Abstract: In this paper we establish a link between probabilistic cost efficiency and bounded rationality in the newsvendor model. This establishes a framework where bounded rationality can be examined rigorously by statistical methods. The paper offers a relatively deep theoretical analysis of underorders/overorders in the newsvendor model. The theory is supported by empirical findings from our analysis of empirical data from laboratory experiments. In particular, we observe that underorders are systematically larger than overorders, an issue that our theoretical model explains. From statistical tests we conclude that all variability in our data can be explained by probabilistic cost efficiency and risk aversion.
The highlight of the award winning film, "The Imitation Game", is when Alan Turing and colleagues devise an ingenious statistical method that eventually helped decipher the Nazis' Enigma code. This breakthrough allowed Allied intelligence to read previously unavailable German military positions and actions, vastly shortening World War II. Interestingly, a team of neuroscientists at Columbia University found that more or less the same statistical method applied by Turing and co. is used by the brain to make any kind of decision, be it going left instead of right in an intersection or placing a higher bet during a high raise power game instead of folding.
Companies get it wrong when they think workers simply calculate the tradeoff between effort and money.
When my kids were small, we participated in a neighborhood carpool. One morning, on my turn, my son had to stay at home due to an illness, and I was going to drive only the neighbors' children to school. The routine morning phone call to my mom ended with the following request: "Drive safely! Those are someone else's kids!"
Crazy as it sounded, my mom was conveying a commonly held moral concern—that I should be more respectful of things that are dear to my friend than dear to me. Most of us, surprisingly, share this stance. And it’s not necessarily because we are altruists, but because it serves us well from a social point of view.
Imagine, as another example, that you forget to pay your parking ticket and incur a $60 added fine. Now suppose instead that you forget to pay your friend's ticket (who has asked you to do so since he is away on vacation) and you incur that same fine for your friend. Which would make you feel worse?
This talk for the How To Academy coincides with the publication of Richard Thaler’s new book on behavioural economics. Richard Thaler has spent his career studying the radical notion that the central agents in the economy are humans—predictable, error-prone individuals. Traditional economics assumes rational actors. Early in his research, Thaler realized these Spock-like automatons were nothing like real people. Whether buying an alarm clock, selling football tickets, or applying for a mortgage, we all succumb to biases and make decisions that deviate from the standards of rationality assumed by economists. In other words, we misbehave. Dismissed at first by economists as an amusing sideshow, the study of human miscalculations and their effects on markets now drives efforts to make better decisions in our lives, our businesses, and our governments. Coupling recent discoveries in human psychology with a practical understanding of incentives and market behaviour, Thaler will enlighten us about how to make smarter decisions in an increasingly mystifying world, revealing how behavioural economic analysis opens up new ways to look at everything.
Paul Offit likes to tell a story about how his wife, pediatrician Bonnie Offit, was about to give a child a vaccination when the kid was struck by a seizure. Had she given the injection a minute sooner, Paul Offit says, it would surely have appeared as though the vaccine had caused the seizure and probably no study in the world would have convinced the parent otherwise. (The Offits have such studies at the ready — Paul is the director of the Vaccine Education Center at the Children’s Hospital of Philadelphia and author of“Deadly Choices: How the Anti-Vaccine Movement Threatens Us All.”) Indeed, famous anti-vaxxer Jenny McCarthy has said her son’s autism and seizures are linked to “so many shots” because vaccinations preceded his symptoms.
But, as Offit’s story suggests, the fact that a child became sick after a vaccine is not strong evidence that the immunization was to blame. Psychologists have a name for the cognitive bias that makes us prone to assigning a causal relationship to two events simply because they happened one after the other: the “illusion of causality.” A study recently published in the British Journal of Psychology investigates how this illusion influences the way we process new information. Its finding: Causal illusions don’t just cement erroneous ideas in the mind; they can also prevent new information from correcting them.
When scientists at Caltech studied the brains of traders who successfully maneuvered through a market bubble, they found markers of two different traits.
One was something along the lines of anxiety. Successful traders, defined as those who sold before the bubble popped in a lab, sensed in themselves an unease stemming from the perception of uncertainty. They had higher-than-normal activity in an area of the brain known as the insula, which keeps track of how the body is feeling, said Colin Camerer, behavioral finance and economics professor at the California Institute of Technology. It's known to be activated by financial risk.
