Showing posts with label behavioral economics. Show all posts
Showing posts with label behavioral economics. Show all posts
Wednesday, December 23, 2015
Friday, September 4, 2015
On the Reading Deck: Richard H. Thaler: Misbehaving, The Making ofBehavioral Economics
Richard H. Thaler is the Charles R. Walgreen Distinguished Service Professor of Economics and Behavioral Science at the University of Chicago's Graduate School of Business where he director of the Center for Decision Research. He is also a Research Associate at the National Bureau of Economic Research where he co-directs the behavioral economics project. Professor Thaler's research lies in the gap between psychology and economics. He is considered a pioneer in the fields of behavioral economics and finance. He is the author of numerous articles and the books Misbehaving: The Making of Behavioral Economics; Nudge: Improving Decisions about Health, Wealth and Happiness (with Cass Sunstein), The Winner's Curse, and Quasi Rational Economics and was the editor of the collections: Advances in Behavioral Finance, Volumes 1 and 2. He also wrote a series of articles in the Journal of Economics Perspectives called: "Anomalies." He is one of the rotating team of economists who write the Economic View column in the Sunday New York Times.
“A sly and somewhat subversive history of [the economics] profession…engrossing and highly relevant.” (Jonathan A. Knee - The New York Times)
“Highly enjoyable…dense with fascinating examples…. It is long past time to replace Econs with Humans, both in theory and in the practice of prediction.” (Carol Tavris - Wall Street Journal)
“In Misbehaving, Thaler offers a dryly humorous history of the revolution he helped ignite, as well as a useful (if sometimes challenging) primer on its key concepts.” (Julia M. Klein - Chicago Tribune)
“A masterful, readable account of behavioral economics. Very well done.” (David Wessel, Pulitzer Prize-winning journalist, author of Red Ink and Ben Bernanke’s War on the Great Panic)
“Misbehaving is bound to become a classic. Now established as one of the great figures in the history of economic thought, Thaler has no predecessors. A rebel with a cause…where he wins Olympic gold is in keen observation; his greatest insights come from actually looking.” (Cass Sunstein - New Rambler)
“Odd and interesting…. It's odd because it's funnier and more personal than books by professors tend to be. It's interesting because it tells the story not just of Thaler's career but also of the field of behavioral economics―the study of actual human beings rather than the rational optimizers of classical economic theory.” (Michael Lewis - Bloomberg View)
“A genial, often humorous account of the progress of behavioral economics by one of its most gifted practitioners. …Important stuff.” (Bryan Appleyard - The Sunday Times (UK))
“The creative genius who invented the field of behavioral economics is also a master storyteller and a very funny man. All these talents are on display in this wonderful book.” (Daniel Kahneman, winner of the Nobel Prize in Economics and author of Thinking, Fast and Slow)
“Misbehaving gives us the story behind some of the most important insights in modern economics. If I had to be trapped in an elevator with any contemporary intellectual, I’d pick Richard Thaler.” (Malcolm Gladwell)
“Richard Thaler has been at the center of the most important revolution to happen in economics in the last thirty years. In this captivating book, he lays out the evidence for behavioral economics and explains why there was so much resistance to it. Read Misbehaving. There is no better guide to this new and exciting economics.” (Robert J. Shiller, winner of the Nobel Prize in Economics and author of Finance and the Good Society)
“Highly enjoyable…dense with fascinating examples…. It is long past time to replace Econs with Humans, both in theory and in the practice of prediction.” (Carol Tavris - Wall Street Journal)
“In Misbehaving, Thaler offers a dryly humorous history of the revolution he helped ignite, as well as a useful (if sometimes challenging) primer on its key concepts.” (Julia M. Klein - Chicago Tribune)
“A masterful, readable account of behavioral economics. Very well done.” (David Wessel, Pulitzer Prize-winning journalist, author of Red Ink and Ben Bernanke’s War on the Great Panic)
“Misbehaving is bound to become a classic. Now established as one of the great figures in the history of economic thought, Thaler has no predecessors. A rebel with a cause…where he wins Olympic gold is in keen observation; his greatest insights come from actually looking.” (Cass Sunstein - New Rambler)
