Golden Balls: Split or Steal?

A variant of the prisoner’s dilemma:

So this was the payoff matrix they faced:

Stealing is a weakly dominant strategy: regardless of whether Sarah splits or steals, stealing always gives Steve a payoff that’s at least as good as splitting. Orange and red indicate the three Nash equilibria, where neither player has an incentive to unilaterally change his or her action. What’s most interesting however, is the strategy of both stealing. In fact, “both get nothing” isn’t exactly representative of the payoff to the loser. After all, if you were Steve, wouldn’t you feel a little consoled if you managed to thwart her plans? At the same time, wouldn’t you be much more upset if you simply allowed her to get away like that?

Some payoff clearly needs to be added for revenge. Indeed this is an important finding in the ultimatum game, where people offered significantly less than a 50-50 split typically choose to punish the other person by rejecting the entire sum. Not economically rational, since getting a little is better than getting nothing; but this experiment shows the importance of emotions in decision making.

Steve wasn’t rational by any measure, but maybe he did it on the (mistaken?) belief that many wouldn’t be able to walk away with that kind of guilt. In her defense, Sarah can truly claim to be a rational economic agent.


A star in the making?

I came across this article today on NYT:

How do you help brick-and-mortar stores sell books? Throw in an e-book.

That is the idea of one publisher, Algonquin, which began a promotion in 300Barnes & Noble stores this month that gives a discounted e-book to customers who buy an Algonquin trade paperback. The publisher has planned a similar effort for October, giving customers who buy a hardcover copy of “When She Woke,” by Hillary Jordan, the digital version of the book free.

I’m not sure about others, but I’m not too keen on having both versions of the same book. One publisher concedes as much:

Several publishers have experimented with bundling, whether by grouping several e-books together for one price or selling a print book paired with an e-book. “Consumers are starting to feel like, ‘If I’m buying the book, why do I have to buy it several times to have multiple formats?’ ” said Robert S. Miller, the group publisher of Workman.

In fact, this practice is pervasive. Newspaper and magazine companies do that all the time – FT, The Economist, NYT, you name it – as long as you subscribe to the print edition, they throw in the digital edition. Do we really need two versions of the same thing? If not, why do they even bother?

Dan Ariely has an answer. In Predictably Irrational (yes, for the umpteenth time – I cannot recommend a better book), he discusses how The Economist uses this strategy to help potential customers make up their minds. Look at the following ad, and before you read on, try and decide which of the three you’d pick if you were planning to subscribe to the magazine.

Internet: $59; Print: $125

Can’t decide which is better? Look at the third option. Internet + Print: $125. Wait, are we missing something? $125 for Print AND Internet? The Internet version is free (gasp) with the bundle! What’s going on here?

Putting these three options side by side, we can guess what The Economist is up to. All of a sudden, the third option seems so much more attractive than the other two, both of which have probably been giving you a tough time. Marginal cost of throwing in the digital edition: Negligible. Marginal benefit: One additional Print + Internet customer, who thinks he’s gotten himself a bargain.

Ariely’s point is that we rarely think in absolute terms; more often than not, we “focus on the relative advantage of one thing over another, and estimate value accordingly.” And my point, is simply that this ostensibly strange strategy of throwing in a digital edition for free is not that strange after all.

All that talk about ebooks – how does the ebook compare with the print book? Here are some statistics:

For the wide range of free books that’s available online, I know I’ll hop onto the ebook bandwagon soonBut for me, it’ll never replace the print book.

The Anchoring and Adjustment Heuristic

Three years ago, I bought myself a PlayStation Portable (PSP) at Sim Lim Square. Prior to the actual buy, I compared the prices at more than five different outlets and realized that they were all selling it at $290. With the assurance that they had done away with the price war that was prevalent years before, I decided to buy it from the very first shop I had gone to.

As I was about to purchase the PSP, the owner of the store started pushing some add-ons to me: first a memory card, then a protective case, and finally a pair of earphones. For some reason unbeknownst to me then, I barely hesitated. Before I realized it, I was $550 down. I had spent almost twice of what I had intended. Two months later, I found out from my friends that I had been cheated. The owner had charged me three times the market prices for both the case and the earphones.

