assumptions of standard economic theory in the light of psychology and behavioral economics

Vaclav Dusek Rationality in the light of psychology and behavioural economics

Title: Evaluation of Standard Economic theory in the light of psychology and

behavioural economics with empirical evidence of the application of the

endowment effect.

Abstract

Standard economic theory assumes that people are rational, act based on full information

have stable preferences and always maximise utility. This dissertation first outlines the

assumptions of the standard theory, and then attempts to answer if the assumptions of the

standard theory are viable in the real world with real people, and if humans truly are

completely rational. Firstly the findings and theories of various fields of psychology are

reviewed that discuss the ways in which actual human mind is different from being

completely rational, and two system theory of decision making is explored along with the

implications of the human ability of being self-aware in relation to rationality. Secondly, the

specific deviations from rationality and their implications are reviewed, with emphasis on the

findings of behavioural economics and the prospect theory value function and probability

weighting. Thirdly, empirical research conducted on the endowment effect is reviewed, and

primary research experiment is proposed that creates a variation on the assessment of the

existence of the endowment effect. Fourthly, the findings of the experiment are explored,

which support the existence of the endowment effect and importance of intuitive system and

contradict the assumptions of standard economic theory, and fifthly conclusions and

recommendations are made for application of the evidence found in literature and during

primary research.

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Acknowledgements

First of all I would like to thank my girlfriend Jing for amazing level of support and

tolerance during the course of completing this dissertation. I would like to also thank

James Mallon, my supervisor for providing the inspiration to explore the intricacies of

human behaviour in economic settings during the behavioural finance module, and

for great insight and conversations on the topic. I also have to thank Collins Ossei,

the administrator at Edinburgh Napier for tremendous help with contacting students

that became the subjects in my primary research, the younger computer suite and

reception staff for great support with producing advertising material used to attract

students and Gary Wright for support with booking rooms at Edinburgh Napier, and

finally players of Edinburgh Eagles Floor ball Club and students of Edinburgh Napier

university for taking part in my experiment.

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ContentsAbstract.....................................................................................................................................4

Acknowledgements...................................................................................................................5

List of tables, figures and other materials.............................................................................6

Chapter 1 - Introduction............................................................................................................9

1.1 The aims of this dissertation are:....................................................................................9

1.2 Objective.......................................................................................................................10

1.3 Research Methodology overview..................................................................................10

1.4 Limitations.....................................................................................................................10

1.5 Resources.....................................................................................................................11

1.6 Structure........................................................................................................................11

Chapter 2 – literature Review.................................................................................................13

2.1 Assumptions of Neo-Classical Standard Economic Model (SEM)................................13

2.1.1 People maximise profits and utility.........................................................................13

2.1.2 People act rationally...............................................................................................15

2.1.3 People act on the basis of full and relevant information.........................................15

2.1.4 Summary of SEM assumptions..............................................................................16

2.2 Views of psychology and systems of decision making..................................................17

2.2.1 Limitations in rational cognitive ability....................................................................17

2.2.2 Role of emotion.......................................................................................................18

2.2.3 Two system decision making model.......................................................................20

2.2.4 Self-awareness, self-control and protection of self-esteem by System 1...............24

2.2.5 Views of Psychology – Summary...........................................................................26

2.3 Behavioural economics, specific biases and implications.............................................28

2.3.1 Belief in the law of small numbers..........................................................................28

2.3.2 The Prospect theory and the value function...........................................................29

2.3.3 Framing anchoring and priming..............................................................................35

2.3.4 Lack of self-control..................................................................................................36

2.3.5 Self-affirmation........................................................................................................37

2.3.6 Herding...................................................................................................................37

2.3.7 – Behavioural economics, specific biases and implications summary...................38

2.4 The Endowment Effect..................................................................................................39

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Chapter 3 - Research methods...............................................................................................41

3.1 Aim of research.............................................................................................................41

3.2 Methodology..................................................................................................................41

3.2.1 Choice of research method....................................................................................41

3.2.3 Method....................................................................................................................42

3.2.3 Limitations...............................................................................................................43

Chapter 4 - Research findings................................................................................................44

4.1 – Supportive test...........................................................................................................44

4.2 – Results and findings...................................................................................................45

Chapter 5 - Conclusions and Recommendations...................................................................47

5.1 Conclusions and recommendations..............................................................................47

References..............................................................................................................................49

Bilbiography.........................................................................................................................57

Appendixes.............................................................................................................................58

Appendix 1 – Research Data..............................................................................................58

List of tables, figures and other materials

Figure 2.1 Indifference curves (Investopedia, 2011)..............................................................13Figure 2.2-Cognitive Systems (Kahneman, 2003:698)...........................................................20Figure 2.3 - Selective Accessibility (Kahneman, 2003:700)...................................................21Figure 2.4 - Decision making process (Based on Kahneman, 2003:717)..............................23Figure 2.5 Prospect Theory value function (based on Kahneman and Tversky, 1979:565)...29Figure 2.6 - Diminishing marginal utility..................................................................................29Figure 2.7 – Multiple reference points for the choice between x and y (based on Tversky and Kahneman, 1991:896)............................................................................................................31Figure 2.8 - Probability weighting function. Based on Tversky and Kahneman, 1992:688-691)................................................................................................................................................32

Table 4.1 Test findings…………………………………………………………………………………..44

Table 4.2 - Run 1 Results…………………………………………………………….. 45

Table 4.3 - Run 2&3 Results………………………………………………………… 46

Table 4.4 - Combined Results ……………………………………………………… 46

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Chapter 1 - Introduction

The Standard Neo-Classical Economic Model (SEM) assumes that economic

agents act rationally without emotion or bias, put fair value on goods and

investment products and always act in a way that maximises utility. This

assumption was challenged over the past decades and it is contradicted by

theories and findings in the fields of psychology and behavioural economics. The

purpose of this dissertation is to evaluate the correctness of the assumptions of

SEM in the light of theories and research in the fields of psychology and

behavioural economics, to review specific implications of deviations from SEM

assumptions, and to provide empirical evidence that will either reinforce

assumptions of SEM or that of psychology and behavioural economics through

assessing the existence and magnitude of impacts of the endowment effect on

valuation of consumer objects.

1.1 The aims of this dissertation are:

Outline the vital assumptions of SEM.

Review the findings and views of psychology on capabilities of cognitive ability

in humans.

Review decision making processes outlined by psychologists with emphasis

on intuitive and rational systems and their tendencies.

Review the specific models and implications outlined by behavioural

economics.

Review empirical evidence and findings collected on the endowment effect.

Conduct an alteration on the endowment effect experiment.

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Analyse collected data and conclude if expectations of standard economic

model or the views of psychology and behavioural economics can be

supported.

