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OMD – The Punishment of Luxury

November 16, 2017 Leave a comment

I came across this new album by Orchestral Manoeuvres in the Dark (OMD) – The Punishment of Luxury. For those of you are unfamiliar, OMD are a band from Merseyside Liverpool and have been long remembered for their hits “Electricity”, in 1979 and the 1980 anti-war song “Enola Gay”. The band achieved broader recognition via their seminal album Architecture & Morality (1981) and its three singles, all of which were international hits.

The “Punishment of Luxury” album is specifically about the global divide. Today the world is more unequal than at any time in world history which is due largely to the fact that 200 years ago everyone was poor. But the increasing wealth of the higher income group has been alarming – America’s top 10% now average more than nine times as much income as the bottom 90%. The fact that people are much better off materially doesn’t seem to translate into a better mental condition – they seem to be unhappy. If you are in this situation you have undoubtedly got on the hedonic treadmill and the marketing people have got under your skin. It seems that if you don’t have the latest brand of a product you are less worthy of being recognized by your peer group and have less self-respect.

It seems that the very wealthy have the same problems as the rest of us but only on a much larger scale. A research paper from Boston College entitled “Secret fears of the super-Rich found that the top fears of the rich are:

  • The rich need increasing amounts of money to make them feel financially secure.
  • They feel isolated and don’t share their concerns or stress as they will sound ungrateful.
  • Thy worry that their children will become spoilt by inheriting so much wealth or resentful if its too little.
  • You are unsure if your friends genuinely like you or your money
  • There is constant dissatisfaction with consumption as something better / new is always being launched. They can’t get off the hedonic treadmill
  • Parents are concerned that money will rob their children of ambition and getting a job.

The title track is below. It is very OMD for those of you who are familiar with the sound of the band.

AS Economics – Inflation Revision

November 13, 2017 Leave a comment

With the Cambridge AS and A2 multiple-choice papers on Wednesday here are some revision notes on inflation and a diagram that I have found useful. As well as cost-push and demand-pull inflation remember:

Inflationary Expectations

In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

Supreme and Economics

November 8, 2017 Leave a comment

SupremeStudents have long been talking about brands and none other than that of Supreme. Supreme was created in the 1980’s and was originally a brand which associated itself with the skateboard industry. There are currently 11 stores worldwide with three in the USA and six in Japan as well as store in Paris and London. In January this year Louis Vuitton held a fashion show featuring LV and Supreme as the two brands joined forces. Since then pop-up stores featuring the collaboration were opened on June 30, 2017 in Sydney, Seoul, Tokyo, Paris, London, Miami, and Los Angeles. It was the London pop-up that was recently the focus of an article in 1843 magazine of The Economist.

At 10am on Day One of the sale, a queue of about 600 people stretched down the Strand and along Surrey Street. Martin, Richard, Alex and Adita were all there. Running the queue for Louis Vuitton was security specialist Lex Showumni. “This is my first experience with Supreme. I was told it was going to be crazy, a lot of people pushing and shoving, but we haven’t experienced that so far.” The Supreme faithful have their own, slightly dubious, process of queue-management based on attendance and standing. It mostly works, but some people were unhappy: a trader had left the head of the queue to withdraw £12,000 from an ATM. He returned without the cash having lost his number 1 spot; eventually, after some animated discussion, he slipped back in near the front.

Each customer was admitted to the store for 15 minutes and allowed to buy six items. Successful trophy hunters included Ari Petrou, with a flipped T-shirt (around £400), that he was definitely keeping. Jeremy Wilson bagged a coveted red-logo baseball shirt (£730) that he planned to resell.

Within an hour, three main secondary exchanges had been set up outside the official store: one in the Pret A Manger, the other beneath a tree, and the third next to a municipal toilet. One dealer, who asked not to be named, explained that he had paid ten people a set fee to get early places in the queue and would give them a cut of the resale value of anything they could get their hands on. “It’s business!” he laughed. Wodges of cash were exchanged and stashed in newly acquired Louis Vuitton bags.

Invariably the hype that surrounds the pop-up store and the limited supply creates a situation where people get extremely anxious and are prepared to pay significant amounts of money for what could be classed as normal consumer goods.

There are certain economic concepts behind this.

Inelastic Demand – people who buy Supreme are are not price sensitive to purchasing items – a flipped T-shirt (around £400) seems quite excessive. A higher price has little impact on the quantity sold. In fact it maybe a Veblen Good – see below.

Limited supply – there is an artificially low supply of the product to maintain its uniqueness and ultimately it becomes very scarce. This creates excess demand which drives up the price

VeblenVeblen Goods – Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status. So-called Veblen goods (also as know as snob value goods) reverse the normal logic of economics in that the higher the price the more demand for the product – see graph.