How is it that I allowed myself to be cheated so spectacularly? How could I have paid so little attention to the prices? Those add-ons did not come cheap. If I had given more consideration to their prices, I might very well have realized that they were grossly inflated. More importantly, why did I buy the add-ons when, on a separate day, I would never have considered them at those prices?

In 1974, Tversky and Kahneman presented the anchoring and adjustment heuristic to account for how people estimate quantities. In the classic study, participants were asked to estimate the percentage of African countries that belonged to the UN. Before making their estimates, half of the participants were asked if it was more or less than 10% (an anchor), while the other half were asked if it was more or less than 65%. Those that were presented with the lower anchor of 10% reported significantly lower estimates (25% on average) than those presented with the higher anchor of 65% (65% on average). Ariely, Loewenstein, and Prelec (2003) carried out a similar experiment in which participants were allowed to bid for items in an auction, but only after writing down their Social Security numbers and asked if they would pay an amount equal to it for the items. Those who had higher Social Security numbers ended up bidding significantly more for the items. These experiments showed that arbitrarily selected anchors could in fact skew the subjects’ judgment considerably.

This was the same anchoring and adjustment heuristic I unconsciously used and fell prey to: I was fixated on the irrelevant price of the PSP (which served as the anchor), and adjusted downward to decide what would have been a reasonable price to pay for the add-ons. However, I failed to adjust downward sufficiently from the high anchor, resulting in a much higher willingness to pay than usual. Since the add-ons were cheaper than the maximum I was willing to pay, they appeared like a bargain to me and I went ahead with the purchases. The result? I ended up paying much more than I really should have. The anchoring and adjustment heuristic led me to think of the values of the add-ons in relative terms; I determined my willingness to pay for them based solely on the price of the PSP.

Having explored the cognitive underpinnings of my irrational behavior, what can we do to avoid making the same mistake? I have found two strategies to be particularly useful. The first is to be constantly aware of the anchoring and adjustment heuristic in daily situations. As with most cognitive heuristics, we often use it without being aware of it. Suppose you are having dinner at a posh restaurant. You aren’t feeling too hungry, so you decide that a beefsteak is just enough for you. You place your order, and the waiter says to you, “ would you like to add on the soup of the day for just three dollars?” Would you? Most people would, since $3 for soup isn’t much compared to $30 for beefsteak. But as you struggle to finish your steak, you catch yourself wondering if this was really a good decision. If we can recognize the prevalence of this cognitive bias in our everyday transactions, we can overcome this temporally heightened willingness to pay and avoid buying what we don’t really need. In my case, I would have paid more attention to the intrinsic worth of the add-ons, instead of simply anchoring on the price of the PSP.

The second strategy requires us to ask ourselves two questions before we commit ourselves to an add-on. First, would the utility you derive from your purchase be at least equal to what you pay for? If so, it may be a good buy. The second and overriding question is, would you be able to better spend that money elsewhere? If so, then it would be a bad buy.[1]Adopting a broad perspective by considering alternative uses of the money serves as an excellent reminder of what we are giving up when we purchase an add-on, and thus forces us to assess it for what it is really worth.

1] The opportunity cost of the add-on is a better decision criterion. An add-on may still be a bad buy if it passes the first test but not the second.


Back from a long, long period of radio silence! I haven’t written in so long in part due to my schedule, but in greater part because I’ve been wondering if blogging is a worthwhile activity. It’s a question that tugs me every time I realize (sadly) how precious time is, especially in Singapore. So I was delighted when I came across Dan Ariely’s thoughts in his latest book, The Upside of Irrationality. (But I wasn’t surprised because he has this remarkable ability to address at length issues that lurk beneath the surface.*)

Dan says:

Now think about blogging. The number of blogs out there is astounding, and it seems that almost everyone has a blog or is thinking about starting one. Why are blogs so popular? Not only is it because so many people have the desire to write; after all, people wrote before blogs were invented. It is also because blogs have two features that distinguish them from other forms or writing. First, they provide the hope or the illusion that someone else will read one’s writing. After all, the moment a blogger presses the “publish” button, the blog can be consumed by anybody in the world, and with so many people connected, somebody, or at least a few people, should stumble upon the blog. Indeed, the “number of views” statistic is a highly motivating feature in the blogosphere because it lets the blogger know exactly how many people have at least seen the posting. Blogs also provide readers with the ability to leave their reactions and comments – gratifying for both the blogger, who now has a verifiable audience, and the reader-cum-writer. Most blogs have very low readership – perhaps only the blogger’s mother or best friend reads them – but even writing for one person, compared to writing for nobody, seems to be enough to compel millions of people to blog.

