Tuesday, 10 October 2017

Richard Thaler and the Nobel Prize for behavioral economics

Officially, Richard Thaler won the Nobel Prize in Economics because he 'has incorporated psychologically realistic assumptions into analyses of economic decision-making. By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes'. 

An interesting thing about this quote is that nudge doesn't get a mention; indeed, it only just about scrapes it into the Academy's official press release. (In the more detailed popular information document it doesn't appear until page 5 of 6.) This is in stark contrast to the popular press: the BBC leads with 'Nudge' economist wins Nobel Prize, the Telegraph leads with 'Nudge' guru wins the Nobel Prize, and so on. To read the papers you would think that Nudge is all there is to it.

There is no doubt that Nudge has been a huge success and made Thaler famous (at least by economist standards). In terms of the Nobel prize, however, it is important to recognize that Nudge is just one of the many, many contributions Thaler has made to economics, and behavioral economics. Let me pick up three of those contributions here.

1. Thaler showed how dumb people can be when making economic decisions. The likes of Herbert Simon, Amos Tversky and Daniel Kahneman paved the way by showing that people can make decisions that are inconsistent with the standard way economists think about things. They, though, typically considered settings that are pretty complex, such as, search, choice with risk or how to interpret information. Thaler took this one stage further and showed that even for the most basic of economic decisions the standard economic model can go astray. 

Consider, by way of illustration the following example, from the classic paper on 'mental accounting and consumer choice':

Mr. S admires a $125 cashmere sweater at the department store. He declines to buy it, feeling that it is too extravagant. Later that month he receives the same sweater from his wife for a birthday present. He is very happy. Mr. and Mrs. S have only joint bank accounts.  

Standard economic theory says that the sweater is either worth $125 or not. But, there seems nothing extraordinary about Mr. S's behavior. To provide a framework within which to make sense of this, and much else, Thaler introduced the notion of mental accounting where we code gains and losses, evaluate purchases and observe budgetary rules. Mr. S would be breaking self-imposed rules to spend $125 from his 'everyday account' but an occasional gift funded from the 'gift account' is to be enjoyed. 

Once we see how easily the framing of a choice can influence behavior it is a relatively short step to Nudge and the idea that framing can be used to positively change behavior. (Crucial in this is also the recognition that people can have self-control problems.)  

2. As well as dumb, people can also be nice, and not so nice. In many ways economists have clung to the notion of selfishness for much longer than that of rationality. Work by Thaler helped turn the tide. Two papers with Daniel Kahneman and Jack Knetsch on 'Fairness as a constraint on profit taking' and 'Fairness and the assumptions of economics' are particularly noteworthy. In the first paper we get a series of questions like the following:

A hardware store has been selling snow shovels for $15. The morning after a large snowstorm, the store raises the price to $20. Please rate this actions as: Completely fair, acceptable, unfair, very unfair.

82% of subjects considered it unfair. Presumably that means they may decide not to buy the snow shovel; fairness matters. In the second paper we get some big advances in the studying of the ultimatum game (first use of strategy method to look at willingness to reject and first look at willingness of a third party to punish) and we see the dictator game for the first time. This may sound a bit technical but it was part of opening up the whole debate on how fairness works and can be modeled by economists.

3. Popularization is not the kind of thing that wins Nobel prizes, but it can be important in driving things forward. In a series of articles published in the Journal of Economic Perspectives (and subsequently turned into the book The Winner's Curse) Thaler and co-authors set out some of the key insights of behavioral economics. I will quote in full the introduction to one of the articles:

Economics can be distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear. An empirical result qualifies as an anomaly if it is difficult to "rationalize," or if implausible assumptions are necessary to explain it within the paradigm. This column presents a series of such anomalies. Readers are invited to suggest topics for future columns by sending a note with some reference to (or better yet copies of) the relevant research. Comments on anomalies printed here are also welcome. After this issue, the "Anomalies" column will no longer appear in every issue and instead will appear occasionally, when a pressing anomaly crosses Dick Thaler's desk. However, suggestions for new columns and comments on old ones are still welcome. Thaler would like to quash one rumor before it gets started, namely that he is cutting back because he has run out of anomalies. Au contraire, it is the dilemma of choosing which juicy anomaly to discuss that takes so much time.

