Economists Do It With Models

2016-05-11 08:13

Economists do it with models.   Classical economists used to do it with two things: an x- and y-axis.   Tickle x- and see what happens to y-.  Economics 101.   Then we started taking psychology and economics courses together, and you know, threw a few spanners in the works:  Bias, Big Data, Culture, Self-concept… Poke x-, predict y-, based on the influence of z-, observed n- times. In real life.

One of the first great behavioural economics books, Freakonomics, showed that if you wanted to predict people’s behaviour, don’t assume they’ll act rationally, rather look how they are truly incentivised.  That sounds obvious.  It’s not.

Ask any real estate agent and they will sell your house at the best price every time, right?  They get a % of the sale price, so one expects they are incentivised to maximise the price, ipso facto their commission.   Yet research shows that if you really want to maximise your chances of getting the best price for your house, you should hire a real estate agent that actually lives in your area.  A little skin in the game is a proper incentive.   The really interesting thing about observed behaviour in real estate broking is that often agents will try sell a property before one of their competitors can.  So now we actually introduce another variable into the equation.  It is now not just about price, but the broker’s personal & binary interest too.  If they miss the sale, their commission is zero.  Yet another example of how real life behaviour challenges traditional economic orthodoxy:  That all competition is good.  One might get lower commission rates due to competition, but do you get the best price?

Returning to incentives, SANRAL’s e-toll discount offer is quite interesting.   If you pay your outstanding debt, you get 60% off what you owe.   Now that can be looked at in two ways.

  1. An incentive to pay up.
  2. Or for the people that have always dutifully paid in the past, an incentive not to pay in the future.  (Because hey, not paying gets you a discount)

Unless the folk that have always paid, at the very least, get a 60% credit on their e-toll account, they are worse off than the people that haven’t been paying all along.  That’s absurd.  Talk about disenfranchising your loyal customers.  Yes, it’s a little more complicated than that (politics, ideology, group dynamics, civil disobedience etc.), but for illustrative purposes let’s explore several interesting behavioural concepts.

  1. The Anchoring Effect
  2. The Sunk Cost Fallacy (close cousin of Loss Aversion)
  3. The Technology = Innovation Myth

Used Car Salesmanship 101.  The Anchoring Effect.  Source of marital strife and a cupboard full of ‘shoes that were on sale’.

Love, I had to buy this bike, it usually sells for R25,000 but I managed to negotiate the guy down to R20,000.  I couldn’t let an opportunity like that pass!”.

Usually followed by a terse, “But you already have a bike?

(Remember Bike / Shoe Limit Equation is S = X - 1, in which X = Max. Number of Bikes/Shoes & S = Separation).      

We have a tendency to rely heavily on the first information we receive: the anchor.  So any future evaluations are made against that reference point.  Salesman opens with R40,000, and we think we’ve got him on the rack at R30,000.  In actual fact he’s got our ego over a barrel.  Oldest trick in the book.   So SANRAL’s discount offer might be appealing to some; though I doubt that many people will get excited about getting 60% off something as sexy as outstanding toll fees.

The Sunk-Cost Fallacy links to SANRAL in an interesting way.  Humans hate losing stuff.   Sure, if you haven’t paid tolls yet, you probably thinking you haven’t lost anything.  But SANRAL are hoping they can get you to start paying something, because once we start, it only gets easier to justify a cost to ourselves in future.  Once we have spent time & money on something, we’re far more likely to continue doing it.  Even if it doesn’t make rational sense.  Farmville, anyone? (McRaney, 2014)

The Sunk-Cost Fallacy is rooted in loss aversion.  SANRAL may believe an upgraded highway is worth it, but people tend to focus far more on what they are losing in an exchange than on what they are gaining.   This means one really needs to sell the benefits.  A good salesman is able to offset the fear of loss by convincing you, or more accurately getting you to convince yourself, of the benefits of something.

Nobel Laureate, Daniel Kahneman suggests that of those of us that have made it this far, probably did so by having ancestors that sought to avoid threats rather than maximise opportunities.  IOW we’re hardwired to evaluate choices in terms of loss rather than gain.  Considering male life expectancy just 100 years ago was only 49.6; on an evolutionary scale the world has only recently got less dangerous, so it’s hard to argue.

Another behavioural economist, Dan Ariel, designed an interesting experiment around loss aversion.  Something like this:  Lindt Chocolate sells for R35 in the shop, a Kit Kat for closer to R8.   So when people are offered a Kit Kat for R5 or a Lindt Chocolate for R20 – most people choose the Lindt.  If we drop the price of the Kit Kat to R0 (zero) and the Lindt to R15, in other words, keep the economic cost difference the same, there should be no change in behaviour.  Yet, the result is obvious.  The Kit Kat offer at R0 means we evaluate the balance between cost and benefit totally differently – there is no loss, no sunk cost in one of the choices.  So people go to town on the Kit Kats.  The question for SANRAL is whether the discount is deep enough to overcome the perceived loss aversion.  A recent extension of the offer beyond the end of April suggests not.

The Fallacy of Sunk-Costs hurts us in other ways too.  That builder that keeps coming back for more cash after you’re already in way over budget and only half a house built; your investment manager that doesn’t sell a share at a loss despite better prospects; the guy driving the price up at an auction he’s bidding in; or when you ‘don’t want to waste the biscuits in the cupboard’ - so you eat them all now and promise to start your diet tomorrow.

In closing, one wonders whether SANRAL is even thinking about behavioural economics.  I doubt it.  Telling people, they must pay for something they already feel they’re paying for; while warning them they only have 7-days to settle their accounts or else, isn’t the best way to elicit a positive response.  Humans don’t respond well to threats – and urban South Africans don’t respond well to imposed authority generally.   So when organised groups form in opposition, group dynamics give individuals the perception of ‘safety-in-numbers’, while giving them a sense of belonging to a greater ideological cause.

Most companies don’t grasp the power of understanding behaviour.  Many think they do, but little of what they do is based on evidence.   But we now have the theory AND the data.  Working with banks, I’m fascinated how few them employ behavioural scientists.  Proper hard-core data scientists.  In their innovation teams?  In their culture and conduct teams?  In their marketing teams?  Nope.  Strange because innovation, culture and marketing are fundamentally attempts to predict human attitudes and behaviour.  Most still seem to think that innovation = technology.  That may have been true in the 90’s, but to that I say once more… Farmville.  The online game isn’t about tech; it’s about sunk-costs.  The more you play, the more you just have to play.  What makes social media so addictive?  Psychology, not technology.  The point is, the future is about understanding why customers behave the way they do, not how you deliver an old concept or a grudge purchase on a fancy mobile app.

If you got this far, I thank you for your Sunk-Cost investment in time.  Pretty sure, I’ll see you next week!

Recommended Reading & Inspiration

  • Anything by David McRaney, Daniel Kahneman, Dan Ariely.

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