Passport Prices

I recently went through the process of getting a new passport and was interested to see the government using some price discrimination: different prices for different people. People self-selected into the different pricing categories. Why? Because the government charged different prices according to how quickly you wanted your passport:

4 weeks - £72.50
1 week - £103
1 day - £128

Thus those who are in a rush and thus prepared to pay more, pay more. While those who are in no hurry and thus prepared to pay less, pay less. Clever. Much cleverer than just one standard price. And it is used by firms/governments all the time. Price discrimination by time is ubiquitous because there will always be some impatient people.

The Confirmation Trap

Example taken from Bazerman and Moore (2009) based on Wason (1960):

Imagine the following sequence of numbers follows a rule, and that your task is to diagnose that rule. When you write down other sequences of three numbers, your instructor will tell you whether or not your sequences follow the rule.

2-4-6

What sequences would you write down?

Commonly guessed patterns include "numbers go up by two" and "the difference between the first two two numbers equals the difference between the last two numbers". In fact, the rule was much broader: "any three ascending numbers". But people had only tried sequences that tested their hypothesis by accumulating evidence that confirmed it, but didn't test for wider rules. They fell into the confirmation trap by just seeking to confirm their suspicions by trying sequences like 1-3-5 and 22-24-26 instead of trying, for example, 1-2-3 or 1-2-10.

This is called the confirmation bias. In all walks of life, from politics to business, people seek to confirm their beliefs rather than really test them.

People ask "May I believe it?" rather than "Must I believe it?"

Econitus

The following problem is adapted from Bazerman and Moore (2009) Judgement in Managerial Decision Making:

Lisa is worried about her health. Her doctor tells her not to worry too much as there is only a 1 in 1,000 chance that women of her age has the dreaded Econitus virus. Nevertheless, Lisa remains anxious about this possibility and decides to obtain a test that can detect Econitus. The test is moderately accurate: When someone has Econitus it delivers a positive result 86% of the time. But there is, however, a small 'false positive' rate: 5% of people produce a positive result despite not having Econitus. Lisa takes the test and obtains a positive result. What are the chances that she has Econitus?

0-20 percent chance
21-40 percent chance
41-60 percent chance
61-80 percent chance
81-100 percent chance

The correct answer is 1.7%!

If you answered 86% then you fell into the common trap of ignoring 'base rates'...

If 1,000 women like Lisa take the test, 999 will not have Econitus. But the false positive result means 50 will be told they have Econitus. Therefore there is only 1.7% chance that Lisa has Econitus (trust me!).

What this demonstrates is that people ignore background information in favour of more salient information about a specific case.

Hopefully this will be useful the next time you are given statistics by a doctor...

Boy Or Girl??

The following problem is taken from Bazerman and Moore (2009) Judgement in Managerial Decision Making:

You and your spouse have had three children together, all of them girls. Now that you are expecting your fourth child, you wonder whether the odds favour having a boy this time. What is the best estimate of your probability of having another girl?

6.25% (1 in 16), because the odds of getting four girls in a row is 1 out of 16

50% (1 in 2), because there is roughly an equal chance of getting each gender

A percentage that falls somewhere between the two estimates (6.25-50 percent)

The answer is 50%. (The sperm that determines gender of the child does not know the gender of previous children! In other words, the gender of each child is independent of that their siblings.)

So what explains our potentially wayward intuition here?

According to Kahneman and Tversky (1974) "Chance is commonly viewed as a self-correcting process in which a deviation in one direction induces a deviation in the opposite direction to restore the equilibrium. In fact, deviations are not corrected as a chance process unfolds, they are merely diluted."

So there you go, hope this helps when you're expecting your fourth child...

Book Review: Basic Instincts

 Basic Instincts by Pete Lunn is an interesting take on behavioural economics that's gets better as it goes on, with applications to marketing and pricing being the highlights. It is not the best introduction to behavioural economics. It is not the best introduction to the psychology of decision making. But it is useful. (It is also full of incredibly interesting meta economics which I lay out in a seperate post.)

Here are some of the most useful highlights regarding marketing:

• Relationship marketing, where companies intentionally build relationships with consumers, is built on an accurate understanding of both the "perceptions and behaviours of existing and potential consumers". Also part of relationship marketing is the importance of likeability - brands try to be funny or irreverent in an attempt to get consumers to like them.
• The intrinsic desire for familiarity is why people are more likely to choose what they feel they already know. This manifests itself in marketing with firms trying to make their products familiar with consumers. Amongst other things, this explains why household names are used to voice commercials.
• The desire to belong manifests itself in marketing too. For example, car adverts portray ownership as membership of an exclusive club, reinforced by paraphernalia proudly bearing the logo or slogan. To summarise, "it's what your says about you..." 