 

A2 Revision – New Classical to Extreme Keynesian

October 27, 2017 Leave a comment

The main competing views of macroeconomics (Keynesian vs Monetarist) is part of Unit 5 in the A2 syllabus and is a popular topic in the essay and multiple-choice papers. Begg covers this area very well in his textbook. In looking at different schools of thought it is important to remember the following:

Aggregate Demand – the demand for domestic output. The sum of consumer spending, investment spending, government purchases, and net exports
Demand Management – Using monetary and fiscal policy to try to stabilise aggregate demand near potential output.
Potential Output – The output firms wish to supply at full employment after all markets clear
Full Employment – The level of employment when all markets, particularly the labour market, are in equilibrium. All unemployment is then voluntary.
Supply-side policies – Policies to raise potential output. These include investment and work incentives, union reform and retraining grants to raise effective labour supply at any real wage; and some deregulation to stimulate effort and enterprise. Lower inflation is also a kind of supply-side policy if high inflation has real economic costs.
Hysteresis – The view that temporary shocks have permanent effects on long-run equilibrium.

There are 4 most prominent schools of macroeconomics thought today.

New Classical – assumes market clearing is almost instant and there is a close to continuous level of full employment. Also they believe in rational expectations which implies predetermined variables reflect the best guess at the time about their required equilibrium value. With the economy constantly near potential output demand management is pointless. Policy should pursue price stability and supply-side policies to raise potential output.

Gradualist Monetarists – believe that restoring potential output will not happen over night but only after a few years. A big rise in interest rates could induce a deep albeit temporary recession and should be avoided. Demand management is not appropriate if the economy is already recovering by the time a recession is diagnosed. The government should not fine-tune aggregate demand but concentrate on long-run policies to keep inflation down and promote supply-side policies to raise potential output.

Moderate Keynesians – believe full employment can take many years but will happen eventually. Although demand management cannot raise output without limit, active stabilisation policy is worth undertaking to prevent booms and slumps that could last several years and therefore are diagnosed relatively easily. In the long run, supply-side policies are still important, but eliminating big slumps is important if hysteresis has permanent effects on long-run equilibrium. New Keynesians provide microeconomics foundations for Keynesian macroeconomics. Menu costs may explain nominal rigidities in the labour market.

Extreme Keynesians – believe that departures from full employment can be long-lasting. Keynesian unemployment does not make real wage fall, and may not even reduce nominal wages and prices. The first responsibility of government is not supply-side policies to raise potential output that is not attained anyway, but restoration of the economy to potential output by expansionary fiscal and monetary policy, especially the former.

A2 Revision – Oligopoly and the kinked demand curve – download

October 25, 2017 Leave a comment

With the A2 Essay paper next week I thought something on the kinked demand curve might be useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

Behavioural Economist Richard Thaler wins Nobel Prize in Economics.

October 10, 2017 Leave a comment

Great news for Behavioural Economists with Richard Thaler winning the Nobel Prize for Economics in 2017. Below is an interview with Richard Thaler on the PBS NewsHour – Making Sense by Paul Solman to launch his then new book “Misbehaving”. Notice that the book is 30% off in the Chicago Booth Bookstore. As Thaler says people love deals and can be driven to purchase things that they don’t really want if the deal is good enough. He explains the concept of sunk costs, time and money already spent with some Cameroonian students. Also the way most people value their time.

Richard Thaler, also the co-author of the book  “Nudge” , has suggested that economics has always been about behaviour. Adam Smith’s first book “The Theory of Moral Sentiments” is in fact a Behavioural Economics treatise and within it Smith talks about its contribution to both psychology and ethics. Its purpose is to find a rationale for ethical judgement in human psychology. The latter is found in human nature: a human being put in a certain situation has a tendency to react in a certain way eg. includes sympathy, feelings and approval by others. It was Smith’s belief that human behaviour was impacted by emotions such as fear and anger and drives such as hunger. However according to Smith these emotions and drives were checked by an “impartial spectator”.

The impartial spectator allows one to see one’s own feelings and the pulls of immediate gratification from the perspective of an external observer.

In the domain of self-control and self-governance, the impartial spectator takes the structure of a long-term interest – “I won’t have that rich cream cake at morning tea because I can see that I will feel guilty about it later”. In the area of social interaction, the impartial spectator allows us to see things from another’s perspective rather than to be blinded by our own needs. The dissention is especially significant when you consider savings decisions – savings is a precision choice to delay immediate indulgence for a long-term interest. So we have the conflict between the voice of a short-term pull versus the voice of the impartial spectator.

Only recently has the field of economics advanced enough to have the tools to reincorporate the factors that Smith had always felt were important in human interaction: our caring about each other and about fairness, our difficulties with aligning our long-term interests with short-term pulls, etc. One of the most unexplored areas, which we are only now beginning to be able to measure, is the degree to which people are motivated by reputation and social status, something Smith thought was a crucial motivation for economic activity.

Nudge

The essence of behavioural economics stems from a concern that rational behaviour driven by self-interest will not guide many of us to health, wealth and happiness. People tend to make bad decisions whether it is not saving or eating the wrong type of food. This disturbing state of affairs arises because homo economicus tends to be in a continuous condition of information overload, and consumer makes errors because of their unfamiliarity about options and their effect. Richard Thaler and Cass Sunstein argue in ‘Nudge’ that subtle changes can influence peoples decision so that they can make choices that will improve their well-being. However, consumers use various methods in deciding their optimal consumption as the cost (time and effort) of acquiring all the information about the benefits of product/service might outweigh the benefits of consuming it.

Homo Economicus – the basis for a majority of economic models is the assumption that all human beings are rational and will always attempt to maximize their utility – whether it be from monetary or non-monetary gains

Categories: Behavioural Economics Tags:

Lower income extroverts spend more on status enhancing goods

October 2, 2017 Leave a comment

People who are ‘extraverted’ and on low incomes buy more luxury goods than their introverted peers to compensate for the experience of low financial status, finds new UCL research. In Psychological Science, Dr Landis and Dr Gladstone analyse a year of data from more than 700 British bank accounts in 2014. They sort purchases into categories, ranging from high-status (foreign air travel, electronic goods and so on) to low-status (money spent at salvage yards and discount stores). They then correlate the results with those from personality tests taken by the account-holders.

People living on a low income often feel low status in society and spend a higher percentage of their money on goods and services that are perceived to have a high status. Previous research has found that people who are sociable and outgoing care more about their social status than others. The new research shows that when extraverted people have a lower income, they spend proportionately more on status goods than introverts on the same income. At higher incomes, the difference in spending lessens as introverted people buy more luxury goods.

The study analysed thousands of transactions from 718 customers over 12 months. The results took into account other factors that could influence spending habits, such as age, sex, employment status and whether the customers had children. Cash spending was also taken into account.

low income conspicuous cons.pngEach person’s spending data were sorted into a number of spending categories from one (very low status) to five (very high status). High-status categories (i.e., those with average scores of four or five) included foreign air travel, golf, electronics and art institutions, whereas low-status categories (i.e., those with average scores of two or one) included pawnbrokers, salvage yards and discount stores.

The team found the interaction between income and extraversion in predicting spending on luxury goods is significant and emphasize that while this useful in understanding the relationship, further research is needed to see whether the relationship is causal and whether the results are representative of the UK population as a whole.

The study found, though, that the gap widened with poverty.

  • Extroverts with an annual income of £10,850 the 25th percentile of British individual incomes in 2014, spent approximately 65% more on high-status goods than similarly remunerated introverts did.
  • Extroverts with an annual income of £28,470 the 75th percentile, they spent only 14% more. This suggests how keenly extroverts feel about keeping up appearances.

Sources:

  • The Economist “Poor extroverts spend proportionately more on buying status” 26th August 2017
  • UCL – Personality drives purchasing of luxury goods – 23rd August 2017

Veblen Goods and inconspicuous consumption?

August 27, 2017 Leave a comment

Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status.

Economists and sociologists often cite the 1980’s as a time of extreme conspicuous consumption. The yuppie materialised as the key agent of conspicuous consumption in the US. Yuppies didn’t need to purchase BMWs or Mercedes’ cars for example; they did so in order to show off their wealth. This period had its origins in the 1930’s with Austrian economists Ludwig von Mises and Fredrick von Hayek – the latter being the author of “The Road to Serfdom”, in which he said that social spending rather than private consumption would lead inevitably to tyranny. Margaret Thatcher (UK Prime Minister 1979-1990) and Ronald Reagan (US President 1981-1989) believed in this ideology and cut taxes and privatised the commanding heights in a move to a free market environment.

VeblenSo-called Veblen goods (also as know as snob value goods) reverse the normal logic of economics in that the higher the price the more demand for the product – see graph below

Over the last three decades conspicuous consumption has accelerated at a phenomenal level in the industrial world. Self-gratification could no longer be delayed and an ever-increasing variety of branded products became firmly ingrained within our individuality. The myth that the more we have the happier we become is self-perpetuating: the more we consume, the less able we are to tackle the myth.

