When loss aversion is your loss

(credit: Jim Culp)

What are we really giving up when we are being led by extreme loss aversion?

An old friend of mine took up an unusual hobby at a relatively advanced age (well he was younger then than I am now, so maybe I will need to rephrase that). About ten years ago, he bought an old Formula Ford car and started participating in the Historic Formula Ford Car championship.

In his Christmas card (traditionally among the first we receive), he mentioned he had been doing quite well (“for his age”, he always adds) in the races he took part in this season. I had to explain to my wife what Formula Ford racing was: driving around at speeds of up to 130mph in an open top, single seater, open wheel car looking somewhat like cross between a go-cart and a Formula-1 car.

An adrenalin problem

There must be something wrong with his adrenalin, my wife said. Why on earth would a sensible person get into such a flimsy vehicle, to drive it around at breakneck speeds, risking life and limb?

I am not sure what it would mean in practice to ‘have something wrong with one’s adrenalin’. But if my friend has a preference for an adrenalin fix that can be fulfilled by driving an old car round a track, trying to overtake without being overtaken, then that might actually be a pretty rational thing to do. And maybe my better half’s conclusion that it would not be for her could be equally rational. The cost represented by the risk of an accident with dire consequences would not be outweighed by any identifiable benefit to her.

Extermeironing

The biggest problem is the extension lead (image: theredrocket)

But when we think of such pastimes, or of even more risky activities like BASE jumping, highlining or (the slightly frivolous) extreme ironing, do we actually make a conscious trade-off when we decide it’s not our bag? Perhaps not. What we do instead is zoom in on the risk, or more precisely on the potential loss (because we don’t even look at the probabilities). We visualize the terrible consequences of a mishap, and we conclude we want to avoid this – effectively at any price. We do not consider the possible upside.

That is, in a way, an extreme version of loss aversion. Typically this refers to our tendency to prefer avoiding a loss over acquiring an equivalent gain – i.e. we think it is worse to lose £5 than to miss the chance of gaining £5. But in this case we make no comparison: we simply choose to avoid the loss, full stop.

Businesses too display  extreme loss aversion. Earlier this week, economist and expert on global inequality Branko Milanovic tweeted his dismay with being unable to open his hotel window in Mexico to enjoy the mild temperatures outside. It did not open ‘for security reasons’.  Presumably the hotel wanted to avoid guests staying with them only to then promptly commit suicide by jumping out of the window.

Self-defenestration is an uncommon way to commit suicide in most countries. But it is the salience of events like this that might be behind such windows-firmly-shut policies. Here too, the thought of a really bad outcome, irrespective of the probability, inspires decision making.

It is not true that there is no loss, though. It is guests like Branko who pay the price, in inconvenience and frustration. (He was cold because of the permanently on aircon fixed to 18 degrees C, and so he had no choice but to switch on the space heater.)

Nuanced reasoning

barredwindow

Let’s not take any risks here. (image: PIRO4D)

It is easy to see (or think we see) irrationality in other people’s actions and decisions. But chances are we, too, are making choices based on fear of a certain outcome rather on a cool evaluation of costs, benefits and actual risk.

When news reports of assaults and muggings on the streets in the evening make us decide not to go out, it is true that we will avoid with certainty being assaulted and mugged out on the street. But the reports don’t give us an accurate view of how likely that is. And by staying in, we lose out on the chance of meeting up with friends, going to the cinema or the theatre. Is that a good trade-off?

When we have an invitation to a function with lots of interesting people, but we are afraid that nobody will pay attention to us and we’ll be a wallflower all evening, not going means we will be spared that deeply awkward experience. But no matter how vividly we can imagine standing on our own in a corner all the time, how likely is this really, and what delightful encounters might we miss?

When look at our savings and we anxiously want to avoid any kind of investment in which we might lose some of our capital, leaving all the money in a savings account with a pitiful interest rate, we definitely avoid losing our capital. But are we, by rejecting any prospect of loss, however improbable, really acting in our interest?

The simplicity of being led by the horror of the worst possible outcome is tempting. But if we really want to do what is best for us, we should try to resist it, and reason in a nuanced way. Only if we consider what we really give up by giving in to extreme loss aversion can we come to the right conclusion.

And who knows, maybe soon you too will be enjoying the thrills of extreme ironing.

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The compartments of your (financial) mind

(credit: Like_the_Grand_Canyon)

We are all mental accountants, for better and for worse

 

You probably have them too in your purse or your wallet: a stack of store loyalty cards. Every time you pass a till, you habitually hand over a piece of plastic, and as if by magic points – it’s always points – get added to your account. And then you get some vouchers to use next time, giving you extra points when you buy deodorant, breakfast cereal or canned plum tomatoes.

