Category Archives: Behavioural Economics

Supreme and Economics

SupremeStudents have long been talking about brands and none other than that of Supreme. Supreme was created in the 1980’s and was originally a brand which associated itself with the skateboard industry. There are currently 11 stores worldwide with three in the USA and six in Japan as well as store in Paris and London. In January this year Louis Vuitton held a fashion show featuring LV and Supreme as the two brands joined forces. Since then pop-up stores featuring the collaboration were opened on June 30, 2017 in Sydney, Seoul, Tokyo, Paris, London, Miami, and Los Angeles. It was the London pop-up that was recently the focus of an article in 1843 magazine of The Economist.

At 10am on Day One of the sale, a queue of about 600 people stretched down the Strand and along Surrey Street. Martin, Richard, Alex and Adita were all there. Running the queue for Louis Vuitton was security specialist Lex Showumni. “This is my first experience with Supreme. I was told it was going to be crazy, a lot of people pushing and shoving, but we haven’t experienced that so far.” The Supreme faithful have their own, slightly dubious, process of queue-management based on attendance and standing. It mostly works, but some people were unhappy: a trader had left the head of the queue to withdraw £12,000 from an ATM. He returned without the cash having lost his number 1 spot; eventually, after some animated discussion, he slipped back in near the front.

Each customer was admitted to the store for 15 minutes and allowed to buy six items. Successful trophy hunters included Ari Petrou, with a flipped T-shirt (around £400), that he was definitely keeping. Jeremy Wilson bagged a coveted red-logo baseball shirt (£730) that he planned to resell.

Within an hour, three main secondary exchanges had been set up outside the official store: one in the Pret A Manger, the other beneath a tree, and the third next to a municipal toilet. One dealer, who asked not to be named, explained that he had paid ten people a set fee to get early places in the queue and would give them a cut of the resale value of anything they could get their hands on. “It’s business!” he laughed. Wodges of cash were exchanged and stashed in newly acquired Louis Vuitton bags.

Invariably the hype that surrounds the pop-up store and the limited supply creates a situation where people get extremely anxious and are prepared to pay significant amounts of money for what could be classed as normal consumer goods.

There are certain economic concepts behind this.

Inelastic Demand – people who buy Supreme are are not price sensitive to purchasing items – a flipped T-shirt (around £400) seems quite excessive. A higher price has little impact on the quantity sold. In fact it maybe a Veblen Good – see below.

Limited supply – there is an artificially low supply of the product to maintain its uniqueness and ultimately it becomes very scarce. This creates excess demand which drives up the price

VeblenVeblen Goods – Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status. So-called Veblen goods (also as know as snob value goods) reverse the normal logic of economics in that the higher the price the more demand for the product – see graph.

 

A2 Revision – New Classical to Extreme Keynesian

The main competing views of macroeconomics (Keynesian vs Monetarist) is part of Unit 5 in the A2 syllabus and is a popular topic in the essay and multiple-choice papers. Begg covers this area very well in his textbook. In looking at different schools of thought it is important to remember the following:

Aggregate Demand – the demand for domestic output. The sum of consumer spending, investment spending, government purchases, and net exports
Demand Management – Using monetary and fiscal policy to try to stabilise aggregate demand near potential output.
Potential Output – The output firms wish to supply at full employment after all markets clear
Full Employment – The level of employment when all markets, particularly the labour market, are in equilibrium. All unemployment is then voluntary.
Supply-side policies – Policies to raise potential output. These include investment and work incentives, union reform and retraining grants to raise effective labour supply at any real wage; and some deregulation to stimulate effort and enterprise. Lower inflation is also a kind of supply-side policy if high inflation has real economic costs.
Hysteresis – The view that temporary shocks have permanent effects on long-run equilibrium.

There are 4 most prominent schools of macroeconomics thought today.

New Classical – assumes market clearing is almost instant and there is a close to continuous level of full employment. Also they believe in rational expectations which implies predetermined variables reflect the best guess at the time about their required equilibrium value. With the economy constantly near potential output demand management is pointless. Policy should pursue price stability and supply-side policies to raise potential output.

Gradualist Monetarists – believe that restoring potential output will not happen over night but only after a few years. A big rise in interest rates could induce a deep albeit temporary recession and should be avoided. Demand management is not appropriate if the economy is already recovering by the time a recession is diagnosed. The government should not fine-tune aggregate demand but concentrate on long-run policies to keep inflation down and promote supply-side policies to raise potential output.

