When The Chips Are Down...

Last night I played poker. Not for money, just pride. I actually did quite well (cue comments about behavioural economists being able to read people - not actually true; I just got lucky!)

But I was, sadly, irrational.

When I bet my chips, I preferred to bet the smaller chips in larger quantities than the larger chips. For example, I'd bet two 500 chips rather than one 1000 chip. Not only this, but I felt more carefree when I had lots of smaller chips. I would bet on things that I definitely wouldn't have done had I had to get change from a large chip.

I sometimes refused to make bets because it would mean sacrificing a sacred 1000 chip, whereas if I had ten 100 chips I would have bet. Irrational. 

In other words, I changed my behaviour based on trivial things. Trivial things that economists assume we pay no heed of.

Book Review - Thinking, Fast and Slow

 

Daniel Kahneman is a world-renowned psychologist who won the Nobel Prize for Economics in 2002 for his contribution to behavioural economics. Thinking, Fast and Slow is his summary of his lifetime's work into understanding the human brain - it is required reading for anyone who wishes to understand how we make decisions. Kahneman effortlessly keeps you gripped as he conducts his whistle-stop tour of your mind. Reading this will improve how you understand the decision-making process, and might just help you make better decisions in future. Leaders take note!

The title comes from the way psychologists separate brain functions: two systems are in operation, one is incredibly fast but prone to making errors, while the other is more accurate but slower and lazier. Kahneman reveals how the interaction of these systems results in systematic errors in our thinking and quirks in our decision-making.

For example, we have a fantastic tendency to fail to look beyond the obvious. Kahneman uses the phrase 'What you see is all there is' to describe our thinking so often he actually shortens it to WYSIATI. His expertise combined with a wonderful turn of phrase results in highly enjoyable quotes, such as:

"Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance."

However, just because Daniel Kahneman has written something doesn't make it true. There are alternative theories (certainly within behavioural economics) worthy of equal attention that don't make the book. Those interested in behavioural economics should not rely on Thinking, Fast and Slow alone. Although, a really nice touch is that the two main papers for which Kahneman received his Nobel Prize are reproduced at the back for those who are really interested.

Given the sheer quantity of material packed into the 400+ pages it may take a while to digest, but don't let that put you off - it's well-worth a read. I thoroughly recommend Thinking, Fast and Slow.

Genre: Psychology
Accessibility: 7/10
Accuracy: 8/10
Readability: 8/10
Usefulness: 10/10
Verdict: Required Reading

Preference Reversal – I Need A Dollar

As we discovered last time, for traditional economics relies upon economic agents being consistent and thus rational. Today we will uncover a common phenomenon: preference reversal.

Let’s start with a little experiment...

You have a choice. There are two options of differing payoff and probability. Imagine that you, the subject, will get to keep any payoff you get. I, the experimenter, will pick a ball at random from a bag (a la bingo) to decide whether you are awarded any payoff. If you choose Option A I will use a set of balls that give you a 70% chance of getting the payoff (of £24), if you choose Option B I will use a set of balls that give you a 25% chance of getting the payoff (of £80).

	Probability	Payoff
Option A	0.7	£24
Option B	0.25	£80

• If you had to choose between them, which option would you rather have?

• Now think about how much each option is worth to you: what amount of money would be of equal value as each option? (What would you deem a fair price for each option to be?)

If you’re anything like me you will have chosen Option A. You may also have valued Option A at something like £17 and Option B at around £20. 

And if you did, you were irrational. 

Why? Because you said you prefer the Option A in the straight choice, but value Option B higher. This is inconsistent. We can infer that you both prefer Option A and Option B (because you valued it at a greater sum of money). You have ‘reversed’ your preferences. This is ‘standard preference reversal’ (‘non-standard’ is where someone chooses Option B, but values Option A higher). PR is asymmetric; the overwhelming majority of preference reversals are the standard type.

