Behavioral Economics Behavioral Finance and Behavioral Economics

Behavioral Economics • Behavioral Finance and Behavioral Economics both begin with ‘anomalies’ to what should be optimal Ø The anomalies suggest a broader definition of the goals of the parties or the constraints or costs facing them. Ø Why do we spend more for items bought on credit than when we pay cash? Example: Tonight, we’ll explore Seven Common Behavioral Traps that impact us and think of ways to avoid these traps. Ø And we will begin to explore psychological factors that affect how consumers perceive price. Ø Economics for Mangers 710 with Dick Marcus – April 21, 2005 1

Prevailing Economic Theory • Rational behavior Ø Ø Ø rational = systematically attempt to achieve a goal the goal may not be praiseworthy, but can still be rational irrational behavior cannot be explained by economists • Self-interested behavior Ø Ø decision based on the impact on the individual can also be concerned about others as it affects the self • Why do people tip? Ø Economics for Mangers 710 with Dick Marcus – April 21, 2005 Who is in the best position to assess the friendliness of the server? 2

Trap 1: Decision Paralysis • The phenomenon of decision paralysis causes loss of wealth over time ØWe see a deal at a price below a previous reference price, then we tend to buy it ØIf see a deal and yet another deal on a higher quality product, then we tend to delay the decision • The more choice, the harder the choice ØMarket experiments with products tend to confirm decision paralysis Economics for Mangers 710 with Dick Marcus – April 21, 2005 3

Bewildering Choice in Financial Products • 7, 000 stock and bond funds, and more every day • Yet, billions stashed in CDs & savings accounts • Once a decision is made, the tendency is not to change it • The success of 401(k) investing is that it tends to be a one time decision with automatic investing elements • The relative failure of Roth IRAs because they tend not to be automatic Economics for Mangers 710 with Dick Marcus – April 21, 2005 4

You may be prone to Decision Paralysis if… • You use Scarlet O’Hara’s approach to investing: “Fiddle-dee, after all tomorrow is another day. ” • You cannot make up your own mind, but rely always on the advice of a stranger. • You only select grocery items with signs saying they are on sale. Ø If you are subject to Decision Paralysis, what can you do about it? Economics for Mangers 710 with Dick Marcus – April 21, 2005 5

Trap 2: Mental Accounting • The Las Vegas honeymoon story Ø honeymooner takes $5 chip to roulette wheel Ø money won in gambling is separated from other monies Ø phrase: playing with house money Ø money isn’t fungible under mental accounting • Going to a movie with pre-paid tickets or $ Ø if lost the tickets or if lost equivalent cash? Economics for Mangers 710 with Dick Marcus – April 21, 2005 6

Motives for Mental Accounts • Self control Ø Ø Ø forced savings penalties for early withdrawal “Christmas club” savings plans • Budgeting & planning Ø Ø Ø gifts tax rebates as “found money viewed as non-essential • Different volatilies in sources or uses of funds Ø Ø Ø Economics for Mangers 710 with Dick Marcus – April 21, 2005 bonus regular salary tax rebate gift lottery nest egg for a house 7

Credit Cards and Mental Accounts • Cash in wallet -- visual evidence of financial loss in purchase • Checking balance -- running subtotal of financial loss in a purchase • Credit card purchase -- harder to remember earlier expenditures, belated accounting of actions Ø Auction bids for items is HIGHER if participants pay for them with credit cards than with cash Economics for Mangers 710 with Dick Marcus – April 21, 2005 UWM 8

• and mental accounts Retirement savings: invest too conservatively even with 30 years ‘til retirement • Tendency to sell winners and hold losers: though winners have tax injury and selling losers have a tax benefit • Tendency to hold onto home or assets in bequests: though best use may be to liquidate and reinvest Economics for Mangers 710 with Dick Marcus – April 21, 2005 9