The interesting thing about this is the target audience. This is about trying to convince economists that behavioral economics matters and should be taken seriously. That is a very hard sell indeed! But ultimately it seems to have worked.

With any Nobel prize there are going to be the critics. And I can already hear some grumbles. But, that seems to come more from ignorance than judgement. If we take Nudge out of the equation the contributions of Thaler are clear enough. With Nudge there is undeniably a lot of hyperbole from some policy makers and consultants. The undeniable truth, however, is that it has made a positive difference to policy making. That is worth celebrating. 

Thursday, 7 September 2017

Honesty around the world

In my last post I looked at dishonesty in the banking industry. Sticking with a similar theme, this time I will at dishonesty across different countries.
       Let us start with a study by David Pascual-Ezama and a long list of co-authors on 'Context dependent cheating: Experimental evidence from 16 countries'. They asked 90 students in 16 different countries to perform a very simple task: toss a black and white coin and record the outcome. If the coin came up white the student obtained a red Lindt Lindor Truffle. If it came up black they got nothing. Crucially, the coin toss took place in private and so the student could report whatever outcome they wanted. If they wanted a chocolate then they simply had to report white. (The study contrasted three different methods of reporting - form put in a box, form given to the experimenter or verbally telling the experimenter - but I will skip those details here.)
          The chart below summarizes the country wide outcomes by focusing on the proportion of the 90 students in each country that 'won' the chocolate. The blue bars give the distribution we would predict if the students reported honestly. As you would expect the distribution is centered on a 50-50 success rate. Compared to this benchmark students were remarkably lucky. In all countries more than 50% of students won the chocolate and in some, such as Spain, the success rate was much higher than seems plausible. So, some students were dishonest (and hungry). Note, however, that the success rates are nowhere near the 100% we would expect if all students lied. So, many students were honest (or not so hungry). Indeed, we could conclude that most students were honest. There is also no compelling evidence of differences across countries. Spaniards won more than Danes but then someone has to come top and someone bottom. The differences we see here are not particularly large.  


 
Consider next a study by David Hugh-Jones on 'Honesty, beliefs about honesty, and economic growth in 15 countries'. In this case the subject pool in each country was a sample of the general population selected by a survey company and the prize was either $3 or $5 and not a chocolate. (The study also involved other measures of dishonesty and beliefs about dishonesty but I'll skip those here.) The findings are summarized in the next figure. The main thing to note is that we get a big swing to the right in those who 'won'. In other words there was a lot more dishonesty in this study. Moreover, the amount of dishonesty significantly varied across countries. Just how much we can read into this variation is not clear. For instance, the US and Canada come out as relatively dishonesty but that may reflect a willingness to 'game' the experiment rather than a predisposition to dishonesty in general life. Even so, it is shown that honesty correlates with GDP per capita and the proportion of the population that is protestant. This hints at cultural roots of honesty.



Which brings us to the final study I will mention, by Simon Gachter and Jonathon Schultz on 'Intrinsic honesty and the prevalence of rule violations across countries'. In this study students from 23 countries were asked to roll a six sided dice and report the outcome. Reporting a 1 earned 1 unit of payment (e.g. £0.50 in the UK), a 2 earned 2 units and so on up to 5 which earned 5 units, but reporting a 6 earned 0. Note that in this experiment a subject can lie 'a little' by say reporting 4 instead of 2 or lie 'a lot' by reporting 5 instead of 6. If subjects were honest the expected payment would be 2.5.  If they lied a lot the payment would be 5. As the figure below shows average payments were well above 2.5 and so there is evidence of dishonesty. Note, however, that payments were well below 5 and so there is, again, lots of honesty as well.