1.2 Objective

Recreate an alteration on the endowment effect experiment and either support or

deny the assumptions of SEM and contradicting theories from the fields of

psychology and behavioural economics.

1.3 Research Methodology overview

As ownership must be established in order to confirm or deny the endowment effect,

physical presence of subjects was required when conducting primary research and

the only suitable method was a physical experiment. An experiment with total of three

runs with conditions with minor variations was conducted, where subjects were first

randomly distributed a consumer object and told it is a reward for their participation,

and then asked to complete a test assessing basic knowledge of mathematics and

logic. The test was designed to create possession time of the object and to shift

attention of subjects from the object to create a more natural response in the main

focus of the study. The results were not the primary focus of the study.

The difference between selling prices and buying prices was evaluated in order to

deny or confirm the influence of the endowment effect. Detailed methodology and

results are included in Chapters 3 and 4.

1.4 Limitations

The total sample size of 24 out of a population of 6.8 billion cannot lead to definite

conclusions about the entire population and there is no guarantee that the results can

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be replicated, although very significant results were identified within the sample size

itself.

The sample size also does not represent a cross section of all demographics, as it

was dominated by male participants and the range for ages was 19-35.

1.5 Resources

Edinburgh Napier library was used for literature overview and academic access to

online journals was obtained through Edinburgh Napier academic access. Microsoft

Excel was used for data processing and Microsoft Visio and Paint were used for

creation of schemas. Edinburgh Napier room facilities were used for conducting runs

2&3 of the experiment.

1.6 Structure

Chapter 2 (Literature review) is divided into four sections. Section 2.1 outlines the

three vital assumptions of SEM. Section 2.2 outlines the theory and research found in

various fields of psychology with emphasis on intuitive and rational systems used in

decision making, and the impacts of self-awareness on decision making. Section 2.3

focuses on specific anomalies and deviations and differences with focus on findings

in the field of behavioural economics and discusses their implication on

understanding economic behaviour and their implications.

Section 2.4 provides a review of empirical evidence collected on the role of the

Endowment Effect.

Chapter 3 (Methodology) outlines the research methodology and settings used to

collect data on the influence of the endowment effect.

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Chapter 4 (Findings) summarises results of primary research and concludes if the

assumptions of SEM or that of psychology and behavioural economics are

reinforced.

Chapter 5 (Conclusions and recommendations) provides overall conclusions and

recommendations.

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Chapter 2 – literature Review

2.1 Assumptions of Neo-Classical Standard Economic Model (SEM)

The roots of neo-classical economic thought stem from the classical economics of

Adam Smith, David Ricardo and John Stuart Mill. Smith (1776) was the first who

used the term ‘an invisible hand’ that leads labourers to promote the highest value

within an industry through their actions, although the prosperity of an industry is not

the labourer’s intentional goal, his self-interests are. This was the basis for the

classical general equilibrium model. Ricardo (1815) added to classical economics by

introducing the law of diminishing returns, comparative advantage, minimum wage

and others. The term ‘classical economics’ ‘was coined by Karl Marx as a description

of Ricardo’s formal economics as contrast to his ‘economics close to

people’(Colander, 2002:5). The term neo-classical was first mentioned by Thorstein

Veblen (1900), who used it as a negative characterisation of Alfred Marshall’s

economics that incorporated marginalism, and the term later caught on (Colander,

2002). The underlying principles of SEM are:

2.1.1 People maximise profits and utility

It is ‘the Idea that a rational individual facing a choice between various alternatives

chooses the ones that maximise his utility function, and its origins go to the 18 th

century and Jeremy Bentham and his utility maximisation paradigm’ – (Aleskerov

et.al:2002:1). Just what is utility? When a good is consumed, the consumer derives

benefits or satisfaction from the activity, and economists call this satisfaction utility.

This allows SEM to explain preference and benefits from consuming a good not only

based on pure monetary profit, but also other benefits such as satisfaction or rise in

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status. The first school of thought of Bentham and Alfred Marshall was cardinalism -

where the benefit was measured in abstract utils. Cardinalism was later replaced by

ordinalists who believed that utility cannot be measured cardinally because it is

impossible to know by how much an individual values one bundle of goods over

another (Hardwick et. al, 1994). Cardinalist approach expects that one consumer

equilibrium exists for two goods, and that people will choose to move towards the

ratio where:

Marginalutility XPrice X

=Marginal utility YPriceY

, where the law of diminishing marginal utility is in

place that predicts that the utility from consuming additional unit within a given period

of time will eventually fall (e.g. One

coffee would return 10 utils, but

another coffee only 6 utils).

Ordinalist approach then uses

indifference curves (see Figure1),

where instead of one equilibrium a

curve exists where different combinations of good A and good B on the indifference

curve will give the consumer the same utility. (Hardwick et. al, 1994)

Both the cardinalist and the ordinalist approaches expect a person to always

maximise utility and reach the optimal state, be it through moving towards the static

equilibrium in the former, or towards a combination of goods on the indifference

curve in the latter, and that the marginal utility curve, equilibrium or the indifference

curves for two goods do not change.

When making decisions under risk the expected utility theory predicts that people

maximise utility based on expected value, i.e. when offered £100 and a 50% chance

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Figure 2.1 Indifference curves (Investopedia, 2011)


for £210, option 2 will be always chosen as the expected value is £210*0.5=£105 and

£105>£100. SEM also allows accounting for risk aversion, and if someone will

believe that risk of 50% of nothing decreases value by more than £5 the option 1 may

be chosen. The domain of the function is final states and overall changes in welfare

and risk aversion is a concave, and risk aversion is the same as concavity of the

utility function (Kahneman and Thaler, 1979).

2.1.2 People act rationally

‘The fundamental principle of economics is that people behave according to rational

self-interest. Rather that viewing humans as inconsistent, incompetent, selfish or

altruistic economists argue that human behaviour is predictably based on person’s

weighting the costs and benefits of decisions’ (Eklund and Tollison, 1991:10). SEM

economists again do not ignore benefits of charitable intention, or that of love, but

they expect that decisions are made rationally, without the influence of emotions, and

that humans in modern society can be called Homo economicus (Eklund and

Tollison, 1991). Homo economicus has a well-organized and stable list of

preferences, and his logical computational skills allow him to evaluate different

courses of action that are available to him, and to choose those that will lead to

achieving the highest possible preference (Simon, 1955). Emotional centres of the

brain therefore are not used when deciding his preferences, and all decisions are

made rationally and lead to maximised utility.

