An Offer You Cannot Refuse

Currency - by bradipo

Imagine that you are on a game show.  Consider the following two scenarios:

The host has given you $2000 to begin with.  You are now given a choice – you can stay with your money or participate in the “Double or Nothing”.  Should you choose the event, the host would flip a fair coin.  Should the coin land heads, you will get an extra $2000.  Should it land tails, you lose the $2000 you have.

The host has given you $4000 to begin with.  You are now given a choice – you can participate pay a fine of $2000 or participate in the “Trap of Doom” event.  Should you choose the event, the host would flip a fair coin.  Should the coin land heads, you get to keep all $4000.  Should it land tails, you loose all $4000 to the “Trap of Doom”.

Would you participate in the “Double or Nothing” event?  Would you participate in the “Trap of Doom”?  Are your answers different?

If you answered differently to each question, don’t worry – you are not alone.  In a number of studies done by psychologists, it has been noticed that a set of test subjects faced with the first “Double or Nothing” problem, would mostly choose to keep the $2000.  Nevertheless, when given the second “Trap of Doom” problem, they would choose to flip the coin to try to keep the $4000.  This particular phenomenon is known as loss aversion.  It has been studied over and over from stock brokers to medical personnel.  It is one of a class of psychological effects known as the framing effect.  This is an artifact of the way our brain processes information.  The framing effect is one of many cognitive biases that psychologists have identified over the last century or two.  Cognitive biases are the brain’s tendency to ‘mis-process’ information from a rational point of view.  They tend to be evolutionary by-products that, at some point in our past, helped us survive.  Studying these biases helps us understand why we come to the decisions we come to and how our environment, our past experiences and our perception can color our decision-making.

Loss Aversion Explained

Let us look at the phenomenon of loss aversion.  Broadly speaking, this is the tendency of humans to disproportionately fear and avoid a loss when compared to acquiring a profit of equal value.  If you noticed carefully, the “Double or Nothing” and the “Trap of Doom” problems were exactly the same – the choices were to either receive $2000 or to have a 50% chance of getting $4000.  In both situations, the expected outcome is a gain of $2000.  The outcomes of the choices are pairwise identical.  Yet, when framed as a gain or a profit, test subjects mostly preferred the guaranteed win, while when framed in terms of a loss, test subject mostly preferred to gamble.  This phenomenon seems to be connected to our instinctual hatred of giving things up versus gaining new things.  We tend to feel bad when gifts are taken back from us, even when they were given to us for free.  Most of us would rather we had never gotten a gift than to hand a gift back.  Nobody really knows the exact reason why we have this strong instinct to avert losses.  What we do know is that this effect exists and can even be manipulated by advertisers, user interface engineers, financial engineers, economists and politicians.  A paper by Kahneman and Thaler describes the effect in more detail.

Endowment Effect

Books - by Ian Britton

A related effect, also studied by economists, is the tendency of humans (even those trained in the mechanics of markets and the concept of supply and demand) to expect to paid more for an item that they own than the amount they are willing to pay to buy an identical item.  As an example, pick a book that you like.  Now, imagine yourself in one universe, where you do not have this book.  How much would you be willing to pay for it?  Now imagine another universe where you have the book.  How much would you be willing to sell it for?  If these numbers are not the same, ask yourself why this is the case.  Take careful note that the prices mentioned are not your initial offering or bargaining prices.  It is reasonable to assume that you will try to low-ball the price when you try to buy and raise the price when you try to sell.  What we are instead considering is the absolute maximum (or minimum) price at which you are willing to buy (or sell) the book given the current situation.  Most human subjects show a considerable difference in these two prices.  This is known as the endowment effect.  Simply the fact that we possess something makes that object more valuable. An economically rational position would not allow these two prices to diverge.  Humans are sentimental.  Humans also inherited the herd and territorial instincts of our evolutionary ancestors.  It would seem that humans not economically rational, at least in this case.  Yet, a common simplifying assumption used in economics is that a consumer’s willingness to pay is equal to their willingness to accept the same good given equivalent situations.  One needs to me mindful of the limitations of these assumptions when dealing with humans in the real world.

Ruminations

The take away lesson from this post is that the human mind is incredibly frail and manipulable especially when it is cornered into an instinctual response that developed evolutionarily.  These failures at “being rational” need to be considered in a number of fields such as the criminal justice, politics, economics, social science and even pure fields of mathematics and philosophy such as game theory and rationality.  Models for the human mind need to incorporate these evolutionary quirks and human social and economic systems need to be designed with human participants in mind.  In future posts, I will talk about a number of other human biases such as the confirmation bias, recall bias, Halo effect, Hawthorne effect and placebo effect.  The last of these effects is crucial to understanding modern medicine and pharmacological interventions and has been a source of endless confusion to the lay non-scientist to their own detriment.  A good understanding of these mental illusions helps us make better sound decisions related to everything from stock markets and retirement accounts to drug prescription and immunization.

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5 responses to “An Offer You Cannot Refuse”

  1. Edward Cating says :

    Great article. Thanks for making the case that institutions need to consider the psychological realities of humans in addition to the theoretical niceties of their foundational theories. The following quote from Alan Greenspan before a House Oversight Committee in October 2008 says it all: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief.”

  2. Simple Scientist says :

    I really should write more articles on behavioral economics (and the caveats that come with it). I plan on describing some interesting cognitive biases but then address the sampling bias incurred when trying to understand human behavior based on studies done on apathetic, entitled, under-rested/hung-over western college students as described here.

  3. Kia says :

    Awesome article! I could understand it well, and it was really interesting

  4. Simple Scientist says :

    You are welcome Kia! You inspire me to write about everything I know about this crazy world :)

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