You may be prone to excessive use of Mental Accounts if… • You know to the dime how much is in your 401 k plan, but have no idea what your credit card balance is. • You have continuing balances on credit cards, but also have money earning 1% in the bank. Ø How can awareness of your own use of mental accounts be accommodated? Ø Can you make a full balance sheet of your financial assets and liabilities? Economics for Mangers 710 with Dick Marcus – April 21, 2005 10

Trap 3: The Sunk Cost Problem • Once committed to a course of action, we feel cognitive dissonance not to continue • Form of ‘Loss Aversion’ when faced with an outcome that is seen as a loss. ØStory of the last game for Michael Jordan. You’ve paid $200 for ticket. At the last minute Michael is hurt and won’t play. Do you go? ØWhat if there’s a terrible snow storm? Economics for Mangers 710 with Dick Marcus – April 21, 2005 11

Problems with Sunk Costs • Half-built large government projects Øseen in Nuclear Plants • Example: A certain nameless professor has 2/3 rds of a medieval costume. Ø W he get the rest? • If stocks fall, we feel we can’t sell. This realizes the loss. • Therefore, we tend to invest in risk-free securities such as money market accounts. Economics for Mangers 710 with Dick Marcus – April 21, 2005 12

You may be prone to Sunk Cost Problems if… • You want to justify all past decisions as correct • You mention to colleagues the profits you made selling your stock market winners! ØWhat can you do to guard your heart against the Sunk Cost problem? Economics for Mangers 710 with Dick Marcus – April 21, 2005 13

Numbers, Percentages & Statistics Sadly, people make errors with numbers • Money Illusion Ø You get a 2% raise and you’re happy, even though the inflation rate is 3% Ø Prices fall 3% and sell your house for 1% less than paid for it. People view this as a loss. Ø Governments in part raise the supply of money to exploit this illusion of better times Economics for Mangers 710 with Dick Marcus – April 21, 2005 14

Salience of Event • Recall of examples or tragedies affect us • Fear of flying, though more die from autos • Fear of shark attack, though more die from dog bites • Fear of stock crash, though more are hurt by non-participation • INSURANCE Ø Ø Ø Insure against lost of left foot and right hand Insure against plane accident Odds are too low to make this reasonable • Larger deductibles are Economics for Mangers 710 with Dick Marcus – April 21, 2005 suggested Ø though I don’t seem to follow this advice 15

Trap 4: The Endowment Trap • If given an asset, people are reluctant to give it up. An “endowment effect. ” • Value what you have more than if you were to buy it Ø Give coffee mugs to participants offer to purchase it back for $6, but few take it Ø Give $6 to to each participant offer to sell mugs for $6, but few purchase UWM mug • Endowment effect leads to keeping proven losers too long Ø So also can switching investments too often can be injurious to wealth Economics for Mangers 710 with Dick Marcus – April 21, 2005 16

• When already invested in one choice and alternatives are presented, many STAY with whatever is the initial endowment ØNo service charges at banks with large minimum balance vs. paying a service charge. • People appear to keep large minimum balances, even though more costly than paying a service charge. • If you have a ticket to an event, its value is greater than if you were to bid for it Ø also an endowment effect • Stay with a mutual fund family, once inside that family Economics for Mangers 710 with Dick Marcus – April 21, 2005 17

You may be prone to Endowment Traps if… • You find it hard to sell any of your stocks or bonds. • You are loyal to your bank, telephone company, or consumer products, even when you think they do a lousy job. ØHow can you reduce your attachment to what you have over what you should have in your investment portfolio? Economics for Mangers 710 with Dick Marcus – April 21, 2005 18

Trap 5: The Anchoring Problem • Wording can alter one’s reference point ØExample: Insurance purchases Q: Is having the lowest cost insurance important to you? – Leads toward selecting term life insurance Q: Is having a built in return and value important to you? – cash Leads toward selecting whole life insurance • The first answer to questions can anchor future decisions Economics for Mangers 710 with Dick Marcus – April 21, 2005 19