Decision theorist Howard Raiffa  introduces useful distinctions among three approaches to the analysis of decisions. Normative analysis is concerned with the rational solution to the decision problem. It defines the ideal that actual decisions should strive to approximate. Descriptive analysis is concerned with the manner in which real people actually make decisions. Prescriptive analysis is concerned with practical advice and help that people could use to make more rational decisions. Financial advising is a prescriptive activity whose main objective should be to guide investors to make decisions that best serve their interests. To advise effectively, advisors must be guided by an accurate picture of the cognitive and emotional weaknesses of investors that relate to making investment decisions: their occasionally faulty assessment of their own interests and true wishes, the relevant facts that they tend to ignore, and the limits of their ability to accept advice and to live with the decisions they make. Our article sketches some parts of that picture, as they have emerged from research on judgment, decisionmaking and regret over the last three decades
Many of us realise that we could be getting better value by switching utility providers, yet never actually muster up the energy to make the switch. Here we make some informed guesses about what could be done to overcome this inertia.
Last week we wrote about how hard behaviour change can be in general, and specifically in the context of switching utility providers – even if it could result in a better deal. The tendency to stick to the status quo, lack of urgency, present bias, and social norms come together in a perfect storm resulting in a lack of appetite to switch utility providers. So if this is the case, how can we encourage switching providers and changing behaviour more generally?
Only five years ago the term ‘Big Data’ was confined to obscure tech blogs and IBM research papers. But today ‘Big Data’ is part of mainstream journalistic parlance, as a Google search for [“big data” site:nytimes.com] will quickly reveal.
So it seems that everyone understands what ‘Big Data’ means. Here’s how Wikipedia defines the term:
“Big Data is a broad term for data sets so large or complex that they are difficult to process using traditional data processing applications. Challenges include analysis, capture, curation, search, sharing, storage, transfer, visualization, and information privacy.”
While this definition is technically correct, for me it fails to convey why Big Data is important.
In this article I’ll take a shot at explaining why Big Data is not just ‘important’ but that it is literally the fuel that will power the next phase of humanity’s development.
It's nice to see some attention being paid to agent-based computational models on economics blogs, but Chris House has managed to misrepresent the methodology so completely that his post is likely to do more harm than good. In comparing the agent-based method to the more standard dynamic stochastic general equilibrium (DSGE) approach, House begins as follows:
Probably the most important distinguishing feature is that, in an ABM, the interactions are governed by rules of behavior that the modeler simply encodes directly into the system individuals who populate the environment.
So far so good, although I would not have used the qualifier "simply", since encoded rules can be highly complex. For instance, an ABM that seeks to describe the trading process in an asset market may have multiple participant types (liquidity, information, and high-frequency traders for instance) and some of these may be using extremely sophisticated strategies. How does this approach compare with DSGE models? House argues that the key difference lies in assumptions about rationality and self-interest:
How to get your own no-nonsense local weather forecast graph for people who understand graphs and probability.
People ask us, “You folks at Decision Science News,here do you get your US weather forecasts?”
Because we like graphs and probabilities, we go to a page the US National Weather Service puts out that tells us just what we want to know. It tells us, for every hour in the next few days, the predicted temperature, the chance of precipitation, the predicted amount of rain, the predicted amount of snow and that’s it.
Reference bias in self-reported personality measuresPosted by Mark Egan at Saturday, February 14, 2015From p18 of Heckman & Kautz (2013). Fostering and Measuring Skills: Interventions that Improve Character and Cognition. NBER Working Paper:
"Answers from self-reports can be misleading when comparing levels of personality skills across different groups of people. Most personality assessments do not anchor their measurements in any objective outcome. For example, the German Socio-Economic Panel (GSOEP) survey asks respondents to rate themselves on the following statement:"I see myself as someone who tends to be lazy". The scale ranges from 1 = "strongly disagree" to 7 = "strongly agree." In answering this question, people must interpret the definition of "lazy," which likely involves comparing themselves to other people. If different groups have different standards or reference points, comparing traits across groups can be highly misleading. Laziness may mean different things to different groups of people.
