I Kahnemans Decision Utilities v. ���and Experience Utilities*

•  Daniel Kahneman won the Nobel prize in economics in 2003. What was extraordinary was he was a psychologist (a professor at Princeton University) whose work on rationality was recognized in economics. Professor Kahneman defined rationality as the consistency between “decision utility” and “experienced utility.”

•  Decision utility, also known as revealed preferences, is also expressed in terms of the weight (or importance) assigned to the decision by the decision maker. The weight is related to the “wanting” of an outcome to come to pass. Whereas, the “experienced utility” is a measure of the “hedonic experience” following that outcome; it is the consequences of choices. Experienced utilities able to be measured. They are the measurements of the hedonic consequences of his choices, such as, his estimate of his well being. These are measured by real time self reports of mood, pain, pleasure or happiness; facial measures, autonomic measures, etc.

•  Measuring experienced utilities is key because it provides a method for measuring rationality. The format is descriptive (psychological methods), not normative (economist methods).

•  See, Daniel Kahneman’s presentation on “Hedonics” at Tufts University, November 2004.

Measuring Experienced & Remembered Utilities

Each moment of experience becomes an affective/hedonic state. This moment utility as in “are you in pain now?” is fleeting. It morphs into “How much did you suffer?” and thus becomes a subjective report of the moment. The interest is to measure the moment. The moment is made up of: Anticipation, the experience, and memory; but also interpersonal comparability across experiences (ordinal measures), and implies time neutrality—moments weighted equally..

Remembered utility is how we evaluate the moments. It seeks a good approximation, supported by abstracted and real stimuli. There is duration neglect in lower animals, but in humans the weight of duration is increased by directing attention to it. There are violations of the dominance rule based upon Peak and End rule results found in Colonoscopy study.

Definition of irrationality: When Decision and Experience Utilities Diverge

•  For a gambler, the decision utility of playing craps in Atlantic City or betting on the horses at Saratoga is determined by the goal of winning money by playing, and the strength of that goal. The decision utility (fear) of losing money, and the strength of that fear is out weighed by the hope of winning money. In economic speak, the decision utility of playing craps exceeds the decision utility of quitting. But say the experience is contrary, the gambler continues to lose. If the experience of losing does not cause a change in the decision utility (to reduce the strength of the goal of winning and increase the fear, then there is a divergence between decision and experience utilities.

•  Likewise for a gas station owner who inflates the price of gas after the Katrina hurricane in New Orleans. His decision utility to gouge the market and gain excessive profits was “wanted” more than being a good citizen. However, the gas station owner’s experience with raising prices after hurricanes is that he is perceived as gouging the marketplace, and customers don’t forget that behavior, and continue to punish him in the months afterward. The gas station owner comes to realize that experienced utility is inconsistent with the decision utility.

•  For an addict, the decision utility of reflecting the anticipated “high” of drug consumption exceeds that decision utility of quitting. The person uses drugs and becomes addicted. Afterward, addicted experienced utilities are very bad. Soon it is evident that the experienced utility is inconsistent with his decision utilities.

When Decision and Experience Utilities Diverge: Economist Reasoning

•  Divergent decision and experience utilities are Kahneman’s measurement of sub-optimal functioning.

•  Normative rules doe not allow for divergence in decision and experience utilities. Economists rationalize behaviors; employing a normative approach, economics presume a rational relation between a person’s choices (decisional utilities) and the consequences of these choices (experienced utilities). They are harder pressed to justify addiction based upon rationality. Psychologists don’t assume anything. They study the behavior of people to find out. For example, when it comes to addicts, psychologists recognize that it is a stretch to draw a consistency between decisional and experienced utilities. Instead they might conclude that an addict is myopic, focusing upon the present pleasures associated with getting high, without not seeing the future longer range consequences of using drugs and becoming addicted to them.

Economist views drug addiction

•  “Susan takes heroin regularly.” “Susan lives on the streets, working as a prostitute to feed her habit.”“Susan, who is now in detention center for allegedly stealing a car and causing police to give chase, says that she wants to quit. She has been to several treatment programs and stopped using drugs temporarily before returning to her drug abuse ways.”

•  Economists observe choices people make. Economists assume there exists a rational relation between a person’s choices (behavior) and the hedonic consequences of these choices (true well being). Perhaps Susan did not have prior notice that heroin would be habit forming and destroy her life when she initially began using. Susan didn’t expect to be a miserable addict when he first tried heroin. Risk seeking choices: Perhaps she risked becoming addicted to heroin, thinking that she would end her use prior her addiction. But, this bad outcome was sufficiently unlikely that her early experiments with heroin made sense (she believed that the probability that she would be addicted was small). She was wrong. Susan prefers taking heroin to quitting. Susan’s speeches about wanting to quit are just cheap talk. Susan might be better off if she were clean. But getting clean is too costly, I.e. there are withdrawal costs.

