In the recent weeks, racism has been on the headlines, and each time we have to realize how seriously harmful the situation is. We could write about a number of things regarding racism. For example, we could cite papers which found that the more intelligent you are, the lesser the chances that you will be racist; however, there are a number of problems with these assessments. Firstly, they could be misinterpreted, and such papers could be found to support either of the ‘agendas’. Secondly, it is counterproductive – informing some of such evidence simply will not stop racism. Thirdly, and perhaps most importantly, it’s such a complex issue, that one cannot possibly grasp the entirety of the matter. We do not aim to shed light on all the faults of society: from ethical issues to problems regarding moral relativism throughout the history of slavery and racism is something that cannot be cut in half, like the Gordian Knot.

Racism as distorted heuristics: identity economics and stigmatizing

First, we need to assess the origins of racism. Sociologists and psychologists keep examining the question whether we are born racist, or it’s something we learn. This raises the question whether racism is a social or a biological construct. If it is the latter one, we might have a harder time tackling it, while if it is a completely social function, great effort and educating ourselves on these “norms” could lead to progress in the foreseeable future. Research shows that we have an innate tendency to make group-based distinctions, particularly, in the form of “us” and “them”. This evolutionary behavioural tendency appears from our past. In tribal culture, groups comprised of loyal members succeeded more often than groups comprised of non-loyal members, leading to a natural selection process in which the human mind has been sculpted to be tribal. Yet, group cooperation is a double-edged sword, as it implicitly implies that there is a tendency to be hostile towards other groups.

As such, racism could be interpreted as a textbook-example for in-group favoritism, where we become more receptive towards those who belong to the same group as we do, while disregarding – or, in certain cases, taking a stance against – the ones we do not associate with. This, however, does not necessarily explain the notion of being predatory towards only certain groups, and not all of them. Why do we like one group, and hate the other? That is where the social context comes into the picture. This could be influenced by a number of things, may that be cultural, religious, or relating to any sort of value differences. Most of these can be traced back to past experiences – personal, or even historical differences among groups – similar to what Romeo and Juliette were forced to face.

Ergo, although racism has its roots in our past, it is also a social construct. Essentially, we are born with an ingroup bias, but the fact that we are not acting hostile against every other group emphasizes that as we get more social, our preferences – and therefore our disposition towards the other group – are adjusted in a selective manner.

The irrationality of racism – how it limits our “playground”

As Adam Smith said: “Every nation lives by exchange” – may it be exchange of articles, ideas, goods or services. In institutional economics, institutions are defined as the “rules of the game”: any factor that restricts these rules, may that be formal rules set by the government, or informal institutions in play in smaller communities. It’s important to note that these institutions – while restrictive of our ground of play – are incredibly useful, as they reduce uncertainty during our conduct of action. When in traffic, you do not need to think about whether it is your turn to go or not – the green light signals to you that it’s safe for you to drive on.

One could argue that racism is such an institution; yet, nothing could be further from the truth. Institutions are there to help coordinate decision-making. Appealing to one’s gender, race, or religious affiliation does not have this property; rather, it is a generalizing, heuristical way of thinking, which is vulnerable to representative bias, selection bias and availability bias, to name a few. Consequently, not only does it reduce the number of potential transactors, it also signals false probabilities. Every transaction that is lost due to the presence of aforementioned in- and out-group preferences is detrimental to the economy, having a deadweight loss as the economy is not in its optimal state. Such distinctions could also undermine trust between economic transactors, which was shown to be a relevant factor in the economy, as it lowers transaction costs – while still being a crucial factor for all democracies. That is why Eurostat, PEW Research Center and the World Values Survey also conduct research in the field.

Another topic to elaborate here concerns the impact of in-group bias on the job market, referred to as favouritism in the literature. Within the labour market, it is not uncommon to observe that jobs, contracts, and resources are offered to one’s social group at the expense of other, outside groups. From an economical perspective, favoritism entails costs as it usually leads to inefficient allocation of resources. This phenomenon is most common in family-owned enterprises, since people at higher level positions in these businesses are usually chosen based on social relations. And do not let us go into politics, where as we all know, favouritism, instead of meritocracy, is the primary factor to get into the White House, implying that in-group bias is rampant, having an indirect effect on all of us.

While it sounds odd, diversity programs at big companies may not be the solution, as it is just going overboard on in-group favouritism. Taking this approach, the problem associated with not hiring applicants based on their qualifications still persists – and so does hiring based on the colour of one’s skin. In economic terms, it is still not the most efficient way of hiring. One might argue that different backgrounds entail different ideas, leading into enhanced creativity. But shouldn’t the way of thinking be a merital factor?

Race preferences and the changes in neighbourhoods

We can put a spin to this whole thing and say: what if there is no such thing as racism (which in itself is irrational and oversimplifying), but rather if there is a preference for races? This is not an unusual thought: we like to surround ourselves with people who are much alike us from a certain point of view, may that be religion, core values held, social standing, and race. Rich people do not really like to live close to poor people. The same thing can be said to followers of opposing religions. Race is no exception.

Have you ever wondered why certain groups have a tendency to live in certain neighbourhoods? This idea of how neighborhoods change originates from Thomas Schelling. Consider a neighborhood where every person has a preference on what proportion of their own race (or political or religious affiliation, mind you) should inhabit the surroundings. We cannot say that white people prefer their neighborhood to consist of at least 50% whites (although certain agent-based models would operate so); however, we can deal with individual preferences: some prefer the neighbourhood where 80% of the population is the same race as them, while some prefer it to be 75%, 70%, 50%, etc. Some, however, have no preference over race. This is very interesting if we want to look at the dynamics of a given area: in the beginning, there seems to be a stable balance. Later on, slowly, those who have no preference may start moving from the neighbourhood. When we hit the threshold of the proportion of given race (in this situation being 80% or less), we arrive at the “tipping point”, where the number of families moving out from the neighborhood grows exponentially. First, the families with 80% threshold move out, then the ones with 78%, and so on.

Note that this example does not imply racism (strictly speaking), only race preference. However, with some adjustments in this “agent-based model”, we can set the rules for discriminating neighbourhoods, as well. After a few turns of play, you could model how the neighbourhood changed, but also you could analyze each dweller’s situation, and how happy and content they are when considering the race of their neighbours. One implication is almost certain: if you put race as a priority to your choice of dwelling, you might not have a content life in the long run.

A question a number of economists ask themselves is what effects does society have on the economy? While this question may strike you as mundane, consider this argument: the market economy and capitalism works as it is because all the transactions happening are voluntary in nature. When you need something, you go to the market and consider your options and the different deals you encounter. If you don’t like the deal you have been given – may it be because of price, quantity, or quality – you can reject the offer and go search for other options. If you don’t find the goods you were looking for, then you might be inclined to search for substitutes.

Many philosophers and economists questioned the nature of these transactions, whether it is intrinsic evaluation and rational thinking that drives us, or something else. Rousseau had his famous argument that civilization had awakened amour propre (or: self-love) in people, leading to pride, vanity and envy. While in the old, natural environment, people were searching for things that were intrinsically good for them, moving to cities caused people to determine their own individual well-being as a comparison to their neighbours, friends and family. This lead to people looking for extrinsic values, instead of focusing on intrinsic ones.

Considering social choices, Veblen (1899) argued that there are two kinds of goods: one that is intrinsically good, and you find “utility” consuming it, while the other is a “social good”, which is good for signaling your social status (while you cannot enjoy it directly, you can enjoy the consequences coming from owning/consuming it). Herd behavior is also something worth considering, as it’s one of the most well-known habits among people in a social (and often economic) context. But what might induce herd behavior? And how do we get to certain social decisions?

A nuclear scientist and an economist walk into a bar

Many economists and economic thinkers from the 20th century had inspirations from various scientific theories, or had come from different scientific backgrounds. John von Neumann, for example, who with Morgenstern created the expected utility theory, was a mathematician and a physicist, and is known as one of the fathers of computers. Similarly, Thomas Schelling was an economist who also happened to be an expert in foreign policy and national security (and inspired Stanley Kubrick’s famous picture “Dr Strangelove”).

