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Lately, I have been reading some papers and books on Behavioral Economics. I must say that I am quite fascinated with the concept of “bounds of Decision Making”:

• Bounded Rationality: Individual judgements are limited in their rationality due to various reasons (lack of complete information, time and cost issues, self-serving bias, intelligence limits, perceptions, limited recall abilities, etc.)
• Bounded Awareness
• Bounded Ethicality: Our ability to be ethical is limited (System 1 effect).

In addition, there are inter-temporal inconsistencies (hyperbolic discounting: excessive importance to the present at the expense of sacrificing the future or long term interests!), bounds on self-interest (fairness bias).

The book by Max. H. Bazerman develops these concepts and is a great read (although it is a “text” book).

Nice editorial by Friedman in NYtimes on the topic.

Hillary Clinton has decided to line up with John McCain in pushing to suspend the federal excise tax on gasoline, 18.4 cents a gallon, for this summer’s travel season. This is not an energy policy.

This is money laundering: we borrow money from China and ship it to Saudi Arabia and take a little cut for ourselves as it goes through our gas tanks. What a way to build our country.

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But here’s what’s scary: our problem is so much worse than you think. We have no energy strategy. If you are going to use tax policy to shape energy strategy then you want to raise taxes on the things you want to discourage — gasoline consumption and gas-guzzling cars — and you want to lower taxes on the things you want to encourage — new, renewable energy technologies. We are doing just the opposite.

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“It’s a disaster,” says Michael Polsky, founder of Invenergy, one of the biggest wind-power developers in America. “Wind is a very capital-intensive industry, and financial institutions are not ready to take ‘Congressional risk.’

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The McCain-Clinton proposal is a reminder to me that the biggest energy crisis we have in our country today is the energy to be serious — the energy to do big things in a sustained, focused and intelligent way. We are in the midst of a national political brownout.

Great article in NYtimes today:

The Invisible Hand is Shaking

ADAM SMITH’S modern disciples are far more enthusiastic about his celebrated invisible-hand idea than he ever was.

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Smith understood that the invisible hand is often benign, but not always.

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Smith’s more nuanced position supports a different view of taxes. When market prices convey accurate signals of cost and value, the invisible hand promotes the common good. But prices often diverge from cost and value and, in those cases, taxes can actually help steer resources toward more highly valued uses.

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That simple example captures the classic breakdown in the invisible hand when a product’s market price doesn’t reflect all its relevant social costs and benefits. In such cases, the simplest solution is to discourage consumption by taxing it.

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THAT the invisible hand often breaks down is actually good news. After all, we need to tax something to pay for public services. By taxing forms of consumption that generate negative side effects, we could not only generate enough revenue to eliminate budget deficits, but also help steer resources toward their most highly valued uses.

Because such taxes make the economy more efficient, it makes no sense to object that they impose hardships on low-income families. Again, an efficient policy is one that maximizes the size of the economic pie. And with a bigger pie, it’s always possible for everyone to get a bigger slice.

I absolutely loved this book: Nudge by Thaler and Sunstein. The book has a very active website as well and a great blog.

The authors make (and build on) the following claims:

1. Seemingly small features of social situations can have a massive effect on people’s behaviors — Everything matters
2. Nudges are everywhere
3. Libertarian Paternalism is not an oxymoron!

The sheer complexity of modern life + the pace of technological and global change => Rigid mandates, dogmatic laissez-faire and “just maximize choices” mantras are undermined.

Here are some of my notes/take-ways from the book — sometimes even shamelessly verbatim and some other sources (in no special order):

[Note that the book is a must read and discusses lots of these concepts and beyond in a much more detailed and coherent manner — consider the following just my ramblings to myself of the first few chapters!]

Choice Architect has the responsibility for organizing the context in which people/choosers make decisions.

Corollary: There is no such thing as a neutral design. Everything matters!

The authors develop the concept of Libertarian Paternalism based on some of the above concepts.

Econs are capable of making unbiased forecasts (no systematic bias), not necessarily make perfect forecasts (This is the rationality argument).

Humans on the other hand are slaves to their biases (Prospect theory). Status quo bias (inertia) is ubiquitous.

Various Heuristics (Rules of thumb) that can lead to systematic biases:

1. Anchoring and insufficient adjustment
   • Anchoring can even affect your thinking (”Dating heuristic”)

2. Availability bias (Vividness, Recency and Salience). Explains:
   • Risk related behavior such as over buying of insurance for natural disasters is greatly influenced by recent events

3. Representativeness
   • Conjunction bias (It is more likely for Linda to be a bank teller rather than a bank teller and a feminist!)
   • Misperception of Chance (Myth of the “hot hand”)
   • Overconfidence bias

4. Loss Aversion, which in turn leads to
   • Status Quo bias (Also, due to lack of attention, the “yeah, whatever” heuristic) — Never underestimate the power of inertia
   • Endowment effect
   • All this implies that “Defaults are really sticky“
   • In addition, usually cost aversion < loss aversion

5. Framing
   • Effects are framing are pervasive (even experts are susceptible) and robust (learning does not help!)
   • Concreteness bias — people take the frame as given, thus choices partly depend on the way in which problems are stated.

