Markets and Fairness

Markets and Fairness

Research from Daniel Kahneman’s book Thinking Fast and Slow may help explain some of the anger and anti-capitalism sentiment that has cropped up in the United States in the last several years. Senator Bernie Sanders is incredibly popular among a segment of the population and he is not afraid to categorize himself as anti-capitalist and as a socialist to a degree that would have been unthinkable just a decade ago. From my perspective, many people feel that they have been treated unfairly by markets, and this lack of fairness contributes to the Sanders support, especially among young people.

 

Kahneman’s writes, “a basic rule of fairness, we found, is that the exploitation of market power to impose losses on others in unacceptable.”

 

My experience is that people are feeling the forces of market power in many different areas, and becoming discontent with their own economic standing and with feeling as though they are being treated unfairly by large market players. It may be that most people can still afford to buy more than what they need and to live comfortably, but on a daily basis they are faced with a barrage of unfair market practices. There may not be anything legally wrong with a market practice, and the market practice may be adjusting for real value rather than just collecting rents, but nevertheless, the exploitation of market power still feels unfair.

 

I spend a lot of time thinking about healthcare in the United States, and for many years the costs of healthcare and health insurance has risen much quicker than employee wages. With employees feeling their wages stagnate, unfair exploitation of market power can become a major outrage. This has been seen with drug prices as some individuals and companies have specifically targeted pharmaceutical mergers and acquisitions with the intention of increasing drug prices. Some medications have risen dramatically in price at the same time that many deductibles for health plans have shot up beyond the savings levels of most Americans. Even though a drug may provide an incredible value like saving a life or dramatically improving the quality of a life, an increase in price while wages stagnate feels deeply unfair to people. This could be a basis for our discontent with markets and capitalism (at least on the healthcare front), and a source of support for Bernie Sanders and his socialism lean.

 

When I think about it, I see this type of market exploitation beyond the world of healthcare. Ice cream cartons continually get smaller, the fun-sized candy is a depressingly small size now, good quality razors seem to be unreasonably costly with the cheap alternatives being effectively useless. Outside of smartphones, most markets seem to be providing less value for higher costs, and it is not hard to understand the frustrations that so many people may feel with markets and market solutions, even if they can still afford to live a comfortable lifestyle. For any given firm, exploiting market power is a rational and reasonable thing to do, but for customers, this adds up to an untenable sensation of loss, and a deep feeling that markets are unfair and should not be trusted. In a global market sense, it is as if we face a universal tragedy of the commons problem, but instead of a habitable grazeland being decimated, it is our economic wellbeing that is destabilized as each player in the market flexes more market power to impose marginal losses on each consumer.
The Dominance of Loss Aversion - Joe Abittan

The Dominance of Loss Aversion

Loss aversion is a dominant force in many of our individual lives and in many of our societies. At this moment, I think it is one of the greatest barriers to change and growth that our entire world needs to overcome in order to move forward to address climate change, to create more equitable and cohesive societies, and to drive new innovations. Loss aversion has made us complacent, and we are feeling the cost of stagnation in our politics and in our general discontent, but at the same time we are paralyzed and unable to do anything about it. As Tyler Cowen wrote in The Complacent Class, “Americans are in fact working much harder than before to postpone change, or to avoid it altogether, and that is true whether we’re talking about corporate competition, changing residences or jobs, or building things. In an age when it is easier than ever before to dig in, the psychological resistance to change has become progressively stronger.”

 

My argument in this post is that much of the complacency and stagnation that Cowen has written about stems from loss aversion. In Thinking Fast and Slow, Daniel Kahneman writes, “Loss aversion is a powerful conservative force that favors minimal changes from the status quo in the lives of both institutions and individuals.” Additional research in the book shows that the pain and fear of loss is generally at least two times greater for most people than the pleasure and excitement of gain. Before we make a bet, the payoff has to be at least twice what we could stand to lose. If we are offered $10 or a gamble for more money, we prefer the sure $10 over the gamble, until the payoff of the gamble far outweighs the possible loss of the guaranteed $10.