2.1.3 People act on the basis of full and relevant information

SEM not only expects people to be able to perfectly evaluate their own preferences

(‘internal’ factors), but also that they work on the basis of full information, and can

rationally take it into account when expecting what happens in the future and when

assessing their decisions, and they always take into consideration the long term

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impact of their decisions (‘external’ factors). For example according to the Rational

Expectations Hypothesis, when expecting future inflation rates people have an

analytical model in mind that explains how the economy works and take fully into

account all factors influencing inflation such as what is happening to money supply,

oil prices, exchange rate or what unions are doing (Hardwick et. al, 1994). Rational

Expectations Hypothesis still allows for changes in rational expectations within a

market, but presumes them to be ‘random’ and ‘normally distributed’ and therefore

not having an overall impact (Muth, 1961). Upon this theory the Efficient Market

Hypothesis is based. It states that ‘markets do not allow investors to earn above

average return without accepting above average risks’ (Malkiel, 2003:60), because

all investors within the market work with full information. For example ‘A well-known

story tells of a finance professor and a student who came across a $100 bill lying on

the ground. As the student stops to pick it up, the professor says ’Don’t bother – if it

were really a $100 bill, it wouldn’t be there’ (Malkiel, 2003:60). Markets and

individuals within them are very successful devices for reflecting and applying new

information rapidly and effectively (Malkiel, 2003).

2.1.4 Summary of SEM assumptions

To summarise the assumptions of SEM, modern human can be described as Homo

economicus. He knows what his preferences are, and he will always choose those

preferences that maximise his utility. His choices are logical, based on rational

thought and always take into consideration all available relevant information and long

term impact (he does not act impulsively and has a perfect self-control).

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2.2 Views of psychology and systems of decision making

2.2.1 Limitations in rational cognitive ability

Does the theory and research in the field of psychology agree with the model of

Homo economicus? The model would be consistent with multi attribute utility theory

(Wright, 1984) which predicts that a decision maker should identify dimensions

relevant to a decision, decide how to weight the dimensions, weight total utility for all

possibilities and select the option with highest weighted total (Eysenck, 2009).

However, Selten (2001:103) noted that ‘in majority of field settings, there is no way to

determine if a decision choice is optimal owing to the time pressure, uncertainty, ill-

defined goals and so forth’ and this distance from optimal solution stems from limited

computational capacities (limited attention or memory) and the nature of the situation

(e.g. where information is expensive or it is timely to obtain). In another words

‘Human rational behaviour is shaped by scissors whose two blades are the

structure of task environments and the computational capabilities of the

actor’(Simon, 1990:7), and human mind works on the basis of bounded rather than

unbounded rationality, contrary to the assumptions of SEM. Simon (1990) argues

that people instead use the concept of satisficing when making decisions, and that

whenever presented with large number of alternatives, when the problem has little

known structure or when numerous dimensions of value or uncertainty are present, a

person will consider various options one at a time and select the first one meeting

their minimum requirement. Payne, Bettman and Johnson (1988) have discovered

that people rarely use only one strategy when facing complex decisions, and instead

adaptively select strategies that are relatively efficient in the context and that people

also change their information processing strategies based on different levels of time

pressure. For example when searching for a flat, subjects in Payne’s (1976) study

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used satisficing to limit the number of flats with 4-12 different attributes to a few

selected through eliminating those that didn’t meet their minimum requirements, but

when only a few flats were left subjects switched to a more complex strategy that

would actually be close to multi-attribute utility theory or assumptions of SEM.

Eysenck (2009) also notes that not all decisions are made consciously but

unconscious thought is used e.g. when there is no time to consciously evaluate all

options, and that unconscious thought can be even superior to conscious thought

under certain conditions. When people are presented with a complex problem, they

are more likely to consider all available information when they are forced to act

subconsciously than when they are given a few minutes to think about the choices.

When given limited time the conscious mind is very likely to focus on a few criteria

and weight them as more important than others. Dijksterhuis and Nordgren (2006)

believe that because of that the unconscious thinking is often actually more likely to

be in line with rational choice as it considers all options, but people often misapply

unconscious and conscious thinking and think consciously about complex problems

that have large amount of information like mortgage and then apply unconscious

thought on small problems with complete information where conscious thought would

be more appropriate.

2.2.2 Role of emotion

We can therefore see that even when using only cognitive processes, people often

cannot consider all information, are influenced by time and environment and can use

and misapply conscious and unconscious thought processes. However despite its

limitations, is the decision making process of humans rational, i.e. does it use the

cognitive strategies without the influences of emotion, biases an prejudice? Emotions

can be split into two groups. The first group of them as basic (sad, happy, disgust,

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surprise, anger and fear), these emotions have easily recognisable facial expressions

identical across cultures and their effect is usually immediate. Second category is

complex emotions such as jealousy, pride, embarrassment and guilt, these emotions

are modulated by cultural rules and show awareness of another person’s attitude

towards oneself (Ward, 2006).

Basic and complex emotions are indeed used indecision making, and ‘cognitive

neuroscience assessed the impact of emotion in its ‘somatic-marker hypothesis, in

which emotions in the form of bodily states, bias decision making toward choices that

maximize reward and minimize punishment’ (Bechara, A. Naqvi, N. Shiv, B.

2006:260). The hypothesis was based on the findings of experiments with patients

with damaged ventromedial prefrontal cortex in their brain. These patients seemed

unable to learn from previous mistakes and made repeated engagement in decisions

that led to negative consequences, and were performing poorly in various problem

solving tests, although their intellect and problem-solving abilities were largely normal

(Bechara, 2004). Their ability to react in emotional situations was impaired and it is

assumed that they are unable to use emotion in decision making in personal financial

and moral realms (Bechara, A. Naqvi, N. Shiv, B. 2006). This clearly shows that

emotions play vital role in successful decision making, and SEM’s emotionless

rational man would paradoxically fail miserably in applying rationality when making

decisions. In Fact Zajonc (1980) argues that very often emotions are what

completely drives decisions with only trace presence of cognitive thinking required for

minimal identification of an object. He also believes that emotion comes first, we

remember it longer and we cannot control emotional feelings and their impact on our

decisions. For example we can completely fail to notice a person’s hair colour or may

hardly remember what it was shortly after meeting said person, but we can seldom

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escape the reaction that the person seemed as friendly or unfriendly, or as someone

who we found attractive or repelling. We can change facial expression and through

cognitive thinking can approach positively a person that evokes negative feelings, but

the emotional response will remain the same and it will be hard to consciously

change the fact that the person’s presence makes us feel bad. (Zajonc,1980).

