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November 6 - November 9, 2019
economics is also considered the most powerful of the social sciences in an intellectual sense. That power derives from the fact that economics has a unified, core theory from which nearly everything else follows. If you say the phrase “economic theory,” people know what you mean. No other social science has a similar foundation.
To simplify somewhat, we can say that Optimization + Equilibrium = Economics. This is a powerful combination, nothing that other social sciences can match.
The primary reason for adding Humans to economic theories is to improve the accuracy of the predictions made with those theories. But there is another benefit that comes with including real people in the mix. Behavioral economics is more interesting and more fun
As Schelling notes, we rarely allow any identified life to be extinguished solely for the lack of money. But of course thousands of “unidentified” people die every day for lack of simple things like mosquito nets, vaccines, or clean water.
People think about life in terms of changes, not levels. They can be changes from the status quo or changes from what was expected, but whatever form they take, it is changes that make us happy or miserable. That was a big idea.
The upper portion, for gains, has the same shape as the usual utility of wealth function, capturing the idea of diminishing sensitivity. But notice that the loss function captures diminishing sensitivity also. The difference between losing $10 and $20 feels much bigger than the difference between losing $1,300 and $1,310. This is different from the standard model, because starting from a given wealth level in figure 1, losses are captured by moving down the utility of wealth line, meaning that each loss gets increasingly painful.
The Weber-Fechner Law holds that the just-noticeable difference in any variable is proportional to the magnitude of that variable.
Roughly speaking, losses hurt about twice as much as gains make you feel good. This feature of the value function left me flabbergasted.
The fact that a loss hurts more than an equivalent gain gives pleasure is called loss aversion. It has become the single most powerful tool in the behavioral economist’s arsenal.
So, we experience life in terms of changes, we feel diminishing sensitivity to both gains and losses, and losses sting more than equivalently-sized gains feel good. That is a lot of wisdom in one image.
Eventually I settled on a formulation that involves two kinds of utility: acquisition utility and transaction utility. Acquisition utility is based on standard economic theory and is equivalent to what economists call “consumer surplus.” As the name suggests, it is the surplus remaining after we measure the utility of the object gained and then subtract the opportunity cost of what has to be given up. For an Econ, acquisition utility is the end of the story.
Humans, on the other hand, also weigh another aspect of the purchase: the perceived quality of the deal. That is what transaction utility captures. It is defined as the difference between the price actually paid for the object and the price one would normally expect to pay, the reference price.
Since transaction utility can be either positive or negative—that is, there can be both great deals and awful gouges—it can both prevent purchases that are welfare-enhancing and induce purchases that are a waste of money.
Because consumers think this way, sellers have an incentive to manipulate the perceived reference price and create the illusion of a “deal.”
In America, some products always seem to be on sale, such as rugs and mattresses, and at some retailers, men’s suits. Goods that are marketed this way share two characteristics: they are bought infrequently and quality is difficult to assess.
The infrequent purchases help because consumers often do not notice that there is always a sale going on.
Most of us are pleasantly surprised that when we wander in to buy a new mattress, there happens to be a sale this week. And when the quality of a product, like a mattress, is hard to assess, the suggested retail price can do double duty. It can simultaneously suggest that quality is high (thus increasing perceived acquisition utility)...
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In fact, the mistake is so common it has an official name—the sunk cost fallacy—and the fallacy is often mentioned in basic economics textbooks. But many people, even if they understand the concept in principle, can find it difficult to follow the advice to ignore sunk costs in practice.
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. Watch out!
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.”
Although it is never stated explicitly as an assumption in an economics textbook, in practice economic theory presumes that self-control problems do not exist.
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.
When a recession hits, either wages do not fall at all or they fall too little to keep everyone employed. Why? One partial explanation for this fact is that cutting wages makes workers so angry that firms find it better to keep pay levels fixed and just lay off surplus employees (who are then not around to complain). It turns out, however, that with the help of some inflation, it is possible to reduce “real” wages (that is, adjusted for inflation) with much less pushback from workers.
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.
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.
But any large first mover who takes an action that violates the norms of fairness runs considerable risks if competitors do not follow suit.
