Irrational Coursemates

This is an experiment used by one of my lecturers (Prof Seidmann) last week on 100 MSc Economics students at the start of a lecture...

We were told the following:

Choose a whole number between 0 and 99 (inclusive).

He will calculate the average (mean) of the numbers chosen by everyone here and divide by 2.

The winner is the person that chooses the number closest to this (half the average).

What number would you pick?

I picked zero.

This is because it is the rational thing to do. If the average is 50 then half the average will be 25. But if half the average is 25 then everyone should choose 25. Then half the average will be 12.5. And so on... Eventually you end up at zero.

My calculation, however, was flawed. I had assumed that MSc Economics students are rational. Further, I had assumed that MSc Economics students think that MSc Economics students are rational.

One person sitting near me was irrational and put 50 (possibly they misunderstood the instructions). Already I knew that my guess of zero was not going to be exactly correct.

In the end the correct answer was about 13.

My first response was "Just how stupid are my coursemates?!"

But then I realised that many in the room would have suspected that others were irrational and so guessed a positive number. For example, the person sitting next to me put 7 although he knew the rational thing to put was zero.

Some people may have been trying to second guess what people thought people thought would do! And so on. Thus we cannot (yet) conclude that all my coursemates are stupid (as well as me).

In conclusion, even if you are rational, you may not always act as economists might expect because you might be expecting others to be irrational. Funny old world.

Survey

I have decided to collect some consumer data...

Please take the survey! It is only 10 questions and you will be contributing to behavioural economics:

http://www.surveymonkey.com/s/7HT99VR

I hope to post the results up here soon...

The Endowment Effect

I am very pleased to introduce a guest blog by Alex Silk. Alex is somewhat of an expert on the endowment effect and I have been bugging him for months to write this post: Enjoy!

The endowment effect is demonstrated in a really simple experiment that was conducted by an economist called Jack Knetsch back in 1989. The experiment had three separate treatments. In the first treatment each participant was given a (identical) mug, they were told that this was a gift. They were then each given the option of switching the mug for a bar of Swiss chocolate (which could be bought at the same price as the mug). The second treatment was the reverse of this; each participant was initially given the chocolate bar and was then asked whether or not they wanted to exchange it for the mug. Standard economic theory predicts that the proportion of subjects who end up leaving the experiment with a mug should be equal in both treatments (allowing for random error) – this appears to be a fairly reasonable assumption. So what do you think happened?

Well what Mr Knetsch found was that in both treatments 90% of people kept the item which they were originally given. Furthermore, in a third treatment where each participant was given a straight choice between the mug and the chocolate bar 56% of people chose the mug (where again economic theory predicts the proportions should be the same as in the first two treatments).

What the experiment demonstrates is something called the endowment effect: people value a good more highly when they are in possession of it. While this is a significant violation of some important economic theories (something that for your sake I hope you are not too concerned about!), on one level this may not seem that surprising to you: a child would value her favourite teddy bear more than an identical one sitting on a shelf in a shop. However, what may be surprising is the fact that other experiments have shown that virtually as soon as you take ownership of a good you value it more (unless you expect to sell it in the near future).

So the next time you buy a can of baked beans remember that, subconsciously at least, you value that can slightly more than each of the cans you left behind you in the shop. Isn’t that useful to know?

- Alex Silk

Book Review: The Power of Habit

The Power of Habit by Charles Duhigg is all about the psychology of habit formation and change. Why then, you may well ask, am I reviewing it here on a blog about behavioural economics? The answer is nudges. Behavioural economists are often interested in things that will change behaviour, and habits are a big part of behaviour. Three examples in the book...

Firstly, an American army major who wanted to stop regular riots in the small Iraqi city of Kufa. People would slowly gather over the course of a few hours in the central plazas and after a while violence would break out. The major had an idea of how to nudge a crowd into staying peaceful: Stop food vendors entering the plazas. The usual practice was for food sellers to enter the crowd, but by stopping them from doing so the crowd got hungry, and so started to dissipate. There were no riots after the food vendors were stopped from supplying food to angry crowds.

