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Priceless, The Myth of Fair Value (and How to Take Advantage of It)

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chin:
When I studied economics in university, we had a very basic assumption that people are rational, and market if efficient. Yet real world anchoring effect clearly shows people do not behave rationally all the time (perhaps the market is not so efficient, and people do not have easy access to full information.) The new study of behavioral economics confronts traditional economic studies.

"Priceless" recounted an exchange between a French economist Allais (who eventually won a Nobel Prize) and Savage from the University of Chicago. The Chicago school of thought assumed decisions about money were (or could be) completely logical. Allais thought it was wrong, and posed the following 3 riddles. "Priceless" adopted a streamlined version, and I will further streamline them.

RIDDLE ONE: which of the following would you rather have
a. a sure $1 million
b. 89% chance getting $1m, 10% getting $2.5m, 1% nothing.
Allais believed most people would choose a for the sure thing. (I believe people with very keen number sense & probability would choose b for the higher expected value.)

RIDDLE TWO: this time your choices
a. an 11% chance to get $1m
b. a 10% chance to get $2.5m
Allais believed most people would choose b for the small difference in chance.

RIDDLE THREE: now you have a sealed box in front of you, and you do not know the content.
a. 89% chance getting whatever in the box, 11% getting $1m
b. 89% chance getting whatever in the box, 10% getting $2.5m, 1% nothing.

In a typical rational decision arguement, since the box exist in both choices, it should be irrelevant to the decision, so in this sense RIDDLE THREE is the same as RIDDLE TWO. Thus b is the preferred choice to most people.

But what if the box contains $1m? Then RIDDLE THREE is the same as RIDDLE ONE, but with contradicting preference. This set of riddle revealed a certainty effect. The conclusion is that "smart people are influenced by mere words, by the way the choices are framed", thus "we choose between description of options, rather than between the options themselves."

More examples in the book illustrated how framing works. Lottery advertisement tells you how big the prize is, but not the (slim) chance of winning. Insurance salesman tells you how bad a catastophe can be, but not the remoteless of the odds. People are being directed to focus on the dollar amount but not the probabilities. In a rational world, both numbers are required to make a logical decision.

(A side story. I have many heated arguments with my friends why most people should not buy any insurance besides those required by law. Most people couldn't believe how bad a gamble insurances are, especially life insurance. My initial objection came from the believe that nothing is free and many financial products are fixed sum games. My conviction was strengthened when doing a M&A deal on a smaller insurer. A industrial standard of 50% or less payout rate means policy holders are expecting to get back only half the value.)

chin:
The above are just some of the tidbits on the formation and reasons behind the study of behavioral economics. Part 4 of the book, which accounted for about half of the total pages, included many chapters in the applications of anchoring and exploitation of our irrational valuations.

For my friends who is running their own business, you should read this book. Even if you are not interested in the historical context of behavioral economics, the case studies in Part 4 should be interesting enough for any business person.

q:
One of my experiences with anchoring is when I made my last trip back to Tasmania.  My notion of prices in Tasmania is stuck 10 years in the past, so I find myself thinking everything is really expensive.

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