Anchors and First Impressions • The first thing seen or heard can become a reference, an anchor • The order of information affects decisions Ø First impressions dominate (anchor) decisions in dating and in business investing • Financial choices can either be viewed as SELECTION of the best or REJECTION of the worst product Ø Emphasis on risk or emphasis on return shape thinking. Economics for Mangers 710 with Dick Marcus – April 21, 2005 20

Beware of Anchors • Price paid for house -- as anchor on selling it • The Power of Suggestion ØThe agent says life insurance is typically 6 times annual income ØThe salesman says that others paid $29. 95, but for you it is discounted to $19. 95 ØYou’re thinking of selling your house that you paid 80 G for in 1987 and note you are hoping to get 125 -G to the prospective RE broker, what do you think she’ll list it for? • Sticker Shock -- as anchor in car purchases Economics for Mangers 710 with Dick Marcus – April 21, 2005 21

You may be prone to Anchoring Problems if… • You find it hard to sell assets for less than what you paid for them. • You detest paying a real estate sales commission on the sale of your home. • You rely on the words of salesmen on the price of other products compared to their price. Ø What can you do to avoid being too influenced by anchoring effects? Economics for Mangers 710 with Dick Marcus – April 21, 2005 22

Trap 6: The Ego Trap • How do you pronounce the capitol of Michigan, Ø“DE-troit” or “de-TROIT”? Ø Would you bet $50? Ø Likely you are overconfident • The greater amount of financial DETROIT information given to a client, the more confident he/she becomes Economics for Mangers 710 with Dick Marcus – April 21, 2005 23

Overconfidence in Stocks & Life • Your stock portfolio earned 60% last year ØNow you want to double your investment since you’re sure to make a killing next year • Heads I win, tails it’s chance Ø success is my own doing, but not failures. • Ask subordinates, how long a task will take ØTend to underestimate the time involved • ROR on restaurants overall below T-bill rate ØEveryone thinks they know how to run it better • Evidence also from FSBO (Fizzbo Fallacy) Economics for Mangers 710 with Dick Marcus – April 21, 2005 24

Confirmation Bias • The tendency for new information to be rejected if it doesn’t fit preconceived view • Those who agree with either Geraldo or Rush watch or listen to them; and are confirmed in their opinions • Basis for brand loyalty, “owners groups”, insignia worn on clothes • Form of avoiding cognitive dissonance Economics for Mangers 710 with Dick Marcus – April 21, 2005 25

You may be prone to the Ego Trap if… • You think you can continually ‘beat the market’ • You know you did well in the past, so you’re sure to do well now • You know that your successes were due to your good decisions ØHow do you guard against overconfidence in our decisions? Economics for Mangers 710 with Dick Marcus – April 21, 2005 26

Trap 7: Irrational Exuberance • Peer pressure, group psychology, and fads all speak of actions that copy others. • Tulipmania in seventeenth century Holland. • Speculative bubbles as self-fulfilling prophesies • Stock markets and Greenspan’s and Shiller’s Irrational Exuberance • Incorrect rumors can add ‘noise’ to prices of securities Economics for Mangers 710 with Dick Marcus – April 21, 2005 27

Example: Mutual Fund Returns • The average stock mutual fund earned 12. 3% • But the average investor earned only 6. 3% • Both true -- so how can we explain this? • Buy and hold vs. switching for optimal asset allocation • Beware of fads in investing Economics for Mangers 710 with Dick Marcus – April 21, 2005 28

You may be prone to the problem of Irrational Exuberance if… • You are prone to do whatever the other guys are doing (herd effects) • You stopped buying stocks now, because the stock prices declined • You make decisions based on what your friends say Ø How do you guard against being subject to the mentality? herding Bah! Economics for Mangers 710 with Dick Marcus – April 21, 2005 29

