Behavioral Economics
Lecture ONE
These lecture notes are written by Dr Munish Alagh for a course on Behavioral Economics for AMSOM Semester VI
We start our study of Behavioral Economics with the concept of the Black Swan. What exactly is this concept? Well, it is a concept which underlies the limitation in our knowledge, and its fragility. It also illuminates the severe limitations of our learning from observation, or experience.
For a long period of time people were convinced that all swans were white, this belief was an unassailable belief as it seemed completely confirmed by empirical evidence.
Then, the first black swan was seen.
The sighting of the first black swan contradicts a general statement derived from a millennia of confirmatory sightings of White Swans.
The Black Swan is an event with the following three attributes:
First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, inspite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable (retrospectively though not prospectively.).
The small number of Black Swans started explaining everything in our world, as after the industrial revolution, the world started getting more complicated, while ordinary events, the ones we study and discuss and try to predict from reading the newspaper have become increasingly inconsequential.
Just imagine yourself to be somewhere in the early 80’s before the IT-revolution, think of how little your understanding of the world on the eve of the IT-revolution would help you guess what would happen next.
There is a combination of factors in the Black Swan: of low predictability and large impact. Infact there is predictability but retrospective not predictive predictability. This means that this combination makes the Black Swan a great puzzle. But, the real point is that we tend to act as if it does not exist! Not just me, you and your cousin Chetan, but almost all ‘social-scientists’ who, for over a century, have operated under the false belief that their tools could measure uncertainty.
Go ask your portfolio manager for his definition of ‘risk’, and odds are that he will supply you with a measure that excludes the possibility of a Black Swan-hence one that has no better predictive value for assessing the total risks than astrology. This problem is endemic in social matters.
The central idea here concerns our blindness with respect to randomness, particularly the large deviations:Why do we, scientists or non-scientists, hotshots or regular Chetan’s tend to see the paises instead of the Rupees? Why do we keep focusing on the minutae, not the possible significant large events, in spite of the obvious evidence of their huge influence?(Reading the paper decreases our knowledge of the world
).It is easy to see that life is a cumulative effect of a series of shocks. How often do things go according to plan? How often did sudden episodes of shocks come in the middle? Think of your own life, how often do things happen on schedule, even if you try to program life how often does it turn out that way? Look at your life both as a citizen of the world and as an ordinary person, In your life as a citizen of the world consider the technological inventions, the great events that have happened since your birth. In your personal life consider the road you have taken, your choice of school, college, university, place to stay? How often have things gone according to plan?
).It is easy to see that life is a cumulative effect of a series of shocks. How often do things go according to plan? How often did sudden episodes of shocks come in the middle? Think of your own life, how often do things happen on schedule, even if you try to program life how often does it turn out that way? Look at your life both as a citizen of the world and as an ordinary person, In your life as a citizen of the world consider the technological inventions, the great events that have happened since your birth. In your personal life consider the road you have taken, your choice of school, college, university, place to stay? How often have things gone according to plan?
What you do not know.
Black Swan logic makes what you don’t know far more relevant than what you do know. Consider that many Black swans can be caused and eacerbated by their being unexpected.
Think of the terrorist attack on September 11, 2001:had the risk been reasonably conceivable on September 10, it would not have happened. Fighter planes would have circled the sky above the twin towers, airplanes would have locked bullet proof doors, and the attack would not have taken place period. Something else might have taken place.What? One does not know.
Is’nt it strange to see an event happening precisely because it was not supposed to happen? What kind of defense do we have against that? Whatever you come to know(that NY is an easy terrorist target, for instance)may become inconsequential if your enemy knows that you know it.It may be odd that, in suchj a strategic game, what you know, can be truly inconsequential.
This extends to all businesses. Think of the ‘secret recipe’ to making a killing in the restaurant industry. If it were known and obvious, then someone next door would have already come up with the idea and it would have become generic. The next killing in the restaurant industry needs to be an idea that is not easily conceived of by the current population of restaurateurs. It has to be some distance from expectations. The more unexpected the success of such a venture, the smaller number of competitors, and the more successful the entrepreneur who implements such an idea. The same applies to the shoe and book business or any kind of entrepreneurship. The same applies to scientific theories-nobody is interested in listening to trivialities. The payoff of a human venture is, in general, inversely proportional to what it is expected to be.
