Nobel Prize in Economic Sciences Winners 2002 The prize was shared between: DANIEL KAHNEMAN for having integrated insights from psychological research into economic science, especially concerning human judgment and decision- making under uncertainty DANIEL KAHNEMAN for having integrated insights from psychological research into economic science, especially concerning human judgment and decision- making under uncertainty DANIEL KAHNEMAN DANIEL KAHNEMANand VERNON L. SMITH, for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms VERNON L. SMITH, for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms VERNON L. SMITH VERNON L. SMITH

Economist As Scientist  Economist devise theories, collect data, then analyze the data to verify or refute the theories analyze the data to verify or refute the theories  Art in Scientific thinking – make assumptions  Economics - distinguished from social sciences by the belief that most (all) behavior can be explained the belief that most (all) behavior can be explained by assuming people have stable well-defined by assuming people have stable well-defined preferences & make RATIONAL choices preferences & make RATIONAL choices If empirical result shows paradigm shift from rational behavior ANOMALY ANOMALY

Anomalies Wine loving economist bought bottles of nice wine at $10 Price appreciated to $200 at auction. Price appreciated to $200 at auction. He is neither willing to sell at $200 nor He is neither willing to sell at $200 nor willing to buy additional bottle at $200. willing to buy additional bottle at $200. Endowment effect People demand much more to give up than they would be willing to pay to acquire it Status Quo A preference for current state that biases the economist against both buying and selling his wine. Richard H. Thaler (1980)

Experiment – Cornell University Value induced tokens – 50% owner Value induced tokens – 50% owner Alternated roles between buyer/seller – learning curve Alternated roles between buyer/seller – learning curve 3 market trials - demand & supply curve – market clearing price 3 market trials - demand & supply curve – market clearing price People understood the task. No high transaction cost People understood the task. No high transaction cost Immediate: Series of experiments Immediate: Series of experiments  Trade Cornell coffee mugs ($6) with same above procedure 50% own mug and 50% buyers 50% own mug and 50% buyers  4 Market trials – one selected at random to be binding trade  Same procedure followed by using ball point pen ($3.98) – swap buyers & sellers swap buyers & sellers 22 mugs assigned at random – 50% mug lovers & 50% mug 22 mugs assigned at random – 50% mug lovers & 50% mug haters haters

Results of Cornell University Experiments Predicted trade should be 11 but actual result is 4,1,2,2. Predicted trade should be 11 but actual result is 4,1,2,2. Low trade – reservation prices of buyer/seller Low trade – reservation prices of buyer/seller Median selling prices are about twice median buying prices and volume is less than half Median selling prices are about twice median buying prices and volume is less than half Another similar experiment – Simon Fraser University also produced low trade and big gap in buying and selling price

Low Volume of Trade : Owner reluctance to part with endowment rather than buyer’s unwillingness to part with their cash * By William Harbaugh of University of Oregon / Kate Krause University of New Mexico & Lise Vesterlund of Iowa State University Endowment Effect Main Effect of endowment : Pain of Giving Up rather than appeal of ownership than appeal of ownership “Are Adults better behaved than Children ? –Age, Experience, and the Endowment Effect” May 2002 * Findings are : No evidence that endowment effect decreases with age

Status Quo California electric power consumer Survey *  2 distinct groups of consumers- one with much more reliable service than the other  Asked preference -6 combinations of service reliabilities & rates  Differences in income & electricity consumption were minor. Results show a pronounced status quo basis. Could it be habit learning ? Low reliability learned to cope with frequent outages or found candlelight dinner to be romantic ? Could it be habit learning ? Low reliability learned to cope with frequent outages or found candlelight dinner to be romantic ? Strong tendency to remain in the status quo because Disadvantages of leaving it loom larger than advantages ! * Hartman, Doane & Woo – Consumer rationality & the Status Quo

Anomaly: Loss Aversion Two conclusions drawn from studies Two conclusions drawn from studies The significant carriers of utility are not states of wealth or welfare, but changes relative to a neutral reference point. The significant carriers of utility are not states of wealth or welfare, but changes relative to a neutral reference point. Changes that make things worse (losses) loom larger than improvements or gains. Changes that make things worse (losses) loom larger than improvements or gains.

Riskless choice B D Graduate Hall D’ Nanyang Valley Subjects are more sensitive to the dimension in which they are losing relative to their reference point. Saving in Commute Time Social Life A’ Orchard A River valley C

A typical Value Function Value Value Losses Gains Losses Gains Slope of small or moderate gains : Slope of losses of money = 2:1

An empirical study Viscusi, Magat and Huber (1987) A can of fictitious insecticide (current price $10) with the risks of inhalation and skin poisoning (child poisoning)—15 injuries /p 10,000 bottles A can of fictitious insecticide (current price $10) with the risks of inhalation and skin poisoning (child poisoning)—15 injuries /p 10,000 bottles The mean WTP to eliminate both risks: $3.78 The mean WTP to eliminate both risks: $3.78 The price reduction to accept an increase risk (WTA): 77% of respondents refuse any positive price The price reduction to accept an increase risk (WTA): 77% of respondents refuse any positive price The striking difference between WTA (willingess to accept to add one risk) and WTP (willingess-to pay to eliminate or reduce risks) reflects the large difference in the responsibility costs associated with voluntary assumption of additional risk, in contrast to a mere failure to reduce or eliminate existing risk.