However a recently published book The Sum of Small Things: A Theory of the Aspirational Class by Elizabeth Currid-Halkett looks at how the power of material goods as symbols of social position has diminished due to their accessibility. Although the lower income groups must dedicate a greater proportion of their income to basic necessities, they spend a higher share of their income to conspicuous consumption than the rich do. Between 1996 and 2014 the richest 1% fell further behind the national average in the percentage of their spending dedicated to bling. The middle income quintile went the other way: by 2014 they spent 35% more than the average as a percentage of their annual expenditure.

According to Elizabeth Currid-Halkett the higher income groups have moved away from buying stuff – materialism – to more subtle expenditures that reveal status and knowledge. The most common of them being education for their children.

Those in the top 10% of income earners now allocate four time as much of their spending to school and university compared to 1996, whereas for other income groups spending has remained fairly constant. However one could say that fees for both school and university have increased over that period of time. The upper class also invest heavily in domestic services such as housekeepers, freeing up time that the less fortunate must spend on chores.

Rather than frittering away that precious leisure time on frivolities, as Veblen’s leisure class did, they devote it to enriching experiences, like attending the opera, holidaying in far-off lands and working out at fancy gyms. Their children, by tagging along and thus absorbing this “cultural capital”, develop the sophistication needed to win admission to selective universities, vastly increasing the odds that they will form the next generation’s elite. The modern equivalent of Victorian worsted-stocking wearers are hipsters, who imitate the wealthy’s penchant for farmers’ markets and fair-trade lattes, even if they cannot afford a cruise to Antarctica.  Source: The Economist – August 5th 2017

 

 

Retail stores now target consumer body language.

August 12, 2017 Leave a comment

Keeping on the behavioral economics topic I was interested to read about shoppers emotions being used by retailers to try an increase sales. Companies now pay large sums of money for software that identifies the following:

  • shoppers’ movements
  • facial expression
  • dissatisfaction
  • surprise
  • eye-tracking
  • dilating pupils
  • thermal-imaging

Body language.pngSome research has shown that when a person who is smiling enters a shop they are on average likely to spend 30% more than others who are more neutral position in their emotion. Conventional research states that when people are interviewed or fill in surveys they tend to edit their responses to make them sound like a ‘rational person’. However a lot of purchases are driven by the subconscious emotions. There are various companies out there today that are trying to get in the mind of consumers namely:

We have all heard of retail therapy which involves people going on a spending spree when they tend to be feeling down. The challenge for all the companies out there is to spot when a person is in this state when they enter their shop. The key to it is tracking the unconscious mind in shoppers.

Try this exercise with your class and see how many stages they can get through. If we make persistent errors in things we are very good at like colours how likely is it that we are also subject to persistent, predictable errors in areas of consumer decision-making?

Categories: Behavioural Economics

More loss aversion in male tennis players when behind.

August 4, 2017 Leave a comment

A paper entitiled ‘Is Roger Federer more loss averse than Serena Williams?’published by By Nejat Anbarci, K. Peren Arin, Cagla Okten and Christina Zenker on tennis serving and loss aversion caught my attention. The paper found that:

Roger_Federer.jpg
1 a server will put more effort into his/her serve speed when behind in score than when ahead in score,
2 players’ effort levels and thus serve speeds get less sensitive to losses or gains
when score difference gets too large,
3 A female player, on the other hand, does not change her serve speed and thus her effort when behind compared to when the score is tied, while she serves slower when ahead than when the score is tied.
4. Overall servers will be more risk averse in the domain of gains than in the domain of losses.
Researchers used serve speed at different points of matches in the high-stakes, professional Dubai Tennis Tournament to test their theoretical predictions and whether overall players exhibited the fundamental bias of loss aversion.

 

Loss Aversion and the  Endowment Effect

Loss aversion can be explained by prospect theory, which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude. This is illustrated below.

Prospect theory

The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained. Golf provides a perfect example of a reference point: par. Every hole on a golf course has a number of strokes associated with it; the par provides the baseline for good – but not outstanding – performance. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Economists have compared two situations a player might face when hear the hole:

  • putt to avoid a bogey
  • putt to achieve a birdie

One group of economists analysed more than 2.5 million putts in exquisite detail to test that prediction and found that whether the putt was easy or hard, at every distance from the hole, the players were more successful when putting for par than for a birdie. The difference in their rate of success when going for par (to avoid a bogey) or for a birdie was 3.6%.

 

Rethinking Economics – Econocracy

August 2, 2017 Leave a comment

You might have come across the book ‘Econocracy’ written by students from the University of Manchester which makes three big arguments about the relevance of economics courses at Universities.

First, economics is part of all aspects of our public life. Second, the economics profession sees the economy “as a distinct system that follows a particular, often mechanical logic” and believes this “can be managed using a scientific criteria”. It would not be recognised by Keynes or Marx or Adam Smith. Thirdly, the authors criticised what economics students are being assessed on – models or theories which were being memorised for exams.