 

I believe this is at the heart of the trite saying that people become more “conservative” as they get older. The reality is that as people get older they acquire more wealth, are more likely to own a home, and secure their social standing. People are not “conservative” in some high-minded ideological sense of “conservativism,” they are self-interested and risk averse. They don’t want to risk losing their wealth, losing value on their home, or losing social status. To me, this more plausibly explains conservatism and complacency than do political ideology explanations or cultural decadence.

 

To me, Kahneman’s quote is supported by Cowen’s thoughts. Institutions are built and run by people. People within institutions, especially as the institutions have become well established, become risk averse. They don’t want to lose their job, their position as the office veteran who knows how to do everything, and their knowledge and authority in their field. As the potential for loss increases, people become increasingly likely to push back against change and risk, ensuring that we cannot lose what we have, but also forgoing changes that could greatly benefit all of us in the long run. Loss Aversion has come to dominate how we organize our societies, and how we relate to one another, at individual, social, and political levels in the United States.
Loss Aversion & Golf

Loss Aversion & Golf

Daniel Kahneman presents research from University of Pennsylvania economists Devin Pope and Maurice Schweitzer to demonstrate the power of loss aversion in his book Thinking Fast and Slow. Pope and Schweitzer specifically look at golf, and how professional golfers perform when putting to demonstrate that loss aversion factors into the golfers’ performance, a conclusion that to me feels both obvious and surprising at the same time.

 

Professional golfers don’t seem like the kind of people who should  be subject to loss aversion on the course. Their performance doesn’t seem like it should be subject to the knowledge that a putt will earn them a birdie, or prevent them from scoring a bogie. However, Pope and Schweitzer challenge this thinking. Kahneman writes:

 

“Pope and Schweitzer reasoned from loss aversion that players would try a little harder when putting for par (to avoid a bogey) than when putting for a birdie. They analyzed more than 2.5 million putts in exquisite detail to tests that prediction.
They were right. Whether the putt was easy or hard, at every distance from the hole, players were more successful when putting for par than for birdie.”

 

Golfers don’t want to shoot over par. They perform better when they face the possibility of being over par rather than when they have a chance to be under par. Exceeding par is viewed as a loss which the golfers want to avoid while putting for birdie is an achievement to gain. Somewhere along the lines, golfers understand this and their physical performance is altered, decreasing the likelihood of a successful birdie putt, but increasing the likelihood of a successful par putt. Loss aversion is a powerful force, even in places we would not expect, like professional golf putting performance. If even professional golfers, who practice continually and are paid for their performance on the course are not able to avoid loss aversion, then we should recognize that it can play a huge role in our own lives, and we should invest in systems and structures to help us avoid making costly mistakes in our own lives from biases related to loss aversion.
Stable Relationships

Stable Relationships

“We all know that a friendship that may take years to develop can be ruined by a single action,” writes Daniel Kahneman in Thinking Fast and Slow. I quit Facebook for 2020 to get away from political ads and posts, but I imagine that this year many friendships and relationships have been ended with just a single post advocating for or against a candidate. People who have known each other for a long time have probably been surprised to see political posts from friends that don’t match what they had expected, creating friction within friendships.

 

At a high minded level, we don’t generally think that friendships should be influenced by something as small as a political post. True friendships, our stories and Disney movies tell us, are built on more than just liking the same sports team, belonging to the same political party, or lending something to our neighbors every now and then. Real life, however, seems to suggest that those things are exactly what friendship is about. We are constantly doing a mental calculation, keeping score of favors and interactions, and cutting out friends who don’t measure up and don’t bring us happiness or don’t appear to be useful allies.