Why do I blog? I blog mainly as a form of keeping my already bad writing skills from degenerating; I also blog to share interesting findings/research/ideas with others, and archive some of these for future reference. But Dan is spot on: I have very, very low readership, but even a few readers spur me to write because of the feeling that my work is at least of value to someone out there – in other words, meaningful. If nobody at all were to read it, it’d probably feel like talking to myself, and I’d probably stop blogging.

*For a preview of Dan Ariely’s work, check out the link to the right of this page: Predictably Irrational.

How far will behavioral economics bring us?

Not very far, according to George Loewenstein, one of the field’s pioneers.

But the field has its limits. As policymakers use it to devise programs, it’s becoming clear that behavioral economics is being asked to solve problems it wasn’t meant to address. Indeed, it seems in some cases that behavioral economics is being used as a political expedient, allowing policymakers to avoid painful but more effective solutions rooted in traditional economics.

Behavioral economics should complement, not substitute for, more substantive economic interventions. If traditional economics suggests that we should have a larger price difference between sugar-free and sugared drinks, behavioral economics could suggest whether consumers would respond better to a subsidy on unsweetened drinks or a tax on sugary drinks.

But that’s the most it can do. For all of its insights, behavioral economics alone is not a viable alternative to the kinds of far-reaching policies we need to tackle our nation’s challenges.

Loewenstein’s article is motivated by his observation that every week, we see books and articles that talk about how irrational decision making can have implications on our life. Indeed, apart from some exceptional ones, many books and articles simply repeat what everyone already knows about how irrational we really are. The book review I spotted on Amazon probably describes better some of the books out there:

This book is a feature length article expanded into a book. After the first 30 pages, I felt like the dead horse was being kicked, and kicked, and kicked, and kicked… and it was dead. I get it… People make bad decisions, and have bad beliefs they cling to. Enough already. I tried reading every tenth page, and it was just the same stuff.

Of course we must remember that behavioral economics is a relatively new – and fertile – field. At this point of time however, I think what we require more is the application of behavioral economics. Richard Thaler and Cass Suntein’s Nudge does a great job on proposing how its findings can be applied in public policy to achieve what they call “libertarian paternalism”. Libertarian paternalism refers to fulfilling the demands of citizens to have freedom of choice (hence libertarian), yet subtly nudging people towards making choices that are good for them (hence paternalism).

An example would be the urinals below – by the way Terminal 3 of Changi Airport has toilets with urinals that have flies etched on them – through the design they prompt males to aim better, reducing spillage.

It would be wonderful if we could see more books like this instead of those that simply repeat the same old experiments that reveal human irrationality.

We might go even further if behavioral economics starts integrating formally with macroeconomics. At present, financial mathematics is receiving plenty of flak all around for its contribution to the financial crisis. Economyths: Ten Ways Economics Gets it Wrong put me to sleep every single time I read it, but its main premise is that economics has hit a brick wall because of how economists have incorporated mathematics based on unrealistic assumptions to make the field more rigorous, like a science.

Nassim Taleb’s Fooled by Randomness very severely denigrates the field of financial mathematics, calling quants and traders alike arrogant in their belief that risk can be systematically managed. For that matter, Taleb harshly criticizes the entire field of economics – the proof being his mockery of the Nobel Prize in Economics – save for the more realistic behavioral economics. In How Markets Fail*, John Cassidy calls traditional economics “utopian economics”, and behavioral economics “reality-based economics.

All these make me wonder about the future of economics and finance. While debates still rage on in these fields, what are we as students going to be taught? Are we going to continue to rely on such theories as the efficient markets hypothesis and capital asset pricing model? How much of the behavioral approach should we be exposed to?  One thing’s for sure: all this uncertainty makes for a very exciting time to learn finance.

*How Markets Fail is a very, very illuminating read of an overview of economics.