Loss Aversion

Did you choose Option A for the dilemma in the last post? When the question was put to a group of doctors, the answers were as follows:

Option A: 72%
Option B: 28%

It seems logical. Save some lives rather than risk the loss of all of them. But then the researchers offered the same doctors this choice:

The U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If program C is adopted, 400 people will die. If program D is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die. Which of the two programs would you favor?

This time the answers were reversed

Option C: 22%
Option D: 78%

This seems crazy. The dilemma is essentially the same - only the wording has been changed. So why the reversal?

The key lies in the direct reference to 'deaths'. Rather than accept limited loss the doctors become willing to risk everything.

Psychologists believe that this indicates what they call 'loss aversion'. Because we hat the idea of losing something we make irrational decisions to protect what we have. For example shareholders will often refuse to sell a falling share because they don't want to accept certain loss.

Perhaps Homer Simpson was speaking for us all when he said, 'It is not okay to lose!

For more on this and other fascinating stuff on how our brains work go to Jonah Lehrer's http://scienceblogs.com/cortex/">The Frontal Cortex

Doctor's Dilemma

Here’s a dilemma for you from the psychologists, Tversky and Kahneman. They asked the following to a group of doctors

The U.S. is preparing for the outbreak of an unusual Asian disease. It is expected to kill 600 people.

Two alternative programs to combat the disease have been proposed.

If program A is adopted, 200 people will be saved.

If program B is adopted, there is a one third probability that 600 people will be saved and a two-thirds probability that no people will be saved.

Which of the two programs would you favor?

What do you think?

Thinking Aloud/the inflation monster

Those of you with less than a passing interest in economics will find your eyes closing at the words inflation and deflation. It's worth opening them again for Amity Shales who does a great job of bring the subject to life. She argues against the current orthodox view that deflation (when prices fall) is not necessarily the biggest danger facing the economy.

Deflation, as we hear so often now, hurts good people, strivers who over-borrow.
What’s the reality about deflation and inflation? Deflation can cause depressions, as the U.S. saw in the early 1930s, the period Bernanke has studied so intensely. In the Great Depression, there wasn’t enough money around -- literally. Lacking cash, banks collapsed, and good people did lose homes or farms. More banks collapsed.
Deflation doesn’t always spell apocalypse. It can coexist with prosperity -- or even perpetuate it. There was deflation in the 1920s. Prices fell in 1923, and 1925 through 1928. The money shortage hit one sector, farming, hard. Overall, the economy grew. Unemployment stayed low. Vigilance on inflation kept prices stable. Stable prices made life easier.
As Harvard University’s alumni magazine reported recently, in wonderment, Harvard’s tuition stood at the same level, $150, between 1870 and the beginning of World War II.
And when prices are rising? How bad can it get? The most famous example is Germany's hyper-inflation of 1923. We often hear about customers taking wheelbarrows of money to the supermarket. But what was the effect on the German equivalent of Harvard University:
“The Department of Canonical Law at the University of Munich had a budget of 2,000 marks in 1922. Yet the subscription price for a single scholarly journal was already 10,000 marks.”
In other words the college did not have the money to buy a copy of its own magazine!

So that's why those meetings of the Federal Reserve, the Bank of England and the European Central Bank are so important. They must decide whether to put up interest rates (to control inflation) or down (to avoid possible deflation). At the moment they are doing neither - let's hope they've got it right.

See here for the full Amity Shlaes article