Lecture 10 - Financial DM and Fairness PDF

Judgment and Decision Making (PSYC10) Fall 2024 Prof. Yoel Inbar Anchoring Results 12 10 8 6 4 2 0 -2 Financial Decision Making Fairness Mental Accounting A friend confessed the following: For Christmas, she received $100 cash from her mother, who told...

Judgment and Decision Making (PSYC10) Fall 2024 Prof. Yoel Inbar Anchoring Results 12 10 8 6 4 2 0 -2 Financial Decision Making Fairness Mental Accounting A friend confessed the following: For Christmas, she received $100 cash from her mother, who told her to only spend it on something that she really wanted. Three months later, my friend, still looking for that special “something,” still had the same $100 in her wallet, though she had gone to the ATM to withdraw $100 many times. Mental Accounting Mr. K admires a $200 cashmere sweater at the department store. He declines to buy it, feeling that it is too extravagant. Later that month he receives the same sweater from his wife for a birthday present. He is very happy. Mr. and Mrs. K have only joint bank accounts. Mental Accounting Which is a better gift, a $100 gift certificate to a fancy restaurant that the recipient will definitely enjoy or $100 in cash? Honeymoon Registries Mental Accounting Money has labels. Those labels affect spending, saving, outcome evaluation, and decision making. Mental Accounting 1. Budgets 2. Hated Payments 3. Open vs. closed accounts Budgets Imagine that you have decided to see a play and paid the admission price of $20 per ticket. As you enter the theater, you discover that you have lost the ticket. The seat was not marked, and the ticket cannot be recovered. Would you pay $20 for another ticket? [42% said Yes] Imagine that you have decided to see a play where admission is $20 per ticket. As you enter the theater, you discover that you have lost a $20 bill. Would you still pay $20 for a ticket for the play? [77% said Yes] Budgets Organizations and households often establish non-fungible budgets. This can lead to odd or seemingly irrational outcomes. Budgets Checking vs. Savings vs. Future Income Do you know anyone who is carrying a credit card balance and who also has enough money in savings to pay off the balance? Budgets Designated-purpose checking accounts Budgets You spend $50 on a sports ticket. Would you purchase a $25 theater ticket later in the week? No. You are given a sports ticket. Would you purchase a $25 theater ticket later in the week? Yes. You hear of a flu epidemic on the news. You spend $50 for an inoculation. Would you purchase a $25 theater ticket later in the week? Yes. Heath & Soll (1996) Budgets A professor of finance prides himself on being a thoroughly rational man. Long ago he adopted the clever strategy to deal with life’s misfortunes. At the beginning of each year he establishes a target donation to the local United Way charity. Then, if anything untoward happens to him during the year, for example an undeserved speeding ticket, he simply deducts this loss from the United Way account. He thinks of it as an insurance policy against small annoyances. Mental Accounting 1. Budgets 2. Hated Payments 3. Open vs. closed accounts  Hated Payments What are some things that people hate paying for? A promotion offering people freedom from paying a fee that they hate will probably be more effective than a different but monetarily equivalent promotion. Tax Aversion You want to buy a new television and have a particular model in mind. Calling around, you find that only two stores, Bob’s Electronics and Tom’s Electronics, carry that model. Bob’s Electronics is located very close, about a 5-minute drive, but offers no discounts on the television set. Tom’s Electronics is located farther away, about a 30-minute drive, but offers the television set … with a 9% discount: 59% tax-free, which is equivalent to an 8% discount: 76% Where do you go to make your purchase? Sussman & Olivola (2011) Mental Accounting 1. Budgets 2. Hated Payments 3. Open vs. closed accounts Open vs. Closed Accounts A realized loss is more painful than a paper loss. In investing, people are particularly reluctant to sell losing stocks. Money Now or Money Later You are going to lose $100. Do you want to lose it