What you surely know, but don’t necessarily realize all the time, is that a point represents real money. Not much money, though. One point, at the supermarket where we get our groceries, is worth half a penny. There isn’t even a 0.5p coin any more – it was taken out of circulation at the end of 1984. But the points do add up, eventually.

A preference for points

They can generally be exchanged for a cash discount at the till, something a rational person would of course do at every occasion. Why leave them in what is effectively a 0% interest savings account? The best thing to do would be to keep your points balance as close as possible to zero, and reduce the shopping bill every shopping trip. But do I do so? Nope. And I am not alone: according to a Daily Telegraph article, in 2015 20% of loyalty scheme members had not cashed in any points in the preceding year, and 7% had never redeemed them.

loyaltycards

I am a very loyal person (image: Gordon Joly)

One possible explanation is the so-called euro effect. In her PhD dissertation, Amelie Gamble, a psychologist at the university of Göteborg, describes how our perception of actual value is influenced by the nominal value of a currency. If they have a higher nominal value (like the points) than the one we’re familiar with (like pounds) they tend to be seen as worth more. That means accumulating points feels more attractive than spending them: the 200 points you add to your account feel more valuable than the £1 reduction to your bill they would give you.

It’s also an example of what the Economics Nobel winner Richard Thaler has termed mental accounting. This is the practice of mentally dividing a resource like money into different categories. Strictly speaking, money is fungible: there is no difference between one pound coin and another one, or indeed between £1 and something else that is worth exactly £1 (such as 200 points). But that is not the way we look at things. Points are points, and money is money. At best, the points can be ‘supermarket money’. But we will not normally feel they can pay for, say, a family meal, even though we could easily use them to pay for our shopping, and then use the money we thus did not have to spend to pay the restaurant.

Jars of money

In an interview for American National Public Radio, Thaler gives a striking example of mental accounting (referring to this video). When they were both young and impecunious actors, Gene Hackman goes to visit Dustin Hoffman. Hoffman asks Hackman whether he can lend him some money. But in the kitchen, Hackman spots a range of jars, each with a label – rent, entertainment, books and so on. All contain some money, except the one labelled ‘food’. So he says, “You don’t need to borrow money – you’ve got money!” upon which Hoffman replies that he can’t take the money out of the other jars to pay for food.

Hoffman’s version of mental accounting may be quirky and amusing. But unlike the variant that leaves tens or hundreds of pounds in an account that doesn’t produce any return to us, it is actually not a bad idea, especially if you’re strapped for cash. It makes your trade-offs very visible. It helps you protect the money for the rent, and hence safeguard the roof over your head, and it challenges you to justify that you value entertainment more than food on the table.

money in the jar

Money in the jar

But mental accounting can also confuse and fool us, especially if others are doing the ‘mentalizing’. When we buy something online, we operate separate mental compartments for ‘stuff’ and for ‘shipping’, and sellers can play with this. If they have a low price for the ‘stuff’ then they can hook and reel us in, while we’re ignoring the ‘shipping’ compartment. Only some weirdo (don’t all look at me!) would scan every supplier’s offer, put prices and shipping charges in a spreadsheet, and work out the total cost for each one to find the cheapest overall. Then again, some sellers include shipping in the selling price. That makes comparison easy, and if they call it ‘free’ shipping, they might have the edge on those who still split it off. Zero cost in one of the compartments is very appealing.

Amazon is very good at using this ploy. With a low threshold to be entitled to free shipping (just $25, £20 or €29), the lure is often so great that we happily add another item to our order simply to get it delivered free of charge. And with Prime, the shipping cost becomes an entirely separate sunk cost we pay once a year as our subscription – which further entices us to buy ‘stuff’, and enjoy our free lunch while we fill Amazon’s coffers.

Is receiving a tax refund a good thing? Intuitively it sounds great: the mental jar labelled ‘tax’ is one to put money in, not one you can take money out. Finding extra money in it obviously brings a big grin to your face. Until you realize you’re fooling yourself: that money was yours all along. The tax man is simply giving you back what you overpaid earlier.

