Episode 17: Cooperation and Punishment

Did you go to college? Hopefully a liberal arts college? Even if you didn’t, think back to some late night with your buddies, maybe a little weed was smoked. Or in some dopy poly-science class with the one know-it-all jerk who would always shoot up their hand to give some long running opinion about society?

Then maybe you have heard of the idea of the social contract. We humans give up some of our freedoms and autonomy to the “state”, or society, in exchange for security. We do this because more things can be done with collective action; there are more benefits to working together than working apart.

But to enforce that “social contract” you must play by society’s rules. No murder, or postal fraud; whatever is the rules are. If you violate those rules, “society” in the form of government, or police, or tribunal elders, or whatever, will punish you to keep you in line.

What does this have to do with behavioral science? When we start thinking about the dynamics of teamwork or working together, then behavioral science gets involved.

And a lot of our interesting social biases show up when we’re trying to do things with other people; especially cooperating. It’s an especially interesting field of research.

The specific topic I want to cover is “crime and punishment”. A great name for a book, and a great idea for a behavioral economics paper. People HATE being a sucker. Let’s go on a mind journey.

You’re a serf in Eastern Europe in the mid 1500’s. You live in a wooden shack in a small rural town with your spouse and three small children. You and about 15 others are woodcutters. You live near a wooded, hilly region so it’s easy to collect small firewood sticks.

With basic hatchets you cut down small trees and chop off small branches. You break those down into yet smaller bits, and smaller sticks yet from those. The sticks are put into carts and pushed by hand up the hill to the governor’s house, who owns the land.

He is in charge of the local region, collects the taxes, maintains order, and generally runs everyone’s life; especially the lives of serfs like yourself.

The governor provides for each woodcutter and their family with a livable amount of grain and other food each week, as well as a small amount of money. Sometimes you get a little bit of gamebird. Or fresh fruit or cabbage if it’s in season. On occasion some butter. Extra supplies like clothing, or nails may also be acquired with special permission, however they are rare.

The governor is more rewarding to the serfs who provide him with more firewood. Firewood is important as it keeps people’s small homes warm in tough winters and provides critical cooking heat. The top choppers get a bit extra here and there as well as first priority for certain favors.

You and the 15 other firewood choppers, over many years of chopping, have realized that one of the biggest waste of daylight is stacking the bits of wood into your cart, and then pushing the carts up to the governor’s storage sheds. The push can be made much faster and easier if all the woodchoppers combine the firewood together into larger carts that can be pushed by multiple people. There is less sorting by size, faster moving, and fewer carts, which means more time during the day for actual chopping.

So, you gather all the choppers together, and after talking to everyone, you all decide to work together.

The plan is to combine some of the firewood together, and then once at the governor’s sheds, divide that wood up amongst yourselves. Everyone has a rough quota they have to fill. Once they fill up their quota for the group, then they can continue chopping for themselves. This way those who cut more still get the credit they deserve, but everyone gets more time to chop more wood to get more food.

There’s one troublemaker, Ciszko (real name I checked historical records at about the time), who recently has been taking extra from the group cart. Every day, when he thinks people aren’t looking, he grabs a bunch of wood off the group cart to claim as his own. But he’s been way too selfish, and has gone from a stick or two, to whole bundles he is claiming for himself.

A few of the woodcutters have confronted him, and he says he’ll stop, but doesn’t. Each day he takes more and more of the group’s wood. Wood you spent your hard hours chopping. Ciszko is a lazy, slimy dirtbag. You worry that if something isn’t done others will start to steal and your whole group haul will fall apart. He even has had the nerve to ask the guard for extra wool and was given it. Dirty, slimy Ciszko. He lies to your face and steals behind your back. You feel like a sucker. Ciszko needs to be punished. He needs to be taught a lesson to prevent others from stealing from the group as well.

Let’s stop this narrative now and move on before this gets too Medieval (in the narrative in the author’s head Ciszko ends up being threatened with the loss of a hand and ends up a finger short).

There is value in punishment. What Ciszko is doing is known in behavioral economics, or political science as “free-riding”. Others are doing work, and he is riding off the backs of the work of others. People in today’s modern society really don’t like this. Charity is one thing but being taking advantage of is another. It triggers anger.

If there’s anything we humans do really well it’s anger and punishment. We’re really good at it. We love to punish. Why? Because it’s easy. It’s really just the inverse of rewards; the easiest and laziest motivator.

It takes very little effort to punish compared to other methods of behavior change. It can “right a wrong”, which satisfies deep emotional feelings we primates have. We are among the few species on earth that go to war or commit genocide. We are tribal, and if someone is undermining the tribe, punishment can be a collective way to restore unity to a group.

What’s fascinating is that people like punishment so much that they will punish free-riders even if it is costly for them to do so. Or to put it another way, people will punish even if it is against their own self-interest.

Fehr and Gächter studied this interesting effect in a paper called “Cooperation and Punishment in Public Goods Experiments.”

They strategically set up a series of games in their experiments with complicated payoff schemes, and times, or opportunities, to see how a group collectively punishes.

Experiment 1 had two groups. The first was the “Stranger” group, which was played with random people each round, and the second was the “Partner” group, which was played with the same people each round (10 rounds, or periods as the study called them).

In a classic 2×2 condition setup, there were multiple Stranger groups, and multiple Partner groups. The difference between them was that some groups played a game where there were no punishment opportunities, and some played a game that had punishment opportunities.

The rules of the game, while simple, are only complicated because of the payoff structure. Each period, each subject in a group gets 20 tokens. They then decide to keep the tokens, or invest the tokens into the “project”. Everyone makes their decisions simultaneously for each round (you won’t know what anyone else does until the big “reveal”).

