Category: choice

Expectations and Anticipations

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June 16, 2024

This week’s letter continues my study of expectations, focusing on the political aspect. While some economists have treated expectation and anticipation as synonyms (the Stockholm school, for one), I want to distinguish between the two. Expectation is planning for or projecting into the future from an observation point in the present. Anticipation is visionary, an imaginative leap into the future in which some event or state has already happened. Anticipation is intuitive; expectation is calculating.

Anticipation invokes our identity and biases as well as our imagination. Political campaigns often target our sense of anticipation with negative advertising that impugns the candidate, then implies that a vote for such a character is an association with that candidate. Imagine how bad things would be if such a person were elected. Do we really want to be associated with someone like that? At a 2008 Presidential debate between Republican candidate John McCain and Democratic candidate Barack Obama, McCain defended Obama’s character against the innuendo spread by right wing TV and talk radio personalities. Much as we deplore negative political advertising, it is effective.

In the game of chess, each player strategizes to take the other’s king. Getting to the other side of the board first does not win the game. One achieves victory by the opponent’s loss. Elections like those in the U.S. are similar to baseball or football. Preventing the opposing team from scoring will not win the game. The victorious team must also make a score. The winner must get more points than the loser, a typical characteristic of a race, which is why our type of elections are called first past the post voting. What makes an election different than a 100-yard dash are the battle tactics employed to weaken an opponent’s efforts to score votes. Successful campaigns strive to get there first while persuading voters to vote NO on their opponent. Campaigns target two separate processes we use to make choices.

One axiom of rational choice theory in economics is a completeness of preferences – that people are able to weigh the costs and benefits of two options and choose the option that maximizes their self interest. We choose an option that provides what we think will give us the most utility. Yes, we make mistakes, but the errors are random. Behavioral economists have challenged the assumption that our choices are rational, pointing out biases that introduce systemic, not random, error in our choices. Losses have a greater impact on our senses than equal gains. Options may be too complex to evaluate fully before making a choice, so we rely on instinct.

 In Chapter 8 of his book, Optimally Irrational, Lionel Page (2023) discusses the debate and presents several examples that test the axiom. Given two grocery lists, could you pick the best option? Consider there might be twenty or more items on the list and a grocery store carries thousands of items. How could any person decide the best option? This past week, after checking out my groceries, I picked up what I thought was the receipt that had fallen out of my pocket. With a glance, I knew it was not mine because there were a few items on the list that I would never buy. I realized then that I could choose between two random grocery lists in less than a minute. I would scan the list for things that I definitely did not like or want. The list that had the fewest of those would be my choice.

When we do have difficulty making choices, it is because we are trying to choose the best, not the worst, option. Page cited (p. 101) an episode of the Big Bang Theory where Sheldon had difficulty choosing between two computer game consoles. He had approached the problem in a very analytical manner typical of Sheldon and was unable to choose. The shortcut, or heuristic, of decision-making that we use in our daily lives is not finding the best, but establishing the worst of two options. We know our dislikes more than our likes because our dislikes amplify the cost of our decisions, helping us choose the cheaper option with less deliberation. Secondly, identifying the worst alternative makes it more probable that we can live with our decision.

A successful political campaign structures its rhetoric to take advantage of this shortcut in decision making. Just before the 1980 election, candidate Ronald Reagan posed a question to President Carter at an October debate: Are you better off than you were four years ago? Despite the word “better” in the question, this was an “identify and reject the worst” choice using both rational expectations and more imaginative anticipations. On the one hand were the empirical realities of high inflation and unemployment, and the energy shortages that voters had experienced during Carter’s term. Voters could form expectations based on that data. Reagan’s term as Governor of California during the 1960s gave voters some basis to form a rational expectation of a Reagan term. However, much was left to voters’ imaginations to construct a post-hoc, or after the fact vision of a Reagan term. This was the anticipation instinct at work. The question helped turn a  close race into a landslide victory for Reagan.

Some voters may not have a clearly defined worst or judge two candidates to be equally worse. Each may have one or two repulsive personal characteristics, political alliances or policy stances. To appeal to those voters, a political campaign offers hope that their candidate will maximize a voter’s income, personal freedom, autonomy or other circumstance like the health of the community a voter lives in. The negative approach targets the cost calculation that voters make. The positive approach appeals to the benefit calculation, but the negative approach is the more powerful. The disadvantage of the negative approach is that it can persuade voters to abstain from voting. In a national campaign for President, a voter’s abstention is neutral, but a lack of turnout can be a decisive factor in local races where a small number of voters can be the tipping point of a political victory.

I hope I have made a clear distinction between expectations and anticipations. When a person stands in the present and plans ahead for some state or event, she is expecting. When a person stands in an imagined future and looks back at an event, she is anticipating. I will take a closer look at the unintentional political alliances between voters as a result of the symbiosis between expectations and anticipations.

