Monday, August 29, 2016

Being rational (2)

Since the Swiss mathematician Daniel Bernoulli developed in 1738 what is now called the utility theory, it has been the mainstream approach in economics for explaining how people make their choices. It supposes that the relationship between the psychological value or desirability of money (“utility”) and the actual value of money is based on rational calculation. The theory has hold up until today, although its foundation begins to show serious cracks, thanks to the work of Daniel Kahneman, Amos Tversky and others. It will need a thorough study to explain why utility theory could stand so long (and it still stands), but that’s another problem than what I want to treat here. Now I want to discuss what’s wrong with it. In doing so I base myself on the so-called prospect theory developed by Kahneman and Tversky and described by Kahneman in his book Thinking, Fast and Slow (see my last blog; all data here are from this book).
Last week I showed already that man is not a rational being but that he or she is often guided by emotions, feelings and intuitions. Actually I think that it’s often better so and that what is rational is not always what is right. Here I want to develop the theme yet a bit more.
Someone offers you a gamble on the toss of a coin. If the coin shows tails, you lose € 100,-, and if it shows heads you win € 150,-. Would you accept it? The expected value of the gamble is positive, for you can gain more than you can lose. Therefore a rational person in the sense of the utility theory would accept it and that’s also what your System 2 tells you to do. However, probably you’ll decline, since your System 1 doesn’t like it. Most people stick to what they have and are afraid to lose it. The psychological cost of losing is bigger than the psychological benefit of gaining. This brought Kahneman to rule one – as I call it – of the prospect theory: Losses loom larger than corresponding gains, or people are loss averse. Of course, if the possible gain is high enough, you’ll accept the gamble. According to Kahneman the gain must be about € 200,- or more in the example. However, in some cases you’ll never accept the gamble, for instance if it is about losing everything you have or gaining € 10 mln.
Now (1) you are given € 1000,- in addition to what you have plus you are asked to choose one of these options: 50% chance to win € 1000,- or getting € 500,- for sure. Or (2) you are given € 2000,- in addition to what you have plus you are asked to choose one of these options: 50% chance to lose € 1000,- or lose € 500,- for sure.
According to utility theory there is no difference between (1) and (2): Either you’ll be richer by € 1500,- or you accept a gamble with equal chances to be richer by € 1000,- or € 2000,-. Nevertheless, most people prefer the sure thing in case 1 and the gamble in case 2. This leads to rule two of the prospect theory: The reference point from which options are valued determines your preferences.
This is not pure theory but it works also in practice. For example, you got a job in another town and you are going to move and must sell your house. For a rational agent the price to ask for the house should be determined by the current market price for such houses. Nevertheless, you’ll ask more if the current market price is lower than what you paid for your house ten years ago. Moreover, you are less willing to lower your asking price in this case than in case what you paid ten years ago was below the current price: Your reference point determines what you ask and you are loss averse. Or another instance – a personal one: During several years car dealers put cards under the windscreen wipers of my old car proposing to buy it for a good price. From the point of utility theory it would have been rational to sell my car, but I didn’t, for I stick to what I have.
Traders behave more in agreement with the utility theory than casual sellers and buyers. In fact this is another argument against the utility theory, for it illustrates that its applicability is dependent on people’s attitudes towards value and money. Also experiments carried out in the USA and the UK gave different results (Kahneman gives an example). But who had ever thought that what is rational for me is also rational for you?
Source: Especially chapters 25-27 in Kahneman's book (see last week).

Monday, August 22, 2016

Being rational

Man is a rational being. Also most economists think man is and they build their theories on it, which often fail. For basically man is not rational. Or rather most of the time he or she isn’t. Usually man lets guide him or herself by feelings and emotions, also in economic decisions and not only in matters of love and relations. That’s what the Israeli psychologist Daniel Kahneman found during many years of research, together with Amos Tversky and others. In 2002 he got the Nobel Prize in Economics for it. Actually, it would have been reasonable that all economic theories had been revised in that light, but it didn’t happen. As we know since Thomas Kuhn published his The Structure of Scientific Revolutions: Mainstream theories that have been refuted in scientific discussions don’t disappear simply because of these discussions. Often they still remain mainstream for a long time, but they disappear because the advocates of these theories become older and have to give their places to a younger generation with new ideas. Mainstream theories are not toppled but die out.
A standard example of man’s irrationality is the research finding by Lawrence Williams and John A. Bargh that holding a warm cup of coffee makes you have more positive attitudes towards a stranger than holding a cup of ice coffee, for what has the temperature of your coffee to do with your likes and dislikes? But this instance doesn’t involve a kind of economic or quasi-economic calculation. So let me take this case, which I have used before in another context (just like the cup-of-coffee-case): A driverless, runaway trolley on a railway is heading for a tunnel, in which it would kill five people. You are standing on a footbridge above the track. You are slim and short but a fat man is just crossing the bridge. If you jump on the track, you will be run over by the trolley, which will kill you and the five people as well. If you push the fat man on the track, he will be killed but the trolley will stop and the five will be saved. A simple economic calculation tells you that this is the best you can do, for the net gain will be four lives saved. But even if you make this calculation, I’m sure that you’ll not push the fat man from the footbridge, for your intuition and your feelings, will tell you that this action is impermissible. And nobody will reproach you that you didn’t. But what if the fat man stumbles over a stone and will fall on the rails so that he will be killed by the trolley and the five other men will be saved, unless you stop him? I’m sure that also then you’ll not make an economic calculation and that you’ll not think: “I can’t help that he stumbled over a stone. I didn’t push him, but if I allow him to fall on the rails, the net gain will be four lives saved, so let him fall.” No, that will not be what you think, but you’ll follow your feelings and grab the fat man by his collar and stop him falling, in spite of the loss of five other lives. If you think, you’ll think “I have to save the fat man.” Nobody will reproach you that you saved the fat man and “so” let five other men die.
Generally we think that we are rational beings. That we are conscious, reasoning selves that have beliefs, make choices, and decide what to think about and what to do. However, psychologists have discovered that this is not how man is made up. Most of what we do is not rationally and consciously considered but we just do. We simply follow our intuitions and feelings, although it can happen that we actively and explicitly think about what we must do or decide, for example if what we are going to do is not routine, if it is complicated, if it requires attention or if we have the time for it. Psychologists say it this way: Our thinking is determined by two systems, a fast system and a slow system; or as the Keith Stanovich and Richard West called them, System 1 and System 2. As Kahneman explains in his book about the subject, System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control. It’s here that we find our emotions, feelings and intuitions. System 2 allocates attention to effortful mental activities that demand it, including complex computations. Here we find our subjective experience of agency, choice and concentration, so Kahneman. And it’s this System 2 that stands for the rational man, as understood by most economists, although it’s actually System 1 that makes most of our economic decisions. Maybe it’s better so that our thinking is organised that way, for if it weren’t, we would often lack the time to act. Too much time would be spent on thinking how to act. We wouldn’t have survived prehistory, for every smilodon or other carnivore that had passed our way would have had time enough to devour us, before we had decided to flee or to fight. It spares us also the impossible decision whether to save the fat man from falling on the railway or the five other men from being killed.
Source: Daniel Kahneman, Thinking, Fast and Slow. Penguin Books, London, 2012.