Perception of Price Differences ü ü People have limited time and interest in studying competing offers. People use methods to reduce the effort to make decisions even if the decision may be sup-optimal. An example is the prevalence of odd price endings to reduce theft at cash registers. We use any of the following second-best methods to make decisions: 1. Stereotypical Reasoning- all branded products are better than generic ones 2. Elimination by Aspects - product choice that cuts off at pre-assigned thresholds 1. 2. Find the BEST microwave oven at American TV & Appliance Pick those less than $500, with at least 750 Watts, etc. 3. Bounded Rationality - Herbert Simon, Nobel laureate. Economics for Mangers 710 with Dick Marcus – April 21, 2005 30

Perception of Percentage Differences • People appear to use percentages rather than absolute cost differences • EXAMPLE: $1, 000 -> $600 vs. $20, 000 -> $19, 600 • Both have $400 savings through a particular action, but which one is viewed as “more important” to undertake? • Weber-Fechner Law: evaluation relative to a base price. • The first offer involves is a 40% savings, whereas the second offers provides only a 2% savings. Economics for Mangers 710 with Dick Marcus – April 21, 2005 31

Implications for Weber-Fechner Law • Changing the price 4% each year for 5 years viewed differently than a one time 20%+ jump in prices. • 2 brokerage houses, one raised fees gradually & 1 held prices constant, but eventually raised them a lot. • School districts and municipalities know this! • Example: Discount gas stations vs. branded ones grant a 2 cent advantage. A: $1. 80 vs. $1. 82 or B: $2. 35 vs. $2. 37 « Weber-Fechner would predict that discount stations would be more successful under A than B. « It is often found however that under B, people act more price conscience, the reverse of Weber. Fechner. Economics for Mangers 710 with Dick Marcus – April 21, 2005 32

Issues in Reference Prices • Marketers realize that the ‘value’ of an offer depends on the items or information the consumer uses to compare. The benchmark. • Mutual fund managers want the benchmark to be passbook savings rates, but rules require them to use appropriate index benchmarks. • We’ll look at Reference Prices based on: 1. Current Prices 2. Past or Recalled Prices 3. Purchase Context Economics for Mangers 710 with Dick Marcus – April 21, 2005 33

Current Price References • Product line pricing » “Well, a Chevy is cheaper then an Olds” » Expansion in the price-quality dimension can make mid-priced products more attractive, sometimes at the expense of competitors. Panasonic I & II vs. Emerson microwave example: • 57% picked the low-priced Emerson vs. Panasonic, but when the bigger Panasonic II appeared, the number dropped to 27% • We read left to right: first seen price is reference point • Focal Point Pricing -- prices with odd endings ØWas $7. 00, now $6. 89, There’s $2. 29, ours $1. 97 Economics for Mangers 710 with Dick Marcus – April 21, 2005 34

• Explanations of Focal Points: 1. Memory and analysis is not free L R 2. Used as a tool of collusion. 3. We process limited information to reduce our cost of decision -making. First number plays biggest role. “How much was the mouthwash? ” “Oh, 2 something, I guess. ” • Experiments » List in ascending order of price and descending order of price. Order effects matter on subject’s reference prices. (Asked to pick one, the Descending Order list lead to higher priced products selected. ) • Catalogues list prices in generally descending order » I view this as Left to Right, as most read page 1 first. Economics for Mangers 710 with Dick Marcus – April 21, 2005 35

Past Prices and Context adjust the Reference Price • Problem with LOW INTRODUCTORY PRICE Ø Leads to a low reference point Ø Prefer use of COUPONS or give away to avoid this problem • Experiment on Sales with and without promotional price cutting on a new toothpaste ó Weekly sales with no price change • the control group ó Weekly sales with low initial price • the experimental group 860 ---> 1, 050 1, 280 ---> 1, 010 • Purchase context: if you purchase a beer at a downtown hotel, a baseball game, or on the beach, the context suggests what you are willing to pay. Economics for Mangers 710 with Dick Marcus – April 21, 2005 36