Humans are very interesting beings. On various different occasions, I have made an assumption that human beings are rational beings able to make thoughtful decisions based on information available on hand to them. In a lot of fields, we use a similar assumption of rational human beings. Economics is one such field.

For those familiar with economics, the demand supply curve is the symbol of rational economics. For most humans as well it should make intuitive sense. As the price of a product goes down, the demand should go up as more and more people can afford to buy the same item. As the assumption goes, given a choice between $5 cup of latte and $10 cup of same latte, humans will inevitably choose $5 cup of latte. There should be no market for $10 cup of latte’s but yet there is. Because human decision making is influenced by our emotions and feelings, which are not always rational.

Let’s say a shirt you want to buy is $50. Alternatively consider the same shirt priced at List price of $100 and discounted by 50% to $50. For most all of us, we would buy the 2nd deal but may not buy the first one. We love deals. We love the perception of discount. We don’t compare prices directly, we compare the perception of the value that price may offer. So to believe that rational humans make rational decisions sometimes makes it hard to predict human behavior from economic first principles.

I had always been fascinated by this discrepancy. I knew that demand-supply curve is not perfect as the demand for luxury goods go up as prices increase. That is what led me down the path where I learned about a new field of economics called behavioral economics which tries to utilize psychology along with economics to predict how people will behave to economic changes. A couple of months ago I picked up a book by Richard Thaler who won the Nobel Prize for his contributions to behavioral economics. The book was titled Misbehaving.

One of the interesting takeaways from behavioral economics is the idea of nudge theory which highlights how humans can be nudged towards certain decisions. For example, until long time the rate of people opting into organ donations in certain countries was low while certain other countries was high. One of the interesting differences that could explain the high opt-in rates was that these countries had default opt-in for organ donation and you had to do extra work (like select a checkbox on form, or send an email) to opt-out. In other countries, you had to opt-in into organ donation. Humans don’t like to do extra work, so default opt-in here leads to better outcomes.

Here are some of my more interesting learnings from the book. It’s not just good exercise in learning new things but also helps explain how we behave, sometimes leading to bad outcomes for ourselves. By knowing, and subsequently changing our behavior, we could theoretically improve our own lives.

Sunk costs matter (for a while)

Remember that membership you bought (eg gym membership) that you thought you will utilize completely. Well now that we have put in the money to buy the membership, we are initially very concerned in getting the full value out of it. So we see more people sign up for gyms in January and then usage of gym membership rates are relatively high in Jan/Feb, eventually declining and plateauing off. So even though the membership is a sunk cost and will not be recovered one way or another, we care about the sunk costs for a while and it motivates our decisions at least for a while.

Similarly when we incur fixed costs like getting a Uber subscription, we tend to use the Uber more than another company even when the actually ride costs are higher. We end up feeling that we need to gain full value out of our membership even though in rational economics it doesn’t make sense. This is perhaps also the reason why loyalty programs work so well.

Endowment effect

Imagine a beautiful porcelain cup on a store shelf. The price is $10. You might be really tempted to buy. If the same price is $30, perhaps you may not buy the same. Now imagine that you were gifted the same cup by a friend a few months ago and you really like it. Would you sell it at $10. Very unlikely. Would you sell it at $30? Perhaps but still unlikely.

Rationally, selling the cup for $30 and then buying a new one for $10, makes you a cool $20 profit. Yet, we will often not do something similar because we attach a much higher value to things we already have. This is also referred to as endowment effect where things we already own are higher valued that similar things we don’t.

Mental accounting

We tend to create virtual accounts for different expenses in our minds. For example we might have a mental budget for paying for gas (petrol). If the price of gas goes down, it was found that people ended up buying more premium gas instead of reallocating this budget to other areas like food etc.

Similarly when we are losing money in poker for example, we end up taking more risks to balance the account back to 0. If we are already down $100, we will have to make more risky bets to win $100 but we might not take similarly risky bets if we were just starting out at the poker table.

Hence, sometimes when we start thinking about how you need to recover certain losses, we tend to make more risky decisions. Reframing this in our heads to consider the lost money as an expense like $100 loss can be considered an expensive meal or $1000 loss a vacation expense, may help us make more rational decisions for ourselves.

We care about fairness

Humans care about fairness. Most people dislike the idea of a shopkeeper increasing price of toilet paper or water by 20% around or after a natural calamity even though it is rational economics of price increasing as demand increases to balance supply.

Similarly we are okay with a car dealer removing a discount from List price if demand increases but we are not okay  with dealer increasing the list price itself. For example if a car was list price $30K and dealer had it discounted by 10% to $27K. If demand increases we don’t find it unfair if dealer removes the discount and car is back at $30K. But if the same car was List price at $28K and dealer increased the list price to $30K, we would never go back to the dealer and write 1* reviews for them.

Perceiving the deal we are getting as fair is as important as the deal itself. In fact, sometimes we are willing to pay more for a fair deal than for a cheaper price which would involve transacting with someone whom we consider unfair.

Narrow framing

We often end up framing our problems narrowly which can lead to poor outcomes. For example, if we look at our stock returns every day and see a stock go down 15% we will panic. But if we look at it in the light of 1Y returns which might imply we have gained 100% even after that crash, we will have a more measured way of acting on it.

Looking at problems from a narrow perspective tends to force us into solutions that may not always be appropriate. Another amazing example from the book related to corporate policies. Imagine there’s a company with 10 business units. The CEO has 10 BU heads reporting to him/her. For each BU, if given a choice of investing $2M into a project with 50% chance of $2M profit or 50% chance of $1M loss, most BU unit heads with not take the deal. That’s because the risk of failure and subsequent loss may put their jobs on line but the chance of $2M profit (and them getting maybe a small bonus) is not worth it.

But for the company as a whole with 10 units, the chance of losing any money is very small and the chance of making positive returns is generally high. So, for the CEO each BU head should take the deal but for the BU head they would be very risk-averse in wanting to take this deal. If the company adapts it’s bonus policies and incentives BU heads in the right way, it could lead to significant returns for the company. But for each BU head, narrow framing the problem can generally lead to a inefficient decision.

Economic policy based on nudge

Knowing that humans are not rational and that our behaviors vary based on the surroundings, the information we have and the context of the situation, the book went to suggest some interesting economic policies that can be implemented to help us all. Rational economics would assume that humans would save appropriately to fund their future life goals and retirement but unfortunately, a lot of people never end up doing this for various reasons.

One of their policy suggestion that I found very interesting was called Save More Tomorrow. It basically signed up people to start saving a part of their pay from next year and automatically increased the savings by a fixed percentage of future pay increases (raises). That way you don’t start saving today (which many people cannot do or don’t want to do) and it increases the savings based on future earnings (which then does not feel like a reduction in paycheck) and does all of this automatically (so we don’t have to think or plan or do any work). Millions of people are saving more for their retirement thanks to this policy.

Takeaways

Understanding how we think about and act upon financial decisions in context of human psychology is an important way to find your own biases and then act to navigate any negative biases. For me, I did start putting more automated savings and also looking at 1Y stock performance instead of everyday up and downs.

Links: Here’s the link to the book. And here’s a link to know more about Behavioral economics.