Behavioural Economics and Finance

Jindal School of Banking and Finance

Aug-Nov, 2023

Lecture 8: Choice
Amlan Das Gupta
Consider:

Imagine that you have been sued for libel and your accuser is demanding 50 lakhs
as compensation. You have a good lawyer, but she has informed you that chances
of success are slim. The day before the verdict your lawyer informs you that the
chances of getting a favourable verdict and not having to pay anything is about
5%. However, there is an offer from the opposition. They will withdraw the case
if you pay them 45 lakhs.

Will you take the offer?

Background: Decision Theory

 The basic building block of economics is the model of how people

choose.
 We know that if people are logically consistent then you can find a
utility function to represent their preferences.

 If you replace the choices by lotteries then we shift to expected

utility.
 Lottery 1: (A, B, 0.5) Lottery 2: (C,D, 0.3)
Bernoulli
 Initially people thought that lotteries should be evaluated by their
expected values.

 Also

 St. Petersburg Paradox: Suppose you are offered to buy into a game
which keeps paying you Rs. 2 as long as a fair coin keeps turning up
heads. How much would you pay?
Value of a lottery (2, 4, 0.5) in expected value.
Value of a lottery that (2, 4, 0.5) in expected utility.
Bernoulli’s innovation

 This idea led to the concepts of risk aversion and risk premium in
economics and finance.

 However there is a problem..

 Consider two people one person has just received a pay cut and the
other one a raise. However both have the same income now. Do they
have the same utility?
Consider Anthony and Betty:

• Anthony’s current wealth is 1 million.

• Betty’s current wealth is 4 million.

They are both offered a choice between a gamble and a sure thing.

• The gamble: equal chances to end up owning 1 million or 5 million

OR
• The sure thing: own 3 million for sure
Reference Point

 Clearly, utility needs to be measured with respect to a reference point.

 The utility of a thousand rupees will not be the same for a person who is
currently at wealth of 1000 and someone else who is currently a billionaire.
Prospect Theory
Loss aversion

 Problem 1: Which do you choose? Get $900 for sure OR 90% chance to
get $1,000
 Problem 2: Which do you choose? Lose $900 for sure OR 90% chance to
lose $1,000

 Attitude to risk reverses if you are dealing with losses

Consider
 Problem 3: In addition to whatever you own, you have been given $1,000.
You are now asked to choose one of these options:
 50% chance to win $1,000 OR get $500 for sure

 Problem 4: In addition to whatever you own, you have been given $2,000.
You are now asked to choose one of these options:
 50% chance to lose $1,000 OR lose $500 for sure
Principles of choice:
 Evaluation is relative to a neutral reference point, which is sometimes
referred to as an “adaptation level.” perhaps the outcome to which you feel
entitled, for example, the raise or bonus that your colleagues receive.
Outcomes that are better than the reference points are gains. Below the
reference point they are losses.
 A principle of diminishing sensitivity applies to both sensory dimensions
and the evaluation of changes of wealth.
 The third principle is loss aversion. When directly compared or
weighted against each other, losses loom larger than gains.
Loss aversion ratio
 Consider the question: What is the smallest gain for which you would
tolerate a 1000 rupee loss with equal probability.

 The ratio between loss and gain is your loss aversion ratio.

 On an average people have this ratio as high as 1.5-2.5.

The Endowment Effect
Indifference curve analysis
Points A(15,84) and E (20,50) are
indifferent.
 Consider two exactly same people on point E and A.

 Do you think they would interchange positions gladly?

Endowment Effect:

 Conventional economic logic would suggest that for any

object selling price and buying price should be the same.

 Consider: You have one ticket to go for a concert that cost

you 2000
 How much will you be willing to pay for the next one?
 If you can’t find the next one how much will you consider
selling it for?
Points to note

 First, tastes are not fixed; they vary with the reference
point.
 Second, the disadvantages of a change loom larger than
its advantages, inducing a bias that favours the status
quo.
 This is a consequence of loss aversion.
Smith’s recreation of an economy
 Individuals would make successive public offers to buy or sell a token, and
others would respond publicly to the offer.

 When trading ends, the tokens are in the hands of those who can get the
most money for them from the experimenter.

 Price and quantity exchanged is exactly what economic theory predicts.

Variation

 Instead of tokens use coffee mugs which could be taken home.

 Buyers could use their own money to buy them from sellers.
 Choosers could either get a mug or the money equivalent of it.

 Sellers $7.12
 Choosers $3.12
 Buyers $2.87
The effect is not universal

 Consider someone comes to exchange 2000 rupee note for four 500s.

 Consider any commercial transaction.