Money that is put into the “project” is magnified, and then split equally between everyone, even if you don’t pay into it. Therefore, while total payout is maximized if everyone fully cooperates by putting all 20 of their tokens into the project, you can make more if you “free-ride”. In game theory we’d say that full free riding is the “dominant strategy”.

In laymen’s terms, it means your optimal outcome is to keep all of your tokens to yourself but have everyone ELSE put all of their tokens into the project. Because then you get to keep your own coins, but also get a big slice from the project payout that everyone else paid into. You’re keeping your cake and eating theirs too. It’s a classic free rider game.

The rub is that everyone knows this. You and everyone else thinks hmmm… If I put my coins into the project they’ll just be going to everyone else. No one else is going to put their coins in, so why should I? In this game, the dominant strategy per game theory (the strategy that will always happen), is that everyone keeps their coins. Everyone free rides.

But that’s without punishment. And that’s why there is a second decision stage. After everyone keeps or puts in their tokens to the project, and the big reveal happens, subjects are given the opportunity to punish each other by assigning so-called punishment points. This also happens simultaneously, so there’s a big reveal to see who is punishing whom all at once.

If you are given a punishment point, your payout is reduced 10%, all the way down to 0%. So if people don’t like you, they can send you home with nothing (10 punishment points means your payout is reduced 100%, or down to 0).

As a small side note just to show off and look cool, this is the payoff of the game:

game payoff

So what happened? To measure cooperation the researchers used the median and average contribution to the project each period. Median again is like average, but instead of adding together and dividing by the number of things, you just put each result in a line and pick the middle-est number. That’s the median.

Let’s start with the “Stranger” groups where each round had different people. I quote from the paper:

“The existence of punishment opportunities causes a large rise in the average contribution level in the Stranger-treatment.”

graph 1

As you can see, when there was punishment, many more people cooperated by contributing their tokens to the project. In all groups without punishment, the average contribution starts decent, around about 8, but then falls off to around 2. There’s still some jolly goodhearted people who just want to work together, but by the end of the game, everyone figures out the dominant strategy, which is to be selfish and keep all of your tokens.

Meanwhile, in the punishment rounds everyone figures it out pretty fast. Pay your tokens into the project, or you’re probably going to get punished. Sure, someone will try and be cute every round or so and try to grab some here and there and get away with it, but most cooperate.

Let’s look at the Partner groups’ graph.

graph 2

Unsurprisingly, the effect is even stronger because you play with these people multiple times. You know who the trouble makers are, and the group can quickly come together and act to punish because of the bonds of trust of working together in the past.

Whereas the highest the stranger contribution rounds ever got to was about 14 tokens contributed with punishment, average contribution per person for the Partner rounds was over 19, almost 20, or complete cooperation.

That’s an interesting insight. But the really fun stuff is when the researchers looked at when and how people decided to punish. It’s probably not something you would have thought about or mapped out. Most people would dole out punishment when it felt right. So, when does it feel right? What do people feel is just?

The magic number it turns out was not how much someone gave to the project. The magic number was how much someone gave relative to the average contribution of other group members.

The researchers looked specifically at how far away each person was for each round from the average contribution to the project, and how many punishment points were applied. For those who tried to freeload 2-8 tokens less than the average, they received on average 3 punishment points, and in the Partner group it was slightly higher than the Stranger group.

For those who tried to freeload between 8-14 tokens less than the average tokens contributed, those people were punished with about 5 punishment points (again with the Partner group being slightly higher). And for those who freeloaded between 14 and 20 points less than the average (the most anti-society), they were hit with the same average 5 punishment points in the Stranger group, but walloped with an average of 7 punishment points in the Partner group.

Remember, for each punishment point you get, you lose 10% of your tokens, so getting 4 punishment points is twice the punishment as getting 2 points.

All sorts of interesting gems can be learned from this.

When it comes to strangers, not playing along is bad, and we will punish strangers, but at a certain point there is a leveling off. So takeaway, if you’re going to freeload, or steal from strangers, freeload either small enough to get away with it, or big enough for the punishment not to matter.

A possible real world example could be international corporations in a new country using some unseemly business practices to drill for a bunch of oil while ignoring some local laws. This study would suggest that if that is indeed your position, either do small stuff or keep it under the public eye to get away with it, or do it huge, get all of the resources out, and get punished. The punishment will be moderate whether or not you transgress moderately, or severely.

However, if you are freeloading, or stealing, from people you know, aka, part of your community, the harshness of the punishment knows no limit.

The worst punishments are reserved for those who know the societal rules and ignore them. Perhaps strangers are given the benefit of the doubt that they are ignorant of the societal rules, and therefore are not punished as harshly in extreme circumstances. Perhaps, when it comes to strangers, there is a natural inclination to not burn bridges. We ought to punish this stranger so he or she understands our societal rules, but not so severely as to completely turn them against us. Perhaps the intuition goes, if we are moderate with a stranger, they will learn and assimilate into our cultural norms.

Maybe that’s how societies and cultures grow and flourish; through the moderate punishment of strangers.

Perhaps we assume strangers are out to get us (stranger danger!), so when they act wrongly there is no surprise, and therefore no shock, and therefore moderate punishment. But when a “friend” (someone within the social circle) breaks those societal rules it is a surprise, and therefore a shock, and feels worse because of the framing. And that leads to harsher punishments.

I quote from the paper:

“It is interesting that in the Partner-treatment it is only the negative deviation that affects punishment levels systematically, where as the level of the others’ average contribution has no significant impact… [this] suggests that only deviations from the average were punished. This may be taken as evidence that in the Partner-treatment subjects quickly established a common group standard that did not change over time.”

