By James Kwak
Although I have written many blog posts pointing out that people are not actually rational maximizers (that is, they don’t know what their preferences are, and even if they did they don’t make rational choices to maximize those preferences), I actually try to be a rational maximizer as much as possible. That is, when making decisions, I try to think about what my expected utility (admittedly, some vague combination of immediate happiness, reflective happiness, reduction in stress, and increase in leisure time*) is from each course of action and decide accordingly. When I was working and very, very busy, this translated into the $25 rule: for personal stuff, I valued my time at $25 per hour.** So if I had to return something to the store, but it cost $10 and it would take me half an hour, I wouldn’t bother.
The problem is that although we human beings are not terrible at comparing expected utility across amounts (e.g., more french fries vs. less french fries***) or within narrow product categories (e.g., LG vs. Samsung TVs), we are very bad at comparing expected utility across different categories of experience and products (e.g., skiing for a day versus a new pair of good earbuds). I just read “Coherent Arbitrariness,” a 2003 QJE paper by Dan Ariely, George Loewenstein, and Drazen Prelect that makes this point beautifully, with some interesting implications. (That link requires some sort of affiliation, but you can just Google it as well.)
The content is probably already familiar to anyone who knows some behavioral economics. The basic point is that our valuations of goods can be manipulated by arbitrary anchors. In one experiment, they first asked people if they would be willing to pay more or less than the last two digits of their social security numbers (in dollars) for each of six common consumer goods, and then asked what their willingness to pay was for each good. (Both answers could determine whether the transaction would actually take place at one of those price points.) People with high SSNs were willing to pay roughly three times as much as people with low SSNs. At the same time, their relative orderings between goods made sense (WTPs were higher for rare wine than for average wine****). Other experiments show that relative orderings over various quantities of the same thing make sense. So the point is that once people’s anchors are set, they will look like they have orderly demand functions, but those anchors can be completely arbitrary. Another experiment shows that market forces (after anchoring, participants bid for things) do not cause convergence between people with different anchors.
The implication they draw for financial markets may be obvious, but it touches on something that has interested me for a while. If preferences are susceptible to anchoring but more or less orderly thereafter, then market prices will respond predictably to changes in information, but they have no fundamental level:
“Thus, studies showing that the market follows a random walk are consistent with fundamental valuation, but are insufficient to demonstrate it; indeed, Summers presents a simple model in which asset prices have a large arbitrary component, but are nevertheless serially uncorrelated, as predicted by fundamental valuation.”
I say this is interesting because, on the one hand, I accept the random walk studies (and I personally believe I have no ability to predict where any security price is going tomorrow), but on the other hand I think that any idea that markets have fundamental levels is flawed. For example, housing prices are still falling. Some people try to predict how far they will fall by looking at the Case-Shiller Index and figuring out where the long-term trend line will be. But how do you look at a chart and figure out what the right value is? What if there has been something different about the market over the last one hundred years from the market today? It’s really a fool’s errand.
On the other hand, in your personal life, you should be aware of anchoring, because it can help you use your money more wisely. For example, for several years I would complain about being cold in the winter in New England. I was coldest when I was walking my dog, because then I had to be outside for half an hour at the time, and my hands were one of the coldest parts of my body. Finally I asked my wife to buy me the warmest mittens she could find for Christmas, and since then my hands have never been too cold. They probably cost $150 or something, but in the three winters since then they have probably given me something like one hundred hours of extra warmth, and they should give me at least another three hundred hours. That comes to less than a penny per minute of warmth (and less than a quarter per walk with the dog), and I would gladly pay more than that. Compare that to, say, two nice dinners that last for a total of four hours, and there’s no contest.
But until I asked for the mittens, I was overconsuming dinners and underconsuming warm mittens — because I was inferring my own preferences from market prices. In short, you are different from the average person, so at the same price level, some things will give you a lot of utility and some will give you not very much. The more you are aware of that, the happier you will be.
* Why isn’t money on the list? Because I usually try to translate money into some combination of reduction in stress and increase in leisure time. That is, the more money I have, the less I have to work in the future or the less I will worry about money.
** You might say this is irrational because my after-tax wage was much higher than $25. But I had no way of cashing in more time for more money. And also, when you’re already working too much the psychological disutility of more work can be pretty high.
