March 29, 2013

Price, Pricelessness, and Behavioral Economics

William Poundstone Priceless

William Poundstone ~ Priceless: The Myth of Fair Value (and How to Take Advantage of It)

Priceless is a book about price. It is pop science writing: the author is an author, not a behavioral economist. The pace is quick and most of the chapters, all of which have clever titles, are just a few pages. It eschews most pretense of grand narrative; the bulk of the book is examples of how the "prices that make our world go around are not so solid, immutable, and logically grounded as they appear." But there is enough there to tie these examples, and the stories of the social scientists that studied them, together

Poundstone opens with some eye-catching experiments and real-world examples, and then moves into section on psychophysics. I had never even heard of the discipline, but it turns out to have some revealing insights into the way we think and the way we percieve the world. From Poundstone's explanation, psychophyics is more or less dead today not because it was wrong, but because it basically exhausted its possibility for learning new things about the world.
Psychophysics established that our perceptions are based on a logarythmic (as opposed to linear) scale that, perhaps surprisingly, is the same across different people. If you think something is twice as bright, I think it is twice as bright as well. We may not think it is equally bright to begin with, but the relative change will be roughly the same.

Psychophysics established quite firmly that our perceptions are relative. You have probably seen optical illusions that convinced you something was darker or lighter than it was, based on what it was next to. All of our perceptions are that way: we judge things based on comparisons, not some absolute scale.

Psychophysics also established the phenomenon of "anchoring", which is one of the primary focuses of Priceless. Anchoring is when I change the way you percieve something by showing you something else first: I show you my wallet full of $100 bills and then give you $5, versus I hold up a penny and then give you $5. William Hunt was one of the first to notice the phenomenon and determined it could be influenced by "recency, frequency, intensity, area, duration, and higher-order attributes such as meaningfulness, familiarity, and ego-involvement."

Poundstone links the lessons of psychophysics directly to our perceptions of price. Part Three of the book is essentially a background on behavioral economics, and Poundstone does a nice job of tracing the development of different theories through various psychologists and economists. It's mostly a story of how the idea of an irrational individual came to be accepted by economists, culminating with Prospect Theory and the ultimatum game.

Prospect Theory is an economic theory with a solid technical/quanitative bases, and as such it is described in more mathematical/economics terms over at Wikipedia. Poundstone summarizes it in three points:
  • we use reference points to judge the value of things, so our judgements are fundamentally relativistic;
  • we have significant loss aversion, so we generally would rather have $10 than a 50% chance of having either $0 or $20 (typically we would only take the 50-50 bet if we were offered $30, or where the gain is double the loss);
  • and, there is a "certainty effect", which means that there is a big jump in value from say, 90% to 100% (much greater than, say the difference between receiving $90 or $100).
One implication of prospect theory is that we may not have consistent preferences, an important quality of the rational individual economists prefer to model.

The rest of the book is basically stories of different experiments based on the ultimatum game. The ultimatum game is where one player is told to divide $10 between them and the second player, and the second player can either accept the split or reject it. If the second person accepts the offer, they both get the amount the first person proposed; if the second person rejects the offer, neither player gets anything. There are hundreds of variations of this experiment and many of them are fascinating, but the last half of the book consists of little else besides bite-sized descriptions of these or related experiments. There are also a few chapters that read like an editor was encouraging the author to add some content for people who might want to read Priceless as a manual for pricing.
The book is not, however, anything like a manual. It certainly contains plenty of useful information, but the presentation is more a history of scientists and ideas than a handbook for pricing consultants. In that sense the parenthetical note in the title is a bit misleading, but it wasn't why I was reading the book so I won't complain. Overall Poundstone is an engaging writer and I enjoyed the book quite a bit.


It made me think, though.

There are two ways to understand the behavioral economics that Priceless is talking about. Behavioral economics is sometimes portrayed as proof of a fundamental flaw in more mainstream neoclassical economics, a set of evidence that undermines the most basic premises of rational-individual-based theory. But at other times behavioral economics appears to be just an interesting set of addenda--some lab experiments that help us fine-tune our neoclassical models, and the idea of 'bounded rationality' that advises against assuming too much about how people thing.

Which is it? Fundamental change or just smoothing out some rough patches? And how do we decide? And if it is fundamental change, how do we ensure that the necessary change is understood and acted upon?

Something [prominent behavioral economist] Dan Ariely said in a talk I was listening to the other day may clear things up. Neoclassical economics is fundamentally about examining static situations where many, many things are taken as given. Behavioral economics uses two key insights from other domains of social science to push against these neoclassical assumptions. First, the idea that social forces can have far-reaching impacts on markets, and second the idea that social actors create and alter their environment--including the markets they engage in.

In some situations, ignoring these two ideas may make perfect sense. Consumers do act in rational ways sometimes. But in other situations, social forces and the ability of actors to change their environment can render static equilibrium modeling absurd. Of course, economists make an effort to think about whether their results make sense on the level of individual studies. The problem is that once you have too many assumptions you start to exit the real world, and you may find a significant effect that is in fact insignificant relative to other (usually less measurable) factors.

These studies, realistic or not, tend to accumulate and coagulate into simplified worldviews like "markets are self-correcting". Behavioral economics challenges these views by lending credence, in a gradual way, to complexities that belie common assumptions. They give people the ability to ask, "Why did you assume XYZ when you were trying to explain this when we know things could be X, H, or F?"

Our economy is glued together by prices: they are the information that allocates our resources and drives our labor. But prices can only be as coherent as the people that pay them. We need to pay close attention to both the vagaries of pricing and the limits of what prices can represent. Please forgive the trite ending: there are some things money can't buy.

1 comment: