Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
7
II. Deviations from Economic Theory: Some examples
1. Sunk costs
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
8
situation should be relevant and not how we arrived at this situation. But
do people act according to this theory?
2. Mental accounting
3. Endowment effect
4. Status quo bias
Examples:
(a) You have invested 1 Mio in a business but, disregarding your
5. Rational expectations and overconfidence
investment, you make losses of 10000 per year. Will your quit
6. Limited depth of reasoning
your business? [Variant: You have sent troops to Iraq or to …]
7. Further biases and fallacies of thinking
(a’) The interest rate is r = 0.05 (5 %) per year. You have invested 1
(Before you read the following, remember the principles of profit
Mio in a business and, disregarding your investment, you make a
maximization and utility maximization – have a look into your textbook on
profit of 10000 a year and expect the same profit also in future
introductory microeconomics)
years. Would you sell your business at 10000/0.05= 200000?
(Why is this number the price you could expect in the market?)
II. 1. Sunk costs
(b) You have bought rather expensive theatre tickets, but on the
Sunk costs are past expenditures (investment, up-front payment, etc.)
evening of the performance you do not feel well and would prefer
which are not recoverable.
to stay at home. Will you? [Variant: You got the theatre ticket by a
lottery or as a gift form an organization]
Examples: - Advertising
- Building a gas pipeline
In (a) and (b), someone could argue that he cannot quit (must go to the
- Theatre tickets (sometimes)
theatre) because, otherwise, he would feel strong regret.
- Losses at the Roulette wheel
(c) Auctioning licences for entry into a business: Frequency auctions
Note that in any case you can imagine circumstances when (part of) the
for mobile telephony all over the world.
expenditure can be regained – but here we talk about cases when it is
Offerman, T. & Potters, J. (2000) find in an experimental study that
impossible.
auctioning increases average market prices.
Economic theory (as well as conventional wisdom) tells us that sunk
Higher rationality:
costs should not be relevant for decisions. However advantageous or
- If someone would argue in case (a) or (a’) that nobody
stupid the expenditure looks from today’s perspective – our current
knows of his losses or meagre profits and that he does not
want to destroy his reputation as a successful business
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
9
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
10
man, then his decision to stay in the business may have
expropriation does not take place (often by long-term contracts) is part of
an additional value and need not be “irrational”.
transaction costs.
- Our tendency to honour sunk costs may be beneficial in
some cases because it provides us with an instrument of
Honoring sunk costs may help to prevent expropriation even without high
precommitment. Example: Buying a year’s membership in
transaction costs.
a fitness club. Though entrance is free, you still prefer to
look television. But you would feel strong regret about your
II.
2. Mental accounting
unnecessary costs and therefore … (But does this always
work?)
Example from Antonides (1996):
“Mr. and Mrs. J have saved $ 15000 toward their dream vacation home.
Nobel Laureate
They hope to buy the home in five years. The money earns 10 % in a
Oliver Eaton Williamson (born September 27, 1932) is a prominent
money market account. They just bought a new car for $ 11000 which
author in the area of transaction cost economics, a student of Ronald
they financed with a three-year car loan at 15 %.”
Coase, Herbert Simon and Richard Cyert.
In 2009 he was awarded the Nobel Memorial Prize in Economics for "his
This seems to be an irrational decision because Mr. and Mrs. J. could
analysis of economic governance, especially the boundaries of the
have saved 5 % interest. Do you know of similar decisions of friends or
[1]
firm", sharing it with Elinor Ostrom. (from Wikipedia).
family or yourself?
An automobile producer orders special parts of his new version of a car
Example from Vedantam (2007):
from a component supplier. Both firms invest in new machines for the
"The source of the money affects how it is spent," said Suzanne Fogel,
production of the new version and its components. After the first order
who heads the marketing department at DePaul University in Chicago.
has expired, they negotiate the terms (price of components) of a second
When she was a graduate student, Fogel waited tables to help pay the
order. As investments are sunk costs the new price need not include
bills. She found that she carried around a figure in her head; the amount
interest on these investments (quasi-rents). The price which the
she wanted to make each day. On any day she passed that target, any
component supplier receives may be so low that only variable costs are
additional income became "free money" -- even though this money ought
covered (his quasi-rents are expropriated). Alternatively, the new price
to have been a cushion for the days she did not meet her income target.
may be so high that the quasi-rents of the automobile producer are
"Someone gives you money for your birthday and they don't say, 'pay
expropriated. Taking care in advance of investment that such
your electric bill,' but money is money and completely fungible, and if you
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
11
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
12
are behind on your electric bill, you should definitely spend your money
on that," she added. "But there is a reluctance to do that."
