Say no to free stuff

I just turned down free stuff. Free stuff that I want. It was a free subscription to LoveFilm for month. Just think how many films I could watch for free? All those blockbusters... All those shoot-em-ups...

So why turn it down?

 

So here's the rub. I know I have finite cognitive power (gasp). I tend to forget things. In this case, I'm fairly likely to forget to cancel the LoveFilm subscription at the end of the month. And the penalty for doing so would be the LoveFilm subscription fee for the next month leaving my bank account.

If I was rational and had an infinitely powerful brain I would get the free month's worth of films, then cancel the subscription. But if I was cognitively limited I would get the free month and then forget to cancel it, and thus have to pay for something I think is good but overpriced.

As it happens, I acted in a rational way to counteract my inherent stupidity: I ignored the deal altogether.

So there you go, a prime example of how seemingly irrational behaviour can be explained by people being aware of their limitations.

The Disposition Effect

A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.

(Kahneman and Tversky, 1979) 

Stock brokers prefer to sell stocks that rise in price than stocks that fall in price. The preference for 'winners' over 'losers' is driven only by the desire to realise gains over losses. This is called the disposition effect, and it is likely to lead to lower profits.

This is because attitude to risk is different for losses than gains. Behavioural economics has shown that people tend to be risk seeking when it comes to losses, but risk averse when it comes to gains. For example, a stock that depreciates in value will be seen as a loss, making the stock broker more risk seeking and therefore more likely not to sell it (it may go up in value again). But if the stock rises in value then the stock broker is more risk averse and therefore more likely to sell it (to avoid the risk of it falling in value).

The disposition effect increases taxable income (Odean, 1998). If stock brokers realise 'winners' they have to pay tax on the gain. But stock brokers do not have to pay tax on 'losers'. Thus stock brokers could put off paying tax (and thus earn money) by holding 'winners' for longer. And by selling 'losers' taxable income reduces; if stock brokers sell the 'losers' and buy almost identical stocks taxable income actually falls. Thus the disposition effect is irrational for stock brokers (but good for the Inland Revenue!).

The disposition effect is a violation of fungibility because investors view units of money either side of the gain/loss boundary as qualitatively different. This is an example of non-fungibility causing market failure. If investors were aware of this non-fungibility they might be less likely to exhibit it.

Putting the Fun into Fungibility

My apologies for my recent silence, I've been working hard on my MSc dissertation (now successfully finished). The topic of my dissertation was 'fungibility'. My next few posts will explore fungibility and why being aware of it may help you make more rational decisions.

Fungibility is the principle whereby economic agents treat all units of money as equal and as perfect
substitutes, regardless of where they came from.

Violations of fungibility occur when individuals use money differently because of the way it was earned, stored or labelled. Violations of fungibility can cause us to make suboptimal decisions and are thus termed irrational.

Take the example of an €8 gift voucher at an expensive restaurant. For some customers the voucher can be spent on beverages (the 'labelled' voucher) while for others the voucher can be spent on either food or beverages (the 'unlabelled' voucher). As almost all customers spend at least €8 on beverages the gift is 'nondistortionary'.

Johannes Abeler and Felix Marklein (2013) ran this field experiment and found that customers who had the labelled voucher spent on average €3.90 more on beverages than those with the unlabelled voucher.

The label attached to the money had changed behaviour (even though, rationally speaking, both groups should have spent the same amount on beverages as the voucher was nondistortionary). This 'labelling effect' violates the principle of fungibility.

So the next time you receive a labelled voucher think to yourself 'Would I have spent that much on ... anyway?' 'How much was I originally prepared to spend on ...?'

It might just help you avoid be more rational in how you spend your money.

Temptation

The neoclassical economics way of viewing people involves assuming that people are fully capable of making the best decisions for themselves. If a neoclassical economist were to see someone (lets call him Nick) blowing all their savings in a Las Vegas casino he would simply assume that Nick had done all the sums and had concluded that his own personal benefit was maximised by gambling his life savings away.

That may be the case.

But behavioural economists tend to think not.

What if Nick knows what is best for him but chooses not to do it?

What if Nick has finite powers of self-control?

What if Nick hasn't even done the sums properly? He might be aware it's not the best option for him, but not just how disastrous it is.

Behavioural economists use the term 'bounded rationality' to refer to instances where people are clearly less than perfect (often by their own admission). If Nick may overly value short term fun over long term welfare. He knows he's being irrational, but he might need a helping hand to maximise his long term welfare. This is why people are increasingly offered commitment devices - in a rare moment of clear thinking Nick could opt into a scheme which bans him from casinos.

Corporate decision making can also fall foul of self-control issues. A timely example is the over-fishing of EU waters. If politicians really had the long term welfare of fishermen (and of the fish!) in mind then they would restrict the amount of fish that can be caught.