Next takeaway, and I quote the paper: “The more an individual negatively deviates from the contributions of the other group members, the heavier the punishment.” So when you are in a group, or making a decision as an organization that’s in a bigger group, look to everyone else. If you want to stand out, just figure out what everyone thinks the average is, and then stick to that.

It doesn’t actually matter what the real number is, the only thing that matters to avoid punishment is what the mini-society thinks is the real number.

For example, let’s take tech company’s privacy policies. If a majority of American’s believe that large tech companies have little or no policies for consumer privacy, that’s the societal standard; even if in fact most large tech companies do provide many consumer protections to protect users’ privacy.

Behavioral economics theory would suggest that if you’re a new company looking to maximize profit you should have little to no consumer privacy policies to make more money. The group members (the public) do not see you as deviating from the average and you will not be punished.

Now you might lose business to other companies, but that’s because privacy is part of the product value. It’s an economic argument over value, not a punishment risk.

Here’s another interesting takeaway, and it’s about consistency. The Stranger groups did not contribute to the project at high rates. Therefore, when punishment was doled out the overall income of all the players combined went down. At least in the Partner group the overall income could go up because punishment of freeloaders leads to increased project contributions, and therefore overall higher incomes.

But if one punishment opportunity is missed, and people feel they can “get away with it”, everyone runs to their “own interest” corners and the cooperation breaks down. To achieve maximum social good, it requires consistent and reliable punishment 100% of the time.

There are very good arguments to be made that the criminal justice system is often rather inefficient at stopping crime  because of the inconsistency of the punishment. Cocaine use is illegal and heavily punished by the penal codes, but only a tiny fraction of people using cocaine are ever actually punished by society for their use (they don’t get caught). And when they are caught the punishments are often so harsh they can turn members of the group against the punishment.

Conversely, professional sports strongly relies on the consistency of punishments. Players know exactly how much they will be punished (ideally) when they transgress, and they know the punishment will be immediate.

If you want to stop goaltending, call it every time and award a basket to the other team on a shot attempt. The action almost immediately stops. Meanwhile travelling in the NBA is called very sporadically, and players often commit small travels without consistent punishment. The result? Lots of players travel, even though the punishment is about on par with a goaltend (I would imagine both are worth about on average 1.1 points, the value of the average possession in the NBA).

And one last take-away. If you want to destroy a society, from a parent-teacher organization, to the Galactic Senate, and completely collapse it from within, all you have to do is figure out how to make punishments for breaking the social norms inconsistent. As soon as that happens everyone will run to their own best interest corners, and the society will lose its economic collective advantage and disintegrate.

The best and most famous example in history perhaps is the appeasement strategy leading up to World War II. After World War I the League of Nations and been formed, and with it a society of nations to collectively punish those rogue states that broke the norms of the world. It worked for two decades, but as soon as it was tested (mainly by Hitler during his annexation of Austria, and further expansions) and was not punished consistently, the actors who wanted to break world nation norms did so (Japan invading the Pacific, Italy, the USSR, etc…), and the League of Nations collapsed. It was replaced by a new society (the Allies), and later, by the UN. But the strategy of deterrence, or consistent punishment if norms are broken, has been the most effective strategy in the world of political science.

Let me know if any of these many lessons from this study have made it to your society, and if a change from you helped stop freeloaders.

Remember, if you want to create a culture of trust and cooperation, the group needs punishment to form collective action.

 

Fehr, E., & Gächter, S. (2000). Cooperation and Punishment in Public Goods Experiments. American Economic Review90(4), 980-994. doi:10.1257/aer.90.4.980

Episode 7: How Using the Ultimatum Bargaining Game Proves That Cultures of Trust Require Public Retaliation (NOT Altruism)

Game theory. Or should I sayyy LAME THEORY. Ayyyyyyy….

This post is about one small game, the ultimatum bargaining game, that’s useful in explaining the tools behavioral scientists can use to measure the reactions of other humans.

Did you ever watch the (now old) movie A Beautiful Mind? It’s about a mathematician named John Nash who developed the now famous Nash Equilibrium. That’s the beginning of the field of game theory. And game theory can be quite useful, as I said earlier, as a tool to measure how humans rate and react to choices.

I’m not going to actually tell you anything about game theory because it’s complicated and hard and there are 100 other posts and videos on Youtube that would do a much better job than I could. I just want you to be familiar with what it is and understand some of the simple games that are commonly used.

Okay, now that I’ve sufficiently buried the lead… The Ultimatum Bargaining Game! Güth, Schmittberger, and Schwartze in 1982 published a paper titled An experimental analysis of ultimatum bargaining. Now I’m not sure if they invented the ultimatum bargaining game, but they certainly get the credit for popularizing it. It goes like this:

There are two players and some money. One person has all the money and makes an offer to the other person.

If the other person accepts the offer, they get the amounts that were offered, but if they reject the offer, both people get nothing.

For example. We start the game and I have $30. I offer you a split where I keep $20, but you get $10. You’re not super happy about it but hey $10 is better than nothing, so you accept and we both get paid.

Next time I have $30, but I offer a split where I keep $29, and you get $1. ”Screw you!” you say. I’m such a jerk. You reject the offer out of spite and no one gets anything. Obviously, you can see the interesting behavioral economics twist.

Classical economic theory would say that the second person always accepts, because any amount of money, be it $5 or $1 or whatever, is more than nothing. The rational person (“actor”) always takes more over less.

And, of course, in the real world why this game is so brilliant is that it doesn’t happen that way.

People reject offers out of spite; especially when multiple rounds are played and there’s a history with someone. This is a classic decision of people making choices against their own self-interest! If I told you that you could make $1 just by accepting the dollar, wow! Sounds too good to be true. But if I tell you someone split $100 and gives you only $1… Not so much. It’s fascinating stuff.

