LECTURE 5-Resisting Temptation

Instructor: Dr. Amrita Kamalini Bhatt acharyya

E-mail: ambhatt acharyy@imt.edu
Mobile: 9432943856
Insti tute Of Management Technology, Ghaziabad
 Brief glimpses at human fallibility
 Resisting Temptation

 The Story of a bowl of nut

 Dynamically inconsistent behavior

 Temptation & mindlessness

The concept of Hot & Cold
 When Akash is very hungry and appetizing aromas are emanating from the kitchen, we can say

he is in a hot state. When Sally is thinking abstractly on Tuesday about the right number of
cashews he should consume before dinner on Saturday, he is in a cold state. We will call
something “tempting” if we consume more of it when hot than when cold. None of this means
that decisions made in a cold state are always better.
 Behavioral economist George Loewenstein (1996) calls the “hot-cold empathy

gap.”

 When in a cold state, we do not appreciate how much our desires and our

behavior will be altered when we are “under the influence” of arousal.

 As a result, our behavior reflects a certain naïveté about the effects that context

can have on choice.

 Similar problems affect those who have problems with smoking, alcohol, a failure

to exercise, excessive borrowing, and insufficient savings.

 Self-control problems can be illuminated by thinking about an individual As

containing two Semiautonomous selves, a far-sighted “Planner” and a myopic

“Doer.”

 Mindless Choosing

 The cashew problem is not only one of temptation. It also involves the type of

mindless behavior.

 ‘Automatic pilot’ in which they are not actively paying attention to the task at hand.

 Driving to wrong destination.

 Forgetting a brunch meeting with friends.

 Forgetting a brunch meeting with friends.

 Eating turns out to be one of the most mindless activities we do. Many of us simply

eat whatever is put in front of us.

 The same is true of popcorn—even stale popcorn.

 The same is true of soup-tomato soup

Large plates and large packages mean more eating.

 When self-control problems and mindless choosing are combined, the result is a

series of bad outcomes for real people.

 Smokers temptation bias. Similarly obese people’s problems, fail to join retirement
 Self Control Strategies

 People are at least partly aware of their weaknesses, they take steps to engage

outside help.

 They make lists.

 Buy alarm clocks.

 Ask friends to stop us from smoking or eating an extra piece of cheesecake.

 In these cases, our Planners are taking steps to control the actions of our Doers.

Often by trying to change the incentives that Doer face.

 Unfortunately, Doers are often difficult to rein in. Example of ‘Clocky’.

 Planners have a number of available strategies, such as Clocky, to control

recalcitrant Doers, but they can sometimes use some help from outsiders.

 We will be exploring how private and public institutions can provide that help. In

daily life, one strategy involves informal bets.

 Story of a Ph.D

 How to help your friend keep the weight level low.

 In some situations, people may even want the government To Help Them Deal

With their self-control problems. In extreme cases, governments might ban some
items like drugs, drunken driving.
 Such bans can be seen as pure rather than libertarian paternalism, Though third-

party interests are also at stake.

 In other cases, individuals may prefer a less intrusive role for the government such

as Cigarette taxes.

 Self registration of ‘gamblers’.

 Since no one is required to sign up, and since a refusal to do so is close to costless,

this approach really can be counted as libertarian as we understand the term.

 One interesting example of a government-imposed self-control strategy is daylight

saving time.
 In many cases, markets provide self-control services, and government is not needed at

all. Companies can make a lot of money by strengthening Planners in their battle with
Doers, often doing well by doing good.

 An interesting example is a distinctive financial services institution that used to be

known as The Christmas savings club from where Dhanteras schemes drew the idea.

 The absence of liquidity was precisely the point.

 Christmas clubs have been replaced by the credit cards in USA.

 Even when we’re on our way to making good choices, competitive markets find ways to

get us to overcome our last shred of resistance to bad ones→ KFC at the airport.
 Mental Accounting

 Alarm clocks and Christmas Clubs are external devices to solve self-control

problems.

 Another way is to adopt internal control systems, known as mental accounting.

 Mental accounting is the system (most of the time implicit) that households use

to evaluate, regulate, and process their home budget.

 Story of two friends and their ‘money jars’

 Money is ‘fungible’ i.e. it does not come with labels but households and

organizations violate fungibility to control spending.

 Gamblers use this mental accounting and ‘house money’

 Experimental evidence reveals that people are more willing to gamble with money

that they consider house money.

 People take more chances with their ‘winnings’ when investments pay-off.

 This has real life repercussions and examples.

 In 1990’s mental accounting contributed to the large increase in stock prices, as

many people took on more and more risk with the justification that they were
playing only with their gains from the past few years.

 People spent or ‘splurge’ on luxury items more with an unexpected windfall than
 Mental accounting matters because these accounts are treated as non-fungible.

 Designate accounts for Children’s education, vacations, retirement and so forth.