•  This is not different than making a rational decision to fly on an airplane that crashes, or to go downstairs to get a bite to eat, fall on the stairs, hit the wall with your head, and die. Choosing to use heroin was unlikely to cause addiction, it was just a lottery winning ticket into hell.

Psychologist views drug addiction

•  Psychologist analysis of Susan’s situation relies upon a medical model. Psychologists diagnose Susan’s condition as being a substance abuse disorder, a medical/psychological impairment, requiring medication and behavioral treatments. Susan lacks insight into her situation, and rationalizes her bad behavior due to her lack of insight. Susan’s impairment interferes with her capacity to make appropriate decisions. Susan is better off treated and cured of her impairment, to do otherwise is not in her best interests. Susan’s addiction was predictable given her predisposition to drug abuse both because of her genetics and her bad family dynamics.

Kahneman’s research: measuring divergence in decision and experience utilities

•  The Colonoscopy Experiment: People undergoing colonoscopy are asked to participate in a study. They are to rate their experience of pain every ten seconds. One group of patients who endured the colonoscopy for 8 minutes were compared with another group who endured the test for 32 minutes. The 8 minute exposure ended with a higher level of pain, and there were higher peak pain experiences. People identified the shorter period as more painful. It would be assumed that people who endured the longer period of exposure to pain were expected to have a worse experience. Kahneman called this duration neglect.

•  In another Colonoscopy experiment: one group received typical colonoscopy, while treatment group had procedure lengthened by one minute with the scope inside the body but stationary for that last minute. Subjects in treatment group had significantly better memories of the overall experience.

The “Cold Presser” Experiment

•  People exposed to cold presser (hand in cold water at 14 degrees C.) for sixty seconds, and at the end there is a warm towel. In a second experience, the sixty seconds in cold water is followed by thirty seconds the temperature is raised from 14 to 15 degree C. Then 7 minutes later, researchers asked subjects which of the two experiences would you like to re-experience, if you had to. 80% chose the longer exposure rather than the shorter exposure. In that delay, seven minutes, Kahneman suggested that the remembering self is the one who retains the experience and acts accordingly. The remembering subject is making the mistake. The person will expose himself to unnecessary prolonged, extra pain. This is a cognitive trap. This is because the only perspective when making decisions is the perspective of the remembering subject. The experiencing self does not have a point of view.

•  Kahneman, Fredrickson et al, 1993, concluded. People form inaccurate memories of their past hedonic experiences, which mislead decision makers about making prospective decisions. People’s decision utilities (their wants) may fail to reflect what they really “should” want, based upon faulty memories of past experiences.

•  The peak and end rule violations are systematic and predictable.

Kahneman’s remembered utility

•  Kahneman regards the distinction between decisional and experienced utilities as opening up new avenues for the study of rationality. –  How much do people know now about their future tastes?

•  Married and having children is the way, right? –  Do people adequately consider the uncertainty of their future tastes in

making decisions? •  Being a lawyer means what to me in ten years?

–  Are decision utilities adequately informed by reasoned beliefs about experienced utility? When is the failure to anticipate adaptation greatest.

•  It would be so great if I won the lottery, won a $100 million. Right? –  People have a lifelong habit of trusting memories of past episodes to guide

choices among future outcomes. And yet, trusted memories are sometimes deceptive. How can one best identify past inaccurate memories of hedonic experiences?

•  Kahneman refers to the construct “remembered utility” to focus upon the adequacy of one’s memory of a past hedonic experience over time.

IV. Hedonics

Hedonics research: Distinguishing ���experiencing and remembering

What is living a good life? How do you measure the quality of a subjective experience, including the good and the bad? According to Mr. Bentham’s notion, experienced utility is the experience of pleasure and pain. There are two ways of studying experienced utility. •  Distinguish between two competing selves: the current and past self.

–  Are you in pain now?, asks the Dentist. But if asking how much pain did you experience at the dentist yesterday, you are talking about something else. It is important to distinguish the two, because you do not get the same results.