The interview below on Newsnight (BBC2) has author and student Joe Earle and Professor Diane Coyle (follow her excellent blog The Enlightened Economist) discussing the state of the discipline at University and what they don’t teach to economics students. More information can be found on the website Rethinking Economics.

The value of beliefs in economic decision-making.

July 24, 2017 Leave a comment

BE - Cognition.jpegThe economic environment is said to be determined by agents or economic decision-makers. Today, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy.These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. However the rise of behavioural economics has shown that cognitive errors are now assumptions in many aspects of economics namely – heuristics, confirmation bias, overconfidence and distorted probability weights.

According to a paper entitled “Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol research has shown that beliefs often fulfill important psychological and functional needs of the individual. Examples include:

  • confidence in ones’ abilities,
  • moral self-esteem,
  • hope and anxiety reduction,
  • social identity,
  • political ideology
  • religious faith.

Therefore people hold beliefs because of the value they attach to them, as a result of the tradeoff between accuracy and desirability. As a consequence of this some of the beliefs do not consider prior knowledge of conditions or events that might be related to their beliefs – Bayseian Updating – this refers to people who are willing and able to modify their beliefs based on new, objective information. This non-Bayesian behaviour includes ignoring signals about their beliefs and denying what in turn will be the reality. Nevertheless motivated beliefs will respond to costs, benefits, and stakes involved in maintaining different self-views and world-views which leads to self-sustaining “social cognitions.”

Overconfidence
Bénabou and Tirol suggest that overconfidence is the most common indicator of the motivated beliefs experience. Overconfidence can be seen as quite damaging although moderate confidence can be quite useful as it often enhances an individuals ability to act successfully on their own behalf and work well with others. Research has shown that psychologically “healthy” people display some degree of overoptimism and biased updating, while it is primarily depressed subjects who seem to be more objective.

If beliefs are shared between parties they may magnify each other and there is a tendency to follow the herd, especially if information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets. Case and Shiller (2003) surveyed the expectations of homeowners during the real-estate bubbles of 1988 and 2003. In both cases, 90 percent of respondents thought housing prices in their city would “increase over the next several years,” with an average expected gain for their own property of 9 to 15 percent per year over the next ten years.

The strategies of self-deception and dissonance-reduction used to protect valued beliefs are many and varied, Bénabou and Tirol group them into three main types: strategic ignorance, reality denial, and self-signaling.

Strategic ignorance is when a believer avoids information offering conflicting evidence.

Reality denial refers to troubling evidence that is rationalised away: house-price bulls might conjure up fanciful theories for why prices should behave unusually, and supporters of a disgraced politician might invent conspiracies or blame fake news.

Self-signaling is when the believer creates his own tools to interpret the facts in the way he wants: an unhealthy person, for example, might decide that going for a daily run proves he is well.

Final thought

People derive utility from a sense of belonging to communities and having a positive self-image. Optimistic beliefs can also be valuable motivators to overcome self-control problems, as well as helpful in strategic interactions. In order to maintain this level of utility people tend to disregard Bayesian updating and are not willing to modify their beliefs based on new, objective information. Even if they did consider new information they will manipulate it to align with what their beliefs are.

Overconfidence is the most common indicator of the motivated beliefs experience and this can be impacted by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.

Sources:

“To err is human; so is the failure to admit it” – The Economist June 10th 2017

“Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol. Journal of Economic Perspectives—Volume 30, Number 3—Summer 2016—Pages 141–16

Categories: Behavioural Economics

1980’s hyperinflation in Bolivia

June 19, 2017 Leave a comment

When you think of hyperinflation countries like post-war Germany and Zimbabwe come to mind. However Bolivia in the 1980’s seems to have been a forgotten example. Below is a very good video about the hyperinflation in Bolivia from the PBS Commanding Heights series. I use it teaching the impact of hyperinflation on an economy and policies that to try and control its impact. Some of the main issues from the video are:

  • Inflation reached 23,500%
  • 7 out of 10 Bolivians live in poverty – the poor get hurt by inflation
  • Inflation averaged 1% every 10 minutes
  • One of the causes of the inflation was government finances – they just printed money and didn’t collect taxes
  • How do you stop a hyperinflation or an inflation? Gradualist steps don’t work and as Jeff Sachs said: “All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”
  • Bolivia didn’t use highly sophisticated economic theory to deal with hyperinflation: Government spending was slashed – Price controls were scrapped – Import tariffs were cut – Government budgets were balanced. 