Schelling made a great contribution to economics by analysing conflicts as well as cooperational problems using game theoretical analysis, for which he received a Nobel-prize. He had an idea built on the concept of “critical mass”, which is used in nuclear physics. Critical mass denotes the smallest amount of material needed to induce nuclear fission. He used this as an analogy to why certain electable seminars at Harvard are doomed to fail.

He came to the conclusion that there are two points which are of stable equilibrium when considering voluntary, after-hours seminars – one where (nearly) everyone is present for a long period of time, and one where the whole thing dies out. Going back to nuclear fission, the more fissile material there is, the higher the probability that nuclear fission will occur. Translating this to social context: the more likely a certain group of people act in a way, the more likely people will follow this trend. If you see that less and less people attend a seminar, you might be inclined to not go next time. Later you could rationalize that it’s because you think that other people have some excess information (that the seminar is not that useful), but in reality, it matters little – you just know it is not as popular as it should be.

He also argued that there are exactly two kinds of people in these sort of “transactions”. Firstly, those, who have some sort of intrinsic evaluation of the situation, and they will act accordingly. Or in plain english: they know whether the course they are currently sitting is valuable to them or not. The second group, however, are those who look at the social environment – to them, the amount of people present is an important signal of quality. Consider the members of the second group. They all have a somewhat individual threshold where they consider a seminar “popular”; for some, it is 80 people present out of 100, for some it is 65, etc.. If we take this (and the knowledge we acquired by studying herd behaviour), we can quickly realize that it takes only a couple of people to leave class to quickly start a domino-effect.

Micromotives and macrobehaviour – the concept of tipping point

Thus, Schelling used this argument to define the so-called “tipping point” in social contexts – the point where the steady state of such social or cooperative games gets defined. It can be best depicted as an “s-curve” shown below:

The part depicted as “hypergrowth” is the most interesting part, where an exponential growth occurs. From the point of the dying seminar: until the tipping point, one or two students leave. After hitting a threshold, those who just go to the seminar because others go as well start to drop out – and suddenly, the majority of the students leave in a relatively short period of time. It also has an interesting implication: if everyone in the population does something only because everyone else is doing it, this will become a social norm, since theoretically nobody will go against it. If, however, a loud minority started arguing against such an action, it might change the whole environment. Others argue that in this area, with little additional added work, great impact could be achieved: if you are currently at a tipping point in your project, one little extra effort could change everything.

This is also a key concept when considering COVID-19. The tipping point in this case is the start of an exponential growth in the number cases. Of course, this is a completely different context, as in this case, it is rather the parameters of pandemics that define this exponential growth rather than individual properties (however, the speed of the virus being transmitted can be affected by reducing personal interactions – the idea behind social distancing).

The previous examples show that the concept of tipping-point has been widely used. It has been used in economic growth models, as well as in social settings, such as the growth in the number of people attending church. More recently, as mentioned before, it has been used for analysis of the coronavirus: not only with how it spreads, but also its potential economic effects. In an analysis done by Christian Aid, they warned that in third-world countries where health-institutions are basically non-existent, COVID-19 could cause a humanitarian disaster not seen in decades. That is why developed countries should help prevent these countries reaching the tipping-point of a disaster involving both economic well-being and health.

In one of our previous blogs, we mentioned that game theory is very important for behavioral economics in general, as it provides a framework where we can explain how interactions happen, and why certain outcomes are dominant. The idea is very simple: by having knowledge of the possible outcomes and the preferences of the other person, taking those into account can lead us to choose from a set of alternative actions. Assigning probabilities to actions can help us to calibrate our choices further.

In short: game theory provides us with the means to model interactions. This is especially useful, as a lot of experiments done by behavioral economists could be interpreted as some sort of game – may that be simultaneous, where choices are made for each person at the same time, or as an action-reaction game.

The Ultimatum Game

One of the more well-known games and experiments is the ultimatum game, created by Güth et. al. (1982). The basic version of the game is pretty simple: there are two players, one sender and one receiver. In the beginning of the game, the sender is given $10, and he needs to decide on how to divide it between himself and the other person. However, there is a twist: the receiver has to accept the offer in question, otherwise nobody will receive anything.

This puts a number of interesting factors into play. First, the sender has to offer an amount that the receiver will surely accept. Ask yourself: playing as the receiver, what would be the minimum amount that you would accept in this case? If your answer is anything greater than $0.01, I’ve got news for you: in economic sense, you are not a rational being. Why? Because you should not care about what the other person receives, you should only consider your own well-being: and as things stand, by only receiving $0.01, you are still better off compared to not receiving anything. In contrast, what you, dear reader, most likely had in mind is a fair division (which does not necessarily mean egalitarian division): maybe you consider that you are entitled to at least $3, and anything below that is just not fair.

This brings us to the second point: by rejecting an offer, you are punishing the other person for being unfair; however, at a cost: the amount of money that you won’t receive. In one interpretation, this means that the “enjoyment” of punishing the other person outweighs the negative utility from not receiving the money offered.

Another aspect which is important to consider is the information the receivers are endowed with – whether they know the amount that is being divided or not. It is somewhat trivial that your perception of the money offered can be altered if you know the budget of the sender. In a behavioural economic sense, this can be interpreted as whether you provide a reference-point to the receiver or not. As we already know from the prospect theory, a negative difference from the reference-point is interpreted as a “loss” by the decision-maker, and since most, or rather, all of us are being dominated by loss-aversion, we want to avoid this. If we tell the receiver that he is being offered $3 out of $10, in his mind he already created a reference-point which is “fair” (let’s say: $4): any negative deviances from that will be instantly rejected. In contrast, by not having any information on the total amount, one can’t really decide whether the offer is fair or not, generous or not, and will likely accept offers which are lower nominally.

Cultural differences are also significant across countries and communities. A great example to this are the findings of Henrich et. al. (2006), which was an enormous project consisting of 17 researchers. Anthropologists, behavioral and social experts conducted ultimatum games, dictator games and public goods games in 15 different small-scale societies. One highlight of their finding was, that in tribal societies, the rate of rejection was smaller than usual, leading the researchers to believe that these societies were “rejection-averse” rather than loss-averse. From interviews, they found out that a lot of senders offered more because they did not want the offer to be rejected – which could have led to conflict in the tribe. In hunter-gatherer societies of Paraguay and Indonesia, senders offered much more than the average, which is due to their lifestyle. Oversharing in these societies is common, because the hunters cannot consume their game privately, so they tend to share it. However, when other members accept these generous offers, it incurs a certain obligation to them to do better in the next hunting party.

You might be inclined to say that if the money in question would be greater, outcomes would differ. Certainly, experiments have been conducted where the stakes were much higher; for instance, a couple of months worth of salaries. These experiments caused the decision-makers to block, because they could not cope with the stress and pressure of the stakes being that high. However, Hoffmann, McCabe and Smith (1996) played the ultimatum game with a budget of $100, and found that the results were remarkably similar to the original experiment. They also found that when people “earned” the role of the sender through competition (for example: by participating in a quiz), their offers tended to be less generous. This was due to a feeling of entitlement from the sender’s side: by being smarter, they felt that they were entitled to earn more money than the receivers. However, and perhaps more interestingly, the receivers were not willing to accede to this sense of entitlement, and the rejection rates were greater as well.

As the saying goes: “It’s the thought that counts”. This can be shown in the case of the ultimatum game as well: Falk, Fehr and Fischbacher (2000, 2002), as well as Andreoni et. al. (2002) showed that intentions do matter. They tested this by modifying the ultimatum game: senders had to choose from two options of distribution. The first one was the same in all conditions: give themselves $8 and offer the receivers $2. The second option varied from the following distributions: offer nothing (selfish option), offer $5 (egalitarian option), and offer $8 (generous option). They found that, for example, the 8/2 offers were rejected 27% of the time in the “2/8 game” and only 9% of the time in the “10/0 game”. The variations in these rejection rates suggest that intention-driven reciprocal behaviour is a major factor behind decision-making. As such, the alternatives did matter: if the sender offered 8/2 instead of 10/0, he was considered to be generous, and was more likely to get the payments. Simultaneously, the unfair 10/0 offers were rejected 90% of the time.

