"Why Psychologists know more about Economic Behaviour than Economists"
Peter Ayton
Department of Psychology
City University
"Why Psychologists know more about Economic Behaviour than Economists"
The Society for Judgment and Decision Making is an interdisciplinary
academic organization dedicated to the study of normative, descriptive,
and prescriptive theories of decision. Its members include psychologists,
economists, organizational researchers, decision analysts, and other
decision researchers.
"Why Psychologists know more about Economic Behaviour than Economists"
The Society for Judgment and Decision Making is an interdisciplinary
academic organization dedicated to the study of normative, descriptive,
and prescriptive theories of decision. Its members include psychologists,
economists, organizational researchers, decision analysts, and other
decision researchers.
Advice from Members of the The Society for Judgment and Decision Making
"Why Psychologists know more about Economic Behaviour than Economists"
The Society for Judgment and Decision Making is an interdisciplinary
academic organization dedicated to the study of normative, descriptive,
and prescriptive theories of decision. Its members include psychologists,
economists, organizational researchers, decision analysts, and other
decision researchers.
Advice from Members of the The Society for Judgment and Decision Making
“Cut and run”
"Why Psychologists know more about Economic Behaviour than Economists"
The Society for Judgment and Decision Making is an interdisciplinary
academic organization dedicated to the study of normative, descriptive,
and prescriptive theories of decision. Its members include psychologists,
economists, organizational researchers, decision analysts, and other
decision researchers.
Advice from Members of the The Society for Judgment and Decision Making
“Cut and run”
“Wear a flak jacket”
"Why Psychologists know more about Economic Behaviour than Economists"
The Society for Judgment and Decision Making is an interdisciplinary
academic organization dedicated to the study of normative, descriptive,
and prescriptive theories of decision. Its members include psychologists,
economists, organizational researchers, decision analysts, and other
decision researchers.
Advice from Members of the The Society for Judgment and Decision Making
“Cut and run”
“Wear a flak jacket”
“Wear a bullet-proof vest”
"Why Psychologists know more about Economic Behaviour than Economists"
The Society for Judgment and Decision Making is an interdisciplinary
academic organization dedicated to the study of normative, descriptive,
and prescriptive theories of decision. Its members include psychologists,
economists, organizational researchers, decision analysts, and other
decision researchers.
Advice from Members of the The Society for Judgment and Decision Making
“Cut and run”
“Wear a flak jacket”
“Wear a bullet-proof vest”
“As a backup plan, you could exploit an inadvertent ambiguity in your talk title, and
claim that you meant that psychologists know more about economic behaviour than
they do about economists.”
Indeed, economists are mysterious beings. Many persevere in the belief that people
must behave optimally, at least on average, and they seem perpetually baffled by
basic psychological phenomena that seem completely intuitive to one's proverbial
grandparent. I feel that psychologists indeed understand them quite poorly”
Risky Decisions
Q1. Imagine that you face the following pair of concurrent decisions. First
examine both decisions and then indicate the options that you prefer.
Decision I: Choose between
A. A sure gain of £2,400
B. B. A 25% chance to gain £10,000, and a 75% chance to gain nothing
Decision II: Choose between
C. A sure loss of £7,500
D. D. A 75% chance to lose £10,000, and a 25% chance to lose nothing
Risky Decisions
Q1. Imagine that you face the following pair of concurrent decisions. First
examine both decisions and then indicate the options that you prefer.
Decision I: Choose between
A. A sure gain of £2,400
B. B. A 25% chance to gain £10,000, and a 75% chance to gain nothing
Decision II: Choose between
C. A sure loss of £7,500
D. D. A 75% chance to lose £10,000, and a 25% chance to lose nothing
We will consider your choices at the end of the session…
"Why Psychologists know more about Economic Behaviour than Economists"
Economics and Psychology as Social Sciences.
Students of (Classical) Economics will understand
economic behaviour in terms of rationality and self
interest.
Students of psychology will know about Cognitive
limitations; Social interaction (trust & fairness);
Sensitivity of perception and cognition (i.e. choice) to
context.
“The economist may attempt to ignore psychology, but it is sheer
impossibility for him to ignore human nature... If the economist borrows
his conception of man from the psychologist, his constructive work may
have some chance of remaining purely economic in character. But if he
does not, he will not thereby avoid psychology. Rather, he will force
himself to make his own, and it will be bad psychology.”
John Maurice Clark, Journal of Political Economy, 1918
It seems clear that people cannot conceivably
represent all the information that normative
models demand we utilise for judgment and
choice:
“Who could design a brain that could perform the
way this model mandates? Every single one of us
would have to know and understand everything
completely, and at once”. (Daniel Kahneman,
1996).