• Measuring the remembering self vs. judgments of the experiencing self. – Measuring the “Experiencing subject” is called experience sampling. The subject carries a computer and the person responds while he is underway with his experiences. Questions such as what are you doing, how do you feel? – Measuring the “Remembered experience.” We come a day later and ask people to reconstruct their day, and ask themselves questions to reveal the distortions of memory. It is possible for people to relive experiences. A lot is known about the experience of the remembered self, but much less about the experiencing self.

Mis-prediction of adaptation of �paraplegics and lottery winners

Study of paraplegics vs lottery winners, see, Beruria Cohn, 1999. One would think paraplegics would be more miserable than they report for an extended period of time. Studies document that paraplegics after suffering from the onset of the impairment return soon after to the general level of happiness they previously experienced. Lottery winners do not remain happy for very long, and return to their prior levels.

Paraplegics One month One year % good mood - %bad mood -50% -20% Respondents did know a paraplegic % good mood - %bad mood -41% -37% Respondents did not know a paraplegic Lottery winners % good mood - %bad mood 64% 25% Respondents did know a lottery winner % good mood - %bad mood 58% 50% Respondents did not know lottery winner

���The Hedonic treadmill: the reality of adaptation

•  Bottom Line: mood reverts at least partly to baseline. Extreme pain or pleasure become less intense (like adaptation to temperature), and extremes in affect become less frequent. Treadmill effects are greater than expected.

–  Getting a substantial raise, but ending up not any more happy, see, Brickman and Campbell in 1971.

–  Marriage and widowhood, see, Clark, Diner and McCulloch, 2001, 5yrs prior to and after marriage or widowhood

•  In everyday life, general life circumstance have a homeostasis. –  Evidence suggests that the average person today is richer, more comfortable (more

food, larger house, more cars, more clothes, for holidays) than he or she was fifty years ago but no happier today than 50 years ago.

–  There are a percentage of people who find themselves very happy. This is not related to income. That is a puzzle. Income should be a proxy for the number of opportunities that you have, so it should be correlated with being better off. Data however do not fit.

•  People ultimately come back from a positive or a negative situation, like widowhood (negative), or sudden wealth (positive). Long term; there is complete or near complete reversion to baseline after life changes.

Happiness is a personality trait, and not an environment impact.

•  The other big finding is that happiness is a personality trait. –  Studies of identical twins (Minnesota Twins Registry study) are much more similar on

happiness measurements than fraternal twins. Even identical twins raised apart have similar happiness levels. There are large differences among people.

–  Happiness disposition is likely to be genetic, it is not tied to wealth. –  Seven factors affecting happiness: including: family relationship, financial situation, work,

community •  The well being literature (Frederick and Lowenstein 1998) finds there are some things

we adapt to rapidly, such as, imprisonment, increases in wealth, disabilities like paralysis; whereas there are conditions that we adapt to slowly like the death of a loved one. There are situations that we never adapt to like noise, debilitating diseases, food, upsetting roommate. Some good things never pall--like sex, friends, etc. People seek out good things that one can never fully adapt to.

•  If we do not foresee that we get used to our material possessions, we shall over invest in acquiring them, at the expense of our leisure. People do underestimate this process of habituation. As a result our life can get distorted towards working and making money, and away from other pursuits. Extra income makes les and less difference the richer the person. Inequality is bad because extra income brings less benefit to the rich than the poor.

•  How do investors adapt to bleeding, the situation in which investors suffer the pain of “Chinese torture” treatment of slow losses?

Momentary life changes ���have a low impact on happiness

•  There is a lot of variability in one’s happiness within a day. Happiness is a bit like one’s temperature, it is always there, fluctuating. But income has a low correlation, age has a negative correlation with happiness overall, etc. whereas the momentary effects that occur within a day are very pronounced. (You don’t need a lot of research to show that sex is better than commuting.)

•  What gives people a lot of pleasure is typically associated with being with other people that you like. Friends more than family; friends are more reliability source of happiness than family.

Research strategy

Experienced utility = from moments to episodes Remembered utility = evaluation of episodes Decision utility = not good at maximizing, aggregating, and being informed by past Adaptation neglect in forecasts of utility Well being and experienced utilities via exploring the hedonic treadmill Hedonic balance in different circumstances Positive Negative Net commuting alone 2.86 1.59 1.27 at work, weak school 3.50 1.56 1.94 housework alone 2.92 0.90 2.02 watching TV alone 3.32 1.07 2.25 housework, w/spouse 3.41 0.92 2.49 at work, good school 3.68 1.12 2.56 commuting w/ spouse 3.97 0.82 3.15 relaxing with friends 4.57 0.65 3.92

Implications: control how to use time

•  Allocating the budget of time, this is the ultimate finite resource. The big changes in people’s lives don’t seem to matter much to their happiness, rather it is how people use their time, such as taking time away from commuting and putting it into one’s social life. Are people optimizing enough their time?

