Two biases - one solution

I was listening to a recent episode of Planet Money that discussed the sunk cost fallacy (or sunk cost bias). The episode reminded of something I’ve long thought: one bias, taken out of context, might in-fact help solve another bias (which itself seems to be problematic when viewed in isolation).

Let me start by describing the two biases. First, the sunk cost bias. I remember well a moment in college when I realized this economics thing might be for me. I was skiing with a group of friends, one of whom was worn out by lunchtime, announcing they were heading back to hotel. Another friend, encouraging the deserter to stay, said something along the lines of: “Common, these lift tickets are expensive. You’ve got to keep going to get your money’s worth.” I remarked we should stop pestering the deserter: the lift ticket was a sunk cost.

Nothing, at this point, would refund the cost of the lift-ticket. So, the decision was not whether to buy a lift ticket or not (that cost was sunk), but, rather, the decision was which course of action, now at lunch, would make the individual happier: A) continue skiing or B) rest in the hotel room. I was pleased that I seemed to convince my friends this was the right way to think about it. Lessons to avoid the sunk cost fallacy (or bias) are probably taught in virtually every ECON 101 class, and yet, it seems to be a bias to which we all routinely fall prey.

Consider a second, seemingly unrelated bias: present bias (or time-inconsistent preferences). It isn’t irrational to care about the present more than the future. But, it is problematic if the rate at which we discount the future changes depending on when we are asked. Consider a simple example. Which would you prefer: A) $100 today or B) 101 tomorrow? Now, a second question. Which would you prefer: C) $100 one year from now or D) $101 one year and one day from now?

It is common for people to choose A over B (“give me the quick $100 bucks now!”) and then D over C (“I’ve already waited a year, what’s one more day to get a dollar?”). There is a problem with that choice pattern. Choice of A over B implies a person is unwilling to wait a day for a dollar but choice of D over C implies the opposite: a willingness to wait a day for a dollar. When people exhibit these sorts of time inconsistent preferences, they tend to want to start a diet tomorrow. But, when tomorrow becomes today, they’re no longer willing to start the diet, and again plan to do it … tomorrow.

These two biases, the sunk cost fallacy and time-inconsistent preferences, are widely discussed in economic research, but rarely together. However, it strikes me that, at least in some circumstances, the sunk cost fallacy can help solve time-inconsistent preferences.

Consider a gym membership. If I exhibit time-inconsistent preferences, I won’t work out as much as I should. I will always imagine my future self being more disciplined and exercise-ready than my present-self ever will be. Yet, many of us pay large up-front gym membership fees. One economics study suggests people significantly over-pay for gym memberships and concludes we’d be financially better off choosing a “pay as you go” plan. But, what if paying a large-up front fee induces the sunk cost fallacy? “I’d better go to the gym to ‘get my money’s worth’”? If so, fretting over our sunk costs would lead us to exercise more than we might otherwise, helping offset the problem of time-inconsistent preferences, which, in isolation, would tend to lead us to exercise less than we otherwise might.

A commonly suggested solution for time-inconsistent preferences is to create commitment contracts. Commitment contracts occur when my present self undertakes actions (or commitments) to bind my future self, or at least makes it more costly for my future self to reverse course. An example is a Christmas Club savings account, a savings account where withdrawals are only allowed (without penalty) around the Holiday season. If people were perfectly rational, a Christmas Club account would be unnecessary; we’d just use our “regular” savings accounts that have more flexibility and, in all likelihood, pays higher interest rates. Yet, some people choose to use Christmas Club savings accounts as a type of commitment device (I’m binding my future self to not spend the money till the Holidays).

It strikes me that the psychological feelings we have around sunk costs act as a sort of commitment device. Although ECON 101 tells us to ignore sunk costs, the fact that we often fret over them suggests that, at least in certain circumstances, they may be binding us to a course of action our previous self wanted us to pursue.