Moderate Keynesians – believe full employment can take many years but will happen eventually. Although demand management cannot raise output without limit, active stabilisation policy is worth undertaking to prevent booms and slumps that could last several years and therefore are diagnosed relatively easily. In the long run, supply-side policies are still important, but eliminating big slumps is important if hysteresis has permanent effects on long-run equilibrium. New Keynesians provide microeconomics foundations for Keynesian macroeconomics. Menu costs may explain nominal rigidities in the labour market.

Extreme Keynesians – believe that departures from full employment can be long-lasting. Keynesian unemployment does not make real wage fall, and may not even reduce nominal wages and prices. The first responsibility of government is not supply-side policies to raise potential output that is not attained anyway, but restoration of the economy to potential output by expansionary fiscal and monetary policy, especially the former.

A2 Revision – Oligopoly and the kinked demand curve – download

With the A2 Essay paper next week I thought something on the kinked demand curve might be useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

Behavioural Economist Richard Thaler wins Nobel Prize in Economics.

Great news for Behavioural Economists with Richard Thaler winning the Nobel Prize for Economics in 2017. Below is an interview with Richard Thaler on the PBS NewsHour – Making Sense by Paul Solman to launch his then new book “Misbehaving”. Notice that the book is 30% off in the Chicago Booth Bookstore. As Thaler says people love deals and can be driven to purchase things that they don’t really want if the deal is good enough. He explains the concept of sunk costs, time and money already spent with some Cameroonian students. Also the way most people value their time.

Richard Thaler, also the co-author of the book  “Nudge” , has suggested that economics has always been about behaviour. Adam Smith’s first book “The Theory of Moral Sentiments” is in fact a Behavioural Economics treatise and within it Smith talks about its contribution to both psychology and ethics. Its purpose is to find a rationale for ethical judgement in human psychology. The latter is found in human nature: a human being put in a certain situation has a tendency to react in a certain way eg. includes sympathy, feelings and approval by others. It was Smith’s belief that human behaviour was impacted by emotions such as fear and anger and drives such as hunger. However according to Smith these emotions and drives were checked by an “impartial spectator”.

The impartial spectator allows one to see one’s own feelings and the pulls of immediate gratification from the perspective of an external observer.

In the domain of self-control and self-governance, the impartial spectator takes the structure of a long-term interest – “I won’t have that rich cream cake at morning tea because I can see that I will feel guilty about it later”. In the area of social interaction, the impartial spectator allows us to see things from another’s perspective rather than to be blinded by our own needs. The dissention is especially significant when you consider savings decisions – savings is a precision choice to delay immediate indulgence for a long-term interest. So we have the conflict between the voice of a short-term pull versus the voice of the impartial spectator.

Only recently has the field of economics advanced enough to have the tools to reincorporate the factors that Smith had always felt were important in human interaction: our caring about each other and about fairness, our difficulties with aligning our long-term interests with short-term pulls, etc. One of the most unexplored areas, which we are only now beginning to be able to measure, is the degree to which people are motivated by reputation and social status, something Smith thought was a crucial motivation for economic activity.

Nudge

The essence of behavioural economics stems from a concern that rational behaviour driven by self-interest will not guide many of us to health, wealth and happiness. People tend to make bad decisions whether it is not saving or eating the wrong type of food. This disturbing state of affairs arises because homo economicus tends to be in a continuous condition of information overload, and consumer makes errors because of their unfamiliarity about options and their effect. Richard Thaler and Cass Sunstein argue in ‘Nudge’ that subtle changes can influence peoples decision so that they can make choices that will improve their well-being. However, consumers use various methods in deciding their optimal consumption as the cost (time and effort) of acquiring all the information about the benefits of product/service might outweigh the benefits of consuming it.

Homo Economicus – the basis for a majority of economic models is the assumption that all human beings are rational and will always attempt to maximize their utility – whether it be from monetary or non-monetary gains

Lower income extroverts spend more on status enhancing goods

People who are ‘extraverted’ and on low incomes buy more luxury goods than their introverted peers to compensate for the experience of low financial status, finds new UCL research. In Psychological Science, Dr Landis and Dr Gladstone analyse a year of data from more than 700 British bank accounts in 2014. They sort purchases into categories, ranging from high-status (foreign air travel, electronic goods and so on) to low-status (money spent at salvage yards and discount stores). They then correlate the results with those from personality tests taken by the account-holders.

People living on a low income often feel low status in society and spend a higher percentage of their money on goods and services that are perceived to have a high status. Previous research has found that people who are sociable and outgoing care more about their social status than others. The new research shows that when extraverted people have a lower income, they spend proportionately more on status goods than introverts on the same income. At higher incomes, the difference in spending lessens as introverted people buy more luxury goods.