2.2.3 Two system decision making model

The way emotion is incorporated in decision making was outlined by Kahneman

(2003) in his two system model. He believes that emotion is present only in System

1, which he labelled intuition (see Figure 2). The operations of this system are fast,

automatic, require no effort and are often emotionally charged. This system is

consistent with the findings of Dijksterhuis and Nordgren (2006) and their label of

unconscious decision making. It is only System 2 that Kahneman labelled reasoning

that is emotionally neutral, flexible and abides by rules. It is also deliberately

controlled but that means that it requires conscious effort and monitoring, and

effortful processes that require attention interfere with each other (Pashler, 1998),

whereas effortless processes do not create interference nor suffer from it

(Kahneman, 2003).

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Figure 2.2-Cognitive Systems (Kahneman, 2003:698)

As shown in Figure 2, both systems can react to current stimulation, but can be also

evoked by language. When a person comes into a contact with a situation or an

object, the intuitive system creates involuntary impressions of perception. The role of

System 2 is to create intentional judgements, and to monitor and control System 1.

This is illustrated in the following example created by Kahneman and Frederick

(2001:7) ‘A bat and a ball cost $1.10 in total. The bat costs $1 more than the ball.

How much does the ball cost?’ Kahneman and Frederick note that almost everyone

they have asked reports initial urge to answer 10 cents, because System 1 naturally

separates $1.10 into $1 and 10 cents, and 10 cents seems about the right amount.

However upon closer inspection the monitoring ‘rational’ System 2 starts to work, and

it is not difficult to quickly arrive at the correct answer, 5 cents ($0.05+$1.05=$1.10).

However Frederick (Frederick IN Kahneman, 2003:699) found out that 50% of

Princeton Students (47/93) and 56% (164/293) of University of Michigan students

gave the wrong answer even though they were given time to think about the question

(and therefore System 2 should have monitored and corrected the error of System 1).

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This shows how lightly the intuitive system is monitored, and that people are not used

to thinking hard and are often content to trust the first plausible judgement that

comes to mind (and therefore not use the rational System 2). However Kahneman

(2003) also notes that System 1 is slow learning, but can indeed be trained and

become skilful and doesn’t only have to lead to rational mistakes. An example would

be a chess master who simply walks past a chess game and can instantly see that

the game can end in three moves. Kahneman calls the ability to solve problems with

System 1 accessibility. This ability is selective and some problems are solved by it

and some aren’t. An example would be Figure 3 – one will get the immediate

impression of height or the size of the area on top of tower A or tower B, putting it

into actual measures in millimetres would require effort, but the impressions are

easily accessible by System 1. But for example the total space the blocks of tower A

would cover if it was dismantled, or the height of tower B if it was put together are not

easily accessible and require deliberate effort.

Figure 2.3 - Selective Accessibility (Kahneman, 2003:700)

This accessibility could be changed however and if a person spent time by long term

practice on similar exercises, the process of counting the blocks would move from

System 2 to System 1 and become more accessible, much like a game of chess

becomes accessible for a chess master.

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Although the above examples could lead to the impression that System 1 and

System 2 are separate, and when System 2 finds a mistake or irrationality in System

1 it flawlessly overrides it (with the limitations of computing ability), this is not how

human mind works. An example of this was presented by Haidt (2001:2):

‘Julie and Mark are brother and sister. They are traveling together in France on

summer vacation from college. One night they are staying alone in a cabin near the

beach. They decide that it would be interesting and fun if they tried making love. At

very least it would be a new experience for each of them. Julie was already taking

birth control pills, but Mark uses a condom too, just to be safe. They both enjoy

making love, but they decide not to do it again. They keep that night as a special

secret, which makes them feel even closer to each other. What do you think about

that, was it OK for them to make love?’

Most people hearing the above story say that it was wrong and stand by their

opinion, although clearly Julie and Mark’s actions maximise utility and were in line

with System 2 rationality. Yet most people still insist that it was wrong, they come up

with arguments of inbreeding, or that Julie or Mark will get hurt, perhaps emotionally.

But two forms of birth control were used, eliminating the danger of inbreeding and no

emotional harm was done, and eventually many people say something on the lines of

‘I just know it’s wrong but I can’t explain’. The reason for this is morals, which like

complex emotion are moulded by culture and environment, and are present in the

intuitive System 1, and because of this ‘irrational’ influence most people become

lawyers trying to build the case on the wrongness of the act rather than allowing

System 2 to rationally search for the truth (Haidt, 2001).

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Figure 4 shows the tree of processes that take place what people make a decision.

Kahneman (2003) notes that most decisions are made through outcomes of intuitive

judgement A and B and System 2 thinking is anchored by intuitive System 1

impressions and intentions even when it is not completely dominated by them (Haidt,

2001) as demonstrated in the example of reaction to Mark and Julie’s story.

Figure 2.4 - Decision making process (Based on Kahneman, 2003:717)

2.2.4 Self-awareness, self-control and protection of self-esteem by System 1

Along with great apes, humans are the only species capable of self-recognition,

which was confirmed with experiments with mirror where great apes recognised

themselves after prolonged contact or e.g. when their eyebrows were painted red

after anaesthesia was applied great apes immediately touched their own eyebrows,

but all other species apart from humans were incapable of such recognition

(Povinelli, et al, 1997. Brehm et al, 2005). Although a sign of intelligence, knowing

21


oneself can often lead to self-awareness trap, where what we actually are and what

we have achieved is below what we ought to be, judged by either our internal

aspirations (private self-consciousness) and/or public and external aspirations (public

self-consciousness) (Brehm et al, 2005). This creates a self discrepancy. Much like

homeostasis keeps the function of the internal organs in balance, human System 1

mind works hard to keep our mental state in balance. When a discrepancy occurs it

causes people either to change their behaviour or remediate the situation that leads

to the discrepancy, or to try to either avoid it or align their aspirations with the actual

outcomes or situations, they withdraw from self-awareness and suppress System 2 in

evaluating their situation realistically. Bulmeister and Heatherton(1996) believe that

procrastination, binge eating, drug abuse or even suicide serve as methods of

withdrawing from self awareness, and that the ability of self-control (i.e. the

monitoring function of System 2) that leads to rationally remediating the underlying

issue rather than avoiding it is a limited resource that can be depleted by usage.

Vochs and Heatherton (2000) confirmed this in their studies where chronic dieters

were shown a movie and half of them were provided with sweets within arm’s reach

(high temptation) and half 10 feet away (low temptation), and after the movie ended

they were put into a room with ice cream taste test where they could eat as much as

they wanted, and were given an impossible cognitive test. Those in the high

temptation scenario ate significantly more ice cream and gave up a lot quicker than

those in the low temptation scenario, because the self control ability was depleted.

To avoid discrepancies and to protect self-esteem several mechanisms of self-

enhancement are created by System1. For example self serving cognitions shield

the mind from failure, as Shepperd (1993) has found, students with low SAT

(American high school leaving cognitive tests) overestimated their scores by 17

22


points on average with low scoring students overestimating their results the most.