Beneficial trickery

But such trickery can actually benefit you. Last week, Moneyweek published a small article (it’s halfway down the page when you click) praising a change by the Nationwide, the world’s largest building society, to its retirement savings scheme. Before, employees contributed 4% of their salary (to which the employer added a further 9%), which they could increase to 7% (matched by the company). After the change, the maximum of 7% became the default, which employees could reduce back to 4% if they so wished. This turned out to be a very successful nudge using the status quo bias to encourage people to save more: while at first only 9% of employees made the maximum contribution, today a whopping 84% are doing so.

The real smoke and mirrors, however, are in the so-called “employer’s” contributions. Free money! Does that money really come from the employer? Well, yes, but so does the salary. The employer simply chooses to divide the total amount it pays an employee into two mental accounts: one in a jar labelled ‘wages’, and one in a jar labelled ‘pension contribution’. The free money is really an illusion, but more than the change in the default contribution, it is this illusion that is the allure of a retirement savings scheme.

Like so many psychological concepts, mental accounting is a two edged sword. Where does it help you, and where does it fool you? Just a little bit of mental effort will tell…

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Choices in the rear view mirror

(featured image credit: Fred Langridge)

A bad experience may look very different when it’s behind you. How bizarre!

Imagine a multi-day public transport strike is called for next week. You can’t take time off, or work from home, and it’ll totally screw up you commute. Is this a great prospect, or would you rather the strike was called off? Even more intense: imagine a soothsayer announces that, in three years’ time, you will go through a really bad patch in life, with alcohol and drug abuse, relationship breakup, and economic hardship. Would you look forward to that, or hope like never before that divination is a load of cobblers?

Given a say in the matter, most people would prefer to avoid both the strike and the down-and-out period in their life. Yet that is when the disruption lies ahead. It seems that when such an episode has happened to us, and we’re looking back on it, we may have a rather different view.

Looking from the other end

London experienced a two-day strike by tube station staff in February 2014, closing many stations completely (while others remained open as normal). Shaun Larcom, an economist at Cambridge University, and colleagues from Oxford and the IMF examined the individual travel patterns of 100,000 commuters during a 4-week period around those two days. Their findings are rather interesting: 5.4% of the travellers in their study changed to a different route during the strike, and continued to use this new route afterwards. This suggests more than 1 in 20 of them discovered a quicker way to and from work as a result of the strike: the typical gain was 3 minutes one-way (thus saving 6 minutes every day). On strike days, the average journey time had been  4.5 minutes longer (one way), so just three days after the strike the commuters who switched had recovered their ‘cost’.

By coincidence, last Sunday morning I was listening to a radio programme in which the host quizzed the guest (an actor) about his past. The conversation turned to a pretty dark episode pretty much like the one described above. Would he, given the chance to turn back the clock, choose to eliminate that period from his life? It didn’t take him long to answer. Despite the unmistakable downsides (addiction, guilt, broken promises, mental and physical bad health), it had led to a kind of rebirth, freed of demons. So no, he would not remove those years: without going through them, he would not have been able to deal with all the stuff that needed dealing with.

coke

But… the benefits! (image: L’Outil)

There is something intriguing about situations like this. It seems that – with the benefit of hindsight at least – the trade of a truly rotten experience, in return for which we get something valuable, is regarded as a rational exchange. But when we’re not looking back, but looking forward, we don’t see it that way.

Sure, not everyone comes stronger out of a drink and drugs fuelled period in their life, and 95% of commuters didn’t discover a better route. There’s no guarantee up front that a bad experience will have a benefit, so perhaps it’s risk aversion that makes us say no, given the choice.

At any cost?

But that doesn’t answer two other nagging questions. One is, how come we feel it has been a good trade after the event, almost irrespective of the cost? A transport strike may not be the end of the world, but a period of addiction can be hell. And there are other examples. You occasionally hear people say that losing their job was the best thing that happened to them. Occasionally? Googling “losing my job best thing” produces more than 100 million hits, and the first few pages are full of testimonials of people claiming just that.

One explanation is that our perception of the cost after the event may not be accurate. We are subject to a phenomenon known as time preference or intemporal discounting. The costs and benefits of a decision are experienced differently depending on whether they are situated in the present or at a more distant point in time. The reason why so many people fail to provide adequately for their retirement is because the future is far away: sacrificing money now for a benefit decades ahead is not attractive.

A 2005 paper by Dilip Soman, a behavioural economist at the university of Toronto and colleagues, comprehensively explains the psychology behind this. But it’s not just the benefit that looks small in the future, costs in the past can look small too. Think back of a time a few years ago when, say, you wasted a lot of time being delayed on a train, a plane or an automobile. It undoubtedly felt pretty unpleasant back then, but does it still weigh on your shoulders today? Probably not. So even the cost of a period of addiction, several years on, eventually fades in your perception, while the lasting benefits are still there.