“Odd and interesting…. It's odd because it's funnier and more personal than books by professors tend to be. It's interesting because it tells the story not just of Thaler's career but also of the field of behavioral economics―the study of actual human beings rather than the rational optimizers of classical economic theory.” (Michael Lewis - Bloomberg View)
“A genial, often humorous account of the progress of behavioral economics by one of its most gifted practitioners. …Important stuff.” (Bryan Appleyard - The Sunday Times (UK))
“The creative genius who invented the field of behavioral economics is also a master storyteller and a very funny man. All these talents are on display in this wonderful book.” (Daniel Kahneman, winner of the Nobel Prize in Economics and author of Thinking, Fast and Slow)
“Misbehaving gives us the story behind some of the most important insights in modern economics. If I had to be trapped in an elevator with any contemporary intellectual, I’d pick Richard Thaler.” (Malcolm Gladwell)
“Richard Thaler has been at the center of the most important revolution to happen in economics in the last thirty years. In this captivating book, he lays out the evidence for behavioral economics and explains why there was so much resistance to it. Read Misbehaving. There is no better guide to this new and exciting economics.” (Robert J. Shiller, winner of the Nobel Prize in Economics and author of Finance and the Good Society)
Sunday, January 20, 2013
Psychology Today: Our Brain's Negative Bias
Why our brains are more highly attuned to negative news.
by Hara Estroff Marano, Psychology Today, 2003
Why do insults once hurled at us stick inside our skull, sometimes for decades? Why do some people have to work extra hard to ward off depression?
The answer is, for the same reason political smear campaigns outpull positive ones. Nastiness just makes a bigger impact on our brains.
And that is due to the brain's "negativity bias": Your brain is simply built with a greater sensitivity to unpleasant news. The bias is so automatic that it can be detected at the earliest stage of the brain's information processing.
Take, for example, the studies done by John Cacioppo, Ph.D., then at Ohio State University, now at the University of Chicago. He showed people pictures known to arouse positive feelings (say, a Ferrari, or a pizza), those certain to stir up negative feelings (a mutilated face or dead cat) and those known to produce neutral feelings (a plate, a hair dryer). Meanwhile, he recorded electrical activity in the brain's cerebral cortex that reflects the magnitude of information processing taking place.
The brain, Cacioppo demonstrated, reacts more strongly to stimuli it deems negative. There is a greater surge in electrical activity. Thus, our attitudes are more heavily influenced by downbeat news than good news.
Our capacity to weigh negative input so heavily most likely evolved for a good reason—to keep us out of harm's way. From the dawn of human history, our very survival depended on our skill at dodging danger. The brain developed systems that would make it unavoidable for us not to notice danger and thus, hopefully, respond to it.
All well and good. Having the built-in brain apparatus supersensitive to negativity means that the same bad-news bias also is at work in every sphere of our lives at all times.
So it should come as no surprise to learn that it plays an especially powerful role in our most intimate relationships. Numerous researchers have found that there is an ideal balance between negativity and positivity in the atmosphere between partners. There seems to be some kind of thermostat operating in healthy marriages that almost automatically regulates the balance between positive and negative.
What really separates contented couples from those in deep marital misery is a healthy balance between their positive and negative feelings and actions toward each other. Even couples who are volatile and argue a lot stick together by balancing their frequent arguments with a lot of demonstrations of love and passion. And they seem to know exactly when positive actions are needed.
Here's the tricky part. Because of the disproportionate weight of the negative, balance does not mean a 50-50 equilibrium. Researchers have carefully charted the amount of time couples spend fighting vs. interacting positively. And they have found that a very specific ratio exists between the amount of positivity and negativity required to make married life satisfying to both partners.