Is the left centre circle bigger?
No, they're both the same
size
Psychological studies of choice show
similar context effects.
Axioms underlying subjective expected utility theory
Transitivity
If you prefer A to B and B to C then you should prefer A to C.
Intransitive Preference
(Tversky, 1969)
Animal Irrationality?
Honey Bees violate transitivity in their foraging preferences for
flowers.
Flower
Flower Depth
(mm)
Sucrose
(µL)
A
40
2
B
60
3
C
80
4
D
100
5
Shafir (1994)
Lichtenstein & Slovic’s research
payoff
$4.00
pw = 0.99
pw =0.33
pL = 0.01
pL =0.67
A
B
-$1.00
Which one do you choose?
Lichtenstein & Slovic 1971, 1973
payoff
$16.00
-$ 2.00
Lichtenstein & Slovic’s research
payoff
$4.00
pw = 0.99
pw =0.33
pL = 0.01
pL =0.67
C
D
-$1.00
Put a price (in $) on both C and D
payoff
$16.00
-$ 2.00
Lichtenstein & Slovic’s findings
payoff
$4.00
pw = 0.99
pw =0.33
pL = 0.01
pL =0.67
-$1.00
payoff
$16.00
-$ 2.00
What did Lichtenstein & Slovic find?
P-bet: most Ss choose this
$-bet: SS gave higher bids to this
About equal EV (~3.945)
Even “within-subjects:” same Subject chooses the P-bet over the
$-bet but bids more for the $-bet than for the P-bet.
Lichtenstein & Slovic’s findings
Two economists, Grether and Plott (1979), realising
that: “It suggests that no optimisation principle of any
sort lies behind even the simplest of human
choices…”(p. 623) conducted a series of studies
“designed to discredit the psychologists’ works as
applied to Economics” (p. 623).
However even after controlling for all the economic
explanations of the phenomenon that they could find
– including that the experiment be conducted by
economists rather than psychologists (“psychologists
have the reputation for deceiving subjects” p.629) the reversals still appeared.
Preference Reversals
Issue M:
Problem: Several Australian mammal species are nearly wiped out by
hunters.
Intervention: Contribute to a fund to provide safe breeding area for these
species.
Issue W:
Problem: Skin cancer from sun exposure is common among farm
workers.
Intervention: Support free medical checkups for threatened groups.
Largest amount willing to contribute?
M>W
Which alternative would rather support?
W>M
Unsurprising Psychological Finding
Often people don’t know what they
like or how much they like it
Separate versus comparative evaluation
Example: Cheeseburgers
50%
50%
Example: Cheeseburgers
50%
30%
50%
60%
10%
Compromise effect
Items can GAIN market share when new
options are added to the market when
they become the compromise or middle
option in the choice set (Simonson 1989)
Example: Cheeseburger
Context effects on Choice
We often don’t know what we want until
we see it in some context.
What sort of phone do you want?
What sort of _____ do you want?
What sort of life do you want?
Context effects on Choice
We often don’t know what we want until
we see it in some context.
• Introducing an inferior (decoy) item will
create a simple comparison with one
option and thereby make it appear
superior
Choice shares
Group 1
40%
N.A.
60%
Choice shares
Group 1
Group 2
40%
20%
N.A.
0%
60%
80%
Attraction effect
• The finding that an item can increase the
favourable perceptions of similar, but
superior, items (Huber et al. 1982)
Ariely, D., Loewenstein, G. and Prelec, D. (2003).
Coherent arbitrariness:
Annoying sounds of 100, 300 and 600 seconds. At
the beginning of the experiment, subjects are asked
about the last 3 digit number of their social security
number. Subjects were then asked whether,
hypothetically, they would listen again to the sound
they just experienced (for 300 seconds) if they were
paid the money amount they had generated from
their social security number (e.g. 997=$9.97). In the
main part of the experiment, subjects had three
opportunities to listen to sounds in exchange for
payment.
Mean willingness to hear (in dollars) for the three annoying sounds. The data is plotted
separately for subjects whose random three digit anchor was below the median (low anchor)
and above the median (high anchor). Error bars are based on standard errors.
Anchoring affects all sorts of
purchases.
Simonsohn and Loewenstein (2006) show that
movers arriving from more expensive cities in
the USA rent more expensive apartments
than those arriving from cheaper cities. (after
controlling for differences in wealth, taste and
information).
