““Constructed” preferencesConstructed” preferencesSS200 Colin CamererSS200 Colin Camerer

Preferences: “complete, transitive” u(x), tradeoffs among Preferences: “complete, transitive” u(x), tradeoffs among goodsgoods Historical note: Axioms not empirically well-founded. They Historical note: Axioms not empirically well-founded. They

were designed to provide simple mathematical framework for were designed to provide simple mathematical framework for aggregation (utilityaggregation (utility demand) and because Pareto won the demand) and because Pareto won the “what is utility?” battle“what is utility?” battle

““Constructed” suggests expression of preference is like Constructed” suggests expression of preference is like problem-solving: problem-solving: Will you vote for John Kerry? Will you vote for John Kerry? Answered by rapid intuition (tall, good hair) and/or deliberate Answered by rapid intuition (tall, good hair) and/or deliberate

logic (positions on issues)logic (positions on issues) Alternative views of preference: Alternative views of preference:

Learned (reinforcement, “locked in a closet” story) Learned (reinforcement, “locked in a closet” story) ““Discovered” (Plott, implies path-independence)Discovered” (Plott, implies path-independence)

Hybrid view: Combination of predisposition (e.g., language, Hybrid view: Combination of predisposition (e.g., language, “preparedness”), learning and logic“preparedness”), learning and logic

““Constructed” preference: effectsConstructed” preference: effects Context-dependence (comparative)Context-dependence (comparative) Description-dependent “framingDescription-dependent “framing

(descriptions guide attention) (descriptions guide attention) Reference-dependence (changes, not levels; Reference-dependence (changes, not levels;

anchoring)anchoring) Some values “protected”/sacred (health, Some values “protected”/sacred (health,

environment)environment) Is too much choice bad?Is too much choice bad? Open questions:Open questions:

Are effects smaller with familiar choices? Are effects smaller with familiar choices? Experts? Experts? Markets?Markets? New predictions (e.g. “big tip” labor supply experiment)New predictions (e.g. “big tip” labor supply experiment) Cross-species (pigeons, rats, capuchins)Cross-species (pigeons, rats, capuchins)

1/n heuristic & partition dependence in the lab 1/n heuristic & partition dependence in the lab (cf. “corporate socialism”, Scharfstein & Stein, at corporate level)(cf. “corporate socialism”, Scharfstein & Stein, at corporate level)

Context-dependence (comparative)Context-dependence (comparative) Objects judged relative to others in a Objects judged relative to others in a

choice setchoice set Asymmetric dominanceAsymmetric dominance Compromise effectsCompromise effects

Economic question: What is seller’s Economic question: What is seller’s optimal choice set given context-optimal choice set given context-dependent preferences? dependent preferences?

Description-dependent “framing” (descriptions Description-dependent “framing” (descriptions guide attention)guide attention)

Analogy to figure-ground in perceptionAnalogy to figure-ground in perception Actual study with n=792 docs (Harvard Med, Actual study with n=792 docs (Harvard Med,

Brigham &Women’s, Hebrew U; McNeil et al Brigham &Women’s, Hebrew U; McNeil et al JAMA ’80s)JAMA ’80s)

treatment 1 yr 5 yrstreatment 1 yr 5 yrs choicechoice Surgery 10% 32% 66%Surgery 10% 32% 66% 53%53% Radiation 0% 23% 78% Radiation 0% 23% 78% 47%47%

treatment 1 yr 5 yrstreatment 1 yr 5 yrs choicechoice both frames both frames Surgery 90% 68% 34%Surgery 90% 68% 34% 82% 82% 60% 60% Radiation 100% 77% 22% Radiation 100% 77% 22% 18% 40% 18% 40%

Asian disease problem (-200 vs (1/3) of -600 / +400 vs (2/3) Asian disease problem (-200 vs (1/3) of -600 / +400 vs (2/3) 600600

Pro-choice vs pro-lifePro-choice vs pro-life Politics: “spin” (Lakoff)Politics: “spin” (Lakoff)

e.g. aren’t we better off w/ Hussein gone? e.g. aren’t we better off w/ Hussein gone? Liberation vs. occupationLiberation vs. occupation ……other examples? other examples?

Supply-side response: Competitive framing; which frame Supply-side response: Competitive framing; which frame “wins”?“wins”?