I want to tell you about another paper entitled “Trust, Reciprocity, and Social History” by Berg, Dickhaut, and McCabe. They ran an experiment using a derivative of the Ultimatum game. Subjects in room A and room B are each given $10.

In room B, they pocket their money. In room A, they must decide how much to send to their (anonymous) counterpart in room B. Whatever amount A sends to B is tripled.

B then gets to choose how much money to return.

This second half of the game is a dictator game, because the room B person doesn’t have to give any money back to the other person in room A.

The optimal strategy for A is to never send any money because there is no guarantee they can get anything back. It’s an experiment in trust. If B doesn’t give back to A, next time they worry A won’t give anything to B.

In 55 out of 60 times running this experiment, A sent money to B. And I quote from the paper:

“In conclusion, experiments on ultimatum game, repeated prisoners’ dilemma games, and other extensive form games provide strong evidence that people do punish inappropriate behavior even thought this is personally costly.”

I’ll talk more about punishment later. Never underestimate the power of humans to make decisions not in their best interest, out of spite, and also give to others not out of kindness, or altruism, but out of fear of spite.

One theory of why 55 out of 60 people sent money even when they may have been better off not giving, was altruism. Altruism is the idea that humans do things that are purely good because we enjoy helping other people.

However, in a follow-up study in 2012, a different group re-investigated the game in “Does the trust game measure trust?” by Brulhart and Usunier. They found that none of their altruism measures were statistically significant, and I quote from the paper:

“In sum, our results suggest that altruism is not a statistically significant motivating force in determining “trust-like” behavior, both across all subjects and for specific groups of players.”

Trust was not formed through kindness, rather it was formed from fear of retribution. Altruism had nothing to do with trust in their Study.

How does this apply to the real world? Well, when people are anonymous weird stuff happens. People aren’t altruistic most of the time, especially when they can directly benefit by keeping money to themselves.

How then do you change behavior? How do you encourage altruistic behavior? Maybe you have a cause that you’d like to promote, or you are trying to create change somewhere.

If you want to create a culture of trust and sharing you must easily allow for public shaming and retaliation. Even if that retaliation ends up being a loss for everyone. People will hit the button that says “Well, if you won’t be nice to me, I won’t help you either even if it hurts me.”

Retaliation does not have to be in money. It could be in PR loss, or some other type. But it is critical that you create an environment that says clearly that these are the rules “we” the members of the community have agreed to. If you violate these rules the community, together, will punish you.

If the rest of the community does not band together to collectively punish the selfish; the selfish act will almost always win. And in systems and markets with especially greedy or immoral behavior you often see that the community does not take action against a bad actor to enforce community standards.

Economists can learn a lot about the process of human decision make through games. I wanted to introduce the idea of a few interesting games where the Nash equilibriums may indicate a different result than what we see in the real world.

I love games and have always found various setups like this exciting and fun. We’ll explore more fun games like the Ultimatum game in the future because it is so useful at eliciting human behavior.

 

Berg, J., Dickhaut, J., & McCabe, K. (1995). Trust, Reciprocity, and Social History. Games and Economic Behavior10(1), 122-142. doi:10.1006/game.1995.1027

Brülhart, M., & Usunier, J. (2012). Does the trust game measure trust? Economics Letters115(1), 20-23. doi:10.1016/j.econlet.2011.11.039

Güth, W., Schmittberger, R., & Schwarze, B. (1982). An experimental analysis of ultimatum bargaining. Journal of Economic Behavior & Organization3(4), 367-388. doi:10.1016/0167-2681(82)90011-7

Episode 6: Using the idea of “utility” to calculate “value”

Economics gets a bad reputation for being wrong about things, or only measuring things in terms of dollars or GDP (gross domestic product).

But most of these “bad raps” are simply because people don’t understand what economics is, and what it is actually capable of.

When I talk about “economics”, I’m not talking about Adam Smith (Wealth of Nations), or Marx, or anything before the 1950’s really. Those guys were philosophers. They looked at the world, thought about things, and then made sweeping guesses about how the world worked.

They get credit for sometimes being right, but just because Aristotle philosophized that there must be some small finite particle because you couldn’t cut things in half forever, it doesn’t mean he discovered the quark!

We wouldn’t call Aristotle a nuclear physicist and we shouldn’t call Adam Smith an economist. Hard science research and philosophy are fundamentally different fields. The biggest difference? A lot of math. Statistics. Econometrics. Linear Algebra. Adam Smith drew some lines on a chart; it’s philosophy.

Modern Economics only really came into its own in the late 1940’s or 1950’s, with the Milton Friedman generation. That makes the science maybe 70 years old at most! And that’s nothing. Modern physics got started in maybe the very late 1800’s, so imagine the difference between what we knew about physics in 1970 (which was a lot, we had nuclear power, etc…), compared to today. It’s a whole different level of sophistication and understanding.

Economics has come a long way, but it is a much newer field and simply hasn’t had time to fully blossom. It also helps your field if the largest nations on earth is pouring billions into research to make weapons to blow other nations up (ahem physics, computing, chemistry, etc…). So you have to forgive the field of economics for being a little bit behind.

With that lengthy precursor; how then does economics calculate value?

When economists try and figure out which decisions people will take, they have to compare apples to apples. There are a few ways to do this. The oldest trick is money, or money equivalents. Would you prefer a massage or a hamburger? Idk. So I instead ask how much would you pay for one or the other.

Just give each a “value” in dollars and compare, poof. Now we’re cooking.

The evolution of this method of comparing values is the idea of “utility”. Instead of money, you figure out how much something is “worth” to a human, or the utility the human gets.