Interestingly, those that scored high praised themselves for their good results and

those that ranked low had blamed the instructor, conditions or other factors for the

negative results – people are ready to praise themselves for gains and blame the

environment for failures. Self serving cognition is also being overoptimistic about the

future, and people often create elaborate theories to justify their optimism (Brehm et.

al. 2003). Other mechanisms include self-handicapping where people handicap

their own performance in order to create an excuse for their failures, or downward

comparisons where people always tend to compare themselves with somebody

worse off. Most people also have a tendency for self affirmation - the tendency to

rationalise their own decisions and choices and rate them more favourably and for

example bettors that already placed a bet on a horse become more optimistic than

those waiting in line to place the bet (Inskter and Knox, 1968), or people that choose

two objects out of six rate them as more desirable when they are asked to re-rate

them later (Brehm, 1956).

2.2.5 Views of Psychology – Summary

This section outlined the limitations of conscious rationality, showed that emotions

are necessary to be present in decision making, summarised System 1 and System 2

processes, and outlined the impacts of self awareness and protection of self esteem.

It is clear that although it is possible to train System 1 to become more rational, an

average human certainly is not capable of acting based on full information especially

in complex or not well defined scenarios, majority of his choices are made through

(or heavily influenced by) emotionally charged, impulsive System 1, that is

susceptible to oversimplification and various biases, often caused by self-awareness,

his preferences can change e.g. merely by making a choice, and the ability of self

23


control is a limited deplete able resource, and when it runs out people often make

choices that are irrational or even harmful even when they are fully aware of better

alternatives.

The views of psychology do not confirm that Homo economicus does not exist with

100% certainty. Should a person train System 1 hard and frequently enough in all

possible aspects so that he or she becomes so profound at rational choices that they

become part of the system, he or she might come close to Homo economicus much

like a chess master’s System 1 mind becomes a chess scenario solving machine,

and no doubt many economists have come close to that state, but the average mind

of a decision maker deviates from the ideal in pretty much every aspect.

24


2.3 Behavioural economics, specific biases and implications

We have now established that System 1 drives decision making and that it deviates

from rationality. But what are the specific deviations from rational expectations and

what do they mean in relation to economic theory, consumer and market behaviours?

The field of behavioural economics attempts to provide the answers. Instead of

focusing on creating internal theories and models such as SEM economists do,

behavioural economics explores actual behaviours and creates models and makes

conclusions based on them.

2.3.1 Belief in the law of small numbers

Arguably the founders of the field of Behavioural economics are Amos Tversky and

Daniel Kahneman, who have collaborated on a number of works in the area. Their

first joint paper was that on belief in the law of small numbers. Due to the natural

tendency of System 1 to simplify, ‘people view a small sample randomly drawn from

a population as highly representative, that is, similar to the population in all essential

characteristics.’(Tversky and Kahneman,1971:194), and they also expect any two

samples from large population to be very similar to each other, and when the

sequence of a small sample goes one way, they expect the rest of the sample to

have a self-corrective mechanism (the so called gambler’s fallacy).

This belief can be seen in countless research papers, where the believer in the law of

small numbers believes in small sample sizes, early trends, and believes that the

results can be easily replicated. Deviation in results is often given causal

explanations for discrepancies, and the researcher has usually little opportunity to

recognize variance in action. (Tversky and Kahneman,1971). Belief in small numbers

also causes gamblers to continue playing or buying lottery, because they believe

25


they are ‘due’ for a win after a series of losses, and a plethora of poker players

believe they are significant winners after a couple hundred hands even though that is

a completely insignificant sample. Investors and e.g. directors in finance also show

symptoms of the belief, as short term increases in share value, exchange rates or

other financial results are often mistaken for a proof of long term results and long

term value, and until recently bonuses and dynamic rewards were rewarded for such

short term results. Tversky and Kahneman (1971) have found that the effects in

System 1 persist regardless of motivation and how much people ‘want’ to believe in

it, but at least researchers, gamblers investors and directors managing dynamic

rewards should be aware of it and try engage system 2 in trying to understand the

laws of probability and apply them correctly.

2.3.2 The Prospect theory and the value function

Although the belief in the law of small numbers is widespread and important, the real

breakthrough of behavioural economics came with Kahneman and Tversky’s (1979)

collaboration that explored prospect theory. Prospect theory is an alternative model

to expected utility theory, which is ‘not an adequate descriptive model. (Kahneman

and Tversky, 1979: 549)

They have proposed an alternative, based on S shaped value function (Figure 5). It is

concave for gains, which means that people do get indeed more satisfaction/value

when they gain for example £1000 than when they gain £500, however not twice the

satisfaction but less than that. It is convex for losses, which means that any loss

causes dissatisfaction, but double the loss will cause less than double the

dissatisfaction. The function is also steeper for losses than for gains; gaining £100

generates less value than losing £100 takes away, and ‘moves’ with reference points

26


(people measure value in terms of gains and losses from their current

situation/reference point rather than in absolute terms).

Figure 2.5 Prospect Theory value function (based on Kahneman and Tversky,

1979:565)

This contrasts with the standard value function of diminishing marginal utility (see

figure 6) which is concave over the whole spectrum, and for example at reference

point A losing £1000 will cause more than double the loss in value than losing £500,

and it is not steeper for losses or gains.

27


Figure 2.6 - Diminishing marginal utility

28


The shape the value function has been confirmed by Kahneman and Tversky

(1979:551), who have created a series of problems that they presented to students

for example one series of the problems was:

Choose Between

Problem 1: A) get 6,000 with probability 25% OR B) get 4000 with probability 25%

and 2,000 with probability 25%

Problem 2: C) lose 6000 with 25% probability OR D) lose 4,000 with 25% probability

and lose 2,000 with 25% probability.

Majority of respondents have answered 1 B) but also 2 C) which confirms the convex

shape for losses and concave shape for gains.

The dynamic position of the reference point and the fact that people naturally

evaluate value in terms of losses and gains rather than in absolute terms comes

naturally through the functions of System 1. For example an object is be evaluated as

hot or cold depending on the temperature that the person touching the object has

adapted to (Helson, 1964), the same amount of wealth can be seen as poverty for a

member of upper class in a developed country but great riches to a person with $1

daily salary in poor parts of Africa.

The presence of loss aversion (steeper losses than gains curve) has many reasons,

one being endowment effect (See Section 2.3, and chapter 4 for detailed analysis),

another reason is the status quo bias, where people favour the retention of the status

quo over other options. In figure 7, a decision maker will be indifferent between item

x and item y from point t, but will prefer x over y from point x and y over x in point y.