And finally, the last case we want to introduce to you today is “the battle of the sexes”. The situation is simple (and all-too familiar): a wife and a husband want to spend time together, but they have different activities in mind. The wife wants to go to the theatre, while the husband wants to go see a boxing match. If they can come to an agreement, they will both benefit from it – if they agree to go to the theatre, the wife obviously will be happier, but the husband is happy as well, as he gets to spend time with his significant other (and vice versa if they end up going to the boxing match together). If, however, they cannot come to an agreement, both will be worse off due to the absence of each other’s company. Traditional game theory declares that the latter (going to the theater and boxing match alone) would be the outcome in most cases.

However, Rabin (1993) considered an alternative. In the model outlined in his article (which incorporates fairness into decision-theory), economic agents, besides having their own interest, also have social interests and goals. In order to achieve more social acceptance, they are willing to sacrifice their intrinsic, individual well-being and help others. Applying this to the battle of the sexes: suppose that the husband chooses boxing. The wife then concludes that choosing the theatre would hurt both players, and is therefore willing to go to the boxing match.

After what some called the worst week since the 2008 crisis, we felt that we should address some of the behavioural effects in the financial markets. More than 3 trillion dollars have just disappeared in the global economy. According to Bloomberg news, the world’s 500 richest people lost approximately $444 billion dollars, and as of February 28th, the Dow Jones Industrial Average lost more than 12%, while the S&P500 index lost 11.5% of its value. While this tumble in the financial markets is as appalling as it is baffling, economists, financial experts and investors try to find out whether such a decline is justified.

The story behind the decline is pretty straightforward: as the potential consequences of the COVID-19 virus began to be perceived as direr, the market reacted. Due to the precautious actions taken by both governments and companies, such as reduced working hours, travel bans, and, in some cases, closed factories, a decline of yield and production is expected. Such market corrections occurred 26 times after the Second World War (Goldman Sachs), and further corrections could be expected in the following months.

The key word in the last paragraph is expectations. Now, obviously, financial experts and economists have calculations and models on the effects of such external shocks (in economics terms).

Efficient markets, with inefficient agents

It is worth talking about one hypothesis in particular: The Efficient Market Hypothesis (EMH), proposed by Eugene Fama. In short, EMH is a model for the financial and capital markets which states that the current prices on the market reflect all available information on that particular stock. As such, the recent surge of Tesla stocks means that some meaningful information surfaced, thus expectations towards Tesla sky-rocketed. It is important to note, however, that not even Eugene Fama thinks that markets are perfect in the short run: he does, however, emphasize that this is a model, and models are always wrong (as George Box famously put it: all models are wrong, but some of them are useful).

Fama received a Nobel-prize for his theory in 2013. Funnily enough, that year he shared the economics Nobel-prize with Robert J. Schiller, who regarded his theory as “one of the most remarkable errors in the history of economic thought”. He is one (if not the) key figure of behavioral finance, along with Richard Thaler. In his work, he analyzed markets and tried to find behavioral patterns on the markets. Along with writing the book “Animal Spirits” with George Akerlof, he is most famous for the behavioral analysis of market bubbles and the creation of the Case-Schiller repeat-sales index for the real-estate market.

Schiller’s proposition of the market is quite different of Fama’s – in his theory, markets are inefficient, and mostly driven by psychology ­– as such, you can easily beat the market as an investor (watch his case against EMH here: https://www.youtube.com/watch?v=Tn-A7eCUrYk). Interestingly enough, he and Fama seem to agree on a lot things. But one of the key aspects that they disagree on is the existence of “bubbles”, that is: whether over-pricing of an information can occur on the markets. If it comes down to the individuals – especially during turbulent times – Schiller might have got a point.

During a crisis or a panic, risk aversion comes into play. We know from Kahneman and Tversky (1979) that not only we are bad at probabilities, but we also perceive them incorrectly. This was depicted in their weighting-function, which can be seen below:

In short, this states that we overvalue the occurrence of low-probability events, and relatively undervalue certain effects. For us in this context, the overvaluation of low-probability events is key, as such it can be utilized to explain the recent unprecedented movement that occurred in the markets. Accordingly, as the market participants overestimated the probability of the coronavirus being a pandemic event, which, based on past occurrences, is highly improbable, market overreaction that does not necessarily reflect the economic reality might have ensued. This, in the context of Fama’s hypothesis, might imply that markets can be emotionally efficient, meaning that information by itself is not reflected in the market, instead, it is the information after being filtered by emotions and biases that the market reflects.

The availability bias is another aspect that might be involved, relating to the tendency to determine the likelihood of an event’s occurrence by the simplicity to retrieve it from the memory. To give you an example: people are more afraid of travelling by plane than they are of travelling by car. Why? If there is a plane accident, it is all over the news. Car accidents are more likely to be reported in traffic news. Because of this, in our mind and in our memories, plane accidents were more impactful than car accidents. In the context of markets, wide coverage of coronavirus news gives the market participants perception that the situation is exacerbating, leading to the overestimation of the possible effects. Yet, when one realizes that total flu deaths every year worldwide is around 389 000, the 2942 deaths caused by coronavirus appear strikingly low. However, the market acts as if it were exactly the reverse. It is a common observation that markets realize this overreaction sooner or later, and a strong retracement follows. Observation of similar past virus outbreaks reveals that twelve months after the overreaction occurred, the markets increased, on average, by 13.62%, emphasizing that the initial concerns were significantly overestimated. Of course an argument can be made that the market is pricing the current expectation of decrease in production, but historically this is still an overreaction – maybe this is the market’s way of “better safe than sorry”.

Clearly, making investments in such a volatile environment depends on your time-horizon: if you are a short-term investor, you might be inclined to invest in safe-havens. If you are a long term investor, however, you might see this as an opportunity, as you are able to buy stocks at a lower price, thus your long-term returns might increase. And, of course, risk appetite is key in both cases.

Panics, safe-havens and animal spirits

But what do investors do when there is panic in the markets? They turn to so-called “safe haven” investments. Investors buy these assets to reduce their exposure to losses during volatile times on the market. Examples include gold (and other commodities), treasury bills (considered to be risk-free, due to the government being the debtor), and defensive stocks. Defensive stocks include companies whose products’ demand can be described as rigid – food, medicine, and all sorts of FMCG markets, all due to the simple fact that there is constant demand for these goods. Most of these are coming from rational expectations, that in the future the demand for these is still going to be high. Investing in gold, however, might not seem as practical as the other ones. One can argue that this is just a “reflex” – after all, coming from a philosophical question: why does gold have such an important intrinsic value, even if it’s not as widely used as it once was? And we have yet to talk about the elephant in the room: cash.

During major economic downturns, people liquidate their investments and try to get as much cash as possible. This was mainly true during major uproars and bank-panics in the 19th and 20th centuries. A famous example is the Bank Panic of 1907. In short, what happened there is that during a recession, one of the largest trust companies of New York, called Knickerbocker Trust Company, was filed for bankruptcy – immediately, people lost their confidence in trust companies, and they tried to gain as much cash as possible. The consequences were decimating, and later it served as a reason to introduce the final lender, the Federal Reserve System in the United States.

Now, we can argue that this story bares some similarity to some of the department stores being overrun, and a lot of sustainable food being purchased. Due to the fear of the spread of the virus, everyone is preparing for a worst-case-scenario. Obviously, Keynes’ Animal Spirits is in play here – there is a sudden decrease of trust, and an increase in uncertainty. This mentality of the market, however, may be completely unsupported by fundamentals. As such, information asymmetry plays a huge role: we do not have complete information about the situation (reading every news article about the effect does not provide us with actual understanding on the effects, rather just the mood of society and the markets). Some actors might have better information on the topic, but it is very hard do distinct these in the noise generated by events.