now or in six months? You are going to gain $100. Do you want to receive it now or in six months? Choosing to Prepay Imagine that, six months from now, you are planning to purchase a washer and dryer for your new residence. The two machines together will cost $1,200. You have two options for financing the washer/dryer: 6 monthly payments of $200 each during the six months before the washer and dryer arrive 6 monthly payments of $200 each during the six months after the washer and dryer arrive 6% choose to prepay Choosing to Prepay Imagine that you are planning a one-week vacation to the Caribbean, six months from now. The vacation will cost $1,200. You have two options for financing the vacation: 6 monthly payments of $200 each during the six months before the vacation 6 monthly payments of $200 each during the six months after the vacation 53% choose to prepay Prepayment vs. Post-payment It is painful to pay for things after we are done consuming them. It is pleasurable to consume things after we have paid for them (we feel like we are consuming for free!). Prepayment vs. Post-Payment Prelec & Loewenstein (1998) When Do You Want To Get Paid? Imagine that you are receiving a salary for an intensive week’s worth of work. When do you prefer to receive payment? Before doing the work After doing the work [60% chose to receive payment AFTER doing the work!] Prelec & Loewenstein (1998) Mental Prepayment A Manhattan newlywed couple were deciding whether to live on the East side (her preference, on account of the better restaurants) or the West side (his preference, on account of the cheaper rent). The clinching argument put forth in favor of the West side was that the rental savings would easily cover any reasonable number of taxi rides to the East side. However, having moved in, the couple soon realized that the cost of the round-trip ride made dining out on the East side look too expensive. Their solution: On the first of the month they would set aside (“prepay”) a certain amount just for the cab rides. Prelec & Loewenstein (1998) Mental Accounting 1. Budgets 2. Hated Payments 3. Open vs. closed accounts Sunk Cost The feeling that past investment obligates you to change your future behavior. Going To Vermont “Well in advance, we planned a January ski trip to Vermont with friends of ours from Baltimore. Unfortunately, as the weekend of the ski trip approached, it was obvious that the skiing conditions would be terrible. Our friends tried to cancel our hotel reservation, in the hopes that they could instead visit us in New Haven while avoiding the needless trek to an inferior town in Vermont. However, because the hotel required payment in full, we went to Vermont as planned.” Radar-Blank Plane As president of an airline company, you have received a suggestion from one of your employees. The suggestion is to use the last 1 million dollars of your research funds to develop a plane that would not be detected by conventional radar, in other words, a radar-blank plane. However, another firm has just begun marketing a plane that cannot be detected by radar. Also, it is apparent that their plane is much faster and far more economical than the plane your company could build. The question is: should you invest the last million dollars of your research funds to build the radar-blank plane proposed by your employee? Yes: 16% No: 84% Arkes & Blumer (1985) Radar-Blank Plane As the president of an airline company, you have invested 10 million dollars of the company’s money into a research project. The purpose was to build a plane that would not be detected by conventional radar, in other words, a radar-blank plane. When the project is 90% completed, another firm begins marketing a plane that cannot be detected by radar. Also, it is apparent that their plane is much faster and far more economical than the plane your company is building. The question is: should you invest the last 10% of the research funds to finish your radar- blank plane? Yes: 82% No: 18% Arkes & Blumer (1985) Why Are We Influenced By Sunk Costs? Aversion to waste: walking away from what you’ve already invested feels wasteful …so we end up ”throwing good money after bad” Even if we don’t believe this, maybe the people