Behavioral economics and decision making

Alexey Mitko

1. Think about times in which you’ve made decisions: what school to attend, what job to take, what kind of car to buy, what to eat for dinner, who to spend your time with, who to date, etc. Now think about how you made those decisions. Do you rely on your gut/intuition or are you more likely to consciously and systematically weight the costs and benefits of your choices? Do different decisions warrant different decision-making styles? Which style of decision-making seems to yield the best results for you? Are you more of an econ or human in general?

Any decision that we make as individuals requires us to have a  certain degree of  information. The degree of information ranges from none to absolute, and when absolute information is present and processed an Econ decision is made. The level of available information is the major factor that will determine what our decision will ultimately be. The level of information available on individual level is influenced by how driven and willing we are to expend effort in pursuit of additional information.

Our motivation levels and thus drive for perfect decision can be influenced by a variety of factors, best illustrated with an example. Let’s imagine that you are considering going for a vacation, you open a newspaper and see an add that says “Perfect Holiday Spot”, there is an address provided but you have no idea where this place is without looking at the map. If you are very particular about your holiday experience you would look at the map and gain additional information about the holiday spot you are considering, you would get a grasp of it’s climate and read some reviews online, thus increasing the level of information available to you. This would illustrate how much you personally care about the decision (aka you base motivational level). But what if you also knew that if you fail to pick a perfect holiday spot your spouse will not talk to you ever again. Assuming you care very much about your spouse, and you don’t want them to stay silent for the rest of your life, the decision importance will increase  thus increasing your drive to get more information about the Holiday Location. However there comes a point where you will get sick of spending additional time and resources to select a vacation spot. Did you get the best possible deal out of your vacation? Probably not, but you made sure you got as close to it as you care.

I agree with a concept of behavioral economics that on the individual level none of us will try to get perfect information required for a perfect decision. We simply will not care enough about the outcome (unless we threatened to be killed if we make a wrong decision or something similar).

However I believe on a group level perfect information is possible. Allow me to move away from complex example and start with a simple group model and expand it little by little.

Let’s assume everyone in the world had to press green or red button. That’s the only thing they had to do during the day, that and nothing else. They can only press either button once a day. People would press either button at 8am and then would have the rest of the day to talk to each other. If they press green button they get food, if they press red button they get nothing.

On the first day 50% of people will get food and 50% will go hungry. On the second day many more people will will get food because they will learn from their previous mistakes by comparing their outcome with that of their peers. On 100th day virtually everyone will be pressing a green button to get food (except the color blind). Now let’s imagine that as it is in the real world conditions change and now red button gives out food and green doesn’t. On the first day after the change 99% of people will go hungry because they pressed green button as a habit expecting the same result. On the second day after the change a few curious souls will try the red button and provided people are allowed to talk to each other everyone will very quickly learn to press the red button instead of the green one. They will call this event “A great button switch disaster” and move on pressing the red button. The point I’m trying to make is here is that people as a group will be able to get to a perfect Econ decision even though majority of them didn’t make the correct decision at first. In order for this to play out, this scenario will need time, free flow of information and constant conditions, something that is very in a real world.

In a way I agree with Rational Choice theory that is it is in the nature of humans move towards a perfect decision/strive to perfect information as a group. In a way I agree with Behavioral Economics theory that it is in the nature of individual humans not care enough about outcomes of their decisions to get perfect information.

However!

I disagree with Rational choice theory on the grounds that time, perfect information and constant conditions are a given. But I also disagree with behavioral economics on the grounds that decision on a group level is subjected to a level or “human randomness”. In my view time, pace of change, and information availability can be measured and affected.

Looking back at any decision I made up to date I can see an interesting pattern emerging. For example relating to my experience of traveling to study in the United States I did follow a group opinion that an education in the United States is highly regarded around the world and will benefit me, however I did not visit every school in the United States. I simply did a level of research I was comfortable accepting. So to answer the question: decisions that I find extremely important to my well being warrant systematic approach, while decisions that do not carry significant consequences are allowed to be made by intuition.

2. Can you think about ways in which default choices have influenced you? Can you think of a way to change a default option that you might encounter in the world (401k plans, etc.) to yield better outcomes? Can you think of a way having more feedback can help you (or others) make better decisions?

I’m actually hard pressed to find a default choice that influenced my life. By default choice I’m assuming people mean being put into a specific group if  no choice is made on my part. Unfortunately I have no experience with employer managed savings plan, the most obvious choice in situation such as this. I do have experience with default choices for tax purposes, that is if W-4 is not filled out by employee employer has to classify that employee as single individual with only one allowance. This basically means that the government set the default so that it gets the most money if no action is taken. I don’t think this is a very good example of the default option because it involves clear incentives for decision makers to make a decision if their family situation is misrepresented by W-4 default.  In 401k plans it is much harder to set a clear cut default option because of the nature of the investment world and multiple preferences among individuals as to how their money should be invested.

In W-4 example it is clear that if people make a decision they will get money out of it, or at least loose nothing. However in case of 401-k plan there are a multiple combinations of risk and return and every person feels differently about each combination. Some people like high risk, high return investments (usually young people). Other people prefer low risk, steady return investments (usually older people). So how can a decision architect create a default that will qualify as the best decision? I think the best way to go about creating default options is to rely on statistics to identify the decision that will benefit the majority and to refine the decision making process as far as possible with available information. For example in 401-k plans and insurance policies people are assigned specific default option. However if a decision architect includes additional variable such as age, gender and occupation people can be assigned better default options. For example, if you are young, and most young people are healthy, you will get an insurance coverage that protects you from hospital bills if you get injured, but doesn’t cover your prescription medication. If you are older, your default investment policies should protect you from economic downturn. It is true however that there are some young people who are sick and some old people who prefer riskier investments, however if we were to base our default decisions based on their needs we would do harm to a greater majority of people. On the other hand if we tailor to majority, minority has always the option of changing their policy, and presumable will care to do so (if you have poor health, I’m assuming it is important to you to have a good insurance plan and you will make sure that it is the case and actually make a decision).