Secondly, McDonald's in their attempts to get people to buy their food out of habit. One of the key insights into habit formation is that each habit has a specific cue. McDonald's realised that they needed to keep the same cues across outlets. Thus each McDonald's looks the same, smells the same and sells exactly the same food. Whatever sparks your habit of buying McDonald's, the same cue will exist at all outlets. Thus your habit is mobile - you don't need to be near your local McDonald's to feed your Big Mac habit.

Thirdly, retailers in their highly successful bid to understand consumers better. Big shops have been collecting data on their customers for decades, but recently they've made a breakthrough: consumer habits (and thus purchasing patterns) change in predictable ways as people face major life events. Retailers realised that if a woman started to buy baby clothes and pregnancy drugs she was likely to be pregnant. Having a baby is a big life event (apparently). Having a baby considerably alters purchasing habits, meaning that marketing at this eventful time is likely to be more successful. The result: shops target (likely) new parents with adverts for products like nappies. They nudge people into buying their products.

My one complaint with The Power of Habit is that not all human behaviour can be called a 'habit'. You cannot explain everything through habits. Having said that, even the non-habits covered by Duhigg are incredibly interesting. In conclusion, I thoroughly recommend The Power of Habit (whether you be an addict or just interested in behavioural economics) but I do not necessarily buy into the book's central argument.

Genre: Psychology
Accessibility: 10/10
Accuracy: 6/10
Readability: 10/10
Usefulness: 8/10
Verdict: A Very Good Read

Book Review: Economyths

Economyths by David Orrell is an accessible critique of economics as we know it, summed up by the following statement:

"Neoclassical economics isn't a theory, it's an excuse."

Orrell attacks economics on ten fronts:

• The economy is more complicated than economics assumes
• The economy is more connected than economics assumes
• The invisible hand cannot explain booms and busts
• Economics cannot predict the future
• Humans are irrational (this chapter covers behavioural economics. While it is only one chapter Orrell successfully weaves it into a larger narrative of disenchantment with neoclassical economics)
• Economics bears all the flaws of a male-dominated discipline
• Economics condones gross inequality
• Economics ignores our dying planet
• Economics cares not for human happiness
• Economics is only sustained by vested interests

Orrell is perceptive when he reasons why Neoclassical economics has lasted so long:

"it tapped into something more enduring... it is based on ideas of unity, stability and symmetry that have characterised Western science since the time of the ancient Greeks." 

And what it promises:

"The neoclassical model for economic growth is unsustainable and unsatisfying, not just because it requires infinite resources and harms the environment, but also because it relies on an eternal desire for more, which can be definition never be satisfied. It offers, not happiness, but the eternal promise of happiness, if we can just work harder and upgrade our lifestyles to the next level before everyone else does."

Part of the solution, according to Orrell, is to open up economics to other disciplines. Let psychologists, philosophers, political scientists, engineers, ecologists, mathematicians and physicists all critique economics. Any economists out there are probably feeling a bit bullied by now, but rest assured the status quo is totally biased in your favour.

Orrell is clearly influenced by Nassim Taleb's The Black Swan (review to follow) - much of it is not original, but that does not stop it from being an engaging argument. I am unsure to what extent I agree with Economyths, but I recommend anyone interested in capitalism or economics read it. There is only a bit on behavioural economics, but it thoroughly reviews the wider context of the economic debate.

Genre: Economics
Accessibility: 8/10
Accuracy: 7/10
Readability: 7/10
Usefulness: 7/10
Verdict: A Good Read

Market Research

Ever wondered why you were called by a market research firm?

One explanation involves behavioural economics...

Apparently (according to the book Supercrunchers by Ian Ayres) credit companies have discovered that people are more likely to respond positively to their marketing if they were recently asked by a market research firm if they are planning any big purchases.

People are being prompted to think about big purchases they would like. Thus when credit cards come along later that week promising such items... Well, it's a no-brainer. People are being nudged.

And thus we conclude...

Companies: think about how you can indirectly encourage people to think positively about your product...

Consumers: be aware of this kind of thing when considering how best to spend your money!

(Oh, and don't let the picture of a red telephone influence your choice of insurer...)

Book review: The Economics of Good and Evil

The Economics of Good and Evil: The Quest for Economic Meaning from Gilgamesh to Wall Street by Tomas Sedlacek is quite possibly the most gripping book I have ever read. I found myself reading it late at night, on the toilet and even (gasp) in lectures.

