Prospect Theory a “Descriptive Theory of Decision Making”

Prospect theory is one of the foundation stones of behavioral economics and behavior sciences overall. It was developed in the 1970s by Amos Tversky and Daniel Kahneman. For this work Daniel Kahneman received the Nobel Prize for Economics. Unfortunately Amos Tversky passed away a few years before the prize was awarded. 

The revolutionary nature of Prospect Theory came from the fact that it challenged a centuries old assumption, namely perfect rationality. It criticized the traditional (normative) model of decision making and replaced it with a positive one (how people actually make decisions).

In order to better understand what are the true innovations of Prospect Theory we should first take a look at the normative model, namely at the Expected Utility Model developed by Daniel Bernoulli in the XVIII-th century.

Before describing the Expected Utility Model, let’s make clear what Utility means. Utility can be perceived as “the amount of pleasure” or “the benefit” given by a certain amount of money. The main characteristic of Utility is that it is not linear. For small and moderate amounts of money it is in fact linear, but after a certain sum the utility per monetary unit starts to decrease.

For example, the utility of 20 Euros is twice the utility of 10 Euros. However, the utility of 2 million Euros is not twice the utility of 1 million Euros. The utility of 2 million Euros is smaller than twice the utility of 1 million Euros.

In mathematical expressions it would go like this:

U(20)=U(10) + U(10)

U(2.000.000) < U(1.000.000) + U(1.000.000)

The Expected Utility Model is straight-forward: The value of an uncertain outcome is the Utility multiplied by the probability of occurring.

To better understand, let’s assume that an alien comes from the sky and sits on your shoulder. The alien says it’s you lucky day and you get to play a series of games with him.  The alien takes out an intergalactic coin that is very similar to the earthly ones, namely it has two sides. If the side with the space ship comes up, you win 100 Euros. If the side with the “2 intergalactic credits” comes up, you win nothing. The coin is not tricked, namely there is a 50-50 chance of either side to come up.

The value of the alien’s proposition can be translated like this:

Expected Value = 0.5*U(100) + 0.5*U(0).

Another example would be if the alien would offer to throw a dice and if the side with “1” comes up you get 20 Euros, if the side with “2” comes up you get 2 Euros, if the side with “3” comes up you lose 10 Euros and if any other side comes up, nothing happens. The value of this proposition is:

E.V. = 1/6*U(20) + 1/6*U(2) + 1/6*U(-10) + ½*U(0).

I gave examples with “gambles” because they are the easiest, but the reality is that we make decisions about uncertain events all the time. For example, what are the chances of getting that nice job and what would the benefit (utility) be? Should I take an umbrella with me today or not? Will it be safer to go on the trip by car or by train?

I assume that you got the main idea of the Expected Value model. Before prospect theory (and even nowadays in some areas of science) this was assumed to be the way people make judgments about uncertain events.

Moreover, this is the RATIONAL way of making decisions. This is HOW WE SHOULD MAKE DECISIONS.

Since in the above paragraph you read “should” it implies that it is not the way we make decisions. Tversky and Kahneman developed prospect theory which describes how people actually make decisions under uncertainty.

  

Prospect theory keeps the “Utility function” or in other words it also uses the concept of utility. The benefit that money brings is not linear in both theory and practice. At the same time prospect theory brings two major new insights into the Expected value model.

First, prospect theory makes a very important distinction between gains and losses. The reality is that we humans do not think (perceive) the same way about what we gain and what we lose. Moreover, gains or losses are relative concepts. What is a gain or what is a loss depends on the reference against which we judge it.

To better understand consider that you are in the following situation. Your salary is 25.000 Euros per year and you have put in a lot of effort in the last year. Now you are up for a raise and in a couple of days the HR department will tell you what your salary will be next year. You can’t help and think about how much you would deserve and you come up with the number 32.000 Euros per year. When you have the meeting with the HR person, she tells you that you will get a raise of 5000 Euros, meaning that your salary next year will be 30.000 Euros.

Will you be happy about the raise? Most likely you will not be unhappy, but neither you will be happy. The explanation is that your reference point was the salary you believed that you deserve – 32.000 euros. In comparison with this amount, the 30.000 you were offered represents a loss of 2000 Euros.

At the same time, you actually get more money than last year and if you change the reference to your current salary, you will in fact experience a gain of 5000 euros.

The main implication of distinguishing between gains and losses is that people “suffer” from loss aversion. In more simple words, we hate to lose and we would put in more effort to avoid a loss than to achieve an equivalent gain.

Let’s illustrate this with the following example. The alien suggests the following bet:

50% chance of gaining 100 Euros and a 50% chance of losing 100 Euros.

What is your attitude about this gamble? Would you be willing to take it? It’s a 50-50 chance of either winning or losing 100 Euros. Will you take it?

Most likely your answer is a definite “NO” and most people in the world would be giving the same answer. From a strictly rational (normative economics) perspective, this answer is at least weird. The reason is that the objective value of this gamble is 100*0.5 + (-100)*0.5=0. If the objective expected value is zero, then you should be indifferent to the gamble and take it (or at least more people would take it). But you and most (normal) people in the world would not even consider taking this gamble.

The idea of being indifferent to a gamble basically means that you are equally inclined to take and to not taking it.

Now the alien can understand to a certain extent humans and he suggests the following bet:

50% chance of gaining 110 Euros and a 50% chance of losing 100 Euros.

What is your attitude about this gamble? Would you be willing to take it? It’s a 50-50 chance of either winning 110 Euros or losing 100 Euros. Will you take it?