Confirmation bias is also an important factor in this situation. Confirmation bias is when you start to interpret every information that you gather in a way which supports your prior beliefs. Basically what this means is that you decide on how to interpret a situation, and then you frame every new information so that you think that your “hypothesis” is more and more probable, thus leading to inductive reasoning. You can, however, defend yourself against this, but you have to be extremely conscious about how you interpret information.

And lastly, from a game-theoretical point of view, it might be worth to make some precautions. If everyone else is making these precautions, you might as well do it – the (perceived) possible losses by not participating in herd behavior might be greater than the gains by not complying – leading to a perverted “fear of missing out”. Again, the “better safe than sorry” argument can be made, with the condition that buyer’s remorse is actually more probable than one might imagine (think back on the weighing-function of Kahneman and Tversky).

So what happens?

Funny you should ask – no one knows. Unfortunately, no economist has the abilities of the Old Testament prophets, nor of Nostradamus. We cannot say what will happen – we have models, and some fundamental changes that we can rely on, but ultimately, behavior of the stock market can be very hectic and sometimes inexplicable, due to animal spirits and herd behavior – as Schiller and Akerlof elaborated on it ten years ago. But such great, sudden changes should be perceived and interpreted with caution – as explained, after such market corrections, there were other corrections in the following months.

As for forecasts and expectations, and old joke comes to mind: why did God create economists? To make weather forecasters look good.

Tim Harford in his recent blog told a joke about a pianist getting caught by the KGB in the Soviet Union. In his suitcase, the pianist was carrying a copy of Beethoven’s Moonlight Sonata, which the KGB thought was some sort of code western intelligence used. They put him into an interrogation room, where he waited. After an hour, the interrogation officer came in and said to the pianist: “You better start talking, comrade! Your partner, Beethoven, has already told us everything.”

This story aimed to serve as a demonstration to one of the great classics in economics – the Prisoner’s Dilemma. The background is: two thieves successfully complete a robbery; however, after a couple of days, both are caught by the police. Each of them is transported to their own separate cells, where they are disconnected from everyone and everything. Later, the interrogator offers each of them a deal: they can make a deal with the police and tell on the other thief, or they can stay silent. If they tell on the other thief while the other stays silent, they get to walk, and the other gets 5 years. If both of them tell on each other, they each get 4 years. If no one tells on the other, they only get charged for minor misdemeanor, each getting 1 year in prison.

Folsom Prison Blues

Classical Game Theory is a tool which aims to predict the outcomes of interactions between two (or more) parties. Mostly building on the Expected Utility Theory, developed by Neumann and Morgenstern (1947), it is founded upon a straightforward idea: how should I act towards someone in order to maximize my well-being? As such, the decision-maker evaluates the other person’s perspective, their choices, and, if applicable, identifies his or her dominant strategy. Based on that knowledge, our economic agent decides what their actions should be, and will act accordingly. However, it is important to note, that in order to evaluate other agents’ possible actions and make relevant judgements about them, an agent requires some information – which could be the outcome probabilities or perhaps some knowledge of their preferences.

In the Prisoner’s Dilemma – a simple and symmetric game – the model suggests that they will always tell on each other. This is depicted in the figure bellow: inside the boxes, the first and the second number defines payoffs for prisoner “A” and “B”, respectively. To see why we arrive at this conclusion, we can attempt to reason from the perspective of A:

• If B chooses not to tell on me, then I should tell on them (because my payoff will be higher than if I do not tell on them)
• If B chooses to tell on me, then I also should tell on them.

As such, based on rational decisions, the outcome should always be both telling on each other. This is called a “Nash-equilibrium”, named after Robert Nash. However, if they both chose not to tell on the other, a better result could be achieved. How can this be achieved, if they do not have any means of communication at their disposal? Well, the answer is trust.

The battle of the sexes

Another case is “the battle of the sexes”. The situation is simple (and all-too familiar): a wife and a husband want to spend time together, but they have different activities in mind. The wife wants to go to the theatre, while the husband wants to go see a boxing match. If they can come to an agreement, they will both benefit from it – if they agree to go to the theatre, the wife obviously will be happier, but the husband is happy as well, as he gets to spend time with his significant other. If, however, they cannot come to an agreement, both will be worse off due to the absence of each other’s company. Traditional game theory declares that the latter would be the outcome in most cases.

However, Rabin (1993) considered an alternative. In the model outlined in his article (which incorporates fairness into decision-theory), economic agents, besides having their own interest, also have social interests and goals. In order to achieve more social acceptance, they are willing to sacrifice their intrinsic, individual well-being and help others. Applying this to the battle of the sexes: suppose that the husband chooses boxing. The wife then concludes that choosing the theatre would hurt both players, and is willing to choose boxing.

Alternatively, if she perceives going for a boxing match as unfair (as they went there for the past 5 weeks straight), she chooses theatre in order to agitate her husband. We covered this topic recently in our blog regarding unfairness. Rolling with this might not have the best outcome for the relationship – but barely anything, that is driven by our emotions, does.

Games we like to play

As you probably guessed by now, this blog-post is not strictly about behavioral economics, as it is more about how it applies methodology to validate or model its findings. In this blog, I wanted to give you a glance into the world of game theory, which can model a wide range of situations and agent interactions.

Camerer (2003) provides a great example of how behavioral economics got integrated to game theory, and thus creating “behavioral game theory”. For the vast majority, this is a formal alteration of classical, rational game theory, using validations from experiments provided by behavioral economics. If we take a look at the Trust Game mentioned a couple of weeks ago, the results from the experiments inspired parameterization of preferences, as well as the “new” homo reciprocus and homo equalis. As such, even institutional economics started to use these “calibrated” models as standards.

Why is game theory so interesting for us? Because it is exceptionally good at modelling things like uncertainty, environmental effects, as well as emotions and feelings in interpersonal settings. In the 18th and 19th century, these factors had a pivotal importance in the political economy. But later, general economics wasn’t really dealing with problems arising from the economy being interpersonal (while justifiably giving a very important role to uncertainty). With the rise of experimental economics, experiments conducted could and should be analyzed in game theoretic settings, cutting away some of the complexities, and decomposing the important factors. In order to do this, behavioural economists have to quantify the effects of these rather qualitative factors; and while it is very complex and difficult to do, there are examples – such as the Trust Game – where this has been successful.

In last week’s blog, we introduced the concept of fairness in economic decision-making, how we perceive it, and how it distorts rational, self-interested mentality. Traditionally, our well-being should not be dependent on the fairness of others, but rather on how well we perceive ourselves to be. As it turns out, during the evaluation of our status and well-being, we tend to compare ourselves to others – using them as reference-points.

A number of emotions can occur when we perceive unfairness, but most importantly – envy. Envy, according to Rawls (1971), occurs when we look at other people’s well-being with malevolence, despite the fact that their superior endowments do not restrict us from enjoying our benefits. Also, we wish to deprive them of their advantages, even if it costs us to do so. Some of the literature calls this “egalitarian” view as malicious envy. Regardless of its name, it is easy to realize that this kind of noxious behavior cannot exactly be called rational, in the sense that acting so, one does not listen to reason, but rather to their emotions.

I can feel it in my guts

The role of emotions in economics was already clear and acknowledged before the creation of behavioural economics. One example for such acknowledgment is Keynes’ “animal spirits”, which was mentioned in his work The General Theory of Employment, Interest and Money (1936). In short: according to Keynes, Animal Spirits are meant to explain all the animal-like “instincts” or intuitions, which affect behaviour, and as such, the whole economy (however, there was never an elaboration on the idea from Keynes.)

A relatively new decision-making model was made by Loewenstein, Weber, Hsee and Welch (2001) called “Risk-as-Feelings Hypothesis”. Standard models, such as Expected Utility Theory and Prospect Theory, expect decision-makers to act rationally at any given point. This theory, however, stresses the importance of emotions in given situations. When decisions under risks are being made under emotional influence, these decisions might be significantly different than those under “rational behavior”. As such, we can differentiate between “hot” and “cold” statuses, the first being the emotional, while the latter being the “rational” state. For which condition will be dominant during the decision is dependent on (among a lot of other, external and environmental factors) how significant visceral factors (“gut feelings”) are at that specific time of the judgment and decision.