Aggregate supply/demand
supply dependent on p
People seem to split their income in different compartments or put it on
disadvantageous
exchange
different accounts for different purposes. This behaviour violates the
principle of fungibility of money but perhaps it is the only way to keep
track on one’s spending and to allocate one’s money in a fairly optimal
way before it is used up.
x∗
demand
dependent
on p
Note that governments and universities and firms also use accounts
when allocating their money and that they, too, restrict fungibility.
III.
3. Endowment effect
How much are you ready to pay for an apple? The amount is called
p∗
advantageous
exchange
p
These owners
These non-owners
value the apple
value the apple
≤ p∗
≥ p∗
“willingness to pay” (WTP). How much do you require for an apple you
own? The amount is called “willingness to accept” (WTA). It is plausible
We determine a market price p* and all owners requiring less than p* sell
and also required by economic theory that WTP = WTA (for the same
their apples to all non-owners who offer more than p*. With so many
person in an otherwise equal situation). In most experiments, however,
market participants, there is no incentive to manipulate one’s WTA or
we find WTP < WTA!
WTP strategically. One average, we should find WTA = WTP. Half of the
apples should be sold. In most experiments, however, significantly less
Typical experiment: 100 subjects (for example), 50 get an apple, 50 do
than half of the apples are sold.
not get one (but possibly some money). All owners of apples write down
their WTA, all non-owners of apples write down their WTP. Then, we
Could there be reasons why the endowment effect might be rational?
construct supply and demand curves.
- The owner may have spent time and/or money to get the good.
Possibly he honours these sunk costs. So, all arguments in favour
of honouring sunk costs apply.
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
13
- Assume that all goods (apples) in today’s market have the same
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
14
When might it be of strategic value to have a status quo bias?
quality but only the owners of the goods know the quality. The nonowners know only the distribution of qualities. (This situation is
Example:
called asymmetric information.) If the non-owners are risk averse
they will offer less than the owners require.
- Consequence of different qualities in the same market and
asymmetric information? Good apples are sold less frequently than
- My competitors know that I will stay in my traditional business,
even if I make less profit. Perhaps, therefore, they do not enter my
market!
bad ones, perhaps good apples are not sold at all, perhaps even
no apples are sold! (Akerlof, 1970, “A market for lemons”)
Did you notice that some examples can be discussed under more than
one point of view? Please find your own examples where two of the four
II.
4. The status quo bias
“Do nothing or maintain your current or previous position” is the definition
of the status quo bias by Samuelson and Zeckhauser (1988).
As an illustration see the offers to deliver electricity to household
customers in Frankfurt (Oder) and note that, on average, in Germany
only 5 % of households switch their electricity supplier (2007).
See
http://www.tarifvergleich.de/energievergleiche/strom-
google/?gclid=CILlxu6Iup0CFdA93god8DZTkA
When might a status quo bias be rational?
- if you know the status quo well but have only incomplete
information about alternatives
- if transaction costs are too high
Examples:
- Not separating from one’s husband/wife
- Not quitting one’s job or changing one’s field of studies
concepts in II.1 to II.4 can be applied.
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
15
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
16
II. 5. Overconfidence
The following questions were asked to a sample of Viadrina students:
Table 2: Subject Groups
Group
N
Description
1. In a mathematics exam, the examiner first determines the percentage
A
177
Germans, economists, first semester
of questions that has been answered correctly. Then he transforms the
AW
90
Women from A
percentages into grades: 1 (very good), 2 (good), 3 (satisfactory), 4
AM
87
Men from A
(adequate), 5 (inadequate=failed). Which transformation of percentage
B
18
Poles, economists, first semester
point into grade do you think is appropriate?