*** Actually, this isn’t a great example. We often eat too many french fries because we assume more is better, and we are susceptible to anchoring by portion size.
**** Another interesting case, since rare wine does no better than average wine in blind taste tests. But presumably people are paying for some utility other than taste when they buy rare wine.
The Baseline Scenario 
Nice post, James.
I would argue that we (mostly) learn from our mistakes, so that we realize we should have bought warm mittens years ago instead of going out to dinner as much as we did, and in the future we can apply that lesson in other areas (if we are adaptive and not responding the same way to base stimuli untethered by higher cognitive functioning).
For the big lessons, we learn after making a couple of mistakes, as in: Note to self: do not lease the E320 again. But if we are suddenly fixated with the hot blond that moved in next door, we may find ourselves craving a sweeter ride even though our rational side knows better.
And finally, there is always a fresh crop of suckers trying to work their way up from the bottom, so the wise consumers that drop out of the impulse markets get replaced. The impulse markets will fail when the new crop has no disposable income or credit so abysmal that even a bankster won’t float them a line of credit. Therein lies the tipping point for irrational consumption decisions.
i’m not sure why a continued drop in housing prices should be an argument for the unpredictability of markets. housing deviated substantially from a long-term trend and a return to trend is what one would predict.
The effects of anchoring are often overstated. Yes, it is a real and robust phenomena. But, anchoring only works when there is real uncertainty about the answer to the question being asked – people will then anchor on irrelevancies in order to provide a calculation. The best way to avoid anchoring is simply to admit that you don’t know, and leave it at that.
Here’s why, at least 18-24 months ago it was relized (by people with money) that any mortgage that was not prime, was so under water that all that was left to do was to write off the losses or pray the mkt turned up. Neither one helped or occured, and now the govt is left holding a ton of paper that is becomeing even more worthless with each day that passes. Possibly creating a “unpredictability of markets” bubble of many types,
Yes, ordinary people are totally helpless and incompetent to make decisions for themselves. One consequence (obviously) is that they need the state to make all of their decisions for them.
This is a common theme on this blog.
Great post. I’ve been thinking a lot about decision analysis after a few that didn’t work out so well for me. Being more aware of anchor points might help out, but I can see that my changing mood and other external factors might significantly shift my utility.
Marketing exists for a reason, ordinary people can be easily led to the descisions they will ultimately make. Just look at the beliefs of the tea party. Ordinay people being easily led by corporate funded “leaders” that they should support policies that will end up destroying them.
The ordinary people don’t have a chance. Greed button, greed button, greed button, bam, fear button.
Has anybody (besides me) ever said that ADVERTISING, more all-pervasive here than Mao propaganda ever was in China, is responsible for creating the culture of greed?
I think centuries from now historians will look back on our times and say “How could they not realize what this distortion of cultural health, generation after generation, was doing to the children?”
House prices will fall until they are 2.4 times the income of the people buying them.
For about 100 years, that is the maximum amount that a banker would lend to a person buying a house. Any more, and there would be a good chance the banker wouldn’t get paid back, because the borrower wouldn’t have enough money left after the mortgage payment to live on. The only reason house prices took off is that bankers bundled and sold the mortgages on to someone else, and at that point, they didn’t care if the borrower defaulted.
The “line” that house prices are reverting to is a line of declining incomes. And you can take that 2.4 multiplier to the bank.
Until about 100 years ago, a worker’s house was without indoor plumbing, central heating or electricity, single-glazed with few windows, and often not insulated, on a lot which was commonly not served by paved roads or gutters.
At 2.4 of today’s low-paid worker, such a house would need to cost about $55,000 — which is a feasible number — except such houses today are not legal because they are not up to code.
Building codes dictate prices far above your 2.4 traditional figure, and houses cannot fall below replacement cost except in a temporary period of adjustment.
Where does that leave the low paid worker? In trailer parks, paying $250 a month rent just to park on a tiny square of land, and making payments on a “house” that will never build up equity.
We need to change building codes to allow “real simple.”
