves, of course. (I try to link to the articles, though sometimes I will link to an earlier version that is publicly available.) I should mention also that I try to put everything in my own words as I prepare a bullet-point outline, but I can't rule out that in some cases, some quotes or near-quotes may have slipped in accidentally, without quotation marks. As you from crimes would pardoned be,/Let your indulgence set me free. Oops, I forgot the quote marks there.
I must warn any readers who stumble upon these outlines that they are not actually faithful summaries of the original articles. Most material is omitted altogether, and sometimes a bullet point or two reflect more of a commentary than a summary. If you want to really learn what the articles say, you should go to the articles themselves, of course. (I try to link to the articles, though sometimes I will link to an earlier version that is publicly available.) I should mention also that I try to put everything in my own words as I prepare a bullet-point outline, but I can't rule out that in some cases, some quotes or near-quotes may have slipped in accidentally, without quotation marks. As you from crimes would pardoned be,/Let your indulgence set me free. Oops, I forgot the quote marks there.
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