 Only works where agents value the object for use and not as store of
value.
Traders
 Experienced traders do not seem to be affected by the endowment
effect.

 Thinking like econs. Using opportunity cost will get you out of the
endowment effect.

 Think about the poor: will they experience this.

Fourfold Pattern
Expected values of gambles are misleading.

In the four examples below, your chances of receiving $1 million improve

by 5%. Is the news equally good in each case?
 From 0 to 5%
 From 5% to 10%
 From 60% to 65%
 From 95% to 100%
Possibility effect

 Occurs when probability changes from 0 to a small

amount.

 People were surprised how we were paranoid in the initial

stages of the pandemic.

 But later we didn’t care as much.

Certainty effect
 A very likely event contrasted with a certain event.

 In most cases the likely event is not given due weight.

 Recall Yudhishthir playing with Shakuni in Mahabharat.

Decision weights
People are willing to pay three times more to
completely eliminate risk than to reduce the risk

Suppose that you currently use an insect spray that costs you $10 per
bottle and it results in 15 inhalation poisonings and 15 child poisonings for
every 10,000 bottles of insect spray that are used.

You learn of a more expensive insecticide that reduces each of the risks
to 5 for every 10,000 bottles. How much would you be wiIling to pay for
it?
Fourfold Pattern
Analyse law suits in this context

 In case of a strong case the plaintiff settles for less than the
statistically expected outcome of the trial.

 Plaintiffs with frivolous claims are likely to obtain a more generous

settlement than the statistics of the situation justify.
Risk Policies
Consider this choice.
Decision (i):
Choose between
 A. sure gain of $240
 B. 25% chance to gain $1,000 and 75% chance to gain nothing

Decision (ii): Choose between

 C. sure loss of $750
 D. 75% chance to lose $1,000 and 25% chance to lose nothing
Four combinations of choices (A and C, A and D, B and C, B and
D)

Now consider the following choice problem:

 AD. 25% chance to win $240 and 75% chance to lose $760
 BC. 25% chance to win $250 and 75% chance to lose $750
Lessons from the previous example:

 Any choice under uncertainty problem can be broken up to generate

inconsistent responses.

 Being risk averse for gains and risk loving for losses is costly.
Broad or Narrow?

 Narrow framing: a sequence of two simple decisions, considered

separately
 Broad framing: a single comprehensive decision, with four options

Broad framing weakly dominates narrow framing.

Samuelson’s Problem

Will you accept a gamble on the toss of a coin in which you could lose
$100 or win $200.

What about 100 such gambles?

Fourfold Pattern
Qualifiers when considering gamble with positive expected value:

 It works when the gambles are genuinely independent of

each other; it does not apply to multiple investments in
the same industry, which would all go bad together.
 It works only when the possible loss does not cause you to
worry about your total wealth. If you would take the loss
as significant bad news about your economic future,
watch it!
 It should not be applied to long shots, where the
probability of winning is very small for each bet.
Risk Policy
 A combination of narrow framing and loss aversion are costly.

 Risk averse individuals would do well to devise risk policies.

 Example: To never buy extended warranty, or to choose the highest

deductible in an insurance policy.
Mental Accounts
Mental Accounts at work

 Our mind works by opening a loss/gain account for each task we do.

 Consider 2 people who need to travel a long way to watch an IPL match.

 Who is most likely to travel, one who has bought the ticket or the one who
has a free pass?
Mental Accounts at work

You need money to cover the costs of your daughter’s wedding

and will have to sell some stock. You remember the price at
which you bought each stock and can identify it as a “winner,”
currently worth more than you paid for it, or as a loser. Among the
stocks you own, Blueberry Tiles is a winner; if you sell it today you
will have achieved a gain of $5,000. You hold an equal
investment in Tiffany Motors, which is currently worth $5,000 less
than you paid for it. The value of both stocks has been stable in
recent weeks. Which are you more likely to sell?
Disposition Effect
 Suppose your investment portfolio has two stocks A and B, each with 1000 units.

 Original price of both stocks was 50, a year back.

 Currently, A is priced at 31 and B at 69.

 You need to raise 30000 at once by selling your stock holdings.

 Which stock will you sell?

Disposition Effect
 In most cases people end up selling stock B.

 In stock B account this registers as a win.

 If stock A is sold it will register as a loss on that account.

 The narrow frame ignores the future relative loss/gain from the two stocks.
Sunk Cost Fallacy
 Refers to the inability of humans to consider opportunity cost.

 Example: A project has gone on for some time with a substantial outlay. It
has very dim prospects. Do you pull out or do you refinance.

 The account for this project in your mind will register a heavy loss.

 Also, a part of the fourfold pattern.