Most likely your answer is still “No”. At the same time you have already learned how to compute the objective value of the gamble and by applying the very simple formula of 110*0.5 + (-100)*0.5=5. As you can see this gamble has a positive objective expected value. From a normative economics (rational) perspective everyone should be willing to take this gamble, but again most people are not willing to take it.

For more on loss aversion please check this post: Loss Aversion and its Implications

Roughly we perceive losses as twice as bad as an equivalent gain. In other words, the pain (dis-utility) of losing 100 Euros is (roughly) twice as large as the pleasure (utility) of gaining 100 Euros.

This would translate in a mathematical expression like this:

|U(-100)| = 2*U(100)

The loss aversion coefficient which in theory is called (lambda) λ is estimated to be approximately 2. This is a general estimate established after averaging values from large sample of people. What this means is that some people might have a loss aversion coefficient smaller or larger than “2”. To what extent this is relevant for your work remains to be established, the key idea is that there can be individual differences in the value of (lambda) λ.

The utility function has similar characteristics in both the gains and losses areas when it comes to linearity. In other words, as in the case of gains, when it comes to losses the (dis)utility of small and moderate amounts is linear. When it comes to large amounts, however, the (dis)utility becomes nonlinear.

To illustrate this, a loss of 20 Euros is equal to twice the loss of 10 Euros. However, a loss of 100.000 euros is smaller than twice the loss of 50.000 Euros.

In Mathematical expressions it goes like this:

U(-20)=U(-10) + U(-10)

U(-100.000) < U(-50.000) + U(-50.000)

The graphic illustration of the utility function is:

The image is a “screen shot” from the original paper introducing Prospect Theory by Tversky and Kahneman.  

To sum up the first part, Prospect theory keeps the concept of utility and its characteristic (non-linearity for large amounts). It makes a difference between gains and losses; in the area of losses the utility function has a steeper slope illustrating loss aversion (losses loom larger than equivalent gains). What is perceived as a gain or a loss is dependent on a reference point.

A major implication of distinguishing between gains and losses is the existence of a differentiated attitude towards risk. There can be two attitudes towards risk, namely Risk Seeking and Risk Averse (avoiding).

Prospect theory has concluded that in the area of gains, people are “Risk averse”, namely that we would reject a risky option if a certain one would be available.

Let’s illustrate this with an example. Imagine that you have to choose from the following options:

Option A. 50% chance of winning 100 Euros and 50% of wining nothing.

Option B. 50 Euros for sure.

Which would you prefer? Most likely you prefer option B and it is normal to do so. The expected value of option A is 50 Euros but it involves a risk, whereas option B has the same expected value, but it has no risk.

Now consider the following options:

Option C. 50% chance of winning 100 Euros and 50% of wining nothing.

Option D. 45 Euros for sure.

Which would you prefer? Most likely you prefer option D. In this case, however, the expected value of the preferred option is smaller than the expected value of the rejected option (C). In other words you would trade 5 euros for having certainty (a sure gain).  

In the area of losses things are different. When it comes to losses people are risk seeking, namely they would take a risk of losing a larger amount than accepting a sure loss.

Let’s illustrate this with an example. Imagine that you have to choose from the following options:

Option E. 50% chance of losing 100 Euros and 50% of losing nothing.

Option F. A sure loss of 50 Euros.

Which would you prefer? Most likely you prefer option E. In this case you would take a 50-50 risk of losing 100 Euros instead of accepting a sure loss of 50 Euros. From the point of view of expected value you should be indifferent between the two options.

Now consider the following options:

Option G. 50% chance of losing 100 Euros and 50% of losing nothing.

Option H. A sure loss of 45 Euros.

Which would you prefer? Most likely you prefer option G. In this case it is rational (from the point of view of expected value) to choose option H since its expected value is smaller than the expected value of option G. Still, the popular choice is option G, illustrating risk seeking in the area of losses.

To sum up attitudes towards risk, People are risk averse (avoiding) when it comes to gains and risk seeking when it comes to losses.

Second, prospect theory questions the way people judge probabilities. From a mathematical perspective probabilities are straight-forward. Probabilities are always between (including) 0 and 1 and they always add up to 1. People perceive probabilities in a different way than the mathematical view. Prospect theory introduces something called a weighting function for probabilities.

To make this a bit more clear, when judging on an uncertain event, even if we know the (real) probabilities we don’t actually take them into account to their “full value”. Instead we use the “probability weights” in making decisions.

Rephrasing this, there are objective probabilities (the real ones) and there are subjective probabilities (the weights we give to probabilities). The subjective probabilities are what we perceive the probability to be.

Having established that people do not perceive (use in judgment) probabilities as they are, the question is how do we perceive probabilities? The answer goes like this.

First, the “0” and “1” probabilities are perceived as they are. In other words certainty and impossibility are perceived as actual certainty and impossibility.

Second, small probabilities are either over-estimated, or ignored. The probability of a rare event that is salient in our mind will be overestimated. For example if you go for the first time by airplane, you will overestimate the probability of something going wrong. At the same time, probabilities of rare events that are not salient in our minds are simply ignored. For example if you take the subway every day to work, most likely you will not even consider the risk of dying in a subway accident.  

If you would like to learn more on this please check out “Certainty and Possibility Effects” 

Third, medium and large probabilities are underestimated. This means that we tend to perceive medium and large probabilities are smaller than they actually are. For example an objective (real) probability of 90% (or 0.9) is perceived (weighted) as a subjective probability of approximately 70% (or 0.7).