Consider the Indian Ocean Tsunami of December 2004. Had it been expected, it would have not caused the damage it did-the areas affected would have been less populated, an early warning system would have been put in place. What you know cannot really hurt you.
Experts and empty suits
The inability to predict outliers implies the inability to predict the course of history, given the share of these events in the dynamics of events.
But we act as though we are able to predict historical events, or even worse, as if we are able to change the course of history. We produce thirty year projections of fiscal deficits and oil prices without realizing that we cannot even predict these for next summer-our cumulative prediction errors for political and economic events are so monstrous that when we look at them we are shocked. What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it. This is all the more worrisome when we engage in deadly conflicts: wars are fundamentally unpredictable (and we do not know it.)
Owing to this misunderstanding of the causal chains between policy and action, we can easily trigger Black Swans thanks to aggressive ignorance-like a child playing with a Chemistry kit.
Our inabilitry to predict in environments subjected to the Black Swan, coupled with a general lack of awareness of thi state of affairs, means that certain professionals, while believing they are experts, are in fact not. Based on their empirical record, they do not know more about the subject matter than the general population, but they are much better at narrating or, worse at smoking you with complicated mathematical models. They are also more likely to wear a tie.
Black Swans being unpredictable, we need to adjust to their existence
(rather than naively try to predict them). There are so many things we can do if we focus on anti knowledge or what we do not know.
(rather than naively try to predict them). There are so many things we can do if we focus on anti knowledge or what we do not know.
Indeed in some domains-such as scientific discovery and venture capital investments-there is a disproportionate payoff from the unknown, since you typically have little to lose and plenty to gain from a rare event.We will see that, contrary to social science wisdom, almost no discovery, no technologies of note came from design and planning-they were just Black Swans. The strategy for the discoverers and entrepreneurs is to rely less on top down planning and focus on maximum tinkering and recognizing opportunities when they present themselves. So the author disagrees with the followers of Marx and those of Adam Smith:the reasons free markets work is because they allow people to be lucky, thanks to aggressive trial and error, not by giving rewards or ‘incentives’ for skill.
Learning to learn
Another related human impediment comes from excessive focus on what we do not know: we tend to learn the precise, not the general.
What did people learn from the 9/11 episode? Did they learn that some events, owing to their dynamics, stand largely outside the realm of the predictable? No. Did they learn the built in defect of conventional wisdom? No. What did they figure out? They learned precise rules for avoiding Islamic prototerrorists and tall buildings. Similar was the case from the earthquake in 2001. People learn that they must avoid tall buildings and worse that the radio announces earthquakes in advance particularly BBC.
Many keep reminding that it is important for us to be practical and take tangible steps rather than to theorise about knowledge. The story of the Maginot line shows how we are conditioned to be specific. The French, after the Great War, built a wall along the previous German invasion route to prevent reinvasion. Hitler just
(almost effortlessly went around it. The French had been excellent students of history; they just learned with too much precision. They were too practical and exceedingly focused for their safety.
(almost effortlessly went around it. The French had been excellent students of history; they just learned with too much precision. They were too practical and exceedingly focused for their safety.
We don’t spontaneously learn that we don’t learn that we don’t learn. The problem lies in the structure of our minds: we don’t learn rules, just facts and only facts.
Our minds do not seem made to think and introspect; we use our brain on topics too peripheral to matter, we do much less thinking than we believe we do-except of course, when we think about it.
We remember the martyrs who died for a cause that we knew about, never those no less effective in their contribution but whose cause we were never aware of-precisely because they were successful.
Who gets rewarded, the central banker who avoids a recession or the one who comes to “correct” his predecessor’s faults and happens to be there during some economic recovery? Who is more valuable, the politician who avoids a war or the one who starts a new one(and is lucky enough to win)?
It is the same logic reversal we saw earlier with the value of what we don’t know; everybody knows that you need more prevention than treatment, but few reward acts of prevention.
Life is very unusual
Consider that in order to understand a phenomenon, one needs to first consider the extremes-particularly if, like the Black Swan, they carry an extraordinary cumulative effect.