Another factor is that we are masters at post-rationalization. We don’t like to admit to ourselves that we’ve made a bad decision, so we re-evaluate costs and benefits so that our choice makes sense. We even go so far as to misremember the facts. A 2006 paper by Linda Henkel and Mara Mather describes how people were asked to make a hypothetical choice between two used cars, each with a different set of attributes. A week later they asked the participants to explain their choice based on the corresponding attributes, but half of them were actually given the attributes of the car they rejected. Intriguingly, being given the wrong features didn’t stop them justifying their decision. Knowing they chose the black car, it must have been because they judged its attributes superior.

redcarblackcar

What were those features again? (images: Juan Salmoral & Natalla Romay)

The same thought process makes us believe that if X led to Y, and Y is a good thing, then X must have been a good thing too. If an unpleasant experience is linked with a beneficial outcome, we prove to ourselves that it was a good deal on balance, and after all.

Stuck in the status quo

The second question is: why do we seem only to make the changes we so value after having paid a high price? It’s easy to pretend your habitual underground station is closed, and look for an alternative – no need to wait for a strike. You can definitely explore alternative occupations without being fired. And it may not actually be easy, but if you have big life issues to deal with, it should be possible (and quite likely easier) to tackle them without adding drug dependency to your problems.

Here, a likely explanation is our old friend the status quo bias. We may not even have considered the possibility there is a better route to work: we simply do today what we did yesterday (something Dan Ariely calls self-herding). Thinking about another job, even if there is plenty in our current job we don’t like, is hard work, and better the devil you know after all. And if that is hard, confronting your own demons is a lot tougher still, so it’s easier to postpone doing so.

Disruption of your life by a strike, by being made redundant, or by engaging in self-destructive behaviour may be bad, really bad even. But it shuffles the deck for you: suddenly the barriers to change are not so big, or have disappeared altogether. You’re forced to change.

If rational thought can come to us after the event, there is no reason why it could not come before the event. We don’t really have to wait for misfortune to strike before we can make changes to our lives for the better. We can choose to challenge our habits, our reluctance to consider alternatives, our tendency to postpone hard decisions. We can choose to think rationally on beforehand, not just with the benefit of hindsight.

It would almost be like getting that most mythical of things: a free lunch – a benefit without a cost. That should be worth a little effort, shouldn’t it?

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Inescapable philosophy?

(featured image credit: Thor Edvardsen)

Do we need philosophy to fully understand and explain our behaviour?

(I am going to make a quick assumption here about your honesty.) How come you never engage in something like shoplifting? Surely doing so is to your economic advantage. Is it because it is against the law? Maybe because you are scared of being punished or humiliated? What if you were certain you wouldn’t get caught – would you then choose to do it? Do you actually consciously consider the possibility every time you are in a shop?

Behaviour and choice are two sides of the same coin. Almost all our behaviour is determined by choices we make. Neoclassical economics treats us largely as rational, self-interested, utility maximizing beings – the so-called homo economicus  – and seeks to explain how we choose, and hence behave, from that perspective. Not so fast, say psychologists and behavioural economists (the line between the two can be a bit fuzzy). We may like to think we are good at making rational decisions, but we have a few problems with willpower and self-control, quite a bit of our behaviour is a matter of habit or unconscious choice, and on top we bulge with cognitive biases and we fall prey to fallacies. We need those insights to explain our behaviour too.

Do these two approaches together give us all we need to understand people’s behaviour, and improve our decision-making? Not quite. Our choices are sometimes also determined by what we think is right and wrong – our moral intuition. Morality may not play a large part in choosing between a dark red or a beige jumper when we get dressed in the morning, but it creeps in when we are shopping (fair trade sugar or own brand?), want to get out of a visit to the in-laws (tell a white lie, or go anyway?), or indeed between sneaking an item past the attention of the shop assistant… or not.

Is it half a century already?

Questions relating to ethics belong in the domain of philosophy. In the same way that a behavioural economist can get excited by situations where people’s intuitions are not necessarily a good guide to what is best for them, a philosopher’s eyes can light up at the thought of moral dilemmas, where moral intuition is likewise not necessarily a good guide. A classic thought experiment that explores such a dilemma is the trolley problem.  British moral philosopher Philippa Foot first formulated it (almost as a by-the-by) in a 1967 paper in the Oxford Review.