Regret
 Imagine a physician with a gravely ill patient.
 One treatment fits the normal standard of care; another is unusual.
 The physician has some reason to believe that the unconventional treatment
improves the patient’s chances, but the evidence is inconclusive.

 What would you choose?

Regret
 The physician can stay safe by choosing option 1.

 Option 2 exposes him to risks of failure, litigation and regret.

 Fear of regret will often dictate safer choice even if the expected gains are positive
for the risky choice.
Responsibility
 The effect of loss aversion, endowment effect etc. are heightened if
you face a choice for which you have to take responsibility.

 Consider: You have been exposed to a disease which if contracted leads

to a quick and painless death within a week. The probability that you
have the disease is 1/1,000. There is a vaccine that is effective only
before any symptoms appear. What is the maximum you would be
willing to pay for the vaccine.
Responsibility
 Now consider an alternative:

 Volunteers are needed for research on the above disease. All that is
required is that you expose yourself to a 1/1,000 chance of contracting
the disease. What is the minimum you would ask to be paid in order to
volunteer for this program? (You would not be allowed to purchase the
vaccine.)
Responsibility
 The difference in willingness to pay and willingness to accept comes from
an idea of responsibility.

 Health is not something that we are supposed to sell.

 If we suffer the negative outcome we might suffer more due to a feeling

of responsibility shrugged.
Reversals
Consider:
A person’s house has burned down because of an accident in the kitchen.

Scenario 1: There was a fire from the gas cylinder he usually uses.
Scenario 2: The fire was caused by a short-circuit caused by the electric heater he
was using because he could not use LPG as the cylinder had just run out.

Would you award the same compensation in either case?

Poignancy:
 When asked in isolation people usually award higher compensation in the
second case.

 This is due to poignancy or the counterfactual emotion.

 “If only the cylinder had not run out”

 System 1 mechanisms of substitution and intensity matching translate the

strength of the emotional reaction to the story onto a monetary scale
You are offered a choice between two bets, which are to be played on a roulette wheel with 36 sectors.

Bet A: 11/36 to win $160, 25/36 to lose $15

Bet B: 35/36 to win $40, 1/36 to lose $10
• First decide which you want to choose.
• Next imagine owning one of the lotteries and decide on
a price at which you would be willing to let it go.

• In most cases you have preference reversal due to

anchoring on the highest prize.
Consider the question:

Dolphins in many breeding locations are threatened by pollution,

which is expected to result in a decline of the dolphin population.
A special fund supported by private contributions has been set up
to provide pollution-free breeding locations for dolphins.

How much will you contribute?

Next Consider:

Farmworkers, who are exposed to the sun for many hours, have a
higher rate of skin cancer than the general population. Frequent
medical check-ups can reduce the risk. A fund will be set up to
support medical check-ups for threatened groups.
How much will you contribute?
Next consider the two appeals together and say
which one you will contribute more towards..
Reversals in Judgements in Law

 Judges are apparently asked not to look at compensations in other contexts

while deciding on a particular case.
 As a result in the US, within category compensations make sense but not
when compared across categories.
Framing
Emotional frames matter

 Would you accept a gamble that offers a 10% chance to win $95 and a 90%
chance to lose $5?
 Would you pay $5 to participate in a lottery that offers a 10% chance to win
$100 and a 90% chance to win nothing?
Medical practitioners were asked

Physician participants were given statistics about the outcomes of two

treatments for lung cancer: surgery and radiation. The five-year survival rates
clearly favor surgery, but in the short term surgery is riskier than radiation.
 The one-month survival rate is 90%.
 There is 10% mortality in the first month.

surgery was much more popular in the former frame (84% of physicians chose it)
than in the latter (where 50% favoured radiation).
Consider the following pair of problems:

A woman has bought two $80 tickets to the theatre. When she
arrives at the theatre, she opens her wallet and discovers that the
tickets are missing. Will she buy two more tickets to see the
play?

A woman goes to the theatre, intending to buy two tickets that

cost $80 each. She arrives at the theatre, opens her wallet, and
discovers to her dismay that the $160 with which she was going
to make the purchase is missing. She could use her credit card.
Will she buy the tickets?
Consider two car owners who seek to reduce their
costs:

Adam switches from a gas-guzzler of 12 mpg to a slightly less voracious guzzler

that runs at 14 mpg.

The environmentally virtuous Beth switches from a 30 mpg car to one that runs
at 40 mpg.
Power of framing

An article published in 2003 noted that the rate of organ donation was close to
100% in Austria but only 12% in Germany, 86% in Sweden but only 4% in Denmark.

The best single predictor of whether or not people will donate their organs is the
designation of the default option that will be adopted without having to check a
box.