Saturday, December 19, 2009

How Much Will You Pay for this Cheese Sandwich? (Part 6 of Cognitive Biases)

A cognitive bias is a pattern of deviation in judgment that occurs in particular situations, and boy howdy, are there a lot of them! Links to the first five parts follow below.

In this week’s installment we’ll look at biases that begin with the letters “D” and “E.”

Disposition effect

Markets are supposed to be rational, but investors aren’t, according to the discipline of behavior finance. Investors have a tendency to sell shares whose price has increased, but hold onto assets that have dropped in value, because the pain of recognizing losses exceeds the potential pleasure of having assets that may yet grow. The disposition effect is measure of that tendency.

Egocentric bias

There are two different types of egocentric bias — social and memory.

The social egocentric bias makes people tend to take more credit for their own part of a joint action than an outside observer would give them. What’s interesting about the egocentric bias is that not only do people claim more credit for positive outcomes (which would make this the same as “self-serving bias”) but also claim more responsibility for negative outcomes.

The memory egocentric bias is a self-serving tendency to remember our own past in a way that makes us look better. Like most memory biases, this isn’t the same thing as lying about our past; it’s a form of self-deception in which we really do recall things that way, facts notwithstanding.

Endowment effect

The endowment effect is also found in behavioral economics, where it’s also called “divestiture aversion.” In one test, people demanded a much higher price to sell a coffee mug they’d been given than they were willing to pay for a coffee mug they didn’t yet own. This contradicts a standard principle of economic theory that a person’s willingness to pay (WTP) should be equal to their willingness to accept payment (WTA).

There are arguments about why this is so. One possibility is that emotional attachments to things you already own may make them seem more valuable to you. It’s also been linked to a form of “status quo bias,” a general dislike of change. Some other experiments have not detected this effect.

Extraordinarity bias

A cheese sandwich that appears to have the image of the Virgin Mary on it isn’t tastier than one without, but a normal cheese sandwich costs a couple of bucks while the one with the Virgin sold for $28,000. A guitar once owned by Elvis Presley might not play better (or possibly even as well) as a new one, but people are willing to pay much more for it.

That's not wrong, it's simply a bias. The extraordinarity bias is the measure of your willingness to pay more (sometimes much more) for an "extraordinarity" of an object that doesn't in itself change the intrinsic value of the object. The extraordinarity can be personal as well as external: a present from a loved one, for example, could have far more value to you than the intrinsic object is worth.

There's no reason to avoid the extraordinarity bias; the only thing you need to do is to be conscious of it.

Previous Installments

Part 1 "Unknown Unknowns — A Survey of Assumptions, Biases, and Bigotry" — Bias blind spot, confirmation bias, déformation professionnelle, denomination effect, moral credential effect.
Part 2 "Looking for the Pony" — Base rate fallacy, congruence bias, experimenter’s bias
Part 3 "Women Drivers and Balls" — Ambiguity aversion effect (Ellsberg paradox), choice-supportive bias, distinction bias, contrast effect
Part 4 "If I Already Know I Don't Like Your Conclusion, Why Should I Listen to Your Argument?" — Actor-observer bias, anchoring effect, attentional bias, availability cascade, belief bias
Part 5 "Patterns, Probability, and Plagiarism" — Clustering illusion, conjunction fallacy, cryptomnesia

See you next week!

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