Over the last 50 years, it has gained an unusual amount of fame for a philosophical device. In case you’ve never heard of it, or have forgotten, it is about the following question. Should you divert a runaway tram (as in Foot’s original) or trolley (in current parlance) headed for a track where five workers will be killed onto another track where just one worker will be killed, or instead do nothing?

trams

A difficult choice. (image: Minnesota Historical Society)

Not everyone is convinced of the value of such thought experiments, though. A couple of weeks ago, an article in Current Affairs entitled “The trolley problem will tell you nothing useful about morality” left little doubt as to the view of the authors. They believe it is so far removed from any ordinary moral choices that it’s ‘close to nonsensical’.

Yet this very problem is being wheeled out to explore and debate the behaviour of autonomous cars. What if a self-driving car is confronted with a situation in which it can either mow down five pedestrians and save the two people it carries, or avoid the pedestrians by crashing into a concrete wall, killing the two passengers? MIT’s Media Lab turned questions like these into scenarios in its Moral Machine. Kill three elderly men and two elderly women who are legitimately crossing road on a green signal, or a couple with two boys and a baby who are crossing on the red signal? Try it out for yourself: there are 13 standard scenarios and hundreds of user-made ones (you can make your own too).

Not a good guide

The trolley problem is not a good guide to help design the algorithms that (literally) drive an autonomous car. For the foreseeable future, cars will not be able to determine whether a person on the crossing is a devout church-goer or an evil killer. They will not know whether the café to the left is empty or hosting a kids’ birthday party, nor whether there is a mother with a baby in a pram about to emerge from behind a parked van.

Self-driving cars cannot help us make better moral choices in emergencies, based on better or more information. What they can do is help us avoid being distracted, or reacting impulsively but unwisely when something unexpected comes into the vehicle’s path. At best the artificial intelligence in self-driving cars can overcome our own weaknesses – from to the temptation to check our phone when it beeps and the susceptibility to road rage, to a tendency for tailgating the car in front and then slamming on the brakes when it slows down. But it is not some kind of superpower that can solve moral dilemmas.

A good guide

On the other hand, the authors of the Current Affairs article are too quick to dismiss the trolley problem as guidance for our human moral choices. Some people, for example those working in healthcare, face tough choices much like it. A paramedic confronted with two critical victims of a car crash must decide on the spot who to treat first. When the UK’s National Institute for Health and Care Excellence (and equivalent bodies in other countries) recommend or reject a new medicine, they effectively make decisions about who will live (longer) and who will not. Funds are limited, and every pound spent on a new anti-cancer drug cannot be spent on diagnostic equipment for ambulances. These choices are barely less horrific than those in the trolley problem.

ambulance

Or maybe an anti-cancer drug would be better? (image: Biotechnose)

And even in our more mundane lives, it is not because our moral dilemmas don’t always involve the choice between killing one person or five people that the choices we do face are trivial. A recent paper by Amitai Shenhav and colleagues describes how banal choices can cause as much anxiety as having to choose between options that are of great importance. Maybe a hypothetical life and death choice is not such a bad thought experiment to help us understand the nature of decisions that involve a moral dimension.

Should we let down our colleague who’s asking us to go for a drink and discuss a serious problem at work, or instead our partner who is cooking a meal this evening? If you’re deciding the fate of an underperforming member in your team, should you give them another last chance, or sack them (knowing that they won’t easily find a new job)? We frequently face situations not unlike these two examples: forced choices leading to a no win outcome… just like in the trolley problem. We can try to avoid them or look away, but that is not always possible.

Unlike irrational decision-making, where there is at least a rational benchmark against which it can be evaluated, such ethical dilemmas never have an obvious correct answer. There is no nudging, no behavioural economics trickery (and no artificial intelligence) that can help us make the right choice.

The best we can do is being aware of such quandaries. And the trolley problem, 50 years old this year, can still be a pretty good guide for us to learn to understand their complexity. If it makes undergraduate students, and the rest of us, realize the limitations of our simple moral intuitions, maybe we should wish it well for the next fifty years.

 

Posted in Behavioural economics, Cognitive biases and fallacies, Economics, Ethics, Morality, Philosophy | Tagged | Leave a comment

Social norms and sexual misconduct

(featured image credit: geralt)

If how we behave is motivated and moderated by what is socially desirable and acceptable, how can this be squared with the unending stream of allegations of inappropriate behaviour?

Social norms influence how we make choices. We are social beings, so it is unsurprising that we take our cues from others, and from how they respond to what we do. We want to belong and identify with our preferred social groups, and behaving in such a way that we conform to the group’s norms helps us do that.

