Behavioural Game Theory Part One: Systematic Divergence from rationality

In everything one thing is impossible: rationality – Friedrich Nietzsche

Recent research has provided empirical evidence for something that will come as a surprise to almost nobody: human beings do not behave as perfectly rational agents. Despite this, a long-standing and prevalent assumption in economic theory has been that people are fundamentally rational and self-interested. Burgeoning research has managed to tease apart some of the mechanisms underlying this systematic divergence from rationality, allowing much more accurate predictive models of economic behaviour to be created. Behavioural Game theory in particular has proved to be a powerful tool in this endeavour and has exposed that divergences from rationality are most often not due to bounded rationality, but to moralistic preferences for fairness and anticipation of positive and negative reciprocity. In order for economic theory to make more accurate predictions about how people really behave, the rational choice paradigm requires the inclusion of biases and tendencies to reciprocate, both positively and negatively. Understanding these questions is essential for a complete picture of human behaviour.

One of the most revealing and frequently tested games is the ultimatum game. In the ultimatum game, two unacquainted subjects are each assigned as either Proposer or Responder. The Proposer makes an offer on a split of money which the Responder can then accept or reject. If they accept, the money is split as proposed. Unless otherwise stated, the game is played only once, so no longer term material gain can be attained by rejecting offers. According to standard economic theory, for any offer size the Responder’s self-interested strategy is to accept; therefore, the Proposer should offer the minimum possible (Kahneman, Knetsch & Thaler, 1986). In practice, however, Responders reject low offers and Proposers, perhaps anticipating the rejection of low offers, make offers that are close to half the total sum. List and Cherry (2000) checked whether the same was true in countries whose inhabitants have low disposable income, and similar results were found, suggesting that a preference for fair treatment is a cross-cultural phenomenon. Universally, reprisals are common when this preference and expectation of fair treatment are violated. This proclivity to reject unfair offers exhibits a tendency for ‘negative reciprocity’ which can demonstrate that subjects’ preferences for fairness can exceed their appetite for monetary gain, causing them to spite the perpetrator even at a substantial cost to themselves. Van’t, Wout, Kahn, Sanfey and Aleman (2006), found these effects to be peculiar to games with human players, suggesting the rejections are in fact exhibiting punishing behaviour. Their results showed that human conspecifics were necessary to spur the desire to reject offers, which testifies to the notion that rejections are punishing unfair behaviour. Moreover, this punishing behaviour is sensitive to the specific environment features that can be modified to elicit different behaviours. Xiao and Houser (2005) found that constraints on the expression of negative emotion which leads subjects to defer from rational strategies- inflicting costly punishment on the Proposer, even at a loss to themselves, becomes their means of conveying disdain for the perceived transgression from equity that the Proposer has commited.

Efforts have been made to explain people’s ‘moralistic’ propensity to punish mistreatment and reward fair treatment by appealing to non-monetary, social (Rabin, 1993) and evolutionary (Gintis, 2004) goals and utilities. A hotly contested debate in behavioural game theory concerns whether the origins of these preferences are genetic or environmental, evolutionary or cultural, an increasingly nuanced experimental approach is beginning to tease apart these relevant variables that will allow for a model of economic behaviour that incorporates any information available that can help make better predictions of behaviour. Psychological findings are attuning abstract economic models to real world behaviour- a vital asset for improving commerce and policy. In coming posts the crucial variables will be explored in greater detail.

References

Ginits, H. (2004). Towards the Unity of the Human Behavioral Sciences.Philosophy, Politics and Economics, 31: 37–57.

Kahneman D, Knetsch JL, Thaler R (1986). Fairness as a Constraint on Profit Seeking: Entitlements in the Market. American Economic Review, 76, 728-741.

List, John A. and Cherry, Todd L. (2000) “Learning to Accept in the Ultimatum Game: Evidence from an Experimental Design that Generates Low Offers.” Experimental Economics, June, 3(1), pp. 11-29.

Rabin, Matthew. “Incorporating fairness into game theory and economics.” The American economic review (1993): 1281-1302.