Inflationary Expectations

A lot of the inflationary problems in Bolivia were caused by inflationary expectations which accelerates the problem. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

 

Behavioural Economics and reclining airline seats

June 2, 2017 Leave a comment

I picked up this topic from Michael Cameron’s blog Sex, Drugs, and Economics which looked in detail at the economics behind reclining airline seats. The issue that he refers to is – who owns the space between reclining airline seats?

Externalities

The person (Recliner) who reclines their seat reduces the amount of space that the person (Reclinee) behind has especially if they have their tray table down and becomes a negative externality to them. Some airlines are worse than others with regard to space – American carriers tend to have very little room as do the low cost airlines. However carriers that operate more long haul flights especially Emirates seem to be more generous with the space between seats. However if there is nobody in the seat behind then there is no externality. This refers to the Coase Theory (see previous blog post) in which Ronald Coase stated that problems are jointly produced by the person who creates the externality and the person who is affected by it. He argued that bargaining between parties could produce a mutually beneficial and efficient solution to problems like the scares resource i.e. the space between airline seats.

An article on the site Evonomics by Buccafusco (Cardozo School of Law) and Sprigman (NYU School of Law) looked at research into how much passengers would be willing to pay to recline their seat. They looked at the following scenarios.

Default – you have the right to recline your seat
Recliners wanted on average $41 to refrain from reclining, while reclinees were willing to pay only $18 on average. Only about 21 percent of the time would ownership of the 4 inches change hands

Default – you don’t have the right to recline your seat and have to negotiate
Recliners were only willing to pay about $12 to recline while reclinees were unwilling to sell their knee room for less than $39. Recliners would have ended up purchasing the right to recline only about 28 percent of the time—the same right that they valued so highly in the other condition.

The Coase theorem suggests that the initial allocation of rights should not matter, because if the person who values the right the most doesn’t start out with it, they will simply purchase it from the other. But what Buccafusco and Sprigman found suggests that this simple solution might not work. What they found was an endowment effect.

Loss Aversion and the  Endowment Effect

Loss aversion can be explained by prospect theory, which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude. This is illustrated below.

Prospect theory

The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained. Golf provides a perfect example of a reference point: par. Every hole on a golf course has a number of strokes associated with it; the par provides the baseline for good – but not outstanding – performance. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Economists have compared two situations a player might face when hear the hole:

  • putt to avoid a bogey
  • putt to achieve a birdie

One group of economists analysed more than 2.5 million putts in exquisite detail to test that prediction and found that whether the putt was easy or hard, at every distance from the hole, the players were more successful when putting for par than for a birdie. The difference in their rate of success when going for par (to avoid a bogey) or for a birdie was 3.6%.

Note that endowment effects are working for the ‘reclinees’ as well – they are willing to give up their extra knee room for $39 if they had the right to keep it, but would only be willing to pay $18 to get that right if they didn’t start out with it.

The endowment effect means that this problem isn’t really amenable to a simple solution, because recliners already have the default rights, and are understandably unwilling to give those rights up. And any change in policy is going to incur passenger protest – because even though we may gain knee room, passengers would be giving up their right to recline, and loss aversion almost ensures that would be a painful and unwelcome trade-off for most passengers.

J.Cole and the Hedonic Treadmill

May 15, 2017 Leave a comment

Below is a very good video from rapper J.Cole in which he talks about the insatiable demand for material things and how it will never make people happy.

Affluent youth in the USA have rates of depression and anxiety which is more than twice the national average. Wealth has been linked to high rates of depression, anxiety, psychosomatic issues and self-mutilation. It seems that the very wealthy have the same problems as the rest of us but only on a much larger scale. A research paper from Boston College entitled “Secret fears of the super-Rich found that the top fears of the rich are:

  1. The rich need increasing amounts of money to make them feel financially secure.
  2. They feel isolated and don’t share their concerns or stress as they will sound ungrateful.
  3. Thy worry that their children will become spoilt by inheriting so much wealth or resentful if its too little.
  4. You are unsure if your friends genuinely like you or your money
  5. There is constant dissatisfaction with consumption as something better / new is always being launched. They can’t get off the hedonic treadmill
  6. Parents are concerned that money will rob their children of ambition and getting a job.

“ONE OF THE SADDEST PHRASES I’ve heard,” Kenny says of his time counseling the wealthy, is when the heir to a fortune is told, “‘Honey, you’re never going to have to work.’” The announcement is often made, Kenny explains, by a rich grandparent to a grandchild—and it rarely sounds as good to the recipient as to the one delivering it. Work is what fills most people’s days, and it provides the context in which they interact with others. A life of worklessness, however financially comfortable, can easily become one of aimlessness, of estrangement from the world. The fact that most people imagine it would be paradise to never have to work does not make the experience any more pleasant in practice.

The Atlantic 

 

Behavioural Economics Presentation – download.

