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A good rule to remember is that people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse.
This distinction between what we want and what we choose has no meaning in modern economics, in which preferences are literally defined by what we choose. Choices are said to “reveal preferences.”
“Nor it is always the worse for society” is hardly the same thing as an assertion that things will turn out for the best.
The crucial feature of Smith’s conception of our passions is that they are myopic, that is, shortsighted. As he framed it, the problem is that “The pleasure which we are to enjoy ten years hence, interests us so little in comparison with that which we may enjoy to-day.”
Smith recognized that willpower is necessary to deal with myopia.
Fisher believed that time preference depends on an individual’s level of income, with the poor being more impatient than those who are better off.
The basic idea is that consumption is worth more to you now than later.
This theory-induced blindness now strikes nearly everyone who receives a PhD in economics. The economics training the students receive provides enormous insights into the behavior of Econs, but at the expense of losing common-sense intuition about human nature and social interactions.
The way in which models of the consumption function evolved illustrates an interesting feature about how economic theory has developed since the Samuelson revolution began. As economists became more mathematically sophisticated, and their models incorporated those new levels of sophistication, the people they were describing evolved as well. First, Econs became smarter. Second, they cured all their self-control problems.
Notice that as we go from Keynes to Friedman to Modigliani, the economic agents are thinking further ahead and are implicitly assumed to be able to exert enough willpower to delay consumption, in Modigliani’s case, for decades.
If we judge a model by the accuracy of its predictions, as advocated by Friedman, then in my judgment the winner among the three models’ ability to explain what people do with temporary changes to their income would be Keynes, modified somewhat in Friedman’s direction to incorporate the natural tendency to smooth out short-run fluctuations.‡ But if instead we choose models by how clever the modeler is, then Modigliani is the winner, and perhaps because economists adopted the “cleverer is better” heuristic, Modigliani’s model was declared best and became the industry standard.
The idea of modeling the world as if it consisted of a nation of Econs who all have PhDs in economics is not the way psychologists would think about the problem. This was brought home to me when I gave a talk in the Cornell psychology department. I began my talk by sketching Modigliani’s life-cycle hypothesis. My description was straightforward, but to judge from the audience reaction, you would have thought this theory of savings was hilarious. Fortunately, the economist Bob Frank was there. When the bedlam subsided, he assured everyone that I had not made anything up. The psychologists
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Hersh Shefrin and I proposed what we called the behavioral life-cycle hypothesis. We assume that a household’s consumption in a given year will not depend just on its lifetime wealth, but also on the mental accounts in which that wealth is held.
To understand the consumption behavior of households, we clearly need to get back to studying Humans rather than Econs. Humans do not have the brains of Einstein (or Barro), nor do they have the self-control of an ascetic Buddhist monk. Rather, they have passions, faulty telescopes, treat various pots of wealth quite differently, and can be influenced by short-run returns in the stock market. We need a model of these kinds of Humans.
Somewhat surprisingly, the amount of time a kid waited in one of those experiments turned out to be a valid predictor of many important life outcomes, from SAT scores to career success to drug use.
strategies for dealing with self-control problems. One course of action is commitment: removing the cashews or tying yourself to the mast. Another is to raise the cost of submitting to temptation. For example, if you want to quit smoking, you could write a large check to someone you see often with permission to cash the check if you are seen smoking.
Self-control is, centrally, about conflict. And, like tango, it takes (at least) two to have a conflict. Maybe I needed a model with two selves.
Our model is really based on a metaphor. We propose that at any point in time an individual consists of two selves. There is a forward-looking “planner” who has good intentions and cares about the future, and a devil-may-care “doer” who lives for the present.
The doer wants to enjoy himself and is completely selfish in that he does not care at all about any future doers. The planner, in contrast, is completely altruistic.
The only way to make the doer eat fewer energy bars is to make eating them less enjoyable. Another way to think about this is that employing willpower requires effort.
Most of us realize that we have self-control problems, but we underestimate their severity.
The first problem to solve was how to raise the ticket price without losing too many customers. We adopted a plan of gradually raising the price over a period of years, thus avoiding a sudden jump that might create backlash.
The price charged to use the racecourse was one dollar. A dollar was not a lot to pay, but the fee was a damn nuisance.
Ten-packs turned out to be wildly popular with the locals. There are a few behavioral factors that explain their popularity. The first is obvious: 40% off sounds like a great deal. Lots of transaction utility. Second, the advance purchase decoupled the purchase decision from the decision to go skiing.
As the season progressed, skiers would be eager to use some of their tickets to avoid wasting the money invested in the ten-pack, and they might bring along a friend who would pay full price.
After a few years, six-packs, ten-packs, and season passes accounted for a substantial portion of the resort’s revenue, and this early money eliminated the need to borrow to stay afloat until the start of the season in December.
After three years of selling the ten-packs, Michael did some analysis and called me with the results. Recall that ten-packs were sold at just 60% of the regular season retail price. “Guess what percentage of the tickets is being redeemed?” Michael asked. “Sixty percent!” The resort was selling the tickets at 60% of the retail price but only 60% of them were being redeemed. In essence they were selling the tickets at full price and getting the money several months earlier: a huge win.