Schmitt, Allik, McCrae, and Benet-Mart nez (2007) administer a Big Five personality questionnaire to groups of people in a variety of different countries. Using their estimates, [the below figure] shows how OECD countries rank in Conscientiousness from high to low. The bars display the average number of hours that people work in the country. The results are surprising. South Korea ranks second to last in terms of Conscientiousness but also ranks first in the number of hours worked. South Korea is not an anomaly. Country-level reports of Big Five Conscientiousness are unrelated to the number of hours worked."
Abstract: This article presents the results of study dedicated to the interrelation of trust, cooperative behavior and the size of the winning prize in the multi-way decision modified prisoners’ dilemma. The experiment was organized using a specially designed computer program. The study involved six groups of participants and each group consisted of 7 players. The experiment consisted of a series of 15 rounds and included preliminary and final testing. The study found that cooperative behavior within the members in the group had fallen during 11 rounds, but there was a tendency to improve it. The trust level of an individual and his/her choice of cooperative strategy in the first series of the experiment are interrelated. Generalized trust is a rather stable construct, but it does not remain unchanged with an actual reduction of cooperative behavior.
It’s all about leveraging the unconscious factors that drive 95 percent of consumer decision-making.
It has created a large and growing list of ways that humans diverge from economic rationality. Researchers have found that all sorts of logically inconsequential circumstances—rain, sexual arousal (induced and assessed by experimenters with Saran-wrapped laptops), or just the number “67” popping up in conversation—can alter the value we assign to things. For example, with “priming effects,” irrelevant or unconsciously processed information prompts people to assign value by association (seeing classrooms and lockers makes people slightly more likely to support school funding). With “framing effects,” the way a choice is presented affects people’s evaluation: Kahneman and Tversky famously found that people prefer a disease-fighting policy that saves 400 out of 600 people to a policy that lets 200 people die, though logically the two are the same. While mainstream economists are still wrestling with these ideas, outside of academe there is little debate: The behaviorists have won.
High-speed cameras reveal when insects become self-organizing.
To most people, a cloud of midges is an annoyance. To Nicholas Ouellette it is the key to a mysterious animal behaviour — the swarm.
Ouellette, who works on complex systems at Yale University in New Haven, Connecticut, and his colleague James Puckett, have found that swarms of these insects become self-organizing when their numbers reach just ten individuals.
Their paper, published on 13 August in Journal of the Royal Society Interface1, is part of a small but growing area of research producing data from real swarms to inform models of this behaviour.
Ouellette and Puckett set up laboratory colonies of Chironomus riparius midges, which live for only a few days after reaching adulthood and tend to fly only at dawn or dusk.
“A lot of people will say a swarm is just a whole bunch of insects,” says Ouellette. “I would like to say a swarm is somehow collective and self-organizing.”
Nudge is one of the most important and influential books on behavioral science and public policy I’ve ever read. Co-authored by economist Richard Thaler and lawyer Cass Sunstein, the book lays out the rationale for adopting policies designed to make it more likely that people will act in their own best interests rather than, say, spend money they shouldn’t spend or eat food they shouldn’t consume. In the book, Thaler and Sunstein discuss how recent advances in behavioral science should inform our attitudes towards rational decision making. Specifically, these behavioral science findings show that people don’t always make rational decisions, raising questions about when or whether outsiders—like governments or employers–should step in to help people avoid making bad choices.
But has enthusiasm for the book led people to see nudges where they don’t exist? That was the question I posed in a recent post, where I argued that it was wrong to call a well-designed traffic light a nudge: “Not all good design, even good design that influences behavior, is a nudge,” I wrote. “A well-designed prison cell is more likely to deter prisoners from trying to escape than a poorly designed one. But that does not make it a nudge.”
When asked whether behavioural economics (BE) applies to business-to-business (B2B) as well as business-to-consumer (B2C), "people are people" has been my response. At least it used to be.
"People are people" does have a lot of truth to it. We are the same person when we buy lunch as a consumer as we are when we negotiate a deal with a supplier – our hats may change but our behavioural biases and mental shortcuts do not. We are just as prone to social norms in the boardroom as we are in the bar – we can't simply shut this stuff off just because it's someone else paying.
That means BE is just as relevant in B2B as B2C environments. But...
The RECOBIA project found break-through solutions to improve the quality of intelligence production and delivers applicable solutions to address the human factor in intelligence.