evaluating us do! Lessons People honor sunk costs, but you shouldn’t. People do not treat all money the same, but you should. People are enticed by promotions that erase hated payments (more than equivalent promotions). People dislike paying for something after consumption or working for something after being paid. Fairness What is Fair? What people think is fair often disagrees with economic theory. “Humans” vs. “Econs” Pricing “Anomalies” “Fans upset after finding Bruce Springsteen tickets on StubHub for nearly $10K” “Retail prices ranged from $75 to $850, but later, the cheapest tickets available on StubHub cost well over $1,000, and others were priced as high as $9,800.” (CBS News, August 2017) Surge Pricing “Uber's New Year's Eve rates anger passengers” “Techies At CES Angry Over Uber’s Surge Pricing” “Uber surge pricing during tube strike infuriates commuters” “£91!? Outrageous” The Price of Beer You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to make a phone call and offers to bring back a beer from the only place nearby where beer is sold – a small, run-down grocery store. He says that the beer might be expensive and so asks how much you are willing to pay for the beer. He says that he will buy the beer if it costs as much or less than the price you state. But if it costs more than the price you state he will not buy it. You trust your friend, and there is no possibility of bargaining with the store owner. What price do you tell him? [Median = $4.00] Thaler (1985) The Price of Beer You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to make a phone call and offers to bring back a beer from the only place nearby where beer is sold – a fancy resort hotel. He says that the beer might be expensive and so asks how much you are willing to pay for the beer. He says that he will buy the beer if it costs as much or less than the price you state. But if it costs more than the price you state he will not buy it. You trust your friend, and there is no possibility of bargaining with the store owner. What price do you tell him? [Median = $5.00] Thaler (1985) Price Increases A hardware store has been selling snow shovels for $15. The day after a heavy snowstorm the store raises the price to $30. Fair or unfair? A hardware store has been selling snow shovels for $15. The price the store’s supplier charges for snow shovels doubles, so the store raises the price to $30. Fair or unfair? Reference Transactions 1. Reference price/wage 2. Reference profit to firm Raise price (or cut wages) to protect reference profit: fair Raise price (or cut wages) for other reasons (increased demand, increased market power): unfair Protecting Profit A small company employs several workers and has been paying them average wages. There is severe unemployment in the area and the company could easily replace its current employees with good workers at a lower wage. The company has been making money. The owners reduce the current workers' wages by 5 percent. Acceptable: 23% Unfair: 77% Kahneman, Knetsch, & Thaler, 1986 Protecting Profit A small company employs several workers and has been paying them average wages. There is severe unemployment in the area and the company could easily replace its current employees with good workers at a lower wage. The company has been losing money. The owners reduce the current workers' wages by 5 percent. Acceptable: 68% Unfair: 32% Kahneman, Knetsch, & Thaler, 1986 Framing A company is making a small profit. It is located in a community experiencing a recession with substantial unemployment but no inflation [and inflation of 12%]. There are many workers anxious to work at the company. The company decides to decrease wages and salaries 7% this year [increase wages and salaries only 5% this year]. Acceptable: 38% [78%] Kahneman, Knetsch, & Thaler, 1986 Framing A shortage has developed for a popular model of automobile, and customers must now wait two months for delivery. A dealer has been selling these cars at list price. Now the dealer prices this model at $200 above list price. Acceptable: 29% Kahneman, Knetsch, & Thaler, 1986 Framing A shortage has developed for a popular model of automobile, and customers must now wait two months for delivery. A