Reducing the price only makes sense if it increases current sales or perhaps future sales by building customer loyalty.
A rebate seems to be just another name for a temporary sale, but they seemed to be more popular than an equivalent reduction in price, as one might expect based on mental accounting. Suppose the list price of the car was $14,800. Reducing the price to $14,500 did not seem like a big deal, not a just-noticeable difference. But by calling the price reduction a rebate, the consumer was encouraged to think about the $300 separately, which would intensify its importance.
rebates were starting to lose some of their luster,
What if GM tried offering a highly discounted rate as a sales inducement? At a time when the going interest rate for a car loan was 10% or more, General Motors offered a loan at just 2.9%. Consumers could choose either a rebate or the discounted loan. The loan offer had an unprecedented effect on sales.
The rebate was a small percentage of the price of the car, but the car loan being offered was less than a third of the usual rate. That sounds like a much better deal. And few people besides accountants and Wall Street Journal reporters would bother to do the math, especially since this was in an era that predated spreadsheets and home computers.
As I have learned over the years, and will discuss further in subsequent chapters, the reluctance to experiment, test, evaluate, and learn that I experienced at General Motors is all too common. I have continued to see this tendency, in business and government, ever since, though recently I have had the chance to try to change that ethos in government settings. Oh, and about that claim that they had a plan to eliminate excess inventory in future summers? It was violated the next summer, the summer after that, and, as far as I know, every summer since. Overconfidence is a powerful force.
One of the things MBAs learn in business school is to think like an Econ, but they also forget what it is like to think like a Human.
Auctioning a doll is fine if the proceeds go to charity, unless the “charity” is the owner’s wallet.
Any firm should establish the highest price it intends to charge as the “regular” price, with any deviations from that price called “sales” or “discounts.” Removing a discount is not nearly as objectionable as adding a surcharge.
Notice that the spending power of the employees is the same for the two versions of the problem, but the reactions are quite different. An actual cut in the nominal wage is viewed as a loss and is therefore unfair, whereas failing to keep up with inflation is judged acceptable since the nominal wage is still going up.
The value of seeming fair should be especially high for firms that plan to be in business selling to the same customers for a long time, since those firms have more to lose from seeming to act unfairly.
But firms don’t always get these things right. The fact that my MBA students think it is perfectly fine to raise the price of snow shovels after a blizzard should be a warning to all business executives that their intuitions about what seems fair to their customers and employees might need some fine-tuning.
The anger in this case might have been particularly acute because in the case of online downloads there is no sense in which the albums have become scarce. Unlike snow shovels after a blizzard, iTunes cannot run out of copies of an album to be downloaded.
As usual in these cases when demand has suddenly risen, a seller has to trade off short-term gain against possible long-term loss of good will, which can be hard to measure.
In this case, as in many others, the key is what happens after the first mover adds a new fee that might be perceived as unfair. If the competition follows the first mover’s lead, then customers may be peeved but have little choice if they must consume the product in question. Had the other major banks in the area followed First Chicago’s example and added a teller fee, customers might well have gotten used to the idea and reluctantly accepted it. But any large first mover who takes an action that violates the norms of fairness runs considerable risks if competitors do not follow suit.
I think it showed bad judgment on the part of Uber management to wait until the attorney general forced them into this concession. If they wanted to establish good long-term relationships with their customers, they should have thought of something like it themselves.
This insensitivity to the norms of fairness could be particularly costly to Uber since the company has had to fight political battles in many of the cities it enters.
When Next first opened and the excitement was at its peak, two economists from Northwestern University tried to explain to Mr. Kokonas that he was doing this all wrong, and that he should instead have auctioned off each reservation so as to maximize his profits. Kokonas strongly disagreed with this advice, and has a long blog entry explaining why. Here is the key sentence in his blog: “It is incredibly important for any business, no matter how great the demand, not to charge a customer more than the good or service is worth—even if the customer is willing to pay more.”
Using the standard economics assumptions that people are selfish and rational, game theory has a clear prediction for this game. The Proposer will offer the smallest positive amount possible (50 cents in our version) and the Responder will accept, since 50 cents is more than nothing. In contrast, we conjectured that small offers would be rejected as “unfair.” That conjecture turned out to be right. Typically, offers that did not exceed 20% of the pie, $2 in our game, were rejected.
Somewhat surprisingly to us (or at least to me), the students in the Dictator stage of our game were remarkably nice. Nearly three quarters (74%) chose to divide the money equally. Of more interest to us, the results of the Punishment stage were even stronger. Fully 81% of the subjects chose to share $10 with a “fair” allocator rather than $12 with an “unfair” allocator.
There is clear evidence that people dislike unfair offers and are willing to take a financial hit to punish those who make them.
The game theoretic prediction is that both players will defect because, no matter what the other player does, it is in the selfish best interest of each player to do so. Yet when this game is played in the laboratory, 40–50% of the players cooperate, which means that about half the players either do not understand the logic of the game or feel that cooperating is the just the right thing to do, or possibly both.
So repeated play of the Public Goods Game does not teach people to be jerks; rather it teaches them that they are playing with (some) jerks, and no one likes to play the role of the sucker.
