emotional economics

Let’s play a game. Imagine you and another person each go into separate rooms. The person in the other room is given an envelope containing $100. You’re told that the person in the other room gets to decide how to split the money with you. They will take the money they want, and leave their offer to you in the envelope, which will then be brought to you by a third party. You can accept or reject the offer. If you accept, you walk away with the amount of money the other person offered you. However, if you reject it, you and the other person both have to give your money back, and walk away with nothing.

What’s the lowest amount of money you would accept? If you’re like most people, you would gladly accept $50. You might even be willing to accept $30. But would you accept $5? $1? Again, if you’re like most people, probably not. But why not? How did you arrive at the minimum offer you would accept?

This problem, called the “ultimatum game,” is widely discussed in business and economics, because it flies in the face of a core assumption a lot of businesspeople and economists make: that people will generally do what’s rational to maximize their individual economic gain. A purely rational person would accept one dollar, because they would walk away from the game a dollar richer. But most people don’t do this, which means there is something else at work in their decision-making.

Let’s look at another example. In this game, one person is given a mug, and told they can either keep the mug as a gift, or sell it. Another person is simply shown the mug, and asked how much they would be willing to pay for it. In this game, people who were given the mug placed its value almost twice as high as people who were shown the identical mug.

This is an example of the “endowment effect,” the finding that people generally value what they already own much more than if they didn’t already own it.

You can tweak the endowment effect to make it work in favor of the seller too. Suppose you see an ad for a used guitar, best offer, with just a general description and a picture. Now suppose you see an ad for the same guitar with the same description and picture, but now the seller has added a story about when they first bought the guitar, and descriptions of the many times they played that guitar on stage. Odds are you would make a much better starting offer if you saw the second ad.

The lesson you could take from all of this is that people are irrational, emotional, easily-deceived creatures, but I think that would be a lazy and misanthropic conclusion. Instead, we can think a little deeper and discover the hidden logic behind these seemingly illogical behaviors. With our used guitar example, it’s easy to see that the added story behind the guitar shows how much value it has to its current owner, which probably makes you willing to pay a little more.

Now suppose instead of talking about guitars and mugs, we’re talking about something vital and perishable, like food. If we were living in a less technologically advanced era when food was more scarce, we would probably place great value on the food we already had stored. Acquiring more food might not always be worth the risk of going hunting or going to war. This could help explain why our brains naturally place greater value on what we already own.

The ultimatum game is a little harder to explain, and people have different theories on it. My own theory is pretty simple, and it starts with the anger we can all imagine feeling if we were offered that single dollar. That anger comes from a sense of injustice. “No,” we think, “you can’t just take $99 and leave me with only one. I’d rather we both walked away with nothing.” To me, this goes back to the lecture on “Retribution and Revenge” from Daniel Breyer’s course on the dark side of human nature: we are driven to get even with people who have wronged us because a society where wrong-doing goes unpunished is not stable. Most of us feel it’s worth a dollar (or five or ten or twenty) to teach that other person a lesson about the kind of society we ought to live in.

All of this can be summed up by a quote from neuroscientist Antonio Damasio: “We are not necessarily thinking machines; we are feeling machines that think.” That’s not a bad thing, either--there’s a kind of wisdom to our emotional decision-making.