That magic ratio is five to one (note: some say three to one). As long as there was five times as much positive feeling and interaction between husband and wife as there was negative, researchers found, the marriage was likely to be stable over time. In contrast, those couples who were heading for divorce were doing far too little on the positive side to compensate for the growing negativity between them.
Other researchers have found the same results in other spheres of our life. It is the frequency of small positive acts that matters most, in a ratio of about five to one.
Occasional big positive experiences—say, a birthday bash—are nice. But they don't make the necessary impact on our brain to override the tilt to negativity. It takes frequent small positive experiences to tip the scales toward happiness.
Thursday, July 5, 2012
The Wisdom of Crowds Book Review
This July 4th was a glorious holiday. I finished three books, including The Wisdom of Crowds by James Surowiecki. Here's a book review.
Review by Aldo Matteucci
Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. John Maynard Keynes
If one asks a large enough number of people to guess the number of jelly beans in a jar, the averaged answer is likely to be very close to the correct number. True, occasionally someone may guess closer to the true number. But as you repeat the experiment, the same person never is better every time - the crowd is smarter than any individual. This finding is counterintuitive.
‘Collective wisdom’ is put to good use to tackle three kinds of problems, and complexity is no bar:
Cognition problems: such problems arise when we can only guess the answer – as e.g. about the contents of the jelly bean jar, or about the future. How do we get the guess right?
Coordination problems: how to we coordinate behaviour with each other – say in traffic – knowing that everyone else is trying to do the same?
Cooperation problems: how do we get self-interested, distrustful people to work together, even when narrow self-interest would seem to dictate that no individual should take part – as in politics?
Behavioural economists and sociologists have gone beyond the anecdotic and systematically studied the issues, and have come up with surprising answers.
Capturing the ‘collective’ wisdom best solves cognitive problems. Four conditions apply. There must be: (a) true diversity of opinions; (b) independence of opinion (so there is no correlation between them); (c) decentralisation of experience; (d) suitable mechanisms of aggregation.
Markets are the oldest and in many ways still the best mechanism aggregation. If the markets work ‘perfectly’ supply and demand match smoothly – Adam Smith’s ‘invisible hand’ has done its work better than any allocation agency ever could. Based on this insight, virtual ‘decision markets’ have been experimentally established [1]. They work beautifully, and in most instances they are superior to market research by experts.
Why are experts not that smart? Because experts tend to be and think alike, and thus do not reflect maximum diversity of opinions; they tend to be internally inconsistent and poor at calibrating their position – in short, they are overconfident. In a group they tend to decide by authority (group-think), which makes dissent within the group improbable – conformity and bias rather than challenge is the result. Finally, past performance is never a predictor of future success – they may have just been lucky [2].
Independence of judgement is essential, but difficult to achieve. Humans tend to herd – it’s much safer to follow a strategy that seems rational rather than one that is rational. A special case is the ‘information cascade’: often we tend to follow early adopters blindly rather than verify their judgement. Not all the ‘information cascades’ are bad: intelligent imitation is a kind of rational response to our own cognitive limits – particularly when time is short. Children instinctively imitate their parents or elders – whose survival is evidence that they have been doing the right thing [3]. The more important the decision - and the more there is time to think - the less likely a cascade is to take hold.
Decentralisation is the key to better diversity, independence and appropriateness of judgements. Aggregation of information, but even more of judgement is paradoxically important to the success of decentralisation. If the aggregation process creates biased filters, then the effect is lost. Markets here remain far superior impartial mechanisms.
Co-ordination problem is one where, in order to solve it, a person has to think not only about what he believes to be the right answer, but also about what other people think the right answer is. So the question is: How can people voluntarily make their actions fit together in an efficient and orderly manner?
When different strategies are devised, the diversity tends to yield an optimal result. It turns out that looking also to one’s own experience alone yields a collectively intelligent answer [4] – even in coordination problems independent thinking is valuable. Usually, expectations rapidly converge spontaneously around a ‘focal point’. It pays to drive on either of the two sides of the street – this is the focal point’ of the experience. Convention decides which side is chosen. Once established, convention creates and maintains order and stability.