29


Figure 2.7 – Multiple reference points for the choice between x and y (based on

Tversky and Kahneman, 1991:896)

Note that this contradicts both the ordinalist theory of indifference curves and

cardinalist prediction of one single equilibrium, as the relative value of good x or y

changes depending on the reference point, and because of the status quo bias leads

to loss aversion effect the indifference curve is not completely reversible as ordinalist

predict, as choosing or obtaining good x will lead to its preference over y. Knetch’s

(1989) study confirmed this in several runs of his study. In one of them he used two

undergraduate classes of students to fill in questionnaires, and as a reward he gave

one class a decorated coffee mug, and the second class got a 400g bar of Swiss

chocolate. When the questionnaires have been filled in, he showed both classes the

alternative object (chocolate to the class that received the mug and vice versa). He

then asked the students if they would be willing to trade their object for the other one.

There were virtually no transaction costs, but about 90% of the students chose to

30


keep the object that they have been given. Although the endowment effect surely

played a role in this experiment, we can clearly see the role of System 1in attempting

to keep the present state in balance, and to induce self-affirmation in what we are or

what we possess.

The prospect theory also includes the weighting function. Figure 8 shows the

updated version based on extensive empirical evidence conducted by Tversky and

Kahneman (1992). The straight line shows actual certainty of outcome as a function

of probability, and the red line shows actual weighting function of tested subjects.

People overweight small probabilities, which explains the popularity of both lottery

and insurance. They also underweight high probabilities, which ‘contributes to both to

the prevalence of risk aversion in choices between probable gains and sure things,

and to the prevalence of risk seeking in choices between probable and sure losses’

(Kahneman and Tversky, 1992:694)

Figure 2.8 - Probability weighting function. Based on Tversky and Kahneman,

1992:688-691)

31


The impacts of the characteristics of the value function are far reaching. One of the

phenomena’s that has been attempted to be explained through the implications of the

value function was the so called equity premium puzzle. $1000 invested in US

treasury bonds in 1925 would yield $12,720 on December 31st 1995, but the same

$1000 invested into a value weighted stock portfolio would yield $842,000, or 66

times more (Siegel and Thaler, 1997:191) The puzzle is that this implies massive

levels of long-term risks. Siegel and Thaler argue that the risk premium is too high as

stocks always outperform bonds in a long term period, but because of the prospect

theory value function investors get utility from the changes in the value in their

portfolio rather than from the overall levels of their assets, and investors display loss

aversion - losses cause significantly bigger pain than gains give pleasure, and since

stock prices fall pretty much as often as they rise in the short term, and are traded

daily and portfolios are evaluated quarterly and yearly, the premium reflects this

increased ‘irrational’ short term risk (Siegel and Thaler, 1997, Camerer et al, 2004)

Therefore the premium is caused by ‘a high sensitivity to losses with a prudent

tendency to monitor one’s wealth, which shifts the utility function from consumptions

to returns which makes people demand a larger premium to accept return volatility’

(Benartzi and Thaler, 1995:90)

The function also impacts flexible labour supply, Camerer et al (1997) studied taxi

drivers in New York, who make most money per hour on rainy days and the least on

sunny days. SEM would expect them to drive a lot on rainy days and cut driving on

sunny days. However because as prospect theory predicts, they saw every day as a

32


separate reference point and set daily targets for their income. This led them to drive

the most on sunny days and the least on rainy days.

Other implications of prospect theory value and weighting function are also the

mentioned popularity of insurance and lottery. The loss aversion and status quo bias

can also affect decision making with serious consequences, such as swapping to a

more lucrative pension or a health plan once people get used to the one they have

already (Samuelson and Zeckhauser, 1988).

2.3.3 Framing anchoring and priming

System 1 has a tendency to simplify and to works based on intuition, morals and

even emotion induced by language. In behavioural economics this can lead to the

situation where people who are presented to a problem with two identical outcomes

change their decision based on how the problem is framed, as System 1 tendency for

loss aversion is triggered by mere change in wording and not only through real

losses or gains. This was showed by a famous experiment conducted by Tversky

and Kahmenan (1981), where in an outbreak of an Asian disease 72% of subjects

chose to surely save 200 people over 66% probability that 0 will be saved and 33%

probability that 600 will be saved in problem 1, whereas in problem two only 22% of

people chose death of 400 people over 33% probability that nobody will die and 66%

probability that 600 people will die. The actual outcomes are identical and differ only

in in the frame used, but that didn’t stop people’s choices to copy the prospect theory

value function. The impacts and usage of framing are most useful in advertising, and

that is why you will see slogans such as ‘free delivery and 10% discount if you collect

in person’ and not ‘no discount when you collect in person and 10% fee for delivery’.

33


Anchoring happens when System 1 automatically targets at similar numbers from

different problems, for example when someone is asked to guess a number between

0-1000 and then asked about a birth of a historical figure, System 1 will create the

tendency to answer close to the guessed random number. Priming then similarly

induces a difference in behaviour based on an anchor, for example after watching a

movie with brave acts, people would be primed to act more courageously, and this

again can be used by advertisers or to influence behaviour of people.

2.3.4 Lack of self-control

As mentioned in section 2.2, self-control is a limited resource. People like to receive

rewards early and put off unpleasant tasks(they are subject to hyperbolic

discounting), and they are generally impatient, O’Donoghue and Rabin (1999) have

found out that when people are asked if they would do 7 hours unpleasant work two

months later or 8 hours of unpleasant work 2.5 months later, most people prefer the

lesser amount of work. But when asked the same question 2 months later, most

people switch to rather do an hour more but with a delay. People have the same

attitude towards money, and most would get rather $50 now than $100 in two years,

forgoing about 41% annual return, but vast majority would choose $100 in six years

rather than $50 in four years. People perceive the present differently than a more

long term horizon, which leads to strong desire and weak willpower (Ainslie, 1991,

Nofsinger, 2008)

The implications of lack of self-control and the impact of hyperbolic discounting can

be seen in under saving and popularity of credit cards, but it is also demonstrated in

the lack of achievement of personal goals such as plans to exercise, plans to stop

smoking, plans to write an undergraduate dissertation in a timely manner, where

people are patient when making plans and evaluating outcomes in the distant future,

34


but as the future quickly arrives the discounting gets steeper and people start binge

eating, light one more ‘last’ cigarette engage in all other activities apart from writing a

dissertation (DellaVigna, 2009)

2.3.5 Self-affirmation

As discussed in section 2.2, System 1 automatically protects from self-discrepancies

and often creates the self-affirmation and self-serving biases which can generate

abnormal confidence and belief in own skills and decision making. This can

negatively affect investors who hold onto stock they have chosen, and can lead to

excessive trading which makes portfolio returns lower, and overconfidence inevitably

leads to higher inclination to risk taking (Nofsinger, 2008) as for example Jerome

Kerviel, the now jailed trader at Societe Generale who took excessive unauthorized

risks has discovered.

