Posts Tagged ‘prospect theory’

About Behavioral Economics: Why Hawks Always Win and Doves Always Lose

Friday, May 29th, 2009

horusThe belief in Rational Decision Making has been the focus of Economic Theory for a very long time.

Although everybody knew that Humans are Highly Impulsive and Emotional, Economists based their theoretical models of the Market on a Rational Human Being who is always able to Calculate the best Alternative possible. This Theory is wrong. The Economic Behavior is controlled by the Emotions.

The current economic crisis shows that the old Rational Theory is not applicable and the attention for alternative theories of Economic Behavior is rising. These theories are called Behavioral Economics.

An important paper in the development of behavioral economics was written by Kahneman and Tversky in 1979 (Prospect Theory, Analysis of Decision Under Risk). Kahneman was awarded the 2002 Nobel Prize in Economics for his research in Prospect Theory.

According to Prospect Theory, Humans attach much greater weight to future losses than to future gains related to their personal reference point. When you expect a certain gain in the future and this gain is lower than you expect the gain is experienced as a loss.

Kahmeman and Tversky became the experts on Cognitive Bias. A Bias is a “not-rational” mostly fast response to a stressful situation. In this case the Human System uses old structures (The Reptile Brain) that were created a very long time ago when the human lived in a completely different environment. The Reptile Brain uses many shortcuts to save time.

Social and cognitive psychologists have identified a number of predictable errors in the ways that humans judge situations and evaluate risks. Biases have been documented both in the laboratory and in the real world. For example, people are prone to exaggerating their strengths: About 80 percent of us believe that our driving skills are better than average.

In 2009 Kahneman and Renshon wrote a paper called Hawkish Biases. It is an attempt to unite the many Cognitive Biases into one Model. The model shows that Humans are highly Confused Predators (Hawks).

As a Predator they protect their Territory with every means possible. They are Confused because they are capable to Observe and Reason about their own behavior and the behavior of others.

Humans need the “Illusion of Control” to sustain their own Identity. Every time something happens they are looking for reasons to believe that they are the Primary Actor in their own context. They don’t want to believe that Other Human Beings are also Active Agents.

If they would believe this was the case their “Unrealistic Optimism” could change into “Realistic Pessimism”. Unrealistic Optimism makes managers, politicians and generals receptive to advisors who offer highly favorable estimates of the outcomes. Such a predisposition, often shared by leaders on both sides of a conflict, is likely to produce a disaster.

When a Human is Depressed by Realism he Loses his Face and moves down in the Picking Order of the Territory.

Humans believe that every other Human is always capable to see their Weaknesses (“the Illusion of Transparency“) just like they are convinced that the intentions of others are always clear to them (“the Fundamental Attribution Error“). To hide their Weaknesses they have to wear a Mask and Play the Strong Leader of the Pack. They have to Keep Up their Appearances.

doveHumans base their theory of the other on inferences about historical behavior and completely forget Situational aspects. When a context is hostile the other must be hostile too. When others behave differently from their expectations they suddenly introduce situational factors to sustain their believe system.

Humans need to sustain their believe-system because this system is the foundation of their personality. Their view on the World has to stay constant because when it changes too fast they will get into big psychological problems. When people get older their believe-system becomes very rigid.

Humans value their own possessions much higher as the possessions of others (“The Endowment Effect”). They even consider possible, imaginary, possessions as real possessions if they are convinced there is an easy way to get them.

If they lose a real or imaginary possession they take tremendous risks to get their possessions back (“Risk Seeking in Losses“). People in general don’t like cutting their losses. They’re willing to gamble on in the hope of recovering them.

Humans simply believe that a Hawk always wins the Game and a Dove always loses. What Humans (want to) forget is that they are living in a group and their In-Group and the many Out-Groups contains many Hawks. They need the confidence that they are “the best” to Survive.

The world of the Human Hawk is a world of Competition (Winner takes all) and therefore highly Stressful. The Sad Thing is that the many faces of Stress are the Major Cause of the Cognitive Bias. When Humans relax and reflect they are much more capable to solve a complicated conflict.

The competitive Hawks always fall in the trap of the Prisoners Dilemma and don’t realize that Cooperation, the Win-Win is the only Certain Way to Leave the Prison.

At this moment another Behavioral Economist, Robert Shiller, is getting a lot of attention. Together with the Economic Nobel Prize Winner George Akerlof he wrote the book “Animal Spirits“.