Internalities

Even casual followers of economics understand the concept of externalities. An externality arises when an individual does not consider the cost of their actions on other people. A classic example is a factory that does not consider the cost of their pollution into nearby streams or rivers when setting the price of their outputs. While the concept of an externality is fairly clear, what to do about it is less so (see this piece I wrote back in 2013), but typical answers include everything from assignment of property rights and negotiation to so-called Pigouvian taxes. The externality argument has been used extensively in food debates to argue various food stuffs are “too cheap” and that items like sodas or meat or ingredients like sugar, fat, or calories should be taxed.

I won’t re-has all the pro- and con-arguments for these taxes here, except to say that the common claim that we need to re-consider the “true cost of food” because the externality consists of impacts on Medicare or Medicaid is much less obvious than is typically presumed. The point of this post, rather, is to note that I’m starting to see a new argument enter the debate. Apparently, drinking soda not only causes externalities, but it also cause internalities.

What is an internality? An internality is thought to arise when an individual does not consider the cost of their current action on their future self. This article by Allcott, Lockwood, and Taubinsky in the Quarterly Journal of Economics in 2019 derives theoretical conditions for optimal soda taxes when there are externalities and internalities. As empirical evidence of the presence of internalities, they show that consumers who score higher on a nutrition knowledge test consume less sugared soda than consumers who score lower on the test. They calculate that if all consumers had the same knowledge as that of trained nutritionists, the average U.S. household would consume 31% fewer sugar sweetened beverages. They calculate that, on average, sugared beverages would need to be roughly 1 cent per ounce higher to induce people to consume an amount equal to what they’d consume if they had the same knowledge as a trained nutritionist.

Moreover, because lower income consumers tend to score worse on nutrition knowledge tests, Allcott et al. argue that lower income consumers suffer from greater internalities than higher income consumers. As such, their logic is that a soda tax is not regressive as is typically assumed (since lower income consumers spend a higher share of income on food), but rather these taxes are helpful in “correcting” the lower income consumers’ lack of knowledge as compared to higher income households. In fact, a soda taxes is now thought to be progressive because there is greater “correction” needed for lower income households’ purchases.

The concept seems to be catching on. Earlier this year, Dubois, Griffith, and O'Connell published a paper in the American Economic Review where they conduct some interesting and careful analysis to determine what types of households would be most affected by a soda tax (there are a lot of interesting results in their paper; I encourage you to check it out). Their baseline result seems to confirm the conventional intuition that soda taxes are regressive (i.e., primarily borne by lower income households). According to the paper:

“We show that compensating variation [the economic welfare losses] associated with a tax on sugary soft drinks is around 20 percent higher for those in the bottom half of the distribution of total annual grocery expenditure (a proxy for income) compared with those in the top half.”

However, after assuming tax revenues are redistributed back to consumers in a lump sum, and employing Allcott et al.’s estimate of the benefits from reduction in internalities, they are able to conclude that soda taxes are (from the abstract):

“unlikely to be strongly regressive especially if consumers benefit from averted internalities.”

I’m a little unsure what to make of the rise of the internality argument as a justification for soda taxes. On a visceral level, it strikes me as paternalistic: “These poor people just don’t know what’s good for them. Experts are here to help.” That’s probably a bit harsh. We have plenty of evidence that people make mistakes; the whole field of behavioral economics rests on this notion (though, as I argue here, it need not justify new regulation).

Though neither of these papers make the link, this work is very similar to the area of literature on the “value of information” (I discuss much of that theory here). The basic idea is that if people change their purchases when they are more informed, then there is value in the information. Or, rather, there would be a “cost” to forcing people to buy what they did in ignorance now that they know more.

All this is a way of saying: if people suffer from the kind of internality discussed above: why is the right policy response a tax rather than information disclosure or education? Do we have any good studies on how people’s soda consumption changes after being exposed to information on health consequences? How does the “value of information” estimate from those sorts of studies compare to the internality estimates? I’d also note that sodas contain a nutrition facts panel, so the calorie consequences are clearly available for those willing to look. (For those who are interested, here is a seminal paper on the value of information contained in nutrition facts panel by Teisl, Bockstael, and Levy; they also tend to find a higher value of information for lower educated consumers).

I also can’t help but wonder how people would feel if we applied the internality argument to other areas where we know people make choices with objectively false beliefs? Let me give two examples from papers I’ve co-authored just this year.

