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Wednesday, September 03, 2003

Theoretical Prospects

An Economist piece on one of their favourite topics, behavioural economics, or, in the version referred to here, 'prospect theory':

FOR several years now, a battle has been raging among economists. On one side are the traditional, “neoclassical” theorists, who believe that people should be thought of as rational economic agents. On the other are the upstart “behaviouralists”, who do not accept that people always get their complicated sums right (maximising utility subject to a budget constraint, and all that), or even act as if they do.

A top behaviouralist, Daniel Kahneman, won last year's Nobel prize in economics for pointing out the differences between Homo sapiens and H. economicus. Real people tend to judge their well-being relative to others, not in absolute terms; their actions depend on the way choices are presented; they fear loss more than they crave gain. Such insights form the core of what is known as “prospect theory”. Some economists think that prospect theory can overthrow two centuries of neoclassical thought. Others say that it only gives credence to the idea that people repeatedly make daft mistakes. Is there a way of settling the dispute?

Some recent work should at least help. It explores the “endowment effect”, one of the chief tenets of prospect theory. Put simply, this means that people place an extra value on things they already own. Think of a favourite sweater, or your house: would you swap either for something of equal market value? Over the past decade, prospect theorists have found support for the endowment effect in scores of experiments. In one of the best-known, researchers at Cornell University began by giving university students either a coffee mug or a chocolate bar, each with identical market values. First the experimenters confirmed that roughly half the students preferred each good. After the goodies were handed out, they let the students trade: those who had wanted mugs but got chocolate (or vice versa) could swap...........

John List, an economist at the University of Maryland, recently tested the existence of the endowment effect in a new way. Instead of using callow students, he went to a real market with traders of varying degrees of experience: a sports-card exchange, one of many such, where Americans trade pictures of their favourite athletes. There, traders dealing in hundreds of cards mix with browsers who might buy only one.

In one experiment, Mr List took aside a group of card fans and gave them an assortment of other, less familiar, sporting memorabilia, such as autographs, badges and so forth. He then let them trade. The less card-trading experience a subject had, the less likely he was to trade, even when a good deal was on offer. More experienced traders were less prone to the endowment effect, and traded as keenly as neoclassical theory predicts.

Although consistent with an endowment effect, this was not proof of one. Novice traders could simply be wary of dealing with those who might get the better of them. To rule this out, Mr List concocted another experiment along the lines of the Cornell study. He gave a similar cross-section of fans chocolate and coffee mugs, whose values are well-known even to the most inexperienced bargainers, and let them trade. Again, Mr List found evidence for an endowment effect—but also that long experience as a card trader spilled over into his experimental mug-and-chocolate market. Only novices, like the students in earlier experiments, tended to be swayed by what they had been given.

This implies that prospect theory can capture the behaviour of inexperienced people, of which the world has many in all sorts of markets. But experienced buyers or sellers in well-established markets get over their psychological “flaws”. They can even transfer their trading skills from one market to another. The neoclassicals, it seems, have scored a point.

Mr List notes that sellers seem to learn how to trade faster than buyers do. What might this imply for, say, stockmarkets? The green investors who discovered shares only when markets boomed in the 1990s had been slower than others to part with their cash and join in. But once in, were they afflicted by the endowment effect? Owning Amazon shares bought for $400 each made it hard to sell until much higher prices came along (they didn't). Sophisticated traders, especially the sell sides of investment banks, had no such baggage, and sold. The bear market, however, should have proved as good a learning experience as novice investors are likely to get.
Source: The Economist

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