A graphic representation of the probability weighting function is presented in the next picture. This is in fact a screen-shot from the original paper introducing Prospect Theory byTversky and Kahneman. 

One issue is rather unclear in the graph above, namely up to what value are probabilities small and subsequently overestimated and from which value are probabilities medium and subsequently underestimated? Looking at the graph, one could say that the “critical value” is 10% (or 0.1).

In his book “Thinking Fast and Slow” Daniel Kahneman leaves this question open. However, in chapter 29 he presents a set of data that suggests that probabilities of 20% (or 0.2) are also overestimated.

In a paper published about 13 years later than the one introducing prospect theory, Tversky and Kahneman (1992) – click here for the paper  the authors refined their description of the probability weighting function and presented the following graph. 

From this graph we can deduce that the “critical value” is around 30% or 0.3.

The exact value of probability that marks the shift from over to under estimating probabilities can be important in some areas of activity such as insurance, while in many other areas is less relevant.

For your general knowledge, it is important to remember that small probabilities are overestimated while medium and large probabilities are underestimated. If, however, you are interested in more mathematical details on the probability weighting function, check out this article.  

To sum up on probabilities, probabilities of 0 and 1 are perceived as such; medium and large probabilities are underestimated; small probabilities are either overestimated or ignored. 

Before ending, I would like to give an advice... if you want to understand and work in behavioral economics, the following picture should be forever imprinted in your mind:

Source of the picture

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Infographic on the Four Dimensional Model of Human Behavior

I've decided to put the Four Dimensional Model of Human Behavior in an infographic. 

It's my first infographic, so don't be too harsh on judging the (graphics) quality.

easel.ly

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Obey! Obey! Obey! – Influences of Authority on Behavior

The second component of the Social influences dimension (of the 4D Behavioral Model) is the Influence of Authority or better said Submission to Authority.

In a previous post - Doing What Others Do – Social Influences of Peers I have stated that human society is by its very nature Hierarchical. Due to this nature of society, human behavior is influenced by others on two dimensions. The Horizontal dimension was discussed in the post mentioned above. In essence we are influenced by the behavior (or mere presence) of people just like us – peers.

In this post I will discuss the influence on behavior on the Vertical Dimension, namely how our behavior is influenced by others that we perceive as authorities (in other words higher in rank).

Even if we don’t like to accept, we are by our very nature obedient in front of authorities. The source of this obedience is, in my opinion, the outcome of both nature and nurture. I believe that our distant ancestors were selected by evolution to live in small social groups that were hierarchical. Life in social organized groups was more advantageous in fulfilling the two macro-goals of evolution – survival and successful reproduction. In my view there is a “hard wired” component of submission to authority.

At the same time, I believe that submission to authority has a nurture (learning) component. Children are taught to “listen to their parents”. They are exposed to various authority figures such as teachers, doctors etc. and are taught to do what they say.

Having clarified to some extent the source of obedience towards authority, I invite you to watch this short video. It is an (amateur, but very cute) experiment that illustrates submission to authority figures.

After watching the short video, I guess you got a general idea of the difference between behavior under the influence of a non-authoritarian figure and behavior under the influence of an authoritarian figure. The simple change from plain clothes to a uniform made a huge difference in the behavior of drivers.

Now, making people honk is quite meaningless. Apart from being somehow annoying, honking is a harmless gesture. Unfortunately our innate obedience to authority figures can lead to much more disturbing behavior.

The first and most known experimental study on obedience to authority is “the Milgram Study”.  Stanley Milgram ran his studies in the early 1960s when the memory of World War II was still fresh in the public mind. The intrigue that lead to conducting this research was the horrible crimes committed by the Nazi against Jews and The Gipsy. The popular view was that such horrors could be done only by very (mentally) sic people. Taking into account that the number of people that have committed the horrors was quite large, it seems unlikely that they were all severely mentally disturbed. Milgram wanted to see if normal, regular people would behave in a horrible manner. Most importantly, Milgram wanted to see under which circumstances regular people would commit such horrors.

In order to increase the validity of the results, Milgram decided to not use students as subjects (as it is customary). The participants in his studies were recruited through newspaper ads and in a nutshell they were “regular people”.

The study was disguised as a “memory and learning” study. There were two roles: the teacher and the learner. Now, the learner was not really a participant, but was a person who was part of the experimental team (confederate as scientists like to call these people). In other words, he was an actor hired to play a role.  

The real participants (the regular people) were all placed in the role of the teacher. Their task was relatively simple: they had to read (teach) to the learner some pairs of words and then check if the learner has actually learned. If the learner gave a wrong answer, then the teacher would have to inflict a punishment, which was an electric shock. The interesting thing was that the shocks were increasing in voltage.

The shocks were delivered through a “shock generator” with several buttons starting at 30 volts (normally people would not feel it) and increasing in increments of 15 volts up to 450 volts. The many switches were labeled with terms including "slight shock," "moderate shock" and "danger: severe shock." The final two switches were labeled simply with an ominous "XXX."

To better understand, your regular socket has 220 volts (in Europe) or 110 volts (in US and Russia). If someone would get 220 volts through his or her body there is a serious risk of death. Now, 450 volts would be more than enough to kill someone or at best to inflict very serious pain and burns.

The “trick” of the experiment was that the learner who was an actor would give wrong answers on purpose. No! He was not a masochist; that was the scenario of the experiment. Of course the learner was not really connected to the device that delivered the electric shocks. The teacher was completely unaware of this. In addition, the teacher and the learner were in separate adjacent rooms (cubicles).