Plato
What the author calls Platonicity, is our tendency to mistake the map for the territory, to focus on pure and well-defined “forms,”whether objects, like triangles, or social notions, like utopias(societies built according to some blueprint of what “ makes sense”), even nationalities.When these ideas and crisp constructs inhabit our minds, we privilege them over other less elegant objects, those with messier and less tractable structures.
Platonicity is what makes us think that we understand more than we actually do.But this does not happen everywhere.I am not saying that Platonic forms don’t exist.Models and constructions, these intellectual maps of reality, are not always wrong; they are wrong only in some specific applications.
The Bottom line
The beast in this book is not just the bell curve and the self-deceiving statistician, nor the Platonified scholar who needs theories to fool himself with.It is the drive to ‘focus’ on what makes sense to us. Living on our planet, today requires a lot more imagination than we are made to have. We lack imagination and repress it in others.
To summarise: the author sticks his neck out and makes a claim, against many of our habits of thought, that our world is dominated by the extreme and the unknown, and the very improbable(improbable according to our current knowledge)-and all the while we spend our time engaged in small talk, focusing on the known, and the repeated.This implies the need to use the extreme event as a starting point and not treat it as an exception to be pushed under the rug.He also makes the bolder(and more annoying) claim that inspite of our progress and the growth in knowledge, or perhaps because of such progress and growth, the future will be increasingly less predictable, while both human nature and social “science” seems to conspire to hide the idea from us.
Scalable Professions-Some professions, such as dentists, consultants, or massage professionals, cannot be scaled: there is a cap on the number of patients or clients you can see in a given period of time.
Other professions allow you to add zeroes to your output(and your income), if you do well, at little or no extra effort.
If you are an idea person, you do not have to work hard, only thuink intensely.You do the same work whether you produce a hundred units or a thousand. But this is not so for a baker:he needs to bake every single piece of bread inb order to satisfy each additional customer.
A scalable profession is good only if you are successful; they are more competitive, produce monstrous inequalities, and are far more random, with huge disparities between efforts and rewards-a few can take a large share of the pie, leaving others out entirely at no fault of their own.
One category of profession is driven by the mediocre, the average, and the middle-of-the road.In it, the mediocre is collectively consequential.The other has either giants or dwarves-more precisely, a very small number of giants and a huge number of dwarves.
The advent of scalability
Consider the fate of an opera singer at the end of the nineteenth century, before sound recording was invented.Say he performs in a small and remote town in central Italy
Now consider that the first music recording ruined the remote performer.
Books are also replicable so u8njust for remote talent.
Cinema rewards success
Globalisation has led to scalability, America
In Mediocristan the particular instances will not affect the total-weight, calories.Wealth belongs to extremistan, a single value can affect.
In mediocristan a single event does not effect, in extremistan a single event can have an impact.Mediocristan is the tyranny of the routine, extremistan the tyranny of the singular.
Some near black swans are predictable.
INDUCTION
1)From specific instances to general conclusions 2) Future given knowledge of the past 3)Properties of the infinite unknown based on the finite known. 4)Same hand that feeds you can wring your neck.5)some thing has worked in the past till it no longer does.6)mistaking a naïve observation of the past as representative of the future.7)Titanic.
The Philosophical Problem of Induction-
Skepticism-In ordinary English, a skeptic is:
Someone who habitually doubts accepted beliefs.
A person who mistrusts other people or their ideas.
Someone who rejects traditional beliefs, such as religious beliefs.
Philosophical Skepticism
Philosophers attach a far more sweeping sense to the idea of skepticism. A philosophical skeptic is someone who claims to:
Doubt that any real knowledge or sound belief about anything is possible.
Skeptical doubt is not ordinary skepticism.Someone may doubt that we will ever find out why the dinosaurs became extinct-and yet admit that some new evidence, some new growth in theoretical understanding, would help clear up the mystery. Such a person is not a philosophical skeptic. A philosophical skeptic argues that nothing can remove the skeptical doubt.
David Hume appears to have been a philosophical skeptic about induction.
Hume seems to be skeptical about every inductive reasoning whatsoever. But don’t people reason inductively? Yes, Hume seems to say, but that is just a habit.
Inductive reasoning can lead us back into the past: why did the dinosaurs become extinct? Why did you not speak to me yesterday? It can lead us to the present, somewhere else: who is she talking to now? But most often when people think of induction, they think of inferring something about the future, from what we know at present.