Conventions need no coercion – they are quickly internalised, because it reduces the amount of cognitive work one has to do in order to get through the day. Culture establishes explicit norms. Eventually, as the group grows, external sanctions may be needed to secure rapid application and compliance – avoidance of the ‘free rider’ problem.
The free market system is a famous example of spontaneous solution of a most important coordination problem: getting resources to the right places at the right cost. This has been verified experimentally. The experiments have also shown that the way people behave in consumer markets and the ways they behave in asset markets differ – here the results are more volatile and erratic.
Today’s societies and organisations work only if people cooperate voluntarily, and not just as a reflex to fear or inducement; nor is it based only on narrow self-interest. In particular, modern societies do not co-operate according to ‘thick relationships’ – the family circle, or ethnic group – but do so regularly and immediately with strangers.
Such co-ordination and co-operation are based on an inner sense of fairness – which might even have genetic roots (capuchin monkeys exhibit this trait already). It is based on 'strong reciprocity' – the willingness to punish bad (or reward good) behaviour even when one gets no material benefits from doing so. This is 'pro-social behaviour', for by adopting it people transcend narrow self-interest and, while not being altruists, act in a way that the group benefits.
Part of the ‘sense of fairness’ may arise from 'the shadow of the future' – the risk that eventually one is at the receiving end of selfish behaviour. More likely, it is simply that a decentralised social system like capitalism and the accumulation of capital can function only on the basis of impersonal trust and transparency – which allows division of labour and specialisation. The sense of trust, to be sure, would not exist without the institutional and legal framework that underpins every modern capitalist economy. But they seldom need overt enforcement by the law – they are internalised by each actor.
Fairness, then, is the sense that the other has done so and is playing by them. Capitalism is healthiest when people believe that fair dealing outweigh the benefits of sharp dealing.
Reciprocity is usually conditional. Next to the ‘selfish’ there are ‘altruists’, but mostly we are ‘conditional consenters’. That is what laws and regulations are for – not so much to punish the selfish (they may cause little damage), but to keep the ‘conditional consenters’ on the right side of the law.
So much for the rules underlying the wisdom and the behaviour of crowds – as it knits paradoxes like Parkinson’s Laws into a coherent whole the foregoing analysis contains enough counterintuitive insights to appear convincing.
Surowiecki then moves on to deal with specific issues. The examples are useful as practice for internalising the theory.
A first one is science. Co-operation in science is the mainstay of a modern society: it allows for division of cognitive labour [5]. It fosters diversity of perspectives and specialisation – and increases in productivity. Knowledge is more than cumulative – profoundly it is collective, and there is no one in charge of directing [6]. It is a ‘gift’ rather than an exchange economy based on ‘peer recognition’. Offerings are made and are eventually accepted into the common fund of knowledge. The process relies on the ‘collective wisdom’ of scientists.
Several dangers lurk. Danger lurks when – instead of relying on objective and independent verification of the offering – science moves incorporation of truths on the basis of scientific hierarchy e.g. as a rational reaction to the issue of information glut. Judging by hierarchy is an avatar of the ‘information cascade’. A result is adopted as truth on the basis of the author’s reputation – which is extrapolation from his past performance.
The second is the breakdown of conventions about quality of the research. If shoddy research is tolerated, more do shoddy research will be carried out, particularly if the purpose of achieving status in the hierarchy.
The third are the current attempts at appropriation of the ‘scientific commons’ for commercial advantage. When hiding rather than sharing information seems the better (if selfish) short-term solution, the market collapses. It is unclear that the replacement – the sale and purchase of scientific information as a generalised system, is workable.
Committees and small groups can produce bad decisions because they easily succumb to ‘group-think’ Thus participants seek information that confirms underlying intuitions (also as a way to handle the information glut); influence each other’s opinions and suppressing cognitive diversity; or they defer to the opinion leader – who may simply be the one who talks the most.