Monday, August 15, 2016

On the move with Montaigne

The French philosopher Montaigne (1533-1592) felt most at ease on horseback. No wonder that he loved travelling. Many trips had a practical reason. “For business”, as we would say today. But once he made a long tour through Central Europe and Italy, which lasted 17 months. As a tourist. The trip would even have lasted longer, if the French King hadn’t ordered Montaigne to return home for taking up the office of mayor of Bordeaux. He obeyed reluctantly.
Montaigne started his trip in Paris. It brought him to Switzerland, Southern Germany and Austria and finally to Rome. He kept a travel diary, which was not meant for publication, although he used some of his experiences in his Essays. The diary was discovered only two centuries later. It showed that Montaigne was an observant person. He wrote about the towns and the landscapes he passed, the habits and customs of the people, the food they ate, the design of the houses and palaces he visited and the rooms where he slept, the beauty of the women he saw, and much more. On my travels sometimes I pass places where Montaigne had stayed a while more than four centuries ago. And so it happened also a few weeks ago.
I first crossed Montaigne’s path when I arrived in Augsburg in Germany and then a few days later again in München. Montaigne doesn’t tell much about his stay in München, but he gives an extensive description of his observations in Augsburg, which was called the most beautiful town of Germany. He tells us that Roman Catholics and Protestants peacefully lived together and that mixed marriages between them were not exceptional. The Protestant ministers were paid by the Senate. For Montaigne all this was remarkable, for in his France one religious war followed another. But in the Thirty Year’s War (1618-1648) the situation would change in Augsburg, too, and nowadays it is an almost exclusively Roman Catholic town.
After München our ways parted, for we followed different roads to the south. However, our most interesting “meeting” had yet to come. When I went home again after a short visit to Northern Italy, our paths crossed anew. Now I followed exactly the same route Montaigne had travelled, but in the opposite direction. In Brixen I came on Montaigne’s road and I made a stop in Vitipeno. Montaigne had spent there the night. I arrived there before noon. I walked through the main street with its medieval houses and a high wall tower on the end. Just when I passed the gate under the tower, its bells ringed the Angelus. Montaigne certainly must have walked here, too, in his black or white clothes of a commoner. He preferred not to present himself as a noble on his trips, so that it was easier to make contact with the common people. Was the street then as crowded as today? If so, probably most of these people will not have been tourists, as now is the case.
Next via the Brenner Pass to Austria and Innsbruck. Of course, I took the old road that was also used by Montaigne. Then the road was busy and also safe. The latter was not obvious four centuries ago. Today the road is still safe but it has become quiet, used by locals and a lost tourist only. Montaigne was right: the road is easy to go, although it is a mountain pass.
Montaigne and his company stayed two nights in Innsbruck; I stopped there only for a lunch and a quick visit, since I had been there before. In the nearby Seefeld it was just the other way round and I spent there the night. Before I left next morning, I wanted to visit the pilgrimage church. I parked my car in front of a hotel that dates from the 14th century, as an inscription on the wall says. Was it here that Montaigne had taken the lunch? Then he walked to the church where he was informed why it was a pilgrims place. As Montaigne tells us: “The church ... is ... famous for a miracle. In 1384 a certain man ... refused to content himself on Easter day with the Eucharist as offered to the people, and demanded to receive that which was wont to be given to the priesthood alone. While he had this in his mouth the earth beneath him opened and swallowed him up to the neck, and while he held for a moment to the corner of the altar the priest withdrew the Host from his mouth [and the man was saved]. They still exhibit the hole covered with an iron grating, the altar which bears the impress of this man’s fingers, and the Host of a reddish hue like drops of blood.” Would Montaigne have believed it? In his Essays he is very sceptical about miracles.
Now I stood there, 436 years later, on exactly the same place, looking at the same hole covered with a grid and at the fingers prints in the altar. Just the idea. Impressed by this “meeting” I left the church. In the nearby Mittenwald, already in Germany, where Montaigne had stayed in the inn, I took a cup of coffee. Then our ways parted another time.