April 2, 2017 Leave a comment

Below is a pdf download of a presentation on consumer behaviour that I did for our Yr12 and Yr 13 students last week. It focuses on the following:

Hedonic Treadmil – Paradox of Choice – Algorithms and Choice – Happy Money – Well-being around the world.

Click here to download. I particularly like these images.

Hedonic-TreadmillTV - paradox

Sky TV and the Paradox of Choice

March 13, 2017 Leave a comment

Flicking through the TV channels one evening one found that what was supposed to be a time of relaxation was actually quite tiring. Surely with more choice and freedom to chose what to watch I would be a lot more content. In the age of the Internet, smartphones etc  there is a paradoxical effect in that we have access to an endless amount of movies, TV programmess, documentaries, sport etc.

My mind went back to Barry Schwartz’s TED talk “The Paradox of Choice” and what he calls the “official dogma of all western industrial societies” – see below. This is the common belief that by maximising one’s choice, we are maximising their freedom, and therefore their welfare. A clear intuitive example is a medical doctor offering a patient certain treatment options. The patient has choice, but he/she would most likely lack the knowledge and physical state of mind to make the best decision. Obviously, it should be better if the doctor, with all their experience and knowledge, makes the decision, even though it restricts the patient’s choice.


However freedom can do more harm than good in that it paradoxically causes paralysis in decision-making. When people have a lot of freedom, they have to spend time and effort considering the many options and making a decision. Should I watch rugby, cricket, league or ESPNFC on Sky? What about PBS News, CNN or Discovery? Some will say just record the programmes you didn’t watch but what you end up doing is filling your disk so that you can’t record anything else. These rather futile, yet difficult decisions make us indecisive, slow, and permanently pre-occupied in our lives, all thanks to the “problem” of having a bit too much freedom. Growing up in Ireland we had access to BBC1 Match of the Day (two games of highlights from English Football Division 1 – Premier League now) and it was something that you really looked forward to – 10pm on a Saturday night. Here there is limited choice and because of this maybe more satisfaction in that I didn’t have to worry about who or what to watch. In fact the pleasures of anticipation of Match of the Day on Saturday built throughout the week and provided more happiness – research shows that waiting for something – a chocolate – makes it taste better when we get it.

However, there are some more subtle cognitive effects that come with more freedom. First, it is very easy to imagine that there was a better choice than the one that you had chosen – i.e. the opportunity cost can take away your happiness from your current decision. This causes us to regret our own decisions (even if the option we took was the best choice), and this can seriously damage how satisfied we are with something. And with more freedom, comes more capacity to imagine that the grass is greener on the other side.

Finally, in this “choice-full” world of today, people are bound to choose an option that is almost perfect. Schwartz talks about how there only used to be one kind of jeans that you could buy, compared to the many different colours, fabric, fit, and size that you can buy today. He claims that by being able to buy such near-perfect jeans, you have such high expectations for the next pair that you can’t be completely satisfied. He jokes: “the secret to happiness is low expectations.”

Maximizers and Satisficers

With so much choice today we tend to fall into two categories of consumers.

Maximizers are those people that spend all their time exhaustively search for every piece of information about a product in order to make what they believe to be the perfect choice. However it can lead to nagging doubts about their choice and they can become unhappy.

Satisficers are those people that settle with the decision that is good enough and seem to be happier with their decision.

Macroeconomic models – a new approach needed.

March 3, 2017 Leave a comment

In 1776 Scottish economist Adam Smith talked of the economy as the invisible hand. Here he emphasized the self-regulating nature of the economy as individuals, firms and companies independently seek to maximize their gain which may produce the best outcome for society as a whole. The capitalist systems seems to rely more on the relentless growth of consumer spending and, although it can lead to dramatic improvements in standard of living, it does require people to become resolutely addicted to products/services and be prepared to get into significant debt.

Today, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy.

DSGE.png

Therefore it assumes that all individuals and firms have identical needs and wants which they pursue with total self-interest and complete knowledge of what they desire. DSGE also takes into account the impact of shocks like oil prices, technological change, interest rates, taxation etc. However a couple of areas that it doesn’t represent accurately is the financial sector and the instability of markets – booms and slumps. A new task will be to include the banking sector into the models as macroeconomists assumed it to be a screen between savers and borrowers rather than profit orientated organisations prepared to take big risks with increased leverage and sub-prime lending. For example as house prices increase banks are willing to lend more money to speculators who bid up the price above what is the fundamental value. The opposite applies if banks become more risk adverse and marginal buyers are forced out of the market causing prices to drop. By representing the financial sector in an economic model you go some way to help solve the major problem with DSGE and other models in that they are useful only if they are not unsettled by external factors like a banking crisis.