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Photo by Ahmed Almakhzanji on Unsplash

Keywords: campaign, election, choice, anticipation, expectation

Page, L. (2023). Optimally irrational: The good reasons we behave the way we do. Cambridge University Press.

Choice and Chance

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October 22, 2023

by Stephen Stofka

This week’s letter is about income and wealth distribution. I’ll take a look at a recent report on those topics through the lens of a  perspective first proposed 70 years ago by a Nobel economist.

This past Wednesday the Federal Reserve released the triennial 2022 Survey of Consumer Finances, or SCF. Gains in household wealth (assets less liabilities) were much more widely distributed than gains in annual income. Real median household net worth increased 37% while its cousin, the mean or average, increased only 23%. Remember that these are percentage gains and percentages depend on the base, or divisor.

A $1 million net worth household with a gain of $200,000 in net worth experiences a 20% increase. A household starting from half that net worth, or $500,000, might have a gain of $150,000 which represents a 30% gain. The second household has experienced a smaller monetary gain but a higher percent gain.

This recent Fed survey found that the median increase was higher than the mean increase, indicating that the increases in wealth were widely distributed. Government support programs during the pandemic helped households reduce their debt levels. Double digit increases in home prices raised the primary asset that is the cornerstone of household wealth. Median net housing values (appraisal value less outstanding mortgage) rose by 45% in the three years between surveys the report found. Gains in income, however, did not exhibit the same equanimity.

I’ll be mentioning top half and bottom half of households a lot in the next sections so I will just refer to them as the Uppers and Lowers. Income gains were not widely distributed. Real median household incomes rose by 1% in each of the three years, but real mean incomes rose by 5% annually. The income gains went to the Uppers and a college degree was a consistent characteristic of the Uppers. Our specialized workplace puts a premium on education. During the period 2019-2022, the retirement account balances of the Uppers rose while those of the Lowers fell. 

Half of Upper households owned their own business but only 1 in 7 of Lower households did so. Let’s visit a paper written by Milton Friedman (1953) called Choice, Chance, and the Personal Distribution of Income. Remember those two words: choice and chance. Friedman remarked “every enterprise in our society is in part an arrangement to change the probability distribution of wealth” (p. 281). Large or small, a business owner takes risks to increase the chance of reaping more income. If an employer cannot sell what their employees produce, the employer’s profit is reduced or disappears entirely. Eventually that business goes out of business.

In his own imaginative way Friedman examined the relationship between employer and employee. An employer makes a profit from the work of an employee in return for the promise of a wage. To the employee, a wage reduces income uncertainty. Friedman reasoned that the calculation of a wage must include an implied premium like that of an insurance policy. Included in an employer’s profit is the price of an insurance policy that the employer sells the employee who desires income certainty.

Friedman pointed out that there is an element of preference in an employee’s decision to work for an employer. He challenged the simplicity of the conventional narrative that the Lowers had, by chance, lacked access to inherited wealth and natural endowments. Friedman constructed a more complex mechanism of income distribution that involved the choices that people made to reduce risk. Yes, those choices might be bounded by the resources available to a person. Their circumstances might induce a preference for certainty but it would be a mistake to disregard the choices that people made as they sought safety in their lives. Imagine a single woman who is the sole provider for two children. For the sake of her children, she needs the certainty of a wage income and is more likely to choose a steady paycheck from an employer rather than start up a business.

On a macro scale, Friedman pointed out that a society makes choices that make it more or less likely that individuals will prefer certainty. If more individuals choose the certainty of wages and there are fewer employers to provide that certainty, employees will be paying higher insurance premiums, i.e. lower wages, to employers in return for that certainty. That is a prediction conforming to the law of supply and demand. Inevitably that will lead to growing income inequality. To make that distribution more equal, a government will have to adopt redistributionist policies that tax employers, essentially stripping away part of the insurance premium and returning it to employees.

Changing mores and welfare policies in the 1960s supported individual independence but inadvertently promoted the growth of a vulnerable demographic. These were single head of households, mostly women, who would be less tolerant of uncertainty. While our society championed the new emphasis on personal freedom, many individuals were becoming less free in their economic circumstances and choosing the certainty of wages rather than risk the unpredictability of business profits. Since the late 1960s, income inequality has grown steadily.

If Friedman’s perspective had some predictive power, economic crisis and redistributive government policies should induce more people to desire certainty. That reach for safety should lead to a decrease in small business startups, enabling employers to pay lower wages to employees seeking income certainty. Does the data support Friedman’s hypothesis? I will look at historical SBA data for businesses with fewer than 20 employees to keep the analysis consistent (see Note). I will call them Smallees, or little small businesses. I will compare the ratio of such businesses to the number of employees in the country.