C
53
Germans, economists, ≥ 2nd semester
Reply: Boundary between 1 and 2: … %, boundary between 2 and 3: …
D
15
Poles, economists, ≥ 2nd semester
%, boundary between 3 and 4: ... %, boundary between 4 and 5: ... %.
E
23
Germans, law students, first semester
2. What percentage of your fellow students do you believe will fall into
F
11
Poles, law students, first semester
each of the five categories? 1 (very good)
... %, 2 (good) ... %, 3
(satisfactory) ... %, 4 (adequate) ... %, 5 (inadequate = failed) ... %
Table 3: Average estimation of one’s own and others’ performance
3. In which category do you estimate your current mathematical abilities
Groups Owngra
to be? 1 (very good) ,
2 (good)
,
3
(satisfactory)
,
Own%
de
4
Othergra Other%
de
(adequate) , 5 (inadequate = failed). (Tick one.)
A
2.95
64.95
3.21
58.57
The questionnaire also asked for such personal characteristics as age,
AW
2.90
63.94
3.13
57.95
semester of study, gender, faculty, nationality, and income.
AM
3.01
66.01
3.30
59.22
A few questionaires were excluded. This happened if the percentage
B
2.67
63.03
2.66
55.58
values in question 1 did not decrease; the percentage values from
C
2.32
75.24
3.45
55.20
question 2 did not add up to 100 %; or more than one question was
D
1.80
81.30
3.56
50.95
unanswered. The distribution of the remaining subjects is shown in Table
E
3.00
52.33
2.93
53.92
1.
F
3.09
50.68
3.69
40.39
The main objective of the study was to show that different groups use
common categories differently. Although it was not central to the topic of
the investigation it is worth noting that many of the results of the table
provide clear examples of an optimism or overconfidence bias: the
average student rates his or her own abilities higher than those of the
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
17
average comparable student. Optimism biases have been frequently, but
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
18
II.6. Limited depth of reasoning
not universally, reported for a variety of psychological attributes
You are planning a weekend trip with your girl friend in your own car?
(Gigerenzer and Selten, 2002; Taylor and Brown, 1988).
How do you decide what to take with you? You have a reserve wheel for
the case that a tyre fails. You have cash and your credit card for
Extreme examples of overconfidence are:
- 82% of American car drivers believe that they belong to the best
unfortunate cases as well as for opportunities to buy something. Or
shouldn’t you take your credit card with you? It might be stolen. But then
30% of drivers (Svenson, 1981)
- Founders of American start-ups believe their firm to have a 70%
you could inform your bank or the emergency centre of your credit card
chance of surviving 5 years though, in reality, only 25% survive.
provider? But maybe you won’t have enough cash in such a case to pay
(URL:http://wianet.bizland.com/archiv/200301bdm6.htm)
read
the bill of the hotel. So, should you take some more cash with you or
also : Lowe, Robert A. ; Ziedonis, Arvids A. (2006), Management
should you rely on your girl friend for this case? But what to do if she
Science
quarrels with you about your permanent negligence and leaves you
,
- The winners curse was first observed in auctions of oil licences:
The most optimistic bidders got the licences – and made losses.
alone? And if she pays the hotel bill, will you have enough money for
gasoline? …..
See also Thaler (1992).
general
How do you play chess (or Go, or a similar game)? Do you ask yourself
knowledge questions and asked them, in addition, whether they
what your opponent will do in his next move? And how you could reply?
were sure to be right with at least 98%. The answers thus indicated
And how he will reply? …
- Russo
and
Schoemaker
(1989)
asked
subjects
to be ”sure” knowledge turned out to be correct only with 46%.
Apparently, it is impossible to take into account all consequences of an
action. Though, in principle, chess is a finite game, i.e. only a finite
Can overconfidence (=optimism) sometimes be advantageous?
while
number positions is possible and the game necessarily ends after a finite
overconfidence sounds negative? Are there “good” and “bad”
number of moves, nobody believes that a man or a computer will ever
mistakes (depending on the situation) in the evaluation of
succeed in determining the optimal decision for every situation.
- Curiously
optimism
is
generally
valued
positive
probabilities? Is there a difference before and after making a
decision?
- Is optimism a deterring signal for a competitor?
It seems, however, that men in principle plan only with limited foresight.
Let us regard the following “beauty contest” experiment.