For example, when your spouse cooks you breakfast that has an inherent value. But because it is not a financial transaction there is no financial transaction where money changes hands; so you must turn to the level of “utility” (happiness essentially) the breakfast provides you.

The main way to measure this is still in dollars (money) instead of “units of utility”; which has little meaning. The best way to measure what a spouse cooked breakfast is worth is usually to illicit how much you would pay for someone else to make that same meal for you. But there are lots of different ways to calculate utility.

The main point is that utility more accurately represents human decision-making because humans make decisions in abstract ways.

We don’t boil everything down into dollars (money) and compare the two values every time we make a decision. And once you get into behavioral economics utility amounts become even more important.

This is because the traditional economic assumption was that humans try to maximize their utility. The axiom, or assumption we take to be true is that we are rational, we want what’s best, so we maximize our utility. If there is a simple way to make $5 we’ll do it because that’s more than $0.

But, of course, there are many many times when that doesn’t happen! Just read the rest of these blog posts. That’s behavioral economics.

The answer is of course that we’re just measuring utility wrong. Traditional economics MISSES critical variables. Mind journey time! Think of a paperclip on a beach.

You are walking down the street with 3 of your closest friends in high school. It’s the suburbs so not a lot is going on.

It’s a tree-lined street, and farther down the street there are kids learning how to bike on a training bike. The sun is out, and birds are singing. It’s a very nice day.

On the ground off to the side of the sidewalk, you spot a crinkled $5 bill. Dirty, but totally spendable. You note “Oh! Look it’s $5!”, the friend walking on your left turns to you and says “Ew, that’s covered in dirt, you weren’t really going to pick that up, were you? It could be poop!”

You glance at your other friend to your left, and then to the friend to your right. All of them are staring at you with one eye raised and a grimace of slight disgust on their face.

Classical economics says you pick up the $5 because your utility of $5 is greater than $0, but of course you don’t pick up the free money. There is a hidden cost that traditional economic theories miss, which is the “social utility”. There is a social cost to your friends thinking you’re weird. Or poor. Or dirty. And that can be insanely powerful, more than a free $5 powerful.

It’s not that economics is broken or doesn’t work; it’s just that often it isn’t advanced enough to correctly calculate all the variables appropriately.

The first MAJOR behavioral economic papers in the 1970’s and 1980’s were all about different ways to calculate utility. There’s transactional utility, social utility, discounted utility, etc… etc… etc… It’s all just trying to reframe what humans are weighing when making their decisions. Some of it is because of fear of loss, or laziness, or social pressures.

I’ll probably devote an entire other blog post just to Kahneman and Tversky’s seminal, groundbreaking, famous-making paper “Prospect Theory: An Analysis of Decision under Risk” from 1979. There’s a reason those two are really considered the grandfathers of the behavioral sciences, especially behavioral economics. This is one of a few famous papers that really defined the genre.

In sum, their whole point was that economists were doing it wrong! It’s not about linear choices or straight classic rational decision making. And I quote from that paper: “people normally perceive outcomes as gains and losses, rather than as final states of wealth or welfare.”

So sure, your final state after you pick up the $5 is +$5 but that’s not the calculation you go through. You feel the loss of your social status, you weigh that decision not as finite, but in the moment. It’s complicated and messy, and human.

And that’s hard to measure; but discovering the Higgs Boson was hard too. It just takes time and refinement. Maybe a few Nobel Prizes, and a few billions of dollars for a huge research facility (CERN Particle Accelerator but for Behavioral Econ) would go a long way.

So I’m positive about the future of the field. And the concept of utility is an important one, and one you should understand. So that’s a brief primer on it.

Btw, I have attached a picture of what real full-fledged economics looks from the original Prospect Theory paper from 1979. The good news is that later papers are… more concise and have more fun field work, although the economic models are more complicated.

This segment is not from some crazy appendix by the way, but from the heart of the paper, perhaps outlining one of the more important points, which is the concavity of u (utility). So just in case you were worried about what you were missing…

Also… this is a formula for the value of different prospects. Economics is so fun!

Don’t worry, they clarify this nicely later in plain English. I’d go through it, but I’ll save it for the post about Prospect Theory.

Episode 5: Consumers overvalue what they have, and that’s a problem.

Another derivative of what I call “ownership bias” is the difference between the willingness to accept money (WTA) and the willingness to pay money (WTP).

People exhibit ownership bias when there is something that they feel is theirs; that they own.

Let me take you on a quick mind-journey.

Your grandfather carefully cut, planed, jointed, and hand sanded a desk. He stained the wood by hand himself. He specifically picked white oak because of its beauty and desire for it to be enjoyed for generations to come. It’s perfect in every way. Solid, friendly, worn yet warm. Just like your grandpa.

Let me pop your mind-bubble. It’s worth about $250 in market value. It’s a worn, decently crafted, brown hardwood desk. Maybe it’s worth even less. Maybe $150. I’d probably lowball you for about $75. You would never part with such a treasured family item. That’s ownership bias.

What’s interesting is that this can happen on a much smaller scale, even as small as “gifting” you a pen. We’ll talk a lot more about ownership bias later, so I don’t want to get too carried away (it’s so fun though)!

Ownership bias is the first half of the willingness to accept/willingness to pay divide (spoiler!).

The second half is fear of loss.  Your old brain is afraid of losing resources. It yells at you to hoard, to not lose what you have.

When someone offers us money (which is basically an abstract construct), for something physical we have in our hand, we often overestimate the value of the thing in our hand because we don’t want to lose it.

Mash those two concepts together and what you get is this gap between the WTA and the WTP. To measure this, the typical experiment goes like this:

Half of the subjects are given an item, and then offered money to return it (willingness to accept).