Depolarisation – arriving to conclusions on objective grounds rather than personalities or authority – is better than leaving the matter even to the best and smartest member. In other words, the key is a good structure that allows for good aggregation of the opinion of the members. In simulations, ‘well ordered’ committees have been shown to come to the conclusions faster, and could do better than their smartest member.
Surowiecki's thoughts on the corporation are to complex for summarising here. The core challenge is the optimal aggregation of information and of collective wisdom – rather than relying on an individual, as gifted as he may appear to be. This applies particularly to the services corporation (education, health come to mind), whose large-scale structures are nevertheless expected to provide tailor-made solutions for the individual.
The author then goes on to explain financial bubbles and crashes. Determining the price of a stock is both a cognitive and a coordination problem. There is always a balance between our guess about the future performance of the firm and that about the attitude that other participants will take on the matter. Bubbles and crashes take place when this equilibrium shifts too much towards the co-ordination side of it – i.e. we worry more about the other participants than about the quality of the firm.
Interesting is the role the media are shown to play. Per se information is a good thing, for it fosters independent judgement. The competitive hyping of information, however, tends to trigger overreactions. If there is not enough time to digest information, we’ll act according to our intuition about what the others will do.
Finally, democracy, as a classic case of emerging wisdom of the crowd, can be shown to be superior to Platonist elitism. But democracy is not so much an instrument to solve cognitive problems – as many today would have us believe. It is not that crowds have superior knowledge. They have superior wisdom – democracy is an instrument to deal first and foremost with issues of coordination and cooperation.
Notes
[1] Examples are success of new products on the market like box office success of movies, or new technologies. But they also work well as predictors of electoral results.
[2] This called the delusion of randomness. Everyone expects to win the lottery. Whoever wins, however, has no superior predictive capacity. The best (and least understood) example is the emergence of mankind. If mankind is the ‘jackpot’ of evolution, it does not mean that someone manipulated in favour of mankind.
[3] There must be, however, willingness of at least some people to stop imitating when they think they know better. Army ants always ‘follow the individual just in front’. Army ants can get themselves in a circle and walk around until they die of exhaustion.
[4] Starlings act in accordance with the following rules: (1) stay as close to the middle of a flock as possible; (b) stay two to three body-lengths away from the neighbour; (3) do not bump into any other bird; (d) if a haws dives at you, get out of the way. These ‘self-referenced’ rules are enough to have the flock move purposefully.
[5] Patents are the equivalent of property titles. Patents are limited in time, however, and the scope of the title is far more difficult to describe.
[6] The whole of scientific enterprise belies the contention that incentives are needed to achieve progress. A modern example is Linus, an+-*- open software that is improved by volunteers. Not surprisingly, Linus is better than Microsoft.
 |
| This was another of my $1 buys -- well worth it. |
Review by Aldo Matteucci
Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. John Maynard Keynes
If one asks a large enough number of people to guess the number of jelly beans in a jar, the averaged answer is likely to be very close to the correct number. True, occasionally someone may guess closer to the true number. But as you repeat the experiment, the same person never is better every time - the crowd is smarter than any individual. This finding is counterintuitive.
‘Collective wisdom’ is put to good use to tackle three kinds of problems, and complexity is no bar:
Cognition problems: such problems arise when we can only guess the answer – as e.g. about the contents of the jelly bean jar, or about the future. How do we get the guess right?
Coordination problems: how to we coordinate behaviour with each other – say in traffic – knowing that everyone else is trying to do the same?
Cooperation problems: how do we get self-interested, distrustful people to work together, even when narrow self-interest would seem to dictate that no individual should take part – as in politics?
Behavioural economists and sociologists have gone beyond the anecdotic and systematically studied the issues, and have come up with surprising answers.
Capturing the ‘collective’ wisdom best solves cognitive problems. Four conditions apply. There must be: (a) true diversity of opinions; (b) independence of opinion (so there is no correlation between them); (c) decentralisation of experience; (d) suitable mechanisms of aggregation.