Loewenstein (2000) argued that these gut feelings may distort decisions from that made under quasi-rationality.

• First it may lead decision-makers in situations where economic or social inequalities and injustice is perceived, to act in a way which contradicts their own interests.
• Second, it has implications on changes in preferences in inter-temporal choice. In a given situation, one might be in a “cold” state, while three months later in a “hot” state – even if their supposed “core preferences” did not change – the outcome might significantly differ. Thus, emotional effects could be looked at as “standard deviations”, which can explain inconsistencies in decisions.
• Finally, Loewenstein points out that feelings can have serious implications for decisions under risk. Under visceral effects such as frustration, a seemingly risk-free prospect might be evaluated as risky. Similarly, while in an optimistic, euphoric state, risky prospects might be evaluated as more secure ones.

It is also important to note that these visceral factors can be a) controlled by individuals, if able, or b) individuals can turn this to their advantages if they “learn” how to use this in heuristic decisions. But in this blog, I would like to concentrate on one particular topic – revenge.

Trust game – with a twist

In economic terms, we can be vengeful in many ways, starting from boycotting a particular brand or store to being malicious towards them (or in more academic terms: us being an actor in decreasing their utility, their profits).

Standard trust game is pretty common amongst experiments in psychology and behavioral economics. The rules are pretty simple: there are two players in separate rooms, with no connections whatsoever. The first one receives $10, and is told that s/he can give “x” amount to the second player. For every dollar, the second player receives four times the money that was originally sent. Then, the second player can decide how much to send back to the first player. Simple enough, right?

There exists, however, a version of the game where upon the second player acting unfairly, the first player has the option to have their revenge, paying from their own wallets. For every dollar they pay to the experimenter, the second player loses twice as much. The results were shocking: a lot of people were very keen on paying even absurd amount of money in order to divest the other player from their prize (de Quervain et. al., 2004). What was even more interesting, that during the games, players were wearing MRI sets monitoring their brains: upon taking revenge (for some, perhaps not surprisingly), the part of the brain which is responsible for the perception of rewards was very active. As such, neurologically, we treat malicious acts coming from envy and feelings of injustice as “making things right”.

“Revenge, the sweetest morsel to the mouth that ever was cooked in hell.” (Walter Scott)

Revenge, or the urge to be vengeful, in economic terms usually occurs when we feel that we have been hurt in a transaction, or we perceived the outcome to be unfair – that is, effort and gains were not in balance. While I do not want to go into how people perceive fairness, and what serious implications it has on economic decisions – this was already discussed in last week’s post – I do want to mention that the trade-off between fairness, redistribution and efficiency has been under heavy research in the field of welfare economics (Atkinson, 2015). But welfare economics primarily takes into account the macroeconomic consequences, and perhaps not so much the emotional and economic-behavioral implications to the individual (which is, by the way, completely fine – that is not the main goal of the topic).

Is taking revenge good? Well, it certainly feels that way. But if we take a look at these examples, it is easy to see that most of the time it costs us, leaving us worse off than before (objectively speaking). Maybe that is why moralists, philosophers, and the Bible speaks at lengths against acting revengefully. But maybe revenge will help us to avoid such situations later (by using the tit-for-tat strategy, which will be discussed in a future blog). Whether we deem it good or bad, when emotions – our “hot” state – come to play, we might not be able to have that firm of a grasp on our decisions.

Economists and social scientists have always been fascinated by fairness, and what defines our perception of it. As straightforward as it seems to talk about fair behaviour, defining it, however, is rather complex: after all, it all depends on individual perception. The radical view is more of an egalitarian point of view, where deviations from the norm are considered to be unfair. However, we do have to keep in mind that fairness and justice are two very different things. I do not wish to give you a “true” definition on fairness (philosophers way more knowledgeable than me have failed to do so), but rather, how important our perception is on fairness, how it affects economics, and whether a fairness-seeking behaviour is rational.

I’m going to make him an offer he can’t refuse: Ultimatum Game

One of the most commonly used games in economics is the ultimatum game. The rules are simple: two players have to divide $10 among themselves. The first player does the division, which the second player can either accept or refuse. However, each of them will only receive their part of the money if the second player accepts the offer. Because of this, the first person has to offer a reasonable amount of money to the second player in order to get anything.

Stop for a second and think: If you were the first player, how much would you offer to the other player?

Unless your answer was 0.01$, your expectations are not rational. If they were, then you would assume that the second player’s actions won’t change whether he gets one cent or nine dollars: in each case, he would be better off than he was previously. However, results show that modal offers are, in fact, 50% of the pie, while the mean of the amount offered is around 40%. Two things come from this: first, people tend to make fair offers, fearing that it might be refused otherwise. And indeed, offers where the offered money was less than 25% of the total, being perceived as inequitable, were commonly rejected. However, if one is aware of the fact that receiving $1 should not be relative to the other person’s gain, then people tend to accept smaller amounts of money. This is why, for example, in one version of the game, economics students (being primed to be more self-interested) offered less and were willing to accept less money in ultimatum games (Carter and Irons, 1991).

Second is that one of the important factors during the division is entitlement and legitimacy, meaning – for what reason, and who is the one with the power to make the offer. In one version of the game, the roles were decided on the basis of performance in a trivia quiz, with the winners becoming the proposers. The proposers were told that they won this right by being smarter, thus gaining public entitlement. When it came to games where people “earned” the right to be proposers, offers were more parsimonious. The proposers appeared to believe that the responders would be willing to accept more modest offers. Surprisingly, however, the receivers were not willing to succumb to this newly-given-authority, resulting in a rise in rejection rates. This has been tested with games played with $10 and $100, and the results were nearly the same (Hoffman et. al. 1996).

Ultimatum game has a very interesting implication: those who were making the offers were doing so to maximize their own expected payoffs (which is consistent with mainstream economics’ self-regarding preferences and “selfishness”). However, those players who rejected had not concentrated on themselves, but rather the difference between their payoffs and that of the other player. Instead of benefiting from receiving some money, they chose to punish the other person for not being fair.

Fair play in the markets

According to Okun (1981), a failure to conduct business in a fair manner could distort consumer markets, which in turn leads consumers to reduce their expenses due to loss of trust in the market. In his view, the supply side has the power to set the prices, and at times it can even have monopolistic power (although he does not mention it, demand side obviously has tools to indirectly affect prices). In essence, Okun found that consumers react in a hostile way to all price-increases which are not justified with some cost-increase. However, they tend to accept “fair” increases if supply stagnates or decreases, due to realizing that otherwise, the business would go bankrupt.

In their research, Kahneman, Knetsch and Thaler (1986) aimed to find patterns in the perception of fairness using survey data. They wanted to find “social norms” in fairness regarding pricing, wage negotiations and rent changes. Also, they were interested in quantifying the effects of unfair behaviour in the markets. They used reference-transactions as anchoring in order to define a superficial “norm”, then they tested how people react to the deviations from this norm. They were curious whether price-changes can be justified in three situations. Are these changes fair, when:

• the firm’s profits increase,
• the firm’s profits decrease, or
• due to structural changes in the market, the firm’s profits increase.

Results, though not exhaustive, suggested that:

• Increases in prices (even significant ones) are considered to be fair when it is preceded by increases in commodity prices, making production costs and costs in general higher. But the firm can only “defend itself” from cost-increases related to the transaction at hand.
• Consecutively, if the previous point is accepted, it is generally considered to be unfair when benefits from decreasing costs are not shared with other stakeholders.
• Increases in profits are deemed fair if it isn’t related to the losses suffered by the consumer.

One of the key findings regarding the perception of fairness is the phenomena of “dual entitlement”. In short, this states that the sellers have an entitlement to achieve their reference-profits, while customers are entitled to the conditions of the reference-transactions. Consecutively, the transactions deemed “fair” are not necessarily fair from an objective point of view – that is, they are not necessarily “just”.