I’m fascinated by the fact that, even after you knew the mittens were a good investment, you delegated the actual task of buying them to your wife and in the guise of a Christmas present. Did you have trouble admitting to yourself that they were worth it? You knew your wife was going to buy you a present anyway, so the price you were willing to pay for the mittens was probably the opportunity cost of having your wife guess what present you wanted — which often results in a unwanted present anyway. Most likely your wife would have bought you a present in the spousal price range ($100+) regardless. One could argue that you never priced the value of the mittens correctly until you had used them. Ownership gave you almost perfect knowledge of their utility, making comparison with other items you consume relatively easy. We are still left with the conundrum of pricing (and choosing between) the expected utility of items we don’t already own.
Information asymmetry is a bugger. Your retreat to a standard talking point is typical of those who benefit from information asymmetry perpetrated on others, like payday lenders.
Off topic but related to themes discussed at Baseline Scenario. There are — campaign financing laws — in the Province of British Columbia where I live. A former BC solicitor general may be required to vacate his seat in the legislature because he spent $4,135.70 (yes folks, that is 70 cents after the decimal point) over the $70,000 campaign financing limit. There is a huge scandal brewing over this and related issues. You can read about it here
Hows that for mittens versus dinner !!!
I have found that, since I have been living solely on Social Security, my decisions about purchasing and utility have been far better than when I was making good money. And, I am at least as happy living on less than 25% of my higher income levels. What does that tell you?
Since the average family income is around $50k, the average house should cost about $120,000, and will, in the not-too-distant future. Count yourself lucky if you borrowed against it when the price was up (if you used the money for investment, that is).
Houses do have more features than they used to, as do cars, but mass production techniques have kept the cost of both down to a constant fraction of worker pay. This has been true for a very long time.
I’m not sure about the overall effect of building codes. They may act to reduce the overall cost of a house, because, for example, better insulation reduces heating bills. Certainly, I know that OSHA regulations enable workers to be more efficient, because a guy can’t concentrate on his work if he thinks he’s going to be sucked into a machine at any moment.
With respect to where this leaves the low-paid worker, it may leave him as a renter, and that might be good for him. Renters can go where the job opportunities are. People in the Detroit suburbs, which has the highest percentage of owned homes in the U.S., are having a hard time following the jobs because they feel they can’t afford to sell their homes at the going price. On the other hand, Switzerland has one of the highest average income levels in the industrialized world, and it has one of the lowest percentages of home ownership. Probably not a coincidence.
Incidentally, houses can certainly fall below replacement levels. You can buy a house in Detroit proper today for the cost of a good VCR. Problem is, it’s in Detroit proper.
Yes, Jacques Barzun said something along those lines in “From Dawn to Decadence”:
“From the machine arose mass production, and hence, advertising, with its peculiar status of approved deceit and temptation. Since techne kept driving production, new appetites as well as old must be kept at a high level, and in effect rich and poor must be made to live with the sense of continual deprivation; there were always new NECESSITIES. Seeing this endless prodding and spending, often entailing perpetualness indebtedness, thoughtful people inveighed against the ‘consumer society’. It seemed animal-like in its concentration on filling physical wants. The consumer could have retorted that he was helpless; the standard of living was an official agent of oppression.”
Isn’t that actually a good argument that one basic assumption of neoclassical economics, perfect information among all market participants, is just plain nuts? What you have described, never pricing the value of the mittens correctly until after having them, seems to me to be nearly universal. Actually, all the neoclassical assumptions of market conditions are just plain nuts. They’re never seen in the real world
Couple of thoughts:
1. Previously, were you wearing mittens or gloves? Gloves isolate each finger while mittens put them all together. In this manner, the fingers each help keep each other warmer than they might in a pair of gloves.
2. Under the old Weight Watchers “counting points” system, you could have a brownie at coffee hour for five points or a nice, nutritional breakfast for five points. Now, if you chose the brownie, you “spent” your points on something that was quickly consumed and not particularly nutritional, tasty though it may have been. Ah, choices, choices, choices.
It tells me you are not married and that you bought your house and your car for cash. What happens if you outlive your car?
In short, think for yourself, difficult as it may be.
Nice world you are living in, inside your head. You, and people like you, need to look at the reality.
Your “average” income number is lifted far above minimum wage earnings by averaging in the high end earners. And “family income” means two wage earners, or more. Some people — a lot of them — earn between $20,000 and $25,000 a year. And would like to own a simple house in a decent neighborhood. A century ago such a thing was possible.
Renters are not building equity and do not have the hope of old age ownership. They are subject to the landlord. Renting is “good for him” because it enables him to uproot himself from his neighborhood and follow the jobs whereever they blow ? You, sir, are the enemy.
And as for your cheap house in Detroit, or Flint, you know perfectly well that is the result of economic storms and not a true reflection of the housing/wage relationship .
I am his mechanic, and he gets a used car owned by me, and a driver of his choice. Hows about you and your car?
OT on regional banks. Yesterday at a regional bank, the banker was encouraging me to by an insurance annuity through the bank because it would yield more than the bank’s various interest bearing products. Question, where will the banks obtain money to lend if the bank’s deposits are moving into insurance products? And is this occurring at other regional banks? This bank is still operating under a consent decree with FDIC.
To say that the “return to trend is what one would predict” is another way of saying, the trend was normal, the current situation is an outlier and not in fact a “new normal”.
Unfortunately paradigm shifts do not always announce themselves, so you can see why it not always correct to infer changes as temporary movements away from the mean.
So said the invisible man.
Some people just like to spend money, I NEVER get into car accidents, so I prefer to pay the minimum. But my mother every 6 months assures herself that I will get into an accident, and so she insists that we pay the maximum. Go figure.
Mr. Kwak
Interesting post.
“the point is that once people’s anchors are set, they will look like they have orderly demand functions, but those anchors can be completely arbitrary”
Consider Soros’ concept of “readical fallibility” to counter the anchoring effects.
Thanks again for an excellent post. I enjoyed the anchoring and mittens story.
It reminded me of purchasing my $80 public economics reader just recently. The instructor was surprised by the cost, and the fact that most of the journal articles and book excerpts were available online or via the library.
Then I thought about all the time (and sometimes $) used to search for the articles/books, as well as print or copy them…and the $80 cost didn’t seem so bad after all. It also helped that the reader was double-sided!
Keep up the excellent work!
$50000 is the median household income, not an average. And you’re delusional if you believe that in 1910 households at half the median income frequently owned “simple homes in decent neighborhoods”. Fewer than 50% of households owned homes in that period (a smaller percentage than today) and as today, the low-income portion of the population did not end up in the nice neighborhoods: they were in tenements or on farms.
James, your thinking about spending, maximizing utility, and how much you value your time are so close to my thought process it’s scary. Right down to the $25/hr for my time.
That kind of thinking led me to make a number of changes in the past 10 years. I get virtually no happiness from driving around in a fancy/new car, but hate having to deal with car problems so I bought a cheap reliable car and have been driving it for 11 years. I like reading books and watching movies at home, but I get extra enjoyment from HAVING a large library or movie collection at home, so I haven’t bought a new book or movie in the past 5 years – the local library and Netflix are my friends.
Those and a bunch of other examples have helped save money. Like the mittens, I’ve also used that thinking to spend money and increase my happiness. I finally hired a lawn service after a decade cutting my own grass and I’m happy every time I come home to see that the lawn has been cut. I also splurged and bought an 11hp beast of snowblower 2 years ago after clearing my driveway with a shovel since I became a homeowner. This year I am especially happy with that purchase. And after renting a tiny house near the beach for two summers we decided to splurge and spend about 50% more for a big place a little further from the water. We had friends and family (up to 12) in and out for 10 days and had a blast.
It’s all about realizing what makes you happy and what doesn’t. Money can be used to increase happiness and free time, and it can be used to decrease frustration and discomfort. Avoid the spending extra in areas where it doesn’t matter to you gives you more money to spend in the areas where it can make a big difference.
Dang it.
I get NO extra enjoyment from having a large library or movie collection.
And that last sentence should be taken out and shot.
Some people only have the options of eating Mittens. I refer you to the woman selling rabbits in Flint Michigan in Roger and Me under the rubric of “Pets or Meat.”
My gosh. In Canada you have laws. How novel.
I’m sure it’s not actually true, but here in the States, sometimes it feels as if we have only lawyers.
Banks do not loan out the money they have on deposit. Banks create new money via fractional reserve lending. Google “Money As Debt.”
BH, I agree with you and James in many respects with regard to my own personal spending habits. And it is really fun and personally satisfying to be able to discover what we really value by making such choices.
But like Jimmy Knickers below, I am acutely aware that tens of millions of Americans do not have the opportunity to learn about themselves in this pleasant, modestly privileged way. Perhaps a million of them or so are too wealthy to have had our experience. But many, many more are stuck, as Jimmy K. says “eating Mittens.”
I hope we can change that.
Fractional lending can not occur without X deposits that create the reserves.
I absolutely agree. There are people with so little money that there are no choices for them to make – they are stuck with lousy food and lousy shelter and a $500 car or the bus.
But we’re talking about spending choices here, which assumes a certain level of income. The point is that people past a subsistence level of income are faced with spending choices. And it doesn’t matter if they have 30K, 50K or 100K, people who understand themselves and make wise choices can be happier than people with higher incomes who make poor choices.
“The point is that people past a subsistence level of income are faced with spending choices.”
No offense, but I was trying to make another point.
The unhappiness of the wealthy just doesn’t keep me awake at night.
Sometimes, thinking about the future of this country does.
I had a very destructive experience with this. After living in a region with very high home prices I became used to seeing housing prices that were very high for rather trashy or terrible houses. As we believed the housing bubble to have announced itself in late 2007 early 2008, we closed on a house at a 10% discount in a stable market.
When comparing our purchase market (a small but vibrant nationally known community) we were getting much much more house than the market we were then living in (a very well known very expensive city).
The upshot, we way overbought the small market. When it entered the recession late, our house tanked in value. We were totally wiped out and have been working our way through a painful, financially destructive foreclosure.
As we thought about the mistakes we made and why, anchoring factored into it. When my wife and I thought back in a “What were thinking???” exercise, we reached a disturbing conclusion. We realized that we had anchored our brains to a notion that the purchase market was “a steal.” Thus, we didn’t look at the housing price in a vacuum, which might have given us pause. Or say, compare it to the housing my very responsible parents bought at our age – much much less.
Instead, we realized that anchoring had so colored our judgment, that we were almost doomed to make this mistake. We had warped our thinking on affordable housing a great deal, and if we hadn’t bought the house we did – we would probably have paid EVEN MORE for another house.
We had, at that time, convinced ourselves that we were getting a deal. And in this state, shaking such a conviction probably was beyond us psychologically. It was a painful lesson, but one that we have learned from. In so doing, we hope over the next 5 to 7 years to rebuild our finances from the ground up in a much more deliberate and thoughtful fashion.
Ella, I believe that when they lend, the banks create entirely new money electronically. As the the loan is paid back, the bank keeps the interest to pay expenses and shareholders, but the actual principal disappears as it is repaid. It’s true that banks are required to be “capitalized” with a certain amount of deposits (and perhaps other assets, I’m not sure) but some would argue that the capital requirements are too low.
Of course, under Glass-Steagall, commercial banks were not permitted to sell you insurance products at all, for a very good reason: too risky.
If I am incorrect about these matters, I hope one of the economists will correct me.
My favorite example of cross-sector grousing: everyone makes fun of folks who drop $4 for a latte (which actually takes a decent amount of work and skill to make) but no one says anything about a $4 Gin & Tonic. In fact, a G&T is even easier to make. Slightly more expensive inputs, but not really.
And, in fact, a $4 G&T is pretty inexpensive. Usually they are more like $5 or $6.
It’s a very similar category and yet one gets lots of attention and the other very little.
Using average income and average house price is misleading. Using the median is probably more coherent.
Median income better reflects the polarization of income and wealth in the US, whereas per capita GDP misrepresents it.
As far as house prices go, we may have a new paradigm for several reasons…a better understanding of risks by lenders and borrowers, our aging population, etc.
The bank was likely selling an annuity that would be carried by an insurance company. They would pocket a commission, usually about 8% of the principle, for selling it.
Asset markets are very different from the markets for commodities, services, etc. The housing market has been increasingly “financial-ized” (sorry to use the “f” word).
When buying spuds or gasoline, you may buy less or drive less if the price shoots up. With an asset, one could feel that if they didn’t buy now, they might never be able to buy. There was a great deal of social confirmation for buying a big house during the boom. And continual re-anchoring of prices. I would like to know if anyone has seen research in the role that newspapers played in the housing boom; they derived substantial revenue from real-estate advertising.