The Consequences of Limited Rationality, Social Preferences, and Lack of Self-Control


  Behavioral Economics explained

“I never could bear the idea of anyone's expecting something from me. It
always made me want to do just the opposite.”

[Jean-Paul Sartre]

    We'd like to think we're enlightened rational actors, that we make choices based on our individual and unique circumstances, and that we're mostly in full command of our actions. Nothing could be farther from the truth. But this is now bad news once we understand how we work.

    Richard H. Thaler has spent time testing how psychologically realistic assumptions come into play into economic decision-making. The field of behavioral economics is richer for his contributions and we can now apply its principles to identify and diagnose problems so we can design tools that address them. 

    Behavioral economists study how the context of decisions interacts with our expanded understanding of human psychology. Many of the tools used by behavioral economists are about helping people make the choices they already want to make. In other words, they help us go from intention to action.

    If we want to remember to do something, for example, we set a reminder on our calendar (environment) because we know we sync all devices to it and it will reach us no matter where we are (unless we turn everything off… which is unlikely anymore.)

    In Misbehaving: The Making of Behavioral Economics, Richard Thaler demystifies the core premise of economic theory that people choose by optimizing. According to the Royal Swedish Academy of Sciences, Thaler has successfully shown how the all too human traits systematically affect individual decisions as well as market outcomes. Homo economicus doesn't exist.

    From the announcement#:

Limited rationality: Thaler developed the theory of mental accounting, explaining how people simplify financial decision-making by creating separate accounts in their minds, focusing on the narrow impact of each individual decision rather than its overall effect. He also showed how aversion to losses can explain why people value the same item more highly when they own it than when they don’t, a phenomenon called the endowment effect. Thaler was one of the founders of the field of behavioural finance, which studies how cognitive limitations influence financial markets.

Social preferences: Thaler’s theoretical and experimental research on fairness has been influential.  He showed how consumers’ fairness concerns may stop firms from raising prices in periods of high demand, but not in times of rising costs. Thaler and his colleagues devised the dictator game, an experimental tool that has been used in numerous studies to measure attitudes to fairness in different groups of people around the world.

Lack of self-control: Thaler has also shed new light on the old observation that New Year’s resolutions can be hard to keep. He showed how to analyse self-control problems using a planner-doer model, which is similar to the frameworks psychologists and neuroscientists now use to describe the internal tension between long-term planning and short-term doing. Succumbing to short-term temptation is an important reason why our plans to save for old age, or make healthier lifestyle choices, often fail. In his applied work, Thaler demonstrated how nudging – a term he coined – may help people exercise better self-control when saving for a pension, as well in other contexts.

    For this work, he was awarded the 2017 Nobel Memorial Prize in Economic Science. Classic economic theory is the reason why we're not very interested in economics, according to Ha-Joon Chang. Chang is a reader in the Political Economy of Development at the University of Cambridge and is the author of several widely discussed policy books. The influencing policy part of Chang's work is why we should care time to do economics as if people mattered.

    Access to data helps us see the importance of behavior. Armed with curiosity Thaler conducted studies that cross-referenced psychology and sociology. He figured out the real reasons behind our decisions and how emotion and irrationality take over our thinking.

    We may acknowledge impulse-buying for small things, but we're hard-pressed to tip our hand in big decisions. Take for example buying a car. An example of business decisions at GM from his book. The financing deal the automaker was offering was worse than other deals they had on the table. Yet cars were going like crazy.

    Thinking about it, Thaler figured out that what was likely happening was that people were thinking a $600 rebate on a car was little, but an interest rate that was one third of the current rate was a good deal. So they went for it. This is what misbehaving in the real world looks like:

In my first meeting (at GM), a vice president of marketing gave me my schedule for the day. I had a series of half hour meetings with different people in the marketing department. Many of them also seemed to be vice presidents.

In that first meeting I asked who was in charge of evaluating the low-interest-rate promotion, which reduced the price of the cars sold by hundreds of millions of dollars. My host was not certain, but assured me it had to be one of the people I would be meeting. By the end of the day I would know.

During the day several people described how the interest rate of 2.9% had been determined. Apparently Roger Smith, the (then) CEO, had called a meeting to determine how they were going to deal with the surplus inventory of that year and someone had suggested a promotion based on lower interest rates. Everyone agreed this was a great idea. But what rate should they use? One manager suggested 4.9%. Another said 3.9%. After each suggestion, someone would be sent to make calculations. Finally, someone suggested 2.9%, and Roger decided he liked the sound of that number. The whole process took less than an hour.

But when I asked people who would evaluate the promotion and decide what to do next year, I got blank stares followed by, "Not me." The day ended in the office of my host. I reported that, as far as I could tell, no one would be thinking about these questions, and this struck me as a mistake. He suggested that I write him a proposal for what might be done.

After what I learned during that visit, I was pretty sure I did not want this consulting job, but I did send him a short proposal making two suggestions for what I thought they should do. First, figure out why the promotion had worked so well. Second, make a plan for the future, especially since they should expect that Ford and Chrysler were likely to copy GM's successful promotion.