Reference-dependenceReference-dependence Sensations depend on reference points rSensations depend on reference points r

E.g. put two hands in separate hot and cold water, E.g. put two hands in separate hot and cold water, then in one large warm baththen in one large warm bath

Hot hand feels colder and the cold hand feels hotter Hot hand feels colder and the cold hand feels hotter Loss-aversion Loss-aversion ≡ -v(-x) > v(x) for x>0 (KT 79)≡ -v(-x) > v(x) for x>0 (KT 79)

Or v’(x)|Or v’(x)|++ < v’(x) | < v’(x) |- - …a “kink” at 0; “first-order risk-…a “kink” at 0; “first-order risk-aversion” aka focussing illusion?aversion” aka focussing illusion?

Requires theory of “mental accounting”Requires theory of “mental accounting” What gains/losses are grouped together?What gains/losses are grouped together? When are mental accounts closed/opened?When are mental accounts closed/opened? Conjecture: time, space, cognitive boundaries Conjecture: time, space, cognitive boundaries

mattermatter Example: Last-race-of-the-day effect (bets switch to Example: Last-race-of-the-day effect (bets switch to

longshots to “break even”, McGlothlin 1956)longshots to “break even”, McGlothlin 1956)

Reference-dependence modellingReference-dependence modelling (Koszegi-Rabin, 05)(Koszegi-Rabin, 05) Two problems in prospect theory:Two problems in prospect theory:

Is v(c-r) the Is v(c-r) the onlyonly carrier of utility? Probably not… carrier of utility? Probably not… How is r “chosen”? Perceptual? Expectations? How are How is r “chosen”? Perceptual? Expectations? How are

expectations chosen? expectations chosen? KR solutionKR solution

U(c|r)= m(c)+U(c|r)= m(c)+µµ(m(c)-m(r)) (m(c)-m(r)) separable into consumption separable into consumption and “surprise” utility and “surprise” utility

For distributions F, F*=argmaxFor distributions F, F*=argmaxFF∫∫ccu(c|r)dF(c)u(c|r)dF(c) For reference distribution G, F*=argmaxFor reference distribution G, F*=argmaxFF∫∫cc∫∫rru(c|r)dF(c)dG(r)u(c|r)dF(c)dG(r)

Axioms:Axioms: A0: A0: µ(x) continuous, twice differentiable (for x≠0), µ(0)=0µ(x) continuous, twice differentiable (for x≠0), µ(0)=0 A1: A1: µ(x) strictly increasing (µ’(x)>0)µ(x) strictly increasing (µ’(x)>0) A2: If y>x>0, then A2: If y>x>0, then µ(y)+µ(-y)<µ(x)+µ(-x) µ(y)+µ(-y)<µ(x)+µ(-x)

(convexity of disutility is weaker than concavity of utility)(convexity of disutility is weaker than concavity of utility) A3: A3: µ’’(x)≤0 for x>0 and µ’’(x)≥0 for x<0 µ’’(x)≤0 for x>0 and µ’’(x)≥0 for x<0 (reflection (reflection

effect)effect) A3’: For all x≠0, µ’’(x)=0 A3’: For all x≠0, µ’’(x)=0 (piecewise (piecewise

linear utility)linear utility) A4: limA4: limx-->0x-->0 µ’(-|x|) / lim µ’(-|x|) / limx-->0x-->0 µ’(|x|) = µ’(|x|) = λλ > 1 (coef. of loss- > 1 (coef. of loss-

aversion)aversion)

Reference-dependence modellingReference-dependence modelling (Koszegi-Rabin, 05)(Koszegi-Rabin, 05)

Prop 1: If µ satisfies A0-A4, then Prop 1: If µ satisfies A0-A4, then “reference point preference” follows“reference point preference” follows (If A3’), then for F and F’, U(F|F’) ≥U(F’|F’) (If A3’), then for F and F’, U(F|F’) ≥U(F’|F’)

U(F|F) ≥U(F’|F) U(F|F) ≥U(F’|F) Big move: What is reference distribution? Big move: What is reference distribution?