If you were inconsistent, don’t worry, you are not alone. If you were consistent you are probably smug, well done. 

Preference reversal (PR) is the phenomenon where individuals change what they say they prefer, purely because the way they were asked was different. Interestingly, people change their preferences in a highly predictable, yet irrational, way. 

The psychologists Lichtenstein and Slovic (1971) first demonstrated PR using their, now famous, experiment design (as roughly replicated above). They called Option A the ‘P-bet’ and Option B the ‘$-bet’.

The first economists to take notice of PR were David Grether and Charles Plott in 1979. They set out to ‘discredit’ the psychologists findings. They failed. Badly. After testing 13 theories they were forced to conclude that PR was not caused by flawed research. My favourite of their theories include:

Theory 12: The original experiments were done on psychology students who are ‘unsophisticated subjects’.

Theory 13: The original experiments were done by psychologists ‘who have a reputation for deceiving subjects’. 

Alas, it turns out that PR is real and here to stay. We will explore the causes of PR in later blogs, but the debate is basically between economists and psychologists over whether it is inherently daft to assume that people have underlying preferences. Psychologists argue that we only ‘construct’ preferences when we face decisions, while economists argue that our preferences already exist and we just refer to them.

I will finish by giving an example of PR in the real world (controversial, I know)...

http://static.guim.co.uk/sys-images/Guardian/Pix/pictures/2012/1/31/1328027920111/high-speed-train-Eurostar-007.jpg

Imagine you own a sheep farm in the Chiltons. However, the Government wants to build a high-speed rail link right through your land. The new line can either go straight past your delightful little cottage (causing you a big headache), or it can take a longer route going through your fields (taking up more of your prime sheep farming land). The Government wants to know which route you’d prefer. They can either ask you which option you would chose in a straight choice, or they can ask you how much compensation you will demand for each option (and choose the cheapest). Governments worldwide use both methods of asking people all the time, assuming they yield the same preference. 

PR would suggest that they might not...

Recommended listening:

I Need A Dollar by Aloe Blacc

Behavioural Economics – What A Wonderful World

Welcome to the world of Behavioural Economics: where Economics meets Psychology and stays for nice little chat, taking a comfy seat by the warming fireside of experimental evidence, holding a hot mug of pure rationality. Hmmm... rationality. The oil that makes the world go round.

Or does it?

Behavioural Economics is the area of study devoted to the exploration of how economic agents (that you and me folks) think, act and react. Put simply: are we rational? Rationality is where people have consistent preferences, and that from any given range of options, people always chose the one they most prefer.

In 1971 two psychologists named Sarah Litchenstein and Paul Slovic stumbled upon a phenomenon that was to rock the economics world: preference reversal. Preference reversal challenges an assumption economists make every day: that economic agents (still talking about you and me) are consistent. If we are not then the cornerstone of microeconomics is compromised.

This is because the accuracy of economic models hinges on whether they are able to predict human behaviour. If we are systemically inconsistent, and thus irrational, economists need to be able to ‘model’ this behaviour. Traditionally, however, economists have circumvented this problem by, well, ignoring it.

Enter stage left, Litchenstein and Slovic. The subject of preference reversal will be my next blog, where we will discover that we are not as logical as we like to think. So for now all we shall note is that it got the attention of economists who, since then, have being trying to define our irrationality and incorporate it into their models.

But why does any of this actually matter?

Because economic models are highly influential. Interest rates, Government spending and taxation are all set according to economic models that are built on the assumption of rationality.

So it’s important, but why should you bother with it?

Because it affects the decisions you make every day: what you say you prefer, what you buy and how much effort you put in at work. Furthermore, companies are starting to wake up to Behavioural Economics and are attempting to use it to manipulate economic agents (still us) to buy their stuff.

You still may not be concerned by that. Which is fine. But then, are you sure you’re rational?

Recommended listening:

What A Wonderful World by Louis Armstrong