After a month I received a curt reply. My recommendation had been discussed bu top management and was rejected. The company had instead resolved to better plan its production and avoid excess summer inventory. This would eliminate the need to evaluate the promotion and plan for the future, since there would be no more end-of-model-year sales. I was astounded. A huge company had spent hundred of millions of dollars on a promotion and did not bother to figure out how and why it worked.

[…]

As I learned over the years […] the reluctance to experiment, test, evaluate, and learn that I experienced at General Motors is all too common.

    If this sounds familiar it's because it is. Incidentally, I watched The Founder this past weekend. It's the  story of how Ray Kroc (an excellent Michael Keaton), a struggling salesman from Illinois, met Mac and Dick McDonald, who were running a burger operation in 1950s Southern California. Kroc was impressed by the brothers' speedy system of making the food and saw franchise potential. To create a billion-dollar empire, Kroc needed to rethink what the business was about. Which is the counter-intuitive part.

     We're irrational, but in ways we can predict. Thaler's work on ownership, confidence, and a sense of fairness helps us understand how Kroc got the upper hand:

  • Ownership ― or the “endowment effect” says that we place higher value on things we already own.

    The McDonald brothers agree to let Kroc lead their franchising efforts only after he agrees to seek approval in writing for any changes. This can work in our favor. The wealthy investors Kroc reaches out to create the same poor management ethic which doomed the original franchise efforts by the brothers.

    So Ray hits on the idea of franchising to middle-class investors, who are more likely to be hands-on and willing to follow the McDonald's formula. This proves successful.

  • Confidence ― we do have an overconfidence problem, and this is a problem in prediction-making. More information may not help us make better decisions. Because we're poor at discounting biases. Often we see what we want to see.

    As new franchises began opening across the Midwest, with Ray Kroc representing himself as the creator of McDonald's, Ray begins to encounter financial difficulties as his share of franchise profits is limited due to his contract, which he negotiated based on what he knew and his skills of salesmanship.

    He had not foreseen how the contract would erode profits. Fortunately, he connect with financial consultant Harry Sonneborn. On reviewing Ray's books, Sonneborn realizes the real profit opportunity is in providing real estate to the franchisees, which will not only provide a revenue stream, but give Ray leverage over his franchisees and over the McDonald brothers.

  • Fairness ― we determine value based on what we think is fair. Which is why surge prices get so much attention in both directions.

    Based on Sonnenborn's analysis, Ray Kroc incorporates a new company, Franchise Realty Corporation, and attracts new investors. This move upsets the brothers and emboldens Ray. For example, he circumvents the brothers by providing powdered milkshakes to all franchisees.

    Ray renames his company to The McDonald's Corporation and demands to be released from his contract and buy the brothers out, the news of which sends Mac into diabetic shock. Ray visits him in the hospital and offers a blank check to settle their business.

    The brothers agree to a $2.7 million lump sum payment, ownership of their original restaurant in San Bernardino, and a 1% annual royalty, but when the time comes to finalize the agreement, Ray refuses to include the royalty in the settlement and instead offers it as a handshake deal.

    Afterwards, in the men's room, Dick asks Ray why he had to take over their business, when he could have easily stolen their idea and recreated it. Ray reveals that to him the true value of McDonald's was the name itself. A road warrior, he felt the name expressed all the attributes of Americana.

Nudging

    Since we can predict behavior to a certain extent, we can create small interventions to lead people in the direction we want them to go. Thaler coined the term “nudging.” There is power in reframing things, but it's up to us to use that power judiciously.

    “A nudge is any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives,” says Thaler. “You want to nudge people into socially desirable behavior, do not, by any means, let them know that their current actions are better than the social norm.” 

    Adman Rory Sutherland says our unpredictable nature helps us serve our self-interest. Nudging is unethical, say some people. But Sutherland begs to differ, because it still depends on why we want to tap into our unconscious biases, to what end.

He says:

We live on the second floor, the bag of trash gets too heavy for my wife to carry downstairs. Now, if she wants to carry the rubbish downstairs because the bag is now too heavy to manage, there are basically two approaches she can adopt.

There's the first approach which is wait until I'm sitting half-dressed with no shoes on, watching a television program, and say, Rory, can you take the rubbish downstairs? This is mistimed, slightly annoying, irritating, and at a moment when I will now have to get up from the chair, put shoes on, and perform this slightly tedious activity.

The alternative is that, without saying a word, she simply leave the rubbish by the back door. The next time I'm headed downstairs I'll carry it down without even thinking about it at all.

   How much we know about the world, and many other things, including current affairs, thus depends on the gap between how information is presented and our ability to figure out what is true. The idea for our attempts at intervention is to help people be “less wrong,” which means we should hedge in favor of what looks reasonable.

    We actually do this reasonably well in the real world. We use our intuition and heuristics to figure out what is what fairly well. It's a better way for us that trying to weigh the pros and cons, as in the GM example from Misbehaving.

    This is why the next big thing is not a technology — as Rory Sutherland says — the next big thing is the application of our understanding of social sciences to designing better experiences.

    Congratulations go to Richard Thaler for pursuing research that will help us improve our ability to make decisions.