Judgments of Fairness and Justice Q1. With a small profit, a company is experiencing a recession with high unemployment but no inflation. It decides to decrease salaries 7% this year. Q1. With a small profit, a company is experiencing a recession with high unemployment but no inflation. It decides to decrease salaries 7% this year. N=125 Acceptable: 37% Unfair: 63% N=125 Acceptable: 37% Unfair: 63% Q2. With a small profit, a company is experiencing a recession with high unemployment and 12% inflation. It decides to increase salaries only 5%. Q2. With a small profit, a company is experiencing a recession with high unemployment and 12% inflation. It decides to increase salaries only 5%. N=129 Acceptable: 78% Unfair: 22% N=129 Acceptable: 78% Unfair: 22%

Judgment in the law In the fields of the law: ”Possession is nine tenths of the law“ In the fields of the law: ”Possession is nine tenths of the law“ A party breaks a contract A party breaks a contract Reason 1: Make an unforeseen gain Reason 2: Avoid a loss

Preference Reversal Flip of Coin FaceBackside Lottery A1 Lose S$0.50 Lottery A2 Lose $S0.80 Lose S$0.10 Lottery A: You start with S$1.00 and lose… Lottery B: You start with S$0.00 and win… Flip of Coin FaceBackside Lottery B1 Win S$0.20 Win S$0.90 Lottery B2 Win $S0.50 Win S$0.50 EV1=-S$0.50 EV2=-S$0.45 EV1=S$0.55 EV2=S$0.50 EU Pair 1 EU Pair 2 Risk Avoiders Risk Takers

Preference Reversal Flip of Coin FaceBackside Lottery A1 Lose S$0.50 Lottery A2 Lose $S0.80 Lose S$0.10  Expected Utility Theory does not tell how to rank lotteries A1 and A2.  Lottery A1 has a larger expected loss (EV1) than lottery A2 (EV2) but there is more risk under lottery A2.  Expected Utility Theory does not tell how to rank lotteries B1 and B2. So we would expect the following outcome:  Risk Avoiders pick A1 and B2.  Risk Takers pick A2 and B1. But the experiment shows that:  Most persons who pick A1, also pick B1.  This is called a Preference Reversal. Flip of Coin FaceBackside Lottery B1 Win S$0.20 Win S$0.90 Lottery B2 Win $S0.50 Win S$0.50

The choice of an option depends on where the person starts from and where the person ends up. The choice of an option depends on where the person starts from and where the person ends up. rather than: Expected Utility Theory says that the choice should only depend on where the person ends up. Expected Utility Theory says that the choice should only depend on where the person ends up. Research 1) has shown that: Persons are risk averse for gambles entailing losses and risk seeking for gambles entailing gains. Persons are risk averse for gambles entailing losses and risk seeking for gambles entailing gains. Preference Reversals are common even among professional Risk Managers and academic economists. Preference Reversals are common even among professional Risk Managers and academic economists. Preference Reversal 1) Kahneman and Tversky

Tversky and Kahneman example Imagine that the U.S. is preparing for an outbreak of an unusual  disease, which is expected to kill 600 people. Two alternate programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences of the programs are as follows: Preference Reversal Options presented to Group 1 If program A is adopted, 200 people will be saved. If program B is adopted, there is a 1/3 probability that 600 persons will be saved, and a 2/3 probability that nobody will be saved. Options presented to Group 2 If program C is adopted, 400 people will die. If program D is adopted, there is a 1/3 probability that nobody will die, and a 2/3 probability that 600 persons will die.

Highway Example The Background: In a small country in Middle East, about 600 persons are killed per year in highway accidents. Two programs have been developed. Program reduces the causalities to 570 persons annually and costs $12 million. Program B reduces the casualties to 500 persons and costs $55 millions. Preference Reversal Options presented to Group 1 Program A saves 30 lives annually and costs $12 million per year. Program B saves 100 lives annually and costs $55 million per year. Which program shall be picked? Options presented to Group 2 Program A saves 30 lives annually and costs $12 million per year. Program B saves 100 lives annually. What would be an adequate price for program B? Dimensions

More prominent dimensions (human lives) loom larger in choice than in matching (price) 1) More prominent dimensions (human lives) loom larger in choice than in matching (price) 1) Predicted variable which is on the same scale gets more weight in the decision. Predicted variable which is on the same scale gets more weight in the decision.Conclusion: If option A is priced higher than option B, we cannot always assume that A is preferred to B in a direct comparison. If option A is priced higher than option B, we cannot always assume that A is preferred to B in a direct comparison. Compatibility Hypothesis 1) Tversky, Slovic, Kahneman.

Conclusion Economic anomalies Economic anomalies happen in reality. happen in reality. violate standard theories in economics. violate standard theories in economics. no obvious way to amend the theory to fit them. no obvious way to amend the theory to fit them. Status Quo effect leads to less changes than what would be expected according to economic theories. Status Quo effect leads to less changes than what would be expected according to economic theories. Loss Aversion effect leads to big differences in WTP and WTA which cannot be explained by economic theories. Loss Aversion effect leads to big differences in WTP and WTA which cannot be explained by economic theories.