The study analysed thousands of transactions from 718 customers over 12 months. The results took into account other factors that could influence spending habits, such as age, sex, employment status and whether the customers had children. Cash spending was also taken into account.

low income conspicuous cons.pngEach person’s spending data were sorted into a number of spending categories from one (very low status) to five (very high status). High-status categories (i.e., those with average scores of four or five) included foreign air travel, golf, electronics and art institutions, whereas low-status categories (i.e., those with average scores of two or one) included pawnbrokers, salvage yards and discount stores.

The team found the interaction between income and extraversion in predicting spending on luxury goods is significant and emphasize that while this useful in understanding the relationship, further research is needed to see whether the relationship is causal and whether the results are representative of the UK population as a whole.

The study found, though, that the gap widened with poverty.

  • Extroverts with an annual income of £10,850 the 25th percentile of British individual incomes in 2014, spent approximately 65% more on high-status goods than similarly remunerated introverts did.
  • Extroverts with an annual income of £28,470 the 75th percentile, they spent only 14% more. This suggests how keenly extroverts feel about keeping up appearances.

Sources:

  • The Economist “Poor extroverts spend proportionately more on buying status” 26th August 2017
  • UCL – Personality drives purchasing of luxury goods – 23rd August 2017

Retail stores now target consumer body language.

Keeping on the behavioral economics topic I was interested to read about shoppers emotions being used by retailers to try an increase sales. Companies now pay large sums of money for software that identifies the following:

  • shoppers’ movements
  • facial expression
  • dissatisfaction
  • surprise
  • eye-tracking
  • dilating pupils
  • thermal-imaging

Body language.pngSome research has shown that when a person who is smiling enters a shop they are on average likely to spend 30% more than others who are more neutral position in their emotion. Conventional research states that when people are interviewed or fill in surveys they tend to edit their responses to make them sound like a ‘rational person’. However a lot of purchases are driven by the subconscious emotions. There are various companies out there today that are trying to get in the mind of consumers namely:

We have all heard of retail therapy which involves people going on a spending spree when they tend to be feeling down. The challenge for all the companies out there is to spot when a person is in this state when they enter their shop. The key to it is tracking the unconscious mind in shoppers.

Try this exercise with your class and see how many stages they can get through. If we make persistent errors in things we are very good at like colours how likely is it that we are also subject to persistent, predictable errors in areas of consumer decision-making?

More loss aversion in male tennis players when behind.

A paper entitiled ‘Is Roger Federer more loss averse than Serena Williams?’published by By Nejat Anbarci, K. Peren Arin, Cagla Okten and Christina Zenker on tennis serving and loss aversion caught my attention. The paper found that:

Roger_Federer.jpg
1 a server will put more effort into his/her serve speed when behind in score than when ahead in score,
2 players’ effort levels and thus serve speeds get less sensitive to losses or gains
when score difference gets too large,
3 A female player, on the other hand, does not change her serve speed and thus her effort when behind compared to when the score is tied, while she serves slower when ahead than when the score is tied.
4. Overall servers will be more risk averse in the domain of gains than in the domain of losses.
Researchers used serve speed at different points of matches in the high-stakes, professional Dubai Tennis Tournament to test their theoretical predictions and whether overall players exhibited the fundamental bias of loss aversion.

 

Loss Aversion and the  Endowment Effect

Loss aversion can be explained by prospect theory, which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude. This is illustrated below.

Prospect theory

The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained. Golf provides a perfect example of a reference point: par. Every hole on a golf course has a number of strokes associated with it; the par provides the baseline for good – but not outstanding – performance. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Economists have compared two situations a player might face when hear the hole:

  • putt to avoid a bogey
  • putt to achieve a birdie

One group of economists analysed more than 2.5 million putts in exquisite detail to test that prediction and found that whether the putt was easy or hard, at every distance from the hole, the players were more successful when putting for par than for a birdie. The difference in their rate of success when going for par (to avoid a bogey) or for a birdie was 3.6%.

 

Rethinking Economics – Econocracy

You might have come across the book ‘Econocracy’ written by students from the University of Manchester which makes three big arguments about the relevance of economics courses at Universities.

First, economics is part of all aspects of our public life. Second, the economics profession sees the economy “as a distinct system that follows a particular, often mechanical logic” and believes this “can be managed using a scientific criteria”. It would not be recognised by Keynes or Marx or Adam Smith. Thirdly, the authors criticised what economics students are being assessed on – models or theories which were being memorised for exams.

