Post No.: 0576
If our rule of thumb when uncertain is to just ‘pick the middle option’ then what we pick will logically be affected by what options are presented. So we might pick a wine that’s worth €10 if we’re presented with €3, €10 and €30 options. Yet we might pick a wine that’s worth €30 if we’re presented with €5, €30 and €80 options. Here, the ordinal ranking matters more than the absolute values of the items. Instead of different wines, these could’ve been different levels of risk or generosity, etc..
There’s no right or wrong answer if several options come to the same expected value so how do we come to a decision? Different individuals will have different risk, etc. preferences. But we’re not guided by stable internal guides as much as unstable environmental ones, which means that our own choices can change from one moment/place to the next. Our risk appetites are less a stable property of ourselves and more a property of the environment we currently find ourselves in – so if we’re a ‘pick the middle option’ kind of individual then we’d pick the middle option no matter if we’re presented with a set of options that range from ‘1 to 5’ in risk (e.g. do you want to flip a coin to double or lose either €10, €14 or €19?), or a set of options that range from ‘6 to 10’ in risk (e.g. do you want to flip a coin to double or lose either €20, €24 or €29?) And we won’t realise that this is what’s going on because we’ll only be presented with one set of options hence we won’t likely question it or mind either.
Bundled items are mentally valued differently to separate items. So a €60 set of mats bundled with a new car worth €30,000 may not seem extortionate, but probably will if bought separately. Also, if bundled within the same purchase, we’re more likely to be okay with spending far more for a sunroof as an added extra in an expensive car than in a cheaper car, even though it adds the exact same function and should offer the exact same utility in each case.
Most people would rather have 2 cookies in 101 days than only 1 cookie in 100 days. Yet some of the same people would rather have 1 cookie today than 2 cookies tomorrow! The preferences change even though both sets of options are identical in that the two choices differ by 1 day. We therefore don’t always treat one unit of time the same as another identical unit of time. Woof!
We don’t always treat one unit of currency the same as another identical unit of currency either. For instance, we’re typically more bothered about saving €1 on a car fill-up/charge than €1 (or even €100) on a house purchase. We’d feel chuffed about negotiating something priced at €10 down to €1, yet not similarly for something priced at €100,010 down to €100,001!
The same with valuing losses, risks and other things. We’re again using relative comparisons and percentage differences (please read Post No.: 0506) – specifically between whatever’s being presently brought to our minds – rather than thinking in terms of absolutes.
We tend to be loss-averse, which means we’ll usually take greater risks to avoid a loss than to make a gain of the equivalent magnitude. This is inconsistent behaviour. We also tend to overweight small risks and will often pay a premium in insurance to eliminate them. If there’s a €1,000 excess if a hire car gets damaged or stolen, but one can pay €20/day to remove that excess – most will pay that €20/day insurance, even though if the holiday is 10 days long, this’d mean paying €200 in total; which signifies, at this rate, one believes that there’s a 20% chance the car will get damaged or stolen within those 10 days, or essentially a 100% chance if the rental were to last 50 days(!) Uncertainty is repellent hence many will pay a premium (a price above and beyond the expected value of the loss) to remove that uncertainty.
In economics, irrationality arises whenever our behaviours are inconsistent with our goals or when we contradict ourselves. Our preferences are often unstable and even circular or intransitive. As a hypothetical example, if you were presented two hot chocolate drinks, where one is priced at €3.00 and a negligibly less-flavoursome one is priced at €2.90 – you might as well pick the cheaper one since the difference between the two in flavour is negligible. Now on a separate occasion, if you were presented two hot chocolate drinks, where one is that same €2.90 one as above and the other is a negligibly less-flavoursome one than that one priced at €2.80 – again, you might as well pick the cheaper one since the difference between the two in flavour is negligible. And we can keep following this logic until the drink options become insipid. If you’re now presented with a choice of either taking the full-flavoured €3.00 drink or a comparably far more insipid, say, €2.20 drink – you might now think the €3.00 one is worth it. Yet you’d swap A for B, B for C, C for D… G for H, H for I, yet I for A(!)
Although we might twig onto what’s happening in this clearly-laid-out example – in financial markets where complex securities and trading patterns exist, and commissions can be extracted per trade, or ‘swap’, and we can transact with different people along the chain hence no single party becomes aware of the full picture of what we’re trying to do, this ‘money pump’ or arbitrage could potentially be exploited and people can be ‘Dutch-booked’ in the real world.
However, if there’s enough competition in the market then perhaps this’d be unlikely, and if we’re transacting with different people then different people having different preferences isn’t evidence of their self-contradicting behaviour. Nonetheless, in lab experiments at least, we can show that this intransitivity of preferences along the lines of ‘A > B, B > C, C > A’ can exist.
Yet in other cases – like gemstones or other luxury goods – the prices we’ll pay for differences that are imperceptible to our eyes can be astronomical! We might think gemstones are about ‘us internally knowing its value and that’s what matters’ but it’s more likely really about showing them off to others, otherwise we’d be wearing them even if no one else could see us wearing them(!) They could be investments but that’s probably not what most people are primarily thinking about when they purchase jewellery for themselves.
It’s reasonably easy to work out the expected values of just monetary payoffs, but in reality, many things are hard to convert into monetary terms for not everything that’s important to us is measured in money. It’s also hard to compare incommensurable things. So when choosing a house, it’s easy to compare like-with-like (e.g. a bigger garage versus a smaller garage) but not between things that aren’t (e.g. a bigger garage versus a better view). So how should we trade-off one thing with another?
Because we make decisions based on making comparisons, a decent product that doesn’t fall neatly within a product category can be overlooked in people’s shortlists. Is it a good product? We don’t know because we’ve nothing to compare it to, until more similar products arrive on the market or someone starts to compare it to products in another category. Marketing your product as ‘totally unique and in a category of its own’ can therefore potentially backfire.
We do have a natural tendency to want to put things into categories though. And the particular way we categorise things and break attributes down into simpler questions and then order/rank them (e.g. according to location, size or architecture when it comes to houses) will affect our final decision.
People sometimes make ‘lexicographic preferences’. For instance, regarding bundled goods – if having more As in a bundle is preferred over any amount of Bs, and having more Bs is preferred over any amount of Cs, then one should pick bundle (5A, 3B, 3C) over (5A, 2B, 5C) over (3A, 4B, 6C). Yet classical economics assumes that people don’t ever behave like this.
What normally happens is that, when we’re trying to decide which, say, TV to buy out of a shortlist, we break the decision down into a series of pair-wise comparisons. So we pick a pair of TVs out of that shortlist, choose an aspect to compare them on (e.g. their screen resolutions) then make that comparison. Whichever TV of the pair is better on that dimension gets a little boost in preference. And we keep doing this with different combinations of pairs of TVs and different features until their rough scores are mentally aggregated and we produce an ordinal list of one’s preferences. And the TV that ends up at the top of this list will be chosen.
So it’s all about making comparisons again. We can’t really say how much we absolutely value a ‘4K’ screen – we’re just saying that we know that it’s better than a ‘2K’ screen, all else being equal; and so forth for each feature. And the TVs will be valued according to their rank position in the shortlist they’re in.
But put your most preferred TV of this shortlist into a different shortlist with different competing TVs and you might end up preferring this TV less if it ends up in a different ranking position in this new list. What we prefer just depends on what options we’re presented with in the moment – or more specifically are currently brought to mind because ‘what you see is all there is’ (WYSIATI) – which mightn’t be consistent with what we’ll prefer in other moments if the things we’re comparing with change (e.g. we might think a great dinner is pizza if the options were pizza or salad, but we might think pizza is a boring dinner if the options were pizza or bibimbap).
Our furry preferences can legitimately change over time, and we can prefer different risks when it regards different things (e.g. one might risk one’s sexual health but not house), but this isn’t about that. We’re affected by irrelevant primes or anchors present in the environment. The value we’ll place on one option will depend on what other options are presented, hence our preferences can be influenced by apparently irrelevant – perhaps intentionally decoy or planted – options. For instance, introducing a dominated option into a choice set (e.g. a functionally worse yet more expensive product) can suddenly make a dominating option seem better, even though the dominated option should be completely disregarded because it’s not competitive or worthy of any consideration. It can lead to situations where, between options A and B, you prefer A, but when an option C is also introduced, you’ll suddenly prefer B – the ‘attraction effect’ refers to an inferior product’s ability to increase the attractiveness of another alternative when added into a choice set.
So we’re very much being influenced, or exploited, by things in our environment – and most of the time without us being aware of it too. Retailers exploit this whilst consumers need to think broader than the frames of references provided by sellers. Having more experience of something or doing more market research to gain more knowledge therefore helps. If we can presently remember that an outside option exists then this will be added into the choice set for consideration too. But forgetting something at the time is as good as not knowing it at the time when it comes to making our decisions.
Naturally, if we’re certain about something then these influences will affect us less (e.g. if we don’t drink wine at all then it won’t matter what wine options are presented to us). This is mainly about making choices in contexts of uncertainty.