In 1988, there were 4.4 million Smallees and 105.4 million employees, a ratio of 4.2 Smallees per 100 employees. In 2006,  there were 5.4 million businesses and 136.4 million employees, resulting in a ratio of 4 businesses per 100 employees. Then came the financial crisis and a slow recovery. In 2019, the year before the pandemic, there were the same 5.4 million Smallees and an employee count of 150.8 million, a ratio of only 3.6 small businesses of this size per 100 employees. Perhaps Friedman had an insight into human behavior after all.

Friedman’s talent was his ability to communicate a change of perspective to his colleagues, his readers and the audiences of his popular lectures. He consistently focused on choices that people make in their personal lives and within the institutions where they work. Friedman concluded that “the foregoing analysis is exceedingly tentative and preliminary” (p. 289) and noted the faults in the simplified model he had presented. The implications of his thought experiment could have undermined a central assumption in neoclassical economics: that workers are paid the marginal product of their labor. More on that next week.

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Photo by Alexander Schimmeck on Unsplash

Keywords: income, choice, chance, small business, income distribution, income inequality

SBA Note: The SBA’s definition of a small business varies with business revenue and number of employees. A micro business is generally one to four employees. Businesses with more than 100 employees is considered a medium business. A small business is in between. The agency used to track businesses with 20 – 49 employees and those with 50 – 49 employees as two distinct groups but now groups them together.

Friedman, M. (1953). Choice, chance, and the personal distribution of income. Journal of Political Economy, 61(4), 277–290. https://doi.org/10.1086/257390

The Ghost of the Past

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December 25, 2022

by Stephen Stofka

Merry Christmas and Happy Holidays! This last letter of the year will be about choices and wishes, about means and ends. Aristotle distinguished between choice as a means and a wish as an end. A wish can be an illusion of choice, but it is not a choice. A choice is a path toward a wish. A wish is the reason for making a choice. Understanding the role of choice and wish in our lives can help us become more prudent investors.

A principle of economics is that choice involves an opportunity cost, the giving up of one thing for another. A child who wishes to be a basketball star soon learns that this requires many hours of layups and passing drills, shooting foul shots and other exercises that are the means to achieve that wish. The time spent doing those activities cannot be spent on some other activity and is an opportunity cost. An opportunity cost is a sunk cost that should not factor into our next decision but people have a natural aversion to loss. Investors are cautioned not to “marry” their investments, meaning that we shouldn’t stick with an investment simply because we don’t like taking a loss.

A post hoc analysis of a series of events may yield little useful information that will guide us in future choices because the pattern of events and choices will likely not be repeated. A seasoned executive of a bankrupt company may make a post-mortem comment, “We expanded too fast for our target market.” When we spend time analyzing a chain of decisions within a unique set of circumstances we do not spend time doing something else. We are lured by the illusion that the ghosts of past events can communicate with the ghosts from our future, that we can learn from the past. Most of the time, we can’t.

“I should have sold this spring when it was near 50 and rates were low,” a guy in front of me in the checkout line remarked to his friend, then they stepped forward to one of the self-checkout machines. I guessed they were talking about Bitcoin and mortgage rates. We judge the quality or accuracy of our choices by the information or insight we gain later. We can drive ourselves crazy with this type of time travel.

During the past two decades, the median sales price of a home has increased 4.7% per year. Disposable (after tax) personal income has risen only 4.1% per year. House prices in relation to disposable income is near the height of the 2000s housing bubble, as shown in the chart below.

A 20% down payment on a conventional house mortgage is a wish that takes a long reach. Choices include an FHA loan with a smaller down payment, cutting back on expenses or working an extra job for additional income. To some, Bitcoin was another choice, an asset whose value would increase faster than the average 10% annual gain in stocks or the paltry interest paid by savings accounts during the past decade. A $10,000 purchase of Bitcoin might grow to the size of a conventional down payment in just a few years. Even though Bitcoin’s price has fallen dramatically from the heady levels of $65,000 in November 2021, the price is still double its $8,000 price in January 2020. That is an annualized gain of almost 20%, double the 9.45% average annual gain of the SP500 total return (2022).

Each year is an unfolding narrative with no dress rehearsals. To alleviate the uncertainty, we look to the past and extrapolate into a future guaranteed to be unlike the past in significant ways. We wish we could predict the future, but our choices help construct our future. We can only look in front of us.

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Photo by Kalen Emsley on Unsplash

S&P 500 Total Return Index, [SP500TR], retrieved from https://finance.yahoo.com/quote/%5ESP500TR/history?period1=1041292800&period2=1671753600&interval=1mo&filter=history&frequency=1mo&includeAdjustedClose=true, December 23, 2022.

U.S. Census Bureau and U.S. Department of Housing and Urban Development, Median Sales Price of Houses Sold for the United States [MSPUS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MSPUS, December 24, 2022.

U.S. Bureau of Economic Analysis, Disposable household income [W388RC1A027NBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/W388RC1A027NBEA, December 24, 2022.

U.S. Census Bureau, Household Estimates [TTLHHM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TTLHHM156N, December 24, 2022.