Predicting the direction of human deviation from optimal choice

What is it about?

Money makes the world go round, but it is not easy to predict the direction of the spin. The difficulty stems from the existence of contradictory deviations from optimal choice. Mainstream decision research explains the contractions by assuming that different choice environments trigger distinct biases. For example, underinvestment in attractive risky options is said to reflect loss aversion, and the opposite bias is said to reflect overconfidence. However, this research sheds limited light on the conditions that trigger the distinct biases. Our analysis highlights the potential of a different approach. It starts by demonstrating that six pairs contradictory deviations emerge in the lab, in response to small changes in the incentive structure, even when the choice environment does not change. For example, underinvestment in risky options emerges when the risky options are positively correlated, and the opposite bias emerges when the risky options are negatively correlated. Next, we show that the results can be captured by simple models assuming a tendency to rely on small samples of similar past experiences.

Featured Image

Photo by Mathieu Stern on Unsplash

Photo by Mathieu Stern on Unsplash

Why is it important?

Since money make the world go round, a better understanding of the way people react to incentives can help reduce social conflicts and increase social welfare. The models supported by our analysis advance us towards this goal. For example, they suggest that the positive impact of incentives can be enhanced by ensuring that the socially desired behavior maximizes the probability of positive outcomes, and not only the expected return.