Cross country differences are not partly stark in the figure above. But another thing to consider is the proportion of subjects who reported a 6. Recall that this meant a payoff of 0 and so there was a strong incentive to lie 'a little' and get some payoff. (Indeed, to not report a 6 would seem analogous to miss-reporting the toss of a coin.) If subjects were honest around 16% should get 0. As the figure below shows in some countries, like Germany, subjects were very honest but in others, like Tanzania, they were not. And evidence for differences across countries is pretty strong. Overall, it is shown that cross country differences correlate strongly with an index of the prevalence of rule violations which captures things like corruption, tax evasion and fraudulent politics. This again points the finger at culture but also brings in the related issue of institutions. Countries with weak institutions see more dishonesty.


So, what to take from all this? One message I would take is that people are, on average, very honest. In all the three studies I have discussed there was more subjects behaved honestly than dishonestly. And let's recall that it was pretty easy for a subject to lie in these studies, both in a practical sense - they just needed to misreport - and in a moral sense - this was not robbing money from an old lady. It seems, therefore, that people the world over are pretty honest. But, that does not mean that dishonesty is not a problem. In my last post we saw that culture in the banking industry might encourage dishonesty. Here we see that culture in society might lead to greater dishonesty. A little bit of dishonesty can have large negative economic consequences.  

Sunday, 27 August 2017

Culture and dishonesty in banking

The film 'A Good Year' starts with a ruthless financial trader called Max, played by Russell Crowe, manipulating bond markets in order to out-maneuver his competitors and make a quick, big profit. But, by the end of the film Max has decided to pack it all in and live out a more fulfilling life in rural France. Could that happen? Can someone really transition from a ruthless, selfish trader to a compassionate, loving family man in the space of a few days?
        A study by Alain Cohn, Ernst Fehr and Michel Marechal, publisehd in 2014 in Nature, suggests it might be possible. They used a standard coin tossing task to measure the dishonesty of 128 employees from a large, international bank. The task works as follows: A subject is asked to toss a coin 10 times and record whether the outcome was heads or tails. Depending on the outcome the subject can win $20 per toss. The crucial thing to know is that the subject records whether or not they won for each toss and there is no way for the experimenter to verify if the outcome is recorded correctly. So, the subject fills in the following table privately. This means a subject could 'easily' lie and walk away with $200.


        The crucial twist in the experiment was to vary the priming subjects faced before performing the coin-tossing task. Roughly half of the subjects were asked questions related to their work in the bank - Why did you decide to become a bank employee? What are the three major advantages of your occupation as a bank employee? Which three characteristics of your personality do you think are typical for a bank employee? etc. The other half of the subjects were asked questions not related to their work - What is your favorite leisure activity? Where did you spend your last vacation? Which three things did you like most about your last vacation? etc. 
        So, to the results. The figure below shows what happens for subjects not primed to think about work in the bank. The blue bars show the observed distribution of earnings and the green bars show the distribution of earnings expected by pure chance. We can see some hints of dishonesty - there are fewer than we would expect getting $40 or less and more getting $200. But, these are small things. The overall picture is that the bankers were honest.   


         Things change when subjects were primed to think about work in the bank. The distributions are shown below. Here we see a sizable increase in the amount of money being claimed. Needless to say, this is highly unlikely to be due to chance. It can be estimated that around 26% of subjects were dishonesty. Let us keep in perspective that this means 74% were honest. Even so, the headline result is that bankers only exhibit dishonesty when they are primed to think about banking.


        This finding feeds into a general debate about whether dishonesty is a personal trait or a product of culture. The results we have looked at here suggest that dishonesty has a large cultural component. That would make it more likely a banker can be ruthless in his job and then help old ladies across the road in his spare time. It is hard to imagine, however, that culture is the only factor at work here because we do know that there are reliable personal differences in dishonesty and willingness to cooperate. It is surely not by chance that some become investment bankers and others pediatricians? An interesting and closely related debate is whether studying economics makes people more selfish (culture at play) or whether more selfish people choose to study economics (personal traits at play). An article by Adam Grant provides a nice overview of the issues.  