Half of the subjects are asked to pay for the item (willingness to pay).

Researchers make a ratio (two numbers divided by each other) out of these, with WTA on the top (because it’s usually bigger), and WTP on the bottom. AKA, WTA/WTP.

For example, if your willingness to accept a deal for my grandfather’s desk is $600, but my willingness to pay is $200, the WTA/WTP ratio is 600/200 or 3:1 (aka, 3).

I won’t bore you with the details of a thousand studies about WTA and WTP. Fortunately, in A Review of WTA/WTP Studies Horowitz and McConnell did this for us! Thanks for that.

Beyond the fact that WTA is almost always higher than WTP for the reasons noted above, let me give you one more smart tid-bit that the researchers discovered, and I quote from the study:

“We find that the farther a good is from being an “ordinary private good”, the higher the ratio”.

So, the MORE unique an item is, the HIGHER the ratio between the willingness to accept (WTA) and the willingness to pay (WTP) is. The researchers found that non-ordinary goods have ratios that are usually about 6-8 points higher.

This makes sense. The imbalance between the willingness to accept and the willingness to pay is because when we own something we overvalue its worth to other people.

The more unique and special it is to us the higher we as humans will overvalue that product. You’re going to proportionally overvalue your grandfather’s desk far more than a cup of regular uncooked white rice (which is the most ordinary good I can imagine).

Let’s talk about real world practicality.

If you are in an industry that buys anything from consumers, you should understand that consumers will almost always overvalue what they have. It will cause them to be uncooperative in the face of reasonable market value deals.

Or, say, in the insurance world a customer would feel cheated because their grandfather’s desk was replaced by market value. They will feel as if the insurance company stiffed them even though that is not the case.

And conversely, if you want to make your customers feel like they have been given something valuable, give them something special they can own and treasure.

 

Horowitz, J. K., & McConnell, K. E. (2002). A Review of WTA/WTP Studies. Journal of Environmental Economics and Management44(3), 426-447. doi:10.1006/jeem.2001.1215

Episode 4: How trying to avoid regret changes our behavior

Let’s talk about regret aversion. Again, fancy phrase, simple idea. Let’s go on a mind-journey!

Imagine this.

You’re at home cleaning out an old shoe box of junk. I mean, you’ve had this stuff forever since you were a kid. But do you really need that candy bar from 17 years ago that you’ve been keeping just to “see what happened in 10 years?” No. No you don’t.

You’re rifling through your items while sitting on the floor, and sifting things into keep or trash piles. Suddenly you spot under some papers a small pack of NBA basketball cards held together with a rubber band. Man! You’d forgotten that your uncle used to buy you these as a bribery present so you’d like him whenever he came to visit.

You did really like them though, so bribe accepted. You ponder that maybe you should be bribing your own nieces and nephews more. Nodding your head as you have learned another lesson about adulting, you pop the rubber band off and take a look to see what you’ve got. Boring. Retired. Meh. OH WOW! It’s a rookie Shaq card. What a find!

You of course know from your great NBA knowledge that Shaq exploded onto the NBA as a rookie, averaging 23 and 14 and instantly dragging the Orlando Magic into the realm of interestingness, only to leave for the Lakers like everyone else, casting Orlando back into uninterestingness until the disaster that was Dwight Howard a decade later.

But this card is worth money. You do some quick research online and find out that this card is actually part of a famous run by a famous brand, is really rare, and in very high demand. You get in touch with a dealer and you negotiate him up to $1,200 for the card. You’re worried you can get a better deal, but there’s no point in holding on to the card. And hey! You forgot you had it, it’s like finding a free $1200 right? It seems like a fair deal.

Full of confidence you pull the trigger and make the deal.

You get the deposit in your Paypal account and spend it to pay down some credit card debt. Sighhh. Life.

Not two weeks later you’re checking out the news on your favorite site and there’s a breaking news alert! OMG! Shaq tragically just passed away far too young. You can’t believe it and neither can anyone else. Memorials are held. Jerseys re-retired (and re-released), and memorabilia sales explode.

With baited breath you terrifyingly check the dealer’s website a few weeks later out of dread, and sure enough, there’s YOUR card, being resold by the dealer for over $13,000.

Gulp.

“Why did I sell that stupid thing! Ugh I knew I should have held onto it. I could have made so much money!” You feel pangs of regret, and have trouble relaxing for a day or two until you go to the gym a few times and play some video games to get it out of your system and let it go.

You have to stop watching all the Shaq memorial coverage. Too many bad memories about your card and what could have been (money).

So that’s regret. Regret aversion is simply the fear of this situation. It makes us doubt and  second guess ourselves. We try really hard to avoid these feelings of regret (that’s the aversion part). There many types of regret, and some types of regret are stronger than others.

A study done by Seiler, Seiler, Traub and Harrison called “Regret aversion and false reference points in residential real estate” tried to test for regret aversion. They did so with simple questions where subjects were asked to assess their regret on a scale of 1 to 9, with 1 being low, and 9 a high level of regret.

The hypothetical situation the subjects were given was that they “purchased” a home for $200k five years ago. Today it’s worth $300k. That’s great news, right? There were two conditions, with half the people in each.

The first condition is “omission”. In the “omission” condition the participants find out that two years ago they could have sold the house for $350k, but were not aware of the potential sale at the time.

The second condition is “commission”. In the “commission” condition they knew two years ago that they could have sold the house for $350k, but believed the price would keep going up and did not pull the trigger.

In both conditions they still made the same amount of money ($100k). Their happiness with the sale should be the same, right?