I’m having what he’s having

As we can see, preferences commonly used in economics might not work in certain situations such as the ones presented by the ultimatum games. Due to this, institutional and behavioural economists came to the idea of using “social preferences” and the concept of “homo equalis”, which can still be mathematised, but can explain a number of economic choices within social context. This will be elaborated on in our next blog, stay tuned!

In mainstream macroeconomic theory, the consumer is an actor who can choose from at least three possible options: make investments in the economy, save a portion of their disposable income, or consume available goods on the market. While both savings and investments in the economy are crucial, in this blog, we would like to concentrate on consumption – specifically, conspicuous consumption.

There is hardly any human behaviour that isn’t influenced by social interactions, and consumption is no exception. One would expect purchase decisions to be based solely on the utility derived from a given article, i.e. the intrinsic value of it. Yet, a simple observation can reveal that it is the extrinsic value that determines the majority of consumption choices. The value derived from the consumption of an article comprises a signal value that evinces wealth and social status to the observers. It is of no coincidence that two articles – such as a Casio and a Rolex watch – satisfying the same need, are valued differently. This phenomenon, the desire to display social status which guides consumption decisions, has been coined as conspicuous consumption. Evidence from sociology indicates that the need for conspicuous consumption is so high, that it becomes the prevailing decision driver after the subsistence level. The vanguard of this theory, Thorstein Veblen, believed that “No class of society, not even the most abjectly poor, forgoes all customary conspicuous consumption”. A quick glance around will reveal that Veblen was right: it is by no means an uncommon spectacle to find a relatively low-income individual working with the utmost effort to purchase the latest iPhone or a designer bag.

Status goods and opportunism – an experiment

While there are many experiments where consumption choices are at the center of investigation, there is one in particular that is of interest to us. Damianov (2009) created an experiment where subjects had to make budgetary decisions on the division of consumption goods. This experiment is exceptionally great and has been devised to be interpreted in economics classes; however, it heavily involves behavioral economics.

In the experiment, subjects have a $1000 budget constraint, and they need to make a decision on whether to buy standard consumption goods, or “status goods”. The two goods have different functions: in economic terms, consumption goods are the ones which objectively increase one’s utility – if you choose to buy $1000 worth of consumption goods, then your base utility will equal 1000 (but it’s not your ‘final utility’).

Status goods, however, is where it gets interesting: investing in these goods – let’s say, jewelry – will measure your social ranking in society. There are four options:

1) If a person has the highest investment in status goods, s/he becomes the ‘Elite’, and his/her consumption utility gets multiplied by 10;

2) If there is more than one person with the highest investment in status goods, they become the ‘Upper class’ ; their multiplicator is 4;

3) If one invests $100 less than the ‘Elite’ or the ‘Upper Class’, one will become ‘Middle class’, and their multiplicator will be 2;

4) Finally, if one’s investment lags behind by $200 or more than the ‘Elite’ or the ‘Upper Class’, one will become ‘Lower class’, and their multiplicator will be 0.5.

Students then have to make simultaneous choices on their consumption. For example, if there are two players, and the first invests his money 50-50, and the second person invests only in consumption goods, then the first student becomes the elite (his utility becomes 500 x 10 = 5000) while the second student will become lower class (thus their utility is 1000 x 0.5 = 500). What would be the rational choice to make while budgeting?

If the whole society would only invest in consumption goods, everyone would be upper class, thus they would achieve the highest social utility possible – this choice being Pareto-optimal. However, this would also give the option to certain people to ‘go rogue’, and play an opportunistic turn by investing into status goods, making them the Elite. This move, however, starts a vicious circle: everyone starts to invest more and more into status goods, turning the whole game into something similar than that of the problem of commons. This experiment provides a great example on how a supposed social maximization can be achieved and in reality, how fragile it really is.

Instagram – the very definition of conspicuous consumption

As we have delineated, conspicuous consumption satisfies the need to communicate the relative standing of an individual, i.e. the social status, to the general public. Subsequently, which platform can be better to achieve this purpose than Instagram, with over 1 billion users, to display the possessed status and image? It is not an uncommon phenomenon to see pages such as ‘Rich Kids of Instagram’ posting pictures with helicopters and race cars in the background. Research conducted by Krause et al. (2019) validates this assertion: in the devised model, the driving factor behind 43% of Instagram posts was found to be predictable by conspicuous consumption.

Conclusion

The role of conspicuous consumption in our daily lives is often indiscernible; yet, it is one of the primary forces that directs our purchase decisions. The effects of conspicuous consumption can be drastic, since it necessitates individuals to consume continuously for displaying their social status to others, creating a vicious circle that has already trapped Millennials.

It should be remembered that Veblen introduced this in 1899 – at an era where conspicuous consumption was much harder to have a grasp on. Today, more than 120 years later, his theory is more relevant than ever.

From the dawn of economic thinking, economists were fascinated by emotions and their role in the economy. The father of economics, Adam Smith, was also fascinated by it. In his idea, the invisible hand – which is perhaps the most misused and misunderstood metaphor in economic thinking – originally applied to distribution problems, where societies did not wish to unjustly distribute the goods and profits in the market. The presence of an invisible hand lead the people to act according to the benefits of society. Numerous economist thinkers were interested in moral and distributive questions, let that be Smith, Mill, Hayek, or Thornton.

However, during the marginalist and neoclassical revolutions, when economists were busy trying to create mathematical models for decision-making processes, emotional factors were omitted. This was due to them being too erratic and way too complicated to include in such models (yet, they still believed that emotions have powerful effects on the economy). Nonethless, a number of economists continued to contribute to the literature of the effects of emotions on the economy: Edgeworth, Scitovsky, Katona, Simon – just to name a few. But perhaps the most widely accepted view came from one of the most influential figures in economic thought – Keynes.

A Brief Story on Animal Spirits

In macroeconomics, there’s a theory for business cycles, which aims to understand why the booms and busts happen in an economy. One of the first written business cycles – as Thomas Sedlacek observed – is documented in the Bible, when Joseph deciphered the dream of the Pharaoh:

(Genesis 41:29-30) Behold, seven years of great abundance are coming throughout the land of Egypt, but seven years of famine will follow them. Then all the abundance in the land of Egypt will be forgotten and the famine will devastate the land. (Genesis 41:34) Let Pharaoh take action and appoint commissioners over the land to take a fifth of the harvest of Egypt during the seven years of abundance.

Thus, the economy is a constant circle of “abundance” and “famine”, booms and busts. First, economists considered these business cycles to be completely exogenous: external shocks that affect an economy. According to this view, fluctuations in an economy can only be attributed to random changes in external variables.

Later, economists began to analyze if these fluctuations can occur even when macroeconomic fundamentals are relatively stable overtime. The first explanation says that in this case, distortions occur when endogenous factors in an economy fail to reach and remain at a stationary state while the fundamentals are intact (For more information, see Hicks (1950) on full-employment equilibrium).

The second view can be traced back to John Maynard Keynes. He argued that our decisions “(…) depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic…” (Keynes ,1936, pp. 161-162.) Keynes called this phenomenon Animal Spirits, however, he never exactly specified or elaborated on what he meant by it (in this sense, Keynes was like Einstein: they both had marvelous ideas, thus giving ‘homework’ for economists and mathematicians alike for the next century to come). Generally, Animal Spirits tend to be understood as the ‘mood of the market’, whether the perceived prospects tend to be positive or negative.

From a macroeconomic point of view, economists try to use the theory of Animal Spirits by applying it to the labor market: when spirits are high, employment will rise, and with greater labor force, an increase in output with follow, validating the original perception of the economic prospects, thus creating a self-fulfilling prophecy. What can be a nuisance, however, is that with the increase of the labor market competitiveness, companies will have to compete for the workers, thus increasing the hiring costs (but this factor is usually simplified or completely neglected). Similarly, in the case of low spirits, the demand for labor will decrease, and consequently, the output is expected to decrease as well.

Another area of macroeconomics where Animal Spirits is present is in the consumption functions, namely the measurement of ‘consumer confidence’. For example, for the 1990-1991 recession, Blanchard (1993) blamed mainly the nature of the business cycles, but also the loss of optimism among the consumers, deriving from the negative experience coming from the recession itself. This will suffice to go back to the recent crisis of 2008, where in the coming years, confidence (and trust) in banks severely declined, and this can be observed even today.

Economist argue that these heuristic expectations can, in fact, be rational. Howitt and McAfee (1992) argue that “people may rationally anticipate the waves of optimism and pessimism that keep employment fluctuating forever” (pp. 498). One would argue that this is not the case. Remember the Monte Carlo fallacy? In the case of a roulette-game, after 49 consecutive plays where the winner was red, we tend to think that the 50th round will surely be black. Why? Because we tend to give probabilistic balance a great role when dealing with uncertainty. Rationally, the 50th round would still be a 50% chance of being black as opposed to red (supposing that the roulette-table is in fact not rigged).

Turning to a more micro-centered approach, Loewenstein and O’Donoghue (2004) applied Animal Spirits in a different way. In their view, people have “dual minds”, two parallel systems in decision-making based on psychological and neuro-scientific research. They call the first one the “deliberative system”, which in essence is along the lines of standard rational economic thinking. The second one is called “affective system”, which accounts for the emotional thinking (or rather the emotional reactions).

This two-sided decision-making system has several important implications. First, they note that external stimuli can have great effects on activating the affective system. Another interesting factor is individuals’ intrinsic (or endogenous) willpower, which accounts for the deliberative system’s oppression over the affective system. In other words: how effective can one’s rationality be in repressing their own gut feelings. This hypothesis also carries in itself the motion of cognitive dissonance, for when a decision is made based on emotions or gut feelings, often times we long for choosing the rational way, and vice versa. Finally, the model manages to explain how in seemingly indifferent situations people often manage to make extremely different actions.

Homo Erraticus rather than Homo Oeconomicus?

With the ever-growing dissatisfaction of complete rationality in economic models, alternatives like behavioral economics are in their Renaissance. Some economists turned to Sociology, Psychology, Neural Sciences and several other fields to resolve the problem of emotions in economics. New theories, such as bounded rationality and reference point-based decision-models, try to explain the effects emotions bring to the table. The purpose of this article was not to critique behavioral-macroeconomics methods; its goal was to address that maybe we should dig even deeper, back to the fundamentals of macroeconomics. Creating a new consumption function, or adding a couple more parameters might not do the trick, as we may have to go back to the micro level. Whether you agree with this or not, one thing is for certain: we still need to do our homework that Keynes and a number of other great economic thinkers left for us.

There is a joke that whenever someone asks an economist about the prospective effects of a policy in question, a good economist should always reply with: ‘it depends’. Why? Because the number of outcomes in theory are limitless. Let’s take a simple example: an increase in taxes. If we want to oversimplify, an increase in taxes – ceteris paribus – will demand taxpayers to pay more money, which decreases their disposable income, in parallel with increasing the government’s tax revenue. One could argue that if the government invests this tax revenue, for example, into education or healthcare – thus increasing the citizens prospects for higher social standing or for longer and healthier life – ‘lifetime utility’ can increase. However, a problem arises: higher taxes can result in higher tax evasion, therefore creating a free-rider problem, while also potentially decreasing the tax revenues of the state.

The purpose of this example was to demonstrate that economists’ take on a problem very much depends on their assumptions on society. You want to use tools for policymaking that concurs with your view on how the economy and the respective agents would react to it. But how can we define what’s good for society? Is it fair to overtax the rich to support the poor? Should we pursue a more egalitarian approach, or should we just go with ‘every man for himself’?

The values that define us

From the earliest days, economics and philosophy have been intertwined when dealing with complex problems. The economy operates between people, therefore interpersonal connections, fairness and justness are key when deciding on what is acceptable and what is not. Ancient Greek philosophers, such as Aristotle or Socrates, gave great importance to what should be the goal of economic decisions or transactions. For example, how should we approach the problem of money lending? Aristotle says that there should be no interest on money lent, not just from a moral point, but also from a metaphysical one. By asking for an interest, we price the time-value of the money lent by us, however, time itself does not belong to us.

The core problem arises from intrinsic and extrinsic values. We can consider something as intrinsically good based on whether it has value on its own. On the contrary, we can assign extrinsic value to things that are valuable for the sake of something else. This brings up one of the greatest questions in philosophy (and thus comes up in economics as well): is there such a thing as intrinsic value at all?

Some philosophers argue that, by the world being so complex, nothing has wholly intrinsic value, and there may be a possibility where something has only extrinsic value. Beardsley (1965), however, argues that nothing has intrinsic value. According to him, whatever has value has extrinsic value, but also nothing has intrinsic value by itself. He argues that intrinsic value is “inapplicable”, so even if something has such a value, we would not be able to distinct it. This may be a strong statement, but it could be right in economic terms. For example, regarding prices: Assuming that we’re not historians, we do not know the value of 10 drachmas from ancient Greece. However, if we have information on the purchasing price of it – we know the amount of goods it could buy – then we are on the right track.

Is there even a morality-problem in economics?

Bentham assumes that anyone can estimate the pleasure they experience based on factors such as intensity, duration, certainty, propinquity and purity. Bentham stated that the intensity of pleasure cannot be measured, thus interpersonal comparability is limited and cannot be based on facts; however, he insisted that institutions should try to evaluate these regardless.

According to Bentham, every person shares certain vital concerns, such as certainty, abundance or equality between people, thus making higher utility inseparable from legal codes (e.g. right to sustenance or right to have disposal over one’s goods (property laws)). He argued that property rights should support egalitarian distribution of income and wealth; however, Bentham gave priority to security (as to secure one’s consumption, sustenance) over equality. This should be achieved in a way where incentives guide society to maximize general welfare of the society as a whole. Sidgwick (1877) concluded that, according to Bentham, self-interest and self-centered behaviour should be in harmony with moral goodness and virtue, thus creating a better society.

Mill believed that cooperation with others and the pleasure that comes from the “security” or “sense of freedom” of the cooperation, which generates a certain moral sentiment of justice, is one of the highest pleasures. This high pleasure can be such a powerful motive that it can even subdue selfishness.

Immanuel Kant stated that if our ‘moral’ decision was built on quasi-rational basis of economic calculus, based on our expectations of later pleasure coming from it, the morality of the action is lost. The increase of our well-being (expected or experienced) negates the morality of our acts. If we accept this reasoning, then consequently, true altruistic behavior should be such that does not calculate with pleasure coming from the consequences of our actions, but it should have strictly intrinsic value to it.

In the 1930s the ordinalist revolution began, spearheaded by Lionel Robbins, John Hicks, Paul Samuelson, Abram Bergson and R.G.D. Allen. They redefined the concept of utility in a more simplistic way: utility represents only what the economic agent chooses, similar to a numerical ordering of choices (which are to be consistent), without taking into account the reasoning behind it. In short: utility represents the preferred choices in order, without taking into account morality or psychological explanations. This makes the calculations easier, and also allows useful ways to gather information regarding preferences. However, one might argue that with this simplification, we lost a lot of meaningful information on the processes behind decision-making.

A mathematician, a statistician and an economist all apply to a job. The interviewer calls in the mathematician and asks him: ‘what does two plus two equal?’ The mathematician asks for a paper and pen, begins to calculate, and says: ‘There exists a solution to the problem.’ Then the interviewer asks for the statistician, and proceeds to ask him the same question. The statistician replies ‘with a certainty of 95% I can state that the solution is somewhere between 3 and 5’. Finally, the economist comes in, and is given the same problem. He stands up, approaches the interviewer, and whispers: ‘What do you want it to equal?’

Have you ever thought, while watching a sport event and the camera showing the fans of the rival team: ‘Gosh, how can they be such animals! Look at our supporters, how well they behave!’ (chances are they behave just the same). Have you ever wondered why you always look favourably to members of parliament close to your political affiliation, while you almost always disagree with the other party? If you did, then this is the blog for you.