Van’t Wout, M., Kahn, R. S., Sanfey, A. G., & Aleman, A. (2006).Affective state and decision-making in the ultimatum game.Experimental Brain Research, 169(4), 564-568.

Xiao E, Houser D (2005). Emotion Expression in Human Punishment Behaviour. Proceedings of the National Academy of Science USA, 102, 7398-7401

Flow and Expertise

… and I just kept going. Suddenly I was nearly two seconds faster than anybody else, including my team mate with the same car. And suddenly I realised that I was no longer driving the car consciously. I was driving it by a kind of instinct, only I was in a different dimension. -Ayrton Senna, during qualifying for the 1988 Monaco Grand Prix.

In the workplace, it is desirable to foster environments in which people are effective, efficient, and fulfilled. Understanding the psychology of expert skill acquisition and the nature of “Flow” can help achieve this end.

Much of life is the acquisition of skills. To be able to drive a car or play a sport requires practice, and for the most part these skills are acquired in a relatively straightforward manner, taking perhaps a few months of practice in order to reach an acceptable level. When this functional level of performance has been reached the skill becomes in some sense automated, where it is easy to remain at a steady standard without an increase in effort (Anderson 1982). However, some of us become experts, and thus show consistently superior performance in certain domains compared to novices and average performers. These experts have amassed greater knowledge and a more detailed set of skills than others, and use it in a well-informed way to achieve the best results in their particular domain of expertise. They more rapidly and accurately find the best solutions when solving problems in their field (Klein 1998). Knowing how people achieve expertise can be beneficial to the process of structuring problems and creating environments that are conducive to effective action.

Despite the somehow resilient concept that innate mental capabilities are the biggest predictor of exceptional performance (cf. Galton 1869), a review by Ericsson and Lehmann (1996) concluded that measuring basic mental ability was an ineffective predictor of expert performance and that differences between experts and novices were almost entirely due to acquisition of knowledge through training and practice. One study failed to distinguish the best players from a group of chess players on the basis of IQ (Doll & Mayr 1987) and others found the same result when looking at groups of artists and scientists (Taylor 1975). Instead, a study which interviewed experts from various domains (from swimming to genetics) found that they were all united in the presence favourable learning environments in childhood, which included strong family support and early instruction (Bloom 1985).

An oft-misunderstood phrase with respect to expertise is the “10,000 hour rule” (see Gladwell 2008), which states that to become highly proficient in any domain takes ten thousand hours of practice. However, while a great deal of practice is certainly a necessary condition for expertise, the crucial factor is the type of practice undertaken.  Already mentioned is the fact that skill acquisition often seems to plateau once it has reached a functional level, and that improvements from then on are unpredictable and do not increase as a function of time spent practicing (Ericsson & Lehmann 1996). So experience and improvement in skill are not continuously correlated. In order to reach an expert level of skill one needs to practice mindfully and with a view to improving specific aspects and gaining useful feedback, and so people who aspire to reach the upper echelons of their domains aim for a particular kind of learning style: deliberate practice (Ericsson,  Krampe, & Tesch-Römer  1993). This consists of structured activities that are designed to improve specific aspects of performance, rather the skill as a whole, and evaluative research has shown how accrued time spent undertaking deliberate practice is related to performance level (Ericsson 1996). The Bloom (1985) study mentioned previously found that experts had had access to a high-quality training environment from an early age, however there were still differences between the performers who did have access the best environments. Ericsson, Krampe and Teschromer (1993) asked expert violinists to keep a diary of duration spent on different activities during the week, and they were all found to be spending an equal amount of time, over fifty hours, on activities related to music. The distinction between the best and the rest was the amount of time spent carrying out deliberate practice, such as reaching specific goals set by their music teacher.