Anchors – not preferences – determine our
choices
Real
estate
agents
All real estate agents inspected a house, and were given a 10 page
booklet on the house (features, prices of other houses in the area,
etc).
Also told what the seller thought the house was worth – either high
or low. The Agents denied this was relevant – but it affected
their judgments.
Seller’s estimate
Appraisal value
Listing price
Purchase price
Lowest acceptable offer
119,900
149,900
114,204
128,754
117,745
130, 981
111,545
127, 318
111,136
123, 818
10% difference!
Northcraft and Neale, 1987
Traditional Economics …
…assumes that prices of products in the market are
determined by a balance between production at each
price (supply) and the desires of those with purchasing
power at each price (demand ).
This assumes that the two forces are independent and
together produce the market price.
BUT What consumers are willing to pay can easily be
manipulated – consumers don’t have a fixed notion of
their own preferences and what they are willing to pay.
Anchoring shows that the two forces are dependent –
prices influence willingness to pay.
If the trades we make are arbitrarily influenced by
anchors then we may not make choices that reflect the
real utility or pleasure we derive from products and the
market may not set optimal prices
Oct. 9th 2002
Daniel Kahneman receives the Nobel
Prize in Economic Sciences
Prospect Theory
“Daniel Kahneman has integrated insights from psychology into economics, thereby
laying the foundation for a new field of research. Kahneman’s main findings concern
decision-making under uncertainty, where he has demonstrated how human decisions
may systematically depart from those predicted by standard economic theory. Together
with Amos Tversky (deceased in 1996), he has formulated prospect theory as an
alternative, that better accounts for observed behavior.”
Prospect theory
implicit ‘value function’ over
changes from ‘r’
1. Diminishing marginal
sensitivity (concave for
gains, convex for losses)
2. Loss aversion: kink at ‘r’:
losses loom larger than
gains
‘r’
Kahneman & Tversky, 1979, 1984
Samuelson’s Lunch Colleague
• Paul Samuelson offered two-to-one odds to
his colleague: colleague wins $200 if heads,
loses $100 if tails. Colleague refused bet.
• Samuelson asked him if he would take 100
such bets. Colleague said yes.
• Samuelson offered mathematical proof that
his colleague was not rational (from expected
utility theory). [Scientia 98:108-13, 1963]
Framing
You are the CEO of a company faced with a
difficult choice. Because of worsening economic
conditions, 6000 people will need to be fired to
reduce the payroll costs and avoid serious
financial problems. Two alternatives programs
to combat the firings have been proposed to
you. The estimates of the consequences of the
programs are as follows:
Version A
If Program A is adopted, 2000 jobs will be saved.
If Program B is adopted, there is a one-third
probability that 6000 jobs will be saved, and a
two-thirds probability that no jobs will be saved.
Which of the two programs would you select?
A
B
Version B
If Program A is adopted, 4000 people will be fired.
If Program B is adopted, there is a one-third
probability that nobody will be fired, and a two-thirds
probability that 6000 will be fired.
Which of the two programs would you select?
A
B
NYC taxi drivers
Camerer, Babcock, Loewenstein, & Thaler (2000)
heuristic: Set daily income target.
Stop working when target
is reached.
phenomenon: Drivers work least when
marginal salaries are highest.
Would earn 8% more if they
worked same # hours every day.
fact: Experienced drivers tend
to even out # of hours. Still
could do better by shifting work to
high demand days.
Mental accounting
Financial resources fall into distinct
accounts or categories that are not
completely interchangeable.
Decisions are made piecemeal and are
influenced by specific context
Mental accounts help us regulate our
consumption behavior
Invest now, drink later, spend never: The mental
accounting of wine cellars.
You purchase several cases of wine at $20 a bottle and, after several
years it has now increased in value. You have been offered $75 a bottle.
You decide to drink a bottle to help you decide about the offer. How
much does this cost you?
Possible mental accounts...
(a) Nothing
(I already
own it)
(b) $20
(what I paid)
Shafir and Thaler (2006)
(c) $20 + interest
(what I paid
+ interest)
(d) $75 (e) A gain of $55
(what I am (I drank a $75
offered)
bottle and it
only cost $25)
Invest now, drink later, spend never: The mental
accounting of wine cellars.
You purchase several cases of wine at $20 a bottle and, after several
years it has now increased in value. You have been offered $75 a bottle.
You decide to drink a bottle to help you decide about the offer. How
much does this cost you?
Possible mental accounts...
(a) Nothing
(I already
own it)
(b) $20
(what I paid)
30%
18%
Shafir and Thaler (2006)
(c) $20 + interest
(what I paid
+ interest)
7%
(d) $75 (e) A gain of $55
(what I am (I drank a $75
offered)
bottle and it
only cost $25)
20%
25%
You decide to give a bottle to a friend. How much does this cost?
(a) Nothing
30%
(b) $20
17%
Shafir and Thaler (2006)
(c) $20 + interest
9%
(d) $75 (e) A gain of $55
30%
14%
You decide to give a bottle to a friend. How much does this cost?
(a) Nothing
30%
(b) $20
17%
(c) $20 + interest
9%
(d) $75 (e) A gain of $55
30%
14%
You accidentally break a bottle. How much does this cost?
((a) Nothing
8%
(b) $20
24%
Shafir and Thaler (2006)
(c) $20 + interest
11%
(d) $75 (e) A gain of $55
55%
2%
Mental accounting
Tversky & Kahneman 1981
Imagine that you have decided to see a play where
admission is $10 per ticket. As you enter the theater
you discover that you have lost a $10 bill.
Would you still pay $10 for a ticket for the play?
Yes 88%
No 12%
Imagine that you have decided to see a play and paid
the admission price of $10 per ticket. As you enter the
theater you discover that you have lost the ticket. The
seat was not marked and the ticket cannot be
recovered. Would you pay $10 for another ticket?
Yes 46%
No 54%
DOMAI N
PHENOMENON
DESCRIPTION
Stock market
Equity premium
Stock returns are too high,
relative to bond returns
Stock market
Disposition effect
Hold losing stock too long,
sell winners t oo early
Labor
economics
Consumer
goods
Macroeconomics
Consumer
choice
Horserace
betting
Horserace
betting
Insurance
Lottery
betting
TYP E OF
DATA
NYSE stock,
bond returns
Individual
investor
trades
DownwardNYC cabdrivers quit around Cabdriver
sloping labor
daily income target
hours,
supply
earnings
Asymmetric price Purchas es more sensitive
Product
elasticities
to price increases than to
purchases
cuts
(scanner data)
Insensitivit y to
Consumers do not cut
Teachers
bad income news
consumption after bad
earning,
income news
savings
Status quo bias,
Consumers do not switch
insurance
Default bias
health plans, choose default choices
insurance Health plan
Favorite-longshot Favorites are underbet,
Track odds
bias
longshots overbet
End-of-the-day
Shift to longshots at the
Track odds
effect
end of the day
Buyi ng phone
Consumers buy overpriced Phone wire
wire insurance
insurance
insurance
purchases
Demand for
More tickets sold as top
State lottery
Lott o
prize rises
sales
ISOLATED
DECISION
Single yearly
return (not longrun)
Single stock (not
portfolio)
INGREDIENT
S
Loss- aversion
REFRERENCES
Reflection
effect
Odean (1998)
Single day (not
week or month)
Loss- aversion
Camerer et al (1997)
Single product
(not shopping
cart)
Single year
Loss- aversion
Hardie, Johnson, Fader (1993)
Loss- aversion,
reflection
effect
Loss- aversion
Shea (1994); Bowman,
Minehart and Rabin (1996)
Overweight
low p(loss)
Reflection
effect
Overweight
low p(loss)
Julli en and SalaniŽ(1997)
Overweight
low p(win)
Cook and Clotfelter (1993)
Single choice
Single race (not
day)
Single day
Single wire risk
(not portfolio)
Single lottery
Benartzi and Thaler (1995)
Samuelson and Zeckhause r
(1988), Johnson et al (1992)
McGlothlin (1956)
Cicchetti and Dubin (1994)
Camerer (2000): Ten field phenomena inconsistent with EU and consistent with cumulative prospect theory
Economic Anomalies accounted for by Prospect Theory
Disposition effect: Trading volumes for stocks that have fallen in price are
larger than for stocks that have risen in price. Traders dislike selling at
a loss – BUT the purchase price of a stock shouldn’t affect whether
you sell it: if you think it will rise, keep it; if you think it will fall sell it.
Economic Anomalies accounted for by Prospect Theory
Disposition effect: Trading volumes for stocks that have fallen in price are larger
than for stocks that have risen in price. Traders dislike selling at a loss – BUT
the purchase price of a stock shouldn’t affect whether you sell it: if you think it
will rise, keep it; if you think it will fall sell it.
Equity Premium Puzzle: Average return on stocks outperforms bonds.
Not plausibly attributable to risk aversion: A person showing enough risk
aversion to explain the equity premium would be indifferent between a coin flip
paying $50,000 or $100,000 and a sure amount of $51,209.