Well, overall, people in the “commission” condition who could have sold the house, but chose not to, had statistically significant higher levels of regret than those in the “omission” condition who were unaware of a potential sale (4.69 regret vs. 5.08 with knowledge).

The bottom line is that people feel more regret when they lost something but feel like they had the control to make a different decision.

To a certain extent this is part of the fear of loss which I will talk about a lot more. But fear of loss manifests in many different ways, and this is just one of them.

Even though the end result is the same, learning that we could have made more money, but that we messed up, made a mistake, and sold at the wrong time, feels worse.

If we had no control over the situation and did not know that we had the option to sell the house at a higher price, then we can shrug and say “It was fate. I’m not responsible; Jesus take the wheel.”

It’s an act of god and out of our hands, we never lost what we could never have achieved. But when we had it in our hands, but then lost it because of our own mistakes; that’s troubling.

When we mess up we feel regret aversion. The next time we have to make a decision, we don’t want to make any decision. We freeze because we’re scared of making the wrong choice. Of selling a week too soon, or a day too late.

Like everything else in the 100, this is one of those peculiarities that causes us humans to make decisions and choices that are not the most logical or predicted by a computer. It’s not a simple sum choice utility function. It’s complex weird primate brains.

So let’s talk real world implications.

You can drive action by stimulating people’s fear of loss. Businesses do this all the time (the deal ends in 4 hours! better buy now).

For example, if you want to make people more cautious about selling stocks, send them alerts about all the times they could have sold their stocks for more money, but now it’s worth less. This strategy might actually cause them to switch partners, so maybe it’s something to avoid, but it certainly would stimulate a fear of loss.

Giving people information, so they have the decision in their hands, and then mess it up, will stimulate more regret aversion.  It’s certainly a tool in your arsenal that you should consider using when needed.

Give it a try! Did you find any difference? This is an especially tricky one to test because it is so specific, and also occurs over a period of time. But it’s fascinating to discuss.

 

Seiler, M., Seiler, V., Traub, S., & Harrison, D. (2008). Regret aversion and false reference points in residential real estate. Journal of Real Estate Research, 30(4), 461–474.

Episode 3: Why something being FREE is so compelling

Everyone loves free. There’s something truly magical about getting something that you value for free and the feeling seems universal.

In another post I’ll talk about why we feel indebted when we get something for free, but for now, I want to focus on the feeling of free. If we want it; we take it. It’s almost like a compulsion; a quick little burst of joy like the pure thought of a child. Here is a thing I wish to possess, and with no effort at all, I simply can possess it. Pure joy. Let me take you on a mind-journey to that feeling.

Imagine I walk up to your desk right now and place in front of you a delicate piece of your favorite candied dessert in the entire world, carefully wrapped in a small square of brown paper wrapper. It sits there perfectly. You reach down, pick it up, and eat it, savoring every second. Is it indulgent chocolate? Smooth and silky dairy crème? Lush strawberry? Fluffy sponge cake?

I encourage you to rate your feelings of joy on a scale of 1-10. Now clear your mind of that fun escape. Picture a paper clip on some sand. Okay, clear? Let’s go on another mind journey.

Imagine I walk up to your desk right now and place in front of you a delicate piece of your favorite candy in the entire world, carefully wrapped in a small square of brown paper wrapper. It sits there perfectly. I look at you and say: “Hi, I am selling this piece of candy. It’s small so I’m going to charge you $.01. If you’d like to purchase it, I only take cash. However, I see that you have a small stack of pennies on your desk so change should be no problem. Would you like to purchase it?”

Think about your decision. Would you pay a penny for the candy? How are you feeling? Are you feeling joy? Even if you did decide to purchase the candy and eat it, which would be amazing, I bet the feeling of pure joy about the transaction was lost or at least greatly diminished. If there was joy it felt different somehow. It was less pure joy and more the happiness and satisfaction of getting a good deal.

To us humans, free feels different somehow, and sure enough, it causes us to act differently too.

In Zero as a Special Price: The True Value of Free Products, a research paper by Shampanier, Mazar, and Ariely, the researchers explored different people’s reaction to encountering free with a series of clever experiments.

Subjects were given a choice between two pieces of chocolate. One was “cheap” (Hershey’s), the other was “expensive” (Lindt or Ferrero Rocher).  The experimenters played around with offering different prices to different people. Importantly, the expensive chocolate was always exactly more ($.25 more in the first experiment) than the cheap offering.

Here are the results:

The column on the left entitled “2 & 27” shows what happened when the researchers set the prices at $.02 for the Hershey’s bar and $.27 for the Ferrero Rocher. 45% chose the cheaper Hershey’s, 40% chose the more expensive Ferrero, and 15% chose nothing.

The column in the middle has the results for when the prices were $.01, and $.26. The results are about the same with a little bit of variance which is expected. The difference in price is still $.25 between the two candies.

The column on the right entitled “0 & 25” is the free condition (free and $.25). There is a huge shift when the price was free. 90% went with the free option and only 10% went for the Ferrero.

But there should be no difference between the different prices! You’re paying $.25 more for the expensive candy in any of the three conditions, and yet way more people choose the cheap candy when it is free vs. $.01. Somehow making it free makes it more valuable or desirable.

But what about transaction costs you might ask? Maybe people like free because the $.01 condition has a hidden cost; the cost of the transaction itself (aka, the pain and hassle of paying).

The researchers smartly accounted for this. They set up a real-world experiment where the chocolate choice was made at the checkout of a cafeteria. Everyone was already going to swipe their credit card. As you can see, there are similar results (although more people in the real world choose neither).

.

The left column entitled “1 & 14” is the condition when both the Hershey’s and Lindt (this time) candies were not free ($.01 and $.14 respectively for a $.13 difference). Only 8% chose the cheap Hershey’s option, and 30% chose the expensive Lindt option.