In the same cubical with the teacher (the real participant) there was another actor who played the role of “The professor”. He was dressed in a white lab-coat and posed as a figure of authority.

The teacher was able to hear the learner through speakers. This allowed the teacher (real participant) to hear the screams of pain of the learner (fake screams of course). Whenever the teacher would hesitate to deliver an electric shock “the professor” would give rather vague instructions to continue such as "Please continue" and "The experiment requires that you continue".

The results of the experiment were at least disturbing. Approximately 65% of the participants went all the way and deliver all the shocks, including the (potentially) lethal ones.

To rephrase this, 65% of a relatively large group of regular normal people went on and deliver electric shocks to a stranger that not only would be very painful, but most likely kill him (her).

I repeat! 65% of a sample of normal people would kill a complete stranger!

There are many things to be learned from the Milgram Studies, but the most important one is that the presence of a figure of authority was crucial. Even if “the professor” was only an actor and he had only a regular “white lab coat”, he was perceived as a figure of authority and people did what he said – “Continue”! To make this a bit more clear. The white lab-coat was not a formal uniform of an authority structure (such as police, military etc.). The actor was presented as “the professor” but no credentials were shown. In fact he was just a regular guy playing a role.

The main conclusion of the Milgram studies is straight-forward: people would behave in a way that they can’t conceive under the presence of an authority figure.

For more information on the Milgram Studies you can watch the next video (a reenacting of the original experiment). 

Also you can check out these links:

A brief description of theMilgram Studies: 

More on obeying authority and manyvideo examples on the topic: 

Now, coming back to less dramatic and horrible, influences of authority, we encounter in daily life significantly more instances of the influence of authority figures.

One very simple example is “the specialist” that recommends something. There are countless commercials that feature a “specialist” who can be a doctor, dentist, carpenter, repair man etc. This authority figure recommends using or buying a certain product. To what extent these recommendations are honest is a different matter. What should be kept in mind is that commercials are written by copywriters.

Another example is the recommendations of books by public figures, usually other writers. Even the best books (at least the ones I have read) had some endorsements from other writers, including ones clearly inferior to the author of the book.

In the end I would like to address the topic of the intersection between peer and authority influences. Sometimes the borderline between peers and authority is a bit unclear. Let me give you an example.

Suppose you want to change jobs and the new potential employer asks for a recommendation from the current (previous) employer. The recommendation given by the current employer can be both peer and authority influence. If the new and old employers are more or less at the same level, then it is peer influence. If the old employer is at a superior level than the new one, then it is authority influence.

Should we question authority more often? Well, that’s for you to decide.

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Dark Examples of Social Conformity – The Broken Window Theory and Its Variations

The influences of peers on one’s behavior (social conformity) have been presented in the previous post  DoingWhat Others Do – Social Influences of Peers.  

In this post I will present (dark) illustrations of social conformity. The main illustration is the “Broken Window Theory” which is “a criminological theory of the norm-setting and signaling effect of urban disorder and vandalism on additional crime and anti-social behavior. … (and) was introduced in a 1982 article by social scientists James Q. Wilson and George L. Kelling.” (Wikipedia)

The broken window theory goes like this: If in a neighborhood a window from a building gets broken and it is not repaired quickly (maximum a couple of days), then another window will get broken. After that some graffiti and other acts of vandalism will occur in and around the building with the broken window. Not before long the entire street and subsequently the entire neighborhood will become a “heaven” of vandalism and crime. For more on the Broken windowtheory click here.  

Apparently this sounds a bit extreme, but it is not. Indeed it is hard to imagine that a good neighborhood will become a “heaven” of vandalism and crime just because a broken window was not fixed (on time). This is true to a certain degree. The broken window in itself is not the only cause of crime spreading, but it is one major factor.

Let’s take a look at this sequence of events from a narrative perspective. Imagine that there is a young man called Peter who lives in a decent neighborhood and one day he sees that at a building a window got broken. Probably he will pass by the building just noticing the broken window. Next day he passes by that building again and sees again the broken window. In his mind Peter says that “probably it was closed at the window repair shop”. The second day he passes by the building he notices again the unrepaired window and thinks “this building must have been abandoned and I never noticed. If someone would be living there they would have fixed the window”.

That evening Peter goes out with some of his neighborhood buddies and they have a couple of beers. They are discussing what would be “cool” to do next and Peter comes with the idea to see whether the building with the broken window is truly abandoned. They go there and see that the window is still broken. Their simple conclusion is that the building is abandoned. They jump the fence and try to enter the building, but the door is locked. One of them finds a stone and throws it at an (unbroken) window. Later they have a few cigarettes and drink a couple more beers. They throw the bottles against the door… of course after beer they need to pee and since the building is (supposed to be) abandoned they decide to urinate on it.

The next day, other people see that the building has two broken windows and a funny smell comes from it. They conclude that the owners of the building must be careless. At the same time a group of “graffiti artists” notices the building and decides to “improve its appearance”. They go that night and paint the allegedly abandoned building.

The next day, the building looks like a dump: broken windows, graffiti, and bad smell. Some homeless people passing by notice the building in a bad shape and decide to check it out if it would be suitable to “move in”. They do so in the next night.

The following day, the building looks even worse and the unpleasant smell is more than noticeable. Some people from the neighborhood start making plans to move out since they are not excited by the thought of living near such a site.

The following night the group of “graffiti artists” returns to contemplate their work and is impressed by their accomplishment. Since they believe such a masterpiece should not be “left alone” they decide to create a companion for it on the building next to it.