 

Describing research from John Gottman, Kahneman writes, “Gottman estimated that a stable relationship requires that good interactions outnumber bad interactions by at least 5 to 1.” If we think about our relationships with others from a Disney movie standpoint, this sounds a little bleak. It sounds like all of our relationships are transactional, as though we are willing to ditch a spouse, an ally, or a close friend as soon as things start to turn a little negative and as soon as we get the sense that we are doing more for the friendship than the other person.

 

I don’t think Gottman’s findings are as negative as they might first appear based on the stories we create about true friendship. I think his research presents some hope. His findings show us that we can maintain friendships and good marriages when we find ways to structure more positive than negative interactions with others. To do this, we can think about others rather than about our selves, and we can do things to help create more positive experiences for the other person. This will get us thinking beyond ourselves and about the people we want to be close to and want to connect with. If we can create many positive interactions and limit the negative interactions then we will maintain strong relationships with others (even if an occasional social media post turns other people off). We will develop the strong friendship and trust that we believe relationships are all about. Having a mental accounting system of good and bad interactions doesn’t have to diminish the quality of the relationships we have, at least not if we find ways to create more positive interactions with others and use it in genuine and non-manipulative ways.
Prioritizing Bad News

Prioritizing Bad News

I hear a lot of criticism of news and the tendency of news organizations to operate under a model of “if it bleeds, it leads.” The idea is that news is too negative, that it focuses too much on violent crime, corruption, and scandal rather than important but often somewhat boring news and developments. The negativity bias within the news is cited for our misunderstandings of violent crime, for tainting our views of politics, and for making us more cynical. But research that Daniel Kahneman presents in his book Thinking Fast and Slow suggests that maybe we shouldn’t blame news organizations for prioritizing bad news.

 

Kahneman writes, “the brains of humans and other animals contain a mechanism that is designed to give priority to bad news.” There appears to be physiological structures in the brain that allow our brains to react at super speeds to threats and injuries. If you hear a lion roar, your body is going to react to the threat immediately, before you consciously recognize exactly what you just heard. Similarly, if you touch a hot stove your body is going to react by jerking your hand back before you even feel the pain from the burn.

 

There is an evolutionary psychology explanation to the immediate reaction of our brain to threats and injuries. If you are deep at work and concentrating intensely on something, you don’t want your brain to be slow to shift gears and respond to the sound of an approaching predator. You want your brain and body to begin reacting to a dangerous sound immediately, to help you survive a potentially fatal attack. Animals, and early human ancestors, that could respond at a subconscious level to threats and injuries were more likely to survive and and reproduce, passing their super quick response system to the next generation.

 

Today we don’t have to run from lions as often as our ancestors, and despite what we might sense from action movies and the news, violent crime is actually rather low compared to historic levels. Our super quick threat detection system is still with us, but many of the evolutionary pressures that built it have been left in the past. Our threat and injury detectors are still operating, and Kahneman’s quote suggests that we see their influence in our lives reflected in the news we prioritize. Bad news may activate the same threat responses in our brain, and we may have an instinctual drive to know about understand threats and dangers. “If it bleeds, it leads” is not a grim decision made by news executives, it is a driving force of our evolutionary past, a part of our brain which once served us well, but now prioritizes bad news and biases our media.
Endowment Effects Joe Abittan

Endowment Effects

In his book Thinking Fast and Slow, Daniel Kahneman discusses an experiment he helped run to explore the endowment effect. The endowment effect is a cognitive fallacy that helps explain our attachment to things and our unwillingness to part with objects, even when we are offered something greater than the objective value of the the object itself. We endow the object with greater significance than is really warranted, and in his book, Kahneman shows that this has been studied with Super Bowl tickets, wine, and coffee mugs.

 

Kahneman helped run experiments at a few different universities where college students were randomly given coffee mugs with the university logo. The mugs were worth about $6 each, and were randomly distributed to about half of a classroom. Students were allowed to buy or sell the mugs, and the researchers saw a divergence in the value assigned to the mugs by the students who randomly obtained a mug and those who didn’t. Potential sellers were willing to part with the mug for about $7 dollars, a price above the actual value of the mug. Buyers, however, were generally only willing to purchase a mug for about $3, or half the value of the mug.