6. Inter-temporal choices (hyperbolic discounting) and dynamic inconsistencies
   • Mindless choosing (such as eating!)
     • Context influences choice
   • Temptation
   • To improve the behavior, make losses salient & vivid.

7. Mental accounting
   • Topical
   • “House” money

8. Fallacy of a single factor model
   • The tendency to think (usually after the fact) that an outcome was entirely predictable, when in fact it could have been a mere coincidence — misperception of chance.

Nudging Strategies:

1. Framing (losses hurt more!)
2. Make losses more salient
3. Vividness and Salience — Always
   • Make the problem salient
   • Bring it closer to home!

4. Social nudge [I totally loved the chapter on “following the herd” in the book, where the author develops the concept of social nudge]
   • Confirming groups — the power of social influences
   • Collective conservatism: The tendency of groups to stick to older more established patterns even as circumstances change
   • Pluralistic ignorance: We may follow a practice not because we like it, but merely because we think that most people like it!
   • Spotlight effect: The belief that others are closely paying attention to what you are doing!
   • Remember: Choice architects can use social nudge to shift behaviors.
   • Use social norms to nudge people (the group “average” exerts a significant influence)
   • Escalation of commitment (make them signal to others about their commitment)
   • People underestimate the importance of exogenous variables on their (or others) successes.
   • People overestimate the effect of exogenous variables on their failures!
   • Use Positive injunctive norms (rather than negative informational ones) to nudge people

5. Priming (Using Recency bias)
   • Mere-measurement effect can be a nudge
   • Asking to recall something => nudge
   • Channel factors: Facilitating certain behavior by removing some obstacles or by subtle escalation of commitment

When to nudge:

1. Temporal separation between benefits (Now) and costs (Later)
2. Difficult decisions
3. Infrequent decisions
4. Lack of feedback (Long term processes)
5. Unclear mapping between gains/losses and actions

For irrational customers to be protected there has to be competition in the marketplace. (Smart by “Shel Silverstein” )

Choice Architecture:

1. N — iNcentives
   • Who pays/buys
   • Who chooses
   • Who uses
   • Who profits
   • Increase salience of the costs and welfare for choosers

2. U — Understand mappings between choice and welfare
3. D — Defaults are
   • ubiquitous
   • powerful
   • Required choice or mandated choice is not always possible or needed or even desired for by the customers!

4. G — Give feedback
5. E — Expect error (Use a forcing function to avoid a post completion error)
6. S — Structure complex choices

Recent articles in the WSJ and FT about Market Bubbles and the recent chatter about Fed taking more activist approach about controlling/reducing the likelihood of bubbles.

WSJ article: Bernanke’s Bubble Lab

Manias can persist even though many smart people suspect a bubble, because no one of them has the firepower to successfully attack it. Only when skeptical investors act simultaneously — a moment impossible to predict — does the bubble pop.

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The insights of bearish investors “are more likely to be flushed out through the trading process when the market is falling, as opposed to when it’s rising,” Mr. Hong and Harvard’s Jeremy Stein write. They say this explains why prices fall more rapidly than they go up. Over 60 years, nine of the 10 biggest one-day percentage moves in the S&P 500 were down.

When a lot of borrowed money is involved — as it often is in a bubble — once prices peak, the speed of their fall is intensified as investors sell urgently to pay down debt. That pattern offers a strong argument, in Mr. Hong’s view, for government to restrain bubbles and the borrowing that fuels them.

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Under the Hayek view, bubbles don’t make sense. As soon as some group of traders irrationally pushes prices way up, more-rational traders should take advantage of the mispricing by selling — bringing prices back down. But the tech boom reinforced an oft-quoted warning from John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.”

FT article: Fed looks at ways to fight asset bubbles

MJ pointed out this really nice article on leisure

“Too often, leisure time that is not used in a satisfying way turns into idle time, or is used to do a single thing to excess (like overeating, or getting into family quarrels). It can even turn negative, which is what happens often in the cases substance use, delinquency and criminal activity. Also, wouldn’t it be great if we didn’t define ourselves by our work? It should be just as valid to define ourselves by our leisure.”

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“Few of us really think about or plan for leisure. We think we should just go with the flow, but too often we end up feeling stressed, overwhelmed and unfulfilled. We need to plan for leisure — perhaps by doing one small thing every day, identifying long- and short-term leisure goals, putting enjoyable activities on the calendar — like we do other aspects of life. But before people start moving up leisure on the priority list, they need to appreciate and recognize the value and benefits of leisure, even when they have constraints (that may be internal or external). We all have obligations and other constraints that inhibit us from engaging in leisure that range from guilt to time or financial constraints. Yet the personal benefits and collective benefits short term and long term are worthwhile.”

http://www.nytimes.com/2008/05/05/business/smallbusiness/05shift.html

From the Co-opetition book:

“When I am getting ready to reason with a man I spend one-third of my time thinking about myself and what I am going to say, and two-thirds thinking about him and what he is going to say.”

–Abraham Lincoln

Always put yourself in other players’ shoes:

Think about how would they analyze the game/situation from their perspective.