Behavioural Economics and Experiments

Ananish Chaudhuri

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000375749
• Edition: 1
• Topic: Volkswirtschaftslehre
• Subtopic: Mikroökonomie

Behavioural Economics and Experiments addresses key topics within behavioural economics, exploring vital questions around decision-making and human nature. Assuming no prior knowledge of economics, the book features wide-ranging examples from literature, film, sport, neuroscience and beyond.

Ananish Chaudhuri explores the complex relationships between human behaviour, society and decision-making, introducing readers to the latest work on heuristics, framing and anchoring, as well as ideas around fairness, trust and social norms. The book offers a fresh perspective on issues such as:

• 
  
  

• Decision-making under uncertainty

• 
  
  

• Firms' pricing decisions

• 
  
  

• Employment contracts

• 
  
  

• Coordination failures in organizations

• 
  
  

• Preventing bubbles in financial markets

This is an ideal introduction for students of behavioural economics, experimental economics and economic decision-making on economics, public policy, psychology and business-related programmes, and will also be accessible to policymakers and curious laymen.

1 How we decide

In this chapter, I talk about

• The assumption of “rationality” in the social sciences;
• The concept of “bounded rationality”;
• The role of social norms and conventions in guiding rational behaviour;
• How economists and psychologists differ in their approach to the study of decision making and how behavioural economics combines insights from both;
• The “guessing game” as an example of this merger of economic and psychological input;
• The canonical problem of choice facing an economic consumer as a demonstration of the “normative” approach in economics.

VIGNETTE 1:

3 February 1953: “The day the music died.” Buddy Holly’s death in a plane crash in Iowa on this day has been immortalized in many ways including in Don McLean’s classic “American Pie”.¹ But the story goes that Holly, Richie Valens and others were supposed to take a bus but had chartered the plane at the last minute. They had been on the road for a while and Holly wanted to arrive early so that everyone could do their laundry.

VIGNETTE 2:

In 2019, James Holzhauer, a professional sports-bettor from Las Vegas, set the world of Jeopardy! on fire and became one of the highest earning players of all time. In his fourth game on April 9, he won $110,914 in a single day, which broke the previous single-game Jeopardy! winnings record of $77,000 set by Roger Craig in 2010. Holzhauer became particularly well known for selecting big value clues at the outset in an attempt to uncover the Daily Doubles and when he found them, he bet it all every single time thereby ending up with huge cash earnings.²

VIGNETTE 3:

In 1994, the players of Major League baseball in the United States of America went on strike. This led to the cancellation of 938 games overall, including the entire post-season and the World Series. Team owners were demanding a salary cap and came up with a new revenue-sharing plan, which required the players’ approval. The players’ union rejected the offer, which they thought was unfair to the players and merely a way to address problems of disparity among the owners. After prolonged negotiations failed to break the impasse, the acting commissioner, Bud Selig, called off the rest of the season on September 14. The move to cancel the rest of the season meant the loss of $580 million in ownership revenue and $230 million in player salaries. Thus, the players essentially walked away from $230 million collectively because of what they considered was an unfair offer. The average salary of players at this time was about $1.2 million per year. This in turn resulted in a loss of more than twice that amount for the owners.

VIGNETTE 4:

One part of the British daytime show Golden Balls works like this: two contestants face each other and decide on a pool of cash that varies from one pair to the next. The pool is typically in the thousands of pounds if not hundreds of thousands. Each contestant is given a set of two balls; one can be opened to reveal the message “Split” written inside, while the other, when opened, says “Steal”. Each contestant knows the content of the message inside each ball; that is, whether the message inside says “Split” or “Steal”. The contestants are given some time to discuss their options and indicate what decision they will take. If both choose “Split”, they each receive half the jackpot. If one chooses “Steal”, while the other chooses “Split”, then the contestant choosing “Steal” will win the entire pool of money and the one choosing “Split” gets nothing. If both contestants choose “Steal”, then neither contestant wins anything. Different pairs arrive at different outcomes. In some, both members choose “Split” and share the pot. But there are plenty of instances, where one member in the pair chooses “Split”, while the other chooses “Steal” even after promising repeatedly that (s)he will choose “Split”. In such cases, the one choosing “Split”, the “nice” option, is left with nothing.

One episode (back in February 2008), saw Sarah from Manchester and Stephen from Hartlepool facing each other. The pot was £100,150! Stephen and Sarah discussed the situation at length, with each promising solemnly and repeatedly that each was going to choose “Split”, thereby walking away with about £50,000 each. Then came the time to reveal their respective choices. Stephen chose “Split” as promised, but Sarah, who had at times tearfully promised to choose “Split”, actually chose “Steal”, walking away with the entire jackpot, leaving Stephen with nothing.