To make a long story short, it will not be long before the neighborhood will suffer a decrease in living standards and an increase in crime levels.

Social conformity is only one element present in the broken window theory, but it is an important one. Let’s take a look at the “story” from a psychological perspective.

Seeing a broken window that is not fixed gives an impression that no one cares about that building. At the same time it says that it is socially acceptable to brake windows and don’t care too much about the surroundings. If the norm is “it’s ok to break windows” sooner or later someone will simply conform to that rule and break another window. 

Since a new window has been broken it means that the social norm of “braking windows / not caring too much is OK” is strengthened. Now, since there are two broken windows, it is really socially acceptable to “vandalize” the building.

The broken window theory is a very good example of escalation in social conformity. If we perceive that something is socially acceptable then we are more likely to do that “something”. This only leads to the strengthening of the perception that that “something” is socially acceptable and will lead to more acts of that “something”.

The broken window theory is a bit “farfetched” and I agree that it is a bit hard to fully accept it. In day-to-day life there are, however, less extreme illustrations of escalation of social norms. Here is one of them.

Imagine that you are visiting a city and on one of your walks you had a cigarette or a chewing gum (you choose). After finishing enjoying it, you have to get rid of the remaining of the cigarette or chewing gum. Unfortunately there are very few garbage cans in that city and it is hard for you to find one within a convenient distance.

You have two options: (1) take the gum / cigarette bud and put it in your pocket and keep searching until you find a garbage can; (2) simply let the bud or the gum slip out of your hand on the street.

Of course the socially desirable answer is to place it in your pocket and wait until you find one of the very few garbage cans in that city. But even if we are not that happy (and willing) to admit it, we don’t always do the “right thing”.

Now imagine that there are two scenarios.

First, the city is very clean, there is virtually no garbage on the streets and everything looks like it was recently polished.

Second, the city is not necessarily filthy, but it is not uncommon to see some pieces of paper or plastic on the streets. On the pavement there are several old chewing gums and cigarette buds.

The question is: in which scenario are you more likely to “let it fall out of your hand”?

I assume that a large majority will agree (admit) that in the second scenario it is more likely to “let it slip”. The reason is that you are not the only / first one to do so.   If others do it, then it must be OK (socially acceptable) to do it.

Similar examples can be developed and I assume that you got the main idea. If other people do something then we imply that that “something” is socially acceptable and we do it also.

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Doing What Others Do – Social Influences of Peers

One of the components of the fourdimensional behavioral model proposed is “social influences”. Now, social influences can be divided in two categories: (1) peer influences and (2) authority influences.

In order to get a better understanding of the differences between the two types of social influences we should go back a bit to the structure of human society. From its early forms, (pre)human society was hierarchical. Now, don’t think about the “classical pyramid” of hierarchical structures since our distant ancestors were not educated in MBA programs. The essence of hierarchy is that not every member of a society is perfectly equal to other members of the same society. Reasons for this are numerous and include age, physical strength, dominance, gender etc.

To make a long story short, let’s just say that hierarchical societies are more efficient at achieving the ancestral evolutionary macro-goals of survival and successful reproduction.

A hierarchical structure, by its nature has two dimensions: horizontal and vertical. On the vertical we have the actual hierarchy such as “Master – Servant”. On the horizontal we have relationships based on “equality” in status and competition for higher status.

The vertical dimension or the power of authority will be addressed in a later post. Now I would like to focus on the horizontal dimension. Apparently the horizontal dimension presents a paradox, namely that relationships are characterized by both equality of status, solidarity and competition for higher status. To better understand how these things work, let’s make a leap of imagination and picture ourselves as “proletarians” in a large scale factory.

We are proletarians, you, me, and all the others around us. We are somehow all equal in status because we all have to answer to the (oppressive) management. At the same time we exhibit solidarity in the sense that we are proud to be proletarians and we go on strikes together to fight for our rights. Moreover, we attend union meetings and have similar leisure (such a bourgeois term) activities such as frying burgers and drinking beer. However, not everything is smooth and nice in our proletarian world. Some of us want to show that they are better skilled than others and compete for the “employee of the month award”; others want to exhibit their leadership skills and run for chairman of the labor union; while others simply want to be the most popular in the group. All these inner wishes lead to competition for status.

Despite being in competitive relationships, we have a need to belong to a group, which in the aforementioned example is the “Proletariat”. In an earlier post I have explained why we needto belong to a group. 

In order to belong to a group we (have to) conform to the group’s social norms. These norms can be formal or informal and just as a hint, informal norms are usually more powerful than formal ones.

Conformity to group (informal) norms was demonstrated by psychologist Solomon Asch in the 1950 in a series of experiments which have been informally named Asch’s lines experiment.

To briefly describe the experiment take a look at the next picture. The question asked in the experiment was a trivial one: “With which of the right hand lines is equal to the left hand line?” Unless you are blind or have a serious seeing problem (and not wear your glasses) the answer is clear as daylight.  

Your answer is “A” and correctly so. But there is a bit more to this experiment than just testing one’s visual ability.

Imagine that you are in a room with another five people who are as far as you know just like you (peers). Every person gives the answer out-loud and you are the last to respond and your peers’ answers are as follows:

Person 1 Answers: “B”;

Person 2 Answers: “B”;

Person 3 Answers: “B”;

Person 4 Answers: “B”;

Person 5 Answers: “B”;

Now, it is time to give your answer. What will it be “A” or “B”? Now, with you in front of the screen you might say that for sure you will say “A” (which by the way is correct, while “B” is not), but when in a room with five other people just like you all saying “B” there is a good chance that you will conform and give the erroneous answer “B”.