2.3.6 Herding

Much like wild antelopes always monitor what the other antelopes are doing and

follow suit to scape predators, people and especially investors show the same

symptoms of herding, they are watching what other investors are doing through

newspapers and news channels, and are constantly checking and adjusting to what

other investors are doing. People don’t want to be left behind and when the market

moves investors follow suit, as can be clearly seen on the frequent rapid coordinated

movements of the stock market which is irrational from the perspective of long term

expectations. When people are a part of a herd, the psychological biases outlined in

this paper only magnify and the feel of the herd surpasses rational analysis

(Nifsinger, 2008).

35


2.3.7 – Behavioural economics, specific biases and implications summary

This section reviewed the alternative to expected utility theory - the prospect theory

value function, reviewed various biases, shortcuts and flaws in economic behaviour

and discussed their implications.

36


2.4 The Endowment Effect

Due to the scope of the topic, primary research could not be conducted to cover the

entire spectrum of anomalies, and the endowment effect was chosen to support or

deny the findings outlined in sections 2.1-2.2.

The endowment effect is an immediate consequence of loss aversion, where loss of

utility associated with giving up a valued good is greater than the utility gain

associated with receiving it (Tversky and Kahneman, 1991:897), value of good raises

when it becomes a part of a person’s endowment. Arguably the best known

experiment is that of Kahneman, Knetch and Thaler (1990) who first conducted a

market experiment with tokens of specific value, which confirmed that subjects

understood the market conditions, and valuation and number of traded items have

been in line with SEM expectations. Then they switched to consumer goods market,

where half of subjects received either a pen or a coffee mug and half did not, and the

subjects were then asked to indicate the minimum potential selling price and the

minimum potential buying price for the objects. A significant impact of the endowment

effect was recognised, and sellers were requesting more than double the price than

buyers were willing to pay.

An alteration on the experiment was re-created by for example Reb and Connoly

(2007), who also used cups, but also tested possession and ownership. They have

confirmed the effect on the endowment effect, and also have identified that physical

possession significantly increases the feelings of ownership.

The effect was tested in different with different goods as well. Ziv and Ariely (2000)

distributed tickets for a Duke University basketball team’s important match to half of

37


100 students (distribution was chosen by lottery) and then conducted a survey asking

how much would the students that were lucky and got the tickets be willing to sell

them for, and vice versa. The price requested was ten times higher on average than

the price offered.

Yet this does not make sense from the perspective of SEM. The willingness to pay

and the willingness to accept should be identical. But by giving the object to the

subjects and establishing ownership their reference point has shifted, and now selling

the object would represent a loss, but from the reference point of those that are not in

possession of the cup it would represent a gain. And as according to prospect theory

value function losses are valued more than gains the possession of the cup which

represents a shift in reference point will cause subjects in possession to value it

higher. (Tversky and Kahneman, 1991:897),

38


Chapter 3 - Research methods

3.1 Aim of research

The primary aim of the research was to confirm or deny the existence of the

endowment effect and therefore reinforce or deny the assumptions of SEM or

prospect theory and psychology.

The secondary aim was to assess ability of rational System 2 to control intuitive

System 1.

3.2 Methodology

3.2.1 Choice of research method

The research is an alteration on experimental research conducted by Kahneman,

Knetch and Thaler (1990) and Reb and Connoly (2007). Ownership must be

established in order to assess the magnitude of the endowment effect, and as

physical possession increases the feeling of ownership, a sole use of a case study,

interview or questionnaires would not be sufficient and therefore naturally the

research method chosen for primary aim was a physical experiment. This method

was also chosen by mentioned previous studies.

A short cognitive test was also used in order to create a time delay between receiving

an object and its evaluation in order to reinforce the feeling of ownership, and to

assess basic logic.

39


3.2.3 Method

A total number of three runs of the experiment were conducted in order to obtain

significant sample size. Run 1 was conducted with the members of Edinburgh Eagles

floor ball club, and runs 2and 3 were conducted with students of Edinburgh Napier

University.

The conditions were nearly identical for all three runs – the participants have been

thanked for taking part of the research, and a reward was presented in a form of a

coffee mug purchased for £0.75, however only a proportion of participants were give

the coffee mug, determined in run 1 by random distribution, and in runs 2 and 3 by a

draw with 50% chance to receive the coffee mug. Once the coffee mugs were

distributed the owners were informed they are theirs to take home, but they were also

instructed to keep them on their desks for the duration of the experiment.

After this instruction and after participants were seated, a cognitive test comprising of

5 questions was distributed, and participants were informed they have 7 minutes to

answer the questions. The primary objective of the test was to create a delay

between receiving and evaluating the mug and therefore establishing stronger feeling

of ownership. First 3 questions included basic mathematics and logic, question 5 was

a difficult question on logic and question 4 was a question designed by Kahneman

and Frederick (2001) to assess the usage of System 2’s monitoring function and it

stated:

‘A bat and a ball cost £1.10 in total. The bat costs £1 more than the ball. How much

does the ball cost’, with answer £0.10 confirming lack of System 2 correction in

answering the question and dominance of System 1 and £0.05 confirming usage of

System 2 correction.

40


After the time has passed the participants in possession of the cup were asked to

evaluate the cup and indicate if they would sell it for series of prices, and conversely

the participants not in possession of the cup were asked to evaluate the cup and

indicate if they would buy it for series of prices.

The price range for experiment 1 was £0.25-£7.25, £0.50 increments and for runs 2

and 3 £0.10-£2.90 with £0.20 increments. The more granular range for experiments 2

and 3 was chosen as especially those not in possessions picked the lowest two

options in majority of cases.

3.2.3 Limitations

The total sample size of 24 out of a population of 6.8 billion cannot lead to definite

conclusions about the entire population and there is no guarantee that the results can

be replicated, although very significant results were identified within the sample size

itself.

The sample size also does not represent a cross section of all demographics, as it

was dominated by male participants and the range for ages was 19-35.

41


Chapter 4 - Research findings

4.1 – Supportive test

Table 4.1 indicates the results of the test. As expected, very high 94% success rate

was achieved for Questions 1-3 that were assessing basic knowledge of numbers

and logic. This confirms that participants of the experiments possess the ability to

think logically to some degree. Question 5 had a very low success rate which was

expected due to its difficulty and short time provided for an answer. See Appendix 1

for the exact questions.