 The sanctity of these accounts leads to seemingly bizarre simultaneously

borrowing and lending at very different rates.

 ‘Arbitrage opportunity’ buying low and selling high, paying off credit card bills

with the money from savings bank account.

 ‘Rainy day account’ and ‘entertainment and fun account’

Let us examine a few alternative scenarios.

Scenario 1:

 Suppose you are a ‘so called’ millionaire.

 You have $10,00,000 in your bank account.

 You are visiting Dubai and you enter a shopping mall.

 Upon entering one of the sales person greets you at the door and hands you a scratch

card to try your luck.

 You decide to amuse yourself and your company and bring out a penny and scratch the

card.
 The Utility theory of money

 In utility theory, the utility of a gain is assessed by comparing the utilities of two

states of wealth.

 There is no way to represent the ‘disutility’ of losing $500 could be greater than

‘utility’ of winning the same amount.

 This is called theory induced blindness where possible difference between

expected gain and losses were neither expected nor studied.

 Researchers have always focused on the issue of ‘winning’ but it is the issue of

‘losing’ or ‘losses’ that brings out interesting characteristics of people.

 Problem 1: Which do you choose?

 Get $900 for sure or 70% chance to get $1,000

 If you choose the option 1 instead of option 2, which 90% of the population do,

they are risk averse.

 In economics and finance, risk aversion is the behavior

of humans (especially consumers and investors), who, when exposed
to uncertainty, attempt to lower that uncertainty.

 It is the hesitation of a person to agree to a situation with an unknown payoff

rather than another situation with a more predictable payoff but possibly
 For example, a risk-averse investor might choose to put their money into

a bank account with a low but guaranteed interest rate, rather than into
a stock that may have high expected returns, but also involves a chance of losing
value.

 Problem 2: You receive $50 with 100% chance or you get $100 with head in a coin

toss, which one would you choose?

 If you calculate the expected pay-off then in both of these scanarios expected

pay-off is the same.

 An individual who is insensitive to the risk or risk neutral will be indifferent

between the two choices.

 But economic theory will say that individuals have different risk attitudes

 A person is said to be:

 risk averse (or risk avoiding) - if they would accept a certain payment (certainty

equivalent) of less than $50 (for example, $40), rather than taking the gamble and
possibly receiving nothing.

 risk neutral – if they are indifferent between the bet and a certain $50 payment.

 risk loving (or risk seeking) – if they would accept the bet even when the

guaranteed payment is more than $50 (for example, $60).

 Problem 3: Which do you choose?

 Lose $900 for sure OR 70% chance to lose $1,000.

 Most people here will choose the gamble.

 The explanation for this risk-seeking choice is the mirror image of the explanation

of risk aversion.

 Sure loss is very aversive which induces people to accept the risky choice.

 People become risk seeking when all of their options are ‘bad’.

 Theory-induced blindness had prevailed.

 Because the dominant theory did not provide a plausible way to accommodate

different attitudes to risk for gains and losses, the fact that the attitudes differed
had to be ignored.

 Problem 4: In addition to whatever you own, you have been given $1,000.

You are now asked to choose one of these options:

50% chance to win $1,000 OR get $500 for sure

 Problem 5: In addition to whatever you own, you have been given $2,000.

You are now asked to choose one of these options:

50% chance to lose $1,000 OR lose $500 for sure.

 Problem 4 and 5 are identical in terms of final state of wealth.

 In the first choice, a large majority of respondents preferred the sure thing.

 In the second choice, a large majority preferred the gamble.

 If the utility of wealth is all that matters, then transparently equivalent statements

of the same problem should yield identical choices.

 The comparison of the problems highlights the all-important role of the ‘reference

point’ from which the options are evaluated. Reference points are generally
ignored.
 The reason we all like the idea of gaining $100 and dislike the idea of losing $100

is not that these amounts change your wealth. You just like winning and dislike
losing —and you almost certainly dislike losing more than you like winning.

 Prospect theory includes this ‘reference point’ which traditional expected utility

theory did not consider. Prospect theory is therefore more complex than utility
theory.

 There are three cognitive features at the heart of prospect theory. They play an

essential role in the evaluation of financial outcomes and are common to many
automatic processes of perception, judgment, and emotion.
 Perceived Value: Anchoring

 The previous pricing policy of markdowns had one other distinct advantage over the

“fair and square” policy – anchoring. An anchor is a cognitive bias that can dramatically
impact our estimation of things. For example, what if I asked you “What is the
population of Venezuela?” versus asking “Is the population of Venezuela greater or
fewer than 65 Million?” With the first question, you will have to make a random guess –
say 10 Million. In the other question, you now have a starting point to work from and
will adjust your answer based on that starting point. You might think 65 Million sounds
like a lot for the small South American country but it must not be too far off, so you
guess something around 40 Million.