Markets are the oldest and in many ways still the best mechanism aggregation. If the markets work ‘perfectly’ supply and demand match smoothly – Adam Smith’s ‘invisible hand’ has done its work better than any allocation agency ever could. Based on this insight, virtual ‘decision markets’ have been experimentally established [1]. They work beautifully, and in most instances they are superior to market research by experts.
Why are experts not that smart? Because experts tend to be and think alike, and thus do not reflect maximum diversity of opinions; they tend to be internally inconsistent and poor at calibrating their position – in short, they are overconfident. In a group they tend to decide by authority (group-think), which makes dissent within the group improbable – conformity and bias rather than challenge is the result. Finally, past performance is never a predictor of future success – they may have just been lucky [2].
Independence of judgement is essential, but difficult to achieve. Humans tend to herd – it’s much safer to follow a strategy that seems rational rather than one that is rational. A special case is the ‘information cascade’: often we tend to follow early adopters blindly rather than verify their judgement. Not all the ‘information cascades’ are bad: intelligent imitation is a kind of rational response to our own cognitive limits – particularly when time is short. Children instinctively imitate their parents or elders – whose survival is evidence that they have been doing the right thing [3]. The more important the decision - and the more there is time to think - the less likely a cascade is to take hold.
Decentralisation is the key to better diversity, independence and appropriateness of judgements. Aggregation of information, but even more of judgement is paradoxically important to the success of decentralisation. If the aggregation process creates biased filters, then the effect is lost. Markets here remain far superior impartial mechanisms.
Co-ordination problem is one where, in order to solve it, a person has to think not only about what he believes to be the right answer, but also about what other people think the right answer is. So the question is: How can people voluntarily make their actions fit together in an efficient and orderly manner?
When different strategies are devised, the diversity tends to yield an optimal result. It turns out that looking also to one’s own experience alone yields a collectively intelligent answer [4] – even in coordination problems independent thinking is valuable. Usually, expectations rapidly converge spontaneously around a ‘focal point’. It pays to drive on either of the two sides of the street – this is the focal point’ of the experience. Convention decides which side is chosen. Once established, convention creates and maintains order and stability.
Conventions need no coercion – they are quickly internalised, because it reduces the amount of cognitive work one has to do in order to get through the day. Culture establishes explicit norms. Eventually, as the group grows, external sanctions may be needed to secure rapid application and compliance – avoidance of the ‘free rider’ problem.
The free market system is a famous example of spontaneous solution of a most important coordination problem: getting resources to the right places at the right cost. This has been verified experimentally. The experiments have also shown that the way people behave in consumer markets and the ways they behave in asset markets differ – here the results are more volatile and erratic.
Today’s societies and organisations work only if people cooperate voluntarily, and not just as a reflex to fear or inducement; nor is it based only on narrow self-interest. In particular, modern societies do not co-operate according to ‘thick relationships’ – the family circle, or ethnic group – but do so regularly and immediately with strangers.
Such co-ordination and co-operation are based on an inner sense of fairness – which might even have genetic roots (capuchin monkeys exhibit this trait already). It is based on 'strong reciprocity' – the willingness to punish bad (or reward good) behaviour even when one gets no material benefits from doing so. This is 'pro-social behaviour', for by adopting it people transcend narrow self-interest and, while not being altruists, act in a way that the group benefits.
Part of the ‘sense of fairness’ may arise from 'the shadow of the future' – the risk that eventually one is at the receiving end of selfish behaviour. More likely, it is simply that a decentralised social system like capitalism and the accumulation of capital can function only on the basis of impersonal trust and transparency – which allows division of labour and specialisation. The sense of trust, to be sure, would not exist without the institutional and legal framework that underpins every modern capitalist economy. But they seldom need overt enforcement by the law – they are internalised by each actor.
Fairness, then, is the sense that the other has done so and is playing by them. Capitalism is healthiest when people believe that fair dealing outweigh the benefits of sharp dealing.
Reciprocity is usually conditional. Next to the ‘selfish’ there are ‘altruists’, but mostly we are ‘conditional consenters’. That is what laws and regulations are for – not so much to punish the selfish (they may cause little damage), but to keep the ‘conditional consenters’ on the right side of the law.