People often argue that we can infer something about the future, from what we know at present, because we know that the future is like the past.
So, here is one picturesque way to start Hume’s problem:
How do you know that the future will be like the past?
CAUSE
One obvious answer to this question is that we know that present states of affairs cause some future events.
Hume is a philosophical skeptic about the very idea of cause.
His famous example of cause and effect involves two billiard balls:
Here is a billiard ball lying on the table, and another moving toward it with rapidity.They strike; and the ball which was formerly at rest now acquires a motion.This is as perfect an instance of the relation of cause and effect as any which we know by sensation or reflection.
It is evident that the two balls touched one another before the motion was communicated, and that there was no interval between the shock and the motion.
What do we have here? The two balls touched each other. Moreover,
The motion which was the cause is prior to the motion which was the effect. Priority in time is, therefore, another requisite circumstance in every cause. But that is not all. Let us try any other balls of the same kind in a like situation, and we shall always find that the impulse of one produces motion in the other.
Like causes always produce like effects. He calls this constant conjunction. But:
Beyond these three circumstances of contiguity, priority, and constant conjunction, I can discover nothing in the cause. The first ball is in motion, touches the second, immediately the second is in motion-and when I try the same experiment with same or like balls, i8n the same or like circumstances, I find that upon the motion and touch of one ball motion always follows in the other.
And that is all that Hume can find, in our experience, corresponding to the idea of cause and effect.
Experience
Hume then wonders whether we might have an innate sense of causation. He imagines “ a man such as Adam created in the full vigour of understanding,’ who has not yet had any experience. Adam would have had no idea what would happen when one billiard ball hit another. But as soon as he played with billiard balls, and acquired a sufficient number of instances of this kind, whenever he saw one ball, moving towards the other, he vwould always conclude without hesitation that the second would acquire motion. His understanding would anticipate his sight and form a conclusion suitable to his experience.
It follows, then, that all reasonings concerning cause and effect are founded on experience, and that all reasonings from experience are founded on the supposition that the course of nature will continue uniformly the same. We conclude that l8ike causes, in like circumstances, will always produce like effects.
Thus cause and effect cannot justify our belief that the future will be like the past, because the very notions of cause and effect are founded upon an assumption of uniformity. Yet cause and effect were offered as the basis for reasoning about the future! To repeat Hume:all reasonings concerning cause and effect are founded on experience, and all reasonings from experience are vfounded on the supposition that the course of nature will continue uniformly the same.
“The course of nature will continue uniformly the same” means, roughly, the future will be like the past.Where do we get the idea that the future will be like the past?
I will go further and assert that Adam could not so much as prove by any probable arguments that the future must be conformable to the past. All probable arguments are built on the supposition that there is this conformity between the future and the past…..
A Famous Circle
Could we justify our expectation, that the future will be like the past, from our previous experience? No that would be circular reasoning.
This conformity is a matter of fact, and if it must be proved it will admit of no proof expect from experience. But our experience in the past can be a proof of nothing for the future but upon a supposition that there is a resemblance between them.This, therefore, is a point which can admit of no proof at all, and which we take for granted without any proof.
Anyone who tries to argue that the future will be like the past, on the ground that past futures have been like past pasts, is arguing in a circle.
Custom
So why do we expect the future to be like vthe past? Because that’s how we are.We have some inductive habits.But we dcannot justify those habits.Reason cannot provide justificatuion.Reasoniong itself is based upon our habits and custioms.
We are determined by custom alone to suppose the future conformable to the past. When I see a billiard ball moving toward another, my mind is immediately carried to the usual effect, and anticipates my sight by conceiving the second ball in motion. There is nothing in these objects-abstractly considered-which leads to form any such conclusion: and even after I have had experience of many repeated effects of this kind, there is no argument which determines me to suppose that the effect will be conformable to past experience.
It is not, therefore, reason which is the guide of life but custom. That alone determines the mind in all instances to suppose the future conformable to the past. However easy this step may seem, reason would never, to all eternity, be able to make it.
Hume’s overall conclusion is that, as a matter of custom or habit ( perhaps even as a matter of a sort of psychological necessity or “hard-wiring”) we do make inductions.We do expect the future to be like the past. But there is no justification in reasoning for this. It is just what we do.
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