First, consider this paper co-authored with Ruoye Yang and Kelly Raper. We find that the median consumer thinks 55% of hogs and 57% of chickens raised in the U.S. are given added growth hormones to promote growth. The truth? Zero. Use of added growth hormones is not allowed with these animals. The trouble is that these mis-perceptions distort demand. The results from one of our pooled models suggests that a person who correctly knows the answer is 0% is willing to pay $0.92/lb more for pork or chicken than someone who incorrectly believes the answer is 100% hormone use. According to the internality argument, we’d need to subsidize pork products by $0.92 *0.55 = $0.51/lb to induce the median consumer (who incorrectly believes 55% of pork has added hormones) to consume the same amount of pork as someone with correct beliefs.

Another example is my paper with Lacy Wilson in Food Policy on redundant labels. We find 47% of consumers are willing to pay a premium for non-GMO salt and 41% are willing to pay a premium for gluten free orange juice. These are almost certainly “mistakes”: there is no DNA in salt (and thus it cannot be a GMO) and there is no gluten in oranges. Additional analysis also bears out the fact that these are choices made in ignorance. People who have farm work experience and who have higher scores on a scientific literacy quiz tend to have lower willingness-to-pay premiums for these redundantly labeled products. We find that a person who got a perfect score on our scientific literacy quiz is willing to pay about $0.30 less for a bottle of “gluten free” orange juice than is someone who missed all the questions in the quiz. According to the internality logic, we need to tax orange juice with a gluten free label $0.33 to induce people with the low scientific literacy to consume the same amount of “gluten free” OJ as people with the highest scientific literacy.

How would advocates for an internality-based soda tax feel about advocates for an internality-based pork subsidy or a gluten free orange juice tax? I might imagine an argument that goes something like the following. Well, excessive soda consumption is going to cause real health care costs in the future that people need to consider now; that’s not comparable to “superfluous” harm of over-paying for non-GMO salt or gluten free orange juice or under-buying pork and chicken. But, not everyone who consumes soda will suffer future adverse health consequences and yet all would have to pay the internality tax. By contrast, virtually everyone who pays a premium for hormone free pork or chicken or non-GMO salt is overpaying now. People foregoing pork or chicken because they mistakenly believe these products contain added growth hormones are foregoing those pleasures now. Moreover, these magnitudes can add up across people and over time. For some context, total retail pork expenditures in the U.S. were in the ballpark of $62 billion last year. If there were even a 1% adjustment in purchases because of incorrect beliefs, it would represent a swing in spending of $600 million.

It is clear internalities exist, but I’m less convinced they represent solid justifications for tax/subsidy policy. For one, it’s a slippery slope. As I’ve illustrated above, there are likely lots of things we know very little about and where the “experts” would exhibit different preferences and beliefs than the lay person. Thus, the scope for internality-based taxes strikes me as nearly limitless. There’s also the issue of whether we in fact know enough to focus people’s attention on the “right” things.

While taxes are likely have a more direct and immediate effect on consumption than information policies, my sense is that, philosophically, the right approach to a lack of information is information provision, not taxes. Nonetheless, one must acknowledge, even if you give people the objective information, as my paper with Lacey shows, it simply isn’t the case that everyone will suddenly agree on the same level of consumption. This also suggests, however, a potential flaw in the way these internalities are calculated; we can’t just assume people with high vs. low nutrition knowledge or scientific literacy are or will behave the same in every other respect except for their nutrition knowledge or scientific literacy no matter how many controls we add to our analysis.

Experimental Auctions - What's New?

It is hard to believe it’s been over a decade since my book with Jason Shogren on experimental auctions was first published. We’ve learned a lot and the field has evolved in the intervening years since this publication. As a result, I’m happy to announce a new review article, just released by the European Review of Agricultural Economics, on experimental auctions with Maurizio Canavari, Andreas Drichoutis, Rudy Nayga, and myself. Maurizio, Andrea, Rudy, and I have been hosting a summer school in various European locations on this topic ever since 2011, and our annual discussions have been very useful in thinking about works well and what doesn’t when conducting an experimental auction.