 

Kahneman suggests that the endowment effect has something to do with the unequal values assigned to the mug by those who received a mug and those who didn’t. He suggests that it is unlikely that those who received the mugs really wanted a university mug and particularly valued a mug relative to those who didn’t receive a mug. Those students should have been willing to trade the mug for $3 dollars which could be used to purchase something that they may have actually wanted, rather than a random mug. To explain why they didn’t sell their mugs, Kahneman suggests that the mugs became endowed with additional value by those who received them.

 

A further study showed similar effects. When all students in the class randomly received either a chocolate bar or a mug, researchers found that fewer students were willing to make a trade than the researchers predicted. Again, it is unlikely that a random distribution of mugs and candy perfectly matched the mug versus candy preferences of the students. There should have been plenty of students who could have used a sugar boost more than an extra mug (and vice versa), but little trading actually took place. It appears that once someone randomly receives a gift, even if the value of the gift was very small, they are not likely to give it up. The gift becomes endowed with some meaning beyond its pure utility and value.

 

Kahneman describes part of what takes place in our minds when the endowment effect is at work, “the shoes the merchant sells you and the money you spend from your budget for shoes are held for exchange. They are intended to be traded for other goods. Other goods, such as wine and Super Bowl tickets, are held for use to be consumed or otherwise enjoyed. Your leisure time and the standard of living that your income supports are also not intended for sale or exchange.”

 

The random mug or candy bar were not seen as objective items intended to be traded or bartered in exchange for something that we actually want. They were viewed as a windfall over the status quo, and thus their inherent value to the individual was greater than the actual value of the object. Kahneman suggests that this is why so few students traded candy for mugs, and why mug sellers asked far more than what mug buyers wanted to pay in his experiments. The endowment effect is another example of how our emotional valence and narrative surrounding an otherwise objectively unimportant object can shape our behaviors in ways that can seem irrational. Next spring when you are trying to de-clutter your house, remember this post and the endowment effect. Remember that you are imbuing objects with value simply because you happen to own it, and remember that you would only pay half price for it if it was actually offered to you for purchase now. Hopefully that helps you minimalize the number of mugs you own and declutter some of your cabinets.
Subjective Gains and Losses

Subjective Gains and Losses

“Outcomes that are better than the reference points are gains. Below the reference point they are losses.”

 

Daniel Kahneman writes extensively about our subjective experiences of the world in his book Thinking Fast and Slow and about how those subjective experiences can have very serious consequences in our decisions, political stances, and beliefs about the world. One area he focuses on are reference points, our baseline beliefs and expectations about the world. As it turns out, our expectations can influence whether we think things are going well or going poorly, regardless of what the actual outcomes are. On top of that, we will make adjustments to our behavior based on what we expect in regard to those outcomes.

 

Kahneman continues, “When directly compared or weighted against each other, losses loom larger than gains. This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.”

 

Without diving into the evolutionary psychology component of Kahneman’s quote (something that I normally would love to do) I want to focus on how complex our reality and decision making becomes when we predict outcomes, shape our behavior in response to those predictions, and bias those predictions based on personal reference points.

 

In the United States, two major economic indicators that are used by banks, economists, and the media for deciding whether we have a good economy or a poor economy are GDP growth and interest rates. Both of these measures are represented as percentages, both have specific targets that we have decided are good, and from both follow a set of decisions that we hope will improve the numbers in the direction we want to see. What is interesting, is that we have reference points for the numbers in terms of what percentages we believe reflect a strong and growing economy, and our subjective experience of the economy can be changed by those outcomes.

 

A 1% increase in GDP growth is growth in overall GDP, but to an economist, that growth is abysmal, and actions need to be taken to get that growth rate closer to 3 to 4%. At the same time, if expectations for GDP growth are only .8% and we hit the same 1% outcome, we might be very happy. In both situations, our decisions and behaviors might change based on the delta from our expected reference point and the final reference point. A gain can feel like a gain, but it can similarly feel like a loss depending on where exactly we placed our reference point.

