Putting the "Cuss" back in "Homo Economicus "
The Maximization Paradox: The costs of seeking alternatives
Ilan Dar-Nimrod, Catherine Rawn, Darrin Lehman & Barry Schwartz
Personality and Individual Differences, forthcoming
Contrary to the common belief that more options lead to better decisions, recent research has demonstrated that choosing from a large number of options can have detrimental psychological effects. We investigated whether people were willing to sacrifice resources for more options, and whether choice-making orientation moderated such willingness. As predicted, people who were motivated to make the best choice possible—“maximizers”—were more willing to sacrifice resources such as time to attain a larger choice array than were people who tend to search for a satisfactory choice (i.e., “satisficers”). Additionally, maximizers who sacrificed to attain more options were ultimately less satisfied with their choice relative to maximizers who chose from a small assortment, and to satisficers (Studies 2 and 3). We term the pattern in which maximizers tend to sacrifice resources to attain more options that ultimately reduce their satisfaction, the “Maximization Paradox”.
Beware of Venturing into Private Equity
Journal of Economic Perspectives, Winter 2009, Pages 147–166
As a step towards understanding whether a private equity governance structure reduces overall agency conflicts relative to a public equity governance structure (as is often argued), this paper describes the contracts between private equity funds and investors, and the returns earned by investors. The paper sets the stage with a puzzle: the average performance of private equity funds is above that of the Standard and Poor's 500 - the main public stock market index - before fees are charged, but
below that benchmark after fees are charged. Why are the payments to private equity buyout funds so large? Why does the marginal investor invest in buyout funds? I explore one potential answer (and probably the most controversial): that some investors are fooled. I show that the fee contracts for these funds are opaque. Considering this and the way that compensation contracts bury, in details, costly provisions that are difficult to justify on the basis of proper incentive alignment, it would be premature to assert that the agency conflicts are lower in private equity
than in public equity.
In Search of Homo Economicus: Cognitive Noise and the Role of Emotion in
Leonard Lee, On Amir & Dan Ariely
Journal of Consumer Research, forthcoming
Understanding the role of emotion in forming preferences is critical in helping firms choose effective marketing strategies and consumers make appropriate consumption decisions. In five experiments, participants made a set of binary product choices under conditions designed to induce different degrees of emotional decision processing. The results consistently indicate that greater reliance on emotional reactions during decision making is associated with greater preference consistency and less cognitive noise. Additionally, the results of a meta-analytical study based on data from all five experiments further show that products that elicit a stronger emotional response are more likely to yield consistent preferences.
Driven to Distraction: Extraneous Events and Underreaction to Earnings News
David Hirshleifer, Sonya Seongyeon Lim & Siew Hong Teoh
Journal of Finance, forthcoming
Recent studies propose that limited investor attention causes market underreactions. This paper directly tests this explanation by measuring the information load faced by investors. The investor distraction hypothesis holds that extraneous news inhibits market reactions to relevant news. We find that the immediate price and volume reaction to a firm's earnings surprise is much weaker, and post-announcement drift much stronger, when a greater number of same-day earnings announcements are made by other firms. We evaluate the economic importance of distraction effects through a trading strategy, which yields substantial alphas. Industry-unrelated news and large
earnings surprises have a stronger distracting effect.
Carrots, Sticks, and the Multiplication Effect
Giuseppe Dari-Mattiacci & Gerrit De Geest
Journal of Law, Economics, and Organization, forthcoming
Although a punishment can be applied only once, the threat to punish can be repeated several times. This is possible because when parties comply, the punishment is not applied and can thus be used to support a new threat. We refer to this feature of sticks as the "multiplication effect." The same is not possible with promises to reward since carrots are used up every time a party complies; hence, at each round a new reward is needed. We show that the multiplication effect of sticks has pervasive consequences in economics and law and provides a unified explanation for seemingly unrelated phenomena such as comparative negligence, legal aid, the dynamics of riots and revolutions, the use of property rules, the commons problem, and the
most-favored-nation clause in settlement negotiations.
Motivating Loan Officers: An Analysis of Salaries and Piece Rates
Sumit Agarwal & Hefei Wang
Federal Reserve Bank Working Paper, December 2008
Whether incentive contracts provide the right incentives to individuals in organizations is a central question in modern economic theory. We study loan officers' incentives for loan origination and their choice of effort to assess loan quality under fixed-wage salary and a piece-rate contract based on loan origination. We find that whether piece-rate contracts distort loan officers' incentive to search for bad credit depends crucially on the strength of the monetary incentive and the information asymmetry between the bank and the loan officers. We further examine the relationship between loan origination decisions, loan size and other loan characteristics under the two compensation schemes, and derive a number of predictions regarding these two types of pays. Using a unique dataset on loan officer compensation from a major commercial bank, we test these implications and find results that generally support the predictions of our model.
Painful Regret and Elation at the Track
Adi Schnytzer & Barbara Luppi
Journal of Gambling Business and Economics, December 2008, Pages 85-99
We present an empirical study of loss aversion in the Hong Kong horse betting market. We provide evidence of the presence of loss aversion in a context of complete absence of the favourite-longshot bias. This would suggest that, since loss aversion is a psychological bias, the favourite-longshot bias may not necessarily be caused by psychological issues and may be due, for instance, to informational asymmetry. We investigate different types of bettors and their attitude towards loss aversion. Our data set enables us to distinguish approximately among insiders, unsophisticated outsiders and sophisticated outsiders. The results show clearly that even sophisticated bettors are beset by loss aversion, while even unsophisticated outsiders display no favourite-longshot bias. Thus, our paper provides evidence that loss aversion may be an attitude innate rather than learned, regardless of the level of sophistication in designing economic behaviour or the extent of information asymmetry. Chen et al (2006) show that capuchin monkeys display biases when faced with gambles, including loss aversion, and provide evidence that loss aversion extends beyond humans. The present work supports the idea that loss aversion may be a more universal bias, arising regardless of experience and culture and demonstrates that loss aversion is displayed even by those bettors regarded in the market as “smart money”. Further, we find that more sophisticated and experienced bettors display a higher level of loss aversion. This result is consistent with the findings of Haigh and List (2005), who show that professional traders in financial markets exhibit more loss aversion than do students.
(Nod to Kevin L.)