So much for the rules underlying the wisdom and the behaviour of crowds – as it knits paradoxes like Parkinson’s Laws into a coherent whole the foregoing analysis contains enough counterintuitive insights to appear convincing.
Surowiecki then moves on to deal with specific issues. The examples are useful as practice for internalising the theory.
A first one is science. Co-operation in science is the mainstay of a modern society: it allows for division of cognitive labour [5]. It fosters diversity of perspectives and specialisation – and increases in productivity. Knowledge is more than cumulative – profoundly it is collective, and there is no one in charge of directing [6]. It is a ‘gift’ rather than an exchange economy based on ‘peer recognition’. Offerings are made and are eventually accepted into the common fund of knowledge. The process relies on the ‘collective wisdom’ of scientists.
Several dangers lurk. Danger lurks when – instead of relying on objective and independent verification of the offering – science moves incorporation of truths on the basis of scientific hierarchy e.g. as a rational reaction to the issue of information glut. Judging by hierarchy is an avatar of the ‘information cascade’. A result is adopted as truth on the basis of the author’s reputation – which is extrapolation from his past performance.
The second is the breakdown of conventions about quality of the research. If shoddy research is tolerated, more do shoddy research will be carried out, particularly if the purpose of achieving status in the hierarchy.
The third are the current attempts at appropriation of the ‘scientific commons’ for commercial advantage. When hiding rather than sharing information seems the better (if selfish) short-term solution, the market collapses. It is unclear that the replacement – the sale and purchase of scientific information as a generalised system, is workable.
Committees and small groups can produce bad decisions because they easily succumb to ‘group-think’ Thus participants seek information that confirms underlying intuitions (also as a way to handle the information glut); influence each other’s opinions and suppressing cognitive diversity; or they defer to the opinion leader – who may simply be the one who talks the most.
Depolarisation – arriving to conclusions on objective grounds rather than personalities or authority – is better than leaving the matter even to the best and smartest member. In other words, the key is a good structure that allows for good aggregation of the opinion of the members. In simulations, ‘well ordered’ committees have been shown to come to the conclusions faster, and could do better than their smartest member.
Surowiecki's thoughts on the corporation are to complex for summarising here. The core challenge is the optimal aggregation of information and of collective wisdom – rather than relying on an individual, as gifted as he may appear to be. This applies particularly to the services corporation (education, health come to mind), whose large-scale structures are nevertheless expected to provide tailor-made solutions for the individual.
The author then goes on to explain financial bubbles and crashes. Determining the price of a stock is both a cognitive and a coordination problem. There is always a balance between our guess about the future performance of the firm and that about the attitude that other participants will take on the matter. Bubbles and crashes take place when this equilibrium shifts too much towards the co-ordination side of it – i.e. we worry more about the other participants than about the quality of the firm.
Interesting is the role the media are shown to play. Per se information is a good thing, for it fosters independent judgement. The competitive hyping of information, however, tends to trigger overreactions. If there is not enough time to digest information, we’ll act according to our intuition about what the others will do.
Finally, democracy, as a classic case of emerging wisdom of the crowd, can be shown to be superior to Platonist elitism. But democracy is not so much an instrument to solve cognitive problems – as many today would have us believe. It is not that crowds have superior knowledge. They have superior wisdom – democracy is an instrument to deal first and foremost with issues of coordination and cooperation.
Notes
[1] Examples are success of new products on the market like box office success of movies, or new technologies. But they also work well as predictors of electoral results.
[2] This called the delusion of randomness. Everyone expects to win the lottery. Whoever wins, however, has no superior predictive capacity. The best (and least understood) example is the emergence of mankind. If mankind is the ‘jackpot’ of evolution, it does not mean that someone manipulated in favour of mankind.
[3] There must be, however, willingness of at least some people to stop imitating when they think they know better. Army ants always ‘follow the individual just in front’. Army ants can get themselves in a circle and walk around until they die of exhaustion.