Strong power or weak power?

Understandably, social scientists have been seeking to use social norms as an instrument to change people’s behaviour. In 2008, Noah Goldstein, Robert Cialdini and Vladas Griskevicius looked at how different messages placed in hotel bathrooms affected the reuse of towels. Compared with a standard message (use your towels again, and save lots of water and energy), one that pointed out that 75% of hotel guests reused their towels led to a 20% increase in towel reuse. If the message referred to the guests that had stayed in the same room, the increase was more than 30%.

towelreuse

…if you can be bothered. (source: A Room with a Viewpoint)

Social norms are now prominent in the toolkit of behaviouralists – it is represented by the ‘S’ in the British Behavioural Insights Team’s EAST framework for example.

But all this makes you wonder to what extent social norms are implicated in the unending string of allegations of sexual harassment and sexual violence, in the entertainment industry, in politics, in sports, and in workplaces everywhere.  If such behaviour is not acceptable, how come it is still happening?

Social norms are of course not black and white. Even the most powerful message in the hotel bathroom did not make 100% of the guests reuse their towels. Some people simply not have been be engaged enough, or distracted. Others may have had (in their eyes) good reasons to require new towels perhaps they were especially sweaty and grubby before showering, or they soiled the towels in some unspeakable way).

Norms influence our behaviour, but they generally don’t fully determine it. We rarely treat them as absolute and unconditional, and they compete with other factors. So we tend to be rather flexible in applying norms, even the ones we hold high, and we may trade off adherence against other considerations. If we are normally a well behaved driver who stops before an amber light and sticks to the prevailing urban speed limit, we may justify deviating from that norm and turning into a rather more aggressive driver when we’re late to get to the airport and catch the last flight.

And perhaps some people just believe that certain norms don’t apply to them – in the hotel bathroom, as in their relationships with co-workers. Like a medieval potentate who, not content with the taxes he raises on the meagre harvest of his serfs, still feels entitled to grab the best looking apple or carrot they’re taking to market, take a bite and then casually and ostentatively throw it away, so they feel entitled to ignore the rights and dignity of those over whom they have power.

Social norms have no grip on people who are convinced they don’t apply to them.

The norm of silence

But social norms appear in more than one way in this context. For a long time, the women and men at the receiving end of sexual harassment and sexual violence were stuck in a social norm in which victims remained silent. The behaviour of the perpetrators may have been unacceptable, but it was, de facto, accepted.

The informal #metoo movement may just be the catalyst that is needed. When victims feel it is OK speak out, the norm of silence is starting to crumble.

metoo

It should be *us* too. (photo: surdumihail)

But it’s not just among the victims that there is a need for a change in social norms. Those of us who are, thankfully, not victims, but witnesses are also stuck in social norms. We may find sexual harassment and sexual violence unacceptable, but do we really, unequivocally refuse to accept it? We’re often subject to a conflict of norms: we see someone do something that is not acceptable, but it turns out to be a friend or a relative, and ‘we are not a grass’, or ‘boys will be boys’. Or we turn a blind eye because we don’t want to get involved, or we appease ourselves with the thought that it’s always been like this.

Stop.

We should change our own norm of silence too. Sometimes there is no room for trade-offs. If behaviour is unacceptable, we should not tolerate it or seek to justify it.

Such social norms may not eradicate the behaviour of sexual predators. But they will more and more limit their ability to intimidate and attack others. And it is down to every single one of us to help them become the new norm.

 

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Is it our business?

(Image credit: stevepb)

Sometimes characteristics of products or services, or of those who sell them, immaterial as they are, can greatly influence our willingness to pay. Should they be any of our business?

500 years ago, on 31 October 1517, Martin Luther is said to have nailed his so-called 95 theses to the door of the chapel of the university where he was a professor of theology, in the German town of Wittenberg. In it he set out his fundamental objections to key elements of the Catholic doctrine and practices at the time. One of Luther’s main beefs with Rome was the widespread selling of indulgences, a kind of fast track ticket to heaven for sinners. In return for a generous donation to the Catholic Church they could redeem some of the time they would have to spend in Purgatory in the afterlife.

Luther’s objection was primarily theological: his conviction was that forgiveness for one’s sins required spiritual repentance, not cash transfers. But in a sense, he acted also as an early-day version of a consumer advocate, exposing indulgences as a product unfit for purpose. Ordinary people at the time had no way of verifying or challenging the claims of dodgy clergy, and so were effectively hoodwinked out of their money.