 

Interest rates reflect similar dynamics, and might be even more complicated by more clear competing interests and desires in terms of interest rates. Banks might want to see higher interest rates, to earn more money, while people taking out loans may love the low interest rates. A 2% interest rate might feel like a huge loss to one entity, while simultaneously feel like a gain to another.

 

This creates strange competitive dynamics, because our brains hate losses. We generally need an expected or realized gain to be 2 times larger than a potential or realized loss before we will risk money or accept an outcome. If we have a certain reference point in mind for the outcome we want or would be happy with, we may need to see a large skew in a positive direction for us to be happy, while even a minor loss will feel disastrous.  (At this very moment in the United States this is what is taking place with the presidential election. Several journalists have noted that in December of 2019, the Democrats would be thrilled with the election outcome we have today, but many adjusted their reference point to a Biden landslide win, so a close win feels like a tragic loss – and somewhat of a win for Trump).

 

Reference points feel like a simple idea, but what I hope this post shows is that they can be hugely consequential, and incredibly complex, especially when we have multiple actors with multiple reference points all interacting on small and large issues. Choose your reference point carefully, and try to recognize when you are operating with a certain refence point in mind and be willing to adjust or discard it when necessary. Don’t let a win get wiped away because it ended up being slightly smaller than your reference point expectation.
Imaginary Reference Points

Imaginary Reference Points

My last post was about reference points and how they can create subjective experiences that differ from person to person. If my refence point is dramatically different than another person’s, then our experience of the same objective fact or reality can be quite different. If I suddenly won $1 million dollars my life might change dramatically, but if an incredibly wealthy person suddenly won $1 million, they might not care at all.

 

Reference points can get even more complicated than the example I just shared which was borrowed from yesterday’s post. Sometimes reference points don’t need to be real in order to shape our subjective experiences of the world. In his book Thinking Fast and Slow, Daniel Kahneman uses the example of an expected raise. If someone knows that their colleagues have received a raise, and expects to get a similar raise but does not, then they can feel as though they have really lost. Their financial situation has not changed, but they created an imaginary reference point in their mind which has shaped the way they think about their current situation.

 

We all have certain expectations about the world that we adopt as reference points. These reference points don’t have to reflect anything real about the world, but they can still greatly impact our subjective opinions and considerations of the world. They can be vain, such as how attractive we expect our spouse to be, or more positively aspirational, such as how much we expect everyone in society to participate in social causes to help those who are the most needy.  There is no real reference point that we are using, just hazy ideas of the way we think things should be, but nevertheless, these imaginary reference points can guide a lot of our thinking and behavior.

 

In my own life, examining these imaginary reference points has been incredibly helpful for making me a more happy and confident person. It is easy to let imaginary reference points fall to the background, where they run our lives without being considered in a critical way. By thinking deeply about our reference points we can better consider what we should and should not strive for, how much effort or money we need to put toward certain endeavors, and whether our behaviors are really reasonable and worthwhile. Through self-reflection and self-awareness we can recognize goals that serve as reference points which are unreasonable, desires which are vain and should be discarded, and ideas about who we are supposed to be that don’t truly align with our lives and what would help us live in a meaningful and fulfilling manner. Imaginary reference points matter, and they can greatly influence how we live our lives. We should make sure we think about them and let go of those which drive us in the wrong direction.
Subjective Reference Points

Subjective Reference Points

One reason why we will never be able to perfectly understand other people and the opinions, decisions, and beliefs that other people hold is because we all have different reference points. I cannot be inside your head, I cannot see things from exactly the same angle that you see things, and I cannot have the same background and experiences that you have. Our differing reference points create subjectivity in our lives, and not just in areas that we would all agree don’t have one true correct answer. Even areas where it seems like there should be a single objective fact or reality can be very subjective. We expect to see a lot of subjective variability in terms of our preferences for living in the city versus the country, in preferring private insurance versus state sponsored insurance, or preferring soft versus firm mattresses, but we probably don’t expect to have the same different subjective experiences or preferences for how loud a sound is, how light or dark a shade of gray appears, or the value of a $2 million dollar gambling win.