dealer has been selling these cars at a discount of $200 below list price. Now the dealer sells this model only at list price. Acceptable: 58% Kahneman, Knetsch, & Thaler, 1986 Gains vs. Losses A small factory produces tables and sells all that it can make at $200 each. Because of changes in the price of materials, the cost of making each table has recently decreased by $20. The factory does not change its price for the tables. Acceptable: 53% Kahneman, Knetsch, & Thaler, 1986 Punishment A drugstore in your neighborhood takes advantage of a competitor closing to temporarily raise prices. Would you switch to a less convenient drugstore even after prices have returned to their previous levels? Yes: 68% Kahneman, Knetsch, & Thaler, 1986 Dictator Game “You have the opportunity to divide $20 between you and another anonymous student in this class. You have two choices: you can take $18 and give the other student $2, or you can split the money evenly, so that you each get $10.” Split evenly: 74% Keep $18: 26% Punishment Game “You have been paired with two students who played the Dictator Game. One, E, divided the money evenly, while the other, U, divided the money unevenly. He took $18 and gave his counterpart $2. Would you like to evenly split $12 with U or $10 with E?” $12 with U: 19% $10 with E: 81% The Ultimatum Game Player A: Divide $10 between yourself and Player B. Player B: Accept the division OR reject (in which case both players get $0) Econs If the game is played only once, what is the MINIMUM an economically rational player should accept? What is the minimum an economically rational player should offer? Humans Most offers are 40-50% of the total Most offers under 30% are rejected Even for large amounts: $100 USD, 3 months salary (!!) in Indonesia Fairness People will pay to punish unfairness Unfairness is emotionally upsetting Unfair Offers Chapman et al., 2009 Fairness Cooperation “Prisoner’s Dilemma” 2-party strategy game often used to study cooperation http://www.radiolab.org/story/golden-rule/ Econs vs. Humans Defection rate 70% 60% 60.4% 50% 40% 38.8% 30% 20% 10% 0% Economics major Nonmajor Econs vs. Humans Defection rate 70% 60% 60.4% 50% 40% 38.8% 30% 20% 10% 0% Economics major Nonmajor Optimal Cooperation Optimal strategy in iterated dilemmas? You play the same player(s) repeatedly. Tit-for-tat: do what the other player did on the last round. *)(A H,*. - (68>*?+ @-( 76.2(,*9 8*540* )J 2.?0*-(*9 +,* 7*0249 ;< +,-+ (68>*?+ 0-2(*9 2.*0< +,-+ +,2( 94*(.4+ ?4.(+2+6+* -. 2.920*?+ 3-+*02-) 8*.*Q+ 45 +,* -?+ 45 76.2(,3*.+ 540 -. 2.92/296-) 76.2(,*0< 8*?-6(* +,* 76.2(,2.1 (68>*?+.*/*0 3**+( 9 48(*0/-+24.(< 2./*(+3*.+ 45.+ ?4.92+24.A U. a 20 With punishment Without punishment 2+24. @-( ,21,*0 18 Mean cooperation (MUs) * 2./*(+3*.+ 2. 16 14 12 10 8 6 4 2 0 1 2 3 4 5 6 1 2 3 4 5 6 ods 1–4 ods 5 and 6 od 6 b 20 Without punishment With punishment 18 Mean cooperation (MUs) 16 14 4.4 12.9 7.8 5.5 10 8 8 to 14 6 n 4 2 0 1 2 3 4 5 6 1 2 3 4 5 6 +2#3- #- # 1*$4)(,$ ,1 Period / )." /"#$ &*$(-./"$) +"'*4"' !"#$%& ( =(/" )+"$' ,1 /"#$ 4,,&"+#)(,$ ),0")."+ D(). )." HIG 4,$J'"$4" ($)"+2#36 )." 5#+- ($'(4#)" )." )@ K*+($0 )." J+-) -(% &"+(,'-@ -*5L"4)-.#2" )." ,&&,+)*$()8 ), &*$(-. )." ,)."+ 0+,*& /&3"@ '*+($0 &"+(,'- /"/5"+-6 M1)"+D#+'-@ )." &*$(-./"$) ,&&,+)*$()8 (- +"/,2"'6 *@ K*+($0 )." J+-) -(% :- 1+,/ )." #2"+#0" &"+(,'-@ &*$(-./"$) ,1 ,)."+ 0+,*& /"/5"+- (- +*3"' ,*)6 M1)"+D#+'-@ &*$(-./"$) (- &,--(53"6 XGC'YZ [ \P] "!: [ !% ^GX'GY_ $%%$ [ @@@A.-+60*A?43 © 2002 Macmillan Magazines Ltd Fehr & Gächter, 2002 Lessons People care about fairness. Making pricing decisions assuming economically rational consumers = angry customers. It may be worth it to leave money on the table to build long-term loyalty. Framing matters: it’s easier to remove a discount than add a surcharge. Closing Arguments Ask: “How Do You Know That?” and “Why Do We Do Things That Way?” Whenever Possible: EXPERIMENT!! (Or Gather Data) When evidence suggests that you should change your policies, then change your policies. Quiz In “What Seems Fair,” Thaler tells the story of First Chicago, a large Chicago-area bank. In the mid-1990s, First Chicago made a change that upset many customers. What was this change?