For readers of this blog who aren’t academic economists, you might be wondering: what, exactly, is an experimental auction and why would you want to conduct one? The motivation for the method comes from the widely known fact that people’s answers on surveys don’t always align with their behavior in a grocery store. A general rule of thumb is that the average willingness-to-pay one finds in a survey can be divided by two if one wants to know know what people will actually pay when money is on the line.

The problem is that we often want to know the value people place on times that aren’t regularly traded in a market, where real economic incentives are at play. An experimental auction solves the non-market problem by creating a market in a lab or online setting. An experimental auction involves people bidding real money to obtain (or exchange) real goods (typically food in my applications) in a type of auction with rules where people have an incentive to truthfully reveal their preferences.

Here’s the abstract:

“In this paper, we review recent advances in experimental auctions and provide practical advice and guidelines for researchers. We focus on issues related to randomisation to treatment and causal identification of treatment effects, design issues such as selection between different elicitation formats, multiple auction groups in a single session and house money effects. We also discuss sample size and power analysis issues in relation to recent trends in experimental research about pre-registration and pre-analysis plans. We position our discussion with respect to how the agricultural economics profession could benefit from practices adopted in the experimental economics community. We then present the pros and cons of moving auction studies from the laboratory to the field and review the recent literature on behavioural factors that have been identified as important for auction outcomes.”

For Ph.D. students, or anyone looking for a new idea to work on, I’ll note that the conclusions section has a slew of ideas for future research.

Income and (Ir)rational food choice

That’s the title of a new paper I have forthcoming in the Journal of Economic Behavior and Organization.

In short, I find the more one spends on food, the less consistent are their choices. In the economic way of thinking, inconsistency is typically associated with irrationality. First saying I prefer A to B, but then later saying B is preferred to A is an inconsistency, which is often referred to as a preference reversal. It’s hard to square such preference reversals with any model of rational choice.

Why might preference reversals increase with a consumer’s income? Here’s a bit from the paper (omitting references):

“This paper sought to determine the relationship between consumers’ incomes and food expenditures on the one hand and preference consistency on the other. Previous literature has suggested at least two channels through which increasing income or expenditure might have deleterious effects on preference stability. The first operates through increasing demand for novelty and variety as incomes rise and the second operates via the relative incentive to behave rationally as the stakes fall.”

In an empirical application involving almost 540,000 food choices made by almost 60,000 people, I find that 47% of respondents committed at least one preference reversal. How do preference inconsistencies relate to income and food spending?

“Results show that the likelihood of a reversal [or preference inconsistency] and the number of reversals are significantly increasing in expenditures on food at home and away from home, and to a somewhat lesser extent, total household income. The magnitudes of these effects are large; larger than that associated with any other demographic or study design variables explored. For example, that the odds of committing a preference reversal [or preference inconsistency] are about 1.8 times (2.5 times) higher for individuals who spend $160/week or more on food at home (away from home) compared to individuals who spend less than $20/week. Exploring responses to three different “trap questions” that measure respondent attentiveness indicates that results cannot be explained by higher income households generally being more careless in their responses to questionnaires.

To explore the extent to which income and preference stability is related to variety or novelty seeking, the relationship between preference reversals and food values is also explored. As hypothesized, of the 12 food values studied, the relationships with preference reversals are strongest for the food values of price and novelty. Consumers for whom food price is a more important food value tend to commit fewer preference reversals. By contrast, consumers who rate novelty as a more important food value are more likely to exhibit unstable preferences. ”

Why does it matter whether rationality falls as incomes and food spending rises? As I’ve argued previously, increasing affluence likely allows us to indulge “higher” needs related to self actualization and self expression. Here’s a last bit from the paper, which is more speculative, and hopefully will spur some additional research (again, omitting references for readability).

“There is a view among many food and agricultural scientists that many new food products marketed to higher income consumers are “unscientific” insofar as they make absence claims about ingredients and processes scientists have deemed safe. The preference instability observed among consumers with greater food expenditures in this study need not necessarily relate to beliefs about food that diverge from scientific consensus. Nonetheless, rising incomes might better enable people to seek out and identify sources of information that conform to their beliefs and cultural identities. It has also been argued that consumers might directly obtain utility from holding certain beliefs, which might lead to information avoidance. Whether certain food and agricultural beliefs are normal or inferior goods, in this framework, is an open question.”

