Misbehaving: The Making of Behavioral Economics (6 page)

The same is true in financial matters. Consider Jane, who makes $80,000 per year. She gets a $5,000 year-end bonus that she had not expected. How does Jane process this event? Does she calculate the change in her lifetime wealth, which is barely noticeable? No, she is more likely to think, “Wow, an extra $5,000!” People think about life in terms of changes, not levels. They can be changes from the status quo or changes from what was expected, but whatever form they take, it is changes that make us happy or miserable. That was a big idea.

The figure in the paper so captured my imagination that I drew a version of it on the blackboard right next to the List. Have another look at it now. There is an enormous amount of wisdom about human nature captured in that S-shaped curve. The upper portion, for gains, has the same shape as the usual utility of wealth function, capturing the idea of diminishing sensitivity. But notice that the loss function captures diminishing sensitivity also. The difference between losing $10 and $20 feels much bigger than the difference between losing $1,300 and $1,310. This is different from the standard model, because starting from a given wealth level in figure 1, losses are captured by moving down the utility of wealth line, meaning that each loss gets increasingly painful. (If you care less and less about increases in wealth, then it follows that you care more and more about decreases in wealth.)

The fact that we experience diminishing sensitivity to changes away from the status quo captures another basic human trait—one of the earliest findings in psychology—known as the Weber-Fechner Law. The Weber-Fechner Law holds that the just-noticeable difference in any variable is proportional to the magnitude of that variable. If I gain one ounce, I don’t notice it, but if I am buying fresh herbs, the difference between 2 ounces and 3 ounces is obvious. Psychologists refer to a just noticeable difference as a JND. If you want to impress an academic psychologist, add that term to your cocktail party banter. (“I went for the more expensive sound system in the new car I bought because the increase in price was not a JND.”)

You can test your understanding of the concept behind the Weber-Fechner Law with this example from National Public Radio’s long-running show called
Car Talk
. The show consisted of brothers Tom and Ray Magliozzi—both MIT graduates—taking calls from people with questions about their cars. Improbably enough, it was hysterically funny, especially to them. They would laugh endlessly at their own jokes.
‡

In one show a caller asked: “Both my headlights went out at the same time. I took the car to the shop but the mechanic said that all I needed was two new bulbs. How can that be right? Isn’t it too big of a coincidence that both bulbs blew out at the same time?”

Tom answered the question in a flash. “Ah, the famous Weber-Fechner Law!” It turns out that Tom also did a PhD in psychology and marketing supervised by Max Bazerman, a leading scholar in judgment and decision-making research. So, what does the caller’s question have to do with the Weber-Fechner Law, and how did this insight help Tom solve the problem?

The answer is that the two bulbs did not in fact burn out at the same time. It is easy to drive around with one bulb burned out and not notice, especially if you live in a well-lit city. Going from two bulbs to one is not always a noticeable difference. But going from one to zero is definitely noticeable. This phenomenon also explains the behavior in one of the examples on the List: being more willing to drive ten minutes to save $10 on a $45 clock radio than on a $495 television set. For the latter purchase, the savings would not be a JND.

The fact that people have diminishing sensitivity to both gains and losses has another implication. People will be risk-averse for gains, but risk-seeking for losses, as illustrated by the experiment reported below which was administered to two different groups of subjects. (Notice that the initial sentence in the two questions differs in a way that makes the two problems identical if subjects are making decisions based on levels of wealth, as was traditionally assumed.) The percentage of subjects choosing each option is shown in brackets.

P
ROBLEM
1.
Assume yourself richer by $300 than you are today. You are offered a choice between

P
ROBLEM
2.
Assume yourself richer by $500 than you are today. You are offered a choice between

The reason why people are risk-seeking for losses is the same logic that applies to why they are risk-averse for gains. In the case of problem 2, the pain of losing the second hundred dollars is less than the pain of losing the first hundred, so subjects are ready to take the risk of losing more in order to have the chance of getting back to no loss at all. They are especially keen to eliminate a loss altogether because of the third feature captured in figure 3: loss aversion.