The RECOBIA project found break-trough results in the field of intelligence and in mitigating the negative effect of cognitive biases. The three-year research project identifies ways to improve the work of intelligence officers by reducing the negative effect of those unconscious cognitive mechanisms. RECOBIA came to a close end of January and the findings are now available to interested parties.
The project team deconstructed the activities of intelligence officers and clustered them into Key Intelligence Tasks (KITs). Those KITs describe for the first time what intelligence officers actually do – both from an intelligence as well as from a psychological perspective. The KITs were used to identify the situation and activities in which cognitive biases are likely to impact intelligence officers. Finally, the project team developed mitigation strategies, which are easy to implement and will boost the quality of analysis.
Standard economic theory makes an allowance for the agency problem, but not the compounding of moral hazard in the presence of informational opacity, particularly in what concerns high-impact events in fat tailed domains (under slow convergence for the law of large numbers). Nor did it look at exposure as a filter that removes nefarious risk takers from the system so they stop harming others. (In the language of probability, skin in the game creates an absorbing state for the agent, not just the principal). But the ancients did; so did many aspects of moral philosophy. We propose a global and morally mandatory heuristic that anyone involved in an action which can possibly generate harm for others, even probabilistically, should be required to be exposed to some damage, regardless of context. While perhaps not sufficient, the heuristic is certainly necessary hence mandatory. It is supposed to counter voluntary and involuntary risk hiding − and risk transfer − in the tails. We link the rule to various philosophical approaches to ethics and moral luck.
Nel XX secolo la teoria economica è stata al centro di intensi dibattiti che ne hanno prodotto una significativa evoluzione. La radicalità dello scontro è stata tale da mettere in discussione la natura stessa dell’economia, arrivando oggi a sviluppi teorici ed empirici sostanzialmente inattesi. Per ripercorrere brevemente le fasi di questo percorso è opportuno iniziare da quando, alla vigilia della seconda guerra mondiale, diversi economisti europei (come Oskar Morgenstern o John von Neumann) emigrarono negli Stati Uniti. Questi studiosi lasciarono in Europa un terreno di discussione ampio e variegato, anche geograficamente, che tuttavia andò perdendo di rilevanza proprio in favore delle nuove scuole anglosassoni. Si formò un approccio unitario e spesso autoreferenziale allo studio economico: l’economia si costituì come una disciplina matematica in cui la maggior parte degli sforzi degli studiosi consisteva nella costruzione di assiomi che definissero con precisione le regole di comportamento degli agenti economici. Una tale impostazione, insieme ad una specifica assunzione comportamentale, fondò in sostanza la visione predominante del secolo, nota come Teoria della scelta razionale (TSR).
Già la nascita dell’economia sperimentale, avvenuta intorno agli anni ’50, aveva indebolito l’approccio tipico della TSR. Gli agenti impegnati negli esperimenti di laboratorio avevano mostrato di deviare dall’assunzione di razionalità con frequenze che risultavano pericolose per la stabilità del sistema. Poco dopo, l’avvento delle scienze cognitive, un approccio interdisciplinare (cui partecipano la linguistica, la filosofia della mente e del linguaggio, la psicologia cognitiva, le neuroscienze, l’intelligenza artificiale e, a partire dagli anni ’70, l’economia cognitiva) che pone l’accento sullo studio della mente in relazione al comportamento, aveva iniziato a mostrare agli economisti la possibilità di integrare il loro corpus di conoscenze con quello di studiosi di discipline come la psicologia cognitiva o le neuroscienze. Un convinto assertore dell’utilità della collaborazione tra l’economia e le due discipline menzionate è proprio Colin Camerer, autore, con George Loewenstein e Drazen Prelec, dell’articolo “Neuroeconomics: How Neuroscience Can Inform Economics” (2005). Nel 2008 Il Sole 24 ore ha riunito “Neuroeconomics” (già apparso in traduzione italiana presso la rivista Sistemi Intelligenti) e il più recente articolo “The Case for Mindful Economics” (2007), a firma del solo Camerer, in un’unica pubblicazione intitolata La Neuroeconomia, offrendo a un più vasto pubblico italiano un pezzo importante del dibattito internazionale sull’economia e sulle scienze cognitive. I due articoli, che nella sostanza possono essere considerati perfettamente uniformi essendo il secondo in qualche misura un aggiornamento del primo, argomentano in favore di un’impostazione mindful (in quanto opposta a quella mindless, adottata da Gul e Pesendorfer nel 2005) allo studio economico, e cioè di una sua apertura verso metodi e concetti di orientamento specificamente neuroscientifico.