The right column entitled “0 & 13” is the free condition. Again, the difference between the expensive and cheap candies is $.13. But once the cheap product is free there a huge increase in the percentage of people who choose the free candy over the more expensive candy.

In sum, in real world tests after accounting for transaction costs, the “value” of making something free is a +387% increase in sales of the free product (8% to 31% of marketshare), and a -230% decrease in sales of its competitor (30% to 13%).

So, let’s talk about some real-world implications. Do you need to destroy the subjective value of a competitor’s offering? Do you need to get a foothold in a market? Use free. And it may seem intuitive, but there’s a good reason why.

The leading theory (which is not yet proven, but makes sense) is that there is a brain science reason behind this. When you present a brain with a buy/not buy decision the brain lights up with activity. There are certain pathways in the brain that evaluate decision factors, determine preferences, and decide if you should make the purchase. Even at $.01 the neural pathways are activated in the same way as if you buy a more expensive item.

But at truly free, the brain uses an entirely different neural pathway. Instead of the “buy” neural pathway, it takes a deeper (mid-brain) pathway that involves feelings and emotions. These pathways determine if you want the item instead of if the item is valuable enough to justify a purchase.

Emotional pathways are processed more quickly. The quicker process feels like the right decision, and is easier to make, making you feel better about it.

Perhaps the “want/not want” pathways are emotionally stronger because the decision is being processed literally closer in the brain to where emotions are processed (mid-brain).

Or perhaps going through a value based buy decision drags up negative emotions because of the sadness of spending money.

Regardless of the reason, the theory is that because free is a different neurological pathway, it feels better and more valuable. Therefore, far more people choose the free item.

Thinking is hard and humans really hate doing it.

Have you seen this effect at work in your own projects? If not try it and see what happens. Again, make sure it is truly free otherwise your mileage may vary.

For example, having a price of 0, but requiring that users fill out their contact information isn’t really free. Other transactional “work” can dampen the effect. Give it a try!

 

Cite:

Shampanier, K., Mazar, N., & Ariely, D. (2007). Zero as a Special Price: The True Value of Free Products. Marketing Science26(6), 742-757. doi:10.1287/mksc.1060.0254

Episode 2: What is Behavioral Economics? Part 2

This is sort of a Part 2 of the introduction. I talk about the basic setup of Behavioral Economics, what it is, and basic terms. I’ll get back to a nice long blog post next time! But enjoy this video for now.

As proof of my bona fides I attach these notes from my masters level labor economics class. Math math math math. Also I’m sorry for my terrible handwriting :(

Thanks,
Guthrie

Episode 1: What Is Behavioral Economics? Part 1

Hello friends,

I am planning on embarking on an epic quest, and I want you to come with me on my journey.

Have you heard of behavioral economics? It’s a very fun, interesting field of research that combines decision making, social behavior, and brain science with our everyday human actions.

I’ve been exploring the topic in-depth, and I want to bring you along to share my findings. The purpose of it all is to de-mystify why we humans do what we do. That, after all, really is the point of economics (that and lots of math).

I’ve found 100 Things That Behavioral Economics Can Tell Us About People. How you may ask? I’ve read the research papers. And not the fun “pop-sciencey” articles and books that famous behavioral economists have written. No! I’ve read the research papers behind the books. Hundreds of research papers. I’ve poured over data, figures, tables, and P, R, and T values.

From that wealth of knowledge, I collated, consolidated, and extracted the important (and statistically significant) takeaways from the research. As of this writing it’s 26481 words on 114 pages of research notes alone. And that’s just my notes; I’m just starting now to write this up in a format that you, the readers, can understand without your eyes glazing over in an econometric fog.

Some of the research is about brain mechanisms of behavior. But because we are still in the early stages of being able to see what is actually going on in the brain, most of the studies use the tried and true method of live experiments in the real world to describe and explain the sometimes strange behavior and choices we humans make.

Some of the research results are intuitive, but deserve exploring an answer as to why they are true. Some of the results are not intuitive and make us humans seem stupid. They deserve exploring an answer as well.

Finally, there are big questions about human society and the impact that behavioral economics has on it. Hopefully there are some answers that will provide clarity to those big questions as well.

To help guide you I’ll be using what I call “mind-journeys”. These are detailed narrations, where you can put yourself in the shoes of the person making a decision to help explain these complex topics.

It is going to be so fun! I hope you’ll join me. I hope I can make it to my goal of 100 things. I hope you find the information useful, and fascinating, and maybe it will explain us humans just a little bit more.

Thanks,

Guthrie Weinschenk

Rating Your Projects A- Vs A+

Logo for HumanTech podcastIn the last blog post Guthrie Weinschenk explained his idea about saving time and money by rating your projects before you start them. In this podcast Susan and Guthrie discuss how this works and why it works.


HumanTech is a podcast at the intersection of humans, brain science, and technology. Your hosts Guthrie and Dr. Susan Weinschenk explore how behavioral and brain science affects our technologies and how technologies affect our brains.

You can subscribe to the HumanTech podcast through iTunes, Stitcher, or where ever you listen to podcasts.

Behavioral Science vs. Behavioral Economics

Logo for HumanTech podcastWhat is behavioral science? How is it different from behavioral economics? And why are both so cool? Plus, Guthrie geeks out about Daniel Kahneman’s research.


HumanTech is a podcast at the intersection of humans, brain science, and technology. Your hosts Guthrie and Dr. Susan Weinschenk explore how behavioral and brain science affects our technologies and how technologies affect our brains.

You can subscribe to the HumanTech podcast through iTunes, Stitcher, or where ever you listen to podcasts.