Examine the value function in this figure at the origin, where both curves begin. Notice that the loss function is steeper than the gain function: it decreases more quickly than the gain function goes up. Roughly speaking, losses hurt about twice as much as gains make you feel good. This feature of the value function left me flabbergasted. There, in that picture, was the endowment effect. If I take away Professor Rosett’s bottle of wine, he will feel it as a loss equivalent to twice the gain he would feel if he acquired a bottle; that is why he would never buy a bottle worth the same market price as one in his cellar. The fact that a loss hurts more than an equivalent gain gives pleasure is called loss aversion. It has become the single most powerful tool in the behavioral economist’s arsenal.

So, we experience life in terms of changes, we feel diminishing sensitivity to both gains and losses, and losses sting more than equivalently-sized gains feel good. That is a lot of wisdom in one image. Little did I know that I would be playing around with that graph for the rest of my career.

________________

*
   I asked Danny why they changed the name. His reply: “‘Value theory’ was misleading, and we decided to have a completely meaningless term, which would become meaningful if by some lucky break the theory became important. ‘Prospect’ fitted the bill.”

†
   The puzzle is this: Suppose you are offered a gamble where you keep flipping a coin until it lands heads up. If you get heads on your first flip you win $2, on your second flip $4, and so forth, with the pot doubling each time. Your expected winnings are ½ x $2 + ¼ x $4 + 1/8 x $8 . . . The value of this sequence is infinite, so why won’t people pay a huge amount to play the bet? Bernoulli’s answer was to suppose that people get diminishing value from increases in their wealth, which yields risk aversion. A simpler solution is to note that there is only a finite amount of wealth in the world, so you should be worried about whether the other side can pay up if you win. Just forty heads in a row puts your prize money at over one trillion dollars. If you think that would break the bank, the bet is worth no more than $40.

‡
   Tom Magliozzi passed away in 2014 but the show lives on in reruns, where the two brothers are still laughing.

5

California Dreamin’

S
herwin Rosen was planning to spend the summer of 1977 at Stanford and invited me to join him out west to do some more work on the value of a life. At some point that spring I learned that Kahneman and Tversky were planning to spend the academic year at Stanford. After all the inspiration their work had provided me, I could not bear the thought of leaving town just before they arrived in September.

Over spring break I flew to California to investigate housing for the summer, and at the same time try to finagle a way to stay around Stanford during the fall semester. I hoped I might get to spend some time with the complete strangers who had become my new idols. I had sent Tversky an early draft of my first behavioral paper, which at the time carried the title “Consumer Choice: A Theory of Economists’ Behavior,” with the implicit suggestion that only economists behave like Econs. He had sent a short but friendly reply saying we were clearly thinking along similar lines, but that was it. In the days before email, it was much more difficult to initiate a long-distance conversation.

I spent a few days begging and pleading around campus for some kind of visiting position, but after two days I had nothing. I was about to give up when I had a conversation with the storied health economist Victor Fuchs, who was the director of the National Bureau of Economic Research (NBER) office, where Sherwin and I would be working. I gave Victor my best song and dance about the List, heuristics and biases, prospect theory, and the Israeli gods who were about to descend on Stanford. Victor either got intrigued or just took pity on me and offered to put me on his grant for the fall semester. After I arrived at Stanford in July, Victor and I had frequent discussions about my deviant thoughts, and in time he would extend his offer to pay my salary until the following summer.