Keynes said “If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!”. To achieve this there needs to be structural reform in the discipline.

Agent-based modeling

An emerging field called agent-based modelling has grabbed the attention of some economists. This is where large amounts of data is collected from individuals who are unique to each other in they have different motives and actions in the market place. The behaviour of these individuals overlap and interact which generate predictions through a messy process but similar to what happens in real life, unlike DSGE and the clean old-fashioned macroeconomic models. Agent-based modeling has also shown promise in other disciplines like Physics and involve real-world problems. The example used by John Lanchester (New York Times magazine) is how Brazil nuts seem to end up towards the top of the mixed-nut package and nut research has since found real-life applications in industries such as pharmaceuticals and manufacturing.

With a better sense of what is influencing behaviour in the economy, economists might become less blinkered by their own theory, and better able to foresee the next crisis. Meanwhile, they would be wise to repeat (daily) the words: “My model is a model, not the model.”

Final thought

Macroeconomic models need to be adapted to take account of the events of the last 20 years. For so long typical macro model has been DSGE but as yet no model includes the impact of recessions and the eighty-year depressions. Economics failed to predict or prevent the GFC and this was based on conceptual faults which included a refusal to engage with the role of the banking and finance system in the economy.

Dani Rodrik of Harvard University splits economists into two camps: hedgehogs and foxes.

Hedgehogs take a single idea and apply it to every problem they come across.

Foxes have no grand vision but lots of seemingly contradictory views, as they tailor their conclusions to the situation.

Maybe more fox like behaviour is needed.

References

New York Times Magazine – The Major Blind Spots in Macroeconomics

The Economist – A less dismal science

 

Cash is a rational birthday present but inappropriate

February 23, 2017 Leave a comment

Here is a clip from Seinfeld that I use when teaching Behavioural Economics. It seems rational that Jerry gives Elaine $182 for her birthday but it really is inappropriate. Cash replaces social norms by market norms and ruins the feelings usually evoked by a typical non-cash birthday gift. The deadweight loss of giving is the loss of efficiency that occurs when the value of the gift to the recipient is less than the cost of the gift to the giver. In this case, economists argue that cash would be a more efficient gift.

Options for taking on Trump – the Japanese Model.

February 7, 2017 Leave a comment

trump-abeA colleague alerted me to a Terrie Lloyd a New Zealand businessman in Japan who writes a weekly newsletter. With the election of Donald Trump his recent writing looked at bullies and ways in which you deal with them. Shinzo Abe, the Japanese prime minister, has been proactive in getting to know Trump and his team and how the two countries can work together.

Research on bullies

Lloyd suggests that there are generally three ways to deal with a bully.

Run – UK seem to be taking this option
Fight – Chinese will do this
Suffer and appease – Japan, having a bullying culture already, will go for appeasement

Abe will be meeting with Trump on 10th February for a second time in as many months and will want to convince him that Japan is one of the good guys and if he has to pick on someone in the area he should pick on China. For this to work Abe also needs to feed Trump’s ego publicly

Lloyd looks at the work of Dacher Keltner who has written about appeasement and related
human emotion and social practice. He looks at two general classes of appeasement.

1) reactive – the person provides appropriate responses after incidents and these responses are usually public displays of embarrassment and shame.
2) anticipatory appeasement where a person is proactive and engages in certain strategies to avoid conflict. Polite modesty and shyness are also considered anticipatory appeasement.

Japanese Model for dealing with bullies

With Japan taking the latter option, Keltner is suggesting that Abe must appease Trump with gifts of value and that they are seen publicly to assist Trumps power and reputation. Last month the Japanese gave access to US car manufacturers but will that be enough to keep Trump happy? At the meeting on 10th February Abe will propose a package that could generate 700,000 U.S. jobs and help create a $450-billion market. It includes the building of infrastructure projects such as high-speed trains in the northeastern United States, and the states of Texas and California, and renovating subway and train cars. It also includes cooperation in global infrastructure investment, joint development of robots and artificial intelligence, and cooperation in cybersecurity and space exploration, among others.

Toyota the car manufacturer has also been taking the appeasement option after the Trump administration criticised their building of a second car assembly plant in Mexico and also threatened to impose a 20% tariff on Japanese automobile and auto parts makers with plants in Mexico. Toyota quickly announced it would invest $10 billion in its U.S. operations over the next five years.

Abe has definitely been massaging the ego of Trump not only being the first international leader to visit Washington after his election but also telling Trump that he “hopes the United States will become a greater country through (your) leadership,” adding Japan wants to “fulfill our role as your ally.” It will be interesting to see what happens after their meeting on Friday 10th February.

Sources: Terrie Lloyd,  The Japan Times

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