Arbitraging the Market for Food Fears

A couple weeks ago, the best selling author Michael Lewis was on campus, and I went to listen to him talk. I’ve read several of Lewis’ books, and it was interesting to hear him talk about some of the underlying themes that united them.

In his 2017 book, the Undoing Project, Lewis writes the history of Kahneman and Tversky and the development of behavioral economics, a field that posits people do not always make rational decisions. In an earlier book, Moneyball (published in 2004), a few stat/econ types realized baseball teams were leaving money on the table by ignoring data on what really drives team wins. One team manager, Billy Beane, attempted to arbitrage the market for players by buying “undervalued” players and putting them to higher-valued use. In another earlier book, the Big Short (published in 2010), Lewis talks about the people who made big bucks on the financial crisis by recognizing that markets were “mispricing” the risks of systemic mortgage failures. In some ways the books are out of order because Lewis’s earlier books described how various people made serious money from the sorts of behavioral biases that Kahneman, Tversky, and others uncovered.

What’s this got to do with food?

Many of the systematic biases that lead people to mis-price baseball players and mortgage-backed securities are likely leading people to mis-price foods made with new technologies. Take GMOs. A Pew study found 88% of scientists but only 37% of the public thought GMOs are safe to eat. Is it possible scientists are wrong and the public is right? Sure, but if you had to place a bet, where would you put your money?

Or, let’s take at a widely studied behavioral bias - the tendency for people to exaggerate the importance of low-probability risks. The propensity to overweight low probability events was one of the cornerstones of prospect theory, which was introduced by Kahneman and Tversky. This theory is sometimes credited as herding the birth of modern-day behavioral economics, and the paper was a key contributor to Kahneman later winning a Nobel Prize. If there is a 1% chance of an outcome occurring, when making decisions, people will often “irrationally” treat it as a 5% or 10% chance. There are many, many studies demonstrating this phenomenon.

Oddly, I have never seen a behavioral economists use this insights to argue that fears over growth hormones, GMOs, pesticides, preservatives, etc. are overblown. However, there are many food and agricultural scientists who argue that many of our food fears are, in fact, irrational in the sense that public perceptions of risk exceed the scientific consensus.

Now, getting back to Michael Lewis’s books on the people who figured out how to profit from behavioral biases in fields as divergent as baseball players and mortgage-backed securities, if we really think people are irrationally afraid of new food technologies, is it possible to put our money where our mouth is? Or, buy fears low and sell them high?

Here are a few half-baked thoughts:

• If people are worried about the safety of food ingredients and technologies, shouldn’t they be willing to buy insurance to protect against the perceived harms? And if consumers are overly worried, they should be willing to pay more for insurance than it actually costs to protect against such harms. If we believe this is the case, then creating insurance markets for highly unlikely outcomes should be a money-making opportunity. On the plus side, such markets might also take some of the fear out of buying foods with such technologies since people can hedge their perceived risks.

• Let’s say your Monsanto (now Bayer), Syngenta, BASF, or another seed/chemical company. What can you do to assuage consumers’ fears of your technologies, particularly if you believe the perceive risks are exaggerated? Why not offer up a widely publicized bond that will be held in trust in case some adverse event happens within a certain period of time? (This is like when contractors or other service suppliers attempt to gain trust by being bonded). If it is really true that consumers’ fears are exaggerated, the bond won’t be paid out (at least not in full), and will revert back to the company.

• Did you know that it is possible to invest in lawsuits? Investors, whose money is used to front the legal bills, earn a portion of the payout if a plaintiff wins a settlement against a corporation or other entity responsible for some harm. The “price” of such investments is likely to rise the greater the public’s perceived odds of winning the case, which presumably related to perceptions of underlying risks. I can imagine institutions or markets arising that would enable investors to short such investments - to make money if the plaintiff losses the case. The current Monsanto-glyphosate verdict not withstanding, shouldn’t it be the case that one could profitability short lawsuits surrounding the safety of food and farm technologies if the fears around them are indeed overblown?

Other ideas?