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.” He felt that even if someone was willing to pay $2,000 to eat at Next, that customer would leave feeling, “Yeah, that was great but it wasn’t worth $2,000.”
The endowment effect experiments show that people have a tendency to stick with what they have, at least in part because of loss aversion.
Loss aversion and status quo bias will often work together as forces that inhibit change.
paradigms change only once experts believe there are a large number of anomalies that are not explained by the current paradigm. A few scattered unexplained facts are not enough to upend the conventional wisdom.
The theory is that if the employer treats the worker well, in terms of pay and working conditions, that gift will be reciprocated with higher effort levels and lower turnover, thus making the payment of above-market wages economically profitable.
Narrow framing prevents the CEO from getting the twenty-three projects he would like, and instead getting only three.
These experiments demonstrate that looking at the returns on your portfolio more often can make you less willing to take risk.
The EMH has two components, which are somewhat related but are conceptually distinct.* One component is concerned with the rationality of prices; the other concerns whether it is possible to “beat the market.”
I call the first of these propositions “the price is right,”
For years financial economists lived with a false sense of security that came from thinking that the price-is-right component of the EMH could not be directly tested—one reason it is called a hypothesis. Intrinsic value, they reasoned, is not observable.
the second component of the theory, what I call the “no free lunch” principle—the idea that there is no way to beat the market. More specifically it says that, because all publicly available information is reflected in current stock prices, it is impossible to reliably predict future prices and make a profit.
But Fama and French were forthright in conceding that they did not have any theory to explain why size and value should be risk factors. Unlike the capital asset pricing model, which was intended to be a normative theory of asset prices based on rational behavior by investors, there was no theoretical reason to believe that size and value should predict returns. Those factors were used because empirical research had shown them to matter.
Extrapolation, and Risk” published in 1994 by financial economists Josef Lakonishok, Andrei Shleifer, and Robert Vishny settled any remaining questions about whether value stocks are riskier. They are not. It also convinced the authors of the paper, since they later started a highly successful money management firm, LSV Asset Management, which is based on value investing.
When prices diverge strongly from historical levels, in either direction, there is some predictive value in these signals. And the further prices diverge from historic levels, the more seriously the signals should be taken. Investors should be wary of pouring money into markets that are showing signs of being overheated, but also should not expect to be able to get rich by successfully timing the market.
there is not as yet a benchmark behavioral theory of asset prices that could be used as a theoretical underpinning of empirical research. We need some starting point to organize our thoughts on any topic, and the EMH remains the best one we have.
I would judge the no-free-lunch component to be “mostly true.” There are definitely anomalies: sometimes the market overreacts, and sometimes it underreacts. But it remains the case that most active money managers fail to beat the market.
I have a much lower opinion about the price-is-right component of the EMH, and for many important questions, this is the more important component. How wrong do I think it is? Notably, in Fischer Black’s essay on noise, he opines that “we might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value. The factor of 2 is arbitrary, of course. Intuitively, though, it seems reasonable to me, in the light of sources of uncertainty about value and the strength of the forces tending to cause price to return
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My conclusion: the price is often wrong, and sometimes very wrong. Furthermore, when prices diverge from fundamental value by such wide margins, the misallocation of resources can be quite big.
Our idea was to introduce some of the essential elements of behavioral economics into such arguments and see how they would have to be modified. By this point I had adopted the pedagogical device of calling these essential elements “the three bounds”: bounded rationality, bounded willpower, and bounded self-interest. In law and economics these properties of Humans had heretofore been assumed to be thoroughly unbounded.
A nudge is some small feature in the environment that attracts our attention and influences behavior. Nudges are effective for Humans, but not for Econs, since Econs are already doing the right thing. Nudges are supposedly irrelevant factors that influence our choices in ways that make us better off.
if you want people to comply with some norm or rule, it is a good strategy to inform them (if true) that most other people comply.
1. If you want to encourage someone to do something, make it easy.
but we rarely hear much from economists about mitigating the downside risk to entrepreneurs if a new business fails, which happens at least half if not more of the time.* We know that losses loom larger than gains to Humans, so this might be an important consideration.
Considering that schools are one of the oldest of society’s institutions, it is telling that we have not figured out how to teach our children well. We need to run experiments to figure out how to improve, and have only just started doing so.