•  Cultures direct and determine how people use their time. The French spend more time at the table, which is typically not spent eating, and with friends or family present.

–  The French do something right. Eating, especially eating with other people, is very important for the quality of life.

Linking notion of well being to addiction

•  While quarrelling with your spouse in your car, does it matter to you that the car is a Mercedes vs. a Ford?

•  Economists say that the Mercedes is more expensive, therefore more valuable. –  There is better ease of handling in a Mercedes. –  The Mercedes’ Blue book value is correlated with the pleasure the person

has in driving it. •  Kahneman asks: “What does it mean to get pleasure from your car?”

–  You get pleasure when you are thinking about your car, and it is a Mercedes.

–  If I don’t think about it, it does not give me pleasure at all. This has implications for the hedonic treadmill.

Cognitive traps and addictions

•  When you are in love (good news), or become crippled in a horrible accident (bad news), then you are obsessed with the experience. When you stop paying attention to a condition, then it is less important, because you don’t think about it.

•  Like thinking about living in California. First you think about the distinctive aspects of living in California, and by doing so you exaggerate its importance. But then you accommodate, and stop thinking about it. It becomes less important. Finally, climate is not important to happiness.

•  Being a paraplegic is not full time. Nothing is full time.

How to live our lives (the utilities of our lives)? •  We are drawn to focusing on our errors too much.

–  Study which type of activities receive more attention than do others; because people prioritize what they choose to focus upon.

•  Americans put too much of their budget into comforts rather than pleasures.

–  Vacations, flowers vs. size of the house, cars. Attention is drawn to comforts, not pleasures. •  Can we change people’s well being by changing how people attend to

things, changing the stimuli to which you are exposed? –  But people resist adaptation when it comes to

•  chronic pain, because it calls your attention to itself, and •  depression, because you constantly attending to bad thoughts, and cognitive

therapy teaches the person to attend differently. –  The effort is to train people to be happier by attending to different experiences. –  Long term training of attention can reflect differences in brain function, in prefrontal areas, the

left is the happy side and the right is the unhappy side. Measure physiological differences. Distribution of left minus right activity (more is better). Several standard deviations away from anyone else to the left is the Tibetan Monk, who is practicing compassion. He is completely positive, working for many years of practice. The right side of his brain shuts off. This view that relates attention to well being has substance behind it.

Psychologists and Economists •  Both psychologists and economists value the importance of reasoning, their disagreement

has been about the amount of weight each places on the side of the trade off between: –  Effort devoted to deliberation (normative, rational, optimizing) vs. –  The economy of the mind (descriptive, quasi-rational)

•  Thaler noted, “If the economist borrows his concept of man from the psychologist,

his constructive work may have some chance of remaining purely economic in character. But if does not, then he will not thereby avoid psychology. Rather he will force himself to make his own, and it will be bad psychology. The goal is (for finance) to borrow good psychology…”

•  Paul Slovic: “Many aspects of investment analysis are said to be psychological in nature;

certainly the appraisal of an investor’s capabilities for integrating information into a judgment or decision is one such aspect. Because of a lack of relevant psychological knowledge, security analysts have all too often been forced to become amateur psychologists themselves.”

Conclusion

•  “…The human mind is powerful and intelligent not because it contains general-purpose rational methods (although it may include some), but primarily because it comes equipped with a large array of what one might call “reasoning instincts.” P. 330 . Leda Cosmides and John Tooby, “Better than Rational: Evolutionary Psychology and the Invisible Hand,” AEA Papers and Proceedings, May 1994, p. 327-32.

•   “In sum, economic theory can increasingly be grounded in the theoretically and empirically derived models of human decision making machinery that are presently being constructed within evolutionary psychology.” P. 332.

•  Behavioral and experimental economics employ a unique blend of psychology, economics and neuroscience can explain more than the overvaluing of stocks. It offers an analytical opening where mainstream economics models have failed. The former theory may help explain questions such as why Americans save too little, acquire too much debt and manage their investment portfolios in self destructive fashion. (Parisi and Smith)

Keynes and the stock market

John Maynard Keynes

•  Keynes applied psychological principles to the study of the stock market. •  Keynes saw the market as a beauty contest, where the only thing that mattered was the

opinion of the judges. He sought to choose the “contestant” that the judges would pick (like a beauty contest---beauty is in the eye of the beholder), and not his personal favorite.