Us and Them

Orthodox economics has a tendency to concentrate only on the individual, disregarding the environment. However, the economic environment can have powerful effects on the individual’s preferences as well as their perceived utility. One could argue that there are two parts to your well-being. The first one is earned happiness or well-being that you get from – in economic terms – consumption of certain goods, let them be food, services, or just your free-time. The second one is more abstract, it being the perceived well-being with respect to others. What this means is that you compare yourself (occasionally, regularly or constantly) to others. This can lead to many outcomes, including jealousy or envy, but it can also lead to altruism.

From the point of social sciences though, we can identify ourselves as part of groups, organizations and social classes, respectively to our endowments or our ideologies. We have an urge to belong somewhere, because – as Aristotle elegantly put it – “Man is by nature a social animal”. In the event of transactions by social categorizations, however, we no longer think of people as individuals, but as members of groups or embodiments of moral codes. By this, we often disregard other people’s individual traits and the available information that we previously obtained from them. If your friend supports FC Barcelona, and you are a hard-core Real Madrid fan, then come game day and you are sworn enemies; for a short time, you put aside your personal friendship, and by identifying as parts of a football club, you two are also competing.

From this comes the concept of in-group favouritism: “the tendency to respond more positively to people from our in-groups than we do to people from out-groups” (Stangor, 2011). In other words: We become more receptive to the needs of the groups we belong, while disregarding or even taking a stance against the other groups.

In an experiment designed by Tajfel et al. (1971), boys were assigned to two groups based on their preferences on paintings by two artists. Subjects had information on which groups they were assigned to, but not of the memberships of any of the other boys. Following the division, they had to divide payoff matrices between two individuals. They were told whether the division was between two ‘out-group’ members, two ‘in-group’ members or between one in-group and one out-group member. The results showed that between two individuals from the same group, the subjects tended to divide the payoffs more evenly. However, when the boys were from different groups, fairness was not the predominant choice; instead, the decision-maker gave larger endowments to the in-group members. The subjects not only displayed in-group favoritism, but they did so by having such a marginal distinction as taste in paintings. This can be shown in groups created on ad hoc, trivial, and random basis as well (Hogg et al. 1986).

Is this good or bad?

As any economist would say: “it depends”. While at first, we would think of the negative effects to be more severe, it is useful to take into account the possible positive effects as well.

It most certainly leads to more emotionally-driven decision-making, both in transactions inside the group and outside of it. In these cases, we use heuristics to define our level of trust to individuals. You are more likely to prefer doing business with an ‘insider’. This of course comes from a supposed feeling of connection with and understanding of the other person: you theorize that because the other person is in the same social group as you are, he must share some of the same traits, values, or preferences with you, thus making transactions seem easier!

As stated earlier, in-group favouritism can also have negative effects, even only on the level of possible transactions. You can squander mutually beneficial transactions by regarding your own group as superior to others and reject any kind of interaction with people from other groups. From a rational point of view, this is a net loss, at least as options go. It can also lead to institutionalized distrust.

It can also disrupt seemingly easy decisions. In an experiment conducted by Gneezy et. al. (2010), they asked people trivial questions framed in two different ways. The control group was asked: “Camels are bigger than dogs. Do you agree?”, while the other group received a framed question: “According to the Democrats, camels are bigger than dogs. Do you agree?”. From the first group, 100% of the people agreed that yes, indeed, camels are bigger than dogs. However – as you probably guessed by now – people from the second group started asking questions. “It depends – what kind of dog are we talking about?” “Maybe the dog is a Saint Bernard, while the camel is only a baby!” People began to question trivial things – which can be harmful, as far as decision-making is considered.

There can also be cases where individuals do not look at certain people favorably from their own groups. This is called the black sheep effect, where a particular individual is at stake of threatening the values of the group in question (Pinto, Marques, Levine, & Abrams, 2010). In other words: in order to reduce cognitive dissonance within the group, members disregard these ‘rebel members’. Alternatively, they can act according to the sociocentric bias, where they only credit the group for its successes, but in cases of failure, members blame external factors, leading to self-justification. Sounds familiar?

Can we avoid these kinds of distinctions? Hardly. Some argue that it is in our nature to make comparisons and to make distinctions based on ideologies, ideas and convictions, let them be political, religious, or just unquestioned fanaticism towards a football club. What we can do is to be aware of these biases and flaws and try to be more open to opinions from other groups. After all, who knows? Maybe having universal healthcare is the way to go in economic policy, the dress is in fact blue and not gold, and maybe Messi is the greatest football player in the world.

Suppose that this morning, when trying to stop the alarm, you accidentally dropped and shattered your beloved phone. After collecting the pieces of the phone (and yourself from the trauma), you realize that you now have to buy a new one. So, you head to the mall: in possession of all the information in the world, based on your preferences (after weighting all the important characteristics of the product), you choose the phone which maximizes your utility with respect to your budget constraint – your wallet. At least that is what the theory of consumer choice and rational decision theory suggest (in which an agent’s goal is to maximize their utility). While there are obvious advantages of this take on the decision theory, let’s see what a non-homo economicus does.

The first problem comes from lack of information. In the classical theory, all the choices are in a given pool, where the decision-maker can decide objectively, for the outcomes are known to them. Simon (1959) argues, however, that perception and cognition play a huge part in decisions. For instance, in different environments, we might perceive the same information in very different ways. Similarly, being savvy within the product category plays a huge role in decisions: maybe we are up-to-date with the new mobile phone trends, or perhaps you just gather information when you are actually planning on buying a new one. It may also be the case that your perceived knowledge can differ from objective knowledge (i.e. when you don’t know how lacking your knowledge really is).

In one of our previous blogs, we talked about the concept of “satisficing utility”; that is, we do not wish to maximize our utility, but rather we just want to keep ourselves “satisfied”. According to Simon, when one cannot reach their desired satisfaction, they turn to search behavior – trying to reach the desired point by searching for alternatives with greater levels of satisfaction.

A significant amount of research papers were dedicated to finding the “Holy Grail” of search behavior. A number of models were proposed, differing mainly in their perspective of the human decision-makers.

John D. Hey (1982) formulated some of the widely-known rules in search behavior. For example, he identified the reservation rule. It states that whenever the search for alternatives yields a price which is lower than some reservation price, it results in a sudden stop of the search, if the product requirements are met. However, there exists a number of rules that, after a number of searches, result in high prices (or to put it simply: after a bunch of unsuccessful search attempts), subjects just stop looking for alternatives and accept the most recent price. In other words – they give up. Perhaps, they realize that the cost of searching is greater than accepting a non-optimal price, or they just simply get tired of it.

Brucks (1985) found that the greater a-priori objective knowledge you have on the subject, the more effective you are in your search for new information. Based on their experimental method, they concluded that basic knowledge helps in prioritizing search for the relevant information, and subjects, who had previous experience, searched for less irrelevant alternatives than their counterparts. This supports Miyake and Norman (1979): “To ask a question, one must know enough to know what is not known”.

The following search behaviour model was designed by Punj and Staelin (1983), which describes the process of information search when buying a new car, Fig.1.

Based on the rational assumptions of this model, the outcome of the search behavior can be called effective when the cost savings from gaining information (e.g. finding lower-priced deals) outweigh the cost of searching (the latter can be interpreted as transaction costs).

Importantly, the search behavior can differ between fast-moving consumer goods and durable goods: indeed, it is not the same to buy an Apple iPhone, as opposed to just an apple. Some would argue that, when the potential risks of bad decisions are apparent, people want to take a safer route: when buying an iPhone, some people might search scrupulously for weeks. In contrast, buying a small item, like an apple, does not come with the same weight. In such a case, we might simply use heuristics to choose. For instance, last time the red ones were better than the greens, so I might just take a bunch of red apples – even though they are from a different producer, or even a completely different apple cultivar.

Regardless of the purchase at hand, whether it be a phone or an apple, search behaviour occurs in almost any of our decisions – it appears to be innate to humans and its existence is irrefutable.