Unfixed values

Such practices are generally considered fraud nowadays. If you sell fake Rolex watches or Gucci bags, you risk prosecution. Misrepresenting material information in order to fool your customer into paying over the odds is generally illegal.

luthernailing

Early consumer champion with hammer

But that kind of fraud aside, knowing certain facts (or not knowing them) can significantly influence the price we are willing to pay for a good or a service. One of Richard Thaler’s classic thought experiments reveals the different price we are prepared for a beer on the beach (see ‘What’s the price?’). Standard economic theory says that we would establish the value of a beer based on how much we desire it, and irrespective of its provenance. But in practice, if we know the beer comes from a posh hotel we are willing to pay a good deal more than if we know it comes from a beach shack.

Let’s take this thought experiment a bit further. Imagine both you and your friend have read Thaler’s paper, and you agree two prices: a low one if she can buy the beer from a shack, and a high one if she needs to get it from a fancy hotel. She returns with the drinks, and you get your wallet to pay her. But how much? At that moment you don’t know where the beer came from, and none of its material features can make you any the wiser.

Your friend also happens to be a behavioural economist. To tease you, she refuses to tell you where she got the beer, and asks you to name your price. If it’s equal to or more than what she paid, you get the bottle, and if it’s less, she’ll drink it herself. Would you offer the true value of a beer to you, there and then, above which you’d rather stay thirsty? And would you feel miffed if that ends up being more than needed?

Not our business

This kind of reasoning, adjusting our willingness to pay to the underlying cost to the seller, doesn’t normally happen when we buy stuff from shops – a cup of coffee on the go, a loaf of bread, a winter coat…. Maybe that is because we assume that there is a reasonable mark-up, but usually we really don’t know. Perhaps the T-shirt for which we’re quite willing to pay the £20 shown on the price tag is bought in for just £2. If we knew, should that affect our willingness to pay?

Rationalists would of course say that is none of our business. As buyers, we should not concern ourselves with the details on the seller’s side prior to the transaction. No nonsense about beer from a shack or a fancy hotel, about mark-ups and profit margins. We should simply establish what a beer, a coffee, or a winter coat are worth to us, and use that to determine how much we’re prepared to pay. When we are thirsty we shouldn’t really be willing to pay less for a beer from one source than from another, any more than we should be offering less for a house that the seller inherited than for a house for which the seller made numerous mortgage repayments.

But it is it really irrational for us to incorporate the provenance of an item, or even the motives of the seller in our price deliberations? Isn’t it perfectly reasonable for someone to attribute value to the fact that their car used to belong to Steve Jobs, or to be inspired when they play on a guitar once owned and played by Beatle George Harrison… and pay literally over the odds for it? And isn’t it equally reasonable to take into account the negative emotions we might feel when we believe we are being overcharged by a seller only interested in a quick buck (and hence to reduce our willingness to pay)?

Our business

Perhaps it is our business after all. Just look at the practices of some el cheapo airlines. Zach Weinersmith captured the trend quite well in a cartoon last weekend:

smbc-discount

Things may not be quite that extreme yet, but what about extra legroom seats? In the olden days, the seats next to the exits were actually a bit inconvenient: backrests that couldn’t recline, and awkward tray tables. But as airlines squeezed more seats into their planes, the safety obligation to leave enough space near the exits became an opportunity. These seats don’t cost them any more than the other seats, yet they charge more for them, because they can. Fast track boarding (not to heaven, though) is a similar case of economic rent: let ordinary people wait longer, and charge those who are in a hurry extra money, simply because you can.

airlineseats

Ouch, my knees! (source: StelaDi)

Ultimately it is our choice whether we want to make those immaterial aspects our business. Yet we should be careful not to actually become irrational in the process. If we are prepared to pay $7 for a beer from a fancy hotel, wouldn’t we be cutting of our nose to spite our face if we refused, out of principle, to buy a beer from a simple shack at the same price, if that was the only place selling it? If it really is worth £10 to us to travel in comfort, would it be rational to refuse to pay for an extra-legroom seat simply because we don’t want to give extra  money to an evil airline?

There is no right answer to this: it depends on how much we value our principles. But that means we need to weigh them up against our thirst or our comfort, and not unconditionally let principles dominate.

The boundary between rational and irrational can be narrow and fuzzy.