Deliberate practice is intrinsically motivating, effortful and repetitive, and includes performance feedback. It also relies on the tasks being within the ability of the practitioner whilst also being of level that is difficult enough to be too strenuous to maintain for long periods of time. Thus, it seems the goal of deliberate practice is in some way to reach a flow state of consciousness (Csikzentmihalyi 1988), whereby an individual becomes lost in their work due to reaching a state of equilibrium between task difficulty and skill. We can see the effects of failing to reach this balance: when task difficulty is too high, anxiety results, and when it is too low, boredom is felt.

Flow is completely focused motivation where emotions are totally aligned with the task at hand, with result being a feeling of energy, or even joy, at performing the task. Flow is essentially an operationalized definition of the feeling of being in the zone, and is defined in this way by the intense concentration on the task leading to a loss of reflective self-consciousness and a sense of total control.

The entering of a flow state can occur in many different domains. Music, in particular, seems to provide much potential for flow, with research showing that performance quality improves when one is in flow. A study of the physiological effects of entering flow during music performance found that heart rate and blood pressure decreased and the major facial muscles relaxed occurring as performance improved (de Manzano et al. 2010). The raison d’être of video games is to induce this state, and often the difficulty level is altered automatically mid-game to cohere with player skill level, keeping motivation and attention at high levels (see e.g. Left 4 Dead).

These descriptions of flow states highlight the similarity of flow with eastern philosophies, of meditation and Zen: the dissolution of the self is central to spiritual development and concepts of “doing without doing” in Buddhist teachings approximate the modern concept of flow. The contentment that results from spiritual development is akin to losing oneself in the study of an intrinsically motivating task.

The conditions that need to be met to achieve a flow state are:

• The activity being performed must have clear goals and progress.

• There must be immediate feedback

• There must be a balance between (perceived) challenge and (perceived) skill. The sweet spot is where the activity slightly stretches the individual’s skills, not too much too induce anxiety but also not too easy as to cause boredom (Csikszentmihalyi, Abuhamdeh, & Nakamura 2005).

One can see the import of flow in workplaces and educational institutions. Enhancing the propensity for flow states to be reached can result in increased satisfaction, efficient learning and high achievement. The goal is to match challenge and skill levels, and activities and the environment can be altered in pursuit of this aim. An important issue to note is that the motivation to perform tasks must be intrinsic – difficult perhaps in a workplace where motivation is ostensibly financially motivated.

The conditions for achieving flow seem to mirror those found in expertise research, where tasks are goal-directed, with immediate feedback (at first via a teacher, before more sophisticated metacognitive skills are developed), and with a balance between difficulty and skill.

Csikzentmihalyi (2004) himself notes the difficulty of achieving flow in the workplace because setting clear goals is often difficult due to the employee’s lack of knowledge about their work’s place in the larger organizational structure of the institution. Further, feedback is often limited or inchoate and so the employee is left in a state of uncertainty as to their accomplishment. The individual’s capacity to achieve flow states in their job is not just beneficial to themselves, creating a sense of motivation and fulfilment, but to the institution as a whole, increasing employee productivity and development, as well as contentment.

The concept of flow, it seems, allows us to operationalize and make practical the ancient concepts of eastern philosophy, and develop them for their application in the present day. Refining the concept via psychological research allows us to more effectively apply it to modern situations in work, play and education. The quest for expertise in a domain relies on appropriate learning strategies of goal-directed, feedback-laden practice, a concept coherent with flow, leading to emotional, practical and educational benefits for individual and institution.

References

Anderson, J. R. (1982). Acquisition of cognitive skill. Psychological Review, 89, 369–406.

Bloom, B. S. (1985). Generalizations about talent development. In B. S. Bloom (Ed.),Developing talent in young people(pp.507–549). New York: Ballantine Books.

Csikszentmihalyi, M. (1988) Optimal Experience: Psychological Studies of flow in consciousnesss.

Csikszentmihalyi, M. (2004) Good Business: Leadership, Flow and the Making of Meaning. Penguin

Csikszentmihalyi, M.; Abuhamdeh, S. & Nakamura, J. (2005), “Flow”, in Elliot, A., Handbook of Competence and Motivation, New York: The Guilford Press, pp. 598–698)

de Manzano, Orjan, Theorell, Harmat, Laszlo, Ullen & Fredrik. (2010) The psychophysiology of flow during piano playing. Emotion, Vol 10(3), 301-311.