•  Keynes invested in assets that he believed someone else would be willing to pay more than he had. For Keynes, it was logical to pay three times what something was worth as long as there was another investor willing to pay eve more. (Known as the “Greater fool” theory)

•  Keynes described the stock market as a beauty contest in which investors try to figure out what stocks other investors find attractive. Finding the stocks early enables the successful investor to buy low and later sell when it is high, when the stock is attractive to all.

•  Keynes’ method of investing earned him several million pounds for his accounts, and a ten fold increase in the market value of the endowment of his college, Kings College, Oxford. History points to periods when the psychology of the crowd overwhelms the rationality of investors.

Present day version of “The Beauty Contest”���Guess the Number

•  Professor Richard Thaler’s contest was picked up by the Financial Times in April 1997. The contest winner won two British Airways round trip tickets between London and New York. Readers were told to choose a whole number between 0 and 100. The winning entry would be the one closest to two thirds of the average entry. The task is to guess the number 2/3rds of the number that represented the mean chosen by the other participants. A short example to help was provided. Suppose five people enter the contest and they choose 10, 20, 30, 40, 50. In this case the average is 30 and two thirds of which is 20.

Analysis •  Players pick a number from 0 to 100 •  All the numbers are collected, and averaged. X = average. •  Calculate 2/3rds of X. Let Y = 2/3X. Player whose number is closest to Y wins. •  To succeed the participant must anticipate what other contestants might do,

accommodate that expectation in forming an answer. The participant recognized that the other contestants likewise are anticipating and accommodating to what competing contestants do.

•  So,

Guess the Number results

•  A player’s thoughts begin with: “I have no idea what to do, it is random, so I’ll guess 50.” Then, one might think: “Most of these other players still seem asleep. They will guess 50. I will guess 33.” the most common choice is 35, assuming 50 is random and 2/3 of that is the choice.

•  OK but, “Most of these players think that they are pretty smart, but they think that everybody else is asleep, so they will probability guess 33. I’ll guess 22.” Finally, “Most of these other players will figure out how this games works. They will think that most people will guess 33, and will guess 22. Therefore, I should guess about 15.” This is the choice of players who anticipate how others are responding.

•  It is not a case of choosing those which, to the best of one’s judgment, is really the prettiest, nor even those which average opinion genuinely thinks that prettiest. We have reached the third degree, where we devote out intelligences to anticipating what average opinion expects the average opinion to be. And there are some who practice the fourth, fifth and higher degrees.

•  The winning number is 13. •  Generally players use 0-3 levels of reasoning, and very few players pick zero, which is

the logical extension, also referred to as the Nash equilibrium.

Why is the Nash Equilibrium wrong?���Cognitive hierarchy

•  The Nash equilibrium choice of 0 is logical, but a bad prediction about what will happen. This is because rational players will not choose 0, they will regard less sophisticated players as choosing a high number like 33, so they will expect a higher number than Nash Equilibrium predicted.

•  Cognitive hierarchy: Zero step players must randomize, guess. Higher step payers think they are playing against players who do fewer steps of thinking than they do. Only 8% of players do more than three steps of thinking. This is because doing many steps of thinking is mentally difficult, and constrained by working memory or people don’t have special knowledge. Cognitive hierarchy proposes that k-step players believe, overconfidently, that they are responding to players who do 0 or k-1 steps of thinking. 1.5 steps is the average steps of thinking done.

•  Rejecting the Nash Equilibrium, Colin Camerer recognized the importance of bounded rationality. See, Camerer and Fehr, 2006, “When does economic man dominate social behavior?” in Science Magazine, vol 311.

Beauty contest, stock market and predictions markets

•  Strategic complimentarity and strategic substitution can amplify or diminish the impact of limits to rationality in financial markets. It is a different strategy for predictions markets than for stock markets.

•  In predictions markets, where bets are made on future events that is settled once and for all, i.e. capture Osma Bin Laden or not by December 31, 2008, the strategy is substitution oriented, more sophisticated traders win at the expense of less sophisticated traders. Trading strategies are substitution oriented.

•  In the stock market, new information is rapidly absorbed, beating the market is difficult, and there is never a fixed future time at which the true value of a firm is established and bets are settled once and for all. As a result well informed traders cannot always guarantee a profit at the expense of traders with limited rationality. Noise traders can win. Trading strategies are compliments to traders with more limited, less steps of thinking in a stock market in that they often match the strategies of other less involved traders. Stock markets are governed by compliment strategies, which permit results to slide far from expected equilibrium, as in the beauty contest game it is 0.