Researchers conducted a series of studies to examine what made people become whistle-blowers. They asked a group of people to write a paragraph about a time when they had witnessed unethical behaviour and reported it. They got another group to write about an occasion when they had witnessed unethical behaviour and kept silent. Both groups had to explain why.
They found that the whistle-blowers used ten times more words related to fairness and justice, than non-whistle-blowers, who used twice as many terms related to loyalty. The evidence suggests that loyalty impulses may conflict with reporting bad behaviour.
How can this finding impact employee behaviour?
The researchers suggested that if we want to encourage people to share their concerns, be it about anything from theft, fraud to sexual abuse, we should emphasise the concept of fairness in our communications. Within an organisation, this could be anything from mission statements, codes of ethics, job profiles or marketing communications. You could also nudge those who highly regard employee loyalty to come forward by re-framing whistle-blowing in terms of the greater good.
If you're already as successful as you want to be, both personally and professionally, congratulations! Here's the not-so-good news: All you are likely to get from this article is a semientertaining tale about a guy who failed his way to success. But you might also notice some familiar patterns in my story that will give you confirmation (or confirmation bias) that your own success wasn't entirely luck.
If you're just starting your journey toward success—however you define it—or you're wondering what you've been doing wrong until now, you might find some novel ideas here. Maybe the combination of what you know plus what I think I know will be enough to keep you out of the wood chipper.
Let me start with some tips on what not to do. Beware of advice about successful people and their methods. For starters, no two situations are alike. Your dreams of creating a dry-cleaning empire won't be helped by knowing that Thomas Edison liked to take naps. Secondly, biographers never have access to the internal thoughts of successful people. If a biographer says Henry Ford invented the assembly line to impress women, that's probably a guess.
A thoughtful correspondent asked me what I thought of proposals to "shame" parents who don't vaccinate their children. I'm against doing that. Actually, I'm not opposed to "shaming" when it makes sense; but I am opposed to doing anything in public policy that disregards the best evidence we have on the challenges we face and the best strategies for combatting them. Here is what I had to say about why shaming parents who don't vaccinate should be viewed as falling into that category:
I myself don't see any value in shaming here.
The conflict-entrepreneur, anti-vax organizers deserve ridicule and are awful people etc. But denouncing orshaming them actually only gives them exactly what they want -- more attention, which in turn does make more members of the public agitated and confused.
I’ve been coming across these issues from several different directions lately, and I wanted to get the basic idea down without killing myself in the writing of it. So consider this a sketchy first draft.
The starting point is “behavioral economics,” also known as the “heuristics and biases” subfield of cognitive psychology. It’s associated with various studies of cognitive illusions, settings where people systematically mispredict uncertain events or make decisions. Within psychology, this work is generally accepted but with some controversy which could be summed up in the phrase, “Kahneman versus Gigerenzer,” but it’s my impression that in recent years there’s been a bit of a convergence: for Kahneman the glass is half-empty and for Gigerenzer the glass is half-full, but whether you’re talking about “heuristics and biases” or “fast and frugal decision making,” there’s been a focus on understanding how our brains use contextual cues to decide how to solve a problem.
In economics, this work is more disputed because it seems to be in head-on conflict with models of utility-maximizing rationality from the 1930s-50s associated with the theories of Neumann and others on economic decision making. While some economists have embraced so-called “behavioral” ideas to explain imperfect markets, other economists are (a) skeptical about the relevance to real-world high-stakes behavior of laboratory findings on cognitive illusions and (b) wary of the political implications of social engineers who want to use cognitive biases to “nudge” people toward behavior they otherwise wouldn’t have done.
Within economics, I’d say that the behavioral/classical debate roughly follows left/right lines: on the left are the behaviorists who say that individuals and firms are irrational and thus we should not trust the judgment of the markets, instead we should regulate and protect people from their irrationality. On the right are the classicists who hold that people are rational when it comes to real economic decisions and thus any interference in the market, whether from governments or labor unions, will tend to make things worse.
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