Priceless: The Myth of Fair Value (and How to Take Advantage of It) (12 page)

Colin Camerer, a behavioral decision theorist at Caltech, encountered the rationalist mind-set at its holy of holies, the University of Chicago, in the 1970s. “I was very young, I was seventeen, and here were these brilliant people preaching this crazy gospel,” he said. “To me it was just kind of ludicrous. I think there was a misplaced, almost religious fanaticism saying that if there is a principle of rationality, you have to obey it. If you don’t obey it, it’s because you didn’t realize you were disobeying it. But when it’s pointed out, you’ll quickly correct yourself.”

Part of the Chicago doctrine was that Savage-Friedman-type rationality was a prerequisite for survival in the cold, hard business world. Those failing to toe the Chicago line “would get taken advantage of in the markets. They wouldn’t go on to govern companies and be successful leaders,” Camerer said. “These rationality principles were like commandments. You’re either good or evil—and evil people get punished.”

It was nonetheless an open secret that economic theories did not predict human behavior especially well. There was more than one way of waving that aside. Economic models typically assume two things: that people are perfectly reasonable, and also that they are perfectly well informed. Some economists adopted the position that the inhabitants of their models were ignorant, not stupid. Much of the 1970s was spent working out the ramifications of this hopeful (?) prospect.

There was also Milton Friedman’s pet idea that quirks of individual psychology might not matter so much to the economic big picture. Markets, by embodying a wisdom of crowds, could be more rational (read: more like the economic models) than the individuals composing them. By the 1970s, few economists were in a mood to believe otherwise.

It fell to two Caltech economists to defend the honor of their profession. They were David M. Grether and Charles R. Plott, and their goal was simple: “to discredit the psychologists’ work as applied to economics.”

In a 1979 article, Grether and Plott described with alarm the decade-old preference reversal experiments. “Taken at face value,” they wrote, “the inconsistency . . . suggests that no optimization principles of any sort lie behind even the simplest of human choices.”

“We knew Charlie Plott,” Sarah Lichtenstein said. “He called several times” during the course of his mission to demolish her and Slovic’s work and was “jocular” about it. “Plott is pretty good at spotting an interesting phenomenon,” Colin Camerer explained. “I think he knew that if they could replicate all this stuff, that would be interesting because it’s so startling. And if they destroyed it, that would be great too because economists could say ‘silly psychologists don’t know how to do this.’ It was perfectly hedged.”

The Caltech team began by making a laundry list of everything they could think of that might account for the Lichtenstein-Slovic results. Their list came to thirteen explanations. Item No. 13 is an interesting social document. It reads, “The Experimenters Were Psychologists.” “In a very real sense,” Grether and Plott warned sternly, “using psychologists as experimenters can be a problem” because “psychologists have a reputation for deceiving subjects.”

As Camerer had it, the paper is “written as if ‘this can’t possibly be true, these guys are crummy experimenters.’ ” The economists were concerned about “Unsophisticated Subjects” (psychology undergraduates fell into that category), “Confusion and Misunderstanding,” “Strategic Responses,” “Misspecified Incentives,” including the use of imaginary rather than real money, and a number of subtle procedural points. Of course, they conceded that the “game” had already been played for real money in Las Vegas.

Grether and Plott replicated the preference reversal experiments using economics and political science students only (informing them that this was an
economics
experiment) and paid up to $40 for the richest $ bet. Their results were essentially identical to Lichtenstein and Slovic’s. Caltech economics students flip-flopped just like Oregon psychology students and downtown Las Vegas gamblers.

“Needless to say, the results we obtained were not those expected when we initiated this study,” Grether and Plott wrote. “We remain as perplexed as the reader who has just been introduced to the problem . . . Our design controlled for all the economic-theoretic explanations of this phenomenon that we could find. The preference reversal phenomenon . . . remains.”