There are numerous versions of this experiment and what they have shown is that about 75% of people conform at least once and give the wrong answer that the other participants were instructed to give. There are some nuances to the conclusions of the experiment. First, people conform only when the answers are spoken out-loud; when asked to write down the answer virtually no one gives the wrong (group) answer. Second, if at least one person out of the previous five gives the correct answer, then the last participant (who is the only real participant) will not conform to the group’s norm.

One particular criticism of this experiment is that it is the product of social norms of the US society in the 1950s. The counterargument suggests that students (who were the participants in the experiment) in the 1950 were more likely to conform than students in the 1990s since there have been consistent changes in the society overall. My opinion is that this criticism has some value in the sense that in today’s society there is a larger variety of “norms” that we conform to. For example non-conformists that buy “apple” products do not conform to the “norm of majority”, but conform to the norms of a minority. At the same time, conformity to social norms still exists.

Another characteristic of the experiment is that the correct answer is obvious. I believe that the main strength of the results comes from this very feature. Everyone sees and knows the correct answer and still in some cases people give the wrong answer which is the social norm. In the real world, however, we encounter numerous situations in which the “correct answer” is not straight-forward.

In day to day life we have to handle many situations which are at least slightly ambiguous and going with the group can be a good rule of thumb. One example of such an ambiguous situation is the “bystander effect” described in Despite 30 People Witnessed a Crime No One Intervened… It’s Not DESPITE; It’s BECAUSE! (1) 

The bystander effect is an extreme example and (fortunately) we encounter less dramatic ambiguous situations in which we go with the group. Let’s see some simpler examples.

First, you might have noticed that on websites there is a “facebook” area where you see who “Likes” the page. The script behind is designed in such a way that you see in the list your “Facebook friends” who like the page… this is well designed since if you see that some of your “peers” (or at least people you know) “like” the page you will be more likely to “give a Like” to the page. The unconscious reasoning goes something like this: “If my friends like this, then there might be something interesting here for me too”.

Second, if you ever shopped on Amazon or searched a movie on imdb, then you might have noticed the area that says “People who bought this also bought…”. In this case, the only thing that you have in common with the group is that you and they have a common interest (bought something). Despite this very weak link, these recommendations have the desired effect, namely to at least look at another product (and sometimes buy it).

Third, in many advertisements there is a mention of “X thousands / millions satisfied customers”. This is another way to say that “The social norm is to buy our product” and it is aimed at making you conform to this norm.

Fourth, in both on-line and off-line commercials a certain product is mentioned as “Popular choice” which has the same meaning as the “X million satisfied customers”.

Fifth, especially in the on-line environment, but not exclusively, you can find “user ratings” which are another form of establishing a norm. The unconscious reasoning goes like this: “If other people say this is a 8.5 (on a scale from 1 to 10) product, then it must be reasonably good”. Moreover, some websites also say how many evaluations have been made. The more people say something is good or bad, the stronger the norm is.  

Up to now, I gave a lot of examples related to marketing, but conformity to social norms has by far many more applications.

One of my favorite examples of using conformity to social norms is in the public transport system in Rotterdam. Everyone checks in and out of the tram (bus) and thus not doing so (free-riding) is diminished by the social pressure. This is not the only factor that influences honest behavior, but it is one of them.

What we have to be aware of is that conformity to social norms has a very serious “Dark side”. We know that people conform to social norms (or in other words go with the group). What is essential is which norm people conform to. 

I come from a country which (still) has serious issues with corruption and at least part of this phenomenon is based on social norms. Of course the formal norm (law) is against corruption, but there still are informal norms which go for corruption and not against it. I will not expand this topic since it is not my purpose to make an analysis on corruption behavior. The key is that conformity to norms does not always mean that people conform to the “right” norm.

  

Before ending this post, I’d like to make one final mention on conformity. People conform to the norms of groups that they want to belong to. If we take a person and place her in a group that she dislikes, most likely she will not conform to the group’s norm. In fact it is very likely that the person will actually act in the opposite way than the norm suggests.

Here’s a video about the Asch’s Lines experiment

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How Do We Judge (absolute) Values... Everything Is Relative

Whether we like it or not, we live in a world full of numbers. In the XXI century we have to handle a huge quantity of information consisting of numbers. The easiest example is money, but by far it is not the only one. Quantity, volume, surface, annual income, costs, credit costs, interest rates and many more are present in each person’s life. However, humans are not designed to be particularly good with numbers.

During its evolution, human kind has developed exceptional verbal skills that come naturally. Think for example of a young child around 4 years of age. This small human can speak correctly and fluently in one or two languages (if raised bilingual) without even knowing that grammar and its rules exist. At the same time, this young human can’t compute mentally 75*32 – 398. In fact for most adults it is challenging to mentally compute the aforementioned mathematical sequence. Most of us need at least pen and paper to find the result.

Psychology and Behavioral Economics have found during the years very interesting effects on how people evaluate and perceive values and numbers. One very nice example is the “Pond effect”. In essence, the pond effect proves that what is big or what is small is in fact very relative.

Imagine a fish, let’s say a carp (or any kind of fish) measuring 50cm from head to tail. If we place this carp in an English garden pond it will seam huge and compared to the colorful decorative fish already existent in the pond it would look like a real monster. Now, let’s take the 50cm long carp and place it in the biggest lake on Earth which is the Caspian Sea. In this “pond” the carp seams small or at best below average.