In the book they identify five distinct elements that blur the theory of the Rational Economy. These elements or “animal spirits” are called: confidence, fairness, corruption; money illusion and the reliance on “stories”of others.

The first three have a lot to do with the “hawk“-theory of Kahneman. The Hawks use the Rational System for their own benifit. They Play with the Rules and invent new exiting possibilities to win more than they ever could imagine.

Sometimes they Play Dirty Games to beat their Opponents. The Doves believe the Economic (Rational) Fairy Tales of the Hawks and are unable to understand the Real Value of their Money.

The Money Illusion is caused by Inflation. Inflation happens when prices Rise but the value of the objects that are priced stays the same. Inflation give people the feeling that they are making money but in reality they are losing money.

The Hawks use Inflation to keep the Doves Buying and Investing. They also use the weapon of Inflation to win the war with the other Hawks.

The Majority of the Human Beings are Doves. They believe the Hawks or are afraid of the Hawks. The Doves are the Workers in the Economy and they make it possible for the Hawks to Hunt.

The Hawks provide the Workers with many things to live an easy life until other Hawks start to Attack the Territory. In this case the Hawks need the Workers to fight and win the War.

Sometimes even the Hawks lose their Rational Capacity. They see a Big Win and become Greedy and Vulnerable. If this happens the Territory is open for other Hawks (The Chinese?) to enter and to take over without any problem.

What has Happened?

The Economic System is just like the Weather System a Cyclic System. When the Economic Cycles and the Weather Systems move UP the Hawks have an Easy Time. Their is enough food for all the Hawks. When the System is going Down Competition starts.

The Hawks forgot to look at the patterns. They did not see or believe that the downfall was approaching. They did not take enough stock to survive the Seven Bad Years. Suddenly the Autumn turned into Winter.

At this moment they are regrouping to create a Powerfull Alliance to take from the other Hawks what they need. They don’t care about the Doves. They always believe the Tales they Tell.

They are afraid of the Other Hawks that are outside their Huge Territory and are Prepared to Fight the Wars that are needed. The Doves will believe them as usual.


About Prospect Theory and Conflict Resolution

About Economic Cycles

Kahneman/Renshon, Hawkish Biases, 2009

A Very Long List of Cognitive Biases

About the Prisoner Dilemma in Foreign Policy

An Abstract of the Book Animal Spirits

How the Chinese Networks are Conquering the World

A Review of the book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George A. Akerlof and Robert J. Shiller by Benjamin Friedman

How to Resolve an Infinite Chain of Conflicts

Saturday, August 9th, 2008

Humans attach much greater weight to future losses than to future gains, especially when the former are certain and immediate and the latter are uncertain. Humans take unwise risks to avoid certain and immediate losses.

They don’t want to take risks to pursue gains or will unwisely turn down proposed changes or concessions that offer a mix of gains and losses, even when the promised gains are objectively greater than the losses.

To calculate a loss a Human chooses a personal reference point which is usually the individual’s status quo.

Human beings reject or devalue whatever is freely available to them. They strive for whatever is denied them. They want to fight because when you win a fight you don’t lose a fight. Humans get exited when they have removed an Obstacle.

Without an obstacle Life is Boring. To remove an Obstacle Humans create Imaginary Obstacles. They need a Challenge.

They don’t believe their adversary offers a compromise because when he offers a compromise he is losing. Somewhere behind the compromise is a hidden tactic. The adversary will attack out of the blue and will suddenly win. On the other hand when the compromise is sincere the enemy is getting weaker and it is possible to increase the demands in the negocation.

The total effect is that future compromises and package deals decrease in attractiveness once they are offered especially when they are put there by one’s adversary rather than by a third party (Reactive Devaluation).

The Effect of Future Losses on Human Decision Making is researched in Prospect Theory.

The basic Stategy of Humans is to avoid the Emotions of Loss (Anger, Frustration, Grief, Fear, Sadness, Yearning, Pity, and Sorrow). This is not strange because the Emotions of Loss have a negative impact on the body. They influence the Immune System and are the cause of many ilnesses.

When two parties imagine a joined future where both of them lose they will never cooperate. In terms of the prisoners dilemma this is called a lose/lose-situation.

When two parties have seen a win/win situation and the realization changes into a lose they are in conflict. They have to envision a new win/win or break the cooperation.

Sometimes it is impossible to break a cooperation because both parties share vital resources or don’t know how to divide the assets of the former cooperation. In this case they are in a the win/lose-mode of the (Iterated) Prisonners Dilemma, constantly switching between losing and winning.