They ruled out twelve of their thirteen possible explanations, leaving only Lichtenstein and Slovic’s own hypothesis, the “anchoring and adjustment mechanism.” As Grether and Plott explained it—making a
heroic effort to reconcile preference reversal with the economic zeitgeist—“it is as though people have ‘true preferences’ but what they
report
as a preference is dependent on the terms in which the reporting takes place. Certain words or contexts naturally induce some dimensions as anchors whereas others induce other dimensions.”

Even with the “as though” qualification, these were radical words for economists in 1979. Appearing in one of the top economic journals (
The American Economic Review
), Grether and Plott’s replication was an “amplifier.” It not only alerted the economic profession to the findings but also convinced them that the results were solid, real, and profoundly incompatible with what they believed.

Slovic remembers receiving a few admiring letters from economists. They said his work had been an inspiration, and that the writer was doing research along much the same lines. Slovic’s initial pleasure was dashed when he looked at the enclosed reprints. They were crankish lunacy. Among economists, only the freaks and weirdos could “appreciate” his work.

During the 1956 Sinai war, Amos Tversky was a platoon commander in an Israeli paratroop regiment. Chief of Staff Moshe Dayan came to observe Tversky’s platoon in exercises one day. A soldier was assigned to blow up some barbed wire. The man set the explosive, lit the fuse, and then froze in a panic attack. Tversky was just yards away. He ran up to the stricken soldier, ignoring the shouted orders of his commanding officer, and pulled the man to safety. When the explosive detonated, the panicked soldier was unharmed. Tversky caught some shrapnel that he kept for the rest of his life.

This story became emblematic. Tversky, who spent most of his career as a psychologist studying how people make decisions, impressed those around him as the one sane, humane person in the midst of chaos. “Amos was something special, really something special,” recalled Sarah Lichtenstein. “You were happy being in his presence,” said mathematician Persi Diaconis, who knew him at Stanford. “There was a light shining out of him.”

Amos Tversky (1937–1996) was born in the biblical city of Haifa, then part of British Palestine. His mother, Genia, a social worker, would later serve fifteen years in the Knesset. His father, Yosef, was a physician turned veterinarian. “The story is that he got tired of people’s complaints,” Tversky’s wife, Barbara, said. “Cows don’t complain.”

Israeli high school students were required to choose between the humanities and the sciences. Amos “surprised everyone by taking the humanities option, for he had such aptitude for math and science,” Barbara
said. “The math he knew was all self-taught.” Self-education was a lifelong project. “He didn’t like to learn anything the schoolbook way. He took tennis lessons but he didn’t like the way they were taught, so he invented his own way of learning tennis.”

Tversky began his academic career at Hebrew University, an institution with the éclat of having Einstein and Freud on its first board of governors. He studied both philosophy and psychology. “Growing up in a country that’s fighting for survival, you’re perhaps more likely to think simultaneously about applied and theoretical problems,” Tversky once explained. He became one of the first Hebrew University students to get a psychology degree after an Arab ambush had killed virtually the entire psychology department in 1948.

After earning his B.A. in 1961, Tversky went on to doctoral work at the University of Michigan. There he met a stimulating group including Ward Edwards, Clyde Coombs, Sarah Lichtenstein, Paul Slovic, and—most significant—Barbara Gans, who became his wife. Initially Tversky struck the Americans as quiet. He had grown up speaking Hebrew, and English was the language of the enemy—the British occupation. Tversky’s verbal skills were formidable, however. He wrote Hebrew poetry (“a little mechanical, but perfectly structured,” said Barbara) and was a friend of the Israeli poet Dahlia Ravikovich. At Michigan, Tversky honed his English to the point where he was able to coauthor a mathematical psychology textbook with his doctoral advisor, Coombs, and Robyn Dawes. When the manuscript was sent to press, Edwards warned the editor that one of the authors was not a native speaker of English. “Amos’s writing was perfect,” Barbara said. “The problems were with Coombs, an American.”

With greater confidence in the language, Tversky blossomed into an extrovert, a man with a mission. “I remember walking home with him once in graduate school,” Barbara said. “He was working on his dissertation, and he anticipated his whole research program in judgment—and he was a twenty-seven-year-old grad student. I was mesmerized at this young man who really had a vision for a life’s work that would make a difference.”

After taking his Ph.D. in 1965, Amos and New York–born Barbara moved to Israel. He spent a dozen years teaching psychology at Hebrew
University. There, in 1968, colleague Daniel Kahneman asked him to give a talk for a graduate seminar. This turned out to be a “life-changing event,” in Kahneman’s words.

Kahneman’s parents were Lithuanian Jews who had moved to Paris in the 1920s. His father headed research at a chemical company. His mother was visiting family in the Palestinian city of Tel Aviv when she gave birth to Daniel in 1934.

Kahneman’s early years were spent in Paris, a city changed irrevocably by the Nazi occupation in 1940. In his Nobel autobiography, Kahneman wrote,

I will never know if my vocation as a psychologist was a result of my early exposure to interesting gossip, or whether my interest in gossip was an indication of a budding vocation. Like many other Jews, I suppose, I grew up in a world that consisted exclusively of people and words, and most of the words were about people. Nature barely existed, and I never learned to identify flowers or to appreciate animals. But the people my mother liked to talk about with her friends and with my father were fascinating in their complexity. Some people were better than others, but the best were far from perfect and no one was simply bad. Most of her stories were touched by irony, and they all had two sides or more.

In one experience I remember vividly, there was a rich range of shades. It must have been late 1941 or early 1942. Jews were required to wear the Star of David and to obey a 6 p.m. curfew. I had gone to play with a Christian friend and had stayed too late. I turned my brown sweater inside out to walk the few blocks home. As I was walking down an empty street, I saw a German soldier approaching. He was wearing the black uniform that I had been told to fear more than others—the one worn by specially recruited SS soldiers. As I came closer to him, trying to walk fast, I noticed that he was looking at me intently. Then he beckoned me over, picked me up, and hugged me. I was terrified that he would notice the star inside my sweater. He was speaking to me with great emotion, in German. When he put me down, he opened his wallet, showed me a picture of a boy, and gave me some money. I went home more certain than ever that my mother was right: people were endlessly complicated and interesting.

The Kahneman family spent the war years trying to stay a step ahead of the Nazis. The first sweep of Jews sent Kahneman’s father to Drancy, a way station to the extermination camps. He was quickly released owing to the pull of the director of his chemical firm—who, it turned out, had been a major financial backer of the French anti-Semitic movement. The family decamped to the Riviera, then to central France, where Daniel’s father died of improperly treated diabetes six weeks before D-Day.

Kahneman’s mother moved the family to Palestine to be close to her relatives. Daniel studied psychology and mathematics at Hebrew University, then was drafted into the Israeli army in 1954. Among his duties was administering a battery of psychological tests inherited from the British Army. In one test, eight soldiers, stripped of all rank insignia, collaborated on moving a telephone pole over a wall or similar obstacle. The rules said the telephone pole must not touch the wall or the ground; if it did, the soldiers had to start over.

The test was intended to distinguish the true leaders from the followers. Kahneman found himself more interested in what the test said about the psychologists. A monthly “statistics day” brought the staff together to compare their evaluations with the grades from officer training school. “The story was always the same,” Kahneman remembered. “Our ability to predict performance at the school was negligible.”

In 1958 Kahneman and his new wife, Irah Kahn, moved to Berkeley for grad school. His eclectic curriculum included studies on subliminal perception, personality testing, and Wittgenstein. One of his teachers was Tom Cornsweet, whose name is now attached to a famous perceptual illusion (opposite page).

Everyone thinks the left half is darker. Wrong! Try placing a finger over the boundary between “dark” and “light” regions. You’ll see that nearly the whole rectangle is the same shade of gray. The boundary region only has been shaded slightly darker on the left, lighter on the right, to create a contrast.