 
Regarding pricing:

• Firms should beware price hikes as "People think a price should fairly reflect costs of production, not an equilibrium between supply and demand." (p.199)
• Fairness is highly valued by consumers, and woe betide any firm that is perceived to be acting unfairly. For example, in July 2007 Apple released a new iPhone for $599. In September 2007 they reduced the price to $399. This is just a textbook example of price discrimination - making those who were desperate for the iPhone pay more - but it was judged by many to be unfair. After a public backlash Apple offered the original customers $100 back, but the damage to their reputation had been done.
• People care more about the present than the future. Thus the Gillette pricing model is genius: a small upfront cost followed by regular expensive payments. Once you've bought the razor you're unlikely to change, despite the expensive blades which you probably didn't think too much about when you first bought the razor.

And a nugget of wisdom regarding management:

"Human organisation is based on our unique ability to trade favours. Effective organisations create a good climate for such social exchanges. This is the defining characteristic of successful organisations, just as it is of successful human societies." (p.164)
 
But I leave you with some political economy that succinctly details a good reason to doubt free market economics:

"Markets are not deterministic and efficient allocation machines. They behave differently according to levels of trust, common identity, the availability of information, perceptions of fair prices, and uncertainty about value and about the future." (p.268)

Genre: Behavioural Economics
Accessibility: 7/10
Accuracy: 7/10
Readability: 7/10
Usefulness: 9/10
Verdict: A Useful Read

Meta

After a bit of reading I feel like presenting some interesting ideas regarding the state of economics. I use the paper Evolution, learning and economic behaviour by Reinhard Selten (1991) and the book Basic Instincts by Pete Lunn (2008) (see here for a full book review).

Where has economic thought been?

"It is no exaggeration to say that orthodox economics is based on the idea that people can be treated, for economic purposes, as if they are selfish, independent calculating machines."
(Lunn, p.ix)

Where should we be?

"The insight the economist offers should echo in our minds when we do business with a company, when we decide to take a job, when we choose one product over another or when we walk down the end of our street to take part in and watch economic life." (Lunn, p.3)

Our task?

"If economists are to be criticised it cannot be for simplifying human nature. We have to. The question is not whether human nature is simplified, but whether the particular simplification is the best one available... Thus the economist needs to isolate the most relevant aspects of our natures; to locate the most powerful determinants of our economic behaviour." (Lunn, p.21)

"[E]conomics has many things going for it. Among the social sciences it is the most numerate. It prides itself on analytical rigour and refuses to tolerate the imprecise definitions and rambling arguments that characterise so much of social science. We don't need less economics; we need better economics." (Lunn, p.259)

And in the mean time?

"It is better to make many empirically supported ad hoc assumptions, than to rely on a few unrealistic principles of great generality and elegance." (Selten)

The way forward?

"We know that Bayesian decision theory is not a realistic description of human economic behavior. There is ample evidence for this, but we cannot be satisfied with negative knowledge - knowledge about what human behaviour fails to be. We need more positive knowledge on the structure of
human behaviour. We need quantitative theories of bounded rationality, supported by experimental evidence, which can be used in economic modelling as an alternative to exaggerated rationality assumptions." (Selten)

"The scientific task ahead is to find a concise description of our most powerful instincts, which can be combined to predict our behaviour in individual transactions, in individual markets or organisations, and finally can be built up into bigger models of the economy - a more behaviourally accurate equivalent of competitive equilibrium." (Lunn, p.264)

On a positive note, what does the future hold?

"Good science involves constant interplay between theory and evidence. It is this interplay which causes scientific revolutions - great leaps in our understanding of the world. Is economics about to be revolutionised? If so, what impact might this revolution have?" (Lunn, p.252)

"A new economics, based on a more accurate theory of our economic instincts, and a more accurate idea of the economic environment in which they prevail, is emerging. Our inability to see where it is going is all part of the fun of the ride." (Lunn, p.266)

Non Je Ne Regrette Rien...

Regret is just one of many possible motivations behind individual decision making and thus is really interesting to behavioural economists.

For example, consider the following game where the strategies are called Blue and Yellow:

Your payoffs (£):		Other Person
		Blue	Yellow
You	Blue	8	0
	Yellow	4	2

So if you play Blue and the other plays Blue then you get £8. But if they play Yellow when you play Blue you get £0.

You and the other person make the decisions simultaneously, and you do not know the other persons payoff or with what likelihood they will choose Blue or Yellow.

Clearly then, Blue is the riskier startegy for you. Yellow is the safer option.

If we ignore regret...

If you chose Yellow and earned £2 - you might be disappointed that you could have £2 more if they had chosen Blue. But if you got a payoff of £4 you should very pleased as it was the best outcome from your strategy.

However, with regret...

If you get £2 after choosing Yellow then you will have no regret (as you got more than if you had followed another strategy). But if you get £4 then you, despite getting the higher payoff, will regret your choice (as you could have got £4 more from choosing Blue).

To find out whether people are motivated by regret we can repeat the game many times, and see how people change their choice. If lots of people choose Yellow and recieve £4, only to switch to Blue the next time they play, then we could conclude that regret is important.

Thus we can use an experiment to discover whether people are primarily motivated by regret.

I first heard of this game in a presentation today, and I look forward to discovering what data has been collected on the matter...