Friday, 28 July 2017

Risk aversion or loss aversion

Suppose you offer someone called Albert a gamble - if the toss of a coin comes up heads then you pay him £100 and if it comes up tails he pays you £100. The evidence suggests that most people will not take on that gamble. If Albert also turns down the gamble, what does that tell you about Albert's preferences?
         One thing we can conclude is that Albert is risk averse. In particular, the gamble was fair because Albert's expected payoff was 0 and, by definition, if someone turns down a fair gamble then they are exhibiting risk aversion. It is hard to argue with a definition and so we can conclude that Albert is risk averse. The more interesting question is why he displays risk aversion?
           The micro-economic textbook would tell us that it is because of diminishing marginal utility from money. A diagram helps explain the logic. Suppose that Albert has the utility function for money depicted below. In this specific case I have set the utility of £m as the square root of m. Notice that the utility function is concave in the sense that it gets flatter for larger amounts of money. This is diminishing marginal utility of money - the more money Albert has the less he values more. 
          Suppose that Albert has £500. If he does not take the gamble then his utility is 22.36. If he takes the gamble then he can end up with either £400 or £600. The former gives him utility 20 and the latter 24.49. The expected utility is midway between this, i.e. 22.25. Crucially the expected utility of the gamble, 22.25, is less than not taking on the gamble, 22.36, and so Albert does not gamble. As the bottom figure shows we get this result because the utility function is concave. That means the utility of not gambling - on the blue line - lies above the expected utility of gambling - on the red line.  


  

There is though a problem with this standard story, formally demonstrated by Matthew Rabin in a 2000, Econometrica paper 'Risk aversion and expected utility theory: A calibration theory'. If Albert is risk averse over a relatively small sum of money like 100 with an initial wealth of £500 then he would have to be unbelievable risk averse over large gambles. Basically, he would never leave his front door. If diminishing marginal utility of money is not the explanation for Albert's risk aversion then what is?
           The most likely culprit is loss aversion. Now we have to evaluate outcomes relative to a reference point rather than a utility function over wealth. It seems natural to think that Albert's reference point is £500. That would mean winning the gamble is a gain of £100 and losing the gamble is a loss of £100. Crucially, the evidence suggests that people typically interpret a loss as worse than a gain is good. This is shown in the next figure.
              In this case everything is judged relative to the status quo of £500. Having more than £500 is a gain and less than £500 is a loss. The steeper value function below £500 captures loss aversion. The crucial thing to observe is that loss aversion effortlessly gives concavity of the value function around the status quo. So, Albert would prefer to not gamble and have value 0 than to gamble and have either +5 or -10 with an expected value of -2.5. Loss aversion has no problem explaining risk aversion over small gambles.  




So, what can we conclude from all this? The first thing to tie down is the definition of risk aversion. Standard textbooks will tell you that risk aversion is turning down a fair gamble. That to me seems like a fine definition. So far, so good. Confusion (including in academic circles) can then come from interpreting what that tells us. Generations of economists have been educated to think that risk aversion means diminishing marginal utility of money. It need not. We have seen that loss aversion can also cause risk aversion. And there are other things, like weighting of probabilities that can also cause risk aversion. It is important, therefore, to consider different possible causes of risk aversion.
           And it is also important to recognize that there is unlikely to be some unified explanation for all risk aversion. We know that people do have diminishing marginal utility of money over big sums of money. We know people are loss averse over surprising small amounts of money. We also know that people are bad at dealing with probabilities. All of these factors should be put in the mix. So, Albert might buy house insurance because of diminishing marginal utility of money, not try the new cafe for lunch because he is loss averse, and buy a lottery ticket because he overweights small probabilities. 

Tuesday, 9 May 2017

Will a vote for Theresa May strengthen her bargaining hand?