I don't agree with everything Sedlacek writes, but boy has reading his work opened my mind. I could easily fill this review with things I disagree with, but that would miss the point. I don't recommend The Economics of Good and Evil because it is tells the truth, but because it will get you questioning: What is the truth? What is economics? Why do we conduct economics in the way that we do? Why do we persist with economics when it persistently fails to live up to its own expectations? Should economics include the ethics of good and evil? Why must the economy always grow?

What marvels me most about the book is that it deals with complex topics in such a fascinating way. Not once did it lose my interest. If you study, or plan to study, economics at any academic level you MUST read this book. As for the casual reader, I still recommend it, but do not be under any illusions - it does cover economics in-depth. It did take me a while to read (although as I say, I was gripped at every point).

The first half of the book takes a historical perspective of economics, mush of which was new to me (having always been taught that economics did not exist before Adam Smith). The second half of the book takes a more thematic approach (this is less brilliant, but still worth reading). Amongst other concepts, Sedlacek challenges utility, homo economicus, ceteris paribus, the need for growth, mathematics in economics, economics as religion and the invisible hand.

The one complaint with the book that I will mention is Sedlacek's attempt to be a theologian - he is not averse to taking biblical passages out of context - I do not advise using him as a guide to Christianity.

Having only just finished the book I am unsure how much I agree with, but this I do know: I am very glad to have read it and am definitely a better economist for doing so.

Genre: Economics/Meta economics
Accessibility: 6/10
Accuracy: 5/10
Readability: 7/10
Usefulness: 10/10
Verdict: Required Reading for Economists

Million Pound Drop

Last night I was absolutely enthralled by the game show Million Pound Drop Live. Game shows aren't usually my thing, but this was just so full of behavioural economics I could not help but be glued to it.

I could probably write  dozens of blogs about various aspects of the game, but today I'll focus on the contestants attitude towards risk.

The show design is simple: the pair of contestants start off with £1m and have to answer 8 questions correctly to win. The twist is that the contestants choose which of the potential answers they want to stake their money on. The incorrect answers are trapdoors - the money placed on these drop away. The correct answer does not drop - the money placed here is kept for the next round. Thus contestants can split their money between answers if they are not sure: they can spread the risk.

It was incredibly interesting watching yesterday's show as the contestants were highly risk averse. They always split their money, regardless of how sure they were of the answer. Even when the were certain they still put some of their money on other options. The end result was that if they'd put all the money on the answer they thought was correct (when they were certain) they would have come out with a lot more than their eventual prize of £150,000 (which is apparently relatively high compared to others).

There are few better examples of risk aversion than watching the contestants on Million Pound Drop, but perhaps why it was so obvious was that as we were playing along at home we never split our money between options. We were risk preferring because we were not playing with real money, I dare say that put me on the show and I would be as risk averse as anyone else. When it is our money it is harder to avoid risk.

PS A few of my sums for you:

If you were to always put 90% of your money on the correct answer you would end up winning £430,467

If you were to always put 75% of your money on the correct answer you would end up winning £100,113

If you were to always put 50% of your money on the correct answer you would end up winning £3,906

(these calculations ignore the fact that the money is bundled up into packets of £25k)

Boots

In a similar vein to Salt and Oats I noticed something in the local Boots pharmacy earlier today...

The seated waiting area is directly facing a shelf full of products. So, what products do you think Boots would place in pride of place for people to stare at while they waited? Chocolate bars? Soft drinks?

Oh no, it was actually pregnancy tests!

If you are going to buy a pregnancy test, surely you have decided before you arrive at the pharmacy. Is sitting opposite one going to make people buy them? Surely sitting opposite food and drink will create a better return?

But maybe I am wrong, maybe sitting opposite pregnancy tests will make women think "Oh golly, what if I'm pregnant? I'd better check just in case." Maybe I underestimate the power of suggestion. Perhaps Boots know exactly what they are doing...

Turn it up to 11

A problem for economists who think that people are rational is that we are sometimes influenced by things that we really shouldn't be. Much thanks to the friend who recently showed me this clip from the comedy Spinal Tap which parodies human irrationality: