ANATOMY OF INCENTIVES

Transcription

1 ANATOMY OF INCENTIVES THE PHYSCOPHYSICS OF RATIONAL DECISION-MAKING LATOURNELL CONSERVATION CONFERENCE By Jack Donnan, Environmental Economics Services November 20, 2008

2 TOPICS ECONOMIC RATIONALISM AND EXPECTED UTILITY THEORY BEHAVIOURALIST ECONOMICS AND PROSPECT THEORY EXAMPLES AND APPLICATIONS

3 THE RISE OF RATIONALISM DANIEL BERNOULLI

4 BERNOULLI S CONTRIBUTIONS EXPOSITION OF A NEW THEORY ON THE MEASUREMENT OF RISK UTILITY (SATISFACTION) : THE VALUE OF AN ITEM MUST NOT BE BASED ON PRICE BUT RATHER ON THE UTILITY THAT IT YIELDS. DECLINING MARGINAL UTILITY: (THE) UTILITY RESULTING FROM ANY SMALL INCREASE IN WEALTH WILL BE INVERSELY PROPORTIONAL TO THE QUANTITY OF GOODS (WEALTH) PREVIOUSLY POSSESSED. EXPECTED VALUE: THE SUM OF THE VALUE OF EACH OF A NUMBER OF OUTCOMES MULTIPLIED BY THE PROBABILITY OF EACH OUTCOME RELATIVE TO ALL OTHER POSSIBILITIES

5 EXPECTED VALUE CALCULATIONS OUTCOMES ARE WEIGHTED BY PROBABILITIES COINS H <-> T P: H or T = 0.5 H = 1 X.5 =.5 T = 1 X.5 =.5 2 / 2 = 1 2 DICE 1, 2, 3. 6 X 2 = 2.12 SUM OF OUTCOMES = 77/11 NO S = 7 EV SUM WEIGHTED PROBABILITIES OF 36 COMBINATIONS YIELD 7.00 (7 HAS HIGHEST PROB (6/36) = 1.17) LOTTARIO = $10 Mil prize /12 Mil tickets sold = Prob. of Win = 1/12 Mil = x $10 Mil = $ % TO WIN $1,000; 15% WIN $0; OR RECEIVE $800 FOR SURE

6 We all stand on the shoulders of giants

7 THEORY OF GAMES AND ECONOMIC BEHAVIOUR, 1944 John Von Neumann Oskar Morganstern

8 NEOCLASSICAL ECONOMICS, RATIONAL CHOICE THEORY KEY PREMISES DOMINANCE TRANSIVITY IF A>B, B>C, THEN A>C INVARIANCE A>B NO MATTER HOW EXPLAINED FULL KNOWLEDGE/INFORMATION INDIVIDUALS CAN WEIGHT AND COMPARE ALL CHOICES PRICES FRM EFFICIENT MARKETS FULLY REFLECT ALL INFO KEY ANALYTICAL TOOLS B-C ANALYSIS COST-EFFECTIVENESS DEMAND FUNCTIONS SUPPLY FUNCTIONS

9 CRITICISMS OF RATIONAL CHOICE LACK OF EMPIRICAL EVIDENCE PRIMARILY NOMINAL RATHER THAN POSITIVE ANALYSES BEHAVIOUR ROUTINELY DEVIATES FROM RATIONAL CHOICE PREDICTIONS

10 RISE OF THE BEHAVIOURALISTS - ENTER PROSPECT THEORY AMOS TVERSKY DANIEL KAHNEMAN 2002 NOBEL LAUREATES DANIEL KAHNEMAN, VERNON SMITH

11 KEY ELEMENTS OF PROSPECT THEORY 1 LOSS AVERSION VALUE LOSSES MORE THAN GAINS, HENCE RELUCTANCE TO DEPART FROM STATUS QUO REFERENCE POINT CURRENT WEALTH, THE WORST CASE OUTCOME, HAVING JUST RECEIVED A WINDFALL RISK AVERSION VRS RISK TAKING RISK AVERSION IN GAINS INVOLVING MODERATE PROBABILITIES AND OF SMALL PROBABILITY LOSSES, RISK SEEKING FOR LOSSES INVOLVING MODERATE PROBABILITIES AND SMALL PROBABILITY GAINS STOCK BROKERS TEND TO SELL THEIR WINNING SHARES AND HANG ON TO LOSERS IN HOPES THEY WILL RECOVER.

12 KEY ELEMENTS OF PROSPECT THEORY 2 OVERCONFIDENT ABOUT ABILITIES IRRELEVANT BUT COMPARABLE OPTIONS OVER-VALUE THINGS THAT HAVE BEEN TOUCHED SHOW INFERIOR OPTIONS TO PROMOTE A SALE. MENTAL ACCOUNTING SEPARATE MENTAL ACCOUNTS FOR DIFFERENT SOURCES OF INCOME OR DEBT. FRAMING THE DECISION LOSSES OR GAINS? HIGH PROBABLITIES OR LOW

13 LOSS AVERSION 1 CANADA EXPECTS 1000 DEATHS FROM FLU THIS YEAR, TWO PROGRAMS PROPOSED A = 300 PEOPLE SAVED B = 33% PROBABILITY 1000 PEOPLE SAVED AND 67% NO ONE SAVED

14 LOSS AVERSION 2 AUTHORITIES HAVE REVISED THEIR MESSAGE C = 700 PEOPLE WILL DIE D = 33% PROBABILITY NOBODY WILL DIE AND 67% 1000 PEOPLE WILL DIE

15 ECONOMIC CONTRIBUTORS TO PROSPECT THEORY JACK KNETSCH RICHARD THALER

16 LOSS AVERSION 3 ENV. POLICY EXAMPLES ENVIRONMENTAL AND HERITAGE FEATURES: WILLINGNESS TO PAY FOR GAINS < COMPENSATION FOR LOSSES ~ 2-6 TIMES WHO OWNS RIGHTS TO ENVIRONMENTAL SINKS? NEW SOURCE PERFORMANCE STANDARDS > STDS/COMPLIANCE TIMING FOR EXISTING FACILITIES.

17 RESPONDING TO HIGH FUEL PRICES 1 How does fuel market economy work? Rational economic model Max(PV fuel savings initial cost) Economists use this language Payback periods Higher price = sum of savings over 2-4 years Manufacturers use this language None of the above but if there are genuine savings why doesn t the market find a way to realize them

18 RESPONDING TO HIGH FUEL PRICES 2 Uncertainty makes higher fuel economy a risky bet for loss-averse consumers. Quantify uncertainty in manufacturers risky bet of building a 35 MPG vehicle. Simulation reflecting uncertainty factors indicates fuel economy has expected PV of $405. Applying a K-T consumer loss aversion function changes expected value of fuel economy to consumer to -$32. Gasoline prices would have to reach $4/gal or more to increase value of fuel economy to consumer to positive value.

19 RESPONDING TO HIGH FUEL PRICES 3 Gasoline prices $4/gal or more to increase value of fuel economy to consumers. Governments (US, EU, Japan, China, Korea, Australia, etc.) adopting fuel economy standards. Markets for energy efficiency of consumer durable goods share this structure. Future energy savings (and cost) uncertain, Net value = PV savings Cost, Manufacturers perceive consumers do not want higher cost fuel efficient products, Consumers are loss averse Manufacturers under-invest in R&D for fuel efficiency.

20 MORE EXAMPLES FROM THE WILD WHEN BUSINESS IS GOOD NEW YORK CAB DRIVERS QUIT WHEN THEY REACH A DAILY INCOME TARGET - LOSS AVERSION WHEN LOTTERY PRIZES GROW, MORE PEOPLE BY TICKETS OVER WEIGHTING LOW PROB OF WIIN HORSE RACING BETTERS PLACE MORE AND HIGHER BETS ON LONG-SHOTS (WITH HIGH ODDS); LESS ON FAVOURITES (WITH LOW ODDS)

21 FINAL THOUGHTS ELEMENTS OF PROSPECT THEORY USEFUL FOR EXPLAINING AND PREDICTING BEHAVIOUR THAT SEEMS IRRATIONAL TO THE CONVENTIONAL WISDOM OF MAINSTREAM ECONOMISTS DANIEL KAHNEMAN S INVESTMENT STRATEGY - BUY AND HOLD!