Introduction

We make hundreds, if not thousands of decisions over the course of a day; big and small. Some of these are inconsequential, while others are much less so (though this is probably relative to the individual and not everyone is as equally vested in all decisions).³ Some of these may not have financial or economic implications but many do; in fact, in a sense it may not be inaccurate to say that most do. For instance, your decision to take this course or buy this book or even read this book required a number of trade-offs; another course you could have taken, another book you could have read or another activity you could have pursued. This is the “opportunity cost” of doing what you are doing; the value of the best alternative activity foregone. The opportunity cost of holding loads of cash in your wallet is the interest income you are foregoing by not putting your money in the bank. The opportunity cost of our fantastic family trip to Europe was the part of the mortgage that could have been paid off had we not taken the trip. In some cases, assigning a dollar cost to the foregone alternative activity is easier. But, if you think hard about it, you could also possibly assign a dollar value to other things; activities that you gave up in order to pursue this current activity. Economists call this “imputed value”; the idea that you could and should assign a value to activities.⁴ When you decide to undertake a particular activity, you have implicitly decided not to undertake another activity.

So, how do we make up our minds when confronted with decisions involving multiple choices? This is no easy matter as Theodore Geisel (popularly known as Dr Seuss) points out in his book Oh, The Places You’ll Go! (1990), a book supposedly written for young children but one which contains profound insights for adults too. Geisel writes that at times the reader may find himself/herself in a place where the streets are not marked, where some windows are lit but others are dark; a place where he/she could fall down and sprain a body part. Does the reader dare to go in, or should he/she stay out? Geisel ends this part by stating that often the reader will find that it is not at all a simple matter “for a mind-maker-upper to make up his mind”.

Some of these decisions are purely individual ones such as: should I get the extended warranty on my big screen television. How about on my iPhone? Should I buy a lottery ticket? But others go beyond just individual decisions, to decisions made by groups, such as the bargaining between players and owners in Major League baseball. Or a company trying to decide whether to cut prices or not to match a competitor; United and Continental trying to decide whether to merge or not … and the response of competitors to a merger; Novartis deciding how much to invest in R&D on a new cancer drug and when to stop.

Other examples include: people trying to decide whether to contribute money towards building a local park or another similar charity; a Persian-rug seller haggling over the price and deciding how quickly to lower the price; a Hadza man in Tanzania deciding whether to join another hunter in order to jointly hunt a large prey for the day, or just try to catch a smaller animal on his own; an employee deciding how hard to work when the employer is away.

But I digress. To get back to the point: we are constantly making decisions and many of these have financial implications. So, it would be good if we knew more about how we make these decisions. While human decision making is of interest to a wide cross-section of researchers, it is probably safe to say that economics and psychology are the two disciplines that spend the most time worrying about this.

Economists start by assuming a certain amount of rationality on the part of humans. It is actually possible to argue over what “rationality” means, and scholars in different disciplines often do. My working definition, or, better yet, my understanding of what economists understand by “rationality”, is that when faced with choices, humans engage in a clear-headed calculation of the benefits and costs; we possess foresight and are able to undertake complex calculations, and finally, that we are interested in maximizing what economists refer to as utility.⁵ Furthermore, we do not have the luxury of choosing anything we want. Our choices are constrained, in the sense that they depend not only on what we want, but also on what we can afford. Left to myself, I always prefer to fly business-class, but my professorial salary prevents me from doing this much of the time.

These are reasonable assumptions and even if one does not necessarily agree with this definition of rationality (say the one about self-interest), one could think of these assumptions as being normative (what should happen); that is, prescribing a course of action rather than being descriptive. After all, it makes sense that individuals should look to maximize happiness; firms should maximize profit. A firm that does not maximize profit will be driven out of the market. So, in a sense, when economists think of humans, they have in mind Mr Spock or Sheldon Cooper.

Psychologists, on the other hand, typically start by assuming humans are “boundedly rational”;⁶ again, one could argue about what exactly this means, but my definition of “bounded rationality” is that we have limits on our cognitive abilities; we face constraints of time, computing ability and foresight; we often fall prey to biases and errors of judgement. Some problems are hard, some others we experience only infrequently. This implies that we have more experience and expertise with some problems than with others. Buying groceries does not pose much of a challenge; we do it all the time. But buying a computer requires more research; buying a car even more so. Buying a house is a decision we make infrequently.

Anyone who has bought a house knows how stressful this is. Which is the right house? Will it still be “right” when the kids are older? What neighbourhood? Which school zone? Close to the ocean? Better lifestyle but a longer commute. Or close to the highway, reducing commuting time but being in a less nice area. Which bank to approach for a loan? Which has the better rates? This bank is giving away a flat-screen TV while the other will pay the lawyer’s fee. A third is offering a low “teaser” rate. Which one works out better over the course of the loan lasting 25 years? Often, we look at a house which just “feels right” and so we ignore other factors that go against our judgement. The Duke psychologist Dan Ariely, supposedly an expert on human decision making, talks about how he found himself driving home in a brand-new, small, bright-red Audi convertible before he realized that, as the father of two young children, the car was far from what he and his family really needed. Even the most sophisticated and computationally savvy person struggles with these choices. This means that the possibility of making mistakes are higher, the less facility we have with the task at hand.

But is this all primarily about self-interest? What is best for me? What makes me and my close ones better off? We want to achieve the optimal outcome. We want to buy the right house in the right school zone, sign up for the right retirement plan, get the best possible health insurance and choose the best possible combined mobile phone and broadband package. But we often fail to do so just because some of these decisions...