Impose “personal equilibrium”: r=F* Impose “personal equilibrium”: r=F* Pro: Ties reference point to expected actionsPro: Ties reference point to expected actions Con: If µ(x) is a “prediction error” designed for Con: If µ(x) is a “prediction error” designed for

learning, r=F* means there is nothing to learn learning, r=F* means there is nothing to learn Implication: Can get multiple equilibria Implication: Can get multiple equilibria

(buy if you plan to buy, don’t buy if you (buy if you plan to buy, don’t buy if you don’t)don’t) Role for framing/advertising etc. in choosing an Role for framing/advertising etc. in choosing an

equilibrium (supply side response)equilibrium (supply side response)

Prospect theory value function: Prospect theory value function: Note kink at zero and diminishing marginal sensitivity Note kink at zero and diminishing marginal sensitivity

(concave for x>0, convex for x<0)(concave for x>0, convex for x<0)

Endowment effects (KKT JPE ’90)Endowment effects (KKT JPE ’90)

KKT “mugs” experiment (JPE ‘90)KKT “mugs” experiment (JPE ‘90)

Plott-Zeiler reviewPlott-Zeiler review

Data from young (PCC) and old (80 yr olds) using Data from young (PCC) and old (80 yr olds) using PZ instructions (Kovalchik et al JEBO in press 04)PZ instructions (Kovalchik et al JEBO in press 04)

Plott-Zeiler (AER 05) results: Plott-Zeiler (AER 05) results: replication (top) vs mugs-first (bottom)replication (top) vs mugs-first (bottom)

““Status quo bias” and defaults in organ Status quo bias” and defaults in organ donation (Johnson-Goldstein Sci 03)donation (Johnson-Goldstein Sci 03)

Loss-aversion in savings decisions (note few points Loss-aversion in savings decisions (note few points with actual utility <0) from Chua & Camerer 03 with actual utility <0) from Chua & Camerer 03

(slopes .86 +, .33 - ratio 2.63)(slopes .86 +, .33 - ratio 2.63)

Actual Utility Vs Optimal Utility

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10

20

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-50 -30 -10 10 30 50

Optimal Utility Gains/Losses

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Data Points Jack Knife Regression

g

Disposition effects in housing (Genesove and Disposition effects in housing (Genesove and Mayer, 2001)Mayer, 2001)

Why is housing important? Why is housing important? It's big: It's big:

Residential real estate $ value is close to stock market value.Residential real estate $ value is close to stock market value. It’s likely that limited rationality persistsIt’s likely that limited rationality persists

most people buy houses rarely (don't learn from experience). most people buy houses rarely (don't learn from experience). Very emotional ("I fell in love with that house"). Very emotional ("I fell in love with that house"). House purchases are "big, rare" decisions -- mating, kids, House purchases are "big, rare" decisions -- mating, kids,

education, jobseducation, jobs Advice market may not correct errors Advice market may not correct errors buyer and seller agents typically paid a fixed % of $ price (Steve buyer and seller agents typically paid a fixed % of $ price (Steve

Levitt study shows agents sell their own houses more slowly and Levitt study shows agents sell their own houses more slowly and get more $). get more $).

Claim: Claim: People hate selling their houses at a "loss" from People hate selling their houses at a "loss" from nominalnominal [not [not

inflation-adjusted!] original purchase price. inflation-adjusted!] original purchase price.

Boston condo slump in nominal pricesBoston condo slump in nominal prices

G-M econometric modelG-M econometric model

Model: Listing price L_ist depends on “hedonic terms” and m*Loss_ist(m=0 is no disposition effect)

…but *measured* LOSS_ist excludes unobserved quality v_i…so the error term η_it contains true error and unobserved quality v_i …causes upward bias in measurement of m Intuitively: If a house has a great unobserved quality v_i, the purchase price P^0_is will be too high relative to the regression. The model will think that somebody who refused to cut their price is being loss-averse whereas they are really just pricing to capture the unobserved component of value.

Results: m is significant, smaller for investors (not Results: m is significant, smaller for investors (not owner-occupants; less “attachment”?)owner-occupants; less “attachment”?)

Cab driver “income targeting” Cab driver “income targeting” (Camerer et al QJE 97)(Camerer et al QJE 97)

Cab driver instrumental variables Cab driver instrumental variables (IV) showing experience effect (IV) showing experience effect

Anchored valuation: Valuations for listening to Anchored valuation: Valuations for listening to

poetry framed as labor (top) or leisure (bottom)poetry framed as labor (top) or leisure (bottom) (Ariely, Loewenstein, Prelec QJE 03 and working (Ariely, Loewenstein, Prelec QJE 03 and working

paperhttp://sds.hss.cmu.edu/faculty/Loewenstein/downloads/Sawyersubmitted.pdfpaperhttp://sds.hss.cmu.edu/faculty/Loewenstein/downloads/Sawyersubmitted.pdf

““Arbitrary” valuationsArbitrary” valuations Stock prices?Stock prices? Wages (what are different jobs really Wages (what are different jobs really

worth?)worth?) Depends on value to firm (hard to measure)Depends on value to firm (hard to measure) & “compensating differentials/disutility (hard to & “compensating differentials/disutility (hard to

measure)measure) Exotic new productsExotic new products Housing (SFHousing (SF Pittsburgh tend to buy “too Pittsburgh tend to buy “too

much house”; Simonsohn and Loewenstein much house”; Simonsohn and Loewenstein 03)03)

Exec comp'n (govt e.g. $150k for senator, Exec comp'n (govt e.g. $150k for senator, vs CEO's, $38.5 million Britney Spears)vs CEO's, $38.5 million Britney Spears)

What econ. would happen if valuations are arbitrary?What econ. would happen if valuations are arbitrary?

Perfect competitionPerfect competition price=marginal cost…anchoring influences price=marginal cost…anchoring influences quantity,quantity, not price; expect large Q variations for similar not price; expect large Q variations for similar productsproducts

Attempts to influence the anchor (QVC home shopping, etc., "for Attempts to influence the anchor (QVC home shopping, etc., "for you just $59.95”). you just $59.95”).

Advertising!!!Advertising!!! If social comparison/imitation is an anchor, expect geographical, If social comparison/imitation is an anchor, expect geographical,

temporal, social clustering (see this in law & medical practice)temporal, social clustering (see this in law & medical practice) E.g., CEO pay linked to pay of Directors on Board's comp'n E.g., CEO pay linked to pay of Directors on Board's comp'n

committee. Geographical differences in housing prices, committee. Geographical differences in housing prices, London,Tokyo, NYC, SF. London,Tokyo, NYC, SF.

Interindustry wage differentials Interindustry wage differentials for the same work for the same work (Stanford (Stanford contracts out janitorial service so it doesn't have to pay as much; contracts out janitorial service so it doesn't have to pay as much; cf. airline security personnel??)cf. airline security personnel??)

Sports salaries: $100k/yr Miami Dolphins 1972 vs $10million/yr Sports salaries: $100k/yr Miami Dolphins 1972 vs $10million/yr modern footballmodern football

Huge rise in CEO comp'n from 1990 (42 times worker wage) to Huge rise in CEO comp'n from 1990 (42 times worker wage) to 2000 (531 times); big differentials between US and Europe2000 (531 times); big differentials between US and Europe

Consumers who are most anchorable or influenceable will be Consumers who are most anchorable or influenceable will be most faddish -- children and toys!!? (McDonald's happy meal etc)most faddish -- children and toys!!? (McDonald's happy meal etc)

Is too much choice bad? Is too much choice bad? Jams study (Iyengar-Lepper):Jams study (Iyengar-Lepper):

6 jams6 jams 40% stopped, 30% purchased40% stopped, 30% purchased 24 jams24 jams 60% stopped, 3% purchased60% stopped, 3% purchased

Assignment study: Assignment study: Short listShort list 74% did the extra credit assignment74% did the extra credit assignment Long listLong list 60% did the extra credit assignment60% did the extra credit assignment

Participation in 401(k) goes down 2% for every 10 extra funds Participation in 401(k) goes down 2% for every 10 extra funds Shoe salesman: Never show more than 3 pairs of shoes…Shoe salesman: Never show more than 3 pairs of shoes… Medical Medical

65% of nonpatients said they would want to be in charge of 65% of nonpatients said they would want to be in charge of medical treatment…but only12% of ex-cancer patients said they medical treatment…but only12% of ex-cancer patients said they wouldwould

Camerer conjecture: The curse of the compositeCamerer conjecture: The curse of the composite Paraphrased personals ad: “I want a man with the good looks of Paraphrased personals ad: “I want a man with the good looks of

Brad Pitt, the compassion of Denzel Washington…”Brad Pitt, the compassion of Denzel Washington…” Is there “too much” mate choice in big cities? Is there “too much” mate choice in big cities?

Choice-aversion Choice-aversion How to model “too much choice”? How to model “too much choice”?

Anticipated regret from making a mistakeAnticipated regret from making a mistake ““grass is greener”/buyer’s remorsegrass is greener”/buyer’s remorse Direct disutility for too-large choice set (e.g. too Direct disutility for too-large choice set (e.g. too

complex)complex) Policy question: Policy question:

Markets are good at Markets are good at expandingexpanding choice…what is a good choice…what is a good institution for limiting choice? institution for limiting choice?

Example: Bottled water in supermarketsExample: Bottled water in supermarkets Limit “useless” substitution? What is the right amount? Limit “useless” substitution? What is the right amount? Pro-govt example: Swedish privatized social securityPro-govt example: Swedish privatized social security

Offered hundreds of fundsOffered hundreds of funds Default fund is low-fee global index (not too popular)Default fund is low-fee global index (not too popular) Most popular fund is local tech, down 80% 1Most popular fund is local tech, down 80% 1stst yr yr

Capuchins obey law of demand Capuchins obey law of demand (K. Chen et al 05)(K. Chen et al 05)

Monkey loss-aversionMonkey loss-aversion (a,b,c) means display (a,b,c) means display

a, then pay b or ca, then pay b or c One: stochastic One: stochastic

dominancedominance Two: reference-Two: reference-

dependence (risky)dependence (risky) Three: reference-Three: reference-

dependence (riskless)dependence (riskless)

Experimental markets & prob judgmentExperimental markets & prob judgment

1. Abstract stimuli vs natural events??1. Abstract stimuli vs natural events?? pro: can precisely control information of individualspro: can precisely control information of individuals can conpute a Bayesian predictioncan conpute a Bayesian prediction con: maybe be fundamentally different mechanisms than for concrete con: maybe be fundamentally different mechanisms than for concrete

events...events... 2. Do markets eliminate biases?2. Do markets eliminate biases? Yes: specializationYes: specialization

Market is a dollar-weighted average opinionMarket is a dollar-weighted average opinion Uninformed traders follow informed onesUninformed traders follow informed ones Bankruptcy Bankruptcy

No: Short-selling constraintsNo: Short-selling constraints Confidence (and trade size) uncorrelated with informationConfidence (and trade size) uncorrelated with information Camerer (1987): Experience reduces pricing biases but *increases* Camerer (1987): Experience reduces pricing biases but *increases*

allocation biasesallocation biases Contingent claims markets:Contingent claims markets: Markets enforce correct prices..BUT probability judgment Markets enforce correct prices..BUT probability judgment

influences allocations and volume of trade influences allocations and volume of trade (example: Iowa political (example: Iowa political markets)markets)

IIlusions of transparencyIIlusions of transparency ““Curse of knowledge”Curse of knowledge” Difficult to recover coarse partition from fine-grained oneDifficult to recover coarse partition from fine-grained one Piaget example: New PhD’s teachingPiaget example: New PhD’s teaching EA Poe, “telltale heart”EA Poe, “telltale heart” Computer manualsComputer manuals “ “ The tapper” study (tapping out songs with a pencil)The tapper” study (tapping out songs with a pencil) Hindsight bias Hindsight bias Recollection of P_t(X) at t+1 biased by whether X occurredRecollection of P_t(X) at t+1 biased by whether X occurred ““I should have known!”I should have known!” ““You should have known” (“ignored warning signs”)You should have known” (“ignored warning signs”) --> juries in legal cases (securities cases)--> juries in legal cases (securities cases) implications for principal-agent relations? implications for principal-agent relations?

Spotlight effect (Tom Gilovich et al)Spotlight effect (Tom Gilovich et al) Eating/movies aloneEating/movies alone Wearing a Barry Manilow t-shirtWearing a Barry Manilow t-shirt psychology: Shows how much we think others are attending when psychology: Shows how much we think others are attending when

they’re notthey’re not