The pond effect shows us that people don’t evaluate size of the carp as being 50cm per se, but rather as being a big or a small fish compared with its environment and fellow fish.

The “pond effect” has numerous consequences in our lives. I believe that the most important one is that we don’t realize in what kind of pond we are in. One might be the best student in school A but be a mediocre student in school B. Being the “biggest fish in a small pond” can give some sense of self-worth. At the same time the status of “the biggest fish in a small pond” lives little awareness of the need to improve and little room for growth. When moving to a bigger pond, the former “biggest fish in a small pond” will have a shock.

Another example comes from the area of prices and money. Let’s make a thought experiment:

Imagine yourself in the following situation: you want to buy a nice new suit and go shopping. After exploring the options in the city center shopping area, you decide to buy a suit that costs 300 Euros. Just before you take it in your hands to go to the cash register, an alien drops out of the sky and sits on your shoulder. The alien tells you that exactly the same suit is on sale at the mall right outside town (30 minutes drive) for 240 Euros. What do you do?

Most people think something like this: “Saving 60 Euros out of 300 just for a half an hour drive, sure! Let’s go there!”

Now, forget everything about the suit and money. Clear your head and let’s do another thought experiment. Imagine that you want to buy a car. You’ve saved some money and decided to get a new car since the old one turned 20 last February. You go to a dealer in the East of the City and look at all those gorgeous pieces of technology. Yes you can imagine yourself driving casually in one of them on a sunny Sunday afternoon and the trunk is big enough to fit in all your (significant other’s) shopping bags.

You go to the sales agent (or consultant as they like to call themselves) and ask how much is the car that you so much can imagine it to be yours. The “consultant” that this is your lucky day because this week there is a Limited Offer and you can buy the car for ONLY 18.990 Euros (yes… psychological price and a lot of bull sh*t sales talk). In that moment a flash appears in the sky and an alien comes and sits on your shoulder. The alien tells you that exactly the same car you want to buy is available at a dealer in the south of the town (30 minutes drive) for 18.930 Euros. What do you do?

Most people think something like this: “What?!? I’m spending over 18.000 euros here and you expect me to drive for half an hour just to get a 60 Euros discount? No way! It’s not worth the effort.”

OK. Now, let’s cool down and breathe. In the first scenario, the alien brought super good news. Our shopper was happy to drive for half an hour to the mall outside town to buy the suit and save 60 Euros. “Man, 60 euros is not spare change!”. In the second scenario the alien was just annoying and really spoiled the magic moment of purchasing a car. How could have the alien suggested that is in any way rational to drive for half an hour just to save 60 Euros???

Again, let’s switch on reasoning. In both scenarios the buyer would have saved 60 Euros at the price of driving for 30 minutes. But in one scenario he was happy to do so, while in the second he was annoyed even by hearing the suggestion. Is this guy stupid or what? After all 60 Euros are 60 Euros and they can buy exactly the same things in either situation.

The key is in the (undiscounted) price of the purchase. In the first case, the guy was buying a 300 euros suit and 60 Euros is a lot when compared to 300. It’s 20%. Who in their right mind would not go to the cheaper shop? In the second case, the guy was buying a car priced at 18.990 Euros. Now 60 euros compared to 18.990 is virtually nothing, or at best some spare change. It’s just 0.3%, who cares about that?

Both rationales tend to make sense, but at the same time, they seem flawed. They make sense if we acknowledge that humans aren’t good at processing absolute values, but are OK processing relative values. It’s hard to understand what 60 Euros mean in different contexts. In the “suit” context it means a nice “going out for pizza”, while in the “car” context it means “yeah… whatever”.

After the 60 Euros saving example we could conclude that people are very good at processing percentages. At the same time, there are two shortcomings of this conclusion. First, from an evolutionary perspective there is no benefit of being better at judging percentages and not absolute values. If we imagine our distant ancestors’ lives there is no evolutionary benefit in being good with percentages. In fact before even the appearance of the notion of percentage the human species had already evolved to what it is today.

Second, evidence from research based on prospect theory shows that people are in fact quite bad at judging probabilities which are generally expressed as percentages. Prospect theory tells us that small probabilities are overestimated and medium and large probabilities are underestimated. Moreover, most people don’t really distinguish between 0.001% and 0.0001%, despite the difference being 10 times.

Moreover, the same prospect theory states that people perceive outcomes as gains or losses relative to a reference point. I have discussed this in “Effects of Framing Outcomes” 

Up to this point we know that people are not so good at evaluating absolute values and are equally bad at judging percentages or relative values. This leaves us with a big and very important question of “how people evaluate values (numbers)”.

The answer to this question is “comparison based”. 

People are shaped to judge values in comparison with other features present either in the mind or simply observed. The observed references have been presented in the earlier examples – environment and other similar characteristics (prices).

To illustrate the mental references imagine yourself taking a trip to Norway and going for a coffee. In most of Europe a coffee costs between 1 and 2 euros. Now, Norway is a special country in many ways. Apart from not being in the EU and not using the Euro as a currency, Norway is THE MOST EXPENSIVE Country on the old continent. A coffee in Norway can cost between 10 and 20 Euros…

If you are not a Scandinavian (all Scandinavian countries are very expensive) and you go out for a coffee in Norway you will find the coffee obscenely expensive. This is because you compare the price of the coffee in Norway with the price of the coffee in other countries such as France (around 2 Euros per coffee, unless in Paris).

Now, I assume that Norwegians do not find the coffee in their country obscenely expensive, but rather they find the coffee in. let’s say, France very cheap.