The interview below on Newsnight (BBC2) has author and student Joe Earle and Professor Diane Coyle (follow her excellent blog The Enlightened Economist) discussing the state of the discipline at University and what they don’t teach to economics students. More information can be found on the website Rethinking Economics.

The value of beliefs in economic decision-making.

BE - Cognition.jpegThe economic environment is said to be determined by agents or economic decision-makers. Today, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy.These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. However the rise of behavioural economics has shown that cognitive errors are now assumptions in many aspects of economics namely – heuristics, confirmation bias, overconfidence and distorted probability weights.

According to a paper entitled “Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol research has shown that beliefs often fulfill important psychological and functional needs of the individual. Examples include:

  • confidence in ones’ abilities,
  • moral self-esteem,
  • hope and anxiety reduction,
  • social identity,
  • political ideology
  • religious faith.

Therefore people hold beliefs because of the value they attach to them, as a result of the tradeoff between accuracy and desirability. As a consequence of this some of the beliefs do not consider prior knowledge of conditions or events that might be related to their beliefs – Bayseian Updating – this refers to people who are willing and able to modify their beliefs based on new, objective information. This non-Bayesian behaviour includes ignoring signals about their beliefs and denying what in turn will be the reality. Nevertheless motivated beliefs will respond to costs, benefits, and stakes involved in maintaining different self-views and world-views which leads to self-sustaining “social cognitions.”

Overconfidence
Bénabou and Tirol suggest that overconfidence is the most common indicator of the motivated beliefs experience. Overconfidence can be seen as quite damaging although moderate confidence can be quite useful as it often enhances an individuals ability to act successfully on their own behalf and work well with others. Research has shown that psychologically “healthy” people display some degree of overoptimism and biased updating, while it is primarily depressed subjects who seem to be more objective.

If beliefs are shared between parties they may magnify each other and there is a tendency to follow the herd, especially if information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets. Case and Shiller (2003) surveyed the expectations of homeowners during the real-estate bubbles of 1988 and 2003. In both cases, 90 percent of respondents thought housing prices in their city would “increase over the next several years,” with an average expected gain for their own property of 9 to 15 percent per year over the next ten years.

The strategies of self-deception and dissonance-reduction used to protect valued beliefs are many and varied, Bénabou and Tirol group them into three main types: strategic ignorance, reality denial, and self-signaling.

Strategic ignorance is when a believer avoids information offering conflicting evidence.

Reality denial refers to troubling evidence that is rationalised away: house-price bulls might conjure up fanciful theories for why prices should behave unusually, and supporters of a disgraced politician might invent conspiracies or blame fake news.

Self-signaling is when the believer creates his own tools to interpret the facts in the way he wants: an unhealthy person, for example, might decide that going for a daily run proves he is well.

Final thought

People derive utility from a sense of belonging to communities and having a positive self-image. Optimistic beliefs can also be valuable motivators to overcome self-control problems, as well as helpful in strategic interactions. In order to maintain this level of utility people tend to disregard Bayesian updating and are not willing to modify their beliefs based on new, objective information. Even if they did consider new information they will manipulate it to align with what their beliefs are.

Overconfidence is the most common indicator of the motivated beliefs experience and this can be impacted by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.

Sources:

“To err is human; so is the failure to admit it” – The Economist June 10th 2017

“Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol. Journal of Economic Perspectives—Volume 30, Number 3—Summer 2016—Pages 141–16

1980's hyperinflation in Bolivia

When you think of hyperinflation countries like post-war Germany and Zimbabwe come to mind. However Bolivia in the 1980’s seems to have been a forgotten example. Below is a very good video about the hyperinflation in Bolivia from the PBS Commanding Heights series. I use it teaching the impact of hyperinflation on an economy and policies that to try and control its impact. Some of the main issues from the video are:

  • Inflation reached 23,500%
  • 7 out of 10 Bolivians live in poverty – the poor get hurt by inflation
  • Inflation averaged 1% every 10 minutes
  • One of the causes of the inflation was government finances – they just printed money and didn’t collect taxes
  • How do you stop a hyperinflation or an inflation? Gradualist steps don’t work and as Jeff Sachs said: “All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”
  • Bolivia didn’t use highly sophisticated economic theory to deal with hyperinflation: Government spending was slashed – Price controls were scrapped – Import tariffs were cut – Government budgets were balanced. 

Inflationary Expectations

A lot of the inflationary problems in Bolivia were caused by inflationary expectations which accelerates the problem. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.