Doll, J., & Mayr, U. (1987). Intelligence and performance in chess—a study of chess experts. Psychologische Beiträge, 29 (1987), pp. 270–289

Ericsson, K. A. (1996). The acquisition of expert performance: An introduction to some of the issues. In K. A. Ericsson (Ed.), The road to excellence: The acquisition of expert performance in the arts and sciences, sports, and games (pp.1–50). Mahwah, NJ: Erlbaum

Ericsson, K. A., Krampe, R. Th., & Tesch-Römer, C. (1993). The role of deliberate practice in the acquisition of expert performance. Psychological Review,100,363–406.

Ericsson, K. A., & Lehmann, A. C. (1996). Expert and exceptional performance: Evidence on maximal adaptations on task constraints. Annual Review of Psychology, 47, 273–305

Galton, F., Sir (1869/1979). Hereditary genius: An inquiry into its laws and consequences. London: Julian Friedman Publishers

Gladwell, M. (2008). Outliers. Little, Brown and Company.

Klein, G.A. (1998) Sources of power: How people make decisions. Cambridge, MA: MIT Press.

Taylor, I.A. (1975). A retrospective view of creativity investigation. In I.A. Taylor and J.W. Getzels (Eds.), Perspectives in creativity (pp. 1-36). Chicago, IL: Aldine Publishing Co.

Do Taxpayers Have Stable Preferences Around Taxation Policy?

In this world nothing can be said to be certain, except death and taxes. – Benjamin Franklin

No one enjoys paying taxes. Taxes are however, one of life’s inevitabilities. It is no wonder then that taxation policy is such a contentious and emotionally charged issue.

It has come to light that large corporate companies have been finding legal loopholes to avoid or evade tax, reportedly costing the exchequer £5bn a year and spurring George Osborne to announce a £4.6bn government crackdown on avoidance and evasion.

Public reaction to tax avoidance by multinational corporations has tended to be one of outrage and a recent poll revealed some 34% of people are boycotting the products and services of companies who do not pay their fair share of tax. Despite the importance of public opinion to taxation, policy seems largely driven by economic arguments, or appeals to ideas like ‘fairness’. However, we know very little about what people think is a fair tax structure, and how this notion of fairness varies across individuals and contexts. In the UK, we adopt a progressive tax system in which the amount of income tax increases as the taxable base amount increases. Is this really the tax system people prefer? As tax policy in a democracy might be expected to take into account public opinion about taxation, it is surprising how little research has been conducted examining what type of tax system people prefer and how people feel about tax issues such as evasion and avoidance.

The literature on psychology of judgment and decision-making provides countless examples of situations in which the choices we make are biased, inconsistent and highly dependent on context. A number of experiments conducted by Nobel prize winner Daniel Kahneman and the late Amos Tversky show that preferences change depending on the description of outcomes, and that they are largely contingent upon how questions are framed. To illustrate this point, Tversky and Kahneman asked people to imagine that the US was preparing for the outbreak of a new Asian disease and that they could choose to adopt a program of intervention that would save 200 people or one where there is a one-third probability to save 600 people and two-third probability that no one would be saved. A large majority of the people they asked chose the first program, they wanted to save 200 people for certain, rather than risk a chance of not saving 600 people. However, when Tverksy and Kahneman asked another group the same question but changed the word ‘save’ to ‘die’, preferences reversed and the majority people preferred to risk a situation in which there was a small probability that no one would die. What this ‘framing’ problem serves to demonstrate is how easily our choices can depend on the way a question is put to us. ‘Framing’ effects have also been found to be associated with lower cognitive capability, Stanovich and West looked at the relationship between aptitude tests and framing they found that people who scored lower on tests were more susceptible to framing biases. It may not seem surprising that the use of a different word can impact on our choices but if we think about this in the broader context of politics and the media such a small contextual difference can lead us to choose options we would not in a different set of circumstances.

