It’s a long weekend so, though we’re barred from enjoying it in the usual way, let’s at least forget the V-word. How about a quiz?
Let’s say the government is preparing for the outbreak of an unusual disease (no, not that kind of disease) that, should we take no action, is expected to kill 600 people. The government could act to combat the disease in either of two ways.
If program A is adopted, 200 people will be saved. If program B is adopted, there’s a one-third chance that 600 people will be saved, and a two-thirds chance that no one will be saved. Which one would you choose?
If you chose A, congradulations. You’re in good company. When this psychology experiment is run, about 72 per cent of subjects favour A and only 28 per cent favour B.
But then the government consults the epidemiologists. Their advice is: forget A and B, and consider program C or program D. If C is adopted, 400 people will die. If program D is adopted, there’s a one-third chance no one will die and a two-thirds chance that 600 will die. Which one would you choose?
If you chose D, more applause. In laboratory experiments, that’s what 78 per cent of subjects choose, leaving only 22 per cent choosing C.
But if you look at the four options again you find that program A and program C are the same. Under A, 200 out of 600 are saved; under C, 400 out of 600 die. It’s just that A highlights the positive, whereas C highlights the negative.
That 72 per cent of subjects favoured A, but only 22 per cent favoured C tells that most of us instinctively favour the safer, more certain outcome. Program B, remember, contained a two-thirds chance that no one would be saved. This instinctive preference confirms economists’ conventional assumption that most people are “risk-averse”.
But a closer look also reveals that program B and program D are the same. Program B offers a one-third chance that 600 people will be saved and a two-thirds chance that no one will be saved, whereas program D offers a one-third chance no one will die and a two-thirds chance that 600 will die.
(If you can’t see that, remember that, in probability theory, the expected outcome is the possible outcome multiplied by the probability of it happening. So B is ⅓(600) + ⅔(0) = 200. And D is ⅓(600) + ⅔(0) = 200.)
But if options B and D are the same thing expressed in different ways, how come the experiments show only 28 per cent of subjects choosing B, but 78 per cent choosing D? It’s because, relative to option C, which offered only the certainty that 400 people would die, option D offered a one-third chance that no one would die, and most subjects thought that was a risk worth taking.
This shows that, while it’s generally true that most people are risk-averse, as conventional economics assumes, a more powerful human characteristic – which conventional economics ignores – is that most of us are “loss-averse”.
A key insight of behavioural economics is that we hate losing something much more than we love gaining something of the same value. So much so that, surprisingly, we’re willing to run risks to avoid any loss.
If you hadn’t noticed, when you look closely you see that all four options offered the same “expected value”: 200 people saved, 400 lost. If everyone had realised this at the time, they should have been equally divided between the options.
Why were we so sure that A and C were much more attractive that B and D? Well, one possibility is that most of us aren’t much good at maths. But the more important explanation is that we are heavily influenced by the way a proposition is presented to us – by the way it’s “framed”, as psychologists say. The same proposition can be packaged in a way we find attractive or repellent.
This, too, is a truth that conventional economics knows nothing of, but behavioural economics – the school of economic thought that uses psychology to throw light on economic issues – has brought to economists’ attention.
Putting it differently, the choices we make are heavily influenced by the context in which we make them. This is one of the key arguments advanced by Robert Frank, an economics professor at Cornell University, is his new book, Under the Influence.
Frank notes that standard economic theory says the spending decisions we make depend only on our incomes and relative prices. People’s assessments of their needs and wants are assumed to be completely independent of the spending decisions of others around them.
But this too is where the assumptions of standard theory are unrealistic. In real life, the things we buy and do are often heavily influenced by the “context” of what our friends are buying and doing.
We wear the clothes we think are fashionable, and we judge what’s fashionable by what our friends are wearing. The best way to predict whether a young person will take up smoking is whether their friends smoke.
We have an impulse to conform – which is stronger than we often realise. That’s why we can’t resist buying toilet paper when others are grabbing it, or selling our shares when others are quitting the market.
Psychologists call this phenomenon “behavioural contagion” – our tendency to mimic the behaviour of others. When some things start to become popular, they often become very popular. Same if they start becoming unpopular.
Frank notes that our tendency to copy what others are doing can have positive consequences (as when people exercise more because their friends are doing it) or negative consequences (as when we drink heavily because the people we live with are).
He argues that economists ought to be more conscious of behavioural contagion because of the opportunities they present for governments to use taxation to encourage us to make better choices.