[4] Starlings act in accordance with the following rules: (1) stay as close to the middle of a flock as possible; (b) stay two to three body-lengths away from the neighbour; (3) do not bump into any other bird; (d) if a haws dives at you, get out of the way. These ‘self-referenced’ rules are enough to have the flock move purposefully.
[5] Patents are the equivalent of property titles. Patents are limited in time, however, and the scope of the title is far more difficult to describe.
[6] The whole of scientific enterprise belies the contention that incentives are needed to achieve progress. A modern example is Linus, an+-*- open software that is improved by volunteers. Not surprisingly, Linus is better than Microsoft.
Tuesday, June 5, 2012
Market Missteps: Two Eye-Openers
How Markets Fail: The Logic of Economic Calamities by John Cassidy
"Behind the alarming headlines about job losses, bank bailouts, and corporate greed is a little-known story of bad ideas. For fifty years or more, economists have been busy developing elegant theories of how markets work—how they facilitate innovation, wealth creation, and an efficient allocation of society’s resources. But what about when markets don’t work? What about when they lead to stock market bubbles, glaring inequality, polluted rivers, real estate crashes, and credit crunches?
In How Markets Fail, John Cassidy describes the rising influence of what he calls utopian economics—thinking that is blind to how real people act and that denies the many ways an unregulated free market can produce disastrous unintended consequences. He then looks to the leading edge of economic theory, including behavioral economics, to offer a new understanding of the economy—one that casts aside the old assumption that people and firms make decisions purely on the basis of rational self-interest. Taking the global financial crisis and current recession as his starting point, Cassidy explores a world in which everybody is connected and social contagion is the norm. In such an environment, he shows, individual behavioral biases and kinks—overconfidence, envy, copycat behavior, and myopia—often give rise to troubling macroeconomic phenomena, such as oil price spikes, CEO greed cycles, and boom-and-bust waves in the housing market. These are the inevitable outcomes of what Cassidy refers to as “rational irrationality”—self-serving behavior in a modern market setting.
Combining on-the-ground reporting, clear explanations of esoteric economic theories, and even a little crystal-ball gazing, Cassidy warns that in today’s economic crisis, conforming to antiquated orthodoxies isn’t just misguided—it’s downright dangerous. How Markets Fail offers a new, enlightening way to understand the force of the irrational in our volatile global economy."
The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox
"The financial crisis of 2008 and subsequent Great Recession demolished many cherished beliefs—most significantly, the theory that financial markets always get things right. Justin Fox's The Myth of the Rational Market explains where that idea came from, and where it went wrong. As much an intellectual whodunit as a cultural history of the perils and possibilities of risk, it also brings to life the people and ideas that forged modern finance and investing—from the formative days of Wall Street through the Great Depression and into the financial calamities of today. It's a tale featuring professors who made and lost fortunes, battled fiercely over ideas, beat the house at blackjack, wrote bestselling books, and played major roles on the world stage. It's also a story of free-market capitalism's war with itself.
At the core of the current financial crisis has been the widely held assumption that markets behave rationally. Fox, Time magazine editor-at-large, isn't the first to bring scrutiny—or censure—to the conceit, but his analysis is singularly compelling, and the rare business history that reads like a thriller.
Fox leads us on a chronological journey of modern economic theory, featuring the cast of scholars who constructed the 20th- and 21st-century financial landscape, from Irving Fisher to such post-WWII figures as Milton Friedman, Harry Markowitz, Franco Modigliani and Merton Miller, Jack Treynor and William Sharpe. Fox offers a behind-the-scenes glimpse at academia's finest, complete with amusing anecdotes about the players and their theories, and illustrates how our economic behaviors and markets have been shaped by a gradually refined theory holding that the stock market prices are both random and perfectly rational. A must-read for anyone interested in the markets, our economy or government, this dense but spellbinding work brings modern finance and economics to life."
Sunday, May 27, 2012
Behavorial Economics
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