Further to the effects of ‘framing’, judgment and decision making research also shows people also prefer to act in accordance with the status quo, viewing deviations from the current situation as a loss. Kahneman, Knetsch and Thaler presented people with a hypothetical situation: “You have just inherited a large sum of money from a great-uncle and need to choose where to invest this money”. The people in their study were presented with a number of options of varying degrees of risk, and it was found that people systematically preferred the option desginated as ‘status quo’ over alternatives Similarly, when electric power consumers in California were asked about their preferences concerning a compromise between the reliability and rates of electricity providers, they strongly preferred options that were determined as the status quo. What these studies demonstrate, is that people are reluctant to deviate from the norm. It might be less cognitively taxing to follow the default as a rule of thumb rather than thoroughly assess each situation individually.

In addition to these biases we seem to hold implicit standards of fairness that strongly influence how we justify our attitudes toward a number of issues. A large body of research has shown, unsurprisingly that we often conflate what is fair with what benefits us personally, mainly as a means of protecting our self-esteem. We are all familiar with football fans of opposing teams vehemently contesting that their interpretation of an event on the field is correct, mysteriously consistently falling in each claimant’s favour. Or the student who attributes their good grades to their own intelligence but their bad grades to some external circumstances, demonstrating that our preferences are often self-serving. Nowhere is this more apparent than in people’s attitudes toward tax. Recently, the US rapper Lauryn Hill has been jailed for evading $1 million in tax, she cited ‘an economic system that had been imposed’ upon her as the reason for her misdemeanour. It seems here that Lauryn, like many before her, might have fallen prey to a self-serving bias. The prevalence of systematic deviations from the rational economic model provides good reason to pause to reflect on how to account for such instability and bias in tax policy preferences.

Numerous studies have now shown that our taxation preferences also fall victim to the same kinds of inconsistencies and biases previously discussed. The economist Thomas Schelling (1981) found that framing can have consequences in the context of tax policy. He pointed out that tax could either be framed as an exemption for a family with children or a premium for a childless family. He asked students in his class about the tax exemptions and premiums they would be happy to offer well-to-do or poor families, and families with and without children. His students asserted they would not grant a rich family with children an exemption but would do so for a poor family. However, they also favoured a larger premium on a rich childless family than on a poor childless family. This may seem fairly innocuous but premium and exemption are merely alternative labels used to describe the same tax differences in the two cases. McCaffery and Baron confirmed Schelling’s observation empricially, also finding that preferences for different tax systems change depending on whether percentages or monetary amounts were used to describe tax. A progressive tax system, in which the rich are taxed more, was preferred when tax was described as a percentage rather than an amount whereas a flat tax, the amount paid is flat and proportional to the amount earned, was preferred when tax was described as an amount paid.

Some work conducted by Stian Reimers of City University London found similar metric effects in people’s tax preferences. He also found that a more progressive tax system was favoured when tax was described, as post-tax income than tax paid yet this effect did not exist when tax was described as percentages. Perhaps when options are described as “tax paid” people consider the tax as their fair contribution to society. Conversely, describing the option as “money left” may lead to considerations of what is reasonable amount of money to live on. Alternatively, the different descriptions may shift the reference point at which the options are evaluated. The amount of tax paid post-tax income might be evaluated in relation to gross income whereas considering the amount of money left after tax may be evaluated relative to no income. The finding that preferences were more stable when tax was described as “money left” than “tax paid” may suggest that preferences are more stable and consistent when tax is described in this manner.

In on-going research, Reimers (in preparation) has found that relative preferences for taking punitive action following evasion of a small amount of tax against high earning versus low earning individuals was also affected by framing. Specifically, when the amount of tax the evaders had already paid was emphasised, participants were more punitive towards the lower earner than when the amount of money the taxpayers had left after tax. Tax evasion and tax avoidance attitudes differ despite the consequences leading to similar outcomes, both being grounded in the same desire to alleviate the tax burden and being economically comparable. Tax avoidance, is perceived as legal, moral and is associated with good intentions, such as ‘to alleviate the tax burden’. In contrast, tax evasion is perceived as illegal, immoral, and is associated with fraud and criminal prosecution (Kirchler, Maciejovsky & Schneider, 2001). However, in unpublished consultancy work for HMRC, Reimers (2008) found that self-assessment UK taxpayers did not differentiate between legal avoidance and illegal evasion of others when expressing attitudes. This accords with the recent outrage of the British taxpayers toward large multinationals and even, to a lesser extent, certain celebrities over their significant avoidance of tax. In Britain at least it seems we strongly feel that individuals and corporations should make a fair contribution to the society they live or operate in.

The little work that has been conducted on people’s tax preferences strongly suggests that people approach a decision problem (a choice between tax systems for instance) with preconceptions, for example to avoid penalties or for the rich to pay more, rather than evaluating the options based on those that are relevant in the given context. The conflicting ideals or perceived norms that people hold may result in inconsistent and unstable preferences. Does this indicate that people do not have preferences when it comes to taxation or do preferences depend on the question they are being asked? When choosing between multiple alternatives a common baseline may be ignored and may lead to inconsistent preferences. Equally, preferences may be self-serving so that when presented with different options people choose the ones that benefit them personally justifying their option as one they think is fair, when it might only be fair for them and not for others. The Veil-of-ignorance thought experiment, used by political philosopher John Rawls in his ‘Theory of Justice’, may provide a means of removing self-serving biases in relation to tax preferences whilst also affording a means of uncovering more stable taxation preferences. The central concept here is that choices about the structuring of the tax system are made whilst one is ignorant to one’s position in society so as to extract personal considerations that cloud judgment over what people think the best tax system should be. Overall, although research in judgement and decision-making has revealed a great deal about the cognitive representations and mechanisms involved in financial decisions, there is only very limited research on how these may affect taxation judgements. This is surprising given it is something we all feel so strongly about.

 

References

Babock, L., Loewenstein, G., Issacharoff, S., & Camerer, C. (1995). Biased judgments in fairness bargaining. The American Economic Review, 85(5), 1337-1343.

Babock, L., & Loewenstein, G. (1997) Explaining bargaining impasse: the role of self-serving biases. Journal of Economics Perspectives, 11, 109-126.

Hsee, C. K. (1996) The evaluability hypothesis: An explanation for preference reversals between joint and separate evaluations of alternatives. Organisational Behaviour and Human Decision Processes, 67(3), 247-257.

Kahneman, D., Knetsch, J.L., & Thaler, R. H. (1991) Anomalies: The endowment effect, loss aversion and status quo bias. Journal of Economic Perspectives, 5(1), 193-206.

Kirchler, E., Maciejovsky, B., & Schneider, F. (2003) Everyday representations of tax avoidance, tax evasion, and tax flight: Do legal differences matter? Journal of Economic Psychology, 24, 535-533.

McCaffery, E., & Baron, J. (2003) Heuristics and biases in thinking about taxes.

McCaffery, E. J., & Baron, J. (2004). Framing and taxation: Evaluation of tax policies involving household composition. Journal of Economic Psychology, 25, 679-705.

McCaffery, E. J., & Baron, J. (2006). Thinking about tax. Psychology, Public Policy, and Law, 12, 106–135.

Rawls, J. (1971). A Theory of Justice. Cambridge, MA: Harvard University Press.

Reimers, S. (2008). Attitudes and behaviours in self-assessment taxpayers. Internal report for HMRC.

Reimers, S. (2009) A paycheck half empty or half full? Framing, fairness and progressive taxation, Judgment and Decision Making, 4(6), 461-466.

Stanovich, K. E., & West, R.F. (1998) Individual differences in framing and conjunction effects. Thinking and Reasoning, 4(4), 289-317.

Tverksy, A., & Kahneman, D. (1981) The framing of decisions and the psychology of choice. Science, 211(1148), 453-458.

Tverksy, A., & Kahneman, D. (1986) Rational choice and the framing of decisions. The Journal of Business, 59(4), 251-278