Sample Size Average Age

Gender-Male

Gender - Female

Average for Q1-Q3

Question 5 Correctly answered

Question 4 - Answered 0.05

Question 4 - Answered 0.1

Q4 - £0.10

24 24.96 20 4 94% 5 12 10 45%

TEST

Table 4.1 - Test results

Now we arrive at the secondary focus of the experiments – does rational System 2

fully control natural System 1 processes? The answer can be seen in Table 4.1, Q4-

£0.10. System 2 corrective function was not engaged when answering the question

in 45% cases, although it is a better score than that of Princeton and University of

Michigan students, who scored 50% and 56% respectively (Frederick IN Kahneman,

2003:699)

42


4.2 – Results and findings

Table 4.2 - Run 1 results

Run 1 was conducted with a price range of £0.25-£7.25 with £0.50 increments. This

run was conducted with the members of the team Edinburgh Eagles, of which the

researcher is a member. There was a significant difference between the averages for

selling and buying prices which amounted to whopping 603% added value for mere

possession of the cup. Note that there were two extremes where the maximum price

was chosen. It is possible that the relationship and belonging to the same team

invoked emotional value on top of the mere possession of the object, but although

this bias may interfere with the true value of the impacts of the endowment effect, it

would only reinforce the assumptions of psychology and that System 1 is emotionally

charged. This is however only a hypothesis not supported by a significant sample

size, and it is possible that the participants valued the cup at that price.

Sample size Average - Minimum Selling

Price

Average - Maximum

Buying Price

£ Difference when cupis

owned

% Increase in valuation when cup is owned

13 (8-Sell, 5-Buy) £1.70 £0.80 £0.90 213%

RUNS 2&3 - Scale 0.10-2.9, £0.2 increases

Table 4.3 - Run 2&3 results

Runs 2 and 3 were conducted with a price range of £0.10 and £2.90 with £0.20

increments. These two runs were conducted with Edinburgh Napier Students and

43


Price

Average - Maximum

Buying Price


owned


11 (6-Sell, 5-Buy) £3.92 £0.65 £3.27 603%

RUN 1 - Scale 0.25-7.25, £0.5 increases


there were no ties between the researcher and the participants. Please note the

disparity between sample size of sell and buy, the randomness of the distribution of

the cup was established through a draw with 50% chance to be awarded a cup, with

total number of tickets being 24. Because as discussed in section 2.3.1 a selected

sample of a larger population does not have to be identical to the overall distribution,

this is a natural result of variance. Again a large increase in value can be seen when

ownership of the cup is established, this time 213% value is added. There can be

several reasons for the lower difference. The first being simply variance where more

‘cup lovers’ received cups in Run 1 than in Run 2 by chance. Another reason is the

mentioned emotional value that was attached to the object in Run 1 because of

belonging to the same group and because of emotion induced the relationships

between researcher and subjects, but is absent in runs 2 and 3, although there is no

significant data to support this hypothesis. The scales could have also played a role,

and where someone who really was in love with the object could value it at £7.20 in

run 1 could value it only at £2.90 in run 2 and 3.

Table 4.4 - Consolidated Results


Price

Average - Maximum

Buying Price


owned


24 (14-Sell, 10-Buy) £2.72 £0.73 £1.99 372%

TOTAL-RUNS 1&2&3

Table 4.4 includes the consolidated results, although the two runs did have slightly

different conditions both have confirmed the significance of the impacts of the

endowment effect (within limitations of the small sample size), and a value of an

object does rise by simply establishing ownership of the object. Whether this is

caused by loss aversion as explained by prospect theory or by self- affirmation as

44


explained by social psychology cannot be concluded. What can be concluded,

however is that the research findings contradict the assumptions of SEM, according

to which the value should have been the same for buyers and for sellers, as a mere

ownership of an object has no rational impact on its value, and that people indeed

cannot be seen as rational maximises of utility that have known stable preferences.

The answers to the secondary question 4 have also confirmed that intuitive System 1

is indeed used in decision making, and about half the people trusted their first

intuition that led them to simplify the problem and answer £0.10 without System 2

using its corrective powers.

Chapter 5 - Conclusions and Recommendations

5.1 Conclusions and recommendations

Standard economic theory and its models are a great way to provide neat, simple,

and often fairly accurate predictions. However as reviewed research in the fields of

psychology, behavioural economics and as the results of the endowment effect

experiment conducted in this dissertation reveal, people cannot be seen as rational

emotionless selfish machines that always maximise their long term utility. In fact,

people cannot even function without emotion, and should the often irrational,

simplifying, biased, System 1 that so easily falls into self-awareness trap stop

working and we were left standing with our limited, slow, deplete able, badly

multitasking but rational System 2 mind, life would become a nightmare where a trip

to a supermarket equals long term preparations of writing down pros and cons of all

cereal and rationally evaluating them against all available alternatives only so that we

can have a breakfast.

45


System 1 is inseparable from decision making, and it indeed does have its flaws, but

there is no point in sticking head in the sand and simply ignore the differences

between actual decision making processes and the dream persona of Homo

economicus. Empirical evidence stemming from the field of behavioural economics

and psychology that was reinforced through findings in this dissertation should be

studied and the flaws and importance and implications of System 1 must be

acknowledged not only by economists, but ideally by policy makers, investors, and in

utopic world, all economic agents.

By acknowledging our flaws and shortcomings the world could become a more

rational place, mortgage contracts would be easy to read and understand, investors

would not blindly follow the herd and would stop being so results oriented because

they would realise that their short term orientedness decreases their satisfaction, and

people would at least stop and think about the language of marketing and what it

really means, and they would understand their internal biases and if not eliminate

them, then at least make them work for them.

46


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Appendixes

Appendix 1 – Research Findings

RUN Gender Age Q1-3 Q4 Q5 CUP? Sell-Minimum Buy-Maxium3 M 19 0.666666 0.1 N Y 2.93 M 20 1 0.1 N Y 2.93 M 26 1 0.1 N N 0.73 M 23 1 0.05 N N 1.13 M 21 0.333333 0.05 N N 0.13 F 21 1 0.1 Y N 1.13 F 23 0.666666 0.1 N Y 1.52 M 20 1 0.05 N Y 1.92 M 21 1 0.05 N n 0.52 M 28 1 0.1 n Y 1.12 F 25 1 X N Y 1.12 m 24 1 0.05 Y Y 0.52 m 21 1 X n Y 1.31 M 28 1 0.05 n N 0.251 M 35 1 0.05 N Y 0.251 M 28 1 0.05 N N 0.751 M 30 1 0.1 Y y 7.251 M 27 1 0.1 N Y 4.251 M 22 1 0.1 N Y 3.251 M 32 1 0.05 y N 0.251 M 20 1 0.05 N N 1.751 M 33 1 0.05 N N 0.251 F 23 1 0.05 Y Y 1.251 M 29 1 0.1 N Y 7.25

54

assumptions of standard economic theory in the light of psychology and behavioral economics

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