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
19
Cited from Camerer, 2003: In Keynes’s famous book “General Theory
of Employment, Interest, and Money”, he draws an analogy between the
stock market and a newspaper contest in which people guess what faces
others will guess are most beautiful: “It is not a case of choosing those
which, to the best of one’s judgment, are really the prettiest, nor even
those which average opinion genuinely thinks the prettiest. We have
reached the third degree, where we devote our intelligences to
anticipation what average opinion expects the average opinion to be.
And there are some, I believe, who practise the fourth, fifth, and higher
degrees” (1936, p. 156).
Often, it is important to guess what other do, but it they can be assumed
to do the same (guess what we do) we easily find ourselves in an infinite
regress. This is the typical problem of Game Theory!
Rational behaviour can be defined by the Nash equilibrium: Every player
(decision maker) i, i = 1, …, n chooses an action ai. (a1, …, an) is a Nash
equilibrium if, given the actions a1, … ai-1, ai+1, …, an, player i could not
improve his outcome (profit, utility, …) by choosing an action different
from ai; i = 1, …, n.
The “Beauty contest game” (Nagel, 1995): n players choose a number
between 0 and 100. That player who is closest to 2/3 of the average wins
a certain amount of money. In the case of draws the money is distributed
randomly to the winners.
The only Nash equilibrium of this game is ai = 0, i = 1, …, n. This is
simple to prove: If ai > 0 exists, then the i with the larges ai has an
incentive to decrease his ai.
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
20
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
21
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
22
II. 7. Further biases and fallacies of thinking
The following pages are taken from Wikipedia. Please, select your
“favorite cognitive bias” and report about it in the class (2-3 minutes).
See
"http://en.wikipedia.org/wiki/List_of_cognitive_biases"
See also
http://www.muellerscience.com/PSYCHOLOGIE/Entscheidung/Cognitive
_Illusions/27_Faelle_irrationalen_Verhaltens.htm
After this long list of human incompetence, can you still believe in
something as higher rationality? Can (most of) these biases (at least
sometimes) have an advantage?
References:
Akerlof, G. (1970): “The Market for Lemons: Qualitiy Uncertainty and the
Market Mechanism”, Quarterly Journal of Economics, 84, 488-500.
Antonides, G. (1996): “Psychology in Economics and Business – An
Introduction
to
Economic
Psychology”,
Kluwer
Academic
Publishers.
Camerer, C.F. (2003): “Behavioral Game Theory: Experiments on
Strategic Interaction”, Princeton University Press [BGT].
Gigerenzer, G. and Selten, R. (Eds) (2002): “Bounded Rationality: The
Adaptive Toolbox”, Cambridge, MA; London: MIT Press.
Prof. Dr. Friedel Bolle
Vorlesung Behavioural economics
23
Lowe, R.A. Ziedonis, A.A. (2006): “Overoptimism and the Performance of
Entrepreneurial Firms”, Management Science, Vol. 52, No. 2, 173186.
Nagel, R. (1995): “Unraveling in Guessing Games: An Experimental
Study”, The American Economic Review, Vol. 85, No. 5, 13131326.
Theo Offerman & Jan Potters, 2000. "Does Auctioning of Entry Licenses
affect Consumer Prices? An Experimental Study," Tinbergen
Institute Discussion Papers 00-046/1.
Russo, J. and Schoemaker, P. (1989): Decision Traps, 70-84, New York.
Samuelson, W. and Zeckhauser, R. (1988): “Status quo bias in decision
making”, Journal of Risk and Uncertainty, Volume 1, No. 1, 7-59.
Svenson, O (1981): “Are we all less risky and more skillful than our fellow
drivers?”, Acta Psychologica, 47, 143-48.
Taylor, S.E. and Brown, J.D. (1988): “Illusions and Well-Being: A Social
Psychological Perspective on Mental Health”, Psychological
Bulletin, Vo. 103, MN. 2, 193-210.
Thaler, R.H. (1992): “The Winner’s Curse: Paradoxes and Anomalies of
Economic Life”, Princeton University Press.
Vedantam, S. (2007): “Mental Accounting – Why It’s Easy to Blow the
Tax Refund and Hard to Catch a Cab in the Rain”, Washington
Post, May 19, 2007, Page F01.