 

Each of these areas of unexpected subjectivity are discussed by Daniel Kahneman in his book Thinking Fast and Slow. He shows that understanding and predicting subjective experiences in these areas is possible if we understand the different reference points that are in play for each individual. There may be an objective and unchanging fact at the base of the reality each individual experiences, but the experience can nevertheless be subjective. Kahneman writes,

 

“To predict the subjective experience of loudness, it is not enough to know its absolute energy; you also need to know the reference sound to which it is automatically compared. Similarly, you need to know about the background before you can predict whether a gray patch on a page will appear dark or light. And you need to know the reference before you can predict the utility of an amount of wealth.”

 

I don’t want to end up in a point where we say there is no objective reality we can all observe, after all, “a dead body is a dead body, and someone is going to jail,” as a friend who is a federal judge here in Reno, NV once said to me. But I do want to highlight just how much of our world can be interpreted differently based on our reference points. Sounds, colors, and the value we would get from a certain amount of wealth are not obviously subjective, but Kahneman shows just how subjective these areas are in his book. This should make us consider how much our backgrounds, our unique points of view, and the circumstances in which we make our observations shape how we understand the world. A lot of our understandings of reality are context dependent, and that should cause us to pause before we say with absolute certainty that reality is exactly as we have experienced it. We should pause to consider the reference classes which shape and influence how we experienced the world, and how those references might be different than those of other people. We can’t just say that there is one way to interpret and experience everything in the world, we have to accept that how we experience the world will be shaped by many factors that we might not be aware of and might not consider if we don’t slow down to think about the references.
Avoiding Gambles

Avoiding Gambles

“Most people dislike risk (the chance of receiving the lowest possible outcome), and if they are offered a choice between a gamble and an amount equal to its expected value they will pick the sure thing,” writes Daniel Kahneman in Thinking Fast and Slow. I don’t want to get too far into expected value, but in my mind I think of it as a discount on the total value of the best outcome of a gamble blended with the possibility of getting nothing. Rather than the expected value of a $100 dollar bet being $100, the expected value is going to come in somewhere less than that, maybe around $50, $75, or $85 dollars depending on whether the odds of winning the bet are so-so or are pretty good. You will either win $100 or 0, not $50, $75, or $85, but the risk factor causes us to value the bet at less than the full amount up for grabs.

 

What Kahneman describes in his book is an interesting phenomenon where people will mentally (or maybe subjectively is the better way to put it) calculate an expected value in their head when faced with a betting opportunity. If the expected value of the bet that people calculate for themselves is not much higher than a guaranteed option, people will pick the guaranteed option. The quote I used to open the post explains the phenomenon which you have probably seen if you have watched enough game show TV. As Kahneman continues, “In fact a risk-averse decision maker will choose a sure thing that is less than the expected value, in effect paying a premium to avoid the uncertainty.”

 

On game shows, people will frequently walk away from the big possibility of a pay off with a modest sum of cash if they are risk averse or if the odds seem really stacked against them. What is interesting is that we can study when people make the bet versus when people walk away, and observe patterns in our decision making. It turns out we can predict the situations that drive people toward avoiding gambles, and the situations which encourage them. It turns out that the reward has to be about two times the possible loss before people will make a gamble. If the certain outcome is pretty close to the expected outcome, people will pick the certain outcome. If there is no certain outcome, people usually need a reward that is at least 2X what they might lose before people will be comfortable with a bet. We might like to take chances and gamble from time to time, but we tend to be pretty risk averse and we tend to prefer guaranteed outcomes, even at a slight cost over the expected value of a bet, than to lose it all.