Investors not averse to variability but dislike the fact that stocks show losses
more frequently than bond returns.
Economic Anomalies accounted for by Prospect Theory
Disposition effect: Trading volumes for stocks that have fallen in price are larger
than for stocks that have risen in price. Traders dislike selling at a loss – BUT
the purchase price of a stock shouldn’t affect whether you sell it: if you think it
will rise, keep it; if you think it will fall sell it.
Equity Premium Puzzle: Average return on stocks outperforms bonds.
Not plausibly attributable to risk aversion: A person showing enough risk
aversion to explain the equity premium would be indifferent between a coin flip
paying $50,000 or $100,000 and a sure amount of $51,209.
Investors not averse to variability but dislike the fact that stocks show losses
more frequently than bond returns.
Race-track betting: The end of the day effect. Adjustment of the reference point
leads people to be more likely to bet $10 on a 15-1 horse if they have lost $140.
Benefit in the light of losses is greater - bigger gain in value for the same amount
depending on location of the reference point.
In fact (McGlothlin, 1956) people do tend to bet more on long-odds horses in the
last race (after, presumably, they have accumulated a significant loss).
Sunk cost effects occur when a decision maker’s choices are
affected by prior investments in the available options.
There is now a large literature testifying to the existence of sunk
cost effects in human decision making (ref). These effects have
been documented in a wide range of circumstances and are not
restricted to laboratory studies.
The amount U.S. professional basketball teams pay for a player
influences how much the player is used - independently of his
performance.
People receiving a surprise discount on theatre tickets they
intended to buy anyway are less likely to attend.
Sunk in the Gym…
Gourville and Soman 2002
Sunk in the Gym…
QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.
To rely on the mere fact of choice, regardless of the kind of motives
behind it, might seem to take economics out of all dependence on
psychology, but it does not really do so, save at the cost of becoming
utterly meaningless.
John Maurice Clark, Journal of Political Economy, 1918
We built economics on the idea of rational choosing only to be told
rational choosing is but a small and very imperfectly developed part of
our mental life
John Maurice Clark, “Economics and Modern Psychology” Journal of
Political Economy, 1918
“If people are so dumb, how come more of us smart people don’t get
rich?”.
Peter Bernstein (1996).
Camerer and Fehr, 2006
Figure: Behavior of buyers and sellers in the ultimatum game and in market games with competing
sellers. In all games the buyer can make a price offer between 0 and 100 for an indivisible good
with value 100. (A) The distribution of accepted price offers across conditions. In the ultimatum
game most prices are between 40 and 50. If there are two competing sellers, most prices are
between 10 and 25; in the case of five competing sellers, the large majority of prices is between 5
and 10. The dotted lines show the predictions of a fairness model for each of the three conditions
(17). The model has one free parameter to fit the data and combines the theory of inequity aversion
(9), which assumes heterogeneous preferences for equitable outcomes, with stochastic best reply
behavior (50). (B) Sellers rejection rate across conditions. More competition leads sellers to reject
low offers less frequently.
Gains and losses
Q1. Imagine that you face the following pair of concurrent decisions. First
examine both decisions and then indicate the options that you prefer.
Decision I: Choose between
A. A sure gain of £2,400
B. B. A 25% chance to gain £10,000, and a 75% chance to gain nothing
Decision II: Choose between
C. A sure loss of £7,500
D. D. A 75% chance to lose £10,000, and a 25% chance to lose nothing
Gains and losses
Q1. Imagine that you face the following pair of concurrent decisions. First
examine both decisions and then indicate the options that you prefer.
Decision I: Choose between
A. A sure gain of £2,400
B. B. A 25% chance to gain £10,000, and a 75% chance to gain nothing
Decision II: Choose between
C. A sure loss of £7,500
D. D. A 75% chance to lose £10,000, and a 25% chance to lose nothing
Most people choose A and D – hardly anyone prefers B and C. They like the sure gain in Decision I and
dislike the certain loss in Decision II. But the pair of choices B and C is much better than A and D.
If you combine the outcomes of the two choices you can add the sure gain of £2,400 to the risky outcomes
in D. So, A and D gives you
A and D. 25% chance to gain £2,400, and
75% chance to lose £7,600
Similarly, B and C can be combined – the sure loss of £7,500 in C can be subtracted from the risky
outcomes from B
B and C. 25% chance to gain £2,500, and
75% chance to lose £7,500
With B and C the chances of winning and losing are the same as in A and D but the amount you might win
is more and the amount you might lose is less.