The Thaler family took a leisurely trip across the country in June, hitting national parks along the way, and the drive offered time to let my mind wander about ways to combine psychology and economics. Any topic was fair game for pondering. For instance: Suppose I will drive 300 miles today. How fast should I drive? If I drive at 70 miles per hour instead of 60, we will get to our destination 43 minutes sooner, which seems like enough time saved to risk a speeding ticket. But when I have only 30 miles left to go, I will only save 4.3 minutes by driving faster. That doesn’t seem worth it. So, should I be gradually slowing down as I get closer to my destination? That can’t be right, especially since we are going to get back in the car and drive again tomorrow. Shouldn’t I have a uniform policy for the entire trip? Hmmm, put it on the List.
*

Our trip’s final detour was to Eugene, Oregon, to see Baruch Fisch-hoff and Paul Slovic, the psychologists who had originally sparked my interest in these ideas. While the family explored the town, I chatted with Baruch, Paul, and their collaborator Sarah Lichtenstein. There was also another psychologist visiting their center who, like Fisch-hoff, had studied with Kahneman and Tversky in graduate school, Maya Bar-Hillel. All of them would join my informal team of psychology tutors in the coming years.

At the end of the summer, the Kahneman and Tversky psychology clan arrived in force. Amos and his wife, Barbara, were visiting the Stanford psychology department. Danny and his future wife, the eminent psychologist Anne Treisman, were to be visiting the Center for Advanced Study in the Behavioral Sciences, located just up the hill from NBER.

Victor Fuchs arranged the lunch where Amos, Danny, and I first met. I don’t remember much about it, except that I was uncharacteristically nervous. I can only trust that the voluble Vic kept the conversation moving. More important, the lunch introduction gave me license to walk up the hill and drop in on Danny. (Tversky’s office was on campus, too far away to just drop in.) He and Tversky were finishing the paper that by now they called “Prospect Theory,” and I would sometimes wander in while they were working. The Center’s primitive phone system made it easier to walk up the hill than to call Danny to see if he was around.

Sometimes when I stopped by to see Danny I would find the two of them at work, putting together the final version of prospect theory. When they were writing, with Danny at the keyboard, they would talk though each sentence, arguing about virtually every word. Their conversations were an odd mixture of Hebrew and English. An exchange in one language might suddenly switch to the other, with no acknowledgment of the flip. Sometimes the switch to English seemed related to the use of technical terms like “loss aversion,” for which they had not bothered to invent Hebrew equivalents. But I failed to generate a viable theory for why they would switch in the other direction. It might have helped to know some Hebrew.

They spent months polishing the paper. Most academics find getting the initial ideas the most enjoyable part of research, and conducting the actual research is almost as much fun. But few enjoy the writing, and it shows. To call academic writing dull is giving it too much credit. Yet to many, dull writing is a badge of honor. To write with flair signals that you don’t take your work seriously and readers shouldn’t either.
†
“Prospect Theory” is hardly an easy read, but the writing was crystal clear because of their endless editing and Amos’s perennial goal of “getting it right.”

Danny and I soon began the habit of taking walks in the hills near the Center just to talk. We were equally ignorant and curious about each other’s fields, so our conversations offered many learning opportunities. One aspect of these mutual training sessions involved understanding how members of the other profession think, and what it takes to convince them of some finding.

The use of hypothetical questions offers a good example. All of Kahneman and Tversky’s research up to this point relied on simple scenarios, such as: “Imagine that in addition to everything you now own, you gain $400. Now consider the choice between a sure loss of $200 or a gamble in which you have a 50% chance to lose $400 and a 50% chance to lose nothing.” (Most choose to gamble in this situation.) As Kahneman delightfully explains in his book
Thinking, Fast and Slow
, they would try these thought experiments out on themselves and if they agreed on an answer they would provisionally assume that others would answer the same way. Then they would check by asking subjects, typically students.

Economists do not put much stock in the answers to hypothetical questions, or survey questions in general for that matter. Economists say they care more about what people
do
as opposed to what they
say they would do
. Kahneman and Tversky were aware of the objections, undoubtedly raised by skeptical economists they had met, but they had little choice. A key prediction of prospect theory is that people react differently to losses than they do to gains. But it is nearly impossible to get permission to run experiments in which subjects might actually lose substantial amounts of money. Even if people were willing to participate, the university committees that review experiments using human subjects might not approve the experiments.