21st Century Economics

Principle of Regression to the Mean: A notion worked out by Sir Francis Galton (1822-1911), an English gentleman-scientist that, in any series of random events clustered around an average or a mean, an extraordinary event was most likely to be followed, just by luck of the draw, by a rather more ordinary event. One application is contrarian investing which works simple because regression predicts that the worst stocks get better.

Representativeness is a mental problem-solving method that is a sort of short-cut the mind takes in dealing with real-world problems that are so complicated they would choke a computer. The mind handles these complex problems by assessing the evidence intuitively and compares it to some mental model. If the two match, then the mind concludes that the event is more likely. For instance, to decide if a particular football team will win a game, the mind compares the team to its internal model of what an ideal team is like. If the two models match, then the mind concludes that the team will win. This works well for most of the time but does poorly when the derived conclusion runs counter to the laws of chance and probability.

Availability is a mental short-cut that occurs when people judge the likelihood of something happening by how easily they can call other examples of the same thing to mind. Availability, too, appears to be a wonderful way to tackle complex problems because, in general, commoner events are more easily remembered. However, it does not always work for less well known subjects. For instance - does the letter K appear more often as the first letter in a work or the third letter in a word? Most people judge that K is commoner at the beginning of words because its easy to recall words that begin with K. Actually K appears about twice as often as the third letter in words. People overestimate the probability of large vividly imaginable causes of death and underestimate the likelihood of more common but less dramatic causes of death simple because vivid accidents are easier to picture in the mind.

How do people formulate strategy? They first decide what their opponents are likely to do. Then they decide how they will respond. Then they decide how their opponents will react, and so on. The theory of Representativeness dictates that the more detailed these future scenarios become, the more likely they will seem - since detail makes an account more strongly resemble the real world. But imagine a scenario involving just seven such assumptions, each of which has a 90% chance of being right. Its overall odds would actually be somewhat less than 50-50 (.9x.9x.9x.9x.9x.9x.9=47.8%). Actions that acknowledge a high degree of uncertainty are often very different than actions that don’t.

“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people that have faith that they know exactly what’s gong on!”

Ignoring the Base Rate or background data against which the probability of an event is judged is a common error. People will the odds are in their favor - “it won’t happen to me”. Aids, cancer from smoking, losses in the stock market, criminal activity are all examples of this. This leads to a strong overconfidence effect. This is a classic example of how the human mind suppresses uncertainty. We’re not only convinced that we know more than we do but that we what we don’t know must be unimportant.

The notion that people are “risk averse” as decision theorists put it, has endured since the 17th century and has become a part of many economic models. People tend to avoid risks when seeking gains but choose risks to avoid losses. People need a strong inducement to gamble but they will expose themselves to tremendous risks in order to avoid a loss. The effect is particularly pronounced in jobs and careers, second only to life and death situations. People avoid risks when seeking to save lives, but choose risks when seeking to avoid deaths.

Prospect Theory says that there is something about the human mind that so abhors a loss that giving up some quantity of money, commodity or privilege is never fully offset by an equivalent gain. “Losses loom larger than gains”. People avoid fair bets not because they are “risk averse” but because they are “loss averse” - the prospect of the gain isn’t worth the pain of the loss. People find it easier to give up a discount (forgo a gain) than pay a cost (suffer a loss). A loss seems less painful when it is an increment to a larger loss than when it is considered alone.

Framing is the principle that if a problem is framed (presented in a different manner) then the response will be different, even if the problem has not changed. In general, the frame that takes the broader view of a situation is more easily defended.