Additional feedback is always helpful when constructing  a default decision policy, since if you make a poor or right decision you will be able to correct or capitalize on your results. The key to collecting the feedback information is to realize that  people that are now faced with a default decision option had done something to be put in the position of making this decision in the first place. They probably left sufficient paper trail to allow you to get hold of basic demographic information such as age, income, marital status, zip code, etc. And even though you cannot ask them directly what decision they prefer, you can closely approximate their preference. Once you do so you should have some sort of proactive feedback method in place for a while to make sure your program creates satisfactory results. If not satisfied with results then you can adjust a variable and test again.

3. Think about the current economic crisis. Do you think all the people involved in creating this situation (bankers, lenders, home buyers, etc.) were making “rational” decisions? That is, were they accurately weighing the costs and benefits of their decisions at every point?

It is very peculiar to see the formation of financial bubbles. After the burst analysis always comes out with the same conclusion – people where too short sighted in making their decisions and failed to see far enough into the future to account for market downturn. It almost seems to me that all the lenders as a group asked themselves the same question everyday: “If I lend today, will I make money?”.  Their decisions were guided by past history and not by possible future predictions. The mechanics behind economic crisis are almost the same as the ones described in my Red/Green button example in question 1. People pushed the green button/bought houses/lent money and were rewarded, anyone who tried to press the red button/not buy a house/not lend money was punished by not getting food/not living in a nice house/not making profit. We can speculate on what truly triggered the economic collapse (adjustable mortgages, toxic assets, fear etc.) but the housing environment heated up to the point where people said: “I will not buy a house for this much money, I’ll rent instead”. And almost like in the “Great Button Switch disaster” the conditions changed. However in my example people had relatively few barriers, other than habit, to switch to an alternative solution. In the real world people were locked into contracts that made sense under the conditions they were established, but no longer made sense under new economic climate, thus creating a trail of losses.

It seems that a pattern is emerging, that is – people make decisions based on past history, with no regard to possible future. If a “rational decision” is defined as aggregating all historical information and making a decision, then all the people involved in the crisis were acting rationally. If we accept that people are not concerned with the possible future then it seems that they were making rational decisions and weighing cost and benefit at every point  (eg. If I don’t lend today I will not make money and that will be bad, because I lent yesterday and made money). If this definition of rationality does not sit well with you, then why do we have to assume that people have to take into account possible future developments in order to be rational? After all future is hazy and uncertain, and a the historical record shows that people as a group fail to take it into account.

My other question to the class is : “If knowledge of bubbles and bursts is common, why do people keep falling into the same cycle over and over? Is it because public memory is limited and people don’t remember the last economic crisis? If it is limited, how limited? 1o years, 1 year, 1 month, a day? changes? depending on what factors?”

Alexey Mitko

I believe strongly that different situations warrant different decisions. And because the variables associated with a given problem/issue may be different at different times, the decision one makes addressing the same problem/issue may be different at different times. I have rarely regretted a decision I have made because, at the time of making the decision, and all things being equal, I believe I made the best decision at the time given the information and experience I had. That does not mean that at a later time, having different information and experience that I would or would not have made the same decision.

I use different methods to make decisions based on the question at hand. For example, most of my big “not involving other people” decisions (which school, which job, how to invest my money, taking this course) are based on identifying the pros and cons of the alternatives. However, once I have “logically” identified and assessed the pros and cons (cost- benefits), I rely on my intuition to make the final decisions. I have to “feel” what it will be like to be in a new place/new job, risk losing money, taking the time necessary to take a course etc. Decisions like what to have for dinner etc would be made assessing some costs-benefits, but ultimately it would be a “gut” decision. I cannot remember making decisions about who to love using any rational means whatsoever.

I believe my decision making style – identifying pros and cons, weighing costs and benefits, and relying on my intuition have for the most part resulted in good decisions for me. Sometimes, with lesser decisions, those I perceive as not having significant consequences, I react too quickly. I do better when I have time to, as fully as possible, process the situation.

Though I try to think things through rationally, I absolutely more human than econ. Emotions play a significant role in the decisions I make.

The one default option that is most relevant to me is my pension plan in higher education. Given the colleges I have been at, I have no choice but to belong to a specific plan, and I have no choice with how much my employer contributes. Having never had any other choice, I am not sure if my investments are better because of this default or whether my investments would have been better had I had a choice or choices. Suffice it to say, I have been content with this default choice as it has resulted in less angst about weighing and deciding among different choices. For me, it has been a better outcome than to have been presented with other choices.

Feedback is necessary in making more effective and efficient decisions. Feedback from experts is incredibly helpful to those of us who are not experts in a given area. When we don’t know something, we have limited knowledge about something (mortgages, insurance plans, loans, investments) and we are likely not sure about what questions to ask..so our questioning can only take us so far. The more knowledge we have about something, the more and better our questions are likely to be. Thus it makes sense for those with expertise, if we could trust them, to provide the clarity and transparency needed that might help improve our decision making.

There is no way to judge whether everyone (all) who made the decisions they made that led to the financial crisis were making “rational” choices. We do not know how “they” define “rational” and what qualifiers they might use to assure alignment with their definition. It is obvious that many, though they may have weighed the cost-benefits to themselves, did not weigh the cost benefits for the general population. It seems to me that many in positions of power are not making decisions based on the “common good”. Decisions for some time now seem to be based on self-interest alone with little moral concern for how decisions might impact others.