I believe that we switch from mental to environmental references when the mental ones do not exist or are very blurry. For example, if you would go to a consumer electronics store, in the TV area you will see for sure a giant TV with an amazing surround sound system and a couch to sit on and experience the marvel of modern technology. Of course on that TV there is a movie with exceptional graphics that points out the resolution of the giant screen. If you take a look at the price tag(s) for the TV and sound system (the couch is not for sale) you will realize that for that money you could easily get a reasonable second-hand car.

The trick is that the electronics store does not necessarily want to sell the 5000 Euros TV + Sound system. They wouldn’t mind if someone bought it, but that is not the main purpose of having the eccentric TV in the store. The purpose of the absurd item is to make all the other TVs more attractive and reasonable.

Most people don’t have a very clear idea of how much a new modern TV should cost, nor do they know if they want a 21 or 25 inches diagonal screen. When in the shop, after seeing the giant screen, suddenly it is reasonable to buy the 30 inches screen because compared to the “garage door like” one the 30” is in fact a decent choice.

Similar things happen in other retail areas such as liquor stores. If you see a really fancy bottle of wine on the self with a price tag of 40 Euros (per bottle), it means that the shop does not want you to buy it, but rather to make the 15 Euros ones look like a great deal.

A very interesting and somehow unpleasant effect of judging values through comparisons is that in certain contexts money loses value. A good example for this is when buying something that it is inherently costly such as a house or a car. The “friendly” sales person (consultant as they like to be called) might say something like this: “Yes, it would be nice to change the floors and think that the expense is not that big. After all, what’s another 5000 Euros when you’re buying a nice apartment that costs 300.000 Euros. Plus, you could take a loan for this also.”

In reality 5000 Euros is a big sum of money, but compared with 300.000 seems like spare change.

To conclude, people judge values by comparing the value subject to judgment with either mental references or environmental references. This leads to different judgment outcomes in different contexts, especially because the environmental references can be manipulated.  

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New Year Resolutions and The “Planner-Doer” Fallacy

Glad to meet you again in the New Year 2013! Since most of you are in the first day(s) of work in this year, I will start with a “light” post on a typical thing related to the start of a New Year, namely Resolutions.

As a new year approaches or just begins many people make a “to do” list with things that they want to accomplish in the following year. These resolutions are a marvel of good wishes and best behavior. On a personal dimension the list includes items such as “losing weight”,  “dieting”, “exercising more”, “quitting smoking”, “call parents more often” and so on. On a professional dimension, things vary a bit, but overall they are in the same line of positive wishes. Common items on the professional list of New Year resolutions are: “getting a new job”, “getting a promotion”, “achieving the (unrealistic) target of sales”, “becoming employee of the month at least three times”, “starting a business”, “being a better leader” and so on.

After the new year party and subsequent hangover, things change a bit. What was so easy to do in the future is suddenly very difficult to do in the present. In more scientific terms this is called the “planner – doer fallacy”. In normal language it means that New Year resolutions are rarely fulfilled.

Let’s see what are the sources of this discrepancy between planning and actually doing. The first source is the human tendency to overestimate future resources. We tend to think that in the future we will have a lot more resources than we will actually have. We believe that in the “new year” we will have more time, more self-control, more money, more strength etc. than what we will actually have.

Our overestimation of future resources is rooted in inherent optimism and in wishful thinking. It is only natural to want to have a better year than the previous one and this leads to making daring or even unrealistic plans. However, usually things do not change that much form one year to another and the same things that kept you from doing what is on the resolutions list will still influence your behavior… and this is how we go to the second source of the “planner doer fallacy”, namely ignoring factors. In scientific terms this is called “focalism”; in normal language it means that we see the future acts out of context.

Let’s take the “exercise more” resolution as an example and imagine a young lady called Dana. Dana wants to lose some weight and she is aware that she could use some “shaping up”, thus she makes a resolution to exercise more in the new year. A few days before new year’s eve she sets a target of going to the gym three times a week, every week for the next year. This is very ambitious and honestly it is very likely that she will not get to do this for more than one month. The first source of fallacy in her plan is the overestimation of resources. She thinks on December 28 that magically next year she will have more time and more will-power to go to the gym three times a week. The second source of fallacy in her plan is “focalism” or ignoring the myriad of factors that will influence her behavior in the future (new year). On December 28 she does not see the colleagues who say “let’s go for a drink after work” exactly on one of her “gym days”. She does not see the subway that will be late and super crowded at the end of a horrible day that by miracle coincides with another “gym day” and thus she will not even think about the feeling of “just wanting to get home, take a shower and be lazy on the couch”.

The examples could go on, but I guess you get the idea. We overestimate the resources available in the future and we ignore the (small) factors that have a super big influence on our behavior.

Now, there’s a legitimate question of “should or should we not make new year resolutions?”. The answer is a bit more complex, but in a nut-shell it goes something like this: Make New Year resolutions, but no more than 2-3. For each think how you are going to accomplish it and do not create a “blank area” which includes a miracle… these things do not exist. At the same time when making new year resolutions, take into account that what prevented you to do what you wanted to do in the past will still act in the future unless you make radical contextual changes. In other words, if you want to go to the gym more often, than you should be aware that whatever kept you from going to the gym in the previous year will still prevent you to go in the next year. This might change if you do some major changes such as taking a job at a gym…

Good luck in 2013 (and 2014 - later edit) and remember that It is easy (and pleasant) to make plans for the future, but we have to live ONLY in the PRESENT.

Learn more on my book:
It Makes (No) Sense: Between the Joy of Gaining and the Fear of Losing

 

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