 

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Comparing minds

(featured image: qimono)

A relativity principle possibly even more fundamental than Albert Einstein’s

A little while ago I sat working with the radio tuned to a show in which the hostess quizzes a celebrity for a couple of hours on the big things in their life: love, money, work, death. I was only half paying attention, but all of a sudden my interest was piqued, and I stopped doing what I was doing. The guest was saying that you can be happier when your car is completely wrecked and written off, than when it has just a few cosmetic scratches and a €1000 (£900) repair bill.

His explanation went like this. When you have a minor collision, the damage, and certainly the amount of money you’ll need to fork out to get the dent undented or the scratches unscratched seem disproportionate. Not just disproportionate compared to the actual severity of the bump, but there’s also the feeling that it was all just really bad coincidence, a millisecond of inattention, a moment of distraction. The price to pay for an event that, in any alternative universe, would never have happened, is way too high.

Good luck and bad luck

When you walk away with nothing worse than a bruised elbow after an almighty crash that reduces your vehicle to a bunch of tangled metal, however, you praise yourself lucky that the damage is just stuff. And this time the alternate universe that was just a millisecond away could have meant death, or worse.

In short: with the small accident, you were unlucky, but with the serious one, you were lucky.

The show’s guest is, to the best of my knowledge, not a behavioural economist, but he did twig an important behavioural economics observation: often the value we perceive in something depends greatly on how it is framed. It depends on what you compare it with.

As is the case for so many behavioural economics insights, this one too goes back to before even the first mention of the term. In 1890, philosopher and psychologist William James wrote (in The Principles of Psychology):

williamjames4

Image: based on Wikimedia

So we have the paradox of a man shamed to death because he is only the second pugilist or the second oarsman in the world. That he is able to beat the whole population of the globe minus one is nothing; he has pitted himself to beat that one; and as long as he doesn’t that nothing else counts.

One century later, psychologists Victoria Medvec, Scott Madey and Tom Gilovich looked at the emotional reactions of silver and bronze medal winners at the 1992 Summer Olympic Games in Barcelona. Both immediately after their performance, and subsequently when they are handed the medal, the silver medalists were rated as significantly less happy than the athletes who won bronze. Strange, isn’t it?

The researchers explain this through the counterfactual thinking of the persons concerned. The silver winner’s prominent counterfactual is the gold medal – a mere step away. Sure, the bronze medal is also just a step away, but that difference is a bit meh. It doesn’t feel like silver is so much more valuable: both silver and bronze are non-winners, and both still merit a place on the medal podium. For the bronze winner, in contrast, the defining counterfactual is not making the medal stand at all. The difference between third place and fourth place is huge.

This is very similar to the hapless driver, whose counterfactual in the one case is no accident at all, making the damage look very large, and in the other case being dead or severely injured, which makes mere material damage look insignificant.

Grounds for comparison

This kind of phenomenon arises even when it doesn’t involve loss (or not winning the big prize). A few days ago my daughter mentioned she was going to see the Royal Opera House ballet performance of Alice’s Adventures in Wonderland. Only, it wasn’t actually at the London Royal Opera House: it turned out to be a live satellite streaming event in a local cinema.

Tickets for the live performance in London were priced between £25 and £165. The cinema ticket cost £15.45, so even compared with the cheapest seat for the real thing (unlikely to be the best one in the house) that feels like a bargain. But the cinema’s other screens show ordinary movies, and then the cost of the Alice ballet is 50% higher than that of, say, Blade Runner. Not quite such a bargain, if that is the basis on which you make the comparison.

nespresso

Cheap or dear? You choose. (image: zeeh)

Small wonder clever marketers make use of how we make comparisons too. In Wiki Man, advertising executive Rory Sutherland explains how Nestlé succeeds in making consumers pay 31p for a cup of coffee they make themselves. A coffee made with the recommended 1.8g of Nescafé from a 200g jar priced at £5 would cost about 4.5p. If you were to buy your Nespresso pods from a similar jar, you’d pay an eye watering £33. Evidently, no one in their right mind would even contemplate that.

But of course they don’t make you compare their pods with (their own!) instant coffee. Instead they ensure the counterfactual is the £2.20 you pay for an Americano at Starbucks. And now your 31p coffee is a bargain for sure – making even the most expensive Nespresso machine (at over £400) pay for itself after just 200 cups. And the more you drink, the more you save!

Our minds are built to compare – or better, we evolved to be the successful species we are thanks to our mind’s ability to compare things.

But we should remember that our conclusions depend a lot on what we compare things with. Everything is relative. And as long as we’re well aware of that, we can truly benefit from our comparing mind.

 

Posted in Behavioural economics, Cognitive biases and fallacies, Economics, Emotions | Tagged | Leave a comment