As the run-up to the UK's snap general election continues, the Conservative party appear content to talk about one thing and one thing only - strong and stable leadership for Brexit negotiations. Throughout the campaign Theresa May has been particularly keen to claim that 'every vote for me strengthens my hand in the Brexit negotiations'. This claim seems to be going down well with voters. But does it make any sense?
          In bargaining theory the disagreement point is of critical importance. In the Brexit negotiations we can think of the disagreement point as the outcome if no deal is done between the UK and the EU and so the UK simply leaves the EU in March 2019 and starts from scratch. Most experts seem to agree that no deal would be bad - very bad for the UK and bad for the EU. That means that a deal is essential. It also means that the UK starts from a bad negotiating position. 
        To put some analysis to this consider the figure below. This plots the payoff of the EU and payoff of the UK depending on what deal is done. The blue line captures all the possible outcomes from a deal - some deals better for the UK and some for the EU. The bottom red dot captures the outcome if no deal is done. Note that if no deal is done then payoffs are well below the blue line - an agreement is good. Also, if no deal is done then the UK loses more than the EU - this puts the UK in a bad negotiating position. 

  
           In a world of calm deliberation the EU and UK could easily come to an agreement that is better than no deal. But, unfortunately, some Brexiters seem to have got over excited by the referendum win and started to believe their own rhetoric. In  particular, they are claiming that no deal is not that bad. This is encapsulated by Theresa May's claim that 'no deal is better than a bad deal'. This statement is either a tautology or a claim that no deal may be relatively good. Brexiters are also fond of claiming that no deal would be worse for the EU than the UK. So, returning to the figure, let the red Eurosceptic dot represent the 'optimistic' stance of Brexiters.
            Before she called an election, Theresa May had a small majority in parliament. That means it was going to be difficult to get anything through parliament that the eurosceptics did not like. And there is not much room for maneuver if you want do a deal better than the eurosceptic initial belief. Note, however, that this strengthened Theresa May's hand quite a lot. In particular, European politicians seemed keenly aware that it was going to be difficult to get any deal through the UK parliament. This means that they might have reluctantly had to make some concessions.
          What if Mrs May has a huge majority in parliament? Well, then anything will get through parliament and so we revert back to the actual disagreement point. The bigger the majority, therefore, the weaker is the UK's position. Ultimately, things are not so bad, because a Conservative majority makes it more likely a deal can be done. Indeed, Theresa May presumably called an election because it was becoming increasingly clear that Conservative backbenchers were going to make life very tough. This made no deal more likely.
         The trouble is, the rhetoric of the Brexiters seems to have no bound. This rhetoric is not convincing anyone in Europe but is being lapped up by much of the British press and public. If we go into these negotiations with a public who think the initial position is the top eurosceptic red dot then it may be difficult for any prime-minister, no matter how big the majority, to sell a deal. In other words, Britain seems to be walking into a cul-de-sac of disaster. The only crumb of comfort is that the UK economy seems to be showing the signs of Brexit. That may concentrate minds.     

Tuesday, 28 March 2017

Brexit and the Condorcet Paradox

Tomorrow the government will trigger Article 50 and start the formal process of getting the UK out of the EU. So, how did we get in this mess in the first place? I think the Condorcet Paradox provides an interesting angle on the problem. In particular, I want to look at preferences for Remain versus Soft Brexit, i.e. leave the EU but still remain in the single market or other collaborations centered on the EU, and Hard Brexit, i.e. walk completely away from the EU. 
          The one thing we know for sure is that in the referendum last June around 52% of people voted Leave and 48% voted Remain. What does that tell us? In my recollection the referendum campaign primarily focused on the question of Soft Brexit versus Remain. No doubt some would disagree with that. But things like the customs union only started being talked about after the vote. Instead we heard a lot during the campaign about the Norway or Swiss model of Soft Brexit. True the Leave camp made promises like 'take back control of our borders' that inevitably mean hard Brexit. But, the Leave camp was far less pro-active in actually joining the dots and saying what hard Brexit would mean. The referendum vote tells us, therefore, that the British people prefer Soft Brexit to Remain.
         Once Theresa May took power the discussion very quickly turned to focus on Soft Brexit versus Hard Brexit. Now, the Brexiters were keen to join the dots and argue that 'taking back control' inevitably meant Hard Brexit. Soft Brexit, they argue, is essentially Remain in different clothes - if we are going to leave then it has to be Hard Brexit. We have no idea how the country would vote on this issue but I think there is a fair chance the country would prefer Hard Brexit to Soft Brexit
        If the country prefers Hard Brexit to Soft Brexit and prefers Soft Brexit to Remain then you might expect they would prefer Hard Brexit to Remain. But, I would be surprised if that was the case. If the original referendum campaign had been a tussle between Hard Brexit and Remain then Remain may well have won. The vote was close enough as it was and opinion polls have consistently shown that people want to remain part of the single market. Overall, therefore, we end up with a Condorcet Paradox:

Hard Brexit beats Soft Brexit
Soft Brexit beats Remain
Remain beats Hard Brexit.

          If there is a Condorcet Paradox then it is impossible to say which option is the most preferred. Note, however, that we are set to end up with an outcome, namely Hard Brexit, that is worse than we started with, namely Remain. That does not look like a good deal! Plaudits should, however, go to the Brexiteers for their strategic opportunism. In particular, we know that whenever there is a Condorcet Paradox the outcome depends on the voting procedures. The only way those favoring Hard Brexit were going to get what they wanted was to play off Soft Brexit versus Remain and Hard Brexit versus Soft Brexit. By design or good fortune that is exactly what has happened. 
          And are we going to get a vote on the final deal, pitting Remain versus Hard Brexit? Of course not. And how long before the UK votes to rejoin the EU because Join is better than Hard Brexit? Probably, a long, long while. 

Monday, 20 March 2017

How to get rid of an incompetent manager?

In a paper, recently published in the International Journal of Game Theory, my wife and I analyze a game called a forced contribution threshold public good game. A nice way to illustrate the game is to look at the difficulties of getting rid of an incompetent manager.
         So, consider a department with n workers who all want to get rid of the manager. If they don't get rid of him then there payoff will be L. If they do get rid of him then there payoff will be H > L. But, how to get rid of him? He will only be removed if at least t or more of the workers complain to senior management. For instance, if a majority of staff need to complain then t = n/2.
        If t or more complain then the manager is removed and everyone is happy. The crucial thing, though, is what happens if less than t complain. In this case the manager will remain and any workers that did complain will face recrimination. To be specific suppose that the cost of recrimination is C. Then potential payoffs to a worker called Jack are as follows:

If t or more complain then Jack gets payoff H.
If Jack complains but not enough others do then he gets payoff L - C.
If Jack does not complain and others don't either then he gets payoff L.

Note that this game is called a 'forced' contribution game because, if the manager is removed, Jack's payoff does not depend on whether or not he complained. This contrasts with a standard threshold public good game in which those who do not contribute (i.e. complain) always have a relative advantage. Hence, there is a sense in which every worker is 'forced to contribute' if the manager is removed.
         The fear of recrimination is key to the game and going to be the potential source of inefficiency. In particular, if Jack fears that others will not complain then it is not in his interest to complain either. Hence we can obtain an inefficient equilibrium in which nobody complains and the manager carries on before. This is not good for the workers and presumably not good for the firm either. So, how can this outcome be avoided?
      In our paper we compare the predictions of three theoretical models and then report an experiment designed to test the respective predictions. Our results suggest that the workers will struggle to get rid of the manager if
This means that the threshold t should not be set too high. For instance, if a simple majority is needed to get rid of the manager, and so t = n/2, then we need H to about 25% higher than L. If less than a majority is enough then H does not need to be as high. This result would suggest that it is relatively simple to have a corporate policy that would incentivise people like Jack to complain about his manager.
           Of course, in practice there are almost certainly going to be some who will defend the manager and so things become more complex. Moreover, there are likely to be significant inertia effects. In particular, the 'better the devil you know' attitude may lead workers to underestimate the difference between H and L. Also senior managers may set t relatively high because of a desire to back managers. These are all things that will make it less likely Jack complains and more likely the incompetent manager continues. Firms, therefore, need to strike the right balance to weed out inefficiency.