When a party wants to move from a lose to a win he has to apply the tactic of Tit-for-Tat. When you apply Tit-for-Tat you simply copy the behaviour of the other. When one of the parties sustains his unwillingness to cooperate both of them are in an Infinite Chain of Conflicts.

When two parties were united it is very difficult to recreate independent disconnected units. Many of the joined activities where performed without negotiation and were never formalized. When two parties cooperate they are acting as one Mind and one Soul.

Moving out of a Cooperative Relationship needs a Cooperative Relationship. When this relationship is broken two parties are needed who enter into a Cooperative Relationship to resolve the Cooperative Relationship on the lower level. When this Cooperative Relationship fails another level has to be created. If all the levels fail they are in an Infinite Chain of Conflicts.

If a Conflict of Interest arises the first action is to avoid the conflict or to speed up the conflict. In the last case the Primary Emotions (Desire, The Emotion of Loss) are bothering them. To avoid a Conflict we have to Articulate our Emotions at the Right Moment in a Respectful Way. We have to Communicate.

Most Conflicts in Nature are violent. Humans have found a way to abstract from Violence. We have created Imaginary Violence. We Fight our Case in Court. We don’t fight our Case in the Court Yard. We have replaced the material Sword of Iron by the Imaginary Silver Sword of Words.

If both parties are unable to define the conflict in a coherent model the conflict will not resolve. They need help to do this. If the advisors of the two parties are unable to do this the conflict has to move to a higher level of abstraction. When the conflict is resolved on this level somebody has to translate the consistent model to the lower level. When this is not possible the conflict starts again. They are in an Infinite Chain of Conflicts.

When an Abstract Model is always Moving Up and Down, the Model is not in Harmony. Harmoniouss Models are applicable on Every Level of Abstraction. Models that are The Same on Every Level are Self-Referencial. When a Conflict is Modelled as a Conflict it will never be solved.

The solution to this problem is to Extend the Context of the Conflict until a Balance has been found. Both Parties have to Widen their Perspective. They have to step out of the Status Quo and Imagine a Bright Future. A Future where the Darkness of the Night has been replaced by the Light of the Day. They have to wake up out of their joint Nightmare and Face Reality.

A Conflict is resolved when all the parties that are involved are Satisfied. They are satisfied when they experience a Balancing of their Emotions. A Victim is satisfied when his Emotion of Revenge is resolved. The Killer is Killed or put into prison for many years. The Emotion of the Killer is balanced by the Emotion of his Victim(s).

To Balance Emotions we have to Objectify Emotions. When we are buying a Car we have to pay Money. The Car is an Objectified Emotion (The feeling of the Freedom to Move) and Money is an Objectified Emotion (The feeling of Freedom to do what we want to Do). The Potential of Money is balanced by the Potential to Move. When we buy we are balancing Potentials.

Humans use Mental Accounting to define what their Potential is. They divide their Potential in many “Isolated” boxes and are unable to combine the boxes. A savings account is meant to save money and not to spend money. If Humans put their Potentials in “closed” Boxes they are Poor although they are Rich.

When they feel Poor they will experience every potential solution of a conflict as a loss. When a Human accepts that the Future is not the Past he will realize that there are many possibilities he has never seen. When a Human accepts that his Potential is his Creativity he is able to negociate with an Open Mind.

Many people believe the Juridical System is the most objective system in our Society. Sadly enough this is not true. The Law is highly confusing. Judges don’t have the background to understand what has really happened. Lawyers are telling their own biased story and most of the cases are very complex. The System is a System of Last Resort. It is used when many future and current losses are accumulating.

The Judicial System is meant to resolve Infinite Chains of Conflict without Applying Violence. This is accomplished by Balancing Emotions by Objectifying Emotions by Articulating the Emotions in Words by Combining the Words into a Model by comparing the Model with an Abstract Juridical Model by Solving the Conflict Applying this Model by Translating the Model to a lower Level by Explaining the Model to the Parties hoping they will Agree so the Emotions are Balanced so both Parties are Satisfied.

If this is not happening the whole process starts all over again until somebody (a Judge, Somebody who Speaks Law) utters a Solomon’s Verdict.

I hope You see why it is much better to settle a Conflict on a Lower